Gladstone Capital Corporation (GLAD) Q3 2020 Earnings Report, Transcript and Summary

Ladies and gentlemen thank you for standing by and welcome to today's Gladstone Capital Corporation’s Third Quarter ended June 30, 2020 earnings call and webcast. At this time, all participants are in a listen-only mode. [Operator Instructions] Please be advised that today’s call is being recorded. [Operator Instructions] I would now like to turn the call over to David Gladstone. Please go ahead.

Alright. Thank you, Michelle. Nice introduction. Got us all warmed up. This is David Gladstone, Chairman [indiscernible] quarter earnings call that we normally do every quarter and this is the third quarter for this company. Its year ending is September 30 and really thank you all for calling in. We're always happy to talk to shareholders and analysts and welcome the opportunity to provide an update on the company and its investment for portfolio. It's really hard today to give you much determination on which way the winds are blowing. The government gets to decide most everything and you've got the State Government, the County Government, the National Government, and it's really hard to figure out which way the winds are blowing, but we'll start out here the way we always do. General Counsel, Michael LiCalsi, he will make some statements regarding forward-looking statements.

Thanks, David and good morning, everybody. Today's report may include forward-looking statements under the Securities Act of 1933, 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, 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 that we listed in our Forms 10-Q, 10-K, and certain other documents that we filed with the SEC to find these on the investor relations page of our website, which is www.gladstonecapital.com. On that website, you can also sign up for our email notification service. You can also find our information on the SEC’s website and that's at 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 remind everybody to today's call is an overview of our results. So, we ask that you review our press release and Form 10-Q, again, both issued yesterday, for more detailed information. These can be found on our website Investor Relations page at www.gladstonecapital.com. Now, I will turn the call over to Gladstone Capital’s President, Bob Marcotte. Bob?

Thank you, Michael. Good morning and thank you all for dialing in this morning. In anticipation of what we might have a few more COVID related questions in this quarter, let's get into the summary for the results for Gladstone Capital for the quarter ended June 30. Originations on the quarter totaled 56.5 million, including two new proprietary investments. Repayments and proceeds on exit totaled 17.1 million and included the exit of three smaller positions. So, net originations for the period were 39.4 million. Interest income rose on the quarter to 11.6 million or up 6% over the prior quarter, with the increase in average investments, as the portfolio yield was unchanged at 10.9%, as most of our investments are well below the applicable LIBOR floors. Prepayment and dividend income was nominal. So, the investment income overall was up slightly to 11.7 million. Borrowing and administrative costs fell on the period with lower LIBOR rates and unused commitment fees. However, net management fees rose by 900,000 with the reduction of an incentive fee credits, resulting in net investment income of 6.1 million or $0.195 per share. Net assets from operations rose to 15 million or $0.48 per share, which included $9 million of net unrealized portfolio appreciation on the quarter as the reduction of market-based spreads, and strong performers more than offset the weakness in our energy and auto-related investments. For the period, NAV rose to $0.28 per share, or 4% to $7.27 per share as of June 30. With respect to the portfolio, as we discussed last quarter, on our call, we were fortunate that our portfolio diversity limited our exposure to the consumer, retail, or travel service sectors most impacted by the COVID-19 pandemic. That said, much of last quarter was focused on working with our companies to make sure appropriate actions were instituted to adjust cost and bolster liquidity to weather any disruptions, including supporting their access to PPP funding. For the period, we did not experience any payment defaults in our one non-accrual investment. Our non-accrual investments declined to 1.5% of the portfolio at fair value. You will note that we did move one investment to pick for the next couple of quarters in connection with the PE sponsor, contributing new equity to bridge the disruption in order flow from the auto manufacturers it serves. From a valuation perspective, the top three companies that increased were driven by improved operating performance, and they were closely followed by a number of our broadly syndicated investments that recovered on average about 60% of the last quarter’s depreciation, with the reduction in applicable market spreads. Much of the unrealized appreciation this quarter can be attributed to our auto and energy sector related exposures. The auto plant shutdowns and subsequent ramp up of [order flow] has hampered the recovery of our two investments in this sector, which represents about 4.2% of our investments at fair value. However, as both companies are on attractive high profile vehicle platforms, and they are continuing to win business and have ample liquidity, we expect these companies to improve in the next couple of quarters. With respect to our energy sector exposures, the pricing volatility and severe production contraction last quarter impacted our investment in an oilfield chemical distribution business. While we've been through energy swings with this company before, and the team has [adapted managing] their cost structure, the speed of the production curtailment in the Permian was unprecedented. Fortunately, many of the [shut-in wells] have already restarted with the improved crude prices, and we expect their revenues to have bottomed in May and trend up this quarter. Lastly, the extreme price swings disrupted the volume of energy property and lease sales last quarter, which negatively impacted our investment in the leading broker of government and auction services for these properties. The company has taken significant cost reductions, bolster liquidity, and is well-positioned to benefit from postpone government sales and auctions of distress and restructured operator properties. The asset mix at the end of the quarter was relatively unchanged based on the net originations as first lien loans dropped to 47% of cost and second lien loan exposure increased to 43% at cost. Our only non-earning asset is our $7.2 million debt investment in B&T, a wireless engineering and contracting business, which represents 1.5% of assets at fair value. B&T is well-positioned to hover with the increase in wireless 5G expenditures, which we're beginning to see. Since the end of a quarter, our investment in Survey Healthcare of approximately 14 million was prepaid at par, plus a prepayment fee of $300,000. We also sold a $6 million piece of our second lien exposure to Lignetics at par, which represents a significant gain over where this position was marked last quarter. Turning to the outlook for the balance of 2020, despite the unprecedented challenges [indiscernible] COVID-19, we feel we weathered much of last quarter’s challenges and our portfolio, composition, and diversity, underwriting discipline, and active company management has affirmed our lower middle market investment focus and position us well to grow. On the new deal front, we are being cautious regarding any lasting COVID related financial impacts and we have recently seen a pickup in the level of deal increase. Given the current market dislocations and more limited competitive conditions, we expect these opportunities to carry more modest leverage levels and improve yields. We intend to continue to proactively manage our investment capacity and sell existing assets to support these new investments – excuse me, sorry, we intend to sell existing assets to support our new investments to maintain our targeted leverage level while enhancing our net interest income. And now, I'd like to turn it over – the call over to Nicole Schaltenbrand, the CFO of Gladstone Capital to provide an update on the details of the financial performance for the quarter.

Thanks Bob. Good morning, everyone. During the June quarter, total interest income increased 600,000 or 5.7% to 11.6 million, primarily due to an increase in the average balance of our interest bearing investment. The investment portfolio weighted average balance increased by 24.7 million or 6.1% to 429 million, compared to 404.3 million for the quarter ended March 31. The weighted average yield on our interest bearing portfolio was unchanged at 10.9%, compared to the prior quarter, as the decline in LIBOR had a minimal effect, given interest rate floors as an effect in our predominantly floating [rate assets]. Other income decreased by 400,000 compared to last quarter with lower prepayment fees and dividends, resulting in the total investment income for the quarter increasing 200,000 or 2.1% to 11.7 million. Total expenses increased 700,000 or 4.2%, quarter-over-quarter, primarily due to a $900,000 decrease in the incentive fee credit granted by the Adviser and small reductions in interest expenses and fees and other expenses. As a reminder, we continue to credit closing fees received directly to the manager, which were 675,000 last quarter, and we continue to provide a credit to reduce the management fees on broadly syndicated investments to 50 basis points, which was 92,000 last quarter. Net investment income for the quarter ended June 30, 2020 was 6.1 million, a decrease of 7.1% as compared to the prior quarter, or $0.195 per share and covered a 100% of shareholder distribution. The net increase in net assets resulting from operations was 15 million or $0.48 per share for the quarter ended June 30, compared to a decrease of 27.8 million or $0.89 per share for the prior quarter. The current quarter increase was driven primarily by 9 million of net portfolio appreciation as Bob covered earlier. Moving over to the balance sheet. As of June 30, total assets were 458 million, consisting of 447 million in investments at fair value, and 11 million in cash and other assets. Liabilities rose to 231 million as of June 30, and consisted primarily of 133.5 million in borrowings on our credit facility, 57.5 million of 6.125% Senior Notes due 2023, and 38.8 million of 5.375% Senior Notes due 2024. Net assets rose by 8.9 million from the prior quarter end with 9 million of net realized and unrealized portfolio appreciation. The NAV rose from $6.99 per share at March 31 to $7.27 per share as of June 30. Our leverage as of June 30, increased from the prior quarter-end to 102% of net assets from 86% with the net origination for the period. As of the end of the quarter, we had an excess of 53 million of current investment capacity and availability under our line of credit. In April, we successfully extended the revolving period ending on the credit facility by six months to July 15, 2021. 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 and new investment opportunities. With respect to distributions, Gladstone Capital has remained committed to paying its shareholders a cash dividend, and in July, our board of directors declared monthly distributions to our common stockholders of $0.065 per common share per month for July, August, and September, which is an annual rate of $0.78 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 a common stock price at about $7.31 yesterday, the distribution run rate is now producing a yield of 10.7%, which continues to be attractive relative to the extraordinary low yields generally available in the market today. And now I’ll turn it back to David to complete the presentation.

Super Nicole. Very nice. Good presentation, Bob and Mike keeping us all up to date. It's a challenging quarter for the participants in leverage lending marketplace these days and Gladstone Capital is no exception. We did well in delivering numbers on this good company. Originated 56 million, we had about 17 million in pay down, so we ended up with about $39 million increase in our assets, and hopefully all of those will produce some good income over the next six months, and we'll be able to report to you some good things on that front as well. We are working hard with our portfolio companies trying to keep the non-performing assets, where they are today, about 1.5%, and help the total investments. Higher assets drove a nice increase in the company's core net interest income of about 8.9 million. And we've maintained a strong balance sheet, including existing assets making additional capital available to provide for more loans to middle market businesses. That's the business we're in. It's the original business that I started out in many years ago. In summary, the company continues to invest in mid-size private businesses with good management. Many of these situations are supported by private equity funds. So, we hang around with those guys looking to provide the debt that they need to buy something. This gives us an opportunity to make attractive interest paying loans in support of ongoing commitments to pay cash distributions to shareholders. As I mentioned at the beginning, forecasting today is very difficult because quite simply, we have no way of knowing which way the state and local governments, as well as the national governments are going to do to what's going on. If you walk down some streets in Washington, D.C. you see them all boarded up, and we wonder how that's going to unbutton at some point in time. We've given the government the power to do most anything in the name of COVID-19 and has some good things and bad things with it, but let's stop here and have the operator come on. If you would Michelle, come on and tell people how they can ask some questions about the company.

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

Yes. Good morning, everyone. First of all, congratulations on what appears to me to be a very strong quarter given how difficult the environment is, so well done. I see that your investment activity was much higher in that quarter than over the last several quarters. And I'd like to understand how much of that was from deals in the pipeline that perhaps you've been working on for a while, and simply came to fruition now versus opportunistic investing during a period of high dislocation?

Good morning, Mickey. Both of those investments, it takes a while for these deals to come to fruition. I mean, so both of them actually pre-dated the quarter, and were adjusted modestly, as a result of the quarter activities, but feel very comfortable as both of those deals are relatively low leveraged. You know, more like twos versus fours terms of leverage. So, we're happy with those investments. Nice yields, but lower risk exposures.

Okay, thank you for that. That's helpful. Bob, I see that your weighted average risk rating on your proprietary investments improved, which certainly [bugs] the trend I've been seeing generally in the sector, where there some particular outliers that drove up the rating?

Some of those numbers are a little bit lagging since, you know, the financial results for the second quarter are in the 9 - the [630] numbers, right? We don't have [630] numbers, as of [630] for all of our companies. So, there is a little bit of lag in there. The second is, I would attribute mostly to the deals that were recently closed. When we put on deals that are leveraged at less than three, in that order of magnitude, it's certainly going to improve the rating. And thirdly, from my earlier comments, the appreciation of the top three performers had to do with improved performance. So, we had three historical companies dramatically improved their financial performance, which is going to weight up the number. So, it may be a little bit of an anomaly given the timing, but some good assets and improvements on some core position. I think were the result, but we will definitely go back and make sure we understand what that swing was.

I appreciate the color, that's really interesting. So Bob, your leverage, at least in terms of debt-to-equity now is within your target range unless, which – last time I looked, I think you mentioned was 0.9 to 1.25. And it sounds like from your prepared remarks that you're not willing to go higher into the target range, given the current market conditions, is that correct?

I don't think that that – I think we are floating around the 1-to-1 leverage net level now. You know, we obviously had some subsequent pre-payments, so it brought us back down I think, gave us about [20 million] additional capacity based on prepayments. We certainly will go back up on leverage, but we are going to, as we go up over 1-to-1, we are going to be looking at our existing assets closely to determine how much further we want to go. Obviously, we're going to maintain a cushion to deal with any portfolio related matters. Once we get over a certain threshold, we're going to keep an amount of reserve. As you may recall, before we moved our leverage multiple, we typically didn't go much past 80%, even though the rule was, you know, 1-to-1. So, we're going to keep a cushion to that 1.25 going forward, and I think the last comment that I would make is, we also want to be very careful that you know, between the line capacity and what's available in the marketplace, to make sure that the marginal funding cost that we are using to fund those new assets is accretive. So, again, you know, it's going to be around or guardrails around the 1-to-1 leverage, and we're going to closely manage it on a go forward basis.

I do understand that and appreciate it. And David Gladstone mentioned how difficult it is to make forecasts right now, and I realize that the decision to issue common equity takes many factors into account, but you've mentioned cushion several times, and that decision to potentially issue common equity, obviously, would have to take into account the opportunity to put the capital to work. Simply put, do you have appetite to issue common equity, given that the stock is trading above NAV?

That's a tough question Mickey. I got to say, we're going to have to have some really attractive continued investment opportunities at a 10.7% yield on that stock today. When you factor in the marginal debt financing costs, which are probably higher than what's currently in our – on our book today, it's going to have to be a pretty accretive investment opportunity to be able to cover that marginal funding cost and that marginal equity cost, would we consider it? Yes, but it's not going to be a significant volume. We obviously believe that there's, you know, there's a path to which this stock is generating a very attractive yield and it should continue to appreciate. We continue to maintain the quality of the portfolio. So, you know, backing up the truck today is probably premature.

I understand. So, if I could summarize based on those last couple of answers, it sounds like the strategy would be more to, you know, just rotate the portfolio perhaps as repayments come in or from lower yielding investments to higher yielding investments as you find them, while constraining leverage in the midst of all of this uncertainty, is that a fair statement?

It's a good re-characterization Mickey. It’s a day-to-day situation that we're managing. I mean, the other thing that I would add is, you know, when we think about issuing equity, we actually anticipate where the market is going, or already beginning to see some price compression and some competition as the market normalizes. So, I wouldn't want to issue a bunch of equity in anticipation of a particular spread in the marketplace, and to see that get a bit down. So, we're certainly going to manage it very closely. And if we do anything, it may be a small amount under our ATM program as the market dislocations support.

Understand. Those are all my questions for this morning. I appreciate your time.

Thanks for calling in.

And I hope everyone on the team stays healthy. Thanks.

We're all in good shape so far. So Michelle, come on and get the next question.

Our next question comes from Henry Coffey of Wedbush. Your line is open.

Good morning and just kind of following up on Mickey's questions. When new loans are put in front of you, what – who's looking for capital in this market and or is it just people looking not for capital for growth, but for capital to survive? What is the nature of the beast that comes walking in the door looking for capital right now?

Henry there’s a fair amount of folks that are looking to recap our existing lenders. Folks that are under stress, folks that you know have come to the end and have had enough, probably had a bump in the road and they've reached their five-year hold period. So, those are tough situations. We generally are not – we're generally somewhat skeptical in those situations that they've had five years and can't deleverage or payout. It's certainly a [tell-tell] sign that we should be careful. There are certainly some new transactions going on. Folks are beginning to think about how to do diligence in a COVID environment, travel is starting to work and folks are even thinking about doing Zoom diligence calls with management teams, but those transactions are just beginning to percolate. They've been pretty much on hold for the last three to four months. Where we see, you know, additional opportunities coming on are also in some add-ons. Folks that are in the business and have the opportunity to acquire accretively, but for the most part, you know, it's still sponsored financing transactions. Albeit, you know, the overall flow is certainly only beginning to re-emerge.

You also talked about spreads tightening. I don't want to characterize the comment, but what if – what is the correlation right now between actual real life trends in businesses and trends in ‘bond values, and spreads and loan values’? How are those two lining up? Or is there a disconnect there in your opinion?

I only can – I think about it in two ways. The one is, in the broadly syndicated marketplace, we have a number of those investments in our portfolio. They are still marked well below where I would expect them to be. And I think that's indicative of the leverage loan market has not fully re-slated, you know, CLO market conditions, investor funds flows have not bid up the syndicated marketplace, as much as I would expect. You still have assets trading in the 80s, not necessarily the 90s. And, but I think you're also talking about higher levels of leverage, and instruments that don't have quite the same controls and covenants in them and protections that we would require in the current environment. So, that's more of a macro funds flow issue that you know, it's going to take longer to resolve. And I think as I mentioned in the comments, we're only back at about 60% of where we marked it down last quarter. In the direct origination front, where you know, proprietary investments, senior funds, you know, continue to proliferate, you know, we're talking about, you know, insurance companies and plenty of folks looking for yield in the current market environment. And, you know, to be able to put a unitranche piece of paper on your investment portfolio, and talk about, you know, an [L plus seven, eight or more]. That's a very attractive yield relative to the marketplace. And the leverage levels are probably half of what some of the syndicated levels are. We are seeing a more active investment activity there. I mean, without sharing names, you know, a major insurance company, you know, pulls in four or five guys and opens up the checkbook for [$750 million] funds last quarter. I mean, take advantage of the marketplace, recognize there's some dislocation and putting on, you know, paper with floor protections that is going to yield almost, you know, high single digit rates. That's a good return for that investor. So, we're definitely seeing more interest in the direct proprietary investments then we are – the market inflating or reflating the leveraged finance syndicated loan market.

And is that going to be – does that than create a challenge for you in terms of wanting to put out money because you've got an insurance company bid to compete against? Or is that an opportunity because you'd rather be involved in a more liquid dynamic situation as a, you know a no bid market can be very scary as we all know.

Yeah. Well, if you've got a $750 million fund, [they got four people]. You're not going to see the market. You're brand new. You don't have reputation. You don't have the flexibility. So we're still going to compete pretty well in that situation. And we are focused on the lower middle market. They're not going to want to touch a business, at least initially, that might be sub $10 million of EBITDA. So, the competitive barriers for that company getting into where we play is still meaningful. They are a potential participant as that company grows. So, if we go in and do a unitranche, and you know, the business grows, we will may need a partner, or we may decide it’s such a good business that we’ll bring in a lower cost senior as part of building a business. So, if it starts at 8 million and an acquisition or two later is 20 million of EBITDA, we're very happy to start in that transition, grow the business and go from a unitranche player, a sub-debt player in that situation, and make money over the entirety of the duration of our investment. So, I'm not worried about it. I will think that it will drive down the margins at the upper end of the size range initially, and that's what we're beginning to see.

Good. That's very helpful. Thank you for your comments.

Thanks for calling in.

There are no further questions.

No further questions.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect. Everyone, have a great day.