Gladstone Investment Corporation 4.875% Notes due 2028 (GAINZ) Q2 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Gladstone Investment Corporation's Second Quarter Ended September 30, 2015, Earnings Call and Webcast. [Operator Instructions] As a reminder, this call is being recorded. I would now like to turn the call over to David Gladstone. Sir, you may begin.

Well, thank you, Tricia. We like those nice introductions, and hello and good morning to everybody out there. This is David Gladstone, your Chairman, and this is the quarterly earnings conference call for shareholders and for analysts for Gladstone Investment, common stock traded on NASDAQ symbol GAIN. We have some preferred stock out as well, GAINO, GAINP, GAINN, so you have your choice of preferred stocks with this company as well. Thank you all for calling in. We love these moments that we have with loyal shareholders that like to listen to these calls and potential shareholders. And we like to give you an update on the company and its investments, and we like to give you a view of the business environment from our point of view. I wish we could do this more often and try to do this sometimes with some press releases, but we've never gotten around to that. Also, the invitation is open if you're visiting this area, the -- McLean is outside Washington, D.C. so please stop by and say hello. We have about 64 people now. I think we only got about 60 here. Now we'll hear from our General Counsel, Secretary Michael LiCalsi. Michael is also our President of Gladstone Administration, which serves as the administrator for all of the Gladstone funds and related companies. He'll make a statement regarding forward-looking statements and some other important information.

Good morning, everyone. This conference call may include statements that constitute forward-looking statements within the meaning of the Securities Act of 1933 and Securities Exchange Act of 1934, including statements with regard to the future performance of the company, and these statements inherently involve certain risks and uncertainties and other factors even though they're based on our current plans, which we believe to be reasonable. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may and similar expressions. There are many factors that may cause our actual results to be materially different from any future results that are expressed or implied by these forward-looking statements, including those factors listed under the caption Risk Factors in our Form 10-Q filing or Form 10-K filing and our registration statement as filed with the SEC, all of which can be found on our website, www.gladstoneinvestment.com, or the SEC's website at www.sec.gov. And the company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, after the date of this conference call, except as required by law. And please also note that past performance or market information is not a guarantee of future results. Please take the opportunity to visit our website, gladstoneinvestment.com, and sign up for our e-mail notification service. You can also find us on Facebook, keyword, the Gladstone Companies, and on Twitter, @GladstoneComps. The presentation today will be an overview of results through September 30, 2015, and for more detailed information, please read our press release issued yesterday and review our 10-Q for the quarter ended September 30, 2015, which we filed with the SEC yesterday. You can access the press release and 10-Q on our website, gladstoneinvestment.com. Now let's turn to Dave Dullum, President of Gladstone Investment, to get an update on the fund's performance and outlook.

Well, Mike, thanks very much for that, and good morning, everybody, on the call. Usually, I try to just give a very brief reminder or recap, so to speak, of what it is we do here at Gladstone Investment. And of course, as everyone knows, we are a publicly traded fund. We are focused on buying businesses, generally U.S. businesses, with annual sales anywhere from roughly $20 million to $100 million. We structure our deals in these buyouts to usually consist of secured first and second lien debt and in a combination with the direct equity investment, because that is where we generate and have our significant ownership position and, ultimately, capital gains. So this combination of using debt and equity does produce a mix of assets, which is really the basis of our investment strategy for Gladstone Investment, whereby the debt portion of the investments provide the income to pay and grow our monthly distributions, and at the same time, we look to the equity portion, of course, to increase in value and provide the capital gains over time. And we'll be able to chat some more about that. So we might ask how are we different from other BDCs or other typical finance-type companies like us, and basically, one very significant difference with us and other BDCs is that we take significant equity positions in the companies that we invest in. And this differs from other public BDCs, generally, that are predominantly debt-focused, and usually those are referred to as credit-oriented BDCs. So for instance, where the proportion of equity to debt for the investments in our portfolio is approximately 25:75 ratio, you'll find that most of the "credit-oriented BDCs", in their portfolio, they'll typically be at around 10%:90% or 10:90 ratio of equity to debt. And as to other sort of private equity funds that are typical buyout funds, usually, they are 10-year type private partnerships with a long-term liquidity horizon for their investors. We differ basically in that as a publicly traded entity, our structure allows for the daily liquidity, so to speak, for our shareholders who are then able to participate in this middle-market buyout business through our structure without being necessarily locked up for at least 10 years. Now let's talk about exit strategies, because realizing capital gains through our portfolio company exits is definitely a component of the value proposition of an investment in our fund. And I do want our shareholders to know that this is an important part of our business planning, and we will be selling or exiting companies from time to time. These activities generally are based on market conditions, obviously, and, to some extent, an assessment that we make of the risk return in, for instance, continuing to hold an investment, even performing well, versus perhaps exiting that investment. So we're trying to assess the benefit, if you will, of taking a gain versus potentially keeping and holding that investment. And of course, some of that is a function, again, of the market. Now in this regard, we are actually expecting to close on the sale of one of our portfolio companies within the next few days. I'm not able to say much more about that, but I will say that it will produce a sizable capital gain on equity and we'll also receive back the repayment of all our debt. So we'll have total cash proceeds of a pretty significant amount. Now during the quarter ended September, we also exited the remaining investment we had in Cavert II Holding. This was where we had a remaining preferred equity investment. It was redeemed at par, roughly $3.4 million, and we also received dividend income on that preferred accrued of approximately $1.5 million. Additionally, we sold the assets of NDLI, which was one of our investments. We sold it to a company called Diligent Delivery Systems. The total proceeds on that one was roughly just under $15 million, which consisted of about $2 million in cash and a secured second lien note of about $13 million with warrants to purchase common stock. So by selling these assets of NDLI to a somewhat similar business, well-managed business, we have continued with an investment, however, we've been able to exit that investment today. So therefore, since June of 2010, which still including these actual exits and, of course, not the aforementioned expected sale, we will have exited 6 of our management-supported buyout investments, generated roughly $52 million in net realized capital gains and a roughly $14.6 million in other income associated with those transactions. We also, I should tell you, are currently in the process of a few other possible sales, which could occur over the next several months. And obviously, we will have to chat more about that as we move further into our calendar year of 2016. I just always like to caution that the buyout market is, obviously, still somewhat, I would say, seller-friendly. So we have to keep in mind that whenever we do sell a portfolio company for the right reasons and good reasons, it will and potentially could reduce our income-producing asset base, and then we are going to have to be, obviously, working very hard and we'll be challenged incrementally to replace that investment as we generate current income as well. So let's turn to deal generation because that impacts how we do that. We have a very high priority of our deal-generation activities, and that has resulted, obviously, in our continuing growth in new buyouts and income-producing assets. We do this with a very broad and deep geographic footprint, which we have offices in New York City, Los Angeles, Chicago and, of course, here in McLean, which, as David Gladstone mentioned, just outside Washington, D.C. Now to generate these new investment opportunities, we have to primarily call on what we refer to as independent sponsors, other middle-market investment bankers, folks that will find deals that we would be interested in acquiring, and other sources that might create and help create proprietary investment opportunities. We do not depend on others to negotiate or structure our investments. Generally, though, our investments, of course, do include partnering with the management teams of those companies and to the extent that there are other sponsors, such as independent sponsors who may be working with us to purchase the business. And again, our strategy, which is providing a package, a financing package, which includes both a secured debt and the majority equity investment, is a very competitive advantage as it gives the seller and the sponsor, independent sponsors, say, if one is involved, and the management team that we'll be working with, a very high degree of comfort that at least from a financing perspective, that purchase will occur. In addition, from time to time, we might do an outright purchase where we occasionally will find an opportunity to partner with, say, a business owner who's not actually selling the whole business, but maybe a portion of the business, and then -- and use our capital to continue growing the business. Where do we focus? Well, we generally invest in companies, as I said before, with revenues $20 million to $100 million, but also more, as importantly, with consistent operating cash flow, and generally, at least, around $3 million annually and ability, of course, to expand and grow that cash flow. Areas of interest that we look at and historically have done are light specialty manufacturing, specialty consumer products and services, industrial products and services and the aerospace and energy area. Now I should note that historically, we -- and is -- energy, we historically have had minimum exposure here, and we do look at that on an opportunistic basis. Currently, we do not really have any major exposure to the energy sector. Our secured debt investments, which are primarily first lien loans, typically carry a cash yield that are in the sort of mid to high teens, and that balances the equity portion of our investments, which, thereby, produce a blended current cash yield which supports our shareholder distribution expectations. We generally also have a success fee on these loans, which are paid in cash on a change of control or, in some cases, in advance at the portfolio company's option. As to the equity portion, when we model out a potential opportunity, we always target an equity portion that will have a return somewhere in the 2 to 3x cash-on-cash return. We believe with what we've been doing, that there is a positive origination trend as we continue through our third quarter fiscal 2016. We are currently in various stages of diligence on a few new investments, and we would hope and expect to close somewhere in the upcoming quarter. So we continue expanding our marketing efforts, and we're definitely continuing to grow our presence in the marketplace. So just take a quick look at our activity over this past quarter and how we've done. Well, we invested $20.9 million in a new deal. We received, as I mentioned earlier, $13 million new debt investment, which had -- included warrants to purchase common stock. And as a result of the aforementioned sale of the -- of that portfolio company, we also invested in incremental $1.8 million into existing portfolio companies. Specifically, in July, we purchased GI Plastek, Inc. with a $20.9 million investment in a combination of secured first lien and equity. GI Plastek, which is headquartered in Wolfeboro, New Hampshire, is a leading manufacturer of medium to large customized plastic injection molding products for various end markets and, generally, nonautomotive. In August, as I mentioned, the assets of NDLI Inc. were acquired by Diligent Delivery Systems, and as previously mentioned, we received consideration of roughly $15 million. This transaction did result in a current net realized loss of about $2.7 million, but we do retain, of course, as I mentioned, an income-producing asset as well as warrants, which will allow us to acquire common equity in Diligent in the future and could, indeed, turn into a positive. In September, we did, as I mentioned as well, sold the remaining preferred stock in Cavert II Holdings, which was redeemed actually at par and generated dividend income of $1.5 million. So with all of that, the outlook I would say is -- and our goal is to continue to strategically add accretive investments, position our existing portfolio for potential exits and, therefore, maximizing distributions to shareholders with a solid growth in both equity and the income portion of our assets. So with all of that, I'm going to conclude my part of the presentation and turn it over to Melissa Morrison, who's our acting Principal Financial Officer, and she'll go into a bit more detail on that performance.

Sure. Thanks, Dave, and good morning, everyone. As Dave just discussed, the fund had a strong quarter. Through this quarter's originations, together with highly successful originations last year, we achieved over $13.7 million in total investment income in the September quarter or 8.1% quarter-over-quarter growth. For the balance sheet at the end of September, we had over $508 million in assets, consisting of $490.6 million in investments at fair value, $5.7 million in cash and cash equivalents and nearly $12 million in other assets. Our portfolio's allocation at cost is currently $387 million of debt securities and $143 million of equity securities or a 73%:27% debt-to-equity allocation. Our liabilities and equity at September 30 consisted of $103.5 million in borrowings outstanding on our credit facility, $121.7 million in term preferred stock, $9.1 million in other liabilities and over $274 million in equity. Our net asset value was $9.05 per share as of September 30, down $0.19 from June 30, which primarily resulted from net unrealized depreciation of $3.4 million this quarter, which we will discuss in more detail later on the call. Consistent with the previous 2 quarters, we continue to use an external third-party valuation specialist to provide additional data points regarding market comparables and other information related to certain of our more significant equity investments. We will continue this practice and will plan to generally update this externally provided data on an annual basis for all of our significant equity investments. Moving over to the income statement. For the September quarter-end, total investment income was $13.7 million versus $12.7 million in the prior quarter. Total expenses, net of credits, were $7.7 million versus $7.5 million in the prior quarter, leaving net investment income of $6 million versus $5.2 million in the prior quarter or an increase of over 16% of our NII. The increase in net investment income quarter-over-quarter was primarily due to higher investment income driven by holding a larger portfolio and the receipt of dividend income, which caused other income to increase by nearly $0.5 million as compared to the prior quarter. This increase was partially offset by the additional costs incurred in originating and carrying the portfolio, including dividends on our term preferred stock. As mentioned on previous calls, historically, other income has been as high as 16% of our total investment income as compared to 13% during the September quarter. We expect other income, which is primarily composed of success fees and dividend income, to remain meaningful but variable from quarter-to-quarter. Our net expenses increased in the current quarter, primarily due to dividend expense on our Series C term preferred stock that we issued in May of this year. Overall, our NII increased to $0.20 per common share for the September quarter from $0.17 per common share for the June quarter, again, an increase of over 16%. Our net investment income more than covered our quarterly distributions to shareholders of $0.1875 per common share. Now let's turn to realized and unrealized changes in our assets. Realized gains and losses result from actual sales or disposals of investments. Unrealized appreciation and depreciation is a noncash event and is driven by the requirement to mark our investments to fair value on our balance sheet, with the change in fair value from one period to the next recognized in our income statement. During the September quarter, we recorded $2.7 million in realized losses related to the restructuring and sale of one of our portfolio companies. And excluding certain tax liabilities related to certain investments and excluding any reversals of net unrealized depreciation, our portfolio had a net appreciation of $2.1 million during the 3 months ended September 30, 2015. For the September quarter-end, our entire portfolio was fair valued at 92.6% of costs, slightly down from 93% of costs last quarter. All of our portfolio companies are current in payment, except one, which continues to remain on nonaccrual, representing approximately 1% of the fair value and less than 3% of the cost basis of our total debt investments as of September 30. Our debt portfolio is well positioned for any interest rate increases, with 81.5% of our loans having variable rates with a minimum or floor and the remaining 18.5% having fixed rates. The weighted average yield on interest-bearing debt investments remain consistent quarter-over-quarter at 12.7% versus 12.6% in the previous quarter. This strong yield excludes success fees on our debt investments. It also does not include any paid-in-kind or PIK income as we do not currently have any debt securities with a PIK feature. Success fees are yield enhancements that are contractually due generally upon a change of control, although there are times when the portfolio company can elect to pay it earlier. We generally only recognize success fees in our income statement when they are received in cash. For comparison purposes, if we had accrued these success fees, as we would if it was paid-in-kind interest like other BDCs do, our weighted average yield on interest-bearing assets would approximate 16.1% during the September quarter. As of September 30, the success fees accruing off-balance sheet, totaled $29.6 million or approximately $0.98 per common share. There's no guarantee that we will be able to collect all of these success fees or have any control over their timing. From a credit priority standpoint, 100% of our loans are secured, with 72.7% having a first lien priority and the remaining 27.3% having a second lien priority in the capital structure of the respective portfolio companies. Overall, Gladstone Investment had another good origination quarter, which helped the company generate strong financial results. We have maintained an increased distribution rate while still remaining committed to covering our distributions by net investment income as we have done consistently over our last several fiscal years. And now, I'll turn the call back over to David Gladstone.

All right. Thank you, Melissa, and that was a good report, same good report from Michael and Dave. And during the past quarter, we were able to report some great accomplishments, such as good origination, increasing our net investment income, of course, successfully exiting one portfolio company at a good return. Several more of our portfolio companies are moving closer to be sold. The one I've been mentioning on the call for, I don't know, last 6 months, has finally signed the definitive deal document, and we're waiting for the final funding to close. I'm hopeful that's in the very near future. I'm afraid to give any projections on that anymore. And if it does close, it should generate a significant capital gain for our funds. And one of our companies is even talking about doing a public offering. We only own a small part of that, but it would be significant. So lots of activity in this company and future outlook of this fund is very good. And we expect to explore an increase in dividend sometime in the near future. I know it doesn't help much when the fund pays an extra dividend, but sometimes we have to use that technique to eliminate taxes and comply with government regulations. So just to recap, the September quarter closed a new investment, $21 million, exited one investment and result in over $1.5 million in dividend income, and sold a company that had gone through a lot of past problems to sort of get that one out of the way and free up people to work on new deals. We believe we can continue this success going to the next few quarters, and after that, we should have some running room to move even faster. As you probably can tell, I'm bullish on this fund, looking very good for the upside. We feel it's a great time to buy and invest in small companies like the ones we invest in. While we continue to monitor the economic recovery, we have seen some positive trends in the recent economic indicators. The economic recovery has been, of course, the slowest and worst one in the last 30 years. I don't think anybody would disagree with that. We still have the same concerns that I mention every time. We, like all the other people sitting around, are watching the direction of the Federal Reserve on monetary policies to see what they'll do. And while we have variable rates on most of our loans, increasing rates are not good for the economy. However, I doubt the Fed will raise rates. Although they have now staked out the December month for the increase, I don't think they're going to increase it more than 1/4 of 1%. So that's not going to do much to -- in terms of impact to the economy. The volatility of oil and gas industry pricing has been just crazy. Low oil prices are a terrific benefit to the economy, and we should get a lift out of that. I just don't know how long that'll last, and our oil and gas concentration in this company tends to be minimal. And if natural gas and oil prices continue to stay down, then the entire industry is going to have a big adjustment to make, and that'll be some big changes in that industry. The fiscal crisis in the federal government is still top of my mind. I'm sure it is of many of you out there as well. The federal deficit's now over $19 trillion and continues to climb as the government spending continues with just no end in sight. They can't seem to stop it, sort of like cocaine addicts. They just keep spending. The federal debt has doubled in the last 10 years. That seems unbelievable, but that's the truth. And this is not sustainable. We can't keep doubling every 8 to 10 years. And the end is going to come, and it's going to be crippling for the U.S. economy and all the Americans. So please vote for fiscally responsible people that are running for President. And perhaps this next election, we can begin to turn the company back to a more sane approach to spending. Many of the private companies we're in, like those -- that -- like ourselves and like those that we invest in, feel there's much too much regulation around health care, financial services, energy and, of course, emissions, and it's just hindering the performance and expansion of job growth. It's crippling so many small businesses. We're now at the same number of small businesses and has reduced so much that we're back to the age of Jimmy Carter, if you can believe that, in terms of number of small businesses. In light of all these concerns, our company, Gladstone Investment, has strengthened its balance sheet in the form of significant new equity and used that new equity to buy into a list of good... [Audio Gap]