Gladstone Capital Corporation (GLAD) Q3 2022 Earnings Report, Transcript and Summary

Greetings. Welcome to the Gladstone Capital Corporation Third Quarter Earnings Call. [Operator Instructions]. Please note this conference is being recorded. I will now turn the conference over to your host, David Gladstone, the Chief Executive Officer. You may begin.

Well, thank you so much. That was a nice introduction, and good morning, everybody. This is David Gladstone, Chairman, and this is the earnings conference call on Gladstone Capital for the quarter ending June 30, 2022. Thank you all for calling in. We're always happy to talk with our shareholders and the analysts who follow us. We welcome the opportunity to provide an update for our quarter that ended. And now we'll hear from our General Counsel, Michael LiCalsi. He'll make a statement regarding certain forward-looking statements. Michael, take over.

Thanks, David, and good morning, everybody. 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. And these forward-looking statements involve certain risks and uncertainties that are based on our current plans, which we believe to be reasonable. 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 you can find in our Forms 10-Q, 10-K and other documents we file with the SEC. You can find them on the Investor Relations page of our website, that's www.gladstonecapital.com. You can also sign up for our e-mail notification service. You can also find these documents on the SEC's website, that's 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. Now today's call is an overview of our results, so we ask that you review our press release and Form 10-Q, both issued yesterday, for more detailed information. And if you go to the Investors page of our website, you can find them there. I'll now 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. I'll cover the highlights for last quarter and provide some comments on the state of the portfolio and market outlook before turning the call over to Nicole Schaltenbrand, Gladstone Capital's CFO, to review our financial results for the period and our capital and liquidity positions. So beginning with our last quarter results. Originations for the quarter recovered after a slow Q1 and totaled $67 million for the period, which included 3 new platform investments and several add-on investments to existing portfolio companies. Amortization and repayments were $6 million, so net originations were strong $61 million for the period. Interest income for the quarter fell 2.8% to $12.6 million as the average outstandings were down approximately $8 million and the weighted average loan yields fell approximately 20 basis points with the roll-off of an investment which represented a large component of our PIK interest income. In the absence of material exits and repayment and fee income, it declined to $1.2 million, which was down from the elevated levels of the past several quarters. Borrowing costs and administrative costs were largely unchanged. However, net management fees declined by $1.8 million to $2.5 million as the new deal closing fees credited against the base management fee rose to $1.1 million and incentive fee credits were $400,000 for the quarter. Net investment income came in at $6.9 million or $0.2025 per share and covered 100% of the recently increased common distributions for the period. The net realized and unrealized losses on the portfolio for the period rose to $12.5 million on a combination of loan depreciation associated with elevated market spreads, reduced equity valuation multiples and the decline of 2 equity investments. As a result, NAV declined $0.37 per share or 3.9% to $9.12 per share as of June 30. Despite the last quarter NAV impact, we're pleased to report our cumulative return on equity over the last year is still 14.9%. With respect to the portfolio, our portfolio continues to perform well with generally modest leverage metrics and favorable liquidity. And as such, we did not experience any payment defaults last quarter. Credit performance aside, the third-party market valuation of our debt investments, combined with a 4.3% decline in the enterprise value multiples on our equity portfolio, combined to total approximately $5.2 million of depreciation or roughly 45% of the depreciation in the quarter. During the quarter, we also completed the restructuring of Circuitronics, which have been a challenge for some time. And coincident with the relocation of the manufacturing operations and the exiting bankruptcy as Lonestar EMS, we recognized $8.5 million of depreciation previously accrued. Lastly, most of the balance of the unrealized depreciation for the quarter is associated with two equity positions in modestly leveraged businesses, which experienced isolated revenue shortfalls, and we expect to recover over the balance of 2022. The asset mix as of the end of the quarter continued to shift in favor of first lien loans, which rose to 74% of assets at fair market value. Looking over the balance of '22, there are a couple of comments I'd like to leave you with. We have a number of new proprietary investments or follow-on investments to existing portfolio of companies we anticipate closing in the near term. In addition, we expect near-term prepayment activity to moderate in the face of higher rates and market conditions, and net originations to remain elevated for the balance of the year. And we'll be closely managing our leverage within the target range of 90% to 110% of NAV going forward. Consistent with a tighter credit environment, we also expect to see an improvement in pricing and relative leverage metrics in the new originations over the balance of the year. We continue to be well positioned to benefit from the increase in short-term rates, with 93% of our investment portfolio subject to floating rates. And as of June 30, 71% of our debt was at fixed rates. Now that LIBOR has increased above the average LIBOR floor in the portfolio of 1.16%, we expect that for each 75 basis point increase above -- in LIBOR above the level as of 6/30, which was 1.8%, we will increase our quarterly net interest margin by $0.5 million and NII per share by $0.01. We continue -- we will continue to assess the outlook for portfolio growth and net interest income increases to sustain any future increases to the shareholder distributions. And now I'd like to turn the call over to Nicole Schaltenbrand, the CFO for Gladstone Capital, to provide some details of the fund's financial results for the quarter. Nicole?

Thanks, Bob. Good morning, everyone. During the June quarter, total interest income declined $400,000 or 2.8% to $12.6 million. The investment portfolio weighted average balance decreased by $8 million to $506 million compared to the prior quarter. The weighted average yield on our interest-bearing portfolio also declined 20 basis points to 10%, most of which was intensified by the PIK interest, which declined 30% to 5.1% of interest income. Other income declined by $3.1 million to $1.2 million. And as a result, total investment income declined to $13.8 million for the quarter. Total expenses increased by $1.7 million quarter-over-quarter as net management fees declined $1.8 million with the $1.1 million of new deal closing fees credited against the base management fee and incentive fee credits of $400,000. Net investment income for the quarter ended June 30 was $6.9 million or $0.2025 per share and covered 100% of our shareholder distribution. The net decrease in net assets resulting from operations was $5.6 million or negative $0.16 per share for the quarter ended June 30, 2022, compared to a net increase in net assets resulting from operations of $8.3 million or $0.24 per share for the prior quarter. And the primary drivers for this change was the realized and unrealized valuation depreciation as covered by Bob earlier. Moving over to the balance sheet. As of June 30, total assets rose to $597 million, consisting of $586 million in investments at fair value and $11 million in cash and other assets. Liabilities increased to $284 million as of June 30, 2022, and consisted primarily of $150 million of 5 1/8% senior notes due 2026 and $50 million of 3 3/4% senior notes due May of 2027. And as of the end of the quarter, advances under our line of credit were $80 million. As of June 30, net assets declined by $12.5 million from the prior quarter end with the realized and unrealized valuation depreciation. NAV declined from $9.49 per share as of March 31 to $9.12 per share as of June 30. Our leverage as of the end of the quarter rose with the increase in total assets and the NAV decline and now stands at 91% of net assets. At quarter end, we had in excess of $70 million of current borrowing availability under our line of credit, the revolving period of which ends in October of 2023. With respect to distribution, Gladstone Capital has remained committed to paying its stockholders a cash distribution. And in July, our Board of Directors declared monthly distributions to our common stockholders of $0.0675 per common share per month for July, August and September, which is an annual run rate of $0.81 per share. The Board will meet again 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 $10.99 per share yesterday, the distribution run rate is now producing a yield of about 7.4%. Distributions, in addition to the NAV growth over the past year of $0.60 per share, have resulted in a total return of $1.39 per share or 16.3% in NAV over the past year. And now I'll turn it back to David to conclude.

Thank you, Nicole. That was a very good presentation. And Bob and Michael and all of you all did a great job of informing shareholders and the analysts that follow our company. So in summary, I think it's just another solid quarter for Gladstone Capital. The company closed $67 million in new proprietary originations and add-on investments to existing investments, which lifted the total investments to new high-water mark of almost $600 million. The company has a solid deal pipeline to support the asset growth continuing into the current quarter. Investment income did fall a little bit due to reduced exit fees. However, the combination of investment portfolio growth, the recent uptick in LIBOR and, in addition to that, the potential for increasing the common distribution rate to common -- in the coming quarter. To be specific, $531 million of loans on the books at the end of the quarter, of which 93% is floating rate and 83% is senior secured, all current and performing. And we only have $80 million of floating rate debt in Gladstone Capital. I think we're very well positioned for support in the dividends to stockholders. And just a side note, there's a lot of debate on whether we're in a recession or not. And I can conclusively report that Gladstone Capital is not in a recession. In summary, the company continues to stick with its strategy of investing in growth-oriented middle-market businesses with good management. Many of these investments are supported of mid-sized private equity funds that are doing buyouts. And they're looking for experienced partners to support the acquisition and growth of the businesses they're investing in. We can provide that. This gives us the opportunity to make attractive interest-paying loans to support our ongoing commitment to pay cash distributions to shareholders. So congratulations to the team at Gladstone Capital, it was another good quarter. And now if the operator will come on and tell callers how they can ask some questions, we'll take some questions from all the people following us.

[Operator Instructions]. Our first question comes from the line of Robert Dodd with Raymond James.

I'm going to apologize upfront, I had a little trouble getting into the call, so I'm going to ask you to repeat a couple of things if I can, Bob and Michael, very briefly at the beginning. Excluding Lonestar EMS, the restructuring there, which I understand that the realized loss and the reversal of the unrealized, how much of the unrealized depreciation would you say was credit-driven versus just mark-to-market? And I think you gave some numbers, I caught the very end of it, but I didn't get to that in time, so I apologize.

Robert, that's fine. I would say in my comments, the amount of credit performance was probably in the $2 million to $3 million range. And in segmenting those, I would say, the vast majority of the movement on the quarter had to do with the revaluation of the yields, the depreciation of the enterprise value multiples applicable to our equity investments and then some movement in our underlying equity investments, which we believe to be temporary dislocations in EBITDA. And obviously, the bigger the EBITDA -- the bigger the equity component, the larger the EBITDA move. So your question around credit performance, it's a relatively small portion of the overall move.

Got it. That's what I thought. On the outlook for the rest of the year, obviously lower repayments, I think, are expected. But I mean, you do sound quite bullish on the amount of new capital being deployed with follow-ons, et cetera. Can you give us any color on kind of what the drivers -- are those follow-on investments that have been working on a long time? Or are they follow-on investments where the business that's seeking the additional capital has now identified an acquisition? Or is it people seeking to just boost their liquidity, given a potentially tough economic environment out there? Can you give us any color on that?

Yes, let me -- I'll give you two examples that I think are indicative of the trend. We've been supporters of certain businesses and sponsors for a while. And occasionally, those deals will grow in size and they'll get beyond our capacity. And so we, as agent and long-standing investors, will work on behalf of our sponsors to find other investments to club and participate in a transaction. And when we bring in new investors into those situations, we always like the opportunity for them to reciprocate and bring us volume. And so we have eared some volume to a couple of large-scale investors and curried favor. And we have several investments that are being brought to us on a noncompetitive basis to participate in very attractive transactions. That's one scenario that we've been playing. The second is with respect to yield movement and opportunities, in a rockier outlook as we face today in certain sectors, the consistency and the strategy that we have of supporting the growth and expansion of a business is even more important. You want partners that can stick with you that understand your business and are willing to weigh in. And we, in fact, have been fortunate enough to sign up several investments that are in very stable food-oriented -- food and beverage-oriented businesses that are looking to transition from family ownership to more entrepreneurial and growth-oriented ownership. And they recognize the ability to grow is going to be a function of the partner they select. And we have won competitive auctions in the food and beverage business, which traditionally is a very stable and good credit play for us to help those businesses expand, so in that particular case, modestly leveraged, attractively priced with an equity co-investment. And if somebody wants to grow over the course of the next 2 years, having the right partner in that kind of a business is very important to them. So we're seeing a combination of banks are out of the market, people are looking for consistency and support. And we can either increase our yield or we can continue to invest in good, solid businesses at modest leverage multiples. And we're kind of seeing both.

I appreciate that color. And yes, I mean, that's kind of the whole advantage of the private credit market, right, is with sticking with people long term. Last one, if I can. I appreciate the color you gave on the earnings interest rate sensitivity. Obviously, there are disclosures in the Q on that as well. Any -- do you think that if rates do go up 75 basis points, another 150 basis points, at what level do you get nervous about the impact on interest coverage at -- I mean, how high do rates have to go from here before that becomes a significant concern?

I don't see -- right now, I think we're factoring in something in the low to mid-3s. And when you look at the majority of our credits, the average portfolio of the core leverage is probably in the mid-3s -- mid- to high 3s. So most of those credits have not only cash availability but are not stretched in terms of their overall leverage. So I guess, I wouldn't have any significant concerns outside of certain limited or isolated instances frankly until we get probably closer to 5%, which is probably twice where we are today. I mean, at that point, I think folks are going to going to be looking at our average spread. I mean, look at where yield would be. Given our floating rate and where we are at 10% today, you'd be talking about on average yield in the portfolio, probably in the low-teens. That's a lot of interest expense to carry. So frankly, I just -- I don't see anything in that in the cards right now. In fact, I think the noise that we're continuing to anticipate is things are slowing and maybe will start to come down by the end of next year. So I don't think it's a long duration even if it were to spike, which is obviously would be a greater concern on a duration of that level.

[Operator Instructions]. Our next question goes -- comes from the line of Mickey Schleien with Ladenburg.

Notwithstanding the comments at the beginning of the call that the portfolio is not in recession, could you give us a sense of how revenues and margins are trending amongst your borrowers, at least broadly speaking? And what's your thesis on how that will develop for the rest of this year and into next year?

Mickey, it's -- our portfolio is so varied, it's hard to make any particular judgments. I would say the two credits that we identified that were certainly more challenged did have an EBITDA decline and that was tied to revenue declines in order of magnitude of 20%, plus or minus. The balance of the portfolio for the most part was, plus or minus, single-digit percentages. So for the most part, some of it is seasonal. Some of it may be slowed logistical demand -- supply chain issues. And some of it is just we're not a very consumer-centric businesses, it's all business-to-business for the most part. So it's not going to get whipsawed by consumer spend or housing demands or construction-related activities. The two that have affected us the most are one was in the -- was a logistical challenge. The ports in the West Coast are still slow at delivering containers. And they couldn't supply the inventories to book the sales they expected. And the other was a wireless construction-related business, where a major customer decided to slow down their spend and resulted in a dip in revenues. Overall, we're still seeing relatively solid demand. Remember, most of our businesses are domestic manufacturing. The focus on domestic manufacturing versus foreign sourcing continues to be a highlight for most folks in trying to manage their supply chains. And we're just not seeing any particular slowdown in those sectors. The auto market, which we have a few credits in that arena, is still relatively slow, expecting pickups as we get into the fall. And the chip availability continues to improve. So I would argue that's certainly on the upside. I would also argue we've been -- we've faced the downside on the couple of energy-related credits in the last couple of quarters. And they're booming. We have two that are doing extraordinarily well, paying down their credits faster than expected. So proportionally, I can't even measure that magnitude of increase. So I think right now, our core focus on sustainable, growth-oriented domestic businesses is still intact and feel that whether it's up 5% or down 5%, we're in the right place with these companies.

That's very helpful, Bob. Just one more follow-up question if I may. We're sort of in the strange environment, where we hear the R word in the media, but we see results like yours, we see a tight labor market, we see corporate borrowers performing generally well. And it begs the question, where are we going to be later this year? So what I want to ask about is your thesis on the net originations remaining strong, I guess, you said for the balance of this year. What are the main drivers of that, given at least at the top line, the economy looks like it's slowing down?

Well, I do believe that the deal environment, while the mega deals have slowed down and it's kind of weighing on the markets and certainly some of the larger banks, I believe that there are still significant opportunities for businesses to go through transformational ownership and private equity-oriented owners are still the most likely place where the transformation of that business, whether it's digital or just operational, is going to create value. So I see family businesses selling with the idea that we're going to put in new measurement systems, new performance, new technologies, improved efficiencies, better automation. That transformation is part of the reason why I think we will continue to see private equity investing in businesses and affecting those changes and improvements. And I don't think that changes because interest rates are up 100 basis points or the housing market dips by 20%. I think there is an ability to transform and create value through managing those businesses. And we're seeing that in some of our investments. Secondly, certain sectors are certainly stronger. I will say that one area that we're seeing a lot of activity is in health care. Health care is not going away. There are continuing to be demographic and fundamental changes in the configuration and delivery systems for health care. And that is going to be an opportunity for us to go forward. So I think the broader thesis of business transformation, domestic manufacturing capability and supply and demographic growth and changes are creating opportunities. And folks that understand where that is and are willing to dig in and underwrite that business are going to do fine. It just so happens at the moment that there are a lot of folks that are not digging in and are pulling back. And it's giving us an opportunity to take on some very nice businesses. I'll give you a point reference. We were told that in a recent award that we have and in the process of closing, they went to 75 lenders, got dozens of term sheets and we won the transaction because we understood the business and leaned in to support their growth. And that kind of a partnership is something that people seek. That's -- it's not transactional. It's about your ability to understand and your reputation in supporting businesses and their growth. That's why I think we're winning.

That's -- those are really interesting comments, Bob. And there is data as we know that lower middle-market investments can perform as well or maybe even better than upper middle-market investments. And with that in mind and maybe for the benefit of the audience, you mentioned targeting family-owned businesses. What sort of typical EBITDA are you looking at? I know it varies by the sector. But what sort of average EBITDA are these companies that you're investing in generating when you invest?

Typically, they're in, let's say, the $4 million to $6 million to $8 million range. And they quickly accelerate. Some of that is probably stripping out cost and improving efficiencies. And then it's the ability to infuse sales capabilities or acquisitions. So we'd like to get them at that size. And if we can ride them until they get to $30 million or $40 million, then we've made a lot of money and our partners have made a lot of money as well.

We have reached the end of the question-and-answer session. So I'll now turn it back over to you, David, for closing remarks.

All right. Well, thank you all for calling in, and we hope the next meeting about a month from now will be just as strong as the one you saw. That's the end of this call.

And this concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.