Gladstone Investment Corporation
Q2 2015 Earnings Call Transcript

Published: 31 Oct 2015

[Operator:]

Good day, ladies and gentlemen and welcome to the Gladstone Investment Corporation's Second Quarter ended September 30, 2015 Earnings Call and Webcast. At this time, all participants are in a listen-only mode. [Operator Instructions]. As a reminder, this conference call is being recorded. I would now like to turn the conference over to David Gladstone, sir you may begin.

[David Gladstone:]

Well, thank you, Trisha. We like those nice introductions, and hello and good morning to everybody out there. This is David Gladstone, your Chairman. And this is the quarterly earnings conference call for shareholders and for analysts, for Gladstone Investment common stock trading on NASDAQ symbol is GAIN. We have some preferred stock data as well GAINO, GAINP and GIANN, so you have your choice of preferred stocks with this company as well. Thank you all for calling in. We love these moments that we have with loyal shareholders that like to listen to these calls and potential shareholders. We like to give you an update on the company and its investments and we like to give you a view of the business environment from our point of view, and we wish could do this more often and try to do this sometimes with some press releases, but we've never gotten around to that. Also the invitation is open if you're visiting this area, the McLean is just outside Washington DC, so please stop by and say hello we have about 64 people now, I think we only got about 60 here. Now we'll hear from our General Counsel and Secretary, Michael LiCalsi, and Michael is also our President of Gladstone Administration which serves as the Administrator for all the Gladstone funds and related companies. He will make a statement regarding forward-looking statements and some other important information.

[Michael LiCalsi:]

Good morning, everyone. This conference call may include statements that constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934, including statements with regards to the future performance of the company. And these forward-looking statements inherently involve certain risks and uncertainties and other factors even though they are based on our current plans, which we believe to be reasonable. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may and similar expressions. There are many factors that may cause our actual results to be materially different from any future results that are expressed or implied by these forward-looking statements, including those factors listed under the caption Risk Factors in our Form 10-Q filing and 10-K filing and our registration statement as filed with the SEC, all of which can be found on our website at www.gladstoneinvestment.com, or the SEC's website at www.sec.gov. And the company undertakes no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise, after the date of this conference call except as required by law. And please also note that past performance or market information is not a guarantee of future results. Please take the opportunity to visit our website, gladstoneinvestment.com and signup for our e-mail notification service. You can also find us on Facebook, keyword The Gladstone Companies, and on Twitter at GladstoneComps. The presentation today will be an overview of results through September 30, 2015, and for more detailed information please read our press release issued yesterday and review our 10-Q quarter ended September 30, 2015, which we filed with the SEC yesterday. You can access the press release and 10-Q on our website gladstoneinvestment.com. Now let's turn to Dave Dullum, President of Gladstone Investment to get an update on the Fund's performance and outlook.

[David Dullum:]

Well Mike, thanks very much for that, and good morning to everybody on the call. Usually I try to skip a very brief reminder or recap so to speak of what it is we do here at Gladstone Investment, and of course as everyone knows we are a publicly traded fund, we are focused on buying businesses, generally U.S. businesses with annual sales anywhere from roughly $20 million to $100 million. We structure our deals in these buyouts to usually consist of secured first and second lien debt and in combination with the direct equity investment because that is where we generate and have our significant ownership position and ultimately capital gains. So this combination of using debt and equity does produce a mix of assets which is really the basis of our investment strategy for Gladstone Investment, whereby the debt portion of the investments provide the income to pay and grow our multi-distributions and at the same time we look to the equity portion of course to increase in value and provide the capital gains over time, and we'll be able to chat some more about that. So we might ask how are we different for the BDCs or other typical finance type companies like us, and basically one very significant difference with us and other BDCs is that, we take significant equity positions in the companies that we invest in, and this differs us from other public BDCs generally that are predominantly debt focused, and usually those are referred to as credit oriented BDCs. So for instance, where the proportion of equity to debt for the investments in our portfolio is approximately 25 to 75 ratio. You'll find that most of the credit oriented BDCs in their portfolio they'll typically be at around 10% to 90% or 10 to 19 ratio of equity to debt. As to others are private equity funds that are typical buyout funds usually they are 10-year type private partnerships with a long-term liquidity horizon for their investors. We differ basically in that as a publicly traded entity, our structure allows for the daily liquidity so to speak for our shareholders who then are able to participate in this middle market buyout business through our structure without being necessarily locked up for at least 10 years. Now let's talk about exit strategies because realizing capital gains through our portfolio company exit is definitely a component of the value proposition of an investment in our fund, and I do want our shareholders to know that this is an important part of our business planning and we will be selling or exiting companies from time to time. These activities generally are based on market conditions obviously and to some extent an assessment that we make of the risk return in, for instance, continuing to hold an investment even performing well versus perhaps exiting that investment, so we're trying to assess the benefit, if you will, of taking a gain versus potentially keeping and holding that investment, and of course some of that is, is a function again of the market. Now in this regard, we are actually expecting to close on the sale of one of our portfolio companies within the next few days, not able to say much more about that but I will say that it will produce a sizable capital gain on equity and will also receive back the repayment of all our debt, so we'll have total cash proceeds of a pretty significant amount. Now during the quarter ended September, we also exited the remaining investment we had in Cavert II Holdings, this was where we had a remaining preferred equity investment and it was redeemed at par roughly $3.4 million, and we also received dividend income on that preferred accrued of approximately $1.5 million. Additionally, we sold the assets of a NDLI which was one of our investments. We sold it to a company called Diligent Delivery Systems. The total proceeds on that one was roughly just under $15 million which consisted of about $2 million in cash and a secured secondly note of about $13 million with warrants to purchase common stock, so by selling these assets of NDLI to a somewhat similar business well-managed business, we have continued with an investment, however we've been able to exit that investment today. So therefore since June 2010 which so including these actual exits and of course not the aforementioned expected sale, we would've exited six of our management supported buyout investments generated roughly $52 million in net realized capital gains and a roughly $14.6 million in other income associated with those transactions. We also, I should tell you, are currently in the process of a few other possible sales which could occur over the next several months, and obviously we will have to chat more about that as we move further into our calendar year of 2016. I just always like to caution that the buyout market is obviously still somewhat, I would say, seller-friendly, so we have to keep in mind that whenever we do sell a portfolio company for the right reasons and good reasons, it will and potentially could reduce our income-producing asset base and then we're going to be obviously working very hard and will be challenged incrementally to replace that investment as we generate current income as well. So let's turn to deal generation because that impacts how we do that. We have a very high priority of our deal generation activities and that has resulted obviously in our continuing growth in new buyouts and income-producing assets. We do this with a very broad and deep geographic footprint which we have offices in New York City, Los Angeles, Chicago, and of course here MacLean which as David Gladstone mentioned just outside Washington DC. Now to generate these new investment opportunities, we have to primarily call on what we refer to is independent sponsors, other middle market investment bankers, folks who will find deals that we would be interested and acquiring and other sources that might create and help create proprietary investment opportunities. We do not depend on others to negotiate or structure our investments. Generally, though investments of course do include partnering with the management teams of those companies and to the extent that there are other sponsors such as independent sponsors who may be working with us to purchase the business. And again, our strategy which is providing a package, a financing package which includes both the secured debt and the majority equity investments is a very competitive advantage as it gives the seller and the sponsor, independent sponsor save what is involved and the management team that we'll be working with a very high degree of comfort that at least from a financing perspective that purchase will occur. In addition from time to time, we might do an outright purchase where we occasionally will find an opportunity to partner with say a business owner, who is not actually selling the whole business, but maybe a portion of the business, and then use our capital to continue growing the business. Where do we focus, well, we generally invest in companies as I said before with revenues $20 million to $100 million but also more as importantly with consistent operating cash flow and generally at least around $3 million annually, an ability of course to expand and grow that cash flow. Areas of interest that we look at and historically have done are, light specially manufacturing, specially consumer products and services, industrial products and services, and the aerospace and energy area. Now I should note that historically, in energy, we historically have had minimum exposure here and we do look at that on an opportunistic basis. Currently, we do not really have any major exposure to the energy sector. Our secured debt investments which are primarily first lien, loans typically carry a cash yield that in the sort of mid to high teens, and that balances the equity portion of our investments which thereby produce a blended current cash yield which supports our shareholder distribution expectations. We generally also have a success fee on these loans which are paid in cash on a change of control or in some cases and advanced at the portfolio company's option. As to the equity portion when we model out our potential opportunity, we always target an equity portion that will have a return somewhere in the 2 to 3 times cash on cash return. We believe with what we have been doing that there is a positive origination trend as we continue through our third quarter fiscal 2016. We are currently in various stages of diligence on a few new investments and we would hope and expect to close somewhere in the upcoming quarter. So we continue expanding our marketing efforts and we definitely continue to grow our presence in the marketplace. So I just take a quick look at our activity over this past quarter and how we've done well. We invested $20.9 million in a new deal. We received, as I mentioned earlier, $13 million new debt investment which had included warrants to purchase common stock and as a result of the aforementioned mentioned sale of that portfolio company, we also invested in incremental [$1.8 million] into existing portfolio companies. Specifically, in July we purchase GI Plastek Inc. with a $20.9 million investment in a combination of secured first lien and equity. GI Plastek which is headquartered in Wolfeboro, New Hampshire is a leading manufacturer of medium to large customized plastic injection molding products for various end markets and generally non-automotive. In August, as I mentioned the assets of NDLI Inc. were acquired by Diligent Delivery Systems and as previously mentioned, we received consideration of roughly $15 million. This transaction did result in a current net realized loss of about $2.7 million, but we do retain of courses as I mentioned an income-producing asset as well as warrants which will allow us to acquire common equity in Diligent in the future and could indeed turn into a positive. In September, we did as I mentioned as well sold the remaining preferred stock in Cavert II Holdings which is redeemed actually at par and generated dividend income of $1.5 million. So with all that the up outlook, I would say is, and our goal is to continue strategically add accretive investments, position our existing portfolio for potential exits, and therefore maximizing distributions to shareholders with the solid growth in both equity and income portion of our assets. So with all of that, I'm going to conclude my part of the presentation and turn it over to Melissa Morrison, who is our acting Principal Financial Officer and she will go in a bit more detail on a net performance. Melissa?

[Melissa Morrison:]

Sure. Thanks Dave and good morning everyone. As Dave just discussed, the fund had a strong quarter. Through this quarter, originations together with highly successful originations last year we achieved over $13.7 million in total investment income in the September quarter or 8.1% quarter-over-quarter growth. For the balance sheet at the end of September, we had over $508 million in assets consisting of $490.6 million in investments at fair value, $5.7 million in cash and cash equivalents and nearly $12 million in other assets. Our portfolio allocation at cost is currently $387 million of debt securities and $143 million of equity securities or 73% to 27% debt to equity allocation. Our liabilities and equity at September 30, consisted of $103.5 million in borrowings outstanding on our credit facility, $121.7 million in term preferred stock, $9.1 million in other liabilities and over $274 million in equity. Our net asset value was $9.05 per share as of September 30, down $0.19 from June 30, which primarily resulted from net unrealized depreciation of $3.4 million this quarter which we will discuss in more detail later on the call. Consistent with the previous two quarters, we continued to use an external third-party valuation specialist to provide additional data points regarding market comparables and other information related to certain of our more significant equity investments. We will continue to practice and will plan to generally update this externally provided data on an annual basis for all of our significant equity investments. Moving over to the income statement for the September quarter-end, total investment income was $13.7 million versus $12.7 million in the prior quarter. Total expenses net of any credits were $7.7 million versus $7.5 million in the prior quarter, leaving net investment income of $6 million versus $5.2 million in the prior quarter, a point increase of over 16% of our NII. The increase in net investment income quarter-over-quarter was primarily due to higher investment income driven by holding a larger portfolio and a receipt of dividend income which caused other income to increase by nearly $0.5 million as compared to the prior quarter. This increase was partially offset by the additional cost incurred in originating and carrying the portfolio including dividends on our term preferred stock. As mentioned on previous calls, historically other income has been as high as 16% of our total investment income as compared to about 13% during the September quarter. We expect other income which is primarily composed of success fees and dividend income to remain meaningful but variable from quarter-to-quarter. Our net expenses increased in the current quarter primarily due to dividend expense on our Series C term preferred stock that we issued in May of this year. Overall our NII increased to 20 per common share for the September quarter from 17 per common share for the June quarter, again an increase of over 16%. Our net investment income more than covered our quarterly distributions to shareholders of 0.1875 per common share. Now let's turn over to realized and unrealized changes in our assets. Realized gains and losses result from actual sales or disposals of investments. Unrealized appreciation and depreciation is a non-cash event and is driven by the requirement to mark our investments to fair value on our balance sheet, with the change in fair value from one period to the next recognized in our income statement. During the September quarter, we reported $2.7 million in realized losses related to the restructuring in sale of one of our portfolio companies and excluding certain tax liabilities related to certain investments and excluding any reversals of net unrealized depreciation our portfolio had a net appreciation of $2.1 million during the three months ended September 30, 2015. For the September quarter end, our entire portfolio was fair valued at 92.6% of cost slightly down from 93% of cost last quarter. All of our portfolio companies are current in payment expect one which continues to remain on non-accrual representing approximately 1% of the fair value and less than 3% of the cost basis of our total debt investments as of September 30. Our debt portfolio is well positioned for any interest rate increases with 81.5% of our loans having variable rate with a minimum or floor and the remaining 18.5% having fixed rates. The weighted average yield on interest bearing debt investments remain consistent quarter-over-quarter at 12.7% versus 12.6% in the previous quarter. This strong yield excludes success fees on our debt investments. It also does not include any paid in client or pick income as we do not currently have any debt securities with a pick feature. Success fees or yield enhancements that are contractually due generally upon a change of control, although there are times when the portfolio company can elect to pay it earlier. We generally only recognize success fees in our income statement when they are received in cash. For comparison purposes, if we had accrued these success fees as we would if it was a paid in client interest like other BDCs do, our weighted average yield interest bearing assets would approximate 16.1% during the September quarter. As of September 30, the success fees accruing off balance sheet, totaled $29.6 million or approximately $0.90 per common share. There is no guarantee that we will be able to collect all of these success fees or have any control over their timing. From a credit priority standpoint, 100% of our loans are secured with 72.7% having a first lien priority and the remaining 27.3% having a second lien priority in the capital structure of the respective portfolio company. Overall, Gladstone Investment had another good origination quarter which helped the company generate strong financial results. We have maintained an increased distribution rate while still remaining committed to covering our distributions by net investment income as we have done consistently over our last several fiscal years. And now I'll turn the call back over to David Gladstone.

[David Gladstone:]

All right, thank you Mellissa and that was a good report, same good report from Michael and Dave. During the past quarter, we were able to report some great accomplishments such as good originations, increased in our net investment income and of course successfully exiting one portfolio of company at a good return. Several more of our portfolio companies are moving closer to be sold, the one I have been mentioning on the call for, I don't know, the last six months is finally signed a definitive deal document, and we are waiting for the final funding to close. I'm hopeful that's in the very near future. I'm afraid that we have any projections on that anymore. And if it does close it should generate a significant capital gain for our funds. One of our companies is even talking about doing a public offering, we only owned a small part of that, but it would be significant. So lots of activity in this company and future outlook of this fund is very good and we expect to explore an increase in dividend sometime in the near future. I know it doesn't help much when the fund pays an extra dividend, but sometimes we have to use that technique to eliminate taxes and [follow] the government regulations. So just to recap the September quarter, closed a new investment of $21 million, exited one investment and result over $1.5 million in dividend income, and sold a company that gone through a lot of past problems to sort of get that one out of the way and free our people to work on new deals. We believe we can continue this success going to the next few quarters and after that we should have some running room to move even faster as you probably can tell. I'm bullish on this fund and looking very good for the upside. We feel it's a great time to buy and invest in small companies like the ones we invest in, and while we continue to monitor the economic recovery, we have seen some positive trends in the recent economic indicators. The economic recovery has been of course the slowest and worst one in last 30 years. I don't think anybody would disagree with that. We still have the same concerns that I mentioned every time and we like all the other people sitting around or watching the direction of a federal reserve, monitory policies to see what they will do, and while we have variable rates in most of our loans, increasing rates that are not good for the economy [have our adopted] that will raise rates. Although they have now staked out the December month for the increase and I don't think they are going to increase in more than one quarter of 1%. So as they are going to do much in terms of impact to the economy. The volatility of oil and gas industry, pricing has been just crazy. Low oil prices are terrific benefit to the economy and we should get a lift out of that. I just don't know how long that will last. Our oil and gas concentration in this company tends to be minimal. Natural gas and oil prices continue to stay down then the entire industry is going to have a big adjustment to make and that will be some big changes in that industry. The fiscal crisis in the federal government is still top of my mind, I'm sure it is of many of you out there as well. The federal deficit is now over $19 trillion and continues to climb as the government spending continues. There is just no end inside. They can't seem to stop it sort of like cocaine addicts, they just keep spending. The federal debt has doubled in the last 10 years. That seems unbelievable, but that's the truth. And this is not sustainable. We can't keep doubling every eight to 10 years. And the end is going to come and it's going to be crippling for the U.S. economy and all the American, so please vote for fiscally responsible people that are running for president, and perhaps this next election we can begin to turn the company back to a more [sane] approach to spending. Many of the private companies vary in like those -- like ourselves and like those that we're investing in until there is much too much regulation around healthcare, financial services, energy and of course emissions, and it just hindering the performance and expansion of job growth. It's crippling so many small businesses. We're now at the same number of small businesses, and it's reduced so much that will back to the age of Jimmy Carter, if you can believe that in terms of number of small businesses. In light of all these concerns, our company Gladstone Investment has strengthened its balance sheet in the form of significant new equity, and use that new equity to buy into a list of good portfolio… (Call ended abruptly due to technical issues in Webcast).