Gladstone Capital Corporation (GLAD) Q3 2019 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for standing by and welcome to the Gladstone Capital Corporation's Third Quarter Earnings Call. 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 the appropriate time. [Operator Instructions] As a reminder, today’s conference maybe recorded. It is now my pleasure to turn the call over to, Mr. David Gladstone. Sir, the floor is yours.

Thank you and hello everyone. Thank you for calling in. This is David Gladstone, Chairman and this is the quarterly earnings conference call for Gladstone Capital for the quarter ending June 30, 2019. Again, thank you for calling in. We are always happy to talk with our shareholders and analysts and welcome the opportunity to provide updates on the company and its investment portfolio. Now we are going to start off with Michael LiCalsi, he is our General Counsel and make some statements with forward-looking statements.

Thanks, David, and good morning. Today’s report may include forward-looking statements under the Securities Act of 1933 and the Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties that are based on our current plans, which we believe to be reasonable. Any 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, 10-K and other documents that we file with the SEC. You can find these on our website, which is www.gladstonecapital.com, specifically look on the Investor Relations page or on the SEC's website 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. We also ask you to take the opportunity to visit our website, once again, gladstonecapital.com. Please sign up for our e-mail notification service. We can also be found on Twitter the handle there is @GladstoneComps and on Facebook, keyword, The Gladstone Companies. Today's call is an overview of our results, so we ask you to review our press release and Form 10-Q, both issued yesterday for more detailed information. Those can be found on the Investor Relations page of our website. With that, I'll turn the presentation back over to Gladstone Capital's President, Bob Marcotte. Bob?

Good morning. Thank you all for dialing-in today to spend a few minutes with us this morning. And now, let's get into the headlines for Gladstone Capital for the quarter ended June 30, 2019. Originations on the quarter were strong at $58 million as we referenced in our prior call and included two new proprietary investments and three syndicated investments. Exits and repayments were higher than anticipated at $41 million and included the prepayment of our senior debt investment in IA Tech, which at $30 million was one of our top-five which was prepaid at par plus the prepayment fee. Net originations on the quarter thus were $17.3 million after all other portfolio movements. Interest income rose slightly to $11.2 million on the quarter from the prior as the decline average yields on our investment portfolio to 11.8% was offset by a small increase in the average interest-bearing investment portfolio from the prior quarter. Prepayment fees in excess – prepayment fees, exit fees and dividend and income rose on the quarter to $1.7 million including the IA Tech prepayment fee of $900,000, which lifted our total investment income to $12.9 million or 2.9% higher than the March quarter. Our borrowing-related costs were unchanged on the quarter as average borrowings fell slightly and commitment fees associated with the lower utilization of our credit line rose on the quarter. Net investment income was up slightly at $6.2 million or $0.21 a share as operating expenses were unchanged and net management fees rose, compared to the prior quarter as incentive fees increased with the increased investment income and incentive fee credit decline. The net assets from operations rose to $8.9 million on the quarter or $0.30 per share as a result of the $2.6 million of net portfolio appreciation in the quarter and NAV rose to $0.12 per share or 1.5% to $8.23 per share at June 30. With respect to the overall portfolio, the asset mix as of the end of the quarter shifted slightly with all the portfolio activity resulting in the senior secured assets falling 3% to 46% of our investment portfolio at fair value while the second lien investments rose to 42% of the portfolio. A major contributor to the portfolio appreciation in the quarter was the continued improvement in ADC’s operating results and better visibility into the potential exit opportunities for that investment. Detracting from this momentum was a realized loss from the exit of a non-core defense sector fund investment FedCap and unrealized depreciation of our equity interest in Lignetics. During the quarter, there was no change to our two non-earning assets which represent an aggregate cost of $8.5 million or 2.2% of all debt investments and aggregate fair value of $2.1 million or 0.6% of the fair value of all debt investments. Since the end of the quarter, we closed an additional $5 million follow-on investment and between repayments and exits total investments have increased by $3.8 million, so our earning assets are up slightly as of today. We also expect to close a new proprietary deal in the very near-term. With respect to the near-term outlook, within our lower middle market focus principally sub-$10 million EBITDA business, we have seen a healthy level of deal flow in the past several months. That said, competitive pressures have also increased particularly for senior investments causing lending margins to inch down. Between our current investment backlog and follow-on fundings to our existing portfolio companies, we expect to be able to outpace some of the anticipated liquidity events on the horizon and continue to increase our average investments and core net interest income. Interest rates are not obviously expected to provide much near-term lift to our interest income. However, we do expect fee and other income to remain elevated as our portfolio continues to mature and expected exits are realized. The flip side of the declining interest rate outlook is that we are optimistic that we are able to refund our existing 6% GLAD and preferred early next quarter at a lower effective cost through some combination of capital market issuance or bank facility borrowings. This refunding is a prerequisite to clearing the last hurdle to be able to lift the 200% minimum asset coverage limitation. However, given our 242% coverage as of June 30, we are probably several quarters of solid originations away from being in a position to utilize any of this additional leverage capacity. And now I’d like to turn the call over to Nicole Schaltenbrand, the CFO for Gladstone Capital to provide some of the details on the Fund’s financial results for the quarter. Nicole?

Thanks, Bob. Good morning, everyone. During the June quarter, total interest income rose 1% to $11.2 million as higher average investments more than offset the 20 basis point decline in the average yield on the investment portfolio. Other income rose by $300,000 to $1.7 million with the IA Tech prepayment fee, as well as other activities and dividends received. Total investment income rose $400,000 or 2.9% to $12.9 million on the quarter. Total expenses for the quarter increased by $200,000 driven mainly by a $600,000 increase in net incentive fees, partially offset by a $400,000 decrease in net base management fees. The increase in net incentive fees is driven by both an increase in net investment income and a $400,000 decrease in advisor fee credits quarter-over-quarter. The $400,000 decrease in net base management fees is driven by the credit receipts associated with origination fees on our new investments during the quarter. Financing expenses were unchanged to $3.2 million and other expenses were also unchanged at $800,000 or 79 basis point on average assets on the quarter. For the quarter ended June 30, net investment income was $6.2 million or $0.21 per share and covered 100% of our shareholder distributions. Moving over to the balance sheet, as of June 30, total assets were $415 million consisting of $408 million investments at fair value and $7 million in cash and other assets. Liabilities rose by $8 million to $169 million and consisted of $59 million in borrowings on our credit facility, $55.6 million of our 6.125% 2023 senior notes and $52 million of series 2024 term preferred stock. Net assets rose by $11.3 million since the prior quarter end with $2.6 million of net realized and unrealized portfolio appreciation and common stock issued under our ATM program which generated net proceeds of $8.6 million. For the quarter, we issued 939,000 common shares at an average price of $9.34 per share or a 113.5% of NAV. The accretive ATM issuance accounted for approximately one-third of the $0.12 increase in NAV which rose to $8.23 as of the June 30, 2019 compared to $8.11 as of March 31, 2019. Our leverage as of June 30 was unchanged from the prior quarter ended 69% of net assets despite the increase in assets for the period. As of the end of the quarter, we had in excess of $75 million of current investment capacity and approximately $117 million of available under our line of credit. With respect to distribution, Gladstone Capital has remain committed to paying its shareholders a cash dividend and in July, our Board of Directors declared a monthly distribution to our common stockholders of $0.07 per common share per month for July, August, and September which is an annual rate of $0.84 per share. The Board will meet in October to determine the monthly distribution to common stockholders for the following quarter. At the current distribution rate for our common stock and with the common stock price of about $9.21 yesterday, the distribution runrate is now producing a deal of about 9.1%, which continues to be attractive relative to most yield-oriented alternatives. And now David will conclude the presentation.

Okay. Thank you, Nicole. Good report and a good report from Bob and Michael as well. I think our shareholders and all the analysts are well informed of what we are doing. This is another good quarter for Gladstone Capital, originated more than more than $60 million in new investments to more than offset the spike in payments and continued growth over the assets generating a record $12.9 million of investment income aided by some significant fees, but nonetheless made good money. Maintaining a strong balance sheet with significant dry powder to grow the investment portfolio in this area that we specialize in and that’s the lower middle market businesses. In the company, we believe has enough liquidity to weather any kind of recession should there be one. In summary, the company sees strength in the private businesses that are mid-size with a good management team. Many of these are owned by mid-sized buyout funds that are looking for experienced partners that can lend money to the business as they have invested their equity and this gives us a chance to make attractive interest paying loans which support our ongoing commitment to pay cash distributions to stockholders. We have a great team here and they are doing a good job and now I am going to ask the operator to come in and get some questions from those out there that would like to ask us some more particulars.

Thank you, Mr. Gladstone. [Operator Instructions] Our first question in queue will come from the line of Henry Coffey with Wedbush. Please go ahead. Your line is now open.

Henry, are you there?

Mr. Coffey, your line is open. Please check your mute.

Can you hear me now?

Yes.

Sorry about that. So, with rates as low as they are, how are you managing around that challenge? And how is market pricing had being affected? And if prices – if yields on investments were low, are there alternatives to, in terms of cutting your funding cost to offset that and keep spreads where they need to be?

. : More than likely there will be some mix of floating rate funding that will come into that and that’s going to be significantly less expensive than the current dividend on that preferred. So those are certainly two parts of it. The more challenging part in the marketplace today is there is clearly been some spread compression in the lower middle market as it continue to be an active buy out area, probably even more active than the larger middle market buy outs. So we’ve seen some incursion of other funds coming in, creating some pressure on margins. So, we obviously are ramping up whatever we see in deal flow and very mindful of the competitive conditions that we are focusing. So, at this point I would say, hit rates are a little bit lower, but we are still in a situation where we are lowering our cost and managing to our current yields and obviously we would love a little bit of rate increase to be able to offset some of the compression. But I think at this point, we are still seeing positive investment opportunities that are accretive to our current book. So, it’s tight. But I think we are still managing flow and I think that’s one of the reasons why you don’t see our assets growing more dramatically. The incremental asset growth is coming from places where competitive pricing is probably less attractive.

So, look, there is obviously different sectors of the economy and there are different sectors of the economy that are affected by what the administration is up to. For example, soybean agriculture or something like that and you look at your portfolio companies, what sort of economic read do you get? And obviously, if you are look at the stock market, very negative, what are your portfolio companies telling you by how business conditions are and how the economy is going?

Well, we’ve always had a healthy mix of manufacturing, smaller manufacturing businesses and there is certainly been in the past five, seven years, a significant outsourcing. But domestic manufacturing which is what BDC is really focused on actually are growing quite well as people realign their supply chains, domestic manufacturing, plant expansion, migration to domestic production where automation, labor cost, delivery times, inventory requirements are all more favorable. So, we are getting to a point where whether it’s aerospace, or maybe some auto-related businesses, those have become a much more significant uptick in opportunity. Obviously, each of those have their own challenges, but domestic manufacturing certainly is stronger. I think in some of the other areas, we are seeing services businesses continue to be strong. We see activity in software-related businesses or things in other service categories are certainly positive and probably more positive than you would think given basic wage increases and some of the pricing pressures, their costs, but they are still very positive on our outlook. So, I would say it’s decidedly a domestic swing for businesses that is creating some of the updraft for us.

Great. Thank you very much.

Okay, next question.

Thank you sir. Our next question comes from the line of Mickey Schleien with Ladenburg. Please go ahead. Your line is now open.

Yes, good morning everyone. Bob, could you give us a bit more background about the trend that alloy die that supported its valuation increase? And also how correlated is its business to a potential slowdown of the economy?

ADC die casting business is symbolic of what I mentioned to Henry’s question. It’s a West Coast based manufacturer that serves aerospace, lighting and some auto-related businesses. The business, when it was acquired, some deferred capital expenditures and over the course of time between those expenditures and some significant management changes as you may know that’s a – one of the co-investments we have these days and it’s controlled by GAIN. So, we have significant insights of what’s going there. Between capital and a swap out in management, and a refocus on domestic customers and what we’ve seen as huge inflow of orders from large-scale multinational corporate that are listing that business. The results has been significant. Sales increase, significant. Margin expansion, and at this point, the cash flow runrate in that business is up very dramatically over the last three years. So in today’s market environment, they are building cash significantly and we feel it’s a business that has clearly turned the corner and it’s currently well above where the original investment was and that’s reflected in our equity adjustment on the quarter. So, I would say that’s endemic of what I think is a very strong story in a domestic manufacturing business. But it’s well supported by the underlying fundamentals.

So, I guess, I’ll congratulate you and Dave Dullum on turning that around. I guess, the downside, Bob is that, it sounds like that’s a business that could potentially be a nice tuck-in acquisition for somebody and this will go off your books or potentially, I guess, if the cash flow profile is as nice as you are indicating you could be refinanced. Is that reasonable?

We are, I guess, we are exploring options in those regards in between the accumulated liability and the ultimate help within the value of that business. That’s a fair assumption that Dave and his team are pursuing.

Okay. Just a couple questions on the risk profile of the portfolio. Could you tell us how your average borrower revenue and EBITDA compares for your first lien versus your second lien investments?

We don’t really break that information down. Obviously, each individual business can be very different. As you can imagine, when you are financing a manufacturer versus a software business versus a healthcare business, you come up with very, very different profiles. So, we don’t try to lump that. I can certainly follow-up with you directly and talk a little bit about specifically overall. But the blend across the portfolio on all of the underlying investments which we obviously report and have very exacting metrics that are required by our secured lenders is approximately 3.7, 3.8 times leverage across the entire portfolio. So, when you think about market comps, that’s probably closer to senior relative to where the middle market might be that will be probably significantly north of that.

That’s helpful. Perhaps I could just follow-up and ask just conceptually, when you look at second liens, do you tend to prefer sponsored deals with lower LTVs or is there a different approach in order for you to get interested in a second lien?

That’s an interesting question and probably moves a lot with the market conditions. I would say, when the leverage starts to increase, second lien certainly become more challenging. You will note that we have closed a number of syndications in the last quarter because we felt the second lien marketplace, the lower leverage levels and the significant equity sponsorship and equity support warranted that. So, that’s a clear example where sponsor and equity were a differentiating factor for us. As it relates to the only restricting our second lien investments to sponsor deals, that’s not a verification in the proprietary transaction. In the proprietary marketplace, many of the sponsors are looking for second lien to reduce leverage and spike their return on equity. We don’t necessarily look at that situation where we are comfortable taking on that level of investments. You also should know that when we classified as a second lien, and this is a bit of a detail, but there are times where we might originate a unitranche loan and we would sell-off a strip of the first lien piece inside that loan. So if we provided a four turns of leverage in a buyout, we might sell-off the first two turns of leverage to a bank at a much lower rate. We would then classify that as a second lien loan as you would expect, but it’s really inside of first lien leverage facility. So from a collateral and control perspective, and from an overall leverage perspective, we are going to be lower than what a traditional second lien would look like. So, we continue to work the second lien angle. It’s certainly an important part of our portfolio, but for the most part I think there is in a syndicated fashion either a large equity or in a proprietary deal significant control that we continue to exert over those assets.

I understand. That’s helpful color, particularly labeling a second lien as second lien as opposed to many of your peers which don’t. I appreciate your time this morning. Thank you.

Thank you, Mickey.

Okay. Do we have any other questions?

I am showing no additional questions in the queue. I’ll turn the program back over to David for any additional or closing comments.

All right. Thank you all for listening to the presentation. The company is in great shape today and we look to see in about three months. That’s the end of this call.

Thank you to our presenters and thank you to all of our attendees for joining us. This concludes today’s call. You may now disconnect and have a wonderful day.