Gladstone Investment Corporation 4.875% Notes due 2028 (GAINZ) Q1 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Gladstone Investment Corporation's First Quarter Ended June 30, 2018 Earnings Call and Webcast. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to David Gladstone. You may begin.

Thank you, Sonia, and thank you to all for calling in today. This is the quarterly earnings conference call for shareholders and analysts of Gladstone Investment, common stocks traded on NASDAQ under the symbol GAIN, and we have 3 versions of preferred stock out there, GAINO, GAINN and GAINM. So thank you all for calling. And again, we're always happy to do these calls with shareholders and potential shareholders and of course, our analysts, who've been giving you an update on your company and the investment provides a view of where we are in the current business environment. Wish we could do this more often. Also you have an open invitation to come by and see us in McLean, Virginia, located just outside Washington, D.C., so please stop by and say hello. And now we'll hear from our General Counsel and Secretary, Michael LiCalsi. Michael is President of Gladstone Administration, which serves as the administrator to all of Gladstone public funds and related companies. He'll make a brief statement regarding forward-looking statements. Michael?

Thanks, David. Good morning everyone. Today's call may include forward-looking statements under the Securities Act of 1933, the Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties and other factors, and they are based on our current plans, which we believe to be reasonable. And many factors may cause our actual results to be materially different from any future results expressed or implied by these forward-looking statements, including all risk factors listed in our Forms 10-Q, 10-K and all the documents that we filed with the SEC. You can find all these documents on our website, which is www.gladstoneinvestment.com, or on the SEC's website, which is www.sec.gov. And we undertake no obligation to publicly update or revise any of these forward-looking statements whether as a result of new information, future events or otherwise, except as required by law. Please also note that past performance or market information is not a guarantee of any future results. We ask you also to take the opportunity to visit our website, once again, gladstoneinvestment.com, specifically the Investor Relations page, sign up for our e-mail notification service. You can also find us on Twitter, the handle there is @GladstoneComps. We're also on Facebook, keyword there is The Gladstone Companies. And today's call is simply an overview of our results through the quarter ended June 30, 2018. So we ask you to review our press release and Form 10-Q, both issued yesterday for more detailed information. In addition to this earnings call, we will also have our Virtual Actual Stockholders Meeting later today. If you haven't already done so, please be sure to vote your shares at the meeting. Now I'll turn the presentation over to Gladstone Investment's President, David Dullum. Dave?

Mike, thank you very much and good morning, everyone. I am pleased to report that during this quarter, which obviously ended 6/30/18, we were able to increase our net asset value from $10.85 at 3/31/18 to $11.57, and this was inclusive of during the quarter, where we made a purchase of one new portfolio company called Bassett Creek and we also exited an existing portfolio company, Drew Foam, at a significant realized gain for your fund. And we also were able to increase our net investment income, adjusted net investment income of $0.20 versus $0.21 in the last quarter. So based on all these results and for the year ended 3/31/18 and as we look forward, we were able, in April, to announce an over 3% increase in our annual distribution rate to common stockholders from $0.78 a share to $0.80 a share. We also were able to announce a continuation of our semiannual supplemental distribution program, with a payment of $0.06 per common share, which is made in June of 2018. We hope and certainly expect that a significant portion of these supplemental distributions will be made from capital gains. In addition, we have seen our stock price increase and in fact, also further quarter-over-quarter, such that the total return, which is inclusive of dividends for the June 2018 quarter was around 20%. And we're proud that our 1-year total return as of June 30, was around 36%, and this compares favorably to a BDC index put out by Wells Fargo, where that index actually was the decline of 2% versus our increase of 36% for the year. So this increased stock price is encouraging to us because we believe that the investor community is recognizing the continuing growth of the income and the distribution and also frankly, the value of the equity component of our buyout business model and therefore, this -- we feel encouraged because it supports our thesis of what we're trying to do with your company. Now we do have a differentiated investment strategy and a business model, in that our investments consist of the majority of equity and the debt capital in our buyouts. These companies generally have earnings before interest, taxes, depreciation and amortization or EBITDA, EBITDA as we call it, generally between $3 million and $20 million. And the structure we use for funding these buyouts consists of a direct equity investment for a significant ownership position, in combination with secured first or second lien debt in any one particular investment. And this definitely differentiates us from a traditional credit-oriented BDC, in that the proportion of equity to debt for the investments in our portfolio could be around 25-or-greater percent of equity to 75% debt at cost. And this compares to most other credit-oriented BDCs, where in their portfolios, you'll typically see around 10% equity and about 90% debt. So therefore, the interest and the success fees that comes along with our debt investments provides steady income to pay, and over time, grow our monthly distributions, which as I mentioned earlier is currently at about $0.80 of common share annually. And then with the significant equity positions that we own in each portfolio company, we look for increasing value so that an increase in the equity value will provide capital gains and other income over the life of the investment or upon exit. These potential capital gains and other income may then be distributed to our stockholders in the form of these supplemental distributions. And to this point, we've made 3 such planned supplemental distributions in the amount of $0.06 per share to common stockholders in June and December 2017, and then recently, in June of this year, 2018. This differentiated investment approach of being a provider of a significant portion of the equity, using the majority and most of the debt in our transactions gives us an advantage to typical lenders and credit-oriented BDCs in that we will have a close working relationship with the management teams and some influence frankly, on the direction and strategy of the company that we buy. Thus, we not only limit the risk of our debt being refinanced, but also our involvement with management provides an interaction with the company, somewhat similar to the traditional private equity fund. This is very important feature of our approach to investing. Now let us have a quick look at our historical performance or our scorecard. We've done this before. And I'd like you to keep it up-to-date on this and so from 3/31/2014 to 6/30/2018, we'll take a look at how we've done. I mentioned also that you will find most of the information, I'm going to be talking about in a graphic form -- in our quarterly investor presentation, which is posted on our website, which as Mike LiCalsi mentioned earlier, you can get to on www.gladstoneinvestment.com. So what have we done since 2014 and so on? Well, we've grown our total assets from about $331 million to about $641 million at fair value. The debt portion at cost has grown from about $279 million to almost $442 million, which is what supports the growth in our regular monthly distributions per common share, which went from $0.66 per share in fiscal 2014 to $0.80 per share annual run rate since April of 2018. The equity portion at cost of our portfolio has grown from about $105 million to about $155 million. Our NAV, net asset value, per share has increased from $8.34 per share to $11.57 over that same period. We had 33 companies in our portfolio at 6/30/18. From inception in 2005 through this period in 6/30/18, we've actually exited 13 of our buyout companies and these exits have actually generated almost $100 million in net realized gains and about $22 million in other income on exit. These exits achieved an aggregate cash-on-cash return on the exit of the equity portion of those investments of approximately 3.4x, which is somewhat our target. It is this equity growth and the exit activity that's allowed us to deliver on our objective of generating capital gains from the equity portion of our assets, which is, of course, what we look forward to continue in the future. So going forward, as we build our investment portfolio with new buyouts, we also will manage these exits or sales of portfolio companies and that's consistent with our strategy of providing realized capital gains from the equity portion of our portfolio. And to this point, as I mentioned, we exited a company called Drew Foam in June of 2018, which generated a capital gain for us of about $13.8 million. As I always say, we will continue to be guided by market conditions, meaning we'll assess the risk return and continue to hold an investment versus the opportunity to exit it and will remain sensitive to preserving our portfolio of assets because this is what produces the income for our monthly distributions. So if we exit, we also have obviously to make new investments, and it's our new buyout generation activities also have a very high priority. To develop new investment opportunities as I mentioned previously, we call on a number of different groups of folks, independent sponsors, middle-market investment banking firms and other sources that help to create the investment opportunities that we look at, a number of which are somewhat proprietary. Generally, our investments in some can include partnering with the management team in the course of the business. But we also believe that our strict adherence to the 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 the supplemental distributions that we've been able to make. In this regard, this quarter, we invested about $29 million to form a group called Bassett Creek Restoration, Inc., which is actually an acquisition platform for businesses in the restoration and renovation services space. This we simultaneously acquired a company called J.R. Johnson as the first operating business in that platform. So we continue reviewing and conducting due diligence on a number of new potential investments, and in addition, we'll -- to these new standalone acquisitions, we are actively pursuing accretive add-on investments for some of our existing portfolio companies. This allows us to, from time to time, also make further investments in some of these existing portfolio companies, so it continues building assets, while accelerating the value creation of these companies that we already own. Now I will say that we're still operating in a buyout environment, where the competition for new investments is elevated, purchase price is being paid very high and frankly, this makes it very challenging for us to close new investments, given our conservative value approach and the expected financial returns. Now this may lead to an appearance of a low rate of investment production at any point in time, however, keep in mind that when we make investments, we're striving for quality to build value in both the income and equity, and we're not volume driven as it might be if we were building a portfolio of loans, where we would, say, be primarily sensitive to yield spreads. And it's important to keep in mind that our process time line for any one acquisition is quite long. And from the time we're introduced to a new potential buyout opportunity to actually closing on that transaction, it could be anywhere from 3 to 5 months. So it takes time, but we keep diligently working at this and building our portfolio. We continue our target for equity investments to provide a minimum of 2 to 3x cash-on-cash return and the debt investments, which are generally secured and primarily first lien loans typically carry a cash yield in the low to mid-teens. And it's again these debt cash returns that balance the equity portion of our investment, producing a blended current cash yield, which is what supports our stockholder distribution expectations. So what's our investment focus? Well, we continue to seek investments in companies with consistent EBITDA, EBITDA and operating cash flow, with a potential to expand into these areas of interest continue to be light, specialty manufacturing, specialty consumer products and services, industrial products and services, from time to time, maybe aerospace and also energy in limited circumstances. So as we look forward, we will continue executing on our plan. We will be adding accretive investments to grow both the income-generating portion and the equity portion of our assets, while we position our portfolio for potential exits, which increases and maximizes distribution to stockholders. We anticipate paying the semiannual supplemental distributions as the portfolio continues to mature and we are able to manage exits and realize capital gains. As I mentioned, these distributions are generally expected to be made from undistributed net capital gains and undistributed net investment income. So with all of that, I'll turn it over to our CFO, Julia Ryan, and she can give a little more detail on the actual financial performance for this past quarter. Julia?

Thanks, Dave, and good morning, everybody. As of June 30, we had $639 million in assets, which included $629 million in investments at fair value. Our liabilities consist of primarily of a $102.5 million in borrowings outstanding on our credit facility and about $139 million in terms of preferred stock at liquidation value. Our net assets totaled $380 million or $11.57 per share as of June 30, which is an increase of $0.72 from March 31 and is primarily a result of net unrealized appreciation and realized gains. Moving over to the income statement for the June quarter, total investment income was relatively flat compared to prior quarter. And expenses net of credits, were $15.4 million compared to $12.2 million in the prior quarter, leaving a small net investment income as opposed to $3.2 million in the prior quarter. Similar to the prior quarter, this difference was principally the result of the required GAAP accrual of $6.5 million of capital gains-based incentive fees, which I will discuss further in a moment. Interest and other income remained consistent quarter-over-quarter. So net expenses increased $3.3 million in the current quarter and that was primarily the result of $6.5 million of this capital gains-based incentive fee, which was required to be accrued under GAAP but which is not contractually due under our investment advisory agreement. This compares to last quarter's accrual of $3.6 million. The investment advisory agreement provides that a capital gains-based incentive fee is determined and paid annually with respect to realized capital gains, but not including unrealized appreciation if such realized capital gains exceed realized losses and unrealized depreciation. However, under GAAP, a capital gains-based incentive fee is accrued if realized capital gains plus unrealized appreciation exceed the sum of realized capital losses and unrealized depreciation. So really it is an "as if liquidated today" point of view. The increase in unrealized appreciation this quarter triggered this incremental accrual. As a result of these factors, our net investment income decreased in the current quarter. When adjusting net investment income to exclude this capital gains-based incentive fee accrual, adjusted net investment income per weighted average common share would have been $0.20 compared to $0.21 in the prior quarter. We believe that adjusted net investment income is a useful and representative indicator of our operations and exclusive of any capital gains-based incentive fee as net investment income does not include the realized or unrealized investment activity associated with this fee. Current and prior period adjusted net investment income again covered current and annual distributions from net investment income by a significant margin. While our balance sheet currently may reflect a line item titled overdistributed net investment income, this is a direct result of roughly $11 million of capital gains-based incentive fees that has been accrued but is not due to be paid. If and when this accrued fee or a portion thereof will be paid, such payment would generally follow the realization of a gain, meaning actual proceeds to us to cover such distributions. As of June 30, 2018, undistributed income and net realized gains totaled $15 million or $0.47 per common share. We continue to actively manage our undistributed income and net realized gains with the goal to cover and over time increase distributions to our shareholders. Let's turn to realized and unrealized changes in our assets. During this quarter, we realized a gain of $14.1 million, which was primarily the result of Drew Foam, and we recorded net unrealized appreciation of $18.1 million, predominantly due to improved operating performance and an increasing comparable multiples of certain portfolio companies. The fair value to cost was 105% and 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. Certain loans to 3 of our portfolio companies that are nonaccrual this quarter, representing about 8% of the fair value of our total debt investments. We are actively working with these companies in an effort to improve operating performance and liquidity. Our portfolio's approximate allocation between debt and equity securities was 74% debt and 26% equity at cost as of June 30. The debt portfolio is well positioned for any interest rate increases, with about 97% of our loans having variable rates with a minimum or floor and the remaining 3%, having fixed rates. The weighted average cash yield on interest-bearing debt investments was 13% this quarter. This yield excludes success fees on our debt investments. For comparison purposes, if it were to include the success fee component, the yield would have been 14.6% during the June quarter. As of June 30, this unrecognized contractual success fee totaled about $29 million or $0.89 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. 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 company. This covers my part of today's call. And back to you, David.

All right, thank you Julia and Dave and Michael. Good reports. The team reported some great accomplishments during this quarter. I believe we can continue our success going in our second quarter ending September 30. I just wanted to mention one thing before I get into the rest of my presentation. If you look at net investment income, that is the adjusted one at $0.20 and versus the $0.21 per share last quarter, it's a small change, but the reason again is this potential fee that's not due today that we're accruing for some strange reason in the accounting profession. Let's take a look at net operating income was $0.99 per common share versus $0.67 per share last quarter. That's a $0.32 change, which is about a 48% change. So you can see that the net operating income, which takes into account all of the items has gone very strong. Net asset value, up 6.6%, $0.72 a share, up to $11.57, another strong indication that the company's moving forward. And again, investing about $30 million versus $27.4 million last quarter. So the company is cranking along at a very good pace. I think the economy today is getting much stronger. We don't have any way of knowing the future, of course, so we're being very careful to counter any unforeseen things that might happen, we're seeking to build a very strong balance sheet, paying dividends is one of our primary goals. Now that the administration has delivered on the changes in the tax code and continues the reduction in regulations of businesses, I think the U.S. middle-market size businesses, the same ones that we invest in. This is going to be a great year, 2018, and I think we'll look back at 2018 and maybe even 2019 as very strong time for middle-market size businesses. The question of tariffs is always out there. We haven't seen any big impact in any of our companies. We are excited about the new business environment that the United States is in now. The middle market is the third largest economy in the world, when carved out by itself. It's a market that we love, we've been in since founding this fund. The middle market is booming today. And this company will benefit from the strengths in the middle-market. Distributions. July 2018, our Board of Directors declared monthly distributions to our common stockholders of $0.067 per share each of the month of July, August and September. Annual run rate is about $0.80 a share. I hope to make an additional supplemental distribution as we did in June and declare that distribution for the quarter ending December 31, 2018. And we will probably look at that in the October board meeting. Through the date of this call, we made 157 sequential monthly cash distributions to our common stockholders and additionally have made several supplemental distributions, 3 today -- 3 to date, of the regular half yearly ones. As of June 30, 2018, we've distributed a total of $228 million, about $9.45 per share to the common stockholders based on the number of shares outstanding at the time the payments were made on these distributions. This company continues to be in a very solid dividend payer position. The current distribution rate on the common stock, with the common stock trading at $11.50 is about 7%, a little less than 7% but right at it. If we look to the future and make assumptions that the company will pay 2 supplemental distributions of $0.06 per common share as we did last year, then the annual payout's $0.92 per share and that's an 8% yield to those folks that are holding the stock. Please note there's no guarantee that regular or supplemental distributions will be paid, but I want to assure you that, that's the central goal for this company -- is making sure we make the distributions. And as most of you know, as a regulated investment company like our company, in simple terms, it has to pay out at least 90% and usually pays out more out of its earnings each year in order to avoid paying taxes and giving you all of that money before we pay it to the government. For the current calendar year at June 30, 2018, we estimate capital gains portion of our distribution was about 11%. That's going to change most likely before we get to March of 2019, but anyway you can get a little bit of capital gains in there, which is a little helpful to those who pay taxes. Our 3 series of preferred stocks are trading above their $25 per share par value, yielding about 6.1% to 6.7%, depending on which series. So 20% to 30% above the $25. In summary, this company, Gladstone Investment, is an attractive investment for investors seeking continuous monthly distribution and also supplemental distributions from potential capital gains, which we keep building up. Hopefully, we'll be able to reap them in the future. We hope to continue to show you some very strong returns on this investment fund. Now let's have some questions from our analysts and any of the shareholders that happen to be on the call. So come on, operator, and tell them how to ask a question.

[Operator Instructions] Our first question comes from Kyle Joseph of Jefferies.

I wanted to dig into the yield a little bit. It looks like the portfolio yield has trended up sequentially and year-over-year. Is that a mix shift on spreads in the portfolio? Or is that more of a -- you guys are starting to see the benefit of rising rates in your portfolio?

Kyle, it's a mix of those two. It's definitely the LIBOR component is kicking in now as most of our loans are above the set floor. So as LIBOR increases absent any credit malperformance, you would see that going up in the future.

And then just on the nonaccruals in the quarter, are you seeing any industry-specific weakness? Were these sort of one-off company issues? And just give us a little bit of color on both the inflows and outflows to nonaccruals in the quarter?

Kyle, it's Dave. I'd say it's more company specific for a variety of reasons, whether it be a -- little management issues that we are having to work through, but nothing that I would say certainly is either damaging to the portfolio. We've worked through these things as we talk from time to time and then we'll continue to do so. So I'm not too concerned about where we are with these.

Next question.

[Operator Instructions] And I am showing no further questions at this time. I would now like to turn the call back over to David Gladstone for any further remarks.

Thank you, Sonia, and thank you all for calling in. We'll see you next quarter. That's the end of this call.

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.