KKR & Co. Inc. (KKR) Q4 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the KKR Financial Holdings LLC Fourth Quarter 2012 Earnings Conference 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 that time. (Operator Instructions) Today’s conference is being recorded. I would now like to turn the call over to Pam Testani.

Thank you, Jamie, and welcome to our fourth quarter 2012 earnings call. I am joined by Bill Sonneborn, our CEO; and Mike McFerran, our COO and CFO. We’d like to remind everyone that this call will contain forward-looking statements based on management’s beliefs, which do not guarantee future events or performance. These statements are subject to substantial risks that are described in greater detail both in our SEC filings and in the supplemental information presentation posted to our website. Actual results may vary materially from today’s statements. We’ll also refer to non-GAAP measures on this call, which are reconciled to GAAP figures in the supplements. Before turning the call over to Mike and Bill to discuss our results, strategy performance, and the macro environment, let me start things off with some fourth quarter highlights. Today, we announced that our Board of Directors declared a regular quarterly cash distribution of $0.21 per common share, which is consistent with the distribution declared for the third quarter and a special distribution of $0.05 per common share. This brings cumulative distributions for the year to $0.86 per common share. The quarterly distribution is payable on February 28 to shareholders of record as of February 14 and the special distribution is payable on March 28 to shareholders of record as of March 14. In addition, this afternoon we reported fourth quarter net income of $77 million, or $0.40 per diluted common share and fiscal year 2012 net income of $348 million or $1.87 per diluted common share. Fourth quarter and 2012 results reflect a 17% and 20% return on shareholders’ equity respectively. Our book value per share totaled $10.31 as of December 31st, which represents a 10% increase from the end of 2011. I’ll now turn the call over to Mike.

Thanks, Pam, and good afternoon, everyone. Before beginning with our financial results, I wanted to highlight that we have changed our income statement presentation slightly to help you match up revenues and expenses for our segments, specifically natural resources. This change in presentation does not impact our net reported results, but it is useful in understanding the company’s revenue and expenses. Now, I’ll review our results for you then spend a little time discussing our liquidity and capital structure. Today, we announced net income of $77 million or $0.40 per diluted common share for the fourth quarter. This is effectively flat with net income of $77 million or $0.43 per diluted common share for the fourth quarter of 2011. The decline on a per share basis year-over-year was related to our 7.5% convertible notes, specifically an increase in the conversion rate to account for distributions made in our common shares in 2012, and the change in our intended settlement method to all equity. Q4 net income consisted of $134 million of total revenues, $73 million of total investment costs, $37 million of other income, and $21 million of other expenses. Total revenues declined 2% from the fourth quarter of 2011. Loan and securities interest income declined in aggregate by $12 million, which was predominantly offset by the increase in oil and gas revenue of $9 million. Overall, the change and composition of our revenue is consistent with our expectations for the following reasons. First, as we have migrated capital from our bank loan and high yield strategy to natural resources during 2011 and 2012. We are seeing a growing portion of our revenue come from natural resources. However, based on where we are in the lifecycle of this strategy. We believe that we are in the expansionary phase from a…

Thank you, Mike. The sentiment in Q4 continued the year’s theme of a global risk on rally despite or maybe even encouraged by the fiscal cliff trauma, yields remained the favorite play of the day and record flows pushed prices even higher than the height they reached in Q3. $85 billion of monthly buying by the fed certainly has influenced investor behavior. The S&P/LSTA leverage loan index was up 1.4% for the quarter while the Merrill Lynch High Yield Master II index gained 3.2%. Between all these inflows and CLO issuance volumes over four times greater than 2011 issuers had been more active than ever. This year’s leverage loan and high-yield issuance of $812 billion beat 2007’s previous record by our whopping 20%. The abundance of buyers in the market means yield is getting squeezed and reward for talking risk is on the decline. High-yield bond yields dipped to a record level of 5.7% during the first few weeks of 2013. When you think of this situation on a spread basis the 10-year treasure went from 1.63% at September 30th to about 2% at the end of January, so the rally experienced in the fourth quarter and so far this year is even more meaningful. Shareholders were asked why we sit today with over $600 million of cash and liquidity. In our view we have entered the sixth inning of the credit cycle. We think that buoyant conditions will last for approximately around another 18 months. We have constantly stated that we will maintain discipline and focus on driving the best outcomes for our common shareholders. Even if that means maintaining excess liquidity to be in a position to drive shareholder returns when that cycle turns. With respect to our portfolio, we saw a consistent opportunity sets in our strategies…

(Operator Instructions)

Should we start with Lee Cooperman at Omega?

Yes, the first question comes from Lee Cooperman from Omega Advisors.

Thank you for very comprehensive rundown in the performance. I just want to make sure I am kind of relating to things properly. We have roughly what the 202 million fully diluted shares presently after the (call of the) risk that’s converters are higher than that?

That’s right, Lee.

That’s approximately correct.

Alright, good. So, if your target lending rate is treasuries plus 1000 and then you have $237.6 million on unrestricted cash and I gather you have the credit line of $350 million which is close to $600 million you are talking about? I am assuming goal in if that cost might be 2%. So, would it be realistic to think in terms of you have unutilized lending capacity of close to $600 million that you could generate between 9 and 10 percentage point net of before loan loss provisioning and additional income. Is that a reasonable way of looking at it?

Yes, but the one thing I want to correct, Lee, is that 600 million is in cash, and in addition to that, we have $150 million untapped line of credit that we can increase to $350 million. So, if we increase that line of credit to $350 million that number will be $950 million.

$950 million. So, theoretically let’s take 9%, 10%, that’s like $80 million or something like that on 202 or 203 million shares that if you had the lending opportunities, you could generate incremental earnings of?

And then above and beyond that, we have still remaining what we have been selling CLO mezz notes, which yielding kind of a cash cost of roughly 3% than we could sell in the market or redeploy. So, there is a lot of leverage there and separating to think we also have capacity for additional long-term debt raises for additional capital given the convert takeout which hurt us with the rating agencies when it was still there and the equity credit that the preferential preferred gives us?

Okay. And then looking at the maturities of your debt, other than a minor amount of money, you have no consequential maturing debt for 23 years?

Really, no maturities for 23 years, well other than a small oil and gas credit facility down and so…

Okay. Let me go on a few other, I am pleased that I understand everything so far. What do you think is the best measure of sustainable profitability that the Board would lever off to determine a dividend, in other words, the cash run-rate of $0.27 was 11% ROE, total net earnings normalized was $0.36 or 14% ROE, what do you think as you look at the structure of your business and how you allocate different amounts of capital to different activities? Is this a 14%, 15% ROE business over time or is it lower than that those earnings that would determine the distributable cash?

Our goal is to generate treasuries plus a 1000, which will flush away based upon what the interest rate environment, so treasuries plus 1000 a day is 12%.

12% right, okay.

On a pro forma basis. We have parts of our portfolio that are earning quite high relative to that, but we are talking about incremental dollar in the ground just given the benefit of some of the legacy CLOs, but if that tenure goes up another 200 basis points, then you would be at that 14% return on equity.

That’s good. And then a couple of years ago, I remember reading in the literature that you had a positive exposure rising interest rates that I think each one of your basis points would add about $10 million to EBITDA, what would that number be today?

So, in a supplement Lee on page 25, you will see the interest rate sensitivity of our credit portfolio. Now, it’s somewhat offset because we have lot of fixed rate debt in the holding company, but roughly you will see that the first kind of 100 basis points costs about $17 million and then we will start to creep that back. So, what we are hoping for in the context of a rate move is something more akin to 1994.

Great, great, great.

That would be very good for KFN.

That’s okay.

In some ways we are shaping up for that as a potential possibility.

Alright, and then one last question, if 12% target ROE cash or earnings let’s say on our book value what kind of payout ratio would you guys be comfortable, you think the Board would be comfortable with. My understanding is that the cap has been removed on the new the credit facility, but I assume you’d like to retain some earnings and payout the bulk of them?

Yeah, I can’t speak for the Board, I’m just one member of that Board, so it will inappropriate for me to do that, but – and we have very fulsome discussions in the context of thinking about how much capital return to shareholders versus retained based upon opportunities we have, existing dry powder we have on the balance sheet and the like and so that all gets factored into the analysis of our distribution every quarter and every year.

I guess one last observation or a question, you are set for rising inflation, rising interest rates, I guess the rest of the company would be if we go into a very deflationary environment.

Well, we tried to protect with that by having 30% of our common book value and cash, which is the best asset to have in deflation. So, we are trying to have a two-thirds of shareholders capital with an inflationary bet on, but we have one-third where we want to protect from our risk management if there is deflation and preserve shareholder capital, that’s one of the reason we’ve created the capital structure and yeah I’ll think of cash as an investment in certain times.

Alright, last one, you would talk about euro CLO efforts, is there anything looking perspective there?

We are still trying to skin that cap, it’s a very complex equation given some of the rules and regulatory regimes that have gone on and continued to transpire in Europe, but it is still strategically a goal that we have.

Alright, just congratulations to you and the whole team, you’ve done a terrific job and I appreciate it. Thank you.

Thank you, Lee.

The next question comes from Daniel Furtado from Jefferies.

Thank you for the opportunity to ask you a question. The first one is assuming the forward outlooks for interest rate, how tight spreads are today. Is it safe to assume that for ‘13 the yield target a little bit more on the natural resources in terms of capital deployment or should we think about the deployment in ’12 as a way to model out ’13?

I mean, I think that’s a reasonable assumptions we set today, I mean if you just look at kind of what the market is saying in the contexts of the interest rate curve, it’s kind of saying very slow growth, low yield to the next five years, because if you look at kind of where the five year treasury is relatively to the 10-year treasury that implies that the buyers in the 10-year are expecting longer term inflation. But buyers that are in that kind of zero to five curve are not willing to admit that’s a possibility, and so natural resources and real estate are two reinvestments that provides cash yield (indiscernible) in different environments. So, we’ll have some capital deployment in this sector, but as we talked about that’s probably will more than a minority of our total capital. And if the CLO market which you’ve seen AAA spreads gone from like 145 to 140 now to 130, they have not tightened as fast as asset spreads have, but as they accelerate in the contexts of tightening, you could see more capital deployment and allocating more subordinated notes based upon the risk adjusted return in future CLO issuance.

Understood. Thank you. And if I may with a follow-up one, when we think about the 2012-1 CLO issuance, is it safe to assume lifetime hurdle rates of treasuries plus 1000 or how do you think about the and I get it there is a lot of moving parts there, but when you get into the deal, you must have some baseline assumption and kind of what formula are you building that CLO to?

For that CLO, that is the bogie, we and clearly when we take on treasuries plus 1000 nicely about that CLO to the nature of it gives us that ability for the portfolio to adjust accordingly if rates go up.

And will there be – can you give us some guidance on how to think about the slope of the ROE if we assume all-in hurdle return or all-in IR is in the T plus 1000 range and is that relatively straight lined of is there some slope because you have that reinvestment period on the front end?

There will be some slope in the first two quarters, but then after that where you will see potentially more opportunity – so then you will actually be in that treasuries plus 1000. After that it really depends on what the credit markets do. If you saw assets that really widen out following a wave of prepayments or something you saw really in 2007 for the first half of the year it seems tight and tight and tight and the second half of the year spreads widened out then you will have the opportunity to employee a lot more capital at wider spreads. If that repeats itself then we can do better than what we are targeting.

Understood, thank you for that clarity, I appreciate it.

Thank you.

Your next question comes from Gabe Poggi from FBR.

Hi, good afternoon guys my questions have been asked. Good job on the quarter.

Thanks Gabe.

Your next question comes from Jason Stewart from Compass Point.

Great, thank you. Can you give us an idea for what the average utilization on that warehouse line that was refinanced has been or maybe like the last year or so?

Absolutely, it was zero and the background on that is and as we mentioned in our remarks, A, we had liquidity where we didn’t need to use that revolving facility. And we haven’t used on for years and we frankly use that, we have that viewed that really as kind of a rainy day backup facility because the way it works it was a borrowing base where you pledge assets and declines in the fair value of assets would resolve then you have to pay it down or propose collateral. So, the benefit of the new facility we have in place is that we would actually expect to have much higher utilization because now we don’t have any negative precaution of asset price is falling. So, this gives us a lot more flexibility to use it opportunistically without the downside risk.

Okay and would there be a target level of cash that you would take that down to before utilizing this facility or…

We definitely would run we have – as we talked about pro forma $600 million of cash toady so we would have drawn that with a much a cash on the account. What it does change for us is Bill and I can operate the business with a different mindset of being able to run the business with a very small amount of cash knowing that we have that tech without any restriction.

Okay and then one last question. I think in one of your answers you said you may have sold some of the retained CLO notes I think 2007-1D was one and then the most recent, have you sold any of those subsequent to quarter end, it doesn’t look like was I missed it they were in the fourth quarter?

There was a small amount at the beginning of October that we talked about on our last call. There were none subsequent to quarter end and today we still hold and it’s in our supplement the number is about $85 million still of those Class D notes.

Got you. Okay, thank you for the questions.

Thank you.

Your next question comes from Stephen Laws from Deutsche Bank.

Hi thanks for taking my questions and I appreciate all the data in the supplemental pack. To kind of follow up a little bit with what Daniel asked earlier kind of looking through the different business segments or targeted asset classes, it seems like you don’t find the mezzanine as attractive here and what you do see you prefer Europe over the U.S. And it looks like you did make some investments in special situations private equity and natural resources especially is that accurate. And then maybe can you comment on page 23 you kind of lay out a little bit of the commercial real estate strategy and maybe what type if any growth you guys think that occur there in 2013?

Sure good question. The U.S. mezz market and the reason that we just haven’t deployed there is we’ve tried to be pretty vocal of shareholders that we kind of have risk tolerance we will undertake and then we want to get that treasuries plus 1000 return with that risk tolerance. And because of the strength of the high-yield market the capital market here in the U.S. and the competition of lots of business development companies that focus exclusively or almost exclusively on the U.S. mezz market or second lien market, the return per unit of risk hasn’t met our threshold. So, where we found more opportunity is in Europe where there is fewer competitors. That being said a return of M&A volume which has also been slow in the U.S. could change that equation from the supply demand balance domestically. So, that’s the issue from a mezz perspective, how we thought about the asset class. When it comes to thinking about real estate, we can provide that disclosure on page 23. My answer is we do expect to announce and you will see press releases potentially in the next few weeks or months of additional asset acquisitions targeting those things again they can protect shareholders’ capital given acquisition at well below replacement cost have an opportunity to provide yield and have upside depreciation particularly in an inflation area.

Great and then I guess one kind of more housekeeping comment, on the share count obviously we had a higher diluted number given some of the – I guess balance sheet restructuring going on which seems like you guys have done a great job of that. Can you give us an idea of what we should look at is a fully diluted share count kind of going forward in our models?

Sure, so what you are seeing at December 31st, the reported share count number on the income statement is consistent with the assumption that we would settle all of the converts with the shares.

Right and so that’s the number we should look at as far as go forward or will you settle some of those conversions?

(Not followed) I think today with cash so that would capture most of the converts than we have may go on top of it, but as we expressed the total increase would be 26.1 million shares.

So, that’s what we should look at the increase from that the number that’s on the balance sheet.

Yes, that will be the increase in outstanding shares.

Perfect. Again thanks for my questions and congratulations on very nice quarter.

Thank you.

The next question comes from Jasper Burch from Macquarie.

Hey, good afternoon guys. Bill I saw you said in the opening remarks that you expect buoyant conditions for at least another 18 months and it sounds like you are talking about in terms of spreads that are available on new investments does that sort of mean that we should expect relatively modest net investment unless we see some sort of disruption in asset pricing or credit spreads?

Well, I mean, especially there is lots of variables to that question, I did say we expect buoyant market conditions in the context of some in the credit markets to continue for at least 18 months and being the fixating of the credit cycle. And the reason being that may not impact capital deployment is talks about answer another question CLOs are very attractive asset class in periods of tightening credit spreads particularly when the liability side tightens at the same pace as the asset side. And you are starting to see liability spread they are tightened by 10 basis points just in the past six weeks they may tighten even further that moved down in the context of those structures locking in senior secured loans. And that treasuries plus 1000 and the optionality on that liability cost is extremely valuable for our shareholders. So, there is ways we can deploy substantial amounts of capital even in kind of those pretty strong credit market conditions that we’ve been experiencing over the past six months.

Thank you, that’s helpful. And then completely different direction we’re seeing some I guess not quite peers, but similar companies announced, are not similar companies, but peers guys like New Castle announced splits, splitting of their companies and it’s definitely given them some sort of valuation premium with the individual parts are being looked as more valuable than the whole. I know that the operational flexibility is sort of one of your trademarks that’s been really helpful to the shareholder returns through the downturn. And I was just wondering do you think that your share price that you have given a full credit for the various parts and sort of what sort of upside would we have to see in your mind to sort of evaluation in order to consider something like that?

Jasper, all good questions and I think we’ve talked in previous calls that we are very, very focused on shareholder value and so yes we have a REIT sub, yes, have an MLP sub and so to the extent that – as those scale over time, the only way we can unlock true shareholder value is through swaps or spin-offs, it’s always something we are opened to consider, that’s an embedded option and quite there is an example of an embedded option we carry in the structure that we can unlock if market condition suggest that’s the best way to drive value for our common holders.

Okay, well, thank you for taking my questions and nice job in the quarter.

Thank you.

(Operator Instructions)

Well, thank you all, I appreciate again your trust and confidence. We look forward to getting back to work and trying to hit the targets we set out for us. Thanks.

Ladies and gentlemen, that does conclude the conference for today. Again, thank you for your participation. You may all disconnect. Have a good day.