PennantPark Investment Corporation (PNNT) Q2 2013 Earnings Report, Transcript and Summary

Good morning, and welcome to the PennantPark Investment Corporation’s Second Fiscal Quarter 2013 Earnings Conference Call. Today’s call is being recorded. At this time, all participants have been placed on a listen-only mode. The call will be opened for a question-and-answer session following the speakers’ remarks. (Operator Instructions) It is now my pleasure to turn the call over to Mr. Arthur Penn, Chairman and Chief Executive Officer of PennantPark Investment Corporation. Mr. Penn you may begin your conference.

Thank you and good morning everyone. I’d like to welcome you to our second fiscal quarter 2013 earnings conference call. I am joined today by Aviv Efrat, our Chief Financial Officer. Aviv, please start off by disclosing some general conference call information and included discussion about forward-looking statements.

Thank you, Art. I’d like to remind everyone that today’s call is being recorded. Please note that this call is the property of PennantPart Investment Corporation, and that any unauthorized broadcast of this call in any form is strictly prohibited. Audio replay of the call will be available by using the telephone numbers and PIN provided in our earnings press release. I would also like to call your attention to the customary Safe Harbor disclosure in our press release regarding forward-looking information. Today’s conference call may also include forward-looking statements and projections, and we ask that you refer to our most recent filling with the SEC for important factors that could cause actual results to differ materially from these projections. We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website at www.pennantpark.com, or call us at 212-905-1000. At this time, I would like to turn the call back to our Chairman and Chief Executive officer, Art Penn.

Thank you, Aviv. I am going to spend a few minutes discussing current market conditions, followed by discussion of investment activity, the portfolio, the financials, the overall strategy, and then open it up for Q&A. As you all know, the economic signals have continued to be mixed with many economist expecting a slowly growing economy going forward. With regard to the more liquid capital markets and in particular the leverage loan in high yield markets, those markets have continued to rally this year as cash flows at high yield funds, leverage loan funds in CLOs have been strong. Risk reward in the middle-market has generally remained attractive as the overall supply of middle-market companies in each financing exceeds the relative demand of applicable lending capacity. As debt investors and lenders, a slow growth economy is fine as long as we have underwritten capital structures prudently. A healthy current coupon with de-leveraging from free cash flow over time is a favorable outcome. That said as the more liquid capital markets have rallied, that overall tone has impacted the middle market. Pricing had continued to compress and purchase price multiples and leverage multiples have increased. As a result, we have continued to be selective about which investments we make in this environment. Given our strong origination network and size of our company, we believe we can continue to prudently grow. We remain focused on long-term value and making investments that will perform well over several years. We continue to set a high bar in terms of our investment parameters and remain cautious and selective about which investments we had to our portfolio. Our focus continues to be on companies or structures that are more defensive, have lower leverage, strong covenants, and high returns. With plenty of dry powder, we are all well…

Thank you, Art. For the quarter ended March 31, 2013, recurring investment income totaled $0.24 per share. In addition, we had $0.01 per share of other income as well as $0.04 per share of one-time bonds issuance expenses. As a result, net investment income for the quarter was $0.21 per share. Looking at some of the expenses categories, management fees totaled $8.9 million, general and administrative expenses and excise tax totaled $1.7 million, and interest expense totaled $4 million. During the quarter ended March 31st, net unrealized and realized gain from investments and debt was approximately $13 million or $0.19 per share. Excess dividend over net income was $2 million or $0.03 per share before one-time debt issuance-related costs of $0.04 per share. Consequently NAV per share went from $10.38 to $10.50 per share. As a remainder our entire portfolio credit facility and senior notes, our mark to market by our Board of Directors each quarter using the exit price provided by independent evaluation firms, securities exchanges or independent broker dealer quotation when active markets are available under ASC 820 and 825. In case where broker dealer quotes are inactive, we use independent evaluation firms to value the investments. Our overall debt portfolio has a weighted average yield of 13.5%. On March 31st, our portfolio consisted of 68 companies across 30 different industries and was invested 26% in senior secure debt, 22% in second lien secure debt, 39% in subordinated debt, and 13% in preferred and common equity. Now let me turn the call back to Art.

Thanks Aviv. To include we want to reiterate our mission. Our goal is a steady, stable and growing dividend stream. Everything we do is aligned to that goal. We try to find less risky middle market companies that have high free cash flow conversion. We capture that free cash flow primarily in debt instruments and payout those contractual cash flows in the form of dividends to our shareholders. In closing, I would like to thank our extremely talented team of professionals for their commitment and dedication. Thank you all for your time today and for your continued investment and confidence in us. That concludes our remarks at this time. I would like to open the call to questions.

Thank you, sir. The question-and-answer session will be conducted electronically. (Operator Instructions) Our first question will come from Troy Ward of Keefe, Bruyette & Woods. Troy Ward - Keefe, Bruyette & Woods: Good morning gentlemen.

Good Morning. Troy Ward - Keefe, Bruyette & Woods: Art with your portfolio yield still north of 13%, as we look at the other BDCs, it seems like you’ve stayed in a higher yield kind of strategy there, while others have maybe moved in a more senior assets with lower yields, can you just talk kind of why you have done that and where you see the appropriate risk reward for your entity?

Thanks Troy. It’s a good question, something we always talk about. We are very focused on not style shipping. We always conceive that PNNT as a generally 12 plus percent vehicle generally second lien, generally sub-debt obviously we are stretch lien, stretch first lien can get us 12% plus where we are obviously interested that may also mean at times we grow less quickly than others. But we are very focused on staying true to our mission, true to the ROEs that we are targeting for our shareholder. And that’s just our focus in the time we are targeted to get higher yield we may grow less quickly which is what we have indicated in our comments. We just want to be highly disciplined about what we put in this portfolio and what we do with our shareholder capital. Troy Ward - Keefe, Bruyette & Woods: So, I guess when others maybe see a little bit of a less favorable environment, they are willing to move into lower yielding deals, you may see less favorable you are just going to grow slower is that kind of a good summary?

Yeah, I think we’ve been absolutely clear for a long time there is no right from a higher power that the BDC should always grow. Certain times BDC might want to stand still and might even want to shrink, so you need to continually evaluate risk reward, we still think we can prudently grow as we say. We may not be growing as quickly as we did in say ‘09 or ‘010, and that’s okay. We are here. We want to be around for decades and decades and decades if we want and we are playing it that way. Troy Ward - Keefe, Bruyette & Woods: Okay. And then kind of you mentioned that you exited the Realogy equity here early in the second quarter. Two things, can you give us any other indication of activity in the second quarter on prepayment or origination side, and also just is there any other equity, non-yielding equity in the portfolio that you may look to monetize as well?

Sure. Other than Realogy, it is public information that a company called Tekelec is getting purchased by Oracle. So, we are having Tekelec book a piece of equity and the values in the Q we think a pretty good approximation of what we are going to get. So, that’s little over $8 million of equity on Tekelec. So, we are excited about taking the roughly $20 million from Realogy and the $8 million from Tekelec, $28 million of equity gain, equity proceeds, and over time, redeploying into yielding assets, which can help our income and dividends over time. So, that’s exciting for us. And generally, we believe our equity co-invest portfolio should be about 5% to 10% of the overall pie. As of quarter end, it was about 13%. With Realogy and Tekelec we get down to about 10. So, we are interested in continuing to rotate that and take equity gains in this environment – in this environment, you can get some equity gains and redeploying those proceeds into cash yielding investments. Troy Ward - Keefe, Bruyette & Woods: Okay, great. And then one final question across the space this quarter, we have seen income generated from activity, whether its originations or prepayments come in lighter than maybe expectations, but assuming the activity returns, can you just speak to kind of where the fee levels are in this environment, have you seen the compression of origination fees?

Yeah. So, just to refresh everybody on our accounting for a moment, upfront fees, we generally amortize over the course of the loan. So, that’s OID to us, so that does not get reflected in current earnings that gets reflected over time over the life of the loan. Prepayment penalties and prepayment fees and amendment fees are one-time events and that is recorded in our Q in the other income line. So, prepayment fees for the quarter ended March were lighter than they had been, because we had fewer repayments. It’s hard to predict. That’s why we put it in the other income line, so that people know it is primarily one-time stuff. It looks like there will be more prepayment fees coming in this quarter ended June, but hard to give you a real strong estimate at this point, but looks like we are going to get some more prepayment fees in this quarter. I am blinking Troy, I don’t know if I answered your question? Troy Ward - Keefe, Bruyette & Woods: Yes, maybe with the origination fees in the current market kind of where those levels are, I know you were amortizing, but….

Yeah, they are – like we said in our comments you are seeing things getting compressed and stretched whether it be yields, leverage, and upfront fees on new mezz, it’s a 2% to 2.5% business versus what it was at 2.5% to 3%. I mean that gives you an indication on mezz. On first lien, self-originated, it’s still around 2ish, but again that’s lower than it was a year or two ago. Troy Ward - Keefe, Bruyette & Woods: Right, thanks guys.

Thank you.

Our next question will come from Chris York of JMP Securities.

Good morning gentlemen. This is (indiscernible) for Chris York. I just have one question on the non-accrual in the quarter, could you please comment qualitatively on that loan and how it was restructured and also your outlook for that investment?

The one restructuring was PAS Technologies, it got restructured intra-quarter, so it was not on the books at quarter end as a non-accrual. It was about $17 million of debt, it converted into equity, which is reflected in the Q. This company was heard, it’s an aerospace company was hurt by defense expenditures getting some focus on sequestering, getting some focus in this environment. It was hurt by the American Airlines bankruptcy, and it was hurt by a general aerospace cycle. So, it’s a long-term investment in our view now in equity, certainly disappointing at $17 million of phase certainly not material to us, but we are very disappointed with it.

Great, thanks for the color. Thanks for taking my question.

Thank you.

Our next question comes from Mickey Schleien of Ladenburg. Mickey Schleien – Ladenburg: Good morning, Art and thanks for taking my question. Art I just want to understand if you’ve become a little bit more optimistic on the economy, I noticed that you increased your asset allocation to second lien and sub-debt in the quarter, which may imply that you are more optimistic. And I also noticed that you marked up Jacuzzi pretty significantly and that may have something to do with the economy, so I’m just curious on your sense of the tone of the economy at this point?

Yeah, so a couple of questions in your comment Mickey, the economy we think is a slow growth economy and again as debt investor that’s absolutely fine, if you’re underwritten well, it all works out. The allocation of second lien sub-debt this quarter is just idiosyncratic to those particular deals. This upcoming quarter and in June you will see some more first lien, so we underwrite on a deal by deal by deal basis. It just depends on what makes sense in a particular transaction, what the risk reward is, so there was no particular movement to second lien to manage those were just the best deals that we saw in this quarter in the marketplace for us. Jacuzzi that’s a broker dealer quoted instrument, the broker dealer quote is up there, is a rumor that there is going to be a refinancing in Jacuzzi, so we are hopeful that we will hopefully get a part to take out at some point and then we redeploy what has been sub-optimally the only piece of paper into something with a better yield. So, that’s another opportunity to increase the income. Mickey Schleien – Ladenburg: Couple of more quick questions, could you walk us through the refinancing of Greatwide Logistics and lastly when can we expect you to start to tap into the second SBIC facility?

Greatwide got merged this past quarter with a company called Cardinal Logistics, so Greatwide we had a piece of debt that was marked in the 50s. Due to the merger it was a really positive credit event, so that’s why that piece of debt is now marked to par and the equity that was marked to zero has now been marked up to having some value and it’s really due to this merger that they have with Cardinal Logistics.

What was the second part of your question Mickey? Mickey Schleien – Ladenburg: When might we expect you to start to tap into the new SBIC?

It’s a great question. When a deal that is applicable to SBIC comes in, we put it there. First what happens is the SBIC I is filled, but if there is a refinancing in SBIC I, and the deal gets taken out, any new deal goes in there first and then going forward if SBIC I is full, we will put it into SBIC II. So, we have had some re-financings in SBIC I, I believe that Paradigm deal we mentioned was in SBIC I that created liquidity there. And that’s been since filled, but it’s a moving target. Mickey Schleien – Ladenburg: Thanks for your time Art.

Thank you.

We will go next to Jonathan Bock of Wells Fargo Securities.

Good morning and thank you for taking my questions. Most of them have been answered, but Art I do appreciate the comment of no right from a higher power to grow and looking at that in terms of leverage, not in terms of the attachment point at which you invest, but what both you and team believe could be the appropriate leverage level for the types of assets say more second lien subordinate debt that you have originated in the past, has your target leverage level for the BDC both regulatory and or non-regulatory has that changed, and maybe taking that a step further, what would cause you to perhaps run with a little bit more excess equity or excess capacity in light of current economic events?

It’s a great question. Look, we are very focused on keeping the equity levels in our portfolio manageable, we still target 5% to 10%, got to 13% this past quarter, it’s coming back down to 10%. So, we want to keep that a manageable percentage of the portfolio for some reason equity levels got to be a bigger percentage. We have to reassess our leverage. We still underwrite the senior, second lien to manage the same way we have always underwritten it, the same methodology, the same discipline, the same focus. So, as a result we still target as an overall company 0.6 to 0.8 times debt to equity having the SBIC and the SBIC assumption in theory we could go north of one to one. To us that’s just extra cushion for defensive purposes and if we needed offensive purposes that we think we got plenty of liquidity in cushion now, even going to 0.6 to 0.8, and then having the extra cushion with the SBIC, just gives us more of a margin of safety for defense. And then if we say see really great opportunities, a really great market we can play off and fill a bit more aggressively.

I appreciate that. And then looking at the liability side of the balance sheet, it’s definitely been diversified and with the SBIC and other financing that’s very attractive, I’ll just call it an asset, if you will. What about the potential for on balance sheet securitization and whether or not that makes sense with the type of assets that you have originated and whether or not you would be comfortable with the restrictions that come with the non-balance sheet securitization in light of the fact that you do have an all-in lower interest cost relative to make what you are borrowing on a term loan basis?

It’s a good question to some of you and we should always be evaluated. For PNNT, it’s probably less applicable than PFLT given the types of assets that we primarily have in PNNT, but it’s something to think about. It is restrictive in terms of your ability to move things. And in some sense, the SBIC is in essence that if you think about it, because you are terming out 10-year money at a low yield, but it does, we like the flexibility the SBIC gives us in terms of movement. So, that’s my attempt in answering your question at least.

Well, it makes total sense. Thank you so much.

We’ll go next to Rich Shane of JPMorgan.

Thanks guys for taking my question this morning. As we go through all the BDC calls, the focus has been on deal structure and on spreads. And one of the things that we have observed over the years and I know you guys have observed as well is that neither of those things really matter in the context of credit, and that you can’t solve bad credits by wide spreads or by good structures.

Right.

When you look at the market right now from a fundamental credit perspective, I don’t think this is coming up, how do you guys feel about the world right now?

Look I mean we have been people have asked question what do you think about the economy. The economy clearly seems like it’s mending slowly. There is a bunch of cross currents. There is certainly pockets of weakness. We have seen weakness obviously related to governmental issues like defense spending under pressure or government spending under pressure. We have seen stress in companies related to the CFPB, the Consumer Financial Protection Bureau that admired a lot of companies and kind of a never, never land. We had an issue with the company that was involved with Keystone Pipeline in the governmental pullback there. So, it’s not all above the cherries for sure, but the economy does seem like it’s slowly mending. You could take a look at our investment in direct buy, which was a restructuring in other piece of equity, and the equity was marked up this quarter. And we are seeing a mending there. We talked about (indiscernible). We talked about Realogy. So, lots of cross currents, but that’s part of the day we all have as investors is although leverage multiples keep getting stretched and yields keep getting compressed. The economy seems okay, this in comparison to what it was, in let’s ‘06, ‘07 where you saw and believe market, yet the economy was on the verge of a recession. So, that’s a real challenging thing that we all have to deal with right now is that issue. But we ultimately need to look at ourselves and say this is what we have pulled our shoulders we are going to do. We don’t want to style shift. We want to generate a sensible risk adjusted return on equity for our shareholders, and we need to be disciplined around that.

Well – and it’s interesting in those comments that there are very clearly a couple of thematic risks related. It’s really sounds primarily related to government intervention or government spending, but other than that, it sounds like you are pretty comfortable with what’s out there. I am assuming that when you are screening things right now, that’s really part of – that that came really enters into what you are talking about?

Sure. You look at it deal-by-deal, and in certain cases, we might stretch a little bit in leverage, but if we think the wins at the back of the particular company, and we think there will be a quick de-leveraging so that you get into more comfortable mode pretty quick. We might do some investing in that way where you say okay it might be five times today, but it’s going to be down to 4.5 and 6 months based on the trends in the market and what’s going on. You can more comfortably do that today than you could in some other times. That said if on average you see a market that’s in the mid-fives again in terms of debt to EBITDA which is kind of it where it was in ’07 very minimum actually give you some pause.

Okay, great. Art, thank you very much.

Thank you.

Our next question comes from Arren Cyganovich of Evercore.

Thanks. You mentioned that the portfolio company measures are pretty strong with cash interest and debt to EBITDA coverage, what about the trends in terms of underlying revenues and EBITDA for your portfolio companies?

There are, as a general proposition Arren we’re seeing nice trends up in general on both sales and in EBITDA. I don’t have the numbers right at my finger tips today, but decent slow growth in general other than the couple of pockets that we mentioned that might be a little softer, overall we’re seeing fine credit metrics.

Thanks. And then I guess back to the portfolio yield question and your desire not to style shift, is that for you at some point a negative selection process with most of the other lenders willing to go more senior and the focus really being on the senior side of the market today in the middle market?

You can never in this business (indiscernible) with respect to credit selection. You have to have an absolute view on a credit regardless of the yield. So, negative selection is something you just can’t go down. So, again we’ve all seen cycles we’ve all – we are through this type of thing before and if it means a slow growth environment for us, it will be, if it means no growth environment for us it will be. I mean you have to ultimately we are in the very important mortgages in that (Rick) acronym which is investments. Ultimately we have to make good investments. We are an investment company. We’re not a growth machine. We’re not an origination machine. We have to make good investments, we can make good investments we should make them.

Great, that’s helpful. And then lastly you mentioned being willing to under earn the dividends a little bit, can you talk about whether or not they would be on a taxable income basis, so do you have any additional carry forward income that will help you kind of go through that path of getting back towards the dividend?

Yeah, we’re not in a rush again, we are going to make the right credit bets, worried about even right now from the standpoint of tax and dividend payouts. And if as we said in our prepared remarks it temporarily we are under run for a few quarters we temporarily under run for few quarters, we don’t want to rush. We still – given all our excess liquidity we will pick our spots and we will gradually grow and we’ll grow into our dividend hopefully well in excess of our dividend over time, but we don’t want to – we don’t want to be forced to make investments that are uncomfortable.

Fair enough. Thank you.

(Operator Instructions) We’ll take a follow up question from Tory Ward. Troy Ward - Keefe, Bruyette & Woods: Hi Art, real quick, a follow-up on Mickey’s question about the SBIC number II, have you pledged unencumbered assets to qualify as regulatory capital to that already. And then so once you do start to use it we’re talking about drawing debentures?

We have put it just a couple of million of equity so far in SBIC II, we haven’t yet funded it with any other capital. Aviv do you have any other…

Essentially the way we’ll play out, so remember its $75 million that’s the government can lend to you and obviously we need to put our $37.5 million. So, the way probably it’s going to be playing out is the first $37.5 million and the first will come from us as equity and then the next $75 million will come from the government. Troy Ward - Keefe, Bruyette & Woods: So, if we were thinking drawing debentures towards the later half of this year that would seem to be in line?

Yeah. Troy Ward - Keefe, Bruyette & Woods: Okay and then Art one other things that we’ve seen across the spaces the BDCs getting more active and meaningfully using their 30% bucket and I mean of course, non-qualified assets whether its financials or CLO equity or international. Can you speak to kind of what you think about how you view the ability to use the bucket for non-qualified assets?

Look we are always open-minded to good risk reward on behalf of our shareholders. We just want to make sure it’s good risk reward. If its equity and a finance company the question is or equity in a CLO, the question is at what price do you price that equity out. Is it a 12%, is it a 15%, is it an 18%? To us, equity risk is equity risk, it’s not debt risk. Right, so you should be getting an equity return. We can all debate what an equity return should be, but for us buying equity in a CLO or finance company should be in mid to upper teens at least, exercise otherwise we can do debt in middle-market companies and get 12%, 13% and be hiring the capital structure. Troy Ward - Keefe, Bruyette & Woods: Okay. And then just as a follow-up, where are you today on your percentage of non-qualified assets?

Very low, few percent.

Yeah, it’s south of 6%, 7% or so, very low. Troy Ward - Keefe, Bruyette & Woods: Okay, great. Alright, thanks guys.

Our next question comes from Doug Mewhirter of SunTrust Robinson Humphrey.

Hi, good morning. Most of my questions have been answered. I wanted to follow up on your – the restructured non-accrual during the quarter, could you quantify the impact to, I guess, investment income. I assume you lost the coupon when you convert the equity reserve, what about, $0.5 million in income that was foregone this quarter because of that?

It was about $0.5 a share.

$0.5 a share.

Okay, thanks for that. And my second and final question, if you look at your what have you in the hopper for deals pipeline or backlog you are going to call it. Over the past couple of quarters, has that pipeline or backlog grown or stayed steady or declined a little bit in terms of what might be in the offing?

It does seem to be picking up a bit, activity levels we are getting more pings from people than we were a month or two ago. So, it’s starting to pick up, hard to predict with accuracy what that will ultimately mean in terms of actual deals that we do, but we are starting to see increased activity levels.

Okay, great. Thanks. That’s all of my questions.

Great.

(Operator Instructions) And there are no other questions at this time. I would like to turn it back to our presenters for any additional or closing remarks.

Thanks everybody. Just want to thank you all for spending time today and your interest in us and we will talk to you next quarter.

Thank you. That does conclude today’s conference. Thank you all for your participation.