Gladstone Investment Corporation
Q4 2017 Earnings Call Transcript

Published: 16 May 2018

[Operator:]

Good day, ladies and gentlemen, and welcome to the Gladstone Investment Corporation Fourth Quarter and Year Ended 03/31/2018 Earnings Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] And as a reminder, this conference call is being recorded. I would now like to turn the conference over to David Gladstone. Please begin.

[David Gladstone:]

Thank you, Latoya. Hello and good morning to all of you. This is David Gladstone, Chairman of Gladstone Investment. This is the quarterly and year-end earnings conference call for shareholders and analysts of Gladstone Investment's common stock, on NASDAQ, at GAIN and we do have three preferred stocks. They all start with GAIN, and then you have an M, and an N, and an O, so you can go by a lot of different stocks that we have out there. First of all, thank you all for calling in. We are always happy to talk to shareholders, potential shareholders and analysts. I'd like to give you an update on your company and its investments and provide our view of the current business environment. I wish we could do this more often, but we only do it once a quarter. Also, there's an invitation out to all of you if you come by McClean, Virginia area, where we're located just outside Washington D.C. Please stop by and say hello. You'll see a few people here. A lot of people are always on the road going places. So now we will hear from our General Counsel and Secretary, Michael LiCalsi. Michael is also the President of Gladstone Administration, which serves as the administrator for all the Gladstone public funds and related companies. He'll make a few statements regarding forward-looking statements. Michael?

[Michael LiCalsi:]

Thanks, David, and good morning. Today's call may include forward-looking statements under the Securities Act of 1933 and the Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties and other factors, even though they're based on our current plans, which we believe to be reasonable. The many factors may cause our actual results to be materially different from any future results expressed or implied by these forward-looking statements, including all Risk Factors listed in our Forms 10-K, 10-Q and other documents that we filed with the SEC. These all can be found on our website, www.gladstoneinvestment.com, specifically the Investor Relations page, or on the SEC's website at www.sec.gov. While we undertake no obligation to publicly update or revise any of these forward-looking statements whether as a result of new information, future events or otherwise, except as required by law, please also note that past performance or market information is not a guarantee of any future results. And we ask that you visit our website once again, gladstoneinvestment.com, sign up for our email notification service. You can also find us on Twitter, @GladstoneComps and on Facebook, the keyword there is The Gladstone Companies. Today's call is simply an overview of our results through March 31, 2018, so we ask that you review our Press Release and Form 10-Q, both issued yesterday for more detailed information. Again, those can be found on the Investor Relations page of our website. Now I'll turn the presentation back over to Gladstone Investments' President, David Dullum. Dave?

[David Dullum:]

Hey, Mike. Thanks very much and welcome to all the participants. I'm very pleased actually today to report that Gladstone Investment had another strong fiscal quarter and a very good year ended 03/31/18. We were able to increase our net asset values to book value from $10.37 a share in the third quarter to $10.85 a share in the fiscal year end and for the 12 months from 03/31/17 to 03/31/18 by $0.90 per share or from $9.95 to $10.85 per share. We also experienced a 10.8% growth in our adjusted net investment income year-over-year from $0.74 per share to $0.82 per share. I'm very happy with these results as year-over-year is a good indicator of the achievement of our plans in growth as we think of our business on an annual basis as we can experience recently significant swings quarter-to-quarter. So the year results are important. And based on this results, in April, we were able to announce an over 3% increase in our annual distribution rate to common stockholders from $0.78 to $0.80 a share. We also were able to announce the continuation of our semi-annual supplemental distributions program with a payment of $0.06 per common share to be made in June of 2018. We fully expect that a significant portion of these supplemental distributions will be made from capital gains. In addition to that, we have seen our stock price increase year-over-year, such that the total one year return on investment was around 22% and this includes the reinvestment of dividends which has significantly outperformed the Wells Fargo BDC Index, which is at minus 9%. The increased stock price is encouraging as I do believe the market is beginning to recognize not only the growth in the income and distribution that we've been having, but also the value of the equity component in our buyout business model. We keep stressing that we do have a differentiated investment strategy and the business model from other BDCs and that our investments are a majority of equity in debt capital in the buyouts of U.S. businesses. These companies generally have Earnings Before Interest, Taxes, Depreciation and Amortization or as we call it EBITDA, generally in the range between $3 million and $20 million. And the structure importantly that we use for funding these buyouts consist of the direct equity investment for significant ownership position which is then in combination with the secured first or second lien debt that we also provide. This is a differentiator to us from traditional credit-oriented BDCs and that the target proportion of equity-to-debt for the investments in our portfolio is in the range of 25% to 30% equity and roughly 75% to 70% debt at cost. And when compared to most of the credit-oriented BDCs and their portfolio as you'll find it typically it's more around 10% equity and 90% debt. So therefore, the interest and the success fees on the debt portion of our investments are able to provide this sort of steady income which pays and over time grow our monthly distributions as we've been able to do in certain in the past. As I mentioned earlier, again in April, we were able to increase our monthly distributions to an annual run rate of $0.80 per share. Secondly with a significant equity position that we own in each portfolio company, we do look for an increasing value so that increasing the equity thus provide capital gains and other income over the life of the investment or when we actually exit that investment. So these potential cap gains and other income may then be distributed to our stockholders in the form of these supplemental distributions and the program that we started. So to this point, we paid the first two of such plans' supplemental distributions in the amount of $0.06 per share to common stockholders in each of June and December 2017 and then in April of this year, we declared this other 6% distribution which we'll dictate in June of 2018. Third, this differentiated investment approach of being a provider of the significant portion of the equity uses the majority and most of the debt in all the transactions gives us this advantage that we believe the typical lenders and credit-oriented BDCs and that we are able to have some influence over the companies that we buy. Thus, not only by limiting the risk of our debt being refinanced, but also where we have participation and an involvement with management which provides an interaction with the company which is similar to a traditional private equity fund and extremely important in terms of preserving and building value over time. Now let's take a quick look at sort of our historical performance, our scorecard, so to speak and I'd like just to look at this from the period of 03/31/14 to 03/31/18, this is essentially a four-year period of time. What have we done then? Well, we've grown the total assets from about $331 million to about $611 million at fair value, the debt portion of our investments at costs have grown from about $279 million to almost $432 million. This is what supports the growth in our regular monthly distributions for common share, which has gone from $0.71 per share in fiscal year '14 to $0.77 in fiscal year '18 and then the ability to have this recent increase to $0.80 per share annually in April of 2018. In addition, the equity portion at cost has grown from about $105 million to about $153 million. Our net asset value again or equity, if you will, has increased from $8.34 a share to $10.85 over that same four-year period. At 03/31/18, we have 33 companies or at that point, 33 companies in our portfolio and from inception in 2005 when this company was taken public, through the 03/31/18 period, we exited 12 buyout companies, with these exits having generated over $85 million in net realized gains at about $22 million and other income on exit. These exits achieved an aggregate cash-on-cash return on the exit of the equity portion of those investments that are approximately 3.3x. Again, the equity aspect of our business model is very important and we're proving it out. This equity growth and exit activity has allowed us to deliver on our objective of generating cap gains from the equity portion of our assets which we will look to continue in the future. Going forward and as certainly as we continue with new buyouts and building our investment portfolio, we must also manage to keep saying the sale turnover if you will or when we exit some of these companies in the portfolio, which needs to be consistent with our strategy of providing realized capital gains from the equity portion of our portfolio. Clearly, we need to be guided by market conditions, so we'll always be assessing the risk and return continuing to hold an investment versus exiting it or selling it and remained sensitive to preserving our portfolio of assets to help and continue producing the income for a month of distributions. Now as we grow and we've talked about this in the past a bit, we must consider raising equity capital, which we try to do in a responsible manner. Since our IPO and at 03/31/18, we have raised equity in three secondary market for transactions and each of those where the net price after commissions and discounts was below NAV at the time. From March until early May of this year 2018, we raised approximately $3.1 million of net proceeds under our aftermarket or ATM offering which in the aggregate though resulted in net prices at or above NAV at the time. So that's just good progress and we've been able to invest the proceeds over the periods of time from these various offerings very constructively as we have been able to grow our NAV while generating capital gains and we will strive for this going forward. Our new buyout generation activities have a high priority and it is a key element obviously to our growth. We will maintain a strict adherence to investment fundamentals and a thorough due diligence process which has enabled us to provide shareholder returns in both our consistent regular monthly distributions as well as the supplemental distributions. In this regard, we made two new buyout investments aggregating about $59 million in fiscal 2018 and subsequent and right at the year-end in April, we invested about $29 million to form our most latest investment Basset Creek Restoration Inc., which is an acquisition platform for businesses in the restoration and renovation services space, which simultaneously acquired a company called J.R. Johnson as its first operating business. So we continue reviewing and conducting due diligence on a number of new potential investments in addition to new standalone acquisition that we are actively pursuing accretive add-on investments for some of our existing portfolio companies. And during 2018, we made add-on investment [indiscernible] degree and chilling both very good add-on investments and those two companies are performing exceptionally well and we look forward to this continuing to build assets within the portfolio while accelerating the value creation of each of these individual companies. We continue to operate in a buyout environment however where the competition for new investments is elevated, purchase price is being paid very high and in a challenge to close deals given our conservative value approach on our expected financial returns. Case In Point [ph], our latest investment at Basset Creek was at a value which we believe is consistent with our expectation of returns while we frankly pass on a number of other opportunities that were just much higher values than we thought warranted. So this really illustrates what may seem and could look like a low rate of production of new investments over the past year. However, when we make investments, not only is it a relatively lengthy time frame from the point of finding a good opportunity to actually closing the investment, but as we strive for quality to build value in both income and equity, we cannot be volume-driven as we might be if we were actually building a portfolio of loans which is not the business that we're in. So our return target for our equity investments is to provide a minimum of 2x to 3x cash-on-cash. The debt investments which go along with it are generally secured and primarily first lien loans and typically carry a cash yield in the low to mid-teens. These debt cash returns helped to balance the equity portion of our investment, thereby producing a blended current cash yield which supports our stockholder distribution expectations. The debt typically also has success B [ph] component which is a yield enhancement and is generally contingent on a change of control such as the sale or an exit for us to receive it. However, in certain circumstance, the success fee may be paid in advance at that portfolio company's option. Our investment focus is general income, is to have good EBITDA and operating cash flow using areas such as light and specially manufacturing, specially consumer products, industrial products and services -- other main areas that we focus on. Again, just to briefly recap, our investment activity for fiscal 2018, we made two new buyout investments during the year and one subsequent and right at year-end in April. We invested another $39 million in follow-on investments or is it a result of some of those add-ons I mentioned and we also actually received back $40 million repayments through sales including the exit of two buyout investments at a gain. So what's our outlook? Well, we continue executing our plan, we will be continuing to add accretive investments to grow both the income-generating portion and the equity portion of our assets while positioning the companies in the portfolio for potential exits, thus maximizing distributions to stockholders. We anticipate paying our semi-annual supplemental distributions as the portfolio continues to mature and we're able to manage the exits and therefore realized capital gains. These distributions again are generally expected to be made from undistributed net cap gains and undistributed net investment income. We and our board of directors will make the determination for the amount and timing of such semi-annual supplemental distributions as we've continued to execute on our strategy. So with that, I'll turn it over to our CFO, Julia Ryan, who will go in with some more of the detail on the actual financial performance for the quarter end the year. Julia?

[Julia Ryan:]

Thank you, Dave, and good morning, everyone. Starting with the balance sheet as of March 31, we had almost $611 million in assets at fair value and which included $599 million of investments at fair value. Our liabilities at the end of the year consisted primarily of $107 million in borrowings outstanding under our credit facility and about $139 million in term preferred stock at liquidation value. Our net assets totaled $354 million or $10.85 per share as of March 31, which was up $0.47 from December. Primarily as a result of net unrealized depreciation of over $18 million this quarter. Moving over to the income statements for the March quarter, total investment income was $15.4 million versus $16.2 million in the prior quarter. Total expenses, net of credits were $12.2 million versus $8.7 million in the prior quarter, leaving net investment income of $3.2 million compared to $7.5 million in the prior quarter. As I will address in a moment, this decline was principally the result of the required accrual under GAAP of $3.6 million of capital gains based incentive fees this quarter. Interest income decreased slightly as the prior quarter included recovery of $1.4 million from one of portfolio companies that was previously a non-accrual. Other income was 14% of total investment income in the current quarter, compared to 16% in the prior quarter, in-line with our expectations. Other income such as dividend and success fee income is a meaningful component of total income, but as Dave addressed earlier, can be variable from quarter-to-quarter and as when we look at those items over the term of the full year. Net expenses increased by $3.5 million in the current quarter which was primarily driven by that $3.6 million accrual of capital gains-based incentive fees which was occurred under GAAP, but which is not currently due under our investment advisory agreement. The investment advisory agreement provides that a capital gains based incentive fee is determined and paid annually with respect to realized capital gains, but not including unrealized depreciation. If such realized capital gains exceed realized losses and unrealized depreciation. However, under GAAP, a capital gains-base incentive fee is accrued as realized capital gains plus unrealized depreciation exceed realized capital losses and unrealized depreciation. For those, the quarter-end the year, the increase in unrealized depreciation triggered the accrual of the capital gains base incentive fee under GAAP. As a result of these factors, our net investment income per share decreased to $0.10 per share in the current quarter from $0.23 per share in the prior quarter. However, when adjusting net investment income to exclude the capital gains based incentive fee accrual, adjusted net investment income per weighted average common share would have been $0.21 in the current quarter, compared to $0.25 in the prior quarter. We believe that adjusted net investment income is a useful indicator of operations, exclusive of any capital gains based incentive fees as net investment income itself does not include realized or unrealized investment activity which is associated with the capital gains based incentive fee. Now moving over to the fiscal year 2018, total investment income was $58.4 million, compared to $51.9 million in the prior year. Interest income increased by $2.7 million as a result of the increase in our interest bearing portfolio, as well as a small increase in the weighted average yield. Other income which includes both dividend and success fees was also higher, totaling $9.6 million in the current year, compared to $5.7 million in the prior year. Total expenses, net of credits was $36.4 million, up from $29.5 million in the prior year, again primarily as a result of the growth in our asset base which includes the related increases in management fees, incentive fees and cost of bearings inclusive of the GAAP accrual. Similar to the earlier commentary on the quarter, for the year, the GAAP-based capital gains base incentive fee accrual was $4.4 million. As a result of these factors, our net investment income per share decreased to $0.68 per share in the current year from $0.74 per share in the prior year. When we again adjust net investment income to exclude the capital gains based incentive fee accrual, the adjusted NII per share would have been $0.82 in the current year compared to $0.74 in the prior year which is a fairly substantial growth. Current and prior period net investment income again covered current quarter and annual distributions from net investment income by a significant margin as is reflect in our distribution's covered ratio of about 158% this quarter and 114% for the year. As of March 31, undistributed income and net realized gains totaled approximately $9.7 million or $0.30 per share. We continue to actively manage our undistributed income and net realized gains with the goal to cover an overtime increase or distributions to stockholders. Besides our regular month of distributions as Dave mentioned, we expect to continue to make supplemental distributions. Now, let's turn to realized and unrealized changes in our portfolio. For the March quarter, we recorded very minimal realized activity. For the fiscal year, we recorded approximately $1.3 million of realized gains which resulted from our exit of Mitchell which was early on the fiscal year. We recorded net unrealized appreciation of $18.4 million in the current quarter and $37.4 million for the fiscal year. Those predominantly due to improved operating performance such as EBITDA and an increase in comparable multiples of certain portfolio companies. Our fair value to cost was 102% at 3.31. We continue to use an external third party valuation specialist to provide additional data points regarding market comparables and other information related to [indiscernible] more significant equity investments. Total loans to two of our portfolio companies continue to be on non-accruals, thus presenting about 3% of the debt investment at $3.31. We're actively working with these companies in an effort to improve operating performance and liquidity and are hopeful that they will return to accrual status and then the account. Our portfolio's approximate allocation between debt and equity securities was 77% to 26% at cost as of year-end. The debt portfolio is well-positioned for any interest rate increases with about 97% of our loans having variable rates with a minimum of floor and a remaining 3% having fixed rates. The weighted average cash yields on interest bearing debt investments was 12.6%. Risk yield excludes success fees on our debt investments. For comparison purposes, if we had accrued success fees, as we would if they were paid in kind interest as some other BDCs do, the weighted average yield on our total of debt investments would approximate 15.1% during the current quarter. As of the end of the year, unrecognized contractual success fees totaled about $28 million or $0.87 per share. There's no guarantee that we will be able to collect any or all of these success fees or have any control over the timing of collection. From a credit priority standpoint, a 100% of our loans are secured at 74% having a first lien priority and the remaining 26% having a second lien priority and the capital structure of the respective portfolio companies. Overall, Gladstone Investment had another quarter and full fiscal year of strong operational performance as well as financing, investment origination and exit successes. We have increased our distribution rate and made supplemental distributions while remaining committed to covering our distributions with income as we have done consistently in the past. And now I'll turn the call to David Gladstone.

[David Gladstone:]

Thank you, Julia, good report. Dave Dullum, good report. Michael, thanks for your report. Team was able to report some great accomplishments this quarter and for the full year. The addition of two new buyout investments during the fiscal year and one subsequent a year-end and April 2018 that closed, increased the regular monthly distribution or current annual rate of $0.80 per share and payment of two supplemental distributions as well as the declaration of another supplemental distribution to be paid in June 2018. Continued strong performance of the companies that we invest in, resulting in an increase in net asset value per share of $0.47 per share. That was just for the quarter. It was a total of $0.90 for the year and with $32.5 million shares outstanding, now you're talking about real money, so it's getting very strong. We believe we can continue this success going into the fiscal year or March 31, 2019. We look forward to giving you a great new report next year this time. I believe the economy is getting stronger, the reduction in regulations, the tax cuts, and the general support of the federal government for businesses in the United States has brought on a very positive outlook for many of the businesses that we invest in and many that we see virtually every day. The company and the stockholders are benefiting from the strong economy, but there's still one obstacle to maintaining a strong economy and that is a reduction of government spending. The government is still printing money to cover the government spending. It's at a unsustainable rate. Excess spending has been the downfall of many economies from Germany after World War I to Zimbabwe, in Venezuela, the day where in Venezuela now, they're printing $1 billion notes which are worth $1.50 to $1.52. It's just I hope our current administration will adapt some form of austerity when it comes to government spending. We're always looking over the numbers that keep rolling in for signs of trouble and while there's no way to predict the future, we do our best to be conservative in our investments to counter the unforeseen and we are of course trying to build a very strong balance sheet and company. We are excited about the new business environment in the U.S. Most people know the U.S. middle market is the third largest economy in the world, it's the market that we love and we've been in it really forever. The middle market is booming right now, this company will benefit from the strengths of the middle market. In April 2018, our Board of Directors declared a monthly distribution to our common stockholders of $6.7 per share for each of the months April, May and June on an annualized run rate that's $0.80 per share and they also declared the $0.06 per common share, supplemental distribution paid in June 2018. We hope to make another additional supplemental distribution perhaps back in some time in December. Through this date of this call, we paid 154 sequential monthly cash distributions to our common stockholders and additionally have made a number of these supplemental distributions. At March 31, 2018, we distributed total of $220 million that's about $9.19 per share. The common stockholders based on the shares outstanding at the time of the payments of the distributions. Current distribution rate for common stock with the common stock priced at $11.27 yesterday. The yield currently on the regular distributions about 7% in the yield included in the supplemental distributions that we paid in June of $0.06 as about 8%. If we look at the future and make assumptions about the company who paid two supplemental distributions, that would be $0.92, we've had 8.2% yield for the stockholders. That's a much better yield than most of the yield stocks that are out there today. Since the company started increasing the dividend and paying out two regular semi-annual supplemental distributions from gains and fees, the stock has gone up. A year ago as about $9.20 and now it's $11.27. That's about $2 or so per share and it's a 21% increase in the price over the last year. Please know while we're having good transactions and good things going on today, there's no guarantee that the regular or supplemental distributions will be paid, but we're certainly working to make that happen. Three series of preferred stocks are out there, too. There's $25, they're all trading above the $25 a share for our value yielding anywhere from 6.1% to 6.7% currently depending on which of the three series are out there. In summary, the company, Gladstone Investment is an attractive investment for investors seeking continuous monthly distribution and some supplemental distributions from potential capital gains and income certainly hope to continue to show you strong returns on your investment in this wonderful fund. Now, Latoya, would you come on and let's tell people how they can ask us some good solid questions so we can have some fun.

[Operator:]

Thank you. [Operator Instructions] The first question is from Kyle Joseph of Jefferies. Your line is open.

[Kyle Joseph:]

Good morning, guys. Congratulations on a good close to the year. Just two questions for me. I think you guys did a good job covering everything that went on in the quarter. But first, just the yields have been a little volatile. Just from the second to the third to the fourth quarter. I know you covered this on the last call, but remind us why the portfolio yield picked up so much in the third quarter?

[Julia Ryan:]

Kyle, we had a large recovery from one of our investments that was previously on non-accrual. So those are probably still recorded in the third quarter.

[Kyle Joseph:]

Got it. So X that, it looks like yields have been fairly stable. Is that accurate?

[Julia Ryan:]

That's accurate.

[Kyle Joseph:]

All right. And then given the environment and all the talk we have about rising rates, can you remind us the impact on your buyout business specifically in terms of asset pricing and competition? And lastly as a follow-up, are you seeing any of those impacts yet?

[David Dullum:]

Hey, Kyle. Dave here. Not really, other than what I mentioned before, we are impacted more, I would say, by the valuation of the companies remembering that we're bringing our own leverage and as a result of that, we have the ability, relative to your earlier question, to sort of establish our own yield on our debt securities if you will. So for us, the challenge is really more around the multiples being paid for portfolio companies. Now having said that, clearly, if interest rates were to rise dramatically and therefore the cost of leverage to our competition which is primarily sort of lower in middle market private equity funds, then theoretically, that might help to moderate perhaps values at folks who are willing to pay. But that would be my response around that as opposed to any immediate effect I see impacting us on rate increases.

[Kyle Joseph:]

Got it. That's helpful. Thanks a lot for answering my questions.

[David Dullum:]

Thanks, man.

[David Gladstone:]

Next question?

[Operator:]

Thank you. [Operator Instructions] There are no further questions. I'll turn the call back over to David for closing remarks.

[David Gladstone:]

All right. Latoya, thanks a lot for helping us out here and thanks, all of you for listening and we'll see you next quarter. That's the end of this call.

[Operator:]

Thank you. Ladies and gentlemen, this concludes today's conference. You may now disconnect. Everyone, have a great day.