KKR & Co. Inc. (KKR) Q3 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for standing by. And welcome to the KKR Financial Holdings LLC Third Quarter 2013 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we’ll conduct a question-and-answer session, and instructions will be given at that time. (Operator Instructions) As a reminder, today’s conference is being recorded. It’s now my pleasure to turn the floor over to Pam Testani. Ma’am, the floor is yours.

Thank you, Harry. Welcome to our third quarter 2013 earnings call. I’m joined by Craig Farr, CEO; and Mike McFerran, our COO and CFO. As a reminder, we’ll be discussing forward-looking statements on today’s call, which are based on management’s belief. These don’t guarantee future events or performance and 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, which are reconciled to GAAP figures in the supplement. I’ll start with some third quarter highlights and then I’ll turn it to Mike and Craig. With Craig taking over a CEO of KFN last quarter, we have undertaken a review of the business. Craig and Mike will give you a fresh assessment of where we are today and where we’d like to go from here to drive value for our shareholders. This afternoon we reported third quarter net income available to common shareholders of $33 million or $0.16 per diluted common share. This compares to $79 million or $0.39 per diluted common share for the second quarter. The largest driven of this decline were lower level of investment gains than in Q2, as well as the fact that we took an incremental provision for loan losses. At the end of Q3, our book value was $10.42 per common share, up from $10.41 at June 30th. We had a very good quarter for capital deployment across our strategies, leaving us with $222 million of cash at September 30th, down from $508 million at the end of Q2. Our Board of Directors has declared the cash distribution of $0.22 per common share for the third quarter, which is up from $0.21 in each of the last five quarters. The distribution is payable on November 20th to common shareholders of record as of November 6th. And finally for those who haven’t seen, we’ve begin posting trustee reports for all of our CLOs to our website. Many of you have asked for more details on the CLOs and how they amortize, they having monthly data on their performance should be helpful. And I’ll now pass it to Mike.

Thanks, Pam, and thanks everyone for joining our call today. I’m going to cover a few topics, first, this quarter’s results and our earnings trajectory, second, where our portfolio is today, third, our capital deployment and liquidity position, and finally, I’ll spend a moment on our distribution and taxation. Starting with the results, our third quarter net income available to common shareholders was $33 million or $0.16 per diluted common share versus $79 million last quarter or $0.39. It’s easier to understand this decline, if you think about things in terms of run rate and then gain-related earnings. Our run rate earnings this quarter [surpassing] everything gains and incentive fees, $0.13 a share or $0.18 if you add back the impact of the loan loss provision we talk. Decline from $0.23 from the second quarter to an adjusted $0.18 this quarter is largely attributable to fewer prepayments in the third consistent with the broader market. We had a $666 million of prepayments on the par base of $6.7 billion in the second quarter versus only $122 million on the base of $6.5 billion to the third quarter. That was $11 million of the $12 million decline in our interest income from the second quarter. On the gain-related side, we had $0.03 per share of other income for the third quarter versus about $0.18 for the second quarter. These earnings had come from two places. First, gains embedded in our bank loan high yield bond portfolio, which have largely resided in our quite KKR Holdings and second, mark-to-market or exits on our total return-oriented strategies, as well as hedges and foreign currency. We have been exiting our quite [KKR] positions. Many of which we held far below par and that was around par, which has driven material gains in the last…

Thanks, Mike. I talked about the quarter of the way we perceive to be keeping strengths, as I took over to CEO soon. And to begin with, we have extremely long live liabilities and no mark-to-market value including our revolver, so we have an enviable capital structure as starting point. We also have a stellar portfolio of assets as you heard from Mike. Having spent some time in the business, I feel comfortable with the diversification in the risk profile of the assets at the funding structure. My job from here is to see here, how we deliver upside in the phase of the amortizing CLO you see in some of our results and the overall yield compression we see across all asset classes today. We spent a lot of time thinking about that and it’s a very dynamic environment. In the process, we have spoken too many of you about a few key things. First, we clearly need to be growing our cash earnings not just overall but per share, that seems to be challenging in the interest rate environment and legacy CLOs amortizing is how meaningful they are to our earnings and cash flow. Second, I hear from a lot of your stories, starting too complicated to be diversified. But if that’s just a network, we would like to see a narrow set of core asset strategies in order to having a easier time involving earnings part of business. And finally, as Mike alluded to their complexities surrounding corporate structure, for example K-1s. It’s clear to me that to get value in the market for KFN and KKR’s key strength, we need to address these points. For using the feedback to adjust accordingly, we are going to increase our capital deployments to more cash building strategies in order…

Thank you, sir. (Operator Instruction) And our first question in queue will come from the line of John Hecht with Stephens. Please go ahead. Your line is now open.

Afternoon. Thanks for taking my question. Just a couple kind of household kind of questions for the model. First is, do you guys have the -- either the sure value or economic book value versus the recently reported GAAP book value?

We -- not handy, John.

Okay.

But we can just close that.

Okay. Next, so I guess -- when I’ll call you on matters you get better in the next few moments you can provide us, it’s not that important. And the second question you have it is, what was the discount accretion in the quarter? Do you have that handy?

Discount accretion from prepayments was pretty anemic at about a $1 million.

Okay.

That compares to $12 million from last quarter.

Yeah. Okay. Moving on to more kind of strategic questions. You guys had a lot of deployment in the quarter, sorry?

I’m going to interrupt you. Assume you’ve -- fair value over corporate GAAP holdings, adjusted book value would be $10.70 per share.

Okay. Great. Thanks for that. Okay. In terms of the deployment in the quarter, you mentioned your asset by asset but can you discuss the timing was just kind of balanced throughout the quarter? Was it late in the quarter? I’m trying to just assess for what run rate earnings might be including the full quarter of performance of the new deployment.

Sure. The $75 million, we contributed to CLO 2011-1, which we up sided by $300 million. That was done in the last day of the quarter. So there’s no impact on the quarter, just last quarter from that when you see it going forward as we ramped. The Maritime deal, which we funded at $84 million of our $115 million commitments to, we talked about, that’s going to ramp up over the next year. And once that portfolio kind of hits this run rate, we would expect later ‘14 or early’15, it will start to begin generating or returning dividends to us, which we hope is not mid-teens range. On the natural resources and commercial real estate front, those were done -- in fact throughout the quarter. But as you know, John, those have little bit mortgage acre for fast run and delay when we start receiving the benefit of income and cash flows.

And then, you guys -- it sounds like you are going to deemphasize other your remaining commitments, deemphasize natural resources. You are considering the commitments and the cash flows and I guess in-ground resources and so forth. When would we see the peak cash flows and when would those start to kind of tail off or amortize, just with the right type of data we should be thinking about?

So on the natural resources, John, you will probably see that mid next year. On the commercial real estate side, as we mentioned in our remarks that we expect to see that where we kind of starting and had more of a recurring basis in early ‘15 with the pickup the second half of ’14.

Okay. And to be clear, you would expect that the peak of the natural resources portfolio middle of the next year then that would start to decrease over time.

Overtime. Correct.

Okay. Appreciate that. Very much. Thanks guys.

Thanks John.

Thank you, sir. Our next phone question will come from the line of Daniel Furtado with Jefferies. Please go ahead, your line is open.

Good afternoon. Thank you for the opportunity. I just had a couple of questions trying to figure out this bank loan and high-yield strategy. The performance quarter-over-quarter, excluding other income, it looks like revenue or income is down about $17 million. I’m just trying to get a handle on, is the $11 million you were talking about in the prepay income that didn’t come true this quarter part of that $17 million and the accretion to delta or how should I think about that $17 million decline considering that the portfolio balance is up quarter-over-quarter?

Daniel, $11 million is part of that. So that’s the key component, which is, one, you have seen the portfolio turnover over time. And the actual portfolio spreads is tightened but what’s most noteworthy is we saw $666 million of prepayments in the second quarter and a little over $100 million this quarter. So that’s 80% drop. So this is the lowest level we’ve seen in quite some time as a result of that level of prepayment is pretty anemic on $1 million. So that would be the driver of that decline we’re referring to.

Okay. And so I guess, looking forward, I mean, the tenure come in this quarter so arguably there is more prepayment activity but in a rising rate are consistently moving higher environment. I mean, is the right way to approach this to back out $11 million or there whatever the ratio happens to be between assets in that prepayment income on a go-forward basis if investors are assuming rates are going up or -- how do you I think about that. I mean, was this $11 million or thereabout pretty consistent in the past and at a rising rate environment, does that come out moving forward?

It’s a great question. Over the last couple of years, that number is varied anywhere, let’s say, $5 million to $12 million on average. So I would definitely not ignore it. If I look at the recent portfolio today, you’ve got $100 million difference between par and cost basis of the assets that needs to be accreted in on a portfolio where leverage loan, you’d assume the average life for them is four years. So if I do that math, obviously straight line, that’s going to be $25 million a year or about $6 million a quarter which would not be too different that kind of a historical norm for us, really independent rates because the fact that loans usually aren’t accompanied by a prepayment penalty, they still get paid off.

Okay. I got you. Thank you for that. I appreciate it. And then I think -- another question, when you think about the CLO de-leveraging, if you look that there is a chart you put in here, the figure, Page 13 where you kind of show the current quarter cash receipts, the interest receipts is like a 3-ish million dollar change there. Is that the way -- is that the best way to kind of track from a higher level of the de-leveraging effect that’s going on in the vintage -- in the CLO book?

Yes. I mean, that -- the cash is obviously driven by two things. But the CLOs are amortizing. Clearly, the biggest volume is going to be amortization and for the other deals that are in reinvestment especially whether they are reinvesting into a wider or tightening spread in items of another variable. But when I look at 2005, 2006 deals and 2007, 2008 which are all amortizing that’s the best indication of seeing that drop-off.

Okay. Thank you. And then finally, one other higher level question. So if we assume rates are moving higher, prepays are slow and so on one hand, you are not going to be getting that prepay income on the revenue side but on the other, couldn’t you argue that the CLOs were de-levered more slowly because the principal payments would be coming in more slowly because of higher rates.

Great observation. Completely agree that -- if I had to pick which one we prefer, we’ll take the slower prepayments and extending the life to our legacy deals.

Understood. Thank you for the responses.

Absolutely.

Thank you, sir. Our next phone question will come from the line of Joel Houck with Wells Fargo. Please go ahead, your line is now open.

Thanks, and good afternoon. One of you guys could maybe talk about the -- perhaps the inflection point is in interest income, I mean, you guys deployed capital this quarter, corporate loans went up about 9% but interest income went down, I guess, largely due to amortization. Can you talk about how we should think about the inflection point in terms of the capital being deployed in the future versus kind of slowdown in prepayments?

I think you hit it on. There is going to be a balance of us putting capital to ramping up, the new capital we’ve contributed to CLOs like level 1, ramping up future CLOs which as Craig mentioned is a key focus for us and the pace of amortization with your deal. I like to think we’re currently around that inflection point today. However, the target is to time that perfectly. If I were to look ahead, I would expect run rate on that portfolio to start increase over time.

Okay. This certainly should be favorable metric in 2014. Is that fair?

That considerably be our objective.

Okay. And then I guess, the second question is maybe talk about the types of returns you are expecting in the maritime finance strategy?

Yes. Joel, I can talk. This is Craig. I think the -- what we’re seeing there is the management team is able to put out loans at -- on LTV basis, about 65% loan-to-value and cash yield anywhere from 10% to 12% on an un-levered basis. And then we do believe as we accumulate that portfolio, we’re going to attract portfolio-based leverage against the advancing company and it could generate returns on a levered basis from the high teens.

Okay. Great. Thanks guys.

Thank you.

Thank you, sir. Our next phone question will come from Scott Valentin with FBR Capital Markets. Please go ahead, your question please.

Good afternoon, and thanks for taking my question. Just kind of high level question in terms of returns, as you move from kind of a long tail, maybe more residual type of investments particularly of a high return to more current cash type of investments. Did your -- you're seeing return bogeys, I think 10-year charge close to 1000 basis cost. Did that change at all with the new kind of investment mix?

I think it’s a great question. I think it’s -- I think the (inaudible) we’re going to balance those two things that we are shifting today and may have been a little more aggressive on CLO activity and try to get that cash yield up in the near term. That’s still very attractive return, still place some of that on a more detailed opportunities like, especially finance side. But yes I do think maybe you come down a little bit onto your point on that overall expectation and a 2.5% rate environment given the yield compression keep us at 1000, that’s probably a big expectation in cash yield in this environment. That doesn’t mean again your five-year period is not reasonable. But I think -- I think in this environment what you’re hearing from us is we are going to focus on growing our cash distribution which may put a little pressure on that total return.

Okay. Thank you.

(Operator Instructions) Our next question on the phone queue will come from the line of Lee Cooperman with Omega Advisors. Please go ahead. Your line is open.

Let me first apologize. I have been in a meeting. So I just walked out. I did not hear about 98% of your formal presentation. So I apologize if anything is redundant. But just have a series of questions, if you back out the non-recurring earnings -- the non-recurring charges, what was the ex run rate of earnings in the quarter back at unusual items. Again, I apologize you may have covered all this, but I have a series of questions that all are linked?

It was $0.18, Lee.

So the non-recurring was only $0.02 but you reported $0.16?

Yes.

Okay. So if I take $0.18, I multiply that by 4, you would have run rate of earnings of $0.72.

Based on net quarterly that’s correct. I think as Mike mentioned, we put in more capital pretty in the quarter that -- which should help grow that over the upcoming quarter that wouldn’t really inflate at this point. And then we had the loan loss provision and some of the amortization discount that was unusually low this quarter.

Lee, to add on to Craig’s point. If you look at our cash on hand at quarter end, the amount of capital that’s kind of falling, we’ll call it a J-curve earnings effect being deployed. We are not yet provided earnings contribution. Our total amount is about $600 million.

$600 million that was unemployed at the end of this quarter or the prior quarter?

$600 million of cash as well as capital that’s already been deployed but for which -- the time lag on the period will actually start earning income from it. So a good amount of our capital is actually not providing earnings contribution today, that’s $600 million.

Right. So if I put a 10% return on $600 million, would that be reasonable?

I think that would be reasonable.

You said $60 million and again I didn’t even read the release, what’s the share count now, 200 and something shares?

Yes. 204 million.

That would be called an extra $7.5 a quarter.

Okay. And so, okay, and then something I said, I think, to is contraindicated, you said that you wanted to grow the distribution which would put pressure on your spreads, why is that?

Yes. I think the question was when you think of total returns versus cash, I think -- what we are saying is with the CLO equity we -- and now we have deployed today natural resources in real estates, those maybe higher total return strategies but we are -- got to shift a little more into higher cash yielding strategy to ensure that we have the adequate cash flow for dividend growth.

I got it. So basically, if you put the $600 million to work, looking at year from now, assuming no other profits crop up, you are like dollar-to-dollar slide kind of earner which would basically be a 10% or little bit less on GAAP book value -- the 10% ROE business? Is that fair?

Your math is very reasonable, Lee.

Okay. So I think this is a little bit less ambitious than we have been, so 10% ROE we generate earnings a little over dollar. You bump the dividend to $0.88 rate. So you are only retaining a very modest amount. Let’s say you are returning -- retain 20% of your earnings on a 10% ROE, so you could finance the growth rate a couple of percent?

While the other aspect, Lee, is there are a couple of things. One, our leverage is under 0.3 times. So frankly with our credit ratings, the debt capital markets are still available to us. But if we rate -- our average borrowing rate today is a little over 7%. So assuming we put a lot of more money, something above 7%, this could be accretive to both cash and income.

Yes. We certainly have the strategy -- capital on the ground with higher expectations obviously than a 10% return whether it’s some of the natural resources, some of the real estate cash or even some of your Maritime Finance that I just went through. So I do think there is -- there is -- we see the growth profile as Mike mentioned some of that capital may take time to like into do that -- that return profile.

Okay. And I know that the Board probably were very low to be in a position to cut the dividend again. We went through that period in ‘08, ‘09 et cetera. So I assume that the dividend of $0.88 you guys secured based upon the business outlook as you see it?

Lee, we want to speak for the board but they clearly made that statement and wouldn’t -- wouldn’t be raising the dividend, they didn’t have that deal of choice.

So just using round numbers, an $0.88 dividend and divide that by -- do that by 11, let’s say, just being optimist. That’s an 8% return and maybe you get 2% to 3% growth and so it’s 10% to 11% return vehicle in a world of zero sure rate and 2.5% 10-year government, something like that?

I think that’s certainly I look at it and I think to get your point. You have to look at the risk profile. I think we are still very good about the downside protection in diversification and zero point when you look at relatively risk rewards, it makes down but it’s not a huge return, but I actually think in this environment it’s such a very reasonable expectation.

Okay. Very good. Thank you very much. I think that’s all I had. Okay. Thank you very much. Again, I am sorry, I missed the call by. I will listen to the replay.

Thanks Lee.

Yes. Thanks Lee. Thanks for coming.

(Operator Instructions) At this time, I’m showing no additional questions in the phone queue at this time. That does conclude our time for questions, and that also does conclude today’s event. Ladies and gentlemen, thank you for your participation and have a wonderful day. Attendees, you may disconnect at this time.