Great Elm Group, Inc. 7.25% Notes due 2027 (GEGGL) Q2 2019 Earnings Report, Transcript and Summary

Good morning. My name is Michelle, and I will be your conference operator today. At this time, I would like to welcome everyone to the Great Elm Capital Group, Inc. Second Quarter 2019 Financial Results. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session [Operator Instructions] I would now like to turn your call over to Adam Yates. Please go ahead.

Thank you, Michelle and good morning everyone. Thank you for joining us for Great Elm Capital Group, Inc.'s second quarter 2019 earnings conference call. As a reminder, this webcast is being recorded on Monday, February 11, 2019. If you'd like to be added to our distribution list, you can either email investorrelations@greatelmcap.com or sign up for alerts directly on our website. This slide presentation accompanying this morning's conference call and webcast can be found on Great Elm Capital Group, Inc.’s website, www.greatelmcap.com under Events & Presentations. A link to the webcast is also available on this section of our website, as well as in the press release that was disseminated to announce the quarterly results. I'd like to call your attention to the customary Safe Harbor Statement regarding forward-looking information. Also, please note that nothing in today's call constitutes an offer to sell or a solicitation of offers to purchase our securities. Today's conference call includes forward-looking statements and projections, and we ask that you refer to Great Elm Capital Group, Inc.’s filings with the SEC for important factors that could cause actual results to differ materially from these projections. Great Elm Capital Group, Inc. does not undertake to update its forward-looking statements unless required by law. To obtain copies of the SEC filings, please visit Great Elm Capital Group, Inc.’s website under Financial Info and select SEC Filings. Hosting our call this morning is Peter Reed, Great Elm Capital Group, Inc.’s Chief Executive Officer. I will now turn the call over to Peter.

Thank you, Adam, and good morning, everyone. Thank you for joining us today. I'm joined this morning by our President and COO, Adam Kleinman; our CFO, John Woods and two senior members of our investment team, Adam Yates, and John Ehlinger. We’ll walk through an update on our recent acquisition of Valley Healthcare and Northwest Medical, as well as a brief update on the Investment Management and Real Estate verticals and their associated segment financials. We're relevant in our prepared remarks. We'll point you to the corresponding slide in the presentation that Adam referenced. Please turn to Slide 5. We have been working to grow Great Elm Capital Group into a diversified publicly-traded holding company across three business verticals: Investment Management, Real Estate, and Operating Companies. As discussed on our acquisition call in September 2018, we are pleased to say that we have now successfully completed a significant transaction in each of these three business verticals. Please turn to Slide 6, to discuss drivers of shareholder value. We have clear objectives in each vertical. In Investment Management, we seek to increase assets under management, both in GECC and in our co-investment vehicles. In Real Estate, we're interested in partnering with owners and lessees to utilize our substantial tax assets. In Operating Companies, we're focused on acquiring profitable companies with significant growth potential, both organic and through M&A. Please turn to Slide 7. It is difficult to overstate how important it is to us to maintain long-term alignment with you, our shareholders. Our team collectively owns over 1.8 million shares or 7% of the company, including our Board of Directors and their funds under management, insiders collectively own approximately 18% of the shares outstanding. We believe this fosters a significant and long-term alignment of interest amongst employees, directors, and shareholders. Let's turn to Slide 9, for an overview of our Operating Company activity. Our team performed diligence on a significant number of deal opportunities with a keen focus on acquiring growing businesses with demonstrated histories of generating meaningful earnings that are high returns on the capital employed by those businesses, all while paying what we viewed to be reasonable multiples of those earnings. In September 2018, we believe we accomplished just that with the acquisition of Valley Healthcare Group and Northwest Medical collectively, Great Elm DME. Importantly, since acquisition, we've been very pleased with the rapid growth DME is experiencing. DME generated $13.2 million of revenue and $3.6 million of adjusted EBITDA during the quarter, exceeding our expectations both for the quarter and year-to-date. During this growth, we're pleased to report new patient setups increased greater than 25% year-over-year in PAP and almost 50% in ventilator. Turning to Slide 10, I think it's important to discuss the nature and timing of the DME businesses’ cash flows. DME’s patient growth is accompanied by success based capital expenditures. In a typical scenario, a new patient is setup with a piece of equipment leased from DME such as the CPAP machine, oxygen concentrator, or ventilator as well as a collection of supplies. The piece of equipment that DME buys and leases to a patient represents CapEx on DME statement of cash flows. The revenue which will have only a small amount of cash OpEx matched against it, will be recognized over the life of the lease. The supplies that DME provides to its patients are consumable and typically reordered every few months. Thus, each new patient setup as to a base of patients who will be reordering supplies on a routine basis. To satisfy patient demand in a timely manner, DME must stock product in inventory for quick delivery in advance of those orders. The investment in growth occurs up front in advance of high margin recurring resupply revenue. The result we hope is an initial capital outlay that creates a lasting relationship with the customer over years. Let's turn to Slide 11 to expand on this concept. Growth, in particular, strong operating growth is a cornerstone of our long-term profitability. This past quarter DME experienced double-digit growth in referrals, new patient setups and active rentals in PAP and ventilators. As we discussed, CapEx in the quarter was approximately $2.3 million, $2.0 million of which we've described as revenue generating CapEx. The associated revenues from this revenue generating CapEx will be recognized over the upcoming year. Importantly, we believe that this quarter’s adjusted EBITDA $3.6 million only reflects a portion of the benefit we anticipate from these immediate CapEx requirements. Turning to Slide 12 to discuss our plan for inorganic growth at DME. DME intends to acquire complimentary, patient-focused businesses and integrate them into the existing platform. The respiratory-focused, durable medical equipment industry is fragmented and ripe for consolidation. DME seeks to pursue a hub-and-spoke expansion strategy that targets tangential and overlapping locations to our existing geographical footprint in Arizona, the Midwest and the Pacific Northwest. We currently have a number of identified acquisition targets including two actionable targets under LOI. Please turn to Slide 13 to walk through the financial update for our DME segment. Total revenue for the quarter was approximately $13.2 million. After deducting approximately $11.7 million in operating expenditure, operating income was reported at a positive $1.5 million. Adjusted EBITDA for the quarter was approximately $3.6 million, which bolsters our view that DME is a business characterized by meaningful growth potential both in the near- and long-term. I'd especially like to highlight this quarter's levered free cash flow generation of roughly $2.4 million as measured by EBITDA, less maintenance capital expenditure, less interest expenses. Please turn to Slide 15 to discuss the Investment Management vertical. We believe Investment Management is an attractive business for Great Elm due to its scalable business model, high margins and the potential for significant free cash flow generation. In the near-term, we plan to grow our Investment Management business in two ways; first, by addition – by issuing additional debt at Great Elm Capital Corp, which would increase GECC’s assets, Investment Management fees for Great Elm; second, by increasing co-investment assets under management. We launched the Great Elm opportunities fund one in July of 2018, creating a vehicle for investors to target the type of asymmetric risk and return co-investment opportunities on which our team is historically focused. With significant embedded operating leverage and an established infrastructure, we believe the Investment Management business has the potential to generate substantial free cash flow. Turning to Slide 16, the year-over-year increase in management fees received its parent in the chart. We intend to continue to grow AUM and the associated fees. On Slide 17, we break out the segment financials for our Investment Management. Total revenue, which includes both management fees and administration fees were $915,000 during the quarter. A full circle consulting fee which will no longer be charged post November 3, 2019, deducted $198,000 from revenues in the quarter. GECM earned but did not recognize incentive fees in the amount of $772,000. Adjusted EBITDA was $983,000 in the quarter. With no CapEx to report, Investment Management free cash flow came in at $167,000. Please turn to Slide 17 to discuss Real Estate. We continue to target credit tenant lease financings and ground lease structures across commercial government and other property types, taking defined situations in which we can use GEC’s substantial tax assets and deal structuring expertise to be a value added partner or landlord. Let's turn to Slide 20. As you see on the chart, assuming no appreciation in the property value, GEC’s equity value in the Fort Myers property will continue to grow between now and lease expiry in 2030. As cash flows from the rental stream have utilized to amortize debt, equity grows from onetime our investment in acquisition to greater than 7x in 2030, all without deploying any additional capital. Turning to Slide 21 to walk through segment financials for Real Estate. During Q2 2019, we generated approximately $1.5 million in rental income, $38,000 in net income and $1.1 million of adjusted EBITDA. We’re not generating free cash flow for Great Elm as we discussed on the prior slide, we continue to build equity value in this investment through the amortization of debt. Now that we've concluded our review of Great Elm’s fiscal second quarter, I'd like to take a moment to discuss John Woods upcoming departure. Since John joined us, Great Elm has transformed from a company with one business to a company with three businesses. John built a department that has managed the associated accounting complexity well, which could not have happened without his tireless efforts. We're all grateful for his contribution to Great Elm.

Thanks, Peter. I would like to thank Peter and Adam for giving me the opportunity to join the Great Elm team, approximately two years ago. I'm proud of the work we have done over the last two years, but the avoidance of doubt, my departure from Great Elm is strictly for personal reasons. I wish Peter and the rest of the team the best of luck going forward.

Thank you, John. Let's open up the call for Q&A.

[Operator Instructions] I do have a question from Kyle Mowery, GrizzlyRock. Your line is open.

Good morning, Peter and team. Two questions from me; number one, on the DME business. I know you went through the numbers relatively quickly. Where are we on a run rate number of EBITDA? I know that there were some deferred EBITDA and also you mentioned 25% growth. So I would guess we're above the $12 million EBITDA that we kind of closed on in September. Am I accurate? And if so, do you have a run rate number that you can discuss?

Sure. Thanks you, Kyle, and good question. So yes, the business is running ahead of our internal expectations and there is some mild seasonality in the business as well as in the four months that we've had it. There have been some timing of expenses that have fallen in particular quarter. So I think the right way to think about it is to look at the year-to-date adjusted EBITDA of just over $4.9 million and to think about analyzing that which is meaningfully ahead of the number that we announced when we announced the transaction in September of last year.

Okay. That makes sense. So there's some bump in Q4 as customers maybe come up against their insurance year-end. Is that why the seasonality exists?

Yes. That is exactly right.

Okay, got it. And then on the co-investment opportunity and investment management, is that for single tranches of distressed debt or is that more of a vehicle to kind of to a number of tranches in one “fund”?

It could be either of those. We've got the flexibility to do both. The intention is to take high quality ideas and to use those and hope – and the money that we will hopefully make for a significant investors to build a more expansive in longer term relationship and ultimately leverage that into a fund or portfolio via separately managed account.

Got it. So that's sort of a fledgling where the industry is going sort of a setup just to kind of prime the pump when you guys find something interesting to do. Is that reasonable?

Very well said.

And then, is that a more of a traditional hedge fund economics with respect to performance allocation product or is that more of a fee on the product?

I think we'd expect the bulk of any fees that we generate from a co-investment product to come from performance-based incentive fees.

Got it. Thanks.

I imagine that each opportunity will have a somewhat different structure, but the bulk of that across the vehicle should come from incentive fees.

Great. Well, it's definitely on trend that’s why we see the industry doing, so keep up the good work.

Thanks, Kyle. I appreciate it.

[Operator Instructions] I have no further questions at this time. I turn the call back over to the presenters for closing remarks.

Thank you, again for joining us this morning to discuss Great Elm Capital Group's second quarter 2019 financial results. We appreciate your support and we look forward to creating long-term shareholder value together. Please do not hesitate to reach out to us if we can be helpful with anything in follow-up and have a great day.

Thank you everyone. This will conclude today's conference call. You may now disconnect.