ArrowMark Financial Corp. (BANX) Q3 2017 Earnings Report, Transcript and Summary

Welcome to the StoneCastle Financial Corp. Q3 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. Now I would like to turn the call over to Rachel Schatten, General Counsel of StoneCastle Financial.

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 September 30, 2017. The company undertakes no duty to update any forward-looking statement made herein. All forward-looking statements speak only as of today, November 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 third quarter 2017 investor call. In addition to Rachel, joining me today is Pat Farrell, our Chief Financial Officer. I would like to start the call today with a review of StoneCastle Financial's quarterly results as well as comment on the current market conditions for community banks. Then I will turn the call over to Pat who will provide you with greater detail on our financial results before I open up the call for questions. StoneCastle's net investment income for the quarter was approximately $2.6 million or $0.40 per share. The company's net asset value per share was $21.56 as of September 30th, up $0.09 from Q2, increasing five out of the last seven quarters. Total assets were approximately $179 million and the value of the invested portfolio increased by approximately $630,000. The estimated annualized portfolio yield was 9.06%, up from 8.96% year-over-year. During the quarter, the company had one full call that totaled $13 million. The full schedule of investments can be found on the company's SEC filings and in the company's website. During the quarter, the Board of Directors elected to raise the cash dividend to $0.38 per share, up approximately 3% from the prior quarter. The board felt the increase was appropriate given the stability of the underlying portfolio. Now let's turn our attention to the business environment for community banks. Over the past few months, we have seen the equity markets reach record levels. As a result, we've seen pressure on investment yields resulting in more aggressively priced transactions in the market, and therefore, we are not in a rush to deploy a lot of capital at this time. As the quarter progressed, we saw the debt markets begin to move back to what we believe is a more reasonable level. We are now seeing deals closer to our pricing targets, although they are fewer in number than this time last year. Our adviser, StoneCastle Asset Management, invest the company's capital with a long-term view. Low portfolio turnover this quarter is indicative of our investment discipline. In turning to the credit markets, we see beginning signs of an increasingly overextended consumer. In August, the Federal Reserve Bank reported U.S. consumer debt at approximately $3.8 trillion, with revolving debt increasing 5% year-over-year and annualizing at a 7% growth rate. Due to the recent hurricanes and wildfires as well as an uptick in interest rates, large money center banks and dedicated consumer lenders have been increasing loan loss reserves, primarily for subprime auto and credit card lending. As we mentioned in the past, community banks have a lower than average exposure to consumer loans, typically under 5% of their total loan portfolios. At the end of the second quarter, that number was 4%. In comparison, during that same period, consumer loans, excluding mortgages, at all FDIC-insured institutions were 16%, half of which was credit card lending. Also, in the third quarter, we have seen anecdotal evidence of some investment vehicles, namely BDCs, seeing credit issues with their portfolios. In general, BDCs make higher yield second-lien corporate loans, which carry commensurate risk. In contrast, StoneCastle invests in debt and preferred stock of typically conservative community bank lenders. These banks generally make secured first-lien loans to their customers. We believe StoneCastle investments are reasonably uncorrelated to general credits since they are sourced from local markets rather than correlated to national markets. When the credit cycle turns, we believe, we should outperform on capital preservation, and we'll be in a strong position to invest at attractive rates to the benefit of our shareholders. Over the last several quarters, I've mentioned macro considerations that could result in continued positive performance for community banks, such as reduced regulation, higher interest rates, and continued industry consolidation. We're pleased to report that this scenario has been unfolding, just as we discussed these past two years. Banks are performing better, interest rates have gone up, and Congress has actively advocated for reduced regulations. We believe the strength and performance of the underlying banks in our portfolio and the community bank sector, in general, reflect these ongoing trends. We continue to see confirmation of our thesis from third-party data. The statistics have shown favorable trends quarter-after-quarter since last year. Let me point out some of the recent community bank results from the Q2 FDIC quarterly banking profile. Net income increased by 8.5% year-over-year. Approximately two-thirds or 62% of community banks saw increases in net income during the past 12 months. Net interest income increased 8.9% year-over-year. Nearly 80% of community banks saw increases in net interest income from the prior year. Annual loan growth rose 2.7% from the previous quarter. Loan growth increased at 78% of community banks. Small business loans from community banks increased nearly 3% year-over-year, totaling $296.6 billion. Noncommunity banks reported a decline of 0.3% or $1.1 billion. Net charge-offs increased slightly to 0.19% in the quarter. However, net charge-offs for noncommunity banks stood at 0.54% during the same period. For these reasons, we continue to believe it is a great time to invest in community banks through StoneCastle Financial. The company currently pays a dividend rate over three times higher than the average community bank dividend rate. StoneCastle also offers considerable relative value when benchmarked against the BofA Merrill Lynch U.S. Corporate BBB effective yield. At quarter end, the index was trading at 3.49% versus StoneCastle's yield of 7.36%. StoneCastle Financial, with an investment-grade issuer rating of A+, was trading at 387 basis points over the index. This continued relative outperformance in yield will be a buffer if and when we see a turn in the credit cycle. We continue to believe StoneCastle is a defensive investment and a company that will afford preservation of capital due to our long-time horizon, low leverage, and dominance in the industry. 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 will present the financials by going through the detailed components to help you understand the value of the company. The net asset value at September 30 was $21.56 per share, up $0.09 per share from last quarter. The change in NAV is composed 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 $2.6 million or $0.40 per share. Net investment income reflects gross income from dividends and interest received from our portfolio investments minus operating expenses. Gross income for the third quarter was $4.4 million or $0.67 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 $1.8 million or $0.27 per share, which was flat from the prior quarter. 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 $147,000 or $0.02 per share and almost entirely related to the call of Citizens Bancshares Series A and B, which was purchased at a slight premium. These investments generated an attractive annualized return of approximately 9% over their holding periods. 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 third quarter, the unrealized appreciation of the portfolio increased by approximately $630,000 or $0.09 per share. 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. At quarter end, the closing stock price of StoneCastle traded at a discount of approximately 4% 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 $0.38 per share, an increase of $0.01 from the prior quarter. The distribution was paid on September 28 to shareholders of record on September 21. In summary, we began the quarter with a net asset value of $21.47 per share. During the quarter, we generated net income of $2.6 million and net realized capital loss of approximately $147,000 and the unrealized value of the portfolio of investments increased by approximately $630,000. Some of these components, offset by a distribution of $0.38 per share, resulted in a net asset value of $21.56 per share at September 30. At quarter end, the company had total assets of approximately $179 million, consisting of total investments of $175 million, cash of $250,000 and other assets of $3.75 million, which includes receivables and prepaid assets. Now I'd like to take a moment to give you an update on our ongoing efforts to monitor and lower expenses. I'm pleased to report that effective September 1, StoneCastle renegotiated the company's contract with the American Bankers Association, resulting in annual savings of $100,000 or $0.015 per share on a new three-year contract. We view the ABA as a valuable partner and are pleased to continue our relationship with them. As you may recall, we realized cost savings from the renegotiation of our credit facility with Texas Capital Bank in May. At that time, we announced the reduction in the credit spread on the facility from LIBOR plus 2.85% to LIBOR plus 2.35%. We also lowered the amount of the facility from $70 million to $62 million, which reduced fees on unused borrowings. In addition, we were able to reduce annual administrative fees by $42,000. The company did incur a one-time 70 basis point commitment fee for renegotiating and extending the credit line. As we mentioned last quarter, depending on the amount drawn, the credit facility's net savings and additional income could be as high as $156,000 for a quarter. For the third quarter, the renegotiated facility saved the company approximately $77,000 or just over $0.01 per share. We are quite pleased with these cost savings and will continue to seek out expense savings that will flow to the bottom line and enhance financial performance. Now let me update you on the balance of our current credit facility. At September 30, the company had $36.5 million drawn from the facility. 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 20.4%. Now I want to turn the call back over to Josh.

Thank you, Pat. Now Operator, we would like to open up the call for questions.

Thank you. At this time we will be conduction a question-and-answer session. [Operator Instructions]. Our first question comes from Devin Ryan with JMP Securities. Please proceed with your question.

Hey, great. Thanks good afternoon everyone.

Good afternoon.

So first off, thank you for the detail on the expenses and the savings. That's really nice to see, so congratulations on that. Maybe my first question, the capacity on your credit facility, obviously, currently at 20% of assets and I fully appreciate and think the commentary is prudent around the backdrop for investing. And so I guess, the question really is more, understanding that you're going to be prudent and you're not going to force the issue, how should we think about that current, call it, 20% level today? And if you kind of look out over the next three to six months, do you think that's moved up closer to the 33%? Or how should we think about that?

The short answer is I wouldn't think too much into it. In any given quarter, we're not -- and I think we've exhibited for years a reticence to pressure ourselves simply to have assets on. So if we see good assets, then we'll fill it up. I mean, I can tell you without detail there's a lot of things in the pipe right now. Sort of tying in exactly what we said on the call is for a while there, things were kind of silly spread-wise, and it literally was a moment in time of which those rates have come back up quite a bit. So with the interest from banks at more reasonable rates, we're active. So in any given quarter, if we don't see things that are interesting, then we won't do it. I mean, if we see two or three quarters like this, then you should start reading into something. But a quarter that's quiet, I wouldn't read into it.

Yes, got it. No, that's my understanding. I just wanted to get that out there and clarify, so appreciate that. Maybe a bigger-picture question, just love to hear your thoughts, obviously, with the House Bill now out there and some elements within it that are interesting. I mean, big picture, the view is tax reform has been positive for a number of firms and financials and banks. And obviously, if you get the economic benefit off of it, that would -- should be -- it should be a positive. There's other elements, the interest deduction, which shouldn't, I guess, directly impact your business model. Is there any kind of second derivative that at least in discussions you're thinking about that either you think are positive or like the interest deduction and others, conversation around could that reduce demand for loans as a financing source? So I'm just curious, like when you think about all of it, does it feel like if tax reform moves forward, that's an opportunity, a nonevent or there's some things that you don't like that you've kind of seen come out of it?

Well, let me start by polishing my crystal ball. Going from there, I'll share thoughts because, clearly, they're not really projections or views, but just the temperature that we take from this. Literally, as of about one hour ago, the Senate released its version of the tax bill and the mortgage deduction remains. So this is a by-the-minute crystal ball. I would tend to think that for a lot of political reasons, that's going to be challenging to remove. But even if it did or didn't, most community banks, they have 19% one-to-four family. That's not typically refinanced business. That's new purchase. Someone's going to not, not -- it's a double negative, not, not buy a home just because of that. So I don't think that, that's going to be any major driver. For a mortgage company, yes, that's going to be an issue if that were to change, not for the banks we're tending to face off to. Two, it depends whether you're a fixed income investor or an equity investor. If you're an equity investor in the financials, the benefit of a reduced corporate tax rate, I believe, and I was public on this recently at a conference, it's fully priced in. If anything, it's only going to drop if that doesn't come true. Given that, of course, most of these banks are private, as a fixed income investor, it'd be great if it did actually happen because then free cash flow increases for these banks, which means they could either improve their earnings grow, put more reserves aside, gives them flexibility. If not, it's the same as it was yesterday, which is very good performance. I do still see quite a strong temperament from DC even with its extreme dysfunction to try to do something to help smaller financial institutions. So I still could not tell you when, but I have not heard any waver in the voices of senators or congressmen/women that they would like to do something to help ease up the community bank burden. So that's about as much crystal ball as serve up.

Good, perfect. Okay, that's helpful. You always have a good perspective there. So I just figured I'd get a little bit of an outlook. Last question, just around Chicago Shore, any maybe quick update there as well and if you have anything to say on expectations?

On Chicago Shore, probably no immediate expectation. The numbers are still fine, directionally good. They're working on some additional ways to build up capital, but no new issues with assets. So our view is it's still going to come back, credit stable to improving. They've got a Fed exam, I don't know if it's FDIC, but an exam coming up. So if I were to play the odds, I'd say it's probably less likely on this upcoming exam they release for the back pay, but our view internally hasn't changed since last quarter that it's just a question of when. And management's view is also the same; it's just a question of when.

Okay, perfect. All right, great. Well thanks Josh, I'll leave it there.

Sure.

Our next question comes from Chris O'Connell with KBW. Please proceed with your question.

So you said the pipeline was looking now pretty good at this point. Can you talk a little bit about maybe the yields that you're seeing in those conversations?

Sure. They really run the gamut. They're up into the nine's and their down into the low seven's, and the mix really depends on any point in time. We're sort of seeing as they come in, when they try to look for yields that we just don't think make sense, we just politely tell them it's not going to work for us. So the range of yields since things reverted back to a bit more normal really are not terribly different than they were before that's sort of where we see things.

Great. And then can you just talk about I mean, you guys are kind of nearing but not quite getting there in touching NAV in the markets through share price. As you maybe approach that or hopefully cross that, could you just talk about how another CLO might occur, what the size might be and just how that whole process would happen?

Sure. I mean, there's not much to tell. The template for the CLO was already done. It takes really two magical things. It takes a critical mass of banks at a moment in time and it takes an open capital markets. Right now, the capital markets are reasonably open; but finding enough banks that want to come together at a minute in time, not as strong. So we've got a reasonably good backlog for another pool, but not enough that we can say in the short-term it's going to be there. That said the pipeline still is reasonably robust of deals coming in since that sort of late summer, early fall crazy tightening, at least the theoretical tightening. I don't think there's any printed there, but that was the expectation of banks, B-A-N-K-S, not B-A-N-X. So yes, we still see a pretty good pipeline for the straight paper to come onto the balance sheet, and we're still continuing to explore ways to use pool vehicles as a way to raise efficient funding to be able to chase maybe deals that would otherwise be a little tight but with very efficient term-matched financing become quite attractive for us.

Great. Thank you. That's all I have. Thanks.

Sure.

Our next question comes from Christopher Testa with National Securities Corp. Please proceed with your question.

Josh, you sort of mentioned in your remarks that loan growth grew at 78% at Community Banks and you had kind of given an outlook that things are maybe getting a little bit frothy. I'm just wondering if you could provide some additional color on where the loan growth was predominantly, whether it's C&I or residential and whether you think that, that growth with that many banks is worrisome in the economic backdrop?

Good question. No, I'm not terribly worried about that when you sort of say a 2.7% growth rate from the previous quarter is not an astounding growth rate. It's -- where I've seen it in the banks is mostly in C&I and local CRE. The banks -- when the Fed had moved, the banks moved their deposit pricing, they haven't had to move that much. And so they still remain quite competitive, especially at smaller institutions that have deposit betas that are lower than market competitive banks, which typically might be the top 50 that really have to price against each other. And so that's allowing them to go pursue things in the local market that wouldn't work for non-local banks, where more of the BDCs have the traffic.

Got it.

It's not really been -- not in the mortgage space. That's been pretty flat. Securities portfolio, flat. But yes, the small business loans and small local CRE mostly are occupied. And if I saw that number going to 5% or 7% per quarter, that would be more concerning. 2.7%, that's fine. I mean, also, if you think about the quarter, Q3, people back from school, there's purchasing, there's things going on, the summer's over. That's historically a time when there's a bit more activity, and it tends to slow in Q4 during the holidays.

Okay, great. That's great color. And just on deposits and potential deposit flight, how much more of a shift up in short-term rates do you think we would need to see before there's meaningful deposit flight and competition on that in kind of the lower 50% of Community Banks in the country?

Oh, good question, and I don't think you can generalize because, right now, the average deposit rate across smaller banks is about 120-plus basis points, right? And if you look at other than teaser rates from Ally and Barclays and things you'd see online only, the rates that you would normally get from a Wells or a JPMorgan or BofA are significantly lower for a real account. And so you're not really seeing a whole lot of pressure on that front. What we are seeing is, as the Fed moves, the banks are generally passing all of that through pretty quickly now. But when you look at where the duration is in the banks' balance sheets, a lot of floating rate loans, so that passes back through to a reasonable extent. Hence, we're not really seeing the net interest margins tightening. In fact, as the rates move up for every 25 basis points, you just pick an average bank; it's going to fund a loan with 90% deposits. So you're asset sensitive to interest rates, right? $100 of a loan goes up, $90 of a deposit go up, so you actually have an expanding NIM.

Right.

And so that actually offsets a bit. It's always a mathematical thing that people tend to miss, right? They're not -- it's not one-to-one. So that's why higher interest rates tend to generate higher NIMs. So from the smaller banks, they're not terribly worried about flight. The banks of the smaller set that have lower deposit market share in the towns, in cities and counties in which they operate, they're going to have more price competition. They're going to have to stay with it. But a lot of the banks in our portfolio are banks that could have 20%, 30%, 50%, 70% market share in the towns they're in, right? When you think community bank, you have to think towns, not counties.

Right.

I mean, we have banks that we've invested in over the years that have 100% market share in the towns they're in. There is no price competition. And those are the banks that you'll see a 30 basis point deposit cost when everybody else is 120. So you have to -- of course, all of our debt is public. You can drill down. And when you see a bank that has deposit rates that are much, much lower or have transaction accounts that are 30%, 40%, 50% of their deposit base that bear 0%, they're not terribly worried and concerned. They have a lot of room to move for a given customer if needed.

That's great detail. Thank you. And I appreciate your commentary on the BBB index and how you guys consistently trade a lot of that despite having the underlying credits that are comparable. Can you maybe just talk about just briefly default rates at community banks historically and kind of how these match up versus nonfinancial companies?

Sure. I can do that very well from memory. So the average failure rate for banks since 1934, right, this is by counts, so we're not weighting a big bank more than a small bank. If you put $1 investment into every bank in the U.S. since 1934, your average annual bank failure rate would be about 0.38%. That includes the Great Depression, the savings and loan crisis and this crisis. During this crisis, the worst was 2010, a whopping 2% of the banks failed, right? From 1940 to 1980, the highest failure for banks was 0.05%, 5 basis points for 40 straight years. During the S&L crisis for banks, it was 1.58%, including savings and loans which don't really exist in that frequency anymore was about 3.4%. So you compare that to what BDCs or bond funds are doing that are doing high yield, a bad year is maybe 18%.

Right.

I mean, there's nothing -- it's not even close. It's just a far more stable regulated capital-intensive free cash flow industry that tends to have a counter-exposure credit-wise to interest rates, right? Interest rates go up, banks do better, corporates do worse. So it has a lot of really fantastic attributes for where we are in the cycle.

Got it. That's great color. And I don't believe for a second you had all that memorized. That's off for me. Thank you for taking my questions.

Any time.

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

Thank you, Operator. To our colleagues and shareholders, we thank you, as always, for listening. And since that we will not be speaking to you until sometime in February, I want to wish you all a healthy and happy holiday season.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.