ArrowMark Financial Corp. (BANX) Q2 2017 Earnings Report, Transcript and Summary

Greetings, and welcome to the StoneCastle Financial Corporation Second Quarter 2017 Investor Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to Ms. Rachel Schatten, General Counsel of StoneCastle Financial. Thank you. Please go ahead.

Good afternoon. Before we begin this conference call, I'd like to remind everyone that certain statements made during the call may be considered forward-looking statements based on current management expectations that involve substantial risks and uncertainties. Actual results may differ materially from the results stated in or implied by these forward-looking statements. This would depend on numerous factors, such as changes in securities or financial markets or general economic conditions; the volume of sales and purchases of shares of common stock; the continuation of investment advisory, administrative and service contracts; and other risks discussed from time to time in the company's filings with the SEC, including annual and semiannual reports of the company. StoneCastle Financial has based the forward-looking statements included in its presentation on information available to us as of June 30, 2017. The company undertakes no duty to update any forward-looking statements made herein. All forward-looking statements speak only as of today, August 9, 2017. Now I will turn the call over to StoneCastle Financial's Chairman and Chief Executive Officer, Josh Siegel.

Thank you, Rachel. Good afternoon, and welcome to StoneCastle Financial's second quarter 2017 investor call. In addition to Rachel, joining me today is George Shilowitz, President; and Pat Farrell, our Chief Financial Officer. I would like to start the call today with a review of StoneCastle Financial's quarterly results and intra-quarter developments, along with commentary on the current market environment for community banks. I will then turn the call over to Pat, who'll provide you with greater detail on our financial results, and the amended credit facility before I open up the call for questions. StoneCastle's net investment income for the quarter was approximately $2.5 million, or $0.39 per share. The company's net asset value per share was $21.47 as of June 30, up $0.15 from last quarter. Total assets were approximately $191 million and the value of the invested portfolio increased by approximately $920,000. The estimated annualized portfolio yield was 9.08% up from 8.97% year-over-year. During the quarter, the company had three full calls that totaled $12.2 million. And the company invested $12.5 million in First Community Holdings, a subordinate term loan with a rate of 7.5%. This type of collectivity has become more commonplace. And we have become accustomed to a certain amount of call activity in the normal course of business. With more than three years of historical data, we expect this pattern to continue into the foreseeable future. For details on the rest of the portfolio, the full schedule of investments can be found on the company's SEC filings and on the company's website. Now I'd like to mention the comments made intra-quarter on the amended credit facility, and StoneCastle's receipt of an A+ investment-grade issuer rating. Due to the fact, we now have a three-and-a-half year track record, consistent asset quality, and consistent income with no portfolio credit events, our advisers StoneCastle Asset Management amended certain terms that reduced the cost of our credit facility. That will review the specific details and estimated cost savings, which we believe could be as high as $156,000 per quarter. In May, StoneCastle received an issuer rating of A+ from Kroll Bond Rating Agency and received a BBB+ rating to preferred shares that could be issued by the company. Kroll stated in their written report that StoneCastle's issuer rating of A+ reflects the credit quality of the underlying portfolio, and the investments in the portfolio in terms of asset coverage, liquidity, and duration. Additionally, the ratings report from Kroll noted that their ratings were influenced by the strong qualitative shadow rating of the company's investment adviser, StoneCastle Asset Management. As many of you already know, Moody's Investors Service also maintains an investment-grade A3 rating on the company's credit facility. StoneCastle now joins a select group of small-cap companies that have received investment-grade ratings. Of which only 101 companies or 5% of the Russell 2000 are rated investment-grade. For more information regarding the key considerations Kroll used to determine the rating, please see our press release dated, May 25, or Kroll's publicly issued report. Over the last several quarters, I have mentioned macro considerations that could result in positive performance for community banks, such as reduced regulations, higher interest rates, and continued industry consolidation. We believe the strength and performance of the underlying banks in our portfolio and in the community banking sector, in general, reflect these trends. Let me point out some statistics from the most recent Q1 FDIC quarterly banking profile. Community bank net income rose 10.4% from a year ago. More than half of community banks, 56%, reported higher net income compared to a year ago. Net interest income increased 7.1% from the prior year. More than two out of three community banks, 69%, reported higher net interest income year-over-year. Non-interest income grew 6.8% year-over-year, almost twice the growth rate of non-community banks at 3.7%. And annual loan growth at community banks outpaced non-community banks rising 7.7% in the last year and more than twice to 3.3% growth at non-community banks. In fact, a little over 75% of community banks increased their loan balances from the prior year. The regulatory environment is also worth noting. In June, the CHOICE Act passed the House of Representatives. The chair of the House Financial Services Committee, Congressman Hensarling, a key sponsor of the bill, is working with the Senate to gain support. The CHOICE Act includes the rollback of some provisions of Dodd-Frank that had unintended consequences, particularly in small community banks across the country. While the outcome of the bill in the Senate is uncertain, it is expected that the Choice Act will be the driver of bank regulatory reform. It is also worth noting that both Republicans and Democrats have been in support of bank regulatory reform, as it pertains to community banks. For these reasons, we continue to believe it is a great time to invest in community banks. To the best of our knowledge, StoneCastle remains the only public vehicle available to investors to own a geographically diversified portfolio of predominantly private community banks. StoneCastle Financial currently pays a dividend rate over three times higher than the average community bank dividend rate. Now I want to turn the call over to Pat to discuss the financial results and provide details on the underlying value of the company.

Thank you, Josh. As I do each quarter, I'll present the financials by going through the detailed components to help you understand the value of the company. The net asset value at June 30 was $21.47 per share, up $0.15 per share from last quarter. The change in NAV for StoneCastle is comprised of four components: net investment income; realized capital gains and losses; the change in value of the portfolios investments; and finally, distributions paid during the period. Let me walk through these components. Net investment income for the quarter was $2.5 million or $0.39 per share. Net investment income reflects gross income from dividends and interest received from our portfolio investments minus operating expenses. Gross income for the second quarter was $4.3 million or $0.65 per share. Now I'd like to review the company's operating expenses, which are comprised of advisory fees, interest expense related to our use of leverage, ABA fees, and various other expenses. Net operating expenses for the quarter were $1.7 million, or $0.26 per share, down approximately $215,000 from the prior quarter or $0.03 per share. This decrease was primarily due to lower interest expense and lower advisory fees. The second component affecting the change in NAV for the quarter is realized capital gains and losses. The net realized capital loss for the quarter was approximately $18,000 related to the call of SouthCrest Financial. The third component, changes in unrealized appreciation or depreciation of the portfolio, relates to how the value of the entire investment portfolio has changed from the previous quarter end to the current quarter end. For the second quarter, the unrealized appreciation of the portfolio increased by approximately $920,000 or $0.13 per share. The unrealized appreciation was primarily driven by evaluation increases in community funding CLO and Chicago Shore Corp., which on a combined basis accounted for over 75% of the increase. As I note each quarter, the vast majority of the portfolio continues to be independently marked from broker dealer quotes. For the quarter, over 98% of the portfolio prices or marks reflect a minimum of two quotations. These represent an independent third-party assessment of the current value of the portfolio, which is used to calculate the net asset value of the company each quarter. At quarter-end, the closing stock price of StoneCastle traded at a discount of approximately 5% to the actual market value of the net assets of the company. The fourth component affecting the change in net asset value is distributions. The cash distribution for the quarter was $0.37 per share paid on June 29, to shareholders of record on June 20. In summary, we began the quarter with a net asset value of $21.32 per share. During the quarter, we generated net income of $2.5 million, a net realized capital loss of approximately $18,000, and the unrealized value of the portfolio investments increased by approximately $920,000. As some of these components, offset by distribution of $0.37 per share, resulted in a net asset value of $21.47 per share at June 30. At quarter-end, the company had total assets of $191 million, consisting of total investments of $186 million, cash of $520,000 and other assets of $4.5 million, which includes receivables and prepaid assets. Now let me update you on our credit facility. At June 30, the company had $49.5 million drawn from the facility, which as a result of the recent amendment in May, now has a maximum draw of $62 million. In accordance with the regulated investment company rules, we may only borrow up to 33.3% of our total assets. Our leverage percentage at the end of the quarter was 25.9%. Let me review specific details of the amended credit facility and its positive impact on the company's financials. The new credit facility with Texas Capital Bank extends the facility up to full five years to mature in May, 2022. It will provide significant expense savings, which we expect will flow to the company's bottom line. First, we were able to lower the credit spread from LIBOR plus 2.85% to LIBOR plus 2.35%, a reduction of 50 basis points from the prior facility. We also lowered the amount of the facility from $70 million to $62 million, eliminating a 50 basis point fee on unused borrowing amounts. Additionally, the company will benefit from a reduction in annual administrative fees of $42,000 related to the facility. I also want to report that the company incurred a 70 basis point commitment fee for renegotiating and extending the new credit line for a total of $434,000 paid up front, which will be amortized against income at a rate of approximately $87,000 per year for five years. Finally, the original facility had a requirement for the company to maintain $3.5 million in cash in a bank account with a lead lender as a liquidity enhancement to cover interest payments. This requirement has been removed. As you can see, we were able to the improve facility in quite a few ways. Now I'd like to put these expense savings into perspective with an example of the earnings impact if these changes were in place for a hypothetical full quarter in a stable interest rate environment and assuming the $3.5 million released from Escrow would be invested at a yield equivalent to our current portfolio. Assuming $62 million is drawn from the facility, for the entire quarter, the new interest rate would result in a lower interest expense by approximately $87,500 for the quarter. Administrative fees that were eliminated would result in expense savings of approximately $11,000 for the quarter. These savings would be offset by the new commitment fee amortized at approximately $22,000 per quarter. Finally, if the previously restricted $3.5 million of cash were to be invested at the estimated annual yield of the portfolio of this quarter of 9.08%, it would have in theory generated approximately $80,000 in net income for the quarter. In summary, based on all of these assumptions, we believe the net savings and additional income could be as high as $156,000 for a quarter. In practice, the savings should be somewhere between $0.005 and $0.02 per quarter depending on the above factors. To reiterate, please keep in mind that the estimated savings are based on the company being fully drawn on the revolver for an entire quarter. The portfolio being fully invested, and interest rates remaining stable. With that said, in all cases, this new facility will reduce expenses. Now I want to turn the call back over to Josh.

Thanks, Pat. Now operator, we would like to open up the call for questions.

Thank you. At this time, we will be conducting a question-and-answer session. [Operator Instructions]. Our first question comes from Christopher Testa of National Securities Corporation. Please proceed with your question.

Hi, good evening. Thanks for taking my questions. Just with the roughly $12.5 million of originations kind of seeing the light on the quarter, just wondering if you could comment on the pipeline and if you had any sizable closings that happened after 06/30?

Not really going to talk about post the quarter end. But what we have to do -- and it's always a bit of a challenge is, weighing the amount of cash that we know will be coming available either from a bank letting us know that next quarter or next month that they intend to redeem. And then lining up enough, but not too much, because if we line up enough banks or too many banks for funding, and we don't have the cash available that creates a very bad problem in the industry of basically failing the fund people. So it is that balance. But that said, in terms of pipeline, we have been trying to line up a pipeline for a potential future securitization, so we do have a pipeline of banks. We're likely going to try to pursue some of them to close, no guarantee that we will. Ahead of the securitization, so we have additional earning assets and that's well above -- the amount of interest is well above the cash we currently have or would have available even if any redemptions are coming due. So we're actually quite comfortable with the ability to originate to satisfy the cash we have. It's just the timing; it's never going to be perfect. Like in this case, right, Pat. We had the $12.5 million, but it was literally the last day of the quarter.

Yes, exactly.

Yes. Okay. That's fair. And Josh, just your comments on, obviously, the CHOICE Act, which would be very beneficial for community banks a regulatory relief? Just curious assuming that this does pass, do you think that this will have the effect of potentially slowing consolidation down in the space? And do you think that it might actually have banks require less capital and might actually reduce your pipeline a bit?

Let's see, there were three questions in there. I'll address the second one first. It wouldn't reduce the capital needs in the industry. There's really nothing in CHOICE that would do that. In fact, part of CHOICE is that banks can opt, and I don't think many will, can opt to increase capital to be exempt from a lot of CFPB and Dodd-Frank rules. From my buzz around the industry I'd be shocked if there is one taker. That said, there are still two main reasons that banks decided to merge away. In my personal opinion, number one is age. As we've talked about in the past, that's not changing, in fact, it gets worse every year, everyone imagine that. As the management teams and boards get older, and they don't have enough young people. Young could be 50, it would be young, to come and take their place. The board's make their decision to sell rather than hand the keys just to people that they don't yet have groomed or know. That said, there is a contingent of smaller banks that has become wary and fatigued from the compliance burden. And it's not because it really changed the operation, it's just so much paperwork for really marginal to any increase in safety and soundness to the industry that they are just tired of it. And I have given examples in the past, and it's still happening where senior compliance officers at smaller banks are literally resigning from their jobs just saying, it's not worth -- a grief, like. I'm seeing CFPB pursue people even if a bank hasn't broken a single rule. And it's just not worth it, I don't get paid enough. So there is that regulatory burden that's out there. And I do think that even if some of the CHOICE Act issue is related to small banks to put in place, it will slow a little bit of the consolidation. But there is still a huge component that isn't regulatory based, it's just generational. And what -- you had one more question. What was the third question embedded in there?

I think you had already kind of indirectly answered it. It was just pertaining to how this affects your addressable opportunity with the capital levels?

Yes, in fact, again, I'll still take the under that anyone opts for the increased capital. But if they did, actually that would help. But the dynamics and it's sort of related. The dynamics, of course, in almost every asset class is that markets are very strong, right? And that does put pressure on the rates we can extract in the immediate term from the banks. We're still getting decent rates, but not as good as we were a year ago, but that could change in a moment's notice, right? So we are quite comfortable with our pipeline, we are comfortable with the credit. The rates aren't the best at the moment but that's fine. That's just the nature of the cycles.

Got it. And just kind of looking at your comments on -- you're seeing more call activity and you're kind of expect this to be the norm. In your experience, who are the players out there who are refinancing these banks and letting them call? I know you guys kind of have a niche in the market, has there been one or two other players who have kind of stepped in there? Or is this just kind of ebb and flow of things?

I wouldn't say that the call pace has picked up. I think what we were trying to communicate to shareholders is that sort of the pace of calls has become more routine, right? So if you've noticed for the last several quarters, we don't have -- $40 million being called away of TARP that has really faded. So what we're getting is the occasional routine call out. And it's not so much that they are refinancing away. It's for various reasons, thinks just might change. So it may be that someone is finally paying off TARP. And they want to replace it with the banks stock loan because they actually have enough capital and simply want to put shorter-term leverage on. Or it might be a bank that through a merger has grown into a case where it could now tap the capital markets and maybe get 100 basis points tighter than we would do, or be comfortable doing for StoneCastle Financial. But it's not that any new players are merging against StoneCastle Financial. It's that strong capital markets still have some larger banks who want to invest in other banks capital, which is somewhat still frowned upon by the Fed reserve, but permissible. And still some insurance companies that are acquiring Kroll-rated transactions that if a bank can migrate to be large enough to tap that market they're doing that. But there is no new competitors showing up, it's still the same dynamics that have been there.

And I just add that from a call activity point of view, we're pretty much on pace with last year, maybe slightly higher year-to-date for six months. This year we're at $24.7 million, in the last year for the first two quarters it was $20 million total. So -- and the last year 2016, about $46 million for the year. So again, we're somewhat on pace with that. So as compared by the way to 2015, it was $80 million. So we've seen a decrease from the initial start-up area, if you will. But it's been somewhat steady, but not -- it's not predictable, but it's steady in a way.

Okay. That's great color. Thank you. And just the last one from me. Looking at the right hand side of the balance sheet, obviously, you guys are all floating rate funded with the fixed rate portfolio. I was just wondering has there been any internal discussions on potentially a note issuance to kind of term out your funding and/or possibly interest rate swap.

We continue to review that and talk about it internally and with the board. We're continuing to sort of look at that, I mean, given our light leverage at roughly 25%, even if rates were to move up 100 basis points, which based on the sort of forward probability of the dot plot. We might see one more raise for this year if the dot plot is correct. So in the short-term, I don't think there's a mass amount of pressure on rates. But even a 100 basis points only affects our funding costs on a blended portfolio of 25 basis points, it just doesn't move the needle a lot. That said we do look at whether we term out a portion, if it can be done efficiently. But it's not a great concern, because the sensitivity is so light.

Our next question comes from Devin Ryan of JMP Securities. Please proceed with your question.

Doing well. Congrats on the nice result, and thanks for the update, I mean, all the detail on the credit facility implications, very helpful. I guess first question here, just on the dividend. The portfolio consistently generating $0.39 of net investment income, you're paying $0.37 dividend currently. I think the outlook commentary was positive. So how are you thinking about some of the considerations around the dividend level today? I guess relative to your outlook for investment income, and is there a buffer that you think about that's appropriate to kind of make sure that you are above in thinking about that? And I guess also what would maybe change the view?

Sure. Well, the each quarter is a distinct discussion amongst management and the board, as to what dividend would be appropriate relative to current earnings for that quarter and sort of the calendar, given the assets we have what it would look like going forward. I wouldn't say that there is a prescribed rule. I don't think you're incorrect that we do like to see some cushion. And depending on how much cushion we run through the year that might have to be special at the end for tax reasons. That's just the nature of it, if it happens. Really, what we think about is, is making sure we have recurrency in that dividend, right? We learned our lesson years ago about being ahead. And we feel positive in our ability to manage it going forward relative to the income. We do have Chicago Shore out there, which is the story of the underlying credits; public knowledge from the regulatory filings continues to get stronger and stronger. The main regulators have been reduced to quite minor orders, so at some point, they'd like to go current. And Pat, what's the current amount of --

"Accrued." Accrued, but unaccrued is about $0.156. The other thing to keep in mind that you mentioned is it's about over $0.02 a quarter to about $0.022 a quarter that they are not declaring, if you will, that would be due to us. So there's certainly a consideration there that when that comes current, we will have an extra $0.02 of income.

Right? And this coming quarter, of course, we'll have the full benefit of a full quarter of the reduced cost of the financing facility. So that will help forward quarters that's model, right? And we have some dollars to put to work, which we're actively doing, again, we don't want to sort of talk about things that are sort of post-quarter end, but we're comfortable that we have the pipeline that completely filled the company that just diligently and carefully, as always, putting it to work. So just in recap, again, we're looking each quarter to make a decision quarter-to-quarter with the view of, we don't want to ever be in a tight position, again, and so we're going to be careful and judicious.

Okay. That's helpful. I just wanted to get some of the moving parts of the framework there. Thank you. And with respect to, I guess, maybe Chicago Shore, which you just mentioned, is there any way to think about timing here? Or things that we should look at from the outside, let's say, when that turns back on, or is it just kind of a difficult thing to handicap?

I mean the exact timing is reading the mind of a chief examiner of a field office of a regulator. So yes, that's kind of hard. But there are some predictable things that investors and you as analysts can watch. So in the regulatory orders from a C&D or written agreement level are public. So you can look at the FDIC and federal regulators, the Fed, for those. And that's one public piece. Of course, every quarter, the bank reports on to the FFIEC on its results. So you can see the trend. If it were to reversing it worse, then it would be longer if they continue as it's been to get better and better it's sooner. I would think the soonest possible is this fall, and we said that before. But I can't say it's going to be because it's again reading the mind of a human. But what is the fact is, internally we were pleasantly surprised that the two orders had been reduced to basically memorandum of understanding from cease and desist orders. It was sooner than we thought. That's actually quite fast for a regulator. Because, I mean, we can read into it, but it's a good fact.

Understood. Okay. Very helpful. Maybe just last one here, I see you have a second credit securitization listed for $1.1 million on the scheduled investments. I'm not sure if you've touched on that. But any more detail you could provide on that?

That was just a secondary piece of paper that we saw in the market. So it's not a deal that we structured, but it's all bank behind it. And it was a secondary piece in the market. And so, we thought that was a -- an opportune, a very inexpensive purchase for a deal that we modeled. It's actually been there for a while. That deal is currently deferring on cash flows, but our modeling says that it will go current at some point here. And if it does go current as we modeled. It's actually very, very high return, high double-digit. So it's an opportunistic purchase that we think will prove quite well over time.

Yes, got it. Okay. I'll permit. I'll leave it there but thank you very much.

Oh, it's our pleasure. Thanks.

Ladies and gentlemen, we have reached the end of our question-and-answer session. I would like to turn the call back over to Mr. Joshua Siegel for closing remarks.

Thank you, Operator. Well, to our colleagues and shareholders, thank you for listening today. And enjoy the rest of the summer, and we will see on the next call in November.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.