ArrowMark Financial Corp.
Q4 2016 Earnings Call Transcript

Published: 1 Mar 2017

[Operator:]

Greetings and welcome to the StoneCastle Financial Corp. Fourth Quarter 2016 Investor Conference Call. It is now my pleasure introduce Rachel Schatten, General Counsel for StoneCastle Financial Corp. Thank you, Rachael. You may begin.

[Rachel Schatten:]

Good afternoon. Before we begin this conference call, I’d like to remind everyone that certain statements made during the call may be considered forward-looking statements based on current management expectations that involve substantial risks and uncertainties. Actual results may differ materially from the results stated in or implied by these forward-looking statements. This would depend on numerous factors, such as changes in securities or financial markets or general economic conditions, the volume of sales and purchases of shares of common stock, the continuation of investment advisory, administrative and service contracts and other risks discussed from time to time in the Company’s filings with the SEC, including annual and semi-annual reports of the Company. StoneCastle Financial has based the forward-looking statements included in this presentation on information available to us as of December 31, 2016. The Company undertakes no duty to update any forward-looking statement made herein. All forward-looking statements speak only as of today, February 28, 2017. Now, I will turn the call over to StoneCastle Financial’s Chairman and Chief Executive Officer, Josh Siegel.

[Josh Siegel:]

Thank you, Rachel. Good afternoon and welcome to StoneCastle Financial’s fourth quarter 2016 investor call. In addition to Rachel, joining me today is George Shilowitz, President; and Pat Farrell, our Chief Financial Officer. I would like to start the call today with a review of StoneCastle Financial’s quarterly results and portfolio highlights, along with comments on the current investment environment. Then, I will turn the call over to Pat, who will provide you with greater detail on our financial results before I open up the call for questions. In the fourth quarter, StoneCastle’s net investment income was approximately $2.5 million or $0.39 per share. There were no asset sales during the quarter, so there were no realized capital gains or losses. The Company’s net asset value per share was $21.22 as of December 31st, down slightly from last quarter. For the full year, I am pleased to report that the share price of StoneCastle Financial returned just over 24%, including reinvestment of dividend. The Company closed the year with the dividend yields of approximately 8%. Total assets were $205.9 million with 96% of total assets invested. The estimated annualized portfolio yield was 9.08%. During the quarter, StoneCastle Financial invested $23.2 million in five investments, which were offset by one repayment of $3.6 million. A significant investment this quarter was a $13 million, 10.5% senior term loan in Baraboo Bancorporation. Baraboo is 106-year old bank located in Baraboo, Wisconsin, about 100 miles northwest of Milwaukee. The bank is a closely held family bank, operating eight branches. The bank required bridge financing in order to repurchase a portion of their outstanding TARP securities in an accretive transaction for the bank. We believe the success of the Baraboo transaction among other factors is due to the reputation of our management team, our ability to provide flexible financing terms and our ability to close quickly when required. For a derailed and the rest of the portfolio, the full schedule of investments can be found on the Company’s SEC filings and on the Company’s website along with a table of our portfolio asset composition. As I mentioned earlier, StoneCastle Financial’s portfolio at the end of Q4 produced an estimated annualized yield of 9.08%, up from 8.96% in Q3 and 9.03% year-over-year. This yield offered a credit spread of approximately 663 basis points over the 10-year treasury rate, which was 2.45% at quarter-end. In addition, our portfolio generated 528 basis-point yield premium to the Bank of America, U.S. Corporate BBB Effective Yield index at yearend. This independent corporate bond index with comparable credit quality to StoneCastle Financial is widely tracked and includes 988 corporate issuers. For reference, the Bank of America index was yielding 3.8% as of December 31st. StoneCastle Asset Management is able to source transactions with attractive credit spreads as a result of its deep industry network and focus on transactions that are either too small or otherwise not the right fit for a syndicated broker dealer transaction. These privately sourced and negotiated transactions generate yields 200 to 400 basis points above those of syndicated single issue bank transactions. Before I turn to the current market environment, I would like to reiterate that an investment in StoneCastle Financial stock today offers investors approximately 7.5% dividend yield, inclusive of management fees, a diversified portfolio of approximately 120 community banks spread across 38 states and in our opinion, a team of investment professionals with deep expertise and deal origination and credit risk. Now, let make a few comments on the current market environment. We believe several factors are improving for the banking industry, and I would like to highlight three in particular. Legislative relief and the regulatory environment; increasing steepness in the interest curve; and industry consolidation. Banks are poised to see regulatory relief under the new administration from both amendments and rollbacks of regulations. We believe the regulatory trends could positively impact bank earnings through reduced regulatory compliance costs, flexibility to expand into new lines of business and an increase in the pace of mergers, which also brings significant cost savings. Given the operating leverage inherent in bank, reduced operating expenses would result in higher earnings and we believe result in stronger credit profile for our portfolio. The new administration has adjusted a path of economic growth, fueled in part by significant spending, a much needed infrastructure repair and expansion. Infrastructure requires mass amounts of goods and services from heavy equipment and raw materials to engineering work and the transportation of goods. An important secondary effect of this spending is the trickledown effect of smaller businesses and local economies. Tens of thousands of local businesses provide the daily needs of food, goods and services sold to the very people working at the companies supplying the heavy equipment raw materials and engineering for such infrastructure projects. As we have mentioned before, community banks are the likely beneficiaries of such economic stimulus, since they provide over 55% of all small business loans aided by banks across America. We believe continued economic growth had an overall positive impact on StoneCastle Financial in two ways, both with existing portfolio and with respect to an increased number of new investment opportunities. Now, let me turn to the interest rate environment. Over the past five years, interest rates have been relatively flat and stable. We believe interest rates may have reached an inflection point in 2016. With the December increase only the second time the U.S. central bank has raised rates since 2006. The difference between the loan rates and bank deposit costs is called net interest margin or NIM and is comparable to gross profit for a bank. NIM tends to increase in higher straight environments and the interest earned increases even more when interest rate curve steepens, likely benefitting community banks. Also, another point I’d like to mention and have mentioned in the past is consolidation. Most industry experts agree that the timing is right for an increase in industry consolidation. We believe the wave of mergers will continue to be driven by the intergenerational change of bank leadership, a direct result of aging management teams and boards of directors at many smaller and family owned banks. This consolidation will fuel the growth of more successful banks and will allow smaller bank investors and opportunity to exit at attractive prices. In closing, we believe the macro environment and investment thesis is attractive for investing in community banks. StoneCastle Asset Management continues to see many accretive investment opportunities as a result of continued economic growth and bank consolidation. We believe StoneCastle posses a unique set of skills to analyze community banks as well as understand the bank’s local market in a broader context of the U.S. economy. StoneCastle’s deep knowledge and experience offers investors what we believe is an attractive yield and a diversified approach to dramatically invest in the community banking sector. Now, I want to turn the call over to Pat to discuss the financial results and provide details on the underlying value of the Company.

[Pat Farrell:]

Thank you, Josh. As I do each quarter, I will present the financials by going through the detailed components to help you understand the value of the Company. The net asset value at December 31st was $21.22 per share, down $0.07 per from last quarter. The NAV for StoneCastle Financial is comprised of four components

[Josh Siegel:]

Thank you, Pat. Now, operator, we would like to open up the call for questions.

[Operator:]

Thank you. Ladies and gentlemen, at this time we will be conducting a question-and-answer session. [Operator Instruction] Our first question comes from the line of Devin Ryan with JMP Securities. Please proceed with your question.

[Devin Ryan:]

A couple of questions here. I guess first on capital and opportunities. Obviously the vast majority of available capital has already been put to work and that’s good for current returns. But now, with little dry powder at the momentum, can you give any perspective around the size of the backlog currently, how that’s been trending? And then, whether you’ll look to grow that backlog just with the expectation that there might be opportunities to bring capital that could be utilized quickly or at least how you are thinking about kind of new business development?

[Josh Siegel:]

That’s actually a great question. So, you touched on quite the challenge we have, keeping banks interested in raising capital while not having any incumbent, [ph] not an easy place to be. Into Q4, we were looking to possibly to do another pool. We made the call given election to postpone, hindsight, very good call. We had a pipeline nearing $130 million to v150 million going into that. We had a number of banks drop out because they wanted to get the funding by yearend and went elsewhere gambling them. We still have a reasonably good pipeline today, probably near $100 million. But we haven’t put a whole lot of effort into growing that significantly, because without some visibility and timing, we don’t want to over promise and under deliver. That said, we still remain interested in trying to do one more pool, but can’t say whether we will be able to do one or when, but we are actively looking. And if we can wind that up, then we would be able to go back to market. At the other side, there was of course our stock price today versus where it was at the end of the quarter. We are trading with almost 5% discount to NAV. So, we are closing in quick. Everybody just needs to buy more shares. But once we are at or above NAV, we can go back to our original business plan, which was to use our shelf and raise just in time capital for investments as they come up. So, the pipeline is still there; there is still demand; still will impact this growth. FDIC just came out with some commentary from their quarterly report, community banks for -- their income up over 10% from last year; asset quality as low it’s been -- the asset question is best; the NPLs are lowest they have been since 2007. So, all of those trends, that’s all public data is so good. So, if you are seeing banks finding opportunity, they’re going to need capital. Consolidation is still a major issue that’s going to drive the investment side. We need capital, we still have some SBLF to refinance. So that all exists. So, I think pipeline wise, we have opportunity; we just need the capital to match it.

[Devin Ryan:]

Got it. So, just to kind of frame it, the position of the Company today versus when the Company was IPOed, you believe that to the extent there were capital available, they period to kind of ramp right, maybe allocate that capital would be much faster today than maybe was coming out of the gates of the IPO?

[Josh Siegel:]

I don’t if I would say it that way. The difference on the IPO is we had 100 plus million to put to work in a moment’s notice, and the banks were little slow to react. Now, the benefit is in the market, the bank’s reaction time to from an interest to closing is much faster than it was three years ago; that part is a markedly different, now that we sort of restarted the bank capital markets for community banks. That said, the amount of available dollars we would have to put the dollars to work, it’s more matched. In another words, assuming we were trading above NAV, we could line up $30 million, $40 million of investments, we’ll raise $30 million or $40 million of capital and deploy. If we find $20 million of investments, we’ll raise 20. So, we can better match the sourcing of capital with the deployment assuming we’re free to raise. That’s very different than raising a $100 million of those secondary offering and now being pressured to put it to work. We don’t want to be in that position. The pool helped us with that a year and a half ago, because we could have banks sort of sit buy and wait to be funded and do that simultaneously, and that worked out well. So, if we can do that again that would be good, but it’s a better business model to not have to rely on the pools and rather do the deals one, two, three at a time as possible. So, I mean also you’re in different market environment, interest rates are different, regulatory environment now is going to be dramatically different -- dramatically maybe overstretching, we don’t know yet. But, it’s not going to get tighter; let’s put it that way. The regulatory environment is neutral to better and that should free us banks to do some more business. So, there is a lot of sort of good tailwinds right now.

[Devin Ryan:]

Yes, got it. Okay, that gets to the question, I really appreciate that color. And then with respect to bank stocks and with the public market, there has been a strong upward move post election, and there has also been a fair amount of common equity achievements in recent months. So, I’m just curious how that has impacted demand at all or more maybe pricing as well for other types of financing outside of public equity?

[Josh Siegel:]

There is two components to the answer. So, one is -- and I know you know well, many who follow the financial space, the access to capital for money center bank and regional banks is almost completely uncorrelated to the ability of private community banks, private equity public equity, entirely different. Many have the differential between raising preferred stock subject versus raising common stock. So, no matter what’s really changing in the expectations of public bank stock prices, which in my personnel has been a little overdone. I don’t see the rationale for stocks going up as much as they have. But that said, you haven’t really seen spread tightening all that much in the community bank sub debt or preferred stock realm, or even still a little bit of concentrate, still trading around part, so at 9%, if you can source it, which is the challenging part. So the differential between the general capital markets being either in fixed income as we cited in the call, that index -- to be the index being 3.6% for BBB paper and we are at over 9% on asset yield, I mean it’s a absurd the gap we’re seeing today is probably in the last five, seven years, we’ve never seen anywhere near this wide between where small financials are pricing at some of their best credit quality that we’ve seen in the decade compared to where more broadly syndicated paper is or general corporate BBB debt or even the equity markets, there is just a lot of value in the space. So, we’re kind of excited about that.

[Operator:]

Thank you. Our next question comes from the line of Collyn Gilbert with KBW. Please proceed with your question.

[Collyn Gilbert:]

Josh, just to go back to your outlook for future investment and future growth. How does that work in terms of -- I mean, it seems like it has to be a pretty in arch [ph] here in balancing when -- let’s assume you do get above NAV and you can raise the capital and match that. Does it change the way you prospect potential investment? As you’d indicated in the fourth quarter, some of these banks are like we can’t wait, we got to go now. I’m just trying to understand sort of the timing of that and how these timing private banks think about their ability to sort of wait or say okay, yes come for 3Q or whatever might be, we’ll be happy to issue?

[Josh Siegel:]

Sure, good question. So, best example would be the pool we did a year and half ago; in November, we’re sort of working towards. Q4 is particularly challenging for banks to wait, right? Because they want to have capital raise that they have either share repurchase or going into their 2017 business plan or deal to close. They don’t have the flexibility where they may in Q1, Q2, Q3 to say, I’ll wait; I have some time, I will wait and see. So, we were able to get 31 out of 35 banks to sort of standstill with docs done waiting for capital. If we’re trading above NAV, rather than trying to have 30 banks waiting in time, we have to do three. So, at least from our standpoint, that’s a much easier ask to find a few banks that want capital and say look, if you want to raise capital, let’s do the docs, let’s get the underwriting done, no guarantee that I can go raise capital at StoneCastle Financial but of course I’m speaking in a theoretical here. We’re trading above NAV; so, there is no restriction. We will go to market and try to raise the amount and close on your deal. So it’s nothing new to us. It’s just actually an easier version of the pool. And these banks really don’t still have many options as they are small and private. It’s not -- as you know, it’s not a credit issue. There just aren’t a pressure [ph] of investors standing by ready. I mean he used to have a competitor when we did the pool last time in Manny Friedman’s fund but even he’s moved on to other things. Because it’s too hard. He doesn’t have the nearly 70 employees we do. In fact, I think he lost a few employees recently; just doesn’t have the coverage to do direct origination model, be by secondary, the hedge fund. So, it just gives us an advantage. And then you add in our advisor’s affiliated deposit business, give us even more reason to be talking to banks on a regular basis. There is 800 banks we talk to every week in any location. And so that just gives us a bit more pricing power and a bit more patience power with smaller banks to line them up for club deals -- club deal is a long thing, bilateral, but really group, small groups of deals to be done at a time.

[Collyn Gilbert:]

Okay. That’s helpful. And then, Pat, how are you thinking about the variability in your debt expense now with higher rates? I know you guys -- I think you have flexibility of pricing there, I think it’s also one month which just saves you a bit in these last few months. But, how should be think about, I don’t know if you want to look at it 25 basis-point increment higher of one month LIBOR, what that would do to your interest expense?

[Pat Farrell:]

Well, we’re -- one of the things that we’ve done throughout the time that we’ve this loan facility in place is make sure that any cash that we have available, if we have a call, we pay down the long right away. So, we are continuing to do that to make sure that we optimize the loan when we have a call then pay it down whenever we can. With regard to the rates, they’ve been relatively consistently through the quarter, up very, very slightly. We’re considering since we’re about 2.5 years into the current facility, we’re looking at may be the possibility to renegotiate it or do something a little different there to bring our cost down. So, we are looking at that. And we continue to do that, we have been looking at that for some time now, and we will continue to monitor that.

[Josh Siegel:]

Yes. And just to follow up on Pat’s comment, there is no way we can forecast whether we can lower the cost, but academically, we are in A3 rated Moody’s rated Company. And if you look at where single A rated debt is trading, it should be in the 125 to 175 over LIBOR range and we’re at 285, because we were a new business and a new idea. We are basically just paying too much in that facility, given that that was locked in at the IPO date of a brand new Company that never existed before.

[Pat Farrell:]

Yes. And I think the other thing I would add is that that initial rate if you will, back then, we were the purple elephant. I mean, people had not seen this type of close in vehicle before. And in terms of the securities that we’re purchasing, they’re not the type of things that you can go out and get a stock quote for immediately. So, then, it was different. Now, we have got a track record. So, we feel pretty confident that we will be able to improve that rate.

[Josh Siegel:]

But another direct answer is when you think about how lightly levered we are, again, we are going to 0.33, we tend to stop at 0.3. I mean right now we are at 0.299. A 25, 50 or even 75 basis-point move on the short end of the curve, yes, they will raise our interest expense but as a percent of the total interest income, it’s not like a big move, small impact, very nominal but not a big move.

[Operator:]

Thank you. [Operator Instruction] Our next question comes from a line of Chris Testa with National Securities Corp. Please proceed with your questions.

[Chris Testa:]

Just curious in terms of the deal flow you have been seeing this quarter and the fourth quarter of 2016, what have been the -- what’s been the mix between the uses of proceeds for the banks that are borrowing from you primarily?

[Josh Siegel:]

Great question. You are not with CNN, right, because we don’t take CNN on these calls. The use of proceeds recently has probably been slightly skewed toward refinancing, either repurchasing existing shares, refinancing TARP or SBLS, but still not by a huge margin. We’ve had a couple of acquisitions behind interesting capital, probably a little less organic growth. So, I’d say that’s probably the slight skew. I mean again, going back for many years, it’s almost been a third, a third, a third between those three. But that is probably just what’s coming to mind is the more recent focus, the share repurchase and little acquisition, lesser so on organic growth.

[Chris Testa:]

Got it. And just also curious, just on Chicago Shore was marked down further this quarter that would be unrealized loss. Was there any news from the regulators about that or did you just kind of pushed back the timeline on when you expect the resumption of a dividend?

[Josh Siegel:]

No, it’s actually a great question. And even Chicago Shore, we are getting level two marks, that’s not a sales mark adjustment, that’s a market mark adjustment, if that’s the real word. Both -- Pat mentioned Pioneer and Chicago Shore, neither of those were credit issues. It’s just change in -- in the case of pioneer being a private equity position that travels more toward change in book and change in market. And there actually were some trades in the private equity that were observable. So, we had to sort off those small private equity trades. Chicago Shore, we are not bound under any confidentiality, but it’s not material, but all of the results have been actually quite strong. We don’t have good visibility on when we expect the dividend to come current, but from recent regulatory meetings the banks had with the regulators, it’s been actually all positive, upgrades and quite good. So we are pleased with that direction, but once again, because it’s a credit that does have some story, you can have volatility quarter-to-quarter, but nothing in Pioneer or Chicago has been negative. In fact, both have been neutral to positive. So, they are not credit moves; they are just market moves.

[Chris Testa:]

Got it. And just I guess segueing my first question my first question, a bit of order there. Just your remarks about obviously deregulation potentially bring up banks. Just curious, what your thoughts on what that’s going to due to M&A volume given that so much of that is driven by them being regulated out of existence?

[Josh Siegel:]

I’ll take the that counter point on that and I’ve said that in front of room full of bankers before. Regulation will rarely put a bank, if ever, out of business, meaning regulatory regulation. Does it cost them some return on equity? Yes. Does it make the difference between those surviving and surviving? I’ll challenge if the claims that. In fact, I’ve often said to a bank -- room full of bankers that if you didn’t have the regulatory construct, you would be out of business in five seconds. So, don’t be so harsh on that regulatory construct. That’s what keeps the regulated banking system safe, sound and these banks in business. That said, I’ve always stood by the greatest reason like you’re seeing bank M&A occurring is age, aging management teams and boards. When you look at enrollment Stone [Indiscernible] or Colorado Graduate School of Banking, attendance is down, there are just less young bankers coming into the market and it’s just very hard for these shareholder groups and boards to say, who do I have to hand the bank to. We are in our 60s and some 80s. So that’s sort of driving that 270 to 320 deals a year. And I’ll see that pace continuing for a while. So, the regulatory regime has made it a little more costly and I have been in many room with regulators trying to quantify that costs, no one has done a great job of quantifying it. But I would venture that nine out of 10 regulators and even bankers would say yes, we are probably not being put out of business by regulation, but we do have some pressure. So, your core question of M&A, I do see that continuing for some time, for years to come.

[Operator:]

Thank you. We have reached the end of our question-and-answer session. I would like to turn the call back to Josh Siegel, Chairman for closing remarks.

[Josh Siegel:]

Yes. Thank you, operator. As always, StoneCastle Financial could not have achieved the success of our organization without your continued support. We invite you, as always, to visit us in New York City or invite us to come speak with you or your colleagues at your site. On behalf of the entire executive team and Board, thank you. And we hope to see you again soon.

[Operator:]

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for participation.