Gladstone Investment Corporationde (GAIN) Q3 2022 Earnings Call Transcript

Greetings and welcome to the Gladstone Investment Corporation’s Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, David Gladstone, Chief Executive Officer.

Alright. Thank you, Peter. Good morning, everybody. This is David Gladstone, Chairman of Gladstone Investment. This is the third quarter of our fiscal year ending March 31, 2022. This is the earnings conference call for shareholders and analysts of Gladstone Investment. The company is listed on NASDAQ under the trading symbol GAIN for common stock and we have two preferreds, GAIN and GAINZ for the registered notes. Thank you all for calling in. We are always happy to provide updates for our shareholders and analysts and the view of the current business environment. Our two goals here are to help you understand what has happened and also give you our best guess of the current views of the future. And now, we hear from our General Counsel and Secretary, Michael LiCalsi. Michael?

Thanks, David. Good morning, everybody. 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 are based on our current plans, which we believe to be reasonable. 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 on our Forms 10-Q and 10-K and other documents that we file with the SEC. You can find all these on the Investors page of our website that’s gladstoneinvestment.com or the SEC’s website, that’s www.sec.gov. Now 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. We ask everybody to take the opportunity to visit our website once again, gladstoneinvestment.com, sign-up for our e-mail notification service. You can also find us on Twitter @GladstoneComps and on Facebook keyword, The Gladstone Companies. Today’s call is simply an overview of our results through December 31, 2021. So we ask that you review our press release and Form 10-Q both issued yesterday for more detailed information. And with that, I will turn it over to David Dullum, President of Gladstone Investment. Dave?

Hey, Mike. Thanks very much and so, good morning to all our shareholders and analysts. And first, I wish to welcome our CFO, Rachael Easton, who joined our team in December. I’m very happy to have her with us and this is her first quarterly call. You will hear from her shortly. As we know, there are many challenges facing our economy, such as labor shortages, supply chain delays, increased material costs, and inflationary trends. While most of our portfolio companies experienced these challenges, we made good progress toward pre-COVID operating status. As a result, I am very happy to report on another strong quarter for Gladstone Investment. We ended the third quarter of fiscal ‘22 with adjusted net investment income of $0.26 per share, which continues to progress, leading us to anticipate a strong finish for fiscal year March 31, 2022, and our future earnings. The total assets as of December 31, though, decreased to $736 million from $746 million at September 30, 2021, primarily due to the successful exits of two portfolio companies during that period. This decrease was partially offset by a few add-ons to existing portfolio companies and, most importantly, the continued recovery of the values of our equity holdings, which today make up a significant 23% of our portfolio at cost. We were able to maintain our monthly distribution of $0.075 per share or $0.90 per share on an annual basis, and we were able to pay a supplemental distribution of $0.09 per share in December 2021. Subsequent to the quarter end, we declared another supplemental distribution of $0.12 per share to be paid in February 2022. During this quarter of fiscal year ‘22, the two portfolio companies we exited resulted in a net realized gain of $22 million and success fee income of $3.4 million. We also invested $37 million in existing portfolio companies, supporting add-on acquisitions, which we view as a positive event. Our strategy as a buyout-focused entity continues to successfully generate income for increasing monthly distributions to shareholders, as well as capital gains on equity from our supplemental distributions based on our capital gains appreciation. Our balance sheet continues to be strong, with very low leverage and a very positive liquidity position. This allows us to continue providing support to our portfolio companies for add-on acquisitions and interim financing if the need arises, all while actively seeking new buyout opportunities and continuing to grow our assets and income. In summary, the outlook for the new acquisition market unfortunately continues to exhibit very high purchase value expectations, and we are seeing strong competition for new acquisitions given the significant capital available in the marketplace. As a result of this dynamic, we remain patient and selective in our diligence and review processes, while aggressively seeking new buyout opportunities. In summing up the quarter and looking forward, the state of our portfolio is very good. We have a strong and liquid balance sheet, an active level of buyout activity, and the prospect of good earnings and distributions during this fiscal year and beyond. Now, I will turn it over to Rachael Easton to provide more details on those specifics. Rachael?

Thanks, Dave. Regarding operating performance for the quarter, we continue to see improvement from the ongoing impact of the pandemic on our portfolio companies. We generated adjusted net investment income of $8.8 million or $0.26 per share, an increase compared to adjusted net investment income of $7.8 million or $0.23 per share in the prior quarter. We continue to believe that adjusted net investment income, which is net investment income exclusive of any capital gains-based incentive fees, is a useful and representative indicator of ongoing operation. Total investment income decreased quarter-over-quarter primarily due to a relative decrease in interest income as we had collected past-due interest in the previous quarter, which did not recur in the same manner in the current quarter. Also, lower dividend income from portfolio companies can vary in timing. As of December 31, 2021, three of our portfolio companies continue to be on non-accrual status. Expenses decreased by $8 million this quarter, primarily driven by a $4.8 million decrease in capital gains-based incentive fees due to the net impact of realized and unrealized gains, as required under U.S. GAAP, as well as an increase in fee credits. We believe that maintaining liquidity and flexibility to support and grow our portfolio are key elements of our success. With the successful issuance of our 2028 notes and the subsequent redemption of Series E term preferred stock in the prior quarter, along with successful exits in December 2021, we have long-term capital in place and the full $180 million available under our credit facility. Our leverage remains low, with an asset coverage ratio as of December 31 of 259.5%. Our NAV remained consistent at $13.27 per common share compared to the previous quarter. Although there was no net change, the reversal of unrealized depreciation on exits was offset by realized gains and unrealized depreciation of investments. Consistent with prior quarters, distributable book earnings to shareholders remain solid, especially considering that book earnings have been reduced by $28.7 million of capital gains-based incentive fees, which equate to about $0.86 per common share, of which only $5.3 million is currently due. As previously announced in January 2022, our Board of Directors declared another supplemental distribution to common shareholders of $0.12 to be paid out this month in February 2022. Assuming the current monthly distribution run-rate of $0.90 per share per year and $0.30 per share per year in supplemental distributions, the total annual distributions would equal $1.20 per common share or a yield of about 7.5% using yesterday’s closing price of $15.90. This concludes my part of today’s call. Back to you, David.

Alright. Thank you, Rachael. That was a great presentation. We are looking forward to having you on all of these calls going forward. Dave, you and Michael both provided good information to our shareholders, and your presentation, plus the 10-Q filed with the SEC yesterday, should bring everyone up to date. The team has reported solid results for this quarter ending December 31, and the exits and add-on investments are encouraging. We believe the team is in a great position to continue these successes through the remainder of the fiscal year ending March 31, 2022. I think the team would concur with me that Gladstone Investment is an attractive investment for those seeking continuous monthly distributions and supplemental distributions from potential capital gains and other income. The team hopes to continue to deliver a strong return on your investment in this fund. Now, let’s bring on Peter, who will open the floor for questions.

Thank you. The first question is from Mickey Schleien with Ladenburg. Please go ahead.

Yes, good morning everyone. Dave, when we look at your portfolio’s breakdown by industry, the largest segment is diversified services, which is a pretty broad description. In your prepared remarks, you mentioned inflation. I’d like to ask how you feel about those companies in those sectors' ability to pass on inflation and protect their margins?

So Mickey, good morning. Good to hear from you. To answer the first part of your question: where is inflation impacting us? We are seeing increased labor costs in the consumer products area due to raw material costs and transportation costs, particularly for products coming in from overseas. We have been experiencing the ability to pass on some of those costs to our customers. For instance, Walmart, which is one of our customers in the consumer space, is accepting price increases from us and passing those through to the consumer. It’s about being aggressive in that regard and advocating firmly with our customers. Some of them have already started implementing price increases, and we are seeing a positive trend in that regard. We hope to continue doing so.

Thanks, Dave. Is there any sense that you can give us about the portfolio’s average interest coverage?

Average interest coverage, just help me with exactly what you mean by that?

You know what we will do that one offline, if that’s okay with you.

Okay.

Dave, as you mentioned in your prepared remarks, multiples in the M&A space are elevated, and it doesn’t look like that’s likely to come down anytime soon. Given the amount of capital chasing deals, how would you describe your interest in possibly paying higher multiples for interesting businesses compared to what you may have historically paid?

Yes, well, whether I would like to or not, Mr. David Gladstone may not let us do that. But no, we look at it hard. It’s clearly a function of, as you mentioned, the service sector type of companies. That’s where we do tend to see higher multiples evaluations. We are slowly modeling out where we could increase based on what works for our model, which is focused on coverage of interest and fixed charge coverage on these companies. So, the short answer is that we will probably slowly see some increase in multiples we will have to pay for some of these companies, but we will maintain our constraints on the returns we are looking for. It’s a competitive environment, so we need to find other avenues. For example, a couple of companies we invested in last year are very good companies. In one case, we are essentially buying a smaller business and adding on to build out the platform while getting accretion from the multiples paid for the add-on acquisitions. We will pursue opportunities like that. We just need to be firm regarding what we are willing to pay going forward, but there is definitely some pressure to pay a bit more than we would prefer.

This quarter, your new investments were focused on follow-ons. Were those the types of deals you just described? In other words, were they tuck-in acquisitions, and what were your portfolio companies using that money for?

Yes, this quarter. That’s exactly right. We had a couple of companies with great opportunities for add-ons. We were able to provide the capital to help those companies, which is a positive thing for us.

Thank you. I have a couple of more questions. I’ll get back in the queue and follow up. Thank you.

Okay. Thanks.

Next question?

Thank you. The next question is from Adrian Day with Adrian Day Asset Management. Please go ahead.

Yes, good morning. Two questions if I may. Just a quick follow-up to the last discussion on competition valuation. It used to be many years ago in your lending market segment that you operated in, there was a lot less competition than with larger companies. Do you think the competition you are seeing is purely due to the increase in available capital? Is that the main reason or are you seeing new competitors who are likely to hang around in your space?

Yes, the middle market, or lower middle market?

Yes.

Yes, Adrian, I would say it’s probably largely a function of more firms entering the business, but clearly, it’s also a result of more capital being available. Not only are our main competitors private equity funds, which are competing to buy businesses, but they also have capital they need to deploy and the ability to leverage bankruptcy or other lending sources. Currently, that leverage has been relatively inexpensive. So, yes, it's a combination of both factors; many more firms are in the market. From the supply-side, we observed a high number of deals reaching the market last year. While we are noticing a bit of a slowdown in deal supply thus far this year, we expect to see a pickup again as we talk to the investment bankers. Our goal is to remain active and competitive every day.

Okay. And my second question, if I may, I was just a bit confused. Can you clarify when you say that your total investment income was affected by the decline in collections of past due interest from companies previously on non-accrual? Do you mean that the companies on non-accrual were previously able to collect from?

That’s exactly right. It’s collections that occurred from past non-accruals. We had about $1.6 million of collections in the prior quarter, but we did not see that same influx this quarter.

And they would be from the same companies?

No, not necessarily. What Rachael stated is correct; it’s a good news scenario. We had some companies that were on non-accrual last quarter, but because of their performance, we were able to remove them from non-accrual status. We also managed to collect some payments from them, and the timing of that occurrence impacted our current quarter's performance in comparison to previous quarters. Hence, we only had our normal interest payments this quarter with no additional likely collections that occurred in the prior quarter.

I got it. Okay. Thank you, sir.

Thank you. Next question.

The next question is from Mickey Schleien with Ladenburg. Please go ahead.

Dave, to follow-up, what drove the large markup of the Brunswick Bowling preferred shares? Does that represent an exit potential for that investment?

No, the valuation methodology was consistent with what we have always done. Part of it is that the business is coming back very strong. Rachael, do you want to touch on that?

Yes, absolutely. That increase was indeed due to an uptick in performance. We are continuing to see improvement from the ongoing impact of the pandemic, resulting in increased EBITDA, which led to the appreciation of the investment.

Yes, this is not related to any exit activity. It is a strong company, and we are pleased that it has returned to levels close to pre-pandemic times. We also made an acquisition of a competitive bowling ball company at the end of 2019, leading to a significant share in the market. The climb at the end of 2019 was very positive, and now it is returning to similar performance. That’s all it reflects.

That’s good news, Dave. Rachael, welcome, first of all. I have a couple of modeling questions. What is the debt portfolio’s average LIBOR floor?

Our assets typically have a LIBOR floor, and we have generally set it around 10%.

Okay. And Dave or Rachael, can you give us some insight on the large credit from the advisor to the base management fee? It was particularly significant this quarter. What was the nature of that, and what’s the outlook for that line item?

Yes, absolutely. The advisor fee this quarter was primarily associated with the asset Pioneer Square Brands, and that’s being credited against our fees to come. So, this is not necessarily comparable quarter-over-quarter.

Mickey, as you know, the way we handle this is when we both make an acquisition and exit a company, and if we generate a fee from the advisor, we then credit that back to our management fee. So again, this can be inconsistent but is typically a positive occurrence when we do exit well.

Yes, I understand the accounting. David, that number was comparatively large this quarter.

But it was indeed a good exit.

Yes, congratulations on a strong exit. What’s your estimated undistributed taxable income following these exits? Can you provide some insight on that and expectations for distribution?

Currently, we have $17.4 million of GAAP undistributed income on the balance sheet, which does include some book to tax differences. These amounts are available for distribution. Dave, would you like to expand on the forward outlook?

Yes, Mickey. As you know, our general approach is to prioritize the monthly distributions, which we have increased to $0.075 per share, amounting to $0.90 annually. We remain cautious about increasing too quickly but strive to do so gradually. It has been a solid model for all Gladstone companies overall. We completed a small increase last year and will focus on continuing that trend. Distributions will primarily stem from operating income. However, supplemental distributions stem from the capital gains we have generated. These aspects are quite positive, and I might be going a bit in-depth regarding them. Classification of income may occur on both from capital gains or other income. Looking ahead, we might entertain an increase in our monthly distribution, but some may originate from accrued income, leading to capital gains classifications. For now, we don’t have any proposals for changes, but we remain focused on maintaining robust monthly distributions and enhancing supplemental distributions based on capital gains.

Thanks for clarifying that. Those are all my questions. I appreciate your time, and congratulations on a strong quarter.

Thanks for your questions.

Do we have any other questions?

There are no further questions. Ladies and gentlemen, we have reached the end of the question-and-answer session. I would like to turn the call back to Mr. David Gladstone for closing remarks.

Well, thank you all for tuning in. We had a great quarter, and I believe we will have another strong quarter next time. We will see you next quarter. That’s the end of the call.

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