Gladstone Capital Corporation (GLAD) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Gladstone Capital Second Quarter Earnings Call. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, today's conference is being recorded. I'd now like to introduce your host for today's conference Mr. David Gladstone. Sir, please go ahead.

Alright, thank you Liz. Nice introduction. Hello, everyone. This is David Gladstone, Chairman. And this is the second fiscal quarter earnings conference call for shareholders and analysts of Gladstone Capital and our common stock is traded under the symbol GLAD and the preferred stock is traded under the symbol GLADO, and thank you all for calling in. We're always happy to talk to our shareholders and the analysts and welcome the opportunity to provide an update on the company and its Investment portfolio. As always, and I do this every time, have an open invitation to stop by and see us here in McLean, Virginia. We're just outside of Washington, D.C. The Gladstone team has grown to over 60 people now and we're little over $2 billion in assets under management. And now General Counsel, Secretary, Michael LiCalsi, who is also President of Gladstone administration, which is the administrator for all of the Gladstone funds and related companies and he is going to make a statement regarding forward-looking statements. Michael?

Good morning, everyone. This conference call may include forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934, including statements with regard to the company's future performance, and these forward-looking 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, intents, will, should, may and similar expressions. And 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 listed under the caption risk factors within our Form 10-K filing and our registration statement, all is filed with the SEC, and they can be found on our website www.Gladstonecapital.Com or the SECs Web site which is www.sec.gov. 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. And please also note that any past performance or market information that we give is not a guarantee of any future results. We ask that you visit our website and sign up for our email notification service. You could also find us on Facebook with the keyword, The Gladstone Companies and follow us on Twitter @GladstoneComps. You can read our earnings press release issued yesterday and also review our Form-10 for the quarter ended 3/31/17 also filed with the SEC yesterday. You can access the press release and 10-Q on our website gladstonecapital. Com. Incidentally, an audio replay of this call will be archived on our website as well. And now, we will begin the presentation by hearing from Gladstone Capital's President, Bob Marcotte.

Good morning and thank you all for dialing in today. As a reminder for any new callers, Gladstone Capital is the lending fund with the Gladstone Companies family of publicly traded funds and our core strategy is to provide cash flow-based loans to privately-held U.S. based lower middle market businesses with $3 million to $15 million in earnings before interest, taxes and depreciation. We target to maintain approximately 90% of our investments in debt investments and the majority of which are senior secured loans to growth oriented or recession resistant businesses, which have the revenue visibility and cash flow profile to support and leverage capital structure. The majority of our loans carry floating interest rates tied to LIBOR and our net investment income should rise with interest rates. With that introduction, let's get into the results for last quarter. Last quarter, we cited a modest improvement in the middle market M&A deal volume and sponsor driven financing activities. And for the quarter, we closed on 2 new investments representing $39 million of new originations. Net of the two prepayments in the quarter, we generated a healthy level of net originations of $26.3 million. Additionally, since the end of the quarter, we are pleased to announce that we closed an additional $22 million proprietary secured second lien investment. Based on the cumulative investment activity since our last call, we've been able to reinvest all of the prepayments of the prior quarter and grow our investments by an additional $15 million since our year-end. While financing conditions may change and portfolio re-financings can be difficult to predict, given our current deal pipeline, we believe we are well positioned to capitalize on the ongoing health in deal flow within the lower middle market to meet our portfolio growth objectives. With respect to the portfolio, the weighted average yield of our loan portfolio was up slightly from the last several quarters to 11.4%, as we've been successful at closing new originations at accretive yields. With the net originations on the quarter, our first lien secured investments rose slightly to 55.5% of the fair value of the portfolio as of March 31st, and second lien investments declined to 38.6% of the portfolio at fair value at the end of the quarter. For the quarter ended March, we experienced a small net realized and unrealized depreciation on the portfolio of $600,000 or approximately $0.03 per share. We experienced positive movements in several credits including SourceHOV due to a pending merger and as a result of significant new business awards at Defiance Stamping, as referenced previously. Unfortunately, the number of negative movements outnumbered the gainers which included Alloy Die Cast, which is undergoing an operational restructuring and was moved to non-accrual during the quarter. Several of the other decliners, while down on the quarter are experiencing positive operating trends and we are optimistic we will see appreciation on several of these investments as they report financial results in the near term. At the end of the quarter, our two non-accrual investments represented a cost of $24.4 million and a fair value of $7.1 million or 2.4% of our portfolio. We currently have 44 companies in the portfolio, which is unchanged from the prior quarter. Our portfolio remains highly diversified by industry classification with 22 different industries and headquartered in 21 different states. With respect to the portfolio yields, for the March quarter, total interest income was flat at 8.6 million compared to the prior quarter, as a small decline in average interest earning assets was offset by the improved weighted average yield. Other fee income on the quarter declined by 1.1 million from the spike associated with the large exits of last quarter to $200,000. Total investment income on the quarter declined with a lower fee income to 8.8 million. While the total investment income was down 11.8%, this decline includes very little interest income from the recent origination volumes, which would have negated much of this decline and lifted the March quarter net interest income by approximately $700,000. Additionally, in the quarter, reduced operating expenses and lower advisory incentive fees contributed to a $500,000 reduction in total expenses compared to the prior quarter. However, in light of the dip in investment income on the quarter, the adviser elected to waive their $1.1 million incentive fee for the quarter. As a result, GLAD generated net investment income of 5.4 million, which represents a 10.1% return on assets in the quarter. For the LTM period, the combination of steady investment yields and lower portfolio volatility has allowed GLAD to lift our average ROE for the last four quarters, inclusive gains and losses and excluding any adviser waivers to 14.9%. Regarding the outlook and the investment climate, based on my market related comments of earlier and our current pipeline of deal opportunities, we're optimistic that we can continue to grow our investments and have significant untapped borrowing capacity to support our net asset growth, while maintaining our investment discipline and portfolio yields. In addition to growing our earning assets, the teams remain committed to the proactive management of our portfolio with the goal to maintain our net asset value and demonstrate a consistent return on equity. And now, I'd like to turn the call over to Nicole Schaltenbrand, our Chief Financial Officer, who'll provide an update on the Fund's second fiscal quarter financial results.

Thank you, Bob, and good morning. Let's start by reviewing the income statement. For the March quarter, total interest income was flat at 8.6 million. Other income, consisting mostly of dividends or success fees received declined quarter-over-quarter from 1.3 million to $200,000 and was the primary cause of the drop in total investment income since the prior quarter to 8.8 million. Interest expenses in the quarter were largely unchanged and total net interest income on the quarter declined by 100,000 to 6.7 million. Non-financing costs declined by 1.4 million compared to the prior quarter, due to a 1.1 million decrease in net management fees and a 300,000 decrease in professional and other general and administrative expenses. For the quarter ended March 31, net investment income was 5.4 million or $0.21 per share and covered 100% of shareholder distribution. As we have demonstrated over the last several years and in the most recent couple of quarters, our adviser remains committed to creating its fees so that annual net investment income covers our shareholder distribution. Moving over to Gladstone Capital's balance sheet; as of March 31, 2017, we had approximately 329 million in total assets, consisting of 314 million in investments at fair value and 15 million in cash and other assets. Liabilities totaled approximately 116 million and consisted primarily of $54 million in borrowings on our line of credit and $59.5 million in our Series 2021 term preferred stock, net of deferred financing cost. Our net asset value declined by $0.03 per share quarter-over-quarter, which was driven by the lower amount of net unrealized depreciation that Bob covered earlier. As of March 31, GLAD's NAV per share was $8.33 compared to $8.36 as of December 31, 2016. Looking forward, we continue to be well-positioned to benefit from any upward movement in interest rate, as 89% of the portfolio is tied to floating rate investments. The weighted average LIBOR floor on these assets is approximately 1.3% and with only $54 million of floating rate debt, a 100 basis point rise in LIBOR should generate an approximate 7% increase to NII. Inclusive of the net originations of the past quarter, we are well-positioned with a very strong capital position with low debt-to-equity of only 55% and approximately $65 million of availability on our credit facility to fund additional new investments. And now, David will conclude the presentation.

Okay. Thank you, Nicole. Nice presentation from you and Bob and Michael. You've done a good job, I think, of informing our stockholders and the analysts that follow our company. In summary, Gladstone Capital had a good quarter and the team made several new investments of about $39.6 million, I round it out to $40 million, and then afterwards, we closed another $22 million. So about $62 million of recent closings and I think that's a good start for this quarter. The company has maintained its middle market focus and overall portfolio yield at 11.4%. We had some payoffs, some big loans paid off in past quarters, but we've now successfully invested that money that we got back, some of it was invested toward the end of last quarter and now some this quarter. So we're doing well and getting back and I think the topline will go up again. We maintained a strong capital position and shaped the growth of the loan assets and I think shareholder distributions are in a good position. Unlike some of the other business development companies that have cut their dividend, or as they call it right-sizing their dividends, Bob Marcotte and his team have focused on leveraging our presence in the lower middle market and maintaining the investment yields. We've reduced cost and have raised the advisory fee where necessary to support the shareholder distributions. Based on the strength of the portfolio, recent growth, and momentum, I think the outlook for possible interest rate increase, well, I just think that's positioned us very well for our net investment income to go up and hopefully that will flow into some strong dividends for our shareholders. Right now, I see nothing in the near-term or in the future that would say to us, we have to cut our dividend like so many other business development companies did. We are in a strong position today. And there are, however, always things in the economy that make one nervous, but at this point, there's so much optimism in the economy and the companies that are out there. I think we are all headed toward some good times. Some of those good times are talked about in terms of the change in the government, but it's largely part of, it has to do with the earnings of public companies that are showing quarter-over-quarter strong results and if half of the tax cuts that you're talking about have been and enumerated many times now by the new administration as well as Congress, if those come true, they will just explode upward in terms of the economy, because all of that money can be used to grow the economy. Keep talking about tax cuts, and as all of you know, many of those tax cuts would be highly beneficial to small businesses and small businesses create 60% to 80% of all the new jobs. So, if they can get half of those through, it will make a great deal of good news for the economy, but also for our portfolio companies, if you want to play on tax cuts for small businesses, this company is the right one to look at. Gladstone Capital has remained committed to paying shareholders a cash dividend. In March, the Board of Directors declared the monthly distribution on our common shareholders of $0.07 per common share per month for April, May and June. I see no reason not to be able to continue that. Through the date of this call, we've made a 171-sequential monthly or quarterly cash distributions to our common shareholders. It's about $289 million, never missed that distribution and about $11.31 per share on the shares outstanding at March 31, 2017. Current distribution rate on the common stock, $0.84 per share per year, the common stock price now at $9.77, that was yesterday; distribution run rate is now producing an 8.6% yield, which is a very attractive yield, given the strength of the company relative to most yield-oriented alternatives; monthly distribution of 6.75% of our preferred stock, so $1.69 annually. The term preferred stock had a closing market price yesterday that gives us a great yield on the stock. And for those who want an absolutely knowing that the dividend is going to be there, GLADO is a terrific yield [ph] for it. In summary, the company sees improving marketplace where we can make interest paying loans and pay cash distributions to stockholders. DA Davidson already came out with a buy recommendation and I think we'll get some more positive news in the marketplace from analysts. And, we have a strong team in place and are going to keep going and doing what we're doing. And now, I'll turn the call back to the operator to take any questions from the good people that have called in.

[Operator Instructions] We have a question from the line of Arren Cyganovich with D.A. Davidson.

The commentary we've had from a couple of BDCs that play in the upper-end of the middle-market has been somewhat cautious about investing environment. I was just wondering if you could contrast that to what you're seeing on the lower middle market, because it sounds like you're seeing deal flow and opportunity that's still consistent with what you have already in the portfolio?

I think when you look at the deal volumes that we'd seen and the opportunities, Arren, on the quarter, it's actually been remarkably consistent. We probably look at, as I said, somewhere between a 100 and 120 deals every quarter and when it works its way through the funnel, we probably chase 15 to 20 and target to close three to five. And that has not changed. Last quarter, the numbers were actually somewhat on the higher side in terms of total number of opportunities and indications and proposals. So, we're continuing to see the volume, but I think that's consistent with a much broader market at the lower middle market. Certainly, there has been an increase in some of the non-sponsored financing activities, which we will do. But I think it's the fundamentals there aren't as many people playing at the lower end of the middle market and the volume of M&A activities at the lower end of the middle market, for example, was up last year, whereas the overall market for M&A in the middle market was down. So I think it's the resilience of the lower middle market, combined with a broad coverage and funnel that continues to provide good opportunities for us.

In terms of the -- you had one relatively small new nonaccrual in die casting and I think it's marked around 80%. What gives you comfort that you have that marked correctly? Are there any assets supporting that, something of that nature?

That asset is a business that we'd had to go through and the company has made some changes to the management team. We had been monitoring it for a period of time. As all of our investments, we have board observation rights. But in this case, it's actually a co investment with GAIN, who is the controlling shareholder in that company. So we have intimate visibility in terms of the operations, the management, and the focus on the activities. Overall, the die casting business has been pretty strong. We actually have another company in our portfolio that we closed couple of quarters ago. So, we have good visibility on the end market, which is strong. We have had some production issues within that company. They're all generally correctable issues and the management team has been turned over and those are in the process of being reworked. So, more than anything else, we focus on the end market and that's a strong end market that we have exposure to and we have good visibility on the changes that are being made at the operations on the part of our affiliated investor team at GAIN. So I think we'll see improvements in that over the course of the next couple of quarters.

Our next question comes from Tyler Agee with Hilliard Lyons.

Could you provide some color on the pricing environment that you're seeing?

Bob, you want to?

The pricing environment is kind of a tough one to call. Certainly, the sponsor market is getting more challenging. Obviously, given the continued elevated valuation levels, sponsors are looking to shop and access capital at elevated multiples as well as, as cheap as they can certainly source that capital. So what we're finding is, deals that have a reasonable size ticket, let's just say, it's a $10 million EBITDA business and they want to raise 3.5 turn or 4 turns of leverage, that $35 million or $40 million ticket is a very attractive investment opportunity for many middle market investment funds. So that could be a BDC or it could be a private debt, credit fund of some form. If that business is relatively straightforward and the sponsor is shopping aggressively, there are a lot of folks that will bid down that pricing on a unitranche basis. And quite frankly, some of those credit funds probably can price below what a BDC typically will require. So, we look at those situations and we're either going to look at the story or look at a sponsor who is looking for a good long-term partner, and there occasionally we'll get priced out of that. But for the most part, what we're seeing is in the smaller end of the market, where your partnerships makes sense, where the magnitude of the dollars are not as meaningful, it doesn't degrade to a commodity approach to the financing. So what you've seen in the market and what you'll see in our SOI is we're continuing to see unitranche pricing that would be in the high-single-digits and we're seeing second-lien pricing that would be in the 11 plus range. And oftentimes, we are still able to get success fees, which are back-end fees that Gladstone has traditionally taken, which is essentially a buildup of equity value or appreciation in our portfolio. So we're still seeing that. That's the benchmarks that we're working from and that's where we are. Obviously, we get priced out of deals from time to time, but there is certainly other opportunities to pursue. As you'll see from our numbers earlier in the year, our mix of second-lien and senior shifted slightly and we had a lot of first-lien loans pay down, and we're gradually trying to work that back. So, I think part of what you're seeing in the pricing side is, we had a shift in second-lien assets that went up to 38%. I would expect that to remain relatively stable since we can obviously attract second-lien assets at a more accretive yield. I would expect us to be more 60-40 type of balance, whereas before, we were probably a little higher in senior loans.

And Tyler, I would just add that pricing is not the only determinant. Many of these sponsors that we've worked with, they've worked with us many times before and they want someone that they can trust and feel good about. We do bring a lot of added value in our analysis and the things that we've done over the years to a transaction. So, I think pricing is important to everybody, but it's not so important that you would cut a single percent off of a deal just to go with somebody new or somebody you didn't know. So we were able to work with the people and they all know what they're doing. So I still feel comfortable that the amount we are getting, which is in the middle range of 11.5% is a good number to use.

Yes, on a $15 million deal, a 100 basis points is a $150,000 a deal a year, are you going to bet your company on what's probably a $20 million equity investment and then proportionally speaking, for $150,000? Probably not.

And then, to follow that up, could you provide an outlook for exit fees for the balance of the year?

We really can't. I think, we do disclose what we have in the way of total exit fees. Obviously, our proposal, our pending exits are kind of tough to call in terms of timing and likelihood. I think majority of those fees were accrued on legacy investments, which had largely run off. So, I don't think you're likely to see a ton of those things. We're more focused on the pace of pre-payment and refinancing activities, given current market situation. So, I'm really not in a position to give you a good read on that.

It's always nice to get those fees, but you have to remember, when you get that fee, you are also getting your loan paid off, so you got to find another one. And as you know, a couple quarters ago, we had a lot of pay-offs and we've just now worked ourselves back, so that we are going to get hopefully enough top-line that we don't have to give back fees to the company.

Okay. And then lastly, were there any common themes that were driving the unrealized losses during the quarter?

As I said, I cited some of the majors beyond the ADC issue, I don't think there was anything common. Clearly, when we look at the valuations and S&P does their marks, there are lot of businesses that don't tend to have very strong winter quarters, our results would have been through January. So December and January aren't necessarily strong business quarters for a lot of our smaller businesses. And so, on a slightly softer EBITDA for those periods, you tend to end up with some marks that come out of that. The other observation that I would make is, a large percentage of our portfolio is valued by S&P, and we've had some discussions with them, but we typically are more aggressively managing some of our more challenged assets and occasionally we will use expiring maturity dates or covenants to pursue and affect restructuring and changes in those credits. S&P tends to look at short-dated maturities or covenant issues as a negative to the valuation and they will depreciate an asset. So we get a little penalized by aggressively managing our companies and driving results and making change that we'd like to see affected as a lender. And we got a few situations where, as you'll note in our financials, we extended some of the maturities on some of our facilities. But the valuation impact of managing those investments more proactive is also sometimes a negative on our valuations. And I think there are a few of those in that category. Hence my remark on, we have a number of ones that the underlying fundamentals are more positive than where those marks are currently trending. So, really do feel good about where some of those marks are likely to go in the coming quarters.

Okay, thank you. That's very helpful. That's all I had.

[Operator Instructions]. Our next question comes from Bill Brown, a private investor.

Yeah, two questions. One is, what would you say your target is for the level of assets that you'd like to be at, assuming you can keep the 11% plus rate on terms of on the interest rate, in terms of both where you'd like to see us at and particularly in terms of, if we're assuming kind of a lower trending success fee going forward, the amount of income needed to support particularly, a growth in the dividend?

Bill, I think we've talked for some time about a target of somewhere between 15 million and 25 million of net adds in assets a quarter, obviously, when we get $50 million in prepayments in the quarter, that's tough to adhere. I think the comment that we've cleared that plus 15 million in the last six months is getting us back to where we want to be. If you extend that, that probably puts us pushing 400 million towards the tail-end of this year. Beyond that, I'm not willing to put forward a crystal ball. I think if you do that, it raises our leverage a bit and it puts our interest earnings in a much stronger position. Obviously, each incremental dollar that we're reinvesting is coming from our line, which is an attractive cost of capital. So it's averaging down our cost of capital and it's a very accretive net spread at 11% in gross average yield and 4.25% today at borrowing rates. That's a pretty accretive move. So if we were to net -- increase over where we are today, after the announced add of last week, that's probably $50 million at a positive spread of the better part of 7%. That's going to put a lot of interest income. And certainly, I suspect if you run the numbers, that's more than adequate to support the distributions without very little in the way of fees. So I think you get to a point of being able to think about moving that distribution as you begin to see some visibility on that asset level. Does that help?

Yes, it helps a lot. The second question I guess is, is more of a -- I guess maybe philosophical kind of a corporate governance standpoint. Anybody who has been watching this company for years knows that there is no question you guys are totally committed to supporting the dividend and have no problem waiving the fee whenever necessary in order to do that. And I guess the question I have is, why we're doing it that way than? In other words, why not just change the agreement with the advisor so that the fee is not payable unless the company meet certain income levels and then it's paid as opposed to having the fee and then waiting it?

Well, there are all kind of ways of doing that. Unfortunately, the SEC has a formula for all of these fees and it's not as easy to do as you would think. They have a pretty much a strait jacket. If you looked at all the BDCs, you would see all of them with the same formula basis of doing it. So, we don't mind doing it this way. And so, from my perspective, you know how we run the company and anybody who has been around us for a while knows how we run the company and as a result, you get the same result at the end of the day, rather than having to go battle it out with the SEC to try to get them to change the way that they approach the formulas for these companies, so from my perspective, probably not going to make any changes.

Got it. I understand it's exactly the same result, but I just didn't know why you had to bother each year but -- each quarter what number is necessary. Okay I appreciate it, thank you.

You can make a call to the SEC and ask them why they do that.

[Operator Instructions]. I'm showing no further questions on the phone lines at this time. I like to turn the call back to Mr. G Gladstone for any closing remarks.

Thank you all again for calling in. We love these times with you, and hopefully, we'll have some great news for you next quarter as well. 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.