Gladstone Capital Corporation (GLAD) Q4 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Gladstone Capital Corporation’s Fourth Quarter and Year Ended September 30, 2017 Earnings Call and Webcast. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this conference call may be recorded. I would now like to turn the conference over to David Gladstone, Chairman, you may begin.

Thank you, Nicole. Nice introduction. Good morning, everybody. This is David Gladstone, Chairman, and this is the fourth quarter and fiscal year-end earnings call for shareholders as well as analysts for Gladstone Capital for the year ending September 30, 2017. 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 for the company and its investment portfolio. And we hope you have some good questions today. And now we’ll hear from our General Counsel and Secretary, Michael LiCalsi. He is President of Gladstone administration, which is the Administrator for all of the Gladstone funds and related companies. And he’ll make a statement regarding forward-looking statements. Mike?

Thanks, David, and good morning. Today’s report may include forward-looking statements under the Securities Act of 1933 and the Security Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties, though they’re 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 on our forms 10-Q and 10-K and other documents that we filed with the SEC. These can be found on our website, www.gladstonecapital.com, specifically the Investor Relations page or, of course, 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 take the opportunity to visit our website, once again, gladstonecapital.com and sign up for our e-mail notification service. That way you can stay up-to-date on our company. You can also find us on Facebook, keyword: The Gladstone Companies. We even have our own Twitter handle these days and that’s @GladstoneComps. Today’s call, of course, is an overview of our results, so we urge everyone to review our press release and Form 10-K, both of which were issued yesterday. Those will provide you more detailed information. Again, those can be found on the Investor Relations page of our website. Now with that, I will turn the presentation back over to Gladstone Capital’s President, Bob Marcotte. Bob?

Thank you, Michael. Good morning, and thank you all for dialing in today. As a quick overview, I’ll focus my comments on the details of the most recent quarter, transition to a few summary remarks for the fiscal year just ended and conclude with some comments on the near-term outlook for 2018. The highlights for the quarter ended September 30, 2017, include investment income rose by $1.2 million or 12.5% to $10.8 million from the prior quarter due to increased average assets and higher fee income. Net investment income rose to $5.5 million or $0.21 per share, consistent with our current shareholder distributions. Net assets from operations totaled $0.26 per share, excluding the $1.3 million write-off of the unamortized issuance costs associated with the refinancing of a higher cost preferred issue last quarter and represented a return on equity of 12.4%. Net asset value per share rose slightly on the quarter to $8.40 per share, as portfolio appreciation more than offset the impact of the $1.3 million write-off of the unamortized issuance costs. During the quarter, we closed one proprietary senior secured investment of $12.5 million to support a sponsor’s acquisition of a regional daycare operator, which, along with several smaller follow-on investments, brought the total originations on the quarter to $16.6 million. We received repayments totaling $12.4 million, resulting in net originations of $4.2 million on the quarter. The asset mix on the quarter was relatively unchanged with secured first lien debts representing 50% of our investment portfolio and total secured debt unchanged at 94% of our investments. Since the end of the quarter, our investment activity has continued to outpace repayments. Through the date of this call, we’ve closed five additional investments totaling $28.5 million and received three repayments totaling $14.7 million for net originations of an additional $13.8 million. From a financial performance perspective, increased income – increased interest income and higher other income contributed equally to the $1.2 million increase in investment income, which lifted the overall portfolio yield on the quarter to 11.8%. Total expenses rose by $1.1 million on the quarter, primarily due to the reduction in adviser incentive fee credits, management fees on higher average assets and a small increase in interest expenses. Net investment income on the quarter was $5.5 million and inclusive of the small net appreciation on the portfolio of $1.3 million we generated at 12.4% return on equity on the quarter. For the quarter, the positive valuation movements were driven by improved operating performance, including a couple of our energy-related investments. Negative valuation movements included a couple of isolated events, which we believe to be short-term valuation impacts, which offset the generally positive operating trends in the portfolio. In total, the portfolio net appreciation represented $0.05 per share. We ended the quarter with the same two non-accrual investments as last quarter. However, recent results in both companies are improving, and we’re looking forward to returning at least one of these assets to earnings status in the coming quarters. At the end of the quarter, these investments represented a cost of $27.9 million, a fair value of $5.6 million were 1.7% of our portfolio at fair value. We currently have 47 investments, which is consistent with the prior quarter. Regarding the fiscal year ended September 30, for the year just ended, we successfully increased our portfolio by just under 10%, which includes the exit of our largest single investment as of 930/16, which represented 11.6% of our portfolio at fair value. We increased our overall yield on the year to 11.6%, despite the generally market – the general compression in market yields and ended the year with non-earning assets up under 2%. For the year, we aggressively managed our operating costs, resulting in a 16% decrease compared to fiscal year 2016, which dropped our overall operating costs to 95 basis points compared to average interest-earning investments. We maintained our annual shareholder distributions at $0.84 per share in the face of other BDC distribution cuts with the support of adviser fee credits, which have been significantly reduced in the most recent quarter. We’ve executed the refinancing and extension of our preferred stock just before the end of the quarter through a combination of a new preferred stock issue ticker GLADN and a small amount of bank borrowings. The net effect of this refinancing reduced our borrowing costs by 116 basis points at current interest rates and is projected to yield annual savings of approximately $725,000 per year beginning in the current quarter. We ended the year with a strong capital and liquidity position to support the continued growth of our investment portfolio, including a debt-to-equity ratio of 65%, borrowing availability of $59 million under bank facility and an active ATM program, which has generated $10.9 million of common equity in the past year at a weighted average price of $9.80 or 117% of the prevailing NAV. With respect to fiscal 2018 and the outlook, as I mentioned earlier, we’re off to a good start with net originations, thus far, just under $15 million. Based on our current pipeline of additional awarded deals, we’re cautiously optimistic that we should see net originations on the current quarter, at least, on par with the elevated levels we reported earlier in fiscal 2017. We attribute the growth experienced in fiscal 2017 and the current deal momentum, as well as our ability to maintain our investment yields, to our continuing focus on delivering added-value solutions to the lower middle market. While the lower middle market is not immune from competitive conditions from larger asset managers looking to book private debt assets, where the occasional regional bank foray into leveraged lending, our focus on growth-oriented, lower middle market situations, leveraged lending experience, responsiveness and reputation are enduring. We continue to believe we’re well positioned to continue to grow our investment portfolio, net investment income and ultimately support the growth of our shareholder distributions. And now I’d like to turn the call over to Nicole Schaltenbrand, our Chief Financial Officer, who will provide an update on the fund’s fourth fiscal quarter financial results. Nicole?

Thank you, Bob. Good morning, everyone. Let’s begin by reviewing the income statement. For the September quarter, total interest income increased by $600,000 or 6% over the prior quarter, primarily due to the increase in the weighted average principal balance of our interest-bearing investment portfolio from $333 million during the prior quarter to $343 million during the current quarter, as well as due to an increase in the weighted average yield quarter-over-quarter. Other income increased by $600,000, primarily due to dividend income recognized on the quarter. Total expenses increased by $1.1 million quarter-over-quarter due to a $900,000 increase in net management and incentive fees and a $200,000 increase in interest expense. The increase in net management and incentive fees was driven by the increase in assets outstanding period-over-period and a $600,000 decrease in adviser fee credits since the prior quarter. For the quarter ended September 30, net investment income was $5.5 million or $0.21 per share and covered 100% of shareholder distribution. As we have demonstrated over the last several years, our adviser remains committed to crediting its fees, so that net investment income covers our shareholder distribution. Moving over to Gladstone Capital’s balance sheet. As of September 30, we had approximately $366 million in total assets, consisting of $352 million in investments at fair value and $14 million in cash and other assets. Liabilities totaled approximately $146 million and consisted primarily of $93 million in borrowings outstanding on our credit facility, $52 million in the recently closed 6% Series 2024 Term Preferred Stock at liquidation value and about $3 million in other liabilities. Net asset increased by $2.7 million since the prior quarter end due to the net portfolio appreciation and issuance of approximately 280,000 shares of common stock under our ATM program at a weighted average price of $9.86 per share for the period. These factors were partially offset by a $1.3 million write-off of our unamortized issuance costs associated with the redemption of our 6.75% Series 2021 Term Preferred Stock. NAV per share increased by $0.02 to $8.40 as of September 30 compared to $8.38 as of June 30. Looking forward, we continue to be well positioned to benefit from any upward movement in interest rates, as 92% of the portfolio is tied to floating rate investments. The weighted average LIBOR floor on these assets is 1.3%, and with only $93 million of floating rate debt, a 100 basis point rise in LIBOR should generate an approximate 6% increase in net interest income. 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 65% and approximately $59 million of availability on our $170 million credit facility to fund additional new investments. And now David will conclude the presentation.

All right, Nicole. Good report. Bob. Good report. Michael. You – all three of you did a great job of informing our shareholders and analysts, who are following our company. I’m sure all of them will read the press release as well as the other documents to get more information. In summary, Gladstone Capital had a good quarter. And our fiscal year was a good one, as well, that ended on September 30, 2017. I think the company is well positioned to continue to grow in 2018. So last quarter, in summary, the team closed three new investments, one proprietary, but a total of about $14 million ending the year on a high watermark with a great backlog. I was on the phone last night talking about one that’s trying to close now. Then after the year-end, the team closed five new investments and exited three investments that are above par, so that was a record-breaking beginning of a new year, so 2018 looks like a great year just starting out of the block. The company has maintained its middle market focus and overall portfolio yields, so nothing big changes there. And the team has been actively involved in managing any of the portfolio challenges that came up during the year as well as the couple that we have left. Maintaining a strong capital position has been something that we’ve prided ourselves on, puts us in a position to continue to grow the loan assets and should enhance shareholders’ distributions. Gladstone Capital has remained committed to paying its shareholders cash dividend in October. The Board of Directors declared our monthly distribution of common stockholders of $0.07 per common share per month for the months of October, November and December. That’s an annual rate of $0.84 a share. And through the date of this call, we’ve made 177 sequential monthly or quarterly cash distributions to our common shareholders or almost $300 million, and we’ve never missed a distribution. It’s about $11.45 per share on the shares outstanding at September 30, 2017. Current distribution rate of our common stock with a common stock priced at $9.76 that closed at yesterday. Distribution run rate is now producing a yield of about 8.6%, which continues to be an attractive relative to most of the yield-oriented alternatives today. Our monthly distribution is 6% on our preferred stock, which translates to $1.50. The term preferred stock trades under the ticker symbol GLADN closed yesterday at $25.45. All of our preferred stocks throughout the portfolios have been above the offering price of $25, so that’s a good testament to a strong portfolio. In summary, the company sees an improving position in private businesses that are midsized with a good management team. Many of these are owned by middle-sized buyout funds that are looking for experienced partners to lend money to their businesses, either growing them or buying them. This gives us a chance to make an attractive interest-paying loans, which support our ongoing commitment to pay cash distributions to our shareholders. So folks, we have a strong team here in place to capitalize on the marketplace. Just a note, 20 years ago, I was looking at statistics. 20 years ago, about 70% of all the financing for these middle market companies came from banks. Today, that’s about 10%. So we are a tremendous beneficiaries of the bank pullback from the improved market, given government regulations and the highly unlikely fact that the banks are going to come back into the middle market. I think we have a good running room to grow this company. And just the other day, somebody asked me, "How big is this middle market?" Well, if the middle market was pulled out of the U.S. economy, then it would rank third largest global economy in the world. It’s just after the U.S. and China, of course, but ahead of Japan, Germany, France, all of those. So the middle marketplace is really large and we hope to take advantage of it during the next year. And now operator, if you will come on, we’ll hear from – some questions from some of the people that are on the line.

Thank you. [Operator Instructions] Our first question comes from the line of Mickey Schleien of Ladenburg. Your line is now open.

Yes, good morning everyone. Bob, I’m sure you’re aware that the House Committee passed the BDC Regulation Reform Bill. I’m curious what you’re thinking about your leverage target down the road if Congress were to pass the bill and it would become a law.

Well, I think the House has done that a number of times. I think the issue has been the Senate. So I don’t think we’ve got a lot of contingency plans at this point in light of that blockade that’s been existed for a number of years. Were it to happen, obviously, I think that’s probably net positive to us. Obviously, as you know, we do not run non-regulatory leverage since we don’t have an SBIC in place. So on an effective balance sheet leverage, we’re probably less leveraged than the average BDC today. So that’s probably a net positive to us. But frankly, we have not laid out a lot of contingencies, plans in light of the – I think our inherent discount to get some of those potential actions.

Okay, that’s helpful. And just a couple more. Certainly, some of the markups in WadeCo and Francis Drilling, and I suppose that’s reflecting better performance of the companies given the strength in the energy markets. I’m wondering if you are thinking about maybe taking some money off the table in the energy allocation in the portfolio given the strength we’ve seen recently.

We obviously don’t control either of those companies, their investments, their debt investments. I would say that sponsors that have lived through the cycle are, obviously, mindful of the current state of liquidity and opportunities. Both of those investments are focused in the Gulf Coast or the Permian Basin, which has been the strongest and most consistent performer of the oil and gas segment. I would expect that those sponsors will consider strategic transactions. But at this point, given the deleveraging of both of those investments, we expect they have further room to run. And it’s quite likely that one or both of those could come off in the coming quarters. But we obviously don’t control that, nor do we, at this point, plan on selling off our current positions.

That’s helpful, Bob. And just one sort of housekeeping question. Can you tell us which company paid the dividend this quarter and whether that’s a recurring sort of cash flow or just a one-time event?

That is a one-time event. We had an investment in a – it was kind of a small buyout fund in the defense and services business. They liquidated a company, and the proceeds we received as a dividend. So I would not expect that to be recurring. I would say, as we referenced, fee income is tied to exits. We have had some exits this quarter. And we are anticipating others as we go into the balance of fiscal 2018. I think it’s, more than anything else, a reflection of the anomaly that we had last quarter when we almost – when we had virtually no exits and no fee income. So I think we’re probably reverting more back to the norm, expecting repayments and exits on a regular – more regular basis.

Okay, that’s good. Thanks for your time this morning. I appreciate it.

Thank you, Mickey. Next question.

Thank you. Our next question comes from the line of Christopher Testa of National Securities. Your line is now open.

Hi, good morning guys. Thanks for taking my question. Just curious. This quarter, why were FedCap and Leeds Novamark valued at NAV this quarter?

When these investments – they’re relatively small, but they go through their J curve. And we invest early stage. There’s operating startup losses. We absorb those startup losses. And eventually, they begin to generate as they scale up interest income that builds NAV. So once they begin to exceed their underlying cost of capital and expenses, we see the earnings begin to support and the NAV is going to rise. Given the age of Leeds, I would expect that to continue. I think on the topic of FedCap, that’s our liquidating portfolio. And I think there’s one investment left that is mostly a debt-oriented investment, which gave rise to the valuation adjustment. But I think it was fairly small and a fabric its size.

Okay, got it. Okay. Got it. And just another small item. Just on the roll forward in the K. The beginning of period balance on your common equity is showing as about $7.8 million. It was $9.8 million as of the beginning of the fiscal year last quarter. So just wondering what changed that roughly $2 million.

That’s been related to the write-off the right, let’s figure it out.

We’ll look it up. You got another question while we’re looking it up?

Yes, sure. You guys have some kind of widely syndicated loans and club deals that you do with partners. Obviously, it’s a small portion of the book. Just wondering if there’s been any internal discussions upon maybe starting a off-balance sheet joint venture, which would, obviously, be beneficial given you don’t have much use of that, if any, of the 30% basket and spreads are tight. Just wondering if that’s something that you’re potentially assessing to boost earnings going forward.

A timely question, Chris. I would say that given the evolving market conditions, particularly the availability of lower-cost bank financing on relatively low-leverage, lower middle market financings, we have seen some increased competition for some of our lower leverage opportunities that would fit nicely into a joint venture arrangement like that. So rather than teaming up with, I would say, an institutional investor or an insurance company, it may make sense to team up with a bank to pursue an off-balance sheet JV. And I would say, we are actively evaluating those alternatives today.

Got it. And just last one for me. I mean, obviously, you guys did the new preferred issue that was great with the 75 bps of savings. Given that you guys have grown and you’ve cleaned up a bunch of the legacy assets in your commentary and potentially cleaning up one of the two remaining non-accruals, is it possible that you could potentially lower the cost of your credit facility?

Yes. Well, I guess, I would say that facility has been in place for some time. Certainly, our assets and equity have grown significantly. I would suspect that if you were to compare the cost of that facility to some of our peers, I believe there were several announced literally within last couple of weeks that probably are slightly less. It is on the agenda for early 2018 when that facility comes up for renewal.

Got it. That’s all for me. Thank you for taking my questions.

We have the answer.

Okay.

Chris, this is Nicole. So to follow up on your other question. So that change, that was just a change in presentation as a result of that accounting standard, which required us to remove investments that were not valued using Level 3 input from that roll forward. So we did remove the FedCap and Leeds entities from the opening balance in that roll forward. So no changes in the underlying values. Just a change in presentation.

Got it. Okay, that makes sense. Thanks very much for taking my questions guys.

Thank you. Next question.

[Operator Instructions] Our next question comes from the line of Andy Stapp of Hilliard Lyons Capital. Your line is now open.

Good morning. Just wondering what type of yields on new investment opportunities are you generally seeing on a blended basis?

Andy, I would say that in the unitranche worlds, which is where most of our senior secured assets would be, there’s a pretty wide spread. We would typically see a L plus eight to nine with a floor kind of in the current range of market that excludes underlying fees. Obviously, as those deals get larger, there are larger credit funds that are either more leveraged or have lower hurdle requirements where those rates can come under pressure. But that’s rough approximation. I think if you were to look at our schedule investments and look at some of the more recent assets, that’s what you’d see, the general pricing parameters. Obviously, behind that, in a second lien type of investment, I would say those yields are probably 200 to 300 basis points higher.

Okay, great. And rest of my questions have been answered. Thank you.

Thanks for calling in.

All right. Do we have any more questions?

Thank you. I’m showing no further questions at this time. I’d hand the call back over to David Gladstone for any closing remarks.

Again, thank you all for calling in. We had a great quarter. And the outlook for 2018 looks spectacular, so we’re off to the races. Thanks, and we’ll see you in January. Bye.

Ladies and gentlemen, thank you for participating in today’s conference. That does conclude today’s program. You may all disconnect. Everyone, have a great day.