Gladstone Capital Corporation
Q1 2008 Earnings Call Transcript

Published: 6 Feb 2008

[Operator:]

Welcome to the Gladstone Capital first quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host, Mr. David Gladstone, Chairman and CEO of Gladstone Capital. Thank you, Mr. Gladstone, you may now begin.

[David Gladstone:]

Thank you, Jackie. This is the quarterly conference call for shareholders and analysts for Gladstone Capital, trading symbol GLAD. Thank you all for calling in. We are happy to talk to shareholders and when you are in the McLean area, you have an open invitation to stop by and say hello; you will see some of the finest people in the business. This conference call may include statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934, including statements with regard to the future performance of the company. These forward-looking statements inherently involve certain risk and uncertainties even though they are based on our current plans and we believe those plans to be reasonable. 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 10-K filing as filed with the Securities and Exchange Commission and can be found on our website at GladstoneCapital.com and also on the SEC website. 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. The quarter ending December 31, 2007 was a good quarter for our company in terms of increasing our assets and was another volatile one obviously for the financial marketplace. We invested about $73 million this quarter, of which $58 million was to five new portfolio companies and the remaining $15 million was to existing portfolio companies in the form of additional investments or draws on our revolving facilities that we provide them. During the quarter, we received repayments of about $4 million due to normal amortization paydowns of our revolvers. This resulted in net production of about $69 million for the quarter. At the end of the quarter, our investment portfolio was valued at about $414 million and our cost basis was approximately $425 million. Although the portfolio was depreciated, our portfolio was fair valued at approximately 97% of cost. We believe this to be a good indicator of the high quality of investments in our portfolio. At December 31, 2007, we invested $13.9 million in one new non-syndicated loan and also about $700,000 in an additional revolver draw to our company. Since inception, we’ve made loans to approximately 125 companies. We’ve been repaid or exited from 60 of those companies and Donya, our Deputy CFO tells me that the average return of the exits has been about 12% for the syndicated loans and about 16% for our non-syndicated loans. At the end of the quarter, we had two loans past due, one with a cost basis of $2.4 million and the other with a cost basis of $6.6 million. We should have one of them fixed very quickly here and the other one back on track in a quarter or so. So, it’s about 2.1% on a cost basis of the portfolio that’s past due. To date, all of our investments have had a positive IRR and I hope that’ll be true in the future as well. This all leads us to say that the program we set up at the founding of the company and as we continue to mature, is performing as planned and we don’t have any need to change the strategy. We have seen a noticeable change in the opportunities coming our way. Banks are calling us to help them with some of the loans that they are making to small and medium-sized businesses and so are the LBO funds. The pipeline is probably as strong as it has ever been in the history of the company. I would say that the market has finally come back our way and we intend to make some good loans during this time period. Our balance sheet is strong. At quarter end we had approximately $162 million borrowed on the line of credit and we had $266 million in equity so we are less than 1

[Operator:]

Our first question comes from Vernon Plack - BB&T Capital Markets.

[Vernon Plack:]

David, I was curious in terms of your debt to equity ratio in this type of environment. Any thoughts in terms of how leveraged you would actually like to take the portfolio?

[David Gladstone:]

I don’t think 1

[Vernon Plack:]

One other question as it relates to asset quality. We’ve seen asset quality fall a little across the board in this industry which is not unexpected and I was just curious in terms of your thoughts, non-performers are a part of the business and that number will likely go up; what are your thoughts on that, at least for the next 12 months?

[David Gladstone:]

Over the past six years we’ve had non-performers that would come in and we would fix them or sell them or do something to rid ourselves of the problem and I think if you are a good workout team and you have good people in that side of the business, while you will get some non-performers, you are able to fix them and sell them or liquidate them or do something in order to avoid losses. As you know, we’ve had one loss. I am not sure how many workouts we’ve had over the last six years. There haven’t been that many and the non-performers have certainly been low. We’ve had one loss on one loan, $1 million out of $14 million and we received so much money at the beginning of that period with that loan that we had a positive internal rate of return. I don’t know that we can maintain that over a significant long downturn, but I do know based on my past experience of being through the ‘81 recession, the ‘90 recession, the ‘01 recessions that the portfolio has performed and we did not have anything diminution in our ability to pay dividends. In fact, the two that we had non-performing now didn’t pay interest during some past periods so we do not have a problem meeting our dividend. We will fix those and move them over and take the money that we get out of them and put it into income producers so it will actually be very positive when we move them across. I just don’t think that portfolio at this stage, again given the fact that this doesn’t seem like big recession, it’s going to have that many problems. We’ve seen 1990 was probably the worst recession I’ve been through and we would see non-performers ballooned up between 5% and 10%, but losses still remained under 1%, which is the real asset test, is how much did you lose? You may have a problem with the loan but if you can fix it and bring it back to interest paying then the question of losses then becomes pretty low in the priority of things to look at if it’s really low. So I don’t know, Vernon, this feels like a very mild downturn to me; I don’t see a real recession in terms of government statistics and so I think the asset quality have performed quite well through this next period.

[Operator:]

Our next question is coming from Kenneth James - Robert W. Baird.

[Kenneth James:]

Good morning. Could you give a little more detail on your non-accruals, particularly the new one? I’m assuming the other one you mentioned was the one that was previously purchased that’s been around for a couple of quarters?

[David Gladstone:]

The new one is a company that we really didn’t expect that much, the LBO Fund is working it hard and my hope is, we’ve been told at end of February we will some resolution to what’s going on and that’s about all I can say. We don’t like to spend a lot of time talking about them for the simple reason that we have what’s known as confidentiality agreements with these companies and they are private and we are not supposed to spend a lot of time talking about the details. But it’s a new one, I think we are all covered, I think we will get our money back, and so I’m not that worried about it and we will probably get all of our accrued interest; but who knows. It is a marketplace that you just never know until you have gone through the whole routine of fixing it before you come out the other side and know whether you have made money or lost money.

[Kenneth James:]

It seems like you feel pretty good about a near-term resolution there.

[David Gladstone:]

I do.

[Kenneth James:]

In terms of the levels of originations this quarter and your recent need to raise capital again, can I extrapolate from that that we could be looking at this level of originations to persist here for at least the next quarter or two?

[David Gladstone:]

Well certainly the opportunities are there. As I mentioned in the prepared part of this presentation, the backlog is as strong as it’s ever been. There is still the process of going through the analysis and due diligence of the business that takes up a considerable amount of time and sometimes it goes quickly and sometimes it goes slow. But the bottom line of it is we do have a very robust pipeline. We are having banks call us now that hadn’t call in a while and a lot of small businesses calling us and the LBO funds are calling us. With interest rates going up much higher and with the opportunity to pick up some equity type of positions in these companies, I think it will be very profitable -- maybe not a quarter-by-quarter analysis -- but I would say every six months you should expect a pretty good increase. Again, its very hard to tell. Even though you have a robust pipeline and its bigger than it was last quarter by a quantum amount, there is no way of knowing until you have delved into these companies whether you are going to be able to go forward or not. I would say I’m optimistic that it will be robust but just don’t want to give you a complete projection.

[Kenneth James:]

What about the headwind you have been facing from elevator repayment activity dropped off significantly this quarter; do you think this is a more normalized level, just normal that we would see in the near term or was this quarter do you think especially low?

[David Gladstone:]

Well it was a very nice low quarter and I think you’re going to see that going forward. Obviously the loans that we have on the books that are say, 200 or 300 over LIBOR are not going to be refinanced and the ones, the second liens that we have at much higher rates are not going to be financed easily because the rates have all moved up in that. So the new loans that we’re putting on the books are substantially higher and that does have a barrier to getting anything refinanced because people don’t want to pay more interest in refinancing; it would cause them to pay a significant amount of interest. We do have some of those lower yielding loans. The businesses do get sold and when they get sold of course we get paid off and while I’m very delighted to have new money to put out at a much higher rate, then we hate to see anything get paid off. But we will just have to see how that shapes out. I think the payoffs will be substantially less in the coming year than they’ve been in prior years.

[Kenneth James:]

One question on the fees this quarter or the fee credit. Was there any kind of an outsized or extra activity by the management company for portfolio companies that generate fees that were credited back to the fund that made that number a little larger in this quarter?

[David Gladstone:]

There were a couple of things. With all the closings that went on we do get a fee when we close a loan and with all those closings we had about $820,000 of what we call investment banking fees that were credited back. So that’s inside that $2.4 million. We also had, as you know, our senior syndicated loans we only charge 0.5%. That’s an ongoing thing and that was not that much, about $103,000. The incentive fee that was given back was about $1.46 million so that was a significant part of the giveback and we are projecting that maybe not by the end of this fiscal year, which is September 30, but probably by this time next year we will pretty much have grown out of the giveback for the incentive fee and it should be in a very good position.

[Operator:]

Your next question comes from John Zimmerman - FBR.

[John Zimmerman:]

Good morning, David. Thank you for taking my question. Can you provide a little context or any changes in the motivation for the companies that seek to borrow from you? Have you seen any inflections or the type of customer that’s coming to you to borrow?

[David Gladstone:]

I think the quality is still more or less the same. We’ve been very picky over the period of time as to who we will lend to but the pipeline has not changed that much in terms of what we see. Normally in a downturn or recession period we will see companies that have significant financial problems; for example in 2001 we would see companies that needed to meet payroll in the next month and next week and didn’t have the money to do it or we saw companies that didn’t have any backlog but wanted you to lend to them so that they could build a backlog; and other companies that were in significant problems. We are just not seeing that coming in the door today and so that’s another reason for saying we don’t think there is a recession on the horizon. The classic for us is the car dealership who comes in who is out of trust on their car loans on their floor plans for their cars and they need to raise money in order to pay the bank; that is they sold the car, but didn’t pay the bank and used the money for operating capital. We are not seeing any of that. So your question is right on point in terms of what are we seeing? Is it really rugged out there or are we just seeing a lot of good businesses that now can get financing or the cheap money that they got before from banks who were dolling out a lot of money at low rates and at very low terms; very easy terms, kind of like the home mortgage business. Or is this a real downturn in the economy? We are just not seeing it yet, so my perception of the world is maybe of debt jaundice in the sense that we are just not seeing the problems and maybe they’re out there and they’re just not showing up on the doorstep, but I doubt it. We normally see literally thousands of businesses and to date, they’re not these very difficult situations coming in the door.

[John Zimmerman:]

In that same vein as we’ve talked about banks exiting the space and therefore you garnering with your capital being able to leverage that for incremental opportunities, when we start talking about growing your business and we start talking about expanding your lines of credit, can you talk about the willingness of banks then to turn around and lend to you? I just want to make sure that obviously the vacation of capital just providing an opportunity, but are you too still being able to access the amount of debt in order to meet some of the growth objectives that you’ve set in front us today?

[David Gladstone:]

Well, I can only speak, as you know, Gladstone Investment had its credit renewed in October last year, which was a pretty rough period and so it had its line of credit renewed and didn’t need to raise additional capital, but the bank that was lead there renewed and we are just fine for another year. In this company we’ve not increased the line of credit beyond the $220 million that we have, but we do have a $30 million request that seems to be approved. We haven’t needed to draw it down quite yet. We do have a couple of banks that are looking to join this syndicate, hopefully that would raise another $50 million to $100 million. So our goal here is just continue to grow it. I think the banks have not pulled out of the marketplace. They are sticking with the guys that they are in with today but they are just not taking on a lot of new business as far as our type of borrowing. As far as the other banks out in the marketplace, many of the banks have not gone away from the marketplace, but what they have done is they have tightened their standard. They used to lend 3.5 times EBITDA, they are now lending 2.5. So they have just pulled back as to what they will do in this credit tightening environment. So I think if you look at what’s going on in the marketplace and couched it in a different term that if the banks are not exiting but there is a flight to quality, and a tightening of the terms and they are charging a little more interest. We had our interest rate go up from about I think it was 80 basis points to 120 and the investment company I think it will go up here about the same amount. So we will have an increase but given the fact that we’ve moved on our senior debt from about 250 to 450, the other day one at 550 over LIBOR, we are maintaining much larger spreads than we had in the so-called profit times when the banks were out there. I think we are okay as far as being able to borrow. But one never knows and that is another unknown out there and to date we seem to be doing just fine.

[John Zimmerman:]

As we start looking at the non-accruals, I know that you are senior secured, the market value of those seems to be at about 70% of the cost basis of the loan or par value of the loan. Does that mark in and of itself reflect a recovery rate from S&P and their methodology or does that represent what you might think would be a potential exit value? I know you don’t take the market value, you take the mark S&P provides, but I’m wondering if you could provide a little bit of context to how we should be interpreting those marks whether it is a recovery value or market value and how to interpret that?

[David Gladstone:]

From my understanding of S&P, this is the value that they believe the loan could be sold for on the last day of the quarter. So they are giving you a sale figure and that doesn’t have any recovery number on it. All of these loans are secured with liens on the assets so I’m assuming they are just looking at their portfolio and saying what are loans trading at today that are similar to this and coming up with a value.

[Operator:]

Our next question is coming from Daniel Furtado - Jefferies.

[Daniel Furtado:]

Just an update on your thoughts on the relationship between credit and management fee and dividend? Do you foresee a situation in which you wouldn’t be fully crediting the entire part -- you would not be crediting that fee but still raising the dividend? Or do you have to kind of come true-up on that fee before you issue a dividend increase?

[David Gladstone:]

This is the discussion we had with the board and where we are going on this is some kind of sharing as we go through this period of time. So I can’t give you what is going to happen in the future with regard to the dividend because I don’t read the minds of my board members, but my guess is we will come to some understanding. As long as we are getting back 100% of it, there is no room to play and that is what we did this last time. But once you got to, let’s say to use an example to getting back only part of it, you could give back a little bit more and have the dividend increase and you could share over a year’s period in the lessening of the need to give back and it would make the dividend go up. So the answer is, yes, the dividend can go up during this period of time when the incentive fee is not being paid, but it has to go up. It will go up slower than it would if you didn’t have to do that at all.

[Daniel Furtado:]

Understood. I just want to make sure that it is similar at GLAD as at Gain in that the FAS 157 and 159 changes that are about a quarter away, you don’t foresee a meaningful impact to valuations are any more volatility towards value because of these?

[David Gladstone:]

I have got four accountants sitting here and they are all shaking their head no. I am assuming that 157, 159 and all those others are not having any impact on us.

[Operator:]

Mr. Gladstone, there are no further questions at this time.

[David Gladstone:]

We thank you all for calling in. We appreciate it and we will do our best to make you happy next quarter. Thank you all for calling in.