Sprott Inc. (SII) Q2 2018 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to Sprott Inc. 2018 Second Quarter Results Conference Call. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. Instructions will be provided at that time for you to queue up for questions. [Operator Instructions] As a reminder, this conference is being recorded today, August 13, 2018. On behalf of the speakers that follow, listeners are cautioned that today’s presentation and the responses to questions may contain forward-looking statements within the meaning of the safe harbor provisions of the Canadian provincial securities law. Forward-looking statements involve risks and uncertainties, and undue reliance should not be placed on such statements. Certain material factors or assumptions are implied in making forward-looking statements, and actual results may differ materially from those expressed or implied in such statements. For additional information about factors that may cause actual results to differ materially from expectations and about material factors or assumptions implied in making forward-looking statements, please consult the MD&A for the quarter and Sprott’s other filings with the Canadian securities regulators. I will now turn the call over to Peter Grosskopf. Please go ahead.

Good morning, everyone, and thank you for joining us today. On the call with me today is Kevin Hibbert, John Ciampaglia and Glen Williams. Our 2018 second quarter results were released this morning and are available on our website, where you can also find our financial statements and MD&A. I’ll start on Slide 4 with a look at our results for the quarter, which were steady. Our financial results have continued to improve since we completed the restructuring of the business a year ago. On a normalized basis, adjusted base EBITDA increased by 47% over Q2 2017. The key drivers of this improvement were the addition of the Central Fund assets to our Physical Trusts franchise and new capital deployments within our Private Resource Lending business. Sprott’s AUM fell by approximately $500 million during the quarter, with almost all of that decline attributable to transaction-related redemptions in our Physical Trusts and the impact of weaker precious metal prices. On a year-to-date basis, our AUM increased by $3.8 billion. Investable capital was $195 million as of June 30. This is down approximately $100 million from the end of 2017 due to the acquisition of the Central Fund. Our balance sheet is now close to fully optimized, and we are focused on deploying our capital to seeding complementary products and on co-investments in our core strategies and alongside clients. Turning now to Slide 5. First, look at some recent highlights of the business. We’re pleased with our steady financial performance during Q2 and year-to-date despite the recent selloff in precious metals. Our flow-through funds and related tax-assisted investing strategies are gaining traction with the most recent offering raising $60 million during Q2. Capital continues to be deployed into our Resource Lending LPs and LP support for further growing that business is increasing. The investments we’ve made in the digital gold space are progressing well, and I’ll talk about those initiatives in more detail in my closing remarks. I’ll now turn the call over to Kevin for a closer look at our financial results.

Thanks, Peter, and good morning, everyone. I’ll start on Slide 6 with a look at our earnings summary. Similar to last quarter, given that 2017 was a year of significant transition and change for our company. I will be separately highlighting the results of our core go-forward businesses to ensure you have a more meaningful analysis of our year-over-year comparative results. As Peter mentioned, adjusted base EBITDA in the quarter was $10.7 million. That was up $1.9 million, or 22% from the prior period. However, on a normalized basis, i.e., excluding earnings generated from non-core assets sold last year, adjusted base EBITDA was up $3.4 million, or 47%. The increase in earnings on a normalized basis was due to higher net fees generated on the newly acquired CFCL assets and higher AUM in our Lending LPs as a result of increased capital calls. We also saw higher earnings on co-investments in our Lending segment. Looking at our revenue performance, details of which can be found on Slide 15. Total net revenues for the quarter were $23.5 million, largely unchanged from Q2 2017. Key revenue items worth noting include net fees, interest income and net commissions. Net fees for the quarter were $14.8 million, a decrease of $1.9 million, or 11% from Q2 2017. Excluding net fees that were earned on the diversified assets sold as part of last year’s sale transaction, net fees generated by our core businesses were actually up $4.8 million, or 48% from this time last year. Again, the increase on a normalized basis was due to management fee generation on the newly acquired CFCL assets, as well as increased fee generation on our Lending LPs, as we continue to deploy call to capital in the form of fee-generating AUM. Interest income for the quarter was $3.3 million, largely unchanged from Q2 2017, and net commissions for the quarter were $4.8 million, down $700,000, or 13% from Q2 2017. The decline was largely due to lower transaction volumes and placement activities in our U.S. broker dealer. Total expenses, details of which can be found on Slide 16, were $17 million, a decrease of $7.8 million, or 31% from Q2 2017. Key expenses worth noting include compensation and SG&A. Compensation, excluding commissions, carried interests and performance fee payouts, which represented net of their related revenues in our MD&A and excluding severance accruals, which are non-recurring was $10.6 million, a decrease of $1.2 million, or 10% from Q2 2017. The decrease was due to lower headcount as a result of last year’s sale transaction. As a reminder, compensation across the organization should drop further next year as 65% of our LTIP amortization will have been fully amortized by the end of this year, leaving only 35% to be amortized over the subsequent three years. Lastly, SG&A was $4.9 million, a decrease of $1.2 million, or 20% from the prior period. That was largely due to lower rent, marketing, sales, technology and fund operating expenses as a result of last year’s sales transaction. We expect our SG&A expense to further benefit from lower corporate SG&A around marketing and technology costs in the back-half of this year, as we implement more cost savings initiatives in that area. Moving back to Slide 7, you’ll see a summary of our AUM, and for greater detail into our individual AUM components, you can refer to Slide 14. As at June 30, AUM was $11.1 billion, down 4% from Q1 of this year. The decrease was primarily due to previously anticipated redemptions on CFCL assets we acquired earlier this year, combined with the decline in precious metals prices in our Physical Trusts during the quarter. Finally, a look at Slide 8 for our investable capital. We have been diligently putting our capital to EBITDA accretive use, most notably with the acquisition of CFCL earlier this year, as well as co-investments in our Lending LPs. Going forward, we continue to deploy capital in a highly disciplined manner so as to ensure maximum shareholder benefit. I’ll now pass it back to Peter for some final final thoughts.

Thanks, Kevin. On the next couple of slides, we highlight that we’re at an interesting juncture in the precious metals cycle. As you can see on Slide #9, the sentiment has seldom been worse and short interest in gold is sitting at an all-time high, meaning that at some point a major reversal is likely. In the past, U.S. dollar strength and emerging market difficulties such as those we’ve seen today have marked turning points in financial markets, and gold is usually one of the first assets to rebound from that distress. On Slide 10, we’ve shown how much gold stocks have underperformed the broader markets over the last couple of – over the last decade really. This situation, particularly in small-cap gold equities has been exacerbated by the decision of several major asset managers in the past two quarters to retreat from the space. We believe that current market conditions are exceptional for quality stock pickers, and we’re working to raise funding for active equity strategies to capitalize on these opportunities. In closing, we’re continuing to focus on execution and on delivering performance and service to our clients. We think that the current market environment offers a unique opportunity to further build our status as the global leader in precious metal investments, and we’re adding sales professionals and new markets to support this. We have a number of growth initiatives underway, including metal ETFs and expanding our institutional private debt franchise and active gold equity businesses. Looking now on Slide 12 for an update on our digital gold investments. As we’ve said now for several quarters, we believe that digitization is next major advancement that will change the way that gold is used by investors. Sprott is committed to being at the forefront of that innovation and we’ve invested in two digital gold technologies, Tradewind’s VaultChain and Emergent Technology’s G-Coin, both of which are getting close to full market launches. Finally, we’ve also planned a JV with a significant U.S. distributor of metals to launch a retail-focused dealer platform to buy and to sell digital precious metals. We expect this effort to give live sometime in Q3, Q4. That concludes our prepared remarks for today, and we’ll now open the call to questions. Operator?

[Operator Instructions] Our first question is from Nik Priebe from BMO Capital Markets. Your line is now open.

Hi, good morning everyone. I’ll start with the Private Lending Fund. It looks like pretty good progress with respect to capital deployment in the quarter. I think, you’d previously indicated that you expect that to be effectively fully deployed kind of in the second-half of this year. I’m just wondering once it is fully deployed, when would you look to initiate the fundraising process for the next successor fund? And do you have a sense of what sort of skill you might target there like should we think about it as comparable to the first one?

Yes. So couple of things. First of all, it’s not practical to deploy one of these funds 100% before you get into the next generation of funds. You really need to leave some room to grow investments, if required. So it’s contractually defined in our LP agreements is being somewhere around the 80% mark. So that means that, because we’re just about there that we’re really already into planning for the new version. And all I can say about it is that, it will be larger than the current version.

Okay, that’s helpful. And then just a quick one on the CFCL-related outflows in the quarter. Any other redemptions that kind of appear visible on the pipeline at this stage, or do you see that activities mostly behind you now?

Sure. Hey – hi, Nik, good morning. It’s John here. I would just say that the redemptions were in line with what we previously experienced with the Central GoldTrust a few years ago. So we know there’s a certain amount that will work through the system. While what’s encouraging to us is that in the month of July, we only had redemptions cumulative across the four Physical Trusts of $3 million. So it’s hard to predict obviously the markets and arbitrage activity, but we saw some encouraging signs in July that they’ve come off quite sharply.

Okay.

We don’t know for the next few days in terms of what August will look like and then that would be public at the end of August.

Okay, that sounds good. Maybe one last one for me. I think last quarter you alluded to entering the Canada space and building a bit of a footprint there. Have you started to see a bit of traction there with respect to the dealer origination or just in terms of building the pipeline?

Yes. We’re starting really slow. As you probably know, that, that sector exploded an interest in valuation in the last quarter or two and we decided to take a slower path. We didn’t want to get caught rushing into anything. So it’s advancing, but it’s advancing slowly. We’ve made a little bit of money in the sector and we’ve chosen a few investments and teams that we think we can back. So it’s just something bubbling under the surface.

Okay, thanks for taking my questions. I’ll pass the line now.

Thank you. Our next question is from Gary Ho from Desjardins Capital Markets. Your line is now open.

Thanks. Good morning. Just – the first question, Peter, just on your comments, you talked about some new competitors lining up equity funds in the mining sector and you’re taking this opportunity to expand your global footprint. Can you maybe elaborate on that? And what are you doing specifically and any timeframe attached to this?

Okay. Well, one significant mid-tier institution sold and wound down its business, another one had a significant portion of its business moved to a different strategy. I think in general, it’s created a bit of distress in the small-cap side of the precious metal area, having been a lot of new monies raised, there haven’t been a lot of stocks that have been well supported. And we’re being approached by high-quality portfolio managers and analysts and also salespeople that believe in their view and we certainly agree with them that it’s a perfect time to build new assets. There’s a real lack of leadership. In the sector right now, there’s really good opportunities on the equity side. And I guess, a couple of natural spots and where we think the markets are largest or the U.S. and Europe. And I wouldn’t rule Asia out, but Asia has proven to be a very slow build for us. It’s continuing to build, but really the big markets that we can address are in the U.S. and Europe.

Okay, that’s helpful. And then, Kevin, just going back to your comments on expenses. Did you say there were some severance accruals this quarter? If so how much? And you talk about some benefits from lower SG&A in the second-half, what would the run rate be over the next two quarters and maybe into 2019?

Yes. Thank you, Gary. So no, I probably just misinterpreted my caveats around what’s excluded from what we considered sort of the run rate comp. So on the severance side, there is – there weren’t any severance items in the quarter. And then when it comes to – you’re asking, I think, for a run rate on comp as well, comp and SG&A?

Yes, please.

Yes. So if you look at Page 13 of the MD&A, while we don’t provide forward-looking guidance around earnings overall and even the total comp number. What I can tell you is, at least, from a salaries perspective, I think the number you’re seeing here at about five, seven, I think, if you’re modeling anywhere under seven – anywhere under seven a quarter on the salaries line, I think, that’s realistic and reasonable.

Okay.

On the AIP side, I think, it’s reasonable for you to continue with what you’re seeing here for the rest of the year and then on the LTIP side. We mentioned, I think, it was in our Q4 – our Q4 analyst deck we showed what that portion of amortization on the stock grant would be in 2017 and 2018 versus the last three years of the program. Yes, so go back to that and you’ll see more specific numbers. But what all that math would work out to is, it probably want to cut our numbers in half on the LTIP side...

Okay.

And we’ll give you a good sense for where we will come out in the year. So if we’re like 5.9 for six months, if you were to extrapolate that to the back-half of the year and divide it by two, that’s probably a reasonable number for you there.

Got it. And then…

And then on the SG&A…

Yes.

...what I was basically saying there is, it’s probably realistic for you guys to estimate about $5 a quarter in SG&A, but we should see some benefits in the back-half of this year from some of the additional cost containment initiatives we have at the top of the house in our corporate – our corporate space.

Okay, that’s helpful. And then just lastly on the digital gold initiatives, what are, if any financial impacts over the next 12 to 18 months rather on the top line side or on the expenses?

So with regard to that, it’s still very much early stages in those businesses. We continue to follow the accounting guidelines around accounting for these investments. And that approach, if you recall, was to look at the overall value of those business investments at the end of each year. So that we had a full 12 months of information whether it be entry and exit points from existing and new investors in those same businesses to whether those businesses are on budget and tracking towards their forecast. So right now, what you should expect to see from the digital gold strategy is mark-to-market adjustments either up or down in the fourth quarter of the year, and it will show up on the gain and loss on long-term investments line of the income statement. And anything leading up to that is just de minimis marks on our other co-investments, but you won’t see any – I don’t think you’ll see any significant operating earnings from those businesses for now. I don’t know, Peter, if you have any other color around that.

Well, we’ve made the investments in other companies that are supported by other investors. So that it’s really a capital item on that side and those companies have plans to continue to be supported outside of us as well, and they have share prices in the private markets, et cetera. So that’s really on the capital account. In terms of this JV for a retail platform, I believe it will also be on the capital account. And I think, the start-up costs are quite low and will easily be covered, that platform will start to cover itself. And although, it’s just one other outside party, it’s a very strong party. So we don’t anticipate being on the hock for start-up expenses. So we won’t have any impact on the expense side to start with. And really in terms of the upside remains to be seen, all of these businesses could be very significant. We think that the product is truly disruptive and we have high hopes that it will start to generate profitability right away.

Correct. And just to add one final thought on that. So what you will see over time is that the earnings pickup, if any on the marking of those positions will eventually be replaced by even more meaningful direct operating income from those investments. But that’ll be sometime down the road.

Got it. That’s helpful. That’s it from me. Thank you.

Thank you. Our next question is from Geoff Kwan from RBC Capital Markets. Your line is now open.

Hi, good morning. Just first question I had was on the Lending Fund you talked about trying to maybe get most of it done for the end of this year. Is there any significant shift that we should think about in terms of as you get those trusts over the remaining kind of few quarters?

Not really. It’s a steady business. It’s steady as she grows. And I think it will be a business that will be bigger over time and will provide us with a nice tailwind. In terms of the overall size of the business, I think, I said before, it could be somewhere between $1 billion and $2 billion. I think right now, we have daylight to say that it will definitely get to a $1 billion-plus. And it’s kind of a steady drawing processes as capital is lined up and as opportunities are lined up.

And just, Geoff, it’s Kevin here. Just to make sure and it kind of goes back to, I think, Gary’s question earlier or Nik, one of the two. But it’s important to also keep in mind when you guys are doing your models and speaking about this business that we – when we talk about deployment of the capital, we’re talking about deploying it to the actual borrowers. Now when the borrowers end up drawing on those facilities, this is just like any other sort of PE style fund, where you don’t actually see the capital in the fund until there’s a capital call, okay? So when we talk about reaching the 80% mark, for instance, that is not directly correlated with what you would see on the capital call column of our AUM summary, very, very important for you guys to keep that in mind.

Okay, yes. And maybe an additional question there is, Peter, I think you were talking about earlier, we shouldn’t expect to see the fund get fully invested before rollover next or just for practical purposes. But how do you kind of think about what that number is? Is it maybe 90% of the fund? Is it a number that higher or lower?

Well, again, I think where you’re going with this is that, if I could guess, it’s – you want to know what the AUM of that fund will be over time, and it’s like Kevin explained. It’s a steady process. First, the capital being committed and then the capital being drawn, new capital being raised, committed and drawn. So. I’d rather lead you to a general conclusion, which is, I think, we will be at a $1 billion drawn and drawn capital under management at some point next year. So the mark, which is the deployed, capital committed is in the process of being reached currently. But that doesn’t mean, as Kevin said, that we’re counting all that AUM yet. The facilities themselves need to be drawn down, and I think it’s going to be a very – actually smooth curve to get to that billion-plus over next year.

Yes. And, Geoff, I’d say, Geoff, to keep in mind, these companies that are doing the borrowing, they’re doing so obviously with every intention of drawing on the loan facilities. And so while there may not be a direct correlation between what’s deployed and called know that it’s the – the deployed capital will eventually sort of move up to a called state. So if you want to get a sense of what the possible earnings are in the pipeline, I would just say you take what we have as deployed once we get to, say, the 80% mark or the billion, as Peter noted, and just look at the management fee estimates we have on a dollar of AUM basis and just run with that as an indicator of what the possibilities are, because to his point, it will be steady, it’ll be a steady call process. But we don’t have a line of sight we can give you right now in terms of the rate at which the capital will be called by the borrowers.

And are these – are these loans fully drawn loans like what’s been experienced so far, or are some of these revolvers where they may not necessarily before draw on the amount that’s been committed?

Well, I mean they all pay to draw the entire facility. So the experience is that, some of them do change over time. But again, the best way to describe at is, it’s a steady process, it’s a steady build.

And so just I want to make sure I understand. So if you’ve got a $20 million loan out to the company unless they only draw $10 million on that. How – like do you get paid on the full $20 million and that’s what your investors sharing that return or they only – the corporate just paying for what has actually they’ve drawn?

We’re not in the business of providing standby credit, which may or may not get drawn. We’re in the business of providing loans that are intended to be drawn. So if they draw that $10 million, in your example, they paid to set up the facility as $20 million. They pay us fees and charges on that $20 million, but the capital and how we counted on AUM is not counted on AUM until the second $10 million is drawn. But in all cases, the intention is to draw all of the capital that’s been committed.

Right. So for every dollar that is actually drawn on the loan facility, Geoff, that loan facility draw has the capital call. So that your unitholders are going to be putting the money in the fund, and then that’s where the management fees get generated.

Okay, got it. Just one other question I had was, in terms of the conversation that you have with your institutional investors, has it been any general themes or trends that you’re finding coming out of that over the last few months?

Well, private credit is hot. In that the amount of interest in specialty private debt funding is high right now. Equity investment in the sector is cold, and has been driven and marked mostly by a change from any kind of preference from active management to passive management. So the GDX index has done quite nicely retaining assets, but no other active manager in the sector has managed to hold AUM levels. We think that that will change and that it’s going to change shortly. And I would think that’s where the real opportunity is. So there are allocators and institutions and very experienced managers that also believe that, that change will come, and they’re doing lots of work in the background to plan how they should allocate the opportunity in the sector.

Okay, perfect. Thank you.

Okay.

Thank you. Our next question is from Graham Ryding from TD Securities. Your line is now open.

Hi, good morning.

Good morning.

Let me just start on the Resource Lending LP just to make sure I fully understand. On a percentage basis if you sort of consider what’s drawn plus commitments to date where you are? Are you close to 80%, or are you still below that?

Well, again, let’s differentiate between what’s committed and what’s drawn. And what’s committed is very close to that 80%. What’s drawn, Kevin, is in the quarter – quarter-end?

Yes. So what is drawn, you’ll see – if you look at note – sorry, Page 10 of the MD&A in the three and six-month AUM results, you’ll see a column that says net sales and capital calls, Graham.

Yes.

So anytime a loan facility within the fund is drawn on, such that the fund has to call on capital from the investors, you’ll see that number and that’s the basis upon, which fees are calculated. That number will show up in this column under Private Resource Lending LPs, sorry, in the row, but the specific capital call column, okay? And if you want to see what has been called to date, then on Page 12 under interest income, there’s a little footnote we put there, that shows you in U.S. dollar terms that of the $640 million of firm commitments to Peter’s point, $296 million of that number has been called.

Okay. And then what – in order to get to…

So it’s fee earning AUM.

Yes. No, I get that. I’m just wondering in order to start raising your next fund, do you need to have that – now that’s called 80%?

No, no.

…$640 million, it’s at 80%?

No, not the call. The call is not – the call isn’t relevant, because at the end of the day, if the capital has been deployed, i.e., if there are loan agreements outstanding, then those loan agreements would constitute the capital being deployed, right? It’s no different than when a bank will go out and write a bunch of facilities to different borrowers. When they do that, they considered to be deployed, which is why if you look at the bank notes, banks will show that they actually have to manage the credit risk of the funds at that point even though it’s not actually drawn by the borrower at that time.

Okay. Okay, I’m good there. On the digital gold side, could you just sort of big picture sort of breakdown your view of why you think retail participation of gold could pickup materially under a digital gold landscape, compared to what’s out there today we’ve been able to invest in exchange-listed products with, et cetera?

Sure. Well, that’s exactly right. The innovation to date has all been in the exchange-listed area. The advantage of digital gold is that, it’s faster, it’s cheaper storage. So it’s faster. It gets inside of the market in terms of how it trades. It’s cheaper to store, it’s cheaper for the investor. And most importantly, it can serve – it can function, both in the existing confines of the financial system and it can also function directly user to user much like a crypto currency. And in terms of what might be attractive to investors, it’s both the cost and the speed. And very importantly, I think, it’s that – it might attract a new user base in those that want to trade gold on their mobile phones or gold – younger users, users that want to use gold as payments, the ability to function in the same technical manner as a crypto currency.

Okay. That’s helpful. On a more just sort of technical question. How should we think about the $3.5 million of other income that was within your lending division. Is this a non sort of recurring type of fee that’s in lieu of lost interest income? And was there any compensation offset to that the $3.5 million?

So within that number, a portion of it was related to the early repayment on a debenture. That is the standard part of our business. It’s no different and it is recurring, it may be lumpy, but it is definitely recurring. It’s no different than not sure, if you’ve covered the banks as well. But I use the bank analogy as well. The banks will have penalty interest payments, for example, on early repayment on a mortgage, right? So from what I recall in my days with the banks, that would be part of their all in interest as well, all in interest income. So we’ll have from time to time in that business early repayment fees. We may have loan restructuring fees, extension fees and so on and so forth, equity kickers. So all these things are part of that business, so we’ll continue to be standard. We can’t predict them, because it is based on the underlying activities and strategic planning from a financing perspective of the borrowers within the funds and on our legacy on balance sheet loans. But it is definitely part of our recurring business.

Okay. And it flows right to the bottom line, there’s no offsetting compensation expense?

No, I’m not sure why they’re not following that. Why would there be?

No, no, if you sort of – that’s fine. I just want to make sure that you’re not accelerating any compensation fees as you sort of accelerate interest income?

No – okay, it’s interesting. No, that’s not the case there. Where you would see accelerations would be, for example, if the loan early paid and maybe there was an up front equity kicker, such that there was unamortized discount. When you have that then you’re exactly right, that would be an acceleration of that interest, but in this case that wasn’t what happened here.

Okay, that’s fine. It’s good. And my last question just a carried interest that you’re earning in your lending division. Is this a mark-to-market type of revenue and that can move around? And I guess, what is the timing of the cash flows that would be associated with that earning – with those earnings?

Right. So the answer is no. It wouldn’t be mark-to-market. We follow the – and we’ve always followed this even though just – it’s been more codified now. But under IFRS 15, we don’t book carried interest and tell all of the critical events in the earnings process took place. So in our case, claw back trade would have expired and there would be no risk of a change in the value. So in this case, all of those gains were realized and all of the fees were received.

Great. That’s good for me. Thank you.

Thank you. At this time, I’m showing no further questions. I’d now like to turn the call back over to Peter Grosskopf for the closing remarks.

Okay. Thank you, everyone, for participating in this call. We appreciate your continued interest in Sprott, and we look forward to speaking with you again after our Q3 results. Have a good day.

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program. You may now disconnect.