Gladstone Capital Corporation (GLAD) Q2 2020 Earnings Report, Transcript and Summary

Ladies and gentlemen, welcome to today's Gladstone Capital Shareholders Call for the quarter ending March 31, 2020. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Mr. David Gladstone. Please go ahead, sir.

Well, thank you Marcia [ph] for that nice introduction. And this is again, David Gladstone, I'm Chairman for the quarterly earnings call for Gladstone Capital for the quarter ending March 31, 2020. Thank you all for calling in. We're always happy to talk to our shareholders and any of the analysts who get on and ask us good questions. And welcome -- we welcome the opportunity to provide updates on our company and the investment portfolio that we have. Now, we'll start off with our General Counsel as we always do. Michael LiCalsi, he'll make some statements regarding certain forward-looking statements. Michael?

Thanks, David and good morning, everybody. Today's report may include forward-looking statements under the Securities Act of 1933 and 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. Now, 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 in our forms 10-Q, 10-K and other documents that we filed with the SEC. You can find these on the Investor Relations page of our website which is www.gladstonecapital.com. You can also sign up for email notification service, and you can also find these documents on the SEC's website, which is www.sec.gov. Now, 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. Today's call is an overview of our results, so we ask that you review our press release and Form 10-Q issued yesterday for more detailed information. Again, you can find them on the Investor Relations page of our website. And with that, I'll turn the call over to Gladstone Capital's President, Bob Marcotte. Bob?

Good morning. Thank you, Michael. Thank you all for dialing in this morning and given we got lots of cover, let's get into the summary of the results for Gladstone Capital for the quarter ended March 31, 2020. Originations for the quarter totaled $29.8 million, including a new proprietary second lien investment and add-on investments to support acquisitions or growth CapEx, and these funding did not include any COVID-19 related line draws. Repayments and proceeds on the quarter totaled $26.4 million, included -- and included the exit of our acquisition of the Mochi Ice Cream Company, which resulted in a realized gain of $2.5 million in Meridian, a non-earning asset which had previously been written-off. Interest income on the quarter declined $500,000 or 4% to $11 million, compared to the prior quarter with a drop in LIBOR and the movement of one credit to non-earning status. Prepayments and dividend income also declined, so total investment income for the quarter was down $700,000 to $11.5 million. Borrowing and administrative costs were largely unchanged on the quarter. However, net management fees declined by $900,000 to $1.1 million with the increase in the incentive fee credit resulting in net investment income of $6.5 million or $0.21 per share on the quarter. Net asset from operations declined by $27.8 million or $0.89 per share, which included $31.4 million of net unrealized portfolio depreciation on the quarter, largely as a result of COVID-19 market disruptions which I'll discuss in a moment. It also included a $3.1 million net realized loss from the exit of Mochi and Meridian. For the period, NAV declined $1.09 per share or 13.5% to $6.99 per share as of March 31, 2020. With respect to the portfolio, we were fortunate that our portfolio diversity and focus on industries which are generally expected to be more insulated from economic cycles, and our limited exposure to the consumer and retail services sectors helps us fair reasonably well in the face of the COVID-19 pandemic. Most of the unrealized appreciation recognized last quarter is as a result of the broad market based move in investment yields which negatively impacted all of our debt investments, and do not necessarily reflect the credit position where the underlying financial performance of the majority of our portfolio companies. To put that in perspective, let me try to break it down a bit for you. The marked increase in benchmark yields can be best measured based on the valuation movement of our performing proprietary credit unaffected by COVID-19 which represented unrealized appreciation of $6.1 million on the quarter or roughly 4% of costs. Broadly, syndicated credits for the most severely impacted by the market liquidity and based on dealer quotes on mostly second lien positions were marked down by $5.4 million or 18% of cost. The COVID-19 impacted businesses are relatively diversified and varied in the magnitude of the impact and include a couple of businesses such as a restaurant chain, a vacation rental company, a chemical distribution business, and energy brokerage business and a child care learning chain. These credits in total were marked down by $11.7 million or approximately 9% of costs. Many of these credits are modestly leveraged senior unitranche loans, which are well supported by the cash flows of the business, as well as the underlying enterprise valuation, and we feel strongly this depreciation will be reversed overtime. Lastly, are the usual watch-list credits which are undergoing some form of operational management restructuring, and these credits represented an incremental approximately $5.5 million of depreciation or 7% of cost. The bulk of these companies are controlled by private equity sponsors who are fully engaged and continue to provide capital support to these businesses. In total, 84% of the unrealized appreciation is related to the write-down of debt investments, and the balance of $5.9 million is associated with the unrealized appreciation of equity investments; principally, the restructuring of Edge Adhesives and the write-down in FES resources. We are continuing to closely monitor our portfolio companies to ensure they have taken appropriate actions and developed contingency and liquidity plans to manage the evolving challenges posed by COVID-19. To date, the majority of our proprietary investments have been able to qualify for the government Paycheck Protection Program, which will serve to supplement liquidity and mitigate a portion of the near-term COVID business throughout these disruptions. The asset mix on the quarter shifted slightly with predominantly second lien origination and first lien loan exits reducing the first lien exposure to 48% [ph] in costs and increasing the second lien exposure similarly to 42% of portfolio at cost. With respect to our non-earning assets, during the quarter, we exited our position in Meridian and classified our $7.2 million investment in B&T, a wireless engineering contracting business, as non-earning. B&T is well positioned to recover from the anticipated uptick in wireless carrier 5G expenditures and represents 1.7% of the fair market value of our assets. There are no other non-performing assets as of the end of the quarter. Since the end of the quarter, we have closed one sizable second lien investment of $30 million and we are currently working on selling down a portion of this position, as well as certain other investments to increase our portfolio granularity and bolster capacity to redeploy capital given the more favorable credit to pricing terms available in the marketplace today. Turning to the outlook for the balance of 2020, given the current market dislocations and more limited competitive conditions, we are seeing a healthy flow of new deal opportunities within sectors that fit our growth-oriented and recurring cash flow profile at lower leverage and improved pricing terms. We intend to selectively pursue these opportunities and we'll proactively manage our available investment capacity in the near term by selectively selling down a portion of these, as well as some of our existing position to maintain our granularity and diversity. Despite the unprecedented challenges of COVID-19 and some of the concerns about the performance of our lower-middle market portfolio, we feel our portfolio composition, underwriting discipline, and active company engagement will affirm our lower-middle market investment focus and position us well as the markets recover to continue to grow our portfolio and net interest margin to enable us to improve the returns to our shareholders. Lastly, since we last had the opportunity to speak with you, the Federal Reserve's decision to reduce interest rates to near zero to offset the COVID-19 impact and stimulate the economy is and will continue to negatively impact the interest earnings on our floating rate portfolio. While interest rate floors will mitigate a portion of this impact, this interest income reduction will reduce our net investment income, and we were compelled to reduce the dividend. This decision was not taken lightly. We want to reiterate our earlier comments that as the economy improves and interest rates return to more normal levels, we will visit the restoration of the recent adjustment. 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 reports -- results for the quarter. Nicole?

Thanks, Bob. Good morning, everyone. During the March quarter, total interest income declined $500,000 or 4% to $11 million, primarily due to lower average LIBOR rates and the effect of higher non-earning assets. The investment portfolio average balance increased slightly to $404.3 million for the quarter compared to $401.4 million for the quarter ended December 31, 2019. The higher investment balance was more than offset by the 40 basis point decline in the weighted average yield on our interest bearing portfolio, which declined to 10.9% from 11.3% in the previous quarter, largely with the 24 basis point decline in the average LIBOR rate. Other income decreased by $200,000 compared to last quarter with lower pre-payment fees and dividend income, resulting in total investment income for the quarter declining $700,000 or 5.5% to $11.5 million. Total expenses decreased by 13.9% quarter-over-quarter, primarily due to an $800,000 increase in the incentive fee credit granted by the Adviser. Net investment income for the quarter ended March 31, was $6.5 million, an increase of 2% as compared to the prior quarter or $0.21 per share and covered 100% of shareholder distribution. The net decrease in net assets resulting from operations of $27.8 million or $0.89 per share for the quarter ended March 31, compared to an increase of $700,000 or $0.02 per share for the quarter ended December 31. The current quarter decrease is driven by $31.4 million of net portfolio depreciation as covered by Bob earlier. Moving over to the balance sheet, as of March 31, total assets were $406 million consisting mainly of $398 million of investments at fair value and $8 million in cash and other assets. Liabilities were unchanged at $188 million as of March 31, and consisted of $92 million in borrowings on our credit facility, $57.5 million of 6.8% [ph] senior notes due 2023 and $38.8 million of 5.38% senior notes due 2024. Net assets declined by $32.9 million from the prior quarter end with $34.3 million of net realized and unrealized portfolio depreciation, partially offset by common stock issued under our ATM program in January and February at a weighted average price of $10.46 per share, which generated net proceeds of $1.5 million for the quarter. Our NAV dropped from $8.08 per share at December 31 to $6.99 per share as of March 31, 2020. Our leverage as of March 31 increased from the prior quarter end at 86% of net assets from 75% with the net depreciation for the quarter. As of the end of the quarter, we had an excess of $65 million of current investment capacity and availability under our line of credit. Our overall leverage continues to compare favorably and we believe we have sufficient levels of liquidity to support our existing portfolio companies as necessary and selectively deploy capital in new investment opportunities. With respect to distribution, Gladstone Capital has remained committed to paying its shareholders a cash dividend and in April, our Board of Directors declared monthly distributions to our common stockholders of $0.065 per common share per month for April, May and June, which is an annual rate of $0.78 per share. The Board will meet in July 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 at about $6.35 yesterday, the distribution run rate is now producing a yield of about 12.3%, which continues to be attractive relative to most yield-oriented alternatives. And now, I will turn it back to David to conclude the presentation.

Thank you, Bob, Michael, Nicole. You all did a great job in informing our stockholders and analysts that follow our company. Gladstone Capital had a good quarter and ended, in a very unknown environment that we're in today, much like all the other lenders in the middle market that are financing business like we finance. And I personally am really bullish on what's going to happen going forward, even though we don't know what the governments are going to do with regard to permitting the opening of businesses and we don't know the reaction of the customers either. Anyway, these companies are continuing to cruise along and have some good things that have been happening. They originated a $30 million new investment, which more than offset all the prepayments that the company has received. And the company did trigger a nice gain of $2.5 million on Mochi Ice Cream company that we had loaned money to, and the team is really busy monitoring the loans that we have to middle market companies. The damage from closing so many businesses that the government decided to do -- we'll not know clear what's going to happen until those businesses open again, we can't [ph] see what's going to happen. I personally am very optimistic about what's going to happen and I think that things will go back and be strong much sooner than I think most people are thinking it's going to happen. So in summary, the company continues to invest in mid-sized private businesses, always with good management teams, many of these situations are supported by private equity funds much like our size, they're mid-sized. And they are looking for experienced partners to support the acquisition and the growth of the business that they're investing in. This gives us an opportunity to make attractive investments in interest paying loans and those loans, of course, support the ongoing commitment to pay cash distributions to shareholders. I'm going to stop now and ask the operator to tell the callers how they can ask some questions of the team.

[Operator Instructions] Your first question comes from the line of Mickey Schleien.

Yes, good morning, everyone. Hope everyone there is doing well. My first question is for David actually. David, at the new dividend level and new hurdle rate, it still appears to me that the external manager may need to subsidize the incentive fee of Gladstone Capital on a net basis to cover the dividend. I definitely think it's commendable for Gladstone as a platform to prioritize shareholders' interests. But I'd like to understand how you and the management and the Board are thinking about this dynamic over the medium term, given the potential for higher non-accruals, and frankly the cost to originate and managing just run the portfolio along with the uncertainty over the length of the pandemic's impact.

Sure, Mickey. As you know, I'm a large shareholder and so I like my dividends, so I'm going to push as hard as I can to keep the dividends. We had a long discussion about the dividend payouts and we don't have a good answer yet because, quite frankly, we don't know how many companies are going to be around and what's going to happen over the next six months to a year. So much is up in the air, it's very difficult to do a good forecast. We did set things so that we think we can make all of the payments that we are trying to make. And I feel really good about being able to make the dividends that we've set at that. There are no guarantees in life, but that's where we are today. Bob, why don't you tune up on that one as well?

Mickey, obviously we -- when we made the announcement, we didn't have full scope and obviously it's still evolving in terms of what the ultimate implications are going to be on the businesses. When we looked at the dividend adjustment, we saw the LIBOR careening down and it subsequently dropped even more. And we basically absorbed much of the drop between where LIBOR was and the floor protections in our underlying portfolio. That was really the cause for the dividend adjustment. At this point, the floors in the portfolio are really supporting where the distribution is. So your question is, ultimately, the degradation or non-heightened non-performing and the impact on the business. At this point, we only have one investment in our non-accrual with an opportunity to, in the not-too-distant future potentially, correct that situation. We're not seeing a huge amount of pressure. It certainly could happen, given the slow recovery of some of these businesses. But I also wanted to emphasize a little different than maybe some of the other middle market businesses, the majority of our companies had either liquidity or relatively strong cash flow and the majority were able to qualify for PPP loan protections. So there was definitely liquidity that was created in those situations, which will help support the businesses. Two or three months from now, if they run out of that support, it may be a different situation, but we didn't feel that the time is appropriate to foreshadow what that might look like. So we adjusted based on what we knew. Under our current framework, we feel we can support this, but it's really a moving target and it may require some measure of support, as we've described, that we feel comfortable with where the dividend is in the portfolio it's currently performing.

Mickey, did you need additional information? You have other questions?

I have several other questions, if that's okay.

Ask on.

I noticed that the mark fair value to cost on second liens was 91.5%, but on first liens it was only 86.6%. My sense is that just may have to do with technical adjustments, but I was a little surprised by that. So any granularity you can or color you can provide there would be helpful.

I'm not exactly sure of the numbers you're referring to. If they were based under my comments, the second lien marks were fairly heavy, particularly in the syndicated realm, where they were down about 18%. As it relates to the proprietary, I think you're also then dealing with two factors. One is the underlying portfolio position but more notably how impacted the businesses were, based upon the perception of the COVID results. To give you an example, if a childcare facility loan -- if there were certain of them shut down, there was uncertainty as to the collection of those revenues, there was obviously a much more significant impact on the valuation of that asset. And so it's very much dictated by the degree to which the businesses were impacted and it's particular to the underlying portfolio. So I think we could talk more specifically about certain elements of your question, but I don't think we can look at it as a broad base, we look -- we marked the senior more than the junior.

Bob, what percentage of the portfolio would you consider to be syndicated or lightly syndicated?

Syndicated portfolio was roughly $30 million so it's a little under 8% or 9%, something like that.

Okay. And I noticed that the weighted average risk rating on the proprietary deals declined only slightly from 6.7% to 6.3%. How did that grading account for COVID risk? In other words, was there any sort of forward-looking assessment in that grading or is it really more in arrears?

As far as the financial results, it's more in arrears, but we did, on top of that, make somewhat of a COVID-type assessment and that's something that will be ongoing. There is potential that, that risk grading will go down a little bit next quarter, but it's something we continue to assess. And one of the major factors is our portfolio company's ability to pay and where that position was as of 3/31.

Well, and that's actually my next question. Besides B&T, did all borrowers make their payments during the quarter -- interest payments during the quarter?

Yes, they did.

Okay. And a couple of more questions, if I may. Bob, you referenced LIBOR floors, but I don't think you actually show them in your schedule of investments. Can you at least give us the average LIBOR floor in the portfolio so that we can get a sense of where things might look?

It's roughly 1%.

Okay. So we're definitely below that.

Yes, we're definitely below every one of the floors that's now in place, so between floors and a few fixed rate assets, we blew through that last month.

And that's a mixture of one month and three months reference -- LIBOR references?

It's almost all one month of LIBOR.

One month.

Some of the syndicated portfolios are three-months LIBOR, but the majority of our portfolio is one month. Yes.

Okay. And my last question, I do appreciate your patience, but there is so much going on, just in terms of risk assessment, could you give us a sense of the portfolio's average EBITDA amongst the borrowers and the average debt to EBITDA of the portfolio?

The average EBITDA, I would put in the $5 million to $8 million range. But you know, Mickey, we have credits that are probably 3 and 30. The deal we just closed had 67 in EBITDA. So I'm not sure the average gets you a lot, given the variability. The way the portfolio tends to roll out the vast majority of our senior secured assets are probably $5 million to $8 million of EBITDA. The vast majority of our second lien assets are probably $10 million to $15 million of EBITDA, because they're larger companies who are taking slightly a riskier positions in their larger businesses. In terms of overall leverage, I -- again averages are somewhat not indicative given what I've described. If you exclude the syndicated credits, the average leverage is -- the average EBITDA leverage is probably in the low 4 turns at the moment, but that could be anywhere between 2 turns and 6 turns. So you definitely have some outliers. The average is just probably north of 4.

That's really helpful. And I appreciate that and those were all my questions. Thank you.

Thank you for calling in, Mickey.

Okay. Do we have some other questions?

[Operator Instructions]

Any other questions?

Not at this time, sir.

All right. Well, that was a short one. And we thank all of you who called in and listened and if we have other ways of communicating, we'll definitely do press releases on things that are happening. So that's the end of this call and thank you all for calling in.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation, and have a wonderful day. You may all disconnect.