Gladstone Capital Corporation (GLAD) Q3 2017 Earnings Report, Transcript and Summary

Good day, everyone and welcome to Gladstone Capital Corporation Third Quarter Earnings ended June 30, 2017 Earnings Call and webcast. At this time, all participants are in a listen-only mode. Following management's prepared remarks, we will host a question-and-answer session and our instructions will follow at that time. [Operator Instructions] As a reminder this conference is being recorded for replay purposes. It's now my pleasure to hand the conference over to Mr. David Gladstone. Sir, you may begin.

Alright, thank you Brian. Nice introduction. Hello and good morning to everyone. This is David Gladstone, Chairman. And this is the third fiscal quarter earnings conference call for shareholders and for analysts of Gladstone Capital. Fiscal year-end is of course is September 30 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 your company and answer any questions you might have. Now, we'll hear from General Counsel and Secretary, Michael LiCalsi, he is President of Gladstone Administration, which is the administrator for all of the Gladstone funds. Michael, take it away.

Good morning, everyone. This conference call may include forward-looking statements within the meaning of the Securities Act of 1933 Securities Exchange Act of 1934, including statements with regard to the company's future performance. 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 or can be found on our website Gladstonecapital.Com or the SECs Web site sec.gov. The Company undertakes 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 and market information is not a guarantee of future results. You can read our earnings press release issued yesterday and also review our Form-10Q for the quarter ended June 30, 2017 and also filed yesterday with the SEC. You can access the press release and the 10-Q on our website at www.gladstonecapital.com and also on the SEC's website at www.sec.gov. An audio replay of this call will be archived on our website. Now, we will begin to hear from Gladstone Capital's President, Bob Marcotte. Bob take away.

Good morning and thank you all for dialing in today. Starting with our investment activities for the quarter, we were successful in closing three new investments representing $29 million of new originations for the quarter. Follow-on investments totaled an additional 8 million. However, after the partial sales on one of our largest investments as well as prepayments, net originations totaled a healthy 31 million. Additionally, since the end of the quarter we exited one syndicated loan investment netting 4.8 million in proceeds. Based on the cumulative investment activity over the past two quarters, we're pleased to report that we've increased the fair value of our investments by $57 million to $345 million as of June 30, which is up 20% for the six months and has significantly improved our core interest earnings position. Looking forward, while re-financings have been light in the past couple of quarters, we do expect them to pick up over the balance of the calendar year. However, we are also proactively managing a sizable new investment pipeline, which we believe should limit the impact of any uptick in prepayments as we continue to strive to maintain our credit discipline and grow the portfolio and interest income to support our shareholder distributions. Drilling deeper into the changes in the portfolio and performance for the quarter, the majority of the investments closed in the quarter were second-lien investments. As a result, our second-lien loans increased from 39% to 44% of the fair value of our investments and first-lien loans dipped to 50% at the end of the quarter. This shift was entirely driven by recent deal flow and we would expect Unitrans loans which tend to be larger in individual size to increase the first-lien loan mix overtime, which is consistent with our long-term investment strategy to have first-lien assets represent the majority of our investments. The cumulative portfolio shifts as well as the increase in LIBOR combined to increase the weighted average yield on the portfolio to 11.5%, which is up slightly from the prior quarter. For the quarter we experienced a small net appreciation in the portfolio of approximately 1 million or $0.04 per share. This positive movement was driven by improved operating performance, which resulted in the reduction in the unrealized depreciation on several investments. Negative valuation movements included in the markdown of two equity positions negated the generally positive operating trends in the portfolio. However, we continue to be optimistic, we should see additional reductions in unrealized depreciations within the portfolio as these companies report their financial results in the coming months. We're continuing to work with new management teams that are two non-accrual investments to effect improvements. However, our financial exposure to these companies is largely unchanged from the last quarter and they continue to represent a cost of approximately 27.9 million and a fair value of 7.5 million or 2.2% of our portfolio at fair value. We currently have 47 companies in the portfolio, which is up three from the prior quarter given our closings discussed earlier. Consistent with the asset growth highlighted last quarter and the slight increase in our average yield total interest income rose by 12.1% to 9.6 million compared to the prior quarter. However, with no exits on the quarter, we realized nominal fee income during the quarter. The total investment income on the quarter rose by 9.5% as a result to 9.6 million. Despite the drop in fee income, an increase in the interest expense is associated with the growth in average earning assets, the net interest margin improved to 8.9% for the quarter. Total expenses including net management fees rose by $800,000 with the increased asset base. Net investment income on the quarter was 5.4 million, which represents a 6.5% return on the average portfolio outstandings. Including the net portfolio appreciation and the slight increase in leverage, we generated 11.7% return on equity on the quarter and the tam remains committed to the proactive management of our portfolio with the goal to maintain our net asset value and demonstrate consistent return on equity. Based on the current pipeline of deal activities, we're optimistic we can continue to grow our assets and core interest earnings while maintaining our investment discipline and portfolio yields. In addition to utilizing our untapped borrowing capacity, we intend to prudently use our recently amended ATM program to issue common stock while we're trading above net asset value to support the growth of our investment portfolio and net investment income. And now I'd like to turn the call over to Nicole Schaltenbrand, our Chief Financial Officer, who'll provide an update and details on the third quarter results.

Thank you, Bob, and good morning everyone. Let's begin by reviewing the income statement. For the June quarter, total interest income increased by $1 million or 12.1% over the prior quarter primarily due to the increase in the weighted average principal balance of our interest-bearing investment portfolio from $305.7 million during the prior quarter to $333.2 million during the current quarter. Other income decreased by $200,000 as there were no significant prepayment fees or success fees received during the current quarter. Total expenses increased by 23.8% quarter-over-quarter primarily as a result of the $400,000 increase in net management fees and a $300,000 increase in interest expense on our line of credit outstanding. Both of these items are driven by the increase in assets outstanding period over period. For the quarter ended June 30, net investment income was $5.4 million or $0.21 per share and covered 100% of our shareholder distribution. As we have demonstrated over the last several years, our advisor remains committed to crediting its fee so that net investment income covers our shareholder distribution. Moving over to Gladstone Capital's balances sheet, as of June 30, we had approximately $361 million in total assets, consisting of $346 million in investments at fair value and $15 million in cash and other assets. Liabilities totaled approximately $144 million and consistent primarily of $82 million in borrowings on our line of credit and $59.6 million in our Series 2021 Term Preferred Stock. Net assets increased by $4.3 million since the prior quarter based on the net portfolio appreciation that Bob talked about earlier, as well as the issuance of approximately 362,000 shares of common stock under our ATM program, at a weighted average price of $9.89 per share for the period. These factors are partially offset by a small $200,000 increase in unrealized depreciation associated with the valuation of our bank credit facility. NAV per share increased by $0.05 to $8.38 as of June 30 compared to $8.33 as of March 31. Looking forward we continue to be well positioned to benefit from any upward movement in interest rates as 89% of the portfolio is tied to floating rate investments. The weighted average LIBOR floor on these assets is 1.3% and with only $82 million a floating rate debt, 100 basis point rise in LIBOR should generate an approximate 7% increase NII. Inclusive of the net originations over the past quarter, we are well positioned with a very strong capital position with low debt to equity of approximately 66% and approximately $70 million of availability on our $170 million credit facility to fund additional new investment. And now David will conclude the presentation.

Okay. Thank you, Nicole. That was a good presentation. Bob and Michael, you did a great job of informing our shareholders and analyst that follow our company. In summary, the team made three new loans and a good quarter, $229 million, the team also maintained a middle market focus and overall portfolio yields managed our portfolio that has a few challenges in it and maintain a strong capital position so that they're in a great shape to continue to grow the assets of the business. Just to mention the economy is stronger. It seems to be hitting on all cylinders. I don't see anything on the horizon that would have a major impact on the economy. If there is something happening in the economy then I think the balance sheet of Glad will be strong and withstand any of the problems that come out of that. So we're just going to keep on trucking down the road and do the best we can and making good loans to good companies. And marketplace for our type loans is competitive but not so bad that we won't get our share of the transactions. We like working with the buyout funds that we work with and the others we help many times they prefer our team over others because we add value to the due diligence process and we also add value to the ongoing management of the businesses. There are few loan funds that are 100% passive and just compete on price. We're not competing on price, we're part of the team that's seeking to get the businesses that we finance over the goal line. On distributions, Gladstone Capital remains committed to paying shareholders a cash dividend. In July, the Board of Directors declared a monthly distribution to common stock of $0.07 per common share from month of July, August and September and annual rate of $0.084 per share. I understand a sizable number of BDCs have cut their dividends but we don't have any reason to cut our dividend. I'm working with the team to grow the assets so that we can increase the dividend. Through the day to this call, we've made 174 sequential monthly quarterly cash distributions to our common stockholders to almost $294 million and we've never missed a distribution. It's about $11.36 per share for the shares outstanding at June 30. Current distribution rate of our common stock and with the common stock price did $9.89 yesterday, the distribution rate is producing a yield of about 8.5% which continues to be an attractive relation to all the yield oriented alternatives of out there especially on a risk adjusted basis. I don't see the great risk here. Monthly distributions of 6.75% on our preferred stock which translates into a $1.69 annually in stocks trading at about $25.50 so that reduces the yield little bit to about 6.6% but that's a very safe stock to hold for income. In summary, the company seems to be improving financially in private businesses that are mid-size with good management teams, many of these are owned by a mid-sized buyout funds that are looking for experienced partners like us to lend the money and be part of the team as it gives us a chance to make attractive interest paying loans and support our ongoing commitments to pay cash distributions to shareholders. With strong team in place, so look for good things to happen as we go forward. And now let's take a minute for questions from the good people that have called in today, so operator, if you'll come in and give instructions on how to ask the question, please.

My pleasure, sir. [Operator Instructions] Our first question will come from the line of Christopher Testa with National Securities. Please proceed.

Hi. Good morning, guys. Thanks for taking my questions. Just for the commentary on unit tranche originations likely picking up. Just curious what you're seeing from the portfolio of companies that you work with and the investments you're seeing in terms of their preference for the unit tranche structure versus the bifurcated structure which kind of made a comeback earlier in the year or just how that's kind of changed for you over the past couple of quarters?

Good morning, Chris. The unit tranche has always been more popular in the lower middle market where we play anywhere between $3 million and $7 million or $8 million. It really doesn't take - it doesn't make sense to bifurcate and go through the legal cost and complications. So unit tranche have always been preferred, the question is whether your leverage level is above what the commercial banks or the traditional cash flow senior lenders are willing to leverage the business at. So if you're at 3.5 or 4 turns to leverage and you're in that size range, you're going to do an unit tranche. And so with the growth opportunities, with the more opportunistic investments in the economy, we're going to see more unit tranches as we go forward and we continue to expect that. As you go larger, the question is whether it's a tradeoff in pricing, do you bring in an ADL at two point, 2 over LIBOR and a subject tranche to do the deal or not. The only case the big guys are good looking for unit tranche is where there's a complicated credit story and the risk profile to the junior capital makes it hard to raise and in that case lower amortization any more secure collateral structure are tracking unit tranches. But that's a different game that we don't traditionally play in today.

Got it. That's great color. Thank you. And just given the past couple of quarters you guys got very strong originations, very like repayments. Just curious in terms of the originations, particular industries or sectors that have been kind of bright spots for you and whether there has been any additions to personnel that have generated this or whether this is just kind of just pick up an activity across the board?

You know the sectors move around a little bit. We always continue to have a healthy mix of healthcare related investments. Obviously we're very cautious in those environments given the shifting situation in D.C. regarding healthcare and ECA. We are having a number of manufacturing oriented businesses, we seem to have a pretty good position in aerospace and defense. We traditionally have done a lot of manufacturing and that kind of business. There is certainly a movement back to the U.S. in some manufacturing sectors. So we're seeing growth in businesses that either supply aerospace and defense or a middle processing highly automated facilities that are growing. We're steering clear of obviously some of the largely the auto-related businesses where we are seeing some investments but that's not a business that we're going after. And then business services continue to be a very healthy position for us. For example, one of the deals that we closed last quarter was business services supporting municipal, purchasing and municipal efficiencies on acquisition and group purchasing. So business services generally speaking is where I think we're seeing most of our growth at this stage. In terms of personnel really no change in personnel, we have maturation and some folks who have been with us for a while that are moving up and beginning to produce more. I think we're also very much focused on where we can play and by being disciplined and pushing harder in areas where we think we have opportunity. We're just seeing more deals. We've traditionally seen somewhere between 100 and 125 deals a quarter. We typically will indicate and get involved in maybe 15 to 20 of them. I think we probably up that pace in the last quarter or two. And while we will lose a few because of pricing. I think we're beginning to take down our fair share in a healthy kind of lower middle market economy today.

Got it. And pricing aside, just curious what you're seeing in terms of structures particularly on the unit tranche products whether companies are kind of asking for more leverage, if sponsors are pushing this, just your thought on that are appreciated.

The leverage levels probably have picked up I think it would be hard to deny that obviously sector by sector they're slightly different but with the lift in enterprise multiples that some of our sponsors are paying, there has been a pickup in leverage levels where we were probably doing 3 to 3.5, we will certainly see some numbers north of that but that's a far cry from obviously the larger syndicated transactions where it's probably a 1.5 turn to 2 turns higher.

Right.

We are very, very focused even at the 0.5 turn to 0.75 turn increase that we're generally seeing. We're very cautious in focusing on two things. One is, with the organic growth profile of the business to deleverage. And two, what's the free cash flow profile to support that leverage in a sensitivity situation. Just because the enterprise value might be up to 7, 8, 9, doesn't necessarily mean that it's got the cash flow to support it. So I continue to like our position in the marketplace in light of where the multiples are and we are very mindful of where the leverage attachment points are going.

Got it. Okay. And just kind of shifting gears and looking at capital I know you guys issued a bit under the ATM program. I guess just how should we look at that going forward? The balance sheet leverage is relatively modest. You have a lot of dry powder in terms of the credit facility. Just curious how you're thinking of opportunistically utilizing that whether we should expect kind of a little bit like $3.5 million or so like each quarter or just whether these are going to kind of be one-off situations?

Look I think the last quarter you can - you've seen our stock performance, it was strong, it was stable. It's helping the liquidity and the opportunity for investors to come into our shares. And I like the impact I would expect that we would keep that open. And if we could do $3.5 million to $5 million in a quarter at 116% of now that's I think a very accretive opportunity for us to continue to grow the balance sheet. And as long as we are looking at opportunities that are a multiple of our additional capacity on our lines, there is no reason not to be continuing to use that facility. It's incredibly cost effective and it has added value for the trading and stability of our shares.

Got it and has there been any thoughts on potentially retaining the preferred stock with potentially a baby bond issuance?

You've raised this I think the last quarter, Chris. Yes, we are evaluating alternatives there and refunding that. We believe that there is a pickup opportunity given current interest rates that issue was callable effective in June. So we are within the call window to pursue, we are evaluating various alternatives. We would obviously look to maintain some measure of fixed rate and extend the maturities as part of that equation. That's certainly on our list to improve our cost structure and it's being evaluated.

Got it. That's all for me. Thanks for taking my questions.

Thanks, Chris. Next question.

Thank you. [Operator Instructions] Our next question will come from the line of Bill Brown, private investor. Please proceed.

Yeah, good morning. Love the continued good work on the return on equity. Question in terms of last time you had talked about hoping to continue the pace of between $15 million and $25 million of net additions, with the goal of maybe even getting closer towards the $400 million mark in net assets is the way of starting to look to raise the income and therefore raise the dividend, is that something that's still looking for in terms of as we look towards the end of the calendar year?

Bill, we're still pushing to increase assets. You have to increase assets, very difficult to increase the dividend unless you increase the assets. So it all works together. You got to have stock price that's high enough to make sense for issuing new shares so that you can do more. You got to have ability to leverage at a decent rate and then at the same time put on the books something's going to be very accretive to shareholders. And so we're always looking at all of those to make sure that shareholders come first. As you know I'm a large shareholder. So I like dividends like everybody else and nothing would please me more than to increase the dividend, but we've got to get a lot bigger before we can get down that road, but we're still on target.

If I can add to that, Bill, we will increase the assets I think that, that momentum I think we've clearly established. I will say that on the other factors that will affect the dividend where interest rates are as a huge impact to our flexibility on dividends. I would think that two or three quarters ago if you were to look at where LIBOR might be at the end of the year, everybody was at least 2% and maybe somewhere upwards of 2.5%. Given the rate sensitivity and what it means to our net interest income, given the hurdle rates in the management fee structures, rate levels are very important. So you tell me when rates start to move. I think generally we probably move the increases to the right a little bit. They're coming a little slower than we expected. If we can get to a 2% LIBOR, I think it certainly makes a heck of a lot easier than 1.25% to move the distributions. The other thing that we need to be pushing on is as some of these repayments come in and while that's contrary to growing the assets, it will generate fee income. Fee income is something that we didn't have a lot of this quarter. Fee income also will help support some of that additional amount. And lastly I think as the last question suggested, lowering our financing costs improve some of it. So there's a combination of things that we will need to work. Assets alone are not necessarily going to get us there. We need to be working on all of those equations, but as long as the health of the portfolio is there, I think we have a solid base to grow off it right now and as you saw our core interest income moved up dramatically this quarter and we are focused on continuing that trend.

That's great. Thank you.

Okay, another question.

Thank you, sir. I'm showing no further questions at this time for now. I'd like to hand it back over to Mr. David Gladstone for some closing comments and remarks.

Alright, thank you all for calling in. The next meeting will be when we finish the year. So it'll be a good time talk about strategy going forward and we'll see in another couple of months. That's the end of this call. Thank you.

Ladies and gentlemen, thank you for your participation on today's conference. This does conclude the program. And you may all disconnect.