Capital Southwest Corporation
Q1 2020 Earnings Call Transcript

Published: 7 Aug 2019

[Operator:]

Thank you for joining today's Capital Southwest First Fiscal Quarter 2020 Earnings Call. Participating on the call today are Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, Vice President Finance. I'll now turn the call over to Chris Rehberger.

[Chris Rehberger:]

Thank you. I would like to remind everyone that in the course of this call, we will be making certain forward-looking statements. These statements are based on current conditions, currently available information and management's expectations, assumptions and beliefs. They are not guarantees of future results and are subject to numerous risks, uncertainties and assumptions that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Capital Southwest's publicly available filings with the SEC. The company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events, changing circumstances or any other reason after the date of this press release, except as required by law.

[Bowen Diehl:]

Thanks, Chris, and thank you to everyone for joining us for our first quarter fiscal year 2020 earnings call. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our website at www.capitalsouthwest.com. We are pleased to be with you this morning to announce our quarterly results for the first quarter ended June 30, 2019. During the quarter, we continued to advance the credit strategy we laid out for our shareholders 4.5 years ago, of prudently building a well-performing credit portfolio, utilizing conservative late-cycle underwriting principles. We continue to be committed and excited about our core investment strategy of building a predominantly lower middle market portfolio consisting largely of first lien senior secured debt with equity co-investments across the loan portfolio, where we believe significant equity upside exists. Executing our investment strategy under our shareholder-friendly internally managed structure closely aligns the interests of our board and management team with that of our fellow shareholders in generating sustainable long-term value through recurring dividends, capital preservation and NAV per share growth and operating cost efficiency. During the June 30, 2019 quarter, as laid out on Slide 6, we generated $0.44 per share of pretax net investment income, representing 42% growth over the $0.31 per share generated in the same quarter a year ago, while paying out our regular dividend of $0.39 per share for the June quarter, representing 34% growth over the $0.29 per share paid out in the same quarter a year ago. Additionally, we distributed $0.10 per share through our supplemental dividend program, funded by our sizable undistributed taxable income balance, or UTI, which was generated by excess income and capital gains accumulated from our investment strategy to date. As of June 30, 2019, we had approximately $19.5 million or $1.10 per share in UTI, providing visibility into continuing the quarterly supplemental dividend program well into the future. For the June quarter, the $0.49 per share paid out in total dividends generated a total annualized dividend yield of 9.4% based upon our June 30, 2019 share price. We are also pleased to announce further growth in our quarterly regular dividend for the September quarter, as our Board has declared dividends of $0.50 per share for the September quarter, made up of a $0.40 per share regular dividend and a $0.10 per share supplemental dividend. This will mark our 15th consecutive quarter of increasing shareholder dividends.

[Michael Sarner:]

Thanks, Bowen. As seen on Slide 15, our investment portfolio produced $15.8 million of investment income this quarter with a weighted average yield on all investments of 11.6%. This represents an increase of $1.5 million from the previous quarter, mostly attributable to net portfolio growth. The weighted average yield on our credit portfolio was 11.7% for the quarter, a slight increase from the previous quarter. As of the end of the quarter, there was one asset on nonaccrual with a fair value of $7.9 million, representing 1.5% of our total investment portfolio. Excluding interest expense, we incurred $4.3 million in operating expenses this quarter, which was an increase of roughly $500,000 from the prior quarter. As noted on our prior quarterly call, the increase was expected as we incur seasonal expenses in the June quarter of each year associated with payroll taxes and the Annual Shareholder Meeting. Additionally, during the June quarter, we incurred a onetime charge for the accelerated vesting of restricted stock awards for a long-time employee upon his retirement. For the quarter, we earned pretax net investment income of $7.7 million or $0.44 per share compared to $0.42 per share during the prior quarter. We paid out $0.39 per share in regular dividends for the quarter, an increase of $0.01 per share over the $0.38 per share regular dividend paid out in the prior quarter. We continue to focus on growing our regular dividends in a sustainable manner, demonstrated by our cumulative regular dividend coverage of 108% over the last 12 months and 105% since the launch of our credit strategy 4 years ago. As Bowen mentioned earlier, we also paid out a supplemental dividend of $0.10 per share this quarter as part of our supplemental dividend program. This program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio. The program will continue to be funded from our UTI earned from both realized gains on debt and equity as well as undistributed net investment income earned each quarter in the excess of our regular dividends. On Slide 16, we illustrate our operating leverage, which as of the end of the quarter, was 3.1%. Excluding the aforementioned seasonal expenses and onetime charge, our operating leverage for the quarter was 2.8%, which continues to migrate towards our target operating leverage of sub-2.5%. We are fully committed to actively manage our -- managing our operating costs in lockstep with portfolio growth and expect to achieve our target operating leverage over the next few quarters. With senior professionals and corporate infrastructure largely in place, operating leverage should continue to improve as the investment portfolio grows due to our internally managed structure.

[Bowen Diehl:]

Thanks, Michael, and thank you, everyone, for joining us today. Capital Southwest has grown and the business and portfolio have developed consistent with the vision and strategy we communicated to our shareholders 4.5 years ago. Our team has done an excellent job generating significant returns for our shareholders. Everyone here at Capital Southwest is totally dedicated to being good stewards of our shareholders' capital by continuing to deliver strong performance and creating long-term sustainable value for our shareholders. This concludes our prepared remarks. Operator, we are ready to open the lines for questions.

[Operator:]

. And our first question comes from the line of Tim Hayes from B. Riley FBR.

[Michael Smyth:]

This is actually Mike on for Tim. My first question is when you look at Slide 13, it looks like you added MRI to the graph, which implies a $53-million-or-so mark, which is largely unchanged quarter-over-quarter. So I was just wondering if this is a reflection of more or less interest you're seeing from bidders? Or I guess if you could just broadly provide any additional commentary on the sale process?

[Bowen Diehl:]

Yes. So you're right, we put MRI to spot the -- on the chart, it has been previous quarters a yielding equity we've been noted as yielding equity. We just decided this quarter to be more specific and separate out from our other general equity co-investments. I would say, generally, the sale process is going well. As I said in my prepared remarks, there's obviously an interest in the asset, and it's progressing forward. So that's really on the sale process really all I want to say, given the buyers looking at the business. But we still think it will exit before the end of the year. As we -- our valuation process methodology hasn't changed, so we incorporate DCF, we incorporate costs. We also incorporate a weighting from the valuations in the market. And as the valuation -- or as the sale process progresses forward, that weighting influence on the valuation increases over time. So we did have a -- we'll see in the Q this afternoon, we did have a $1.2 million write-up this quarter. So it's not exactly flat, as you said. But as again, the weighting of the valuations in the market increases as they influence on valuation over time as the sale process progresses and you get more clarity and visibility on where it might ultimately trade.

[Michael Smyth:]

And then just a follow up. Do you have any updates on the decision once the sales process is complete? Or is that something you guys are still thinking about in terms of retaining versus paying out a special dividend?

[Bowen Diehl:]

Yes. So I mean the board is going to make that determination, and we'll make that determination once it sells. So the answer is, no. We don't have anything else additional to tell the market other than a reminder that we'll have the option to -- we will restuff, we will replenish the UTI bucket, first and foremost, the gain will, obviously, most likely very likely be much in excess of that. So the remainder of the gain, we will we have options. We can either retain it and do a deemed distribution to the shareholders, pay a 21% tax or we can distribute it in a special dividend or a third option do a combination of both. And so the Board, like I said, will ultimately decide that once the sale is complete, and we'll announce it.

[Michael Smyth:]

Got you. And then one more question. How does the pipeline look maybe compared to a year ago?

[Bowen Diehl:]

Yes, the pipeline is -- as far as the number of deals that are in the shop that we're reviewing is up year-over-year. Hence, my comment that the pipeline is strong. Market competitiveness is still very competitive. I wouldn't say it's more competitive today than it was 6 or 9 or even 12 months ago. It's been very competitive for a while. But our pipeline as far as deals we're reviewing looks good. We're being very careful in diligence. We definitely have had a couple of deals that have -- closings have been pretty materially delayed based on diligence findings and needing to see a few more months of performance, that type of thing, but that's pretty normal in our business. So it makes it -- tends to make it, like, I've always said a lumpy business. But overall, we're pretty happy with the pipeline. We're certainly getting a lot of looks.

[Michael Smyth:]

Got you. And have you seen any changes in the upper middle market versus the lower middle market? Have you seen any improvements in the upper middle market or vice versa?

[Bowen Diehl:]

No, we definitely, right now, continue to see the best opportunities in the lower middle market with a few exceptions, iEnergizer in this quarter is actually an upper middle market deal. But I would say, still the same environment, largely in the lower middle market, and I would say same -- generally same environment in the upper middle market. It's in the upper middle markets, we all know the frothiness in that market. So that continues today.

[Operator:]

Our next question comes from the line of Mickey Schleien from Ladenburg.

[Mickey Schleien:]

I wanted to follow up on that last question about upper middle market versus lower middle market. There's -- I think investors and analysts are struggling with the outlook for defaults and recoveries in those 2 different markets, if the economy were to slow meaningfully down the road. So when you look at those 2 markets, how do you gauge the risk-adjusted returns? And how do you judge the differences in the potential default and recovery probabilities in those 2 markets?

[Bowen Diehl:]

Yes. Thanks, Mickey. I hope you're well. So on that, I would tell you that clearly, a textbook view is while larger companies are more established, and therefore, they do better in a recessionary environment. And while that's not wrong, the other thing that goes into that is structure and leverage levels. And so we're a first lien lender. And if we can lever our business appropriately versus the potential volatility of that business in dollar one risk and so we can control the dialogue and ultimately have much better control of our destiny, which is ultimately what our shareholders care about with our capital. So in the lower middle market, where leverage levels are lower and structures are tighter, they're smaller companies, clearly. And so we've got to pick the companies correctly, but it's not correct to say that there aren't good, sustainable full cycle businesses in the lower middle market. That's not -- that's -- we don't believe that that's the case. But you have to have less leverage, and you have to have tighter structures, and indeed, the market follows that largely because the lower middle market has definitely tighter structures, lower leverage. In the upper middle market, we all know of very loose structures, a lot of covenant-light deals, higher leverage, even if they are a larger company. So if you think about a full cycle in a recessionary environment, I've got a lot more options if I'm dollar one risk at a lower leverage level going into the cycle than I am if I'm -- even if I'm dollar one risk going into the cycle at a higher leverage level. So as a general -- and then also in the lower middle market, absent a recession when things are going well, we have some equity upside in our portfolio as well. So as an investor, I see that, okay, good times, I'm going to make some money. In bad times, I can control my destiny, the company survives, the capital structure survives, and we ride out the other side of a recession, which are typically what 18 months or so long. And so you can basically live to play for another day, and you've gotten appropriate full-cycle returns for your shareholders. So long-winded answer, but that's kind of how I look at those 2 markets. So both have their advantages and there's disadvantages, but that's why we do find full cycle, the lower middle market being more interesting.

[Mickey Schleien:]

So just a follow up, if I can, Bowen. When you talk about cycles and weathering the storm, we're in the longest expansion in the history of the country, obviously, off of a very low base. But my sense is that a lot of the borrowers and a lot of BDC portfolios are -- weren't around in the Great Recession. So you don't necessarily have data to look at how revenues and margins behaved in 2008, 2009 and so forth. So with that in mind, how do you underwrite the downside to a borrower that didn't exist or wasn't really -- perhaps it was a very different business model that far back in time?

[Bowen Diehl:]

Yes. So those are good questions. So one of the things we said from the beginning, as we do look at the Great Recession as an analog for the current situation, we've been doing that since 2015. And you're right. I mean not every company we invest in was even here in 2008. I would tell you, a lot of them were. But even the ones -- some of the ones that were, were a lot smaller, maybe had one special customer, large customer in 2008 and 2009, which skewed the results. So a lot of times, we have to go back and we do -- and you can do this when you work. But we go back and look at the industry and we look at other players that were there. And we do a pretty deep dive into exactly what was happening in that time frame in that industry and in that company with respect to suppliers, customers, customer behavior, pricing, and then we basically then construct a simulation that if we do a loan today, it's '20 and '21, a simulation of that same dynamic happening to the company. And so are we going to get that perfectly right every time? Of course, not. But I think we're going to get pretty close, and we're going to be right more than we're wrong. And so we've been doing that. And our team goes -- our deal teams go through a fair amount of work to construct that simulation or that downside economic case. And so we've done that loan by loan. And from the very beginning, we believe that if we do that loan by loan, we're going to be better positioned as a whole of the portfolio to weather that storm. And hence, you see our weighted average leverage in our lower middle market portfolio is lower than many of the BDCs. And that, I believe, in part reflects what I just said.

[Mickey Schleien:]

Bowen, just one last question because you jog my memory about quite something I'd like to follow up on. Given that you've looked at a variety of industries. And I know the question I'm going to ask is going to be very much dependent on the industry. But when you look at '08 and '09 in the lower middle market, can you tell us broadly how did revenues behave and EBITDA during that recession? Again, I know comparing a software company to somebody manufacturing widgets, it's not a fair comparison. But in broad brush strokes, how did they do?

[Bowen Diehl:]

I mean obviously, the answer is, as you said, it depends on the company in the industry. I mean more fundamentally, we're trying to match the capital structure we're putting on that particular company in that industry to match the potential volatility so that your dollars stay within enterprise value and your interest continues to get paid. As far as a macro lower middle market asset class, if you will, stats, honestly, I don't have that in front of me. So I actually -- I don't know the answer to that. We've just always focused on a company-by-company basis.

[Operator:]

Our next question comes from the line of Kyle Joseph from Jefferies.

[Kyle Joseph:]

I wanted to focus on yields. We've seen a modest bit of upward pressure on yields for the overall portfolio. Is that more of a sense of a portfolio mix rather than yields on new deals being higher than yields coming off?

[Bowen Diehl:]

That's probably a portfolio mix. We've done recently a couple of first out/last out deals where we'll invest in the -- we'll sell a small first out piece, that pays a much lower rate and then we'll scrape the rest to our position, controlling the loan along the way. So that's going to have an influence and might...

[Michael Sarner:]

Yes, so that overall, the overall yield went up based on the dividend, one from MRI produced a larger dividend this quarter based on it having additional free cash flows. And then I-45, we had a refinancing of the portfolio company that had a $400,000 gain that flowed through as a dividend to Capital Southwest. So those 2 enhanced the overall yield for the entire portfolio.

[Bowen Diehl:]

In spite of all those things.

[Kyle Joseph:]

Got it. And then given sort of the rate outlook and everything, can you give us a sense of where you would anticipate that yields heading going forward?

[Bowen Diehl:]

Well, I think based on the -- assuming the last cut, I think it's going to be flat based upon -- assuming that Fed doesn't make any additional cuts in the future. What we would say is from our yields, the LIBOR reset date doesn't occur until the first of the next quarter. So we're going to see a 25 basis point hit. And so that's about $0.01 a quarter reduction in yield.

[Kyle Joseph:]

Okay. Got it. And then one last one from me. Obviously, this is dependent on market conditions, but can you remind us your sort of target leverage ratios in the near term, intermediate term and longer term?

[Bowen Diehl:]

Yes, target leverage ratios at the BDC?

[Kyle Joseph:]

Yes.

[Bowen Diehl:]

Yes. So our target leverage ratio, we kind of define it as a fairway, but a fairway between kind of 1

[Michael Sarner:]

And I think we probably said in the past calls too, sort of a glide path, we're going to be issuing a little bit of equity off our ATM program and making certain we always have borrowing capacity on the debt side to sort of steadily move leverage up towards those levels and not just to bring it up in a quick fashion or raise large amounts of equity and bring it crashing down.

[Operator:]

Our next question comes from the line of Chris York from JMP Securities.

[Christopher York:]

So Michael, you touched on my question a little bit here in your answer to the last question. But given that the Q is not out, could you elaborate on the drivers of the increase in the dividend from controlled portfolio companies in the quarter? And whether you think this increase is sustainable?

[Michael Sarner:]

Yes. So the two ones that I noted earlier. So MRI being the one controlled portfolio company and then I-45 being the other. So the dollar amount, I think I noted whereas the MRI dividend increased by $150,000 and the I-45 was $400,000.

[Christopher York:]

Got it. And then so are either of those sustainable, so the sequential increase...

[Michael Sarner:]

Yes, correct. Neither of those are going to be sustainable going forward. So that $500,000 is a run rate for this -- is a onetime for this quarter. You'll see that it was sort of met by $400,000 of additional expenses this quarter that were not run rate as well.

[Bowen Diehl:]

Yes, MRI increase -- slight increase was a function of the cash flows on MRI. The I-45 was a refinancing . Most of it is I-45.

[Michael Sarner:]

I will probably get to your question, too, Chris, I'll tell you the $0.44 of NII, of that, the run rate on that was really around $0.43 going forward.

[Christopher York:]

Okay. So you take out the..

[Michael Sarner:]

Yes, take out the revenue onetime hits and the expense as well.

[Christopher York:]

Okay. And just to be clear, on the share-based comp, $400,000 of the $837,000 was nonrecurring or onetime?

[Michael Sarner:]

Yes. So of the $837,000, $150,000 was onetime in nature, and the rest is ongoing and recurring.

[Operator:]

Thank you. And this does conclude the question-and-answer session of today's program. I'd like to hand the program back to Bowen Diehl, Chief Executive Officer, for any further remarks.

[Bowen Diehl:]

Thank you, operator, and thanks everybody for joining us today. We really appreciate it. I appreciate all your support, and we look forward to keeping you apprised on the business as we report. Have a great week.

[Operator:]

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.