Gladstone Investment Corporation 4.875% Notes due 2028 (GAINZ) Q2 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Gladstone Investment Corporation second quarter earnings conference call. [Operator Instructions] As a reminder, today's conference may be recorded. I would now like to introduce your host for today's conference, Mr. David Gladstone, Chairman. Sir, please go ahead.

All right, thank you, Liz. Nice introduction and good morning to all of you. This is David Gladstone, and this is the quarterly earnings conference call for the shareholders and some of the analysts that follow Gladstone Investment, common stock traded on NASDAQ symbol GAIN. We also have some preferred stock out there, GAINO and GAINN and GAINM. You can remember it easy enough by saying GAIN and then the first three letters of money, M, O, N and then you just plug it in on the end of GAIN and you can look at the preferred stocks. Thank you, all for calling in. Always, we're happy to talk with loyal shareholders who like to listen to these calls and potential shareholders. We'd like to give updates on the company and its investments, and we'd like to give you a view of the business environment. I wish we could do this more often. We try to do this in some of our press releases. Also, you have an open invitation. We're here in McLean, Virginia, located just outside Washington, D.C., so if you're ever in the area and you want to stop by and see some of your team in action, there's about 60 people now and I think they're the finest in the business. You're going to begin to hear from our General Counsel and Secretary, Michael LiCalsi. Michael is also the President of Gladstone Administration, which serves as the administrator to all of the Gladstone public funds and related companies. He'll make a statement regarding forward-looking statements and some other information. Michael, go ahead.

Good morning, everyone. This conference call may include statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933, the Securities Exchange Act of 1934, including statements with regard to the company's future performance. These forward-looking statements involve certain risks and uncertainties and other factors, even though they are 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 information listed under the caption Risk Factors in our Form 10-Q and 10-K filings and in our registration statement, all as filed with the SEC, which can be found on our website at www.gladstoneinvestment.com or the SEC's website, www.sec.gov. 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 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 to sign up for our e-mail notification service. You can also find us on Facebook under the keyword Gladstone Companies and on Twitter @GladstoneComps. The call today will be an overview of our results through September 30, 2016. So for more detailed information, we ask that you read our press release issued yesterday and also review our Form 10-Q for the quarter ended September 30, filed yesterday with the SEC. You can access the press release and 10-Q on our website, gladstoneinvestment.com. Now let's turn to David Dullum, President of Gladstone Investment to give an update on the fund's performance and outlook.

Thanks, Mike. Good morning. I generally like to give everyone a quick refresher on who we are and what we do. Gladstone Investment is a publicly-traded business development company, otherwise known as a BDC. And of course, we're focused on buyouts of the U.S businesses in which annual earnings, which means EBITDA, which is earnings before interest, taxes, depreciation and amortization. Generally the range for these earnings or this EBITDA is between $3 million and $10 million. That's our area of interest. The financial structure that we use for funding our buyouts usually consists of a secured first or second lien debt instrument in combination with the direct equity investment for significant ownership position. So this combination of debt and equity in the individual transactions that we do produces our portfolio of assets and gives us current income for monthly distributions to our stockholders and potential capital gains and other income upon the sale of a portfolio company, which then may be distributed to shareholders in the form of incremental dividends. How are we different from other BDCs? Well, I wish to highlight that the GAIN is not managed as a traditional credit or debt oriented BDC. And so what does that mean? Well, we invest in operating companies and when we make an investment in a company, we take -- we do not depend on others of course to negotiate or structure our investments. Generally though, our investments do include partnering with the management teams and as in the case of our investment early this year in The Mountain, we had management and sometimes we may have other sponsors in the purchase of a particular business. So our strategy of providing a financing package, which includes both secured debt, the majority of the equity gives us a competitive advantage as it gives the seller or the independent sponsor, if one is involved and the management team, a high degree of comfort that the purchase will occur at least from the financing perspective. And we believe that our strict adherence to investment fundamentals and our thorough due diligence process have enabled us to provide shareholder returns in both our consistent regular monthly distributions as well as incremental distributions from time to time. We do continue to build our pipeline of opportunities and while we made no new investments in this quarter, we are actively reviewing and conducting due diligence on a number of potential investments. And I should say that the current market valuations for buyouts is still pretty challenging and again, our business is one where we have to -- we make investments and looking to acquire these businesses and it's not a consistent process. Now when we do make investments, the target for the equity portion of our investments is generally minimum of 2x to 3x cash-on-cash return and indeed, based on our exits as we mentioned earlier, we seem to have been able to maintain those levels of returns. For our secured debt investments, we primarily are firstly in loans. We typically carry a cash yield in the low teens, which balances the equity portion of our investment, thereby producing a blended current cash yield which supports our shareholder distribution expectations. Typically, we also have what we call success fees, which are generally due upon a change of control. These may be paid in cash in advance in limited circumstances at the portfolio company's option. Now what's our investment focus? Well, generally we invest in companies with consistent EBITDA and operating cash flow, which generally have a potential to be expanded. Areas of interest that we like are the sort of light and specialty manufacturing, and companies such as GI Plastek and our portfolio falls in that category, especially consumer products and services and examples of those would be Brunswick Bowling and The Mountain, which were recent acquisitions, industrial products and services and examples there would be Counsel Press, a company in New York and Nth Degree company in Atlanta, and from time to time aerospace and energy and frankly historically, we really have minimal exposure here and right now, we're not necessarily considering investing in this area other than opportunistically, if it really were to make some sense. So with all of this, our activity this quarter, second quarter ending September 30, we only invested about $2-point million in existing portfolio companies and we received about $2-point million in repayments in sales. I would add also that we were able to, and we previously announced the successful issuance of our Series D Term Preferred Stock in September, which generated net proceeds of $55.4 million and this was to redeem a $40 million preferred, which was coming due in February of 2017. So we're very excited about that because it showed an oversubscription to our efforts and also locked in a reasonably good long-term rate given that this is a 7-year term preferred. So what's the outlook? Our goal is to continue strategically, add accretive investments and position our existing portfolio for potential exits, thus thereby maximizing distributions to shareholders, with solid growth in both the equity and income portions of our assets. And I will say that we are going to continue our diligence. We're going to continue our consistency in a way which we think about new investments and we may have to go a period or two where we make no new investments but at the same time, we keep very concentrated on our current run rate of income, which thereby continues to produce the efforts we need and the levels of capital and income to pay our distributions to shareholders. So with that, I'm going to turn this now over to our Chief Financial officer, Julia Ryan and she can give some more details. Julia?

Thanks, Dave and good morning, everyone. As Dave just touched on, the fund had a strong quarter, with the successful issuance of our new Series D Term Preferred Stock and the generation of about $5 million in net investment income. At the end of September, we had over $499 million in assets, consisting of approximately $486 million in investments at fair value, $5.1 million in cash and cash equivalents and about $8 million in other assets. Our portfolio's approximate allocation between debt and equity securities was 72% to 28% at cost. Our liabilities and equity at the end of the quarter consisted of $63.5 million in borrowings on our line of credit, $139.2 million in term preferred stock at liquidation value, which includes the new Series D, about $9 million in other liabilities and about $292 million in equity. Our net asset value per share was $9.65 as of September 30, which was down $0.19 from the prior quarter and which primarily resulted from net unrealized depreciation of $5 million this current quarter. This decrease is principally due to a small decline in the operating performance such as EBITDA of certain portfolio companies. However, overall, our fair value to cost remains at over 90%. Consistent with the previous 6 quarters, we continue to use an external third-party evaluation specialist to provide additional data points regarding market, comparables and other information related to certain of our more significant equity investments. We plan to continue this practice and update the externally provided data on an annual basis for all of our significant equity investments. Moving over to the income statement for the September quarter, total investment income was $11.7 million compared to $14.4 million in the prior quarter. Total expenses net of credits were $6.6 million versus $7.6 million in the prior quarter, leaving net investment income of about $5 million compared to $6.8 million in the prior quarter. The decrease in total and net investment income was primarily due to little dividend income received this quarter versus the $2.8 million of dividend income received in the prior quarter related to our exit of Acme. Other income was less than 1% of total investment income in the current quarter as compared to the 19% in the prior quarter. As we have mentioned on previous calls, we expect other income, which is primarily composed of success fees and dividend income, to remain meaningful but variable between quarters. Net expenses decreased by $1 million in the current quarter, which was primarily driven by a $1.2 million reduction of the incentive fee as a result of lower pre-incentive fee net investment income due to the decrease in other income as previously discussed. As a result of these factors, our net investment income per share was $0.17 per share in the current quarter compared to $0.23 during the June quarter. Consistent with previous quarters, our current-period net investment income, together with undistributed net investment income from the prior period, or the spillover amount, more than covered our quarterly distribution to shareholders of $0.1875 per common share. Our distribution coverage ratio was more than 230% this quarter, which means that distributions were covered by current or prior-period income by over 230%. As of September 30, total undistributed income was $7.7 million or $0.25 per common share. We continue to actively manage our undistributed income with the ultimate goal to cover and over time increase distributions to shareholders. This may take the form of incremental periodic distributions. Let's turn to realized and unrealized changes in our assets. Realized gains and losses generally result from sales of investments. Unrealized appreciation and depreciation is a noncash event and is driven by the requirements to mark our investments to fair value with the change in fair value from one period to the next recognized in our income statement. For the quarter ended September 30, 2016, realized activity was minimal. During the previous quarter, we recorded net realized gains of $18.6 million primarily related to the sale of Acme. We recorded $5 million of net unrealized depreciation in the current quarter, which was principally due to a decline in performance of certain portfolio companies and which we do not believe to be indicative of a permanent decline in value. At September 30, our entire portfolio was fair valued at 93% of cost, which compared to 94% in the prior quarter. One portfolio company continues to remain on nonaccrual, representing less than 1% of the fair value and cost of all of our debt investments at quarter-end. Our debt portfolio is well-positioned for any interest rate increases with about 90% of our loans having variable rates with a minimum or a floor and the remaining 10% having fixed rates. The weighted average yield on interest-bearing debt investments remained relatively consistent quarter-over-quarter at about 12.5%. This strong yield excludes success fees in 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 this feature. Success fees are yield enhancements that are generally contingent upon a change of control, such as an exit or sale, although there are certain circumstances when the portfolio company can elect to pay it earlier. We recognize success fees in our income statement when they are earned, which generally coincides with the receipt of cash. For comparison purposes, if we had accrued these success fees, as we would if it was paid-in-kind interest, like many other BDCs do, our weighted average yield of interest-bearing assets would approximate 13.4% during this past quarter. And at the end of the quarter, the success fees that are accruing off-balance-sheet totaled about $31 million, or $1 per common share. There is no guarantee that we will be able to collect any or all of these success fees or have any control over the timing of collection. From a credit priority perspective, 100% of our loans are secured with 75% having a first-lien priority and the remaining 25% having a second-lien priority in the capital structure of the respective portfolio companies. Overall, Gladstone investment had another quarter of strong operating performance and financing success. We have maintained our distribution rate while remaining committed to covering our distributions with income, as we have done consistently in the past. And now I will turn the call over to David Gladstone.

All right. Thank you Julia. Nice report. Good report from Michael and Dave. So we are still on track to continue with strong results. During this past quarter, we reported some of the great accomplishments, but I think the Series D was a good indication that the market likes what we're doing. Additionally, we have certain portfolio companies on the path to being positioned for sale. We have offers on one and we're moving that along and hopefully that happens in this quarter that we are in. We also have one that became public during the quarter -- right after the quarter, not in the quarter and this particular portfolio company, we don't have a significant impact on our portfolio but it's nice to have some publicly traded shares in our portfolio, lots of activity going on in the portfolio and I think you'll be pleased that we'll share some good success going into the third quarter December 31, 2016. Some of the people say we may be entering into a recession. We don't quite see it that way today and our company is well-positioned. For example, we have a good diversification of deals across many different areas and some people ask me then, why do you worry about and I go through this each time like everybody else who's still watching which direction the Federal Reserve or Fed is going to go with its monetary policies. And we have variable rates on most of our loans so increasing rates is not going to hurt us but it's really not good for the economy. However, I doubt that Fed will raise rates again until there is much stronger signal that the economy is improving and even if they do it in December as people keep talking about, it's probably only going to be 0.25%, so it's more of a psychological rate rise than it is a big impact on us or maybe other people. I think the main reason that Janet Yellen at the Fed keeps pushing for higher rates is because she has to find buyers for all the money that she's borrowing using Treasury Notes and T-bills and to get people to buy these U.S. Treasuries, you have to have a good higher rate to get people to buy them. Anyway, turning over to volatility then in the oil and gas industries is one that we watch. Low oil prices, terrific benefits to the consumers and many businesses. We don't have investments in the oil and gas industry. They're not significant. On the other hand though, you have to realize that the oil and gas industry is an integral part of the U.S. economy and losses there will again equal a lot of pain to the economic activity. I'm just glad that this company doesn't have a lot of investments even related to oil and gas. Then we worry about the federal deficit. No one seems to talk about that much anymore. $19 trillion and at the end of the year that we've just started in September for the government, probably going to go well past $20 trillion. This spending is just putting pressure on the Fed to find more ways to bring money into the government so that they can meet their goals and objectives, but they're certainly borrowing at a furious rates and spending at a furious rate. On another note, many of the private companies, like those we invest in, feel there's far too much regulation around all of those areas that are going on today. First of all, healthcare, a lot of activity in healthcare. I heard a lot of small businesses. Financial services, like our company, are constantly seeing changes in regulation and increasing regulatory environment. Energy emissions and now one that's popped up is minimum wages. We just see this hindering the performance and expansion of job growth, especially from the small business community. We understand why big businesses moved their operations out of the United States to places like Latin America and Asia where there's less regulations and very low taxes but midsized businesses then, similar to the ones in which we invest in, end up having to hire manufacturing operations outside the United States in order to stay competitive. This is not good for our economy. In light of these concerns, our company Gladstone Investment has continued to be very selective in investing in new business and we'll keep doing so. We've very conservative orientation. In October, 2016, our Board declared our monthly distributions to our common stockholders at $0.0625 per common share for each of the months of October, November and December. It's an annual run rate of $0.75 per common share, which is consistent with prior quarters. Just as a note there, some number of BDCs now who have cut their dividend, we're not one of those so don't look for us in that category. As mentioned before, we have about $7.7 million in our spillover reserve that we could use. We also, as many of you know, have cut our incentive fee in the past in order to cover the dividend. So don't look at us to be one of those that cuts the dividend. We're in a very strong position today. Now through the date of this call, we've made 136 sequential monthly cash distributions to our common stockholders and additionally have made some special distributions in prior years. As of September 2016, we've distributed a total of $179.5 million at $7.92 per share of common shareholders. That's a great long-term record that we have out there. The current distribution rate of common stock, which is common stock price about $8.40 yesterday, the yield current distribution rate is about 10.2% and so ridiculously high rate for a company that's doing so well. And if you don't like the 10.2% on the common stock, you can always switch over to the Series B. They're getting a 6.6% return today so if you bought that. The Series C is running at about 6.3% and the Series D is running at about 6.2% so you've got your choice of preferred stocks if you want a lower yield but be in a preferred stock status. In summary, Gladstone Investment is an attractive investment for investors seeking continuous monthly distribution and increased distributions over the potential capital gains that we should get. We expect a good quarter for December 31, 2016 and hope to continue to show you strong returns for the coming years. So Liz, if you'll come on now, we're going to have some questions from the analysts and some of the loyal shareholders. So start that up now.

[Operator Instructions] Our first question comes from the line of Mickey Schleien with Ladenburg.

Dave, a question for you and I apologize, you may have commented about this in your prepared remarks but I'm juggling a couple of calls at the moment, but the income machine was extended if I recall correctly in the first quarter of 2015 and now it's been restructured. I was just hoping you could review what the issues are that are confronting them and I understand you've given management an equity stake. What are the strategies that they're pursuing to improve the performance of the company?

Okay, well first of all, Mickey, the good news is that since 2015, they actually have improved the performance of the company. That's going back then, we took the -- we made moves regarding management, improved the management team. We have a really strong management team now, it has taken us about this past year to work it through and this was also a company that was made back in the sort of '07, '08 timeframe. So it's been in our portfolio a while. It's one that we had to essentially take more control over, if you will, one that was done with a smaller or private equity firm. So that's just historic. The business though, it's a fundamentally good business and so with a good management team and with the progress they've made, we felt that we had reached a point where we don't have to put any more money in and we wanted to actually give incentive to the management team to really drive the business. So by restructuring it, we would help to reduce some of the burden on the business. The EBITDA has picked up nicely and looks continuing. They've just recently done some interesting things that I really can't talk about with some major customers. So we feel like the future looks very good and this is a chance now for again management to be incentivized. At the same time, it gives us a solid base on the debt that we now have with them as a current pay and also opportunity for the significant equity position that we retain.

Next question comes from Laura Engel with Stonegate Capital.

I wondered that given all that you discussed and the trends you're seeing in the industry and the potential rate changes, how that might affect your rate of these deals going forward and if you're factoring in changes in maybe the size of the deals, the location or just the general mix of industry types to keep that diversification but keep the risk low as well?

Hi, Laura, Dave here. You're referring to what we're seeing in terms of valuations. Is that what you're touching on?

Well, yes. What you're seeing in the industry as far as going forward, your historical rates of doing these deals, how do you see that increasing or decreasing and then what you're looking at as far as steering clear of certain industries? I know there are some that historically you've stayed away from that. I'm just looking forward if there's way you're going to change the search for these companies and how quickly you make the deals through the pipeline?

Right. Okay, got it. No, we're not going to change anything. We think we've got a good model. We go out, we research. As you know, we have offices in a couple of other spots, L.A. and New York. We cover the Midwest from this area. So we think we've got very good coverage and our managing directors and directors are out doing all the right things, beating the bushes, our discipline around the industries and the areas that we like as we mentioned in the script. We're not going to change that. And as far as the, I call it production rate, we will have to keep working hard to find companies that we think have the value that are necessary. So what we're not going to do is make an investment at some silly, or try to make an investment at some silly multiple of EBITDA, which is not going to either give us a return or more importantly, might have to have it so highly levered that it puts us at a risk. So this is not unusual. We've been through this sort of periods before and we just keep with the discipline of making investments we make. We keep balancing with our current portfolio base generating the income stream that we generate. We feel good about where we are. We just have to remain disciplined and as I said, our team, a lot of shoe leather.

Right. Then I guess you referenced you're looking at several things right now and then specifically some comments about the upcoming quarter. Are there, would you say are there deals in the pipeline that are close to closing even having just finished the sale of Acme and the purchase of The Mountain? Would you say, can you give us any additional color on that or any further comment on that?

I'd rather just say what I said. With the pipeline, it is what it is. We're working hard and you know this business, you can get close on a deal and then something falls apart in the last minute. So I would really be remiss in making any predictions in that regard. So we just got to keep working the pipeline and again keeping the discipline.

[Operator Instructions] I am not showing any further questions in queue, I would like to turn the call back to Mr. Gladstone for closing remarks.

Thank you, Liz and thanks to all of you calling in. Mickey and Laura, we appreciate the questions. We'll see you next quarter. Thank you very much. That's the end of this conference call.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program and you may now disconnect. Everyone, have a great day.