Gladstone Capital Corp (GLAD) Q3 2020 Earnings Call Transcript

Ladies and gentlemen, thank you for standing by and welcome to today's Gladstone Capital Corporation’s Third Quarter ended June 30, 2020 earnings call and webcast. At this time, all participants are in a listen-only mode. Please be advised that today’s call is being recorded. I would now like to turn the call over to David Gladstone. Please go ahead.

Alright. Thank you, Michelle. Nice introduction. You've got us all warmed up. This is David Gladstone, Chairman of the Gladstone Capital Corporation. This is the quarterly earnings call that we normally do every quarter, and this is the third quarter for this company. Its year ending is September 30, and thank you all for calling in. We're always happy to talk to shareholders and analysts and welcome the opportunity to provide an update on the company and its investment portfolio. It's really hard today to provide much determination on which way the winds are blowing. The government gets to decide most everything, and it's tough to figure out which way those winds are blowing. But we'll start out here the way we always do. General Counsel, Michael LiCalsi, will make some statements regarding forward-looking statements.

Thanks, David, and good morning, everybody. Today's report may include forward-looking statements under the Securities Act of 1933 and Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties 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 in our Forms 10-Q, 10-K, and certain other documents we filed with the SEC. We undertake no obligation to update or revise any of these forward-looking statements except as required by law. We remind everyone that today's call is an overview of our results, so we ask that you review our press release and Form 10-Q for more detailed information. Now, I will turn the call over to Gladstone Capital’s President, Bob Marcotte. Bob?

Thank you, Michael. Good morning, and thank you all for dialing in this morning. In anticipation of potential COVID-related questions this quarter, let’s get into the summary of the results for Gladstone Capital for the quarter ended June 30. Originations for the quarter totaled $56.5 million, including two new proprietary investments. Repayments and proceeds on exit totaled $17.1 million and included the exit of three smaller positions. Thus, net originations for the period were $39.4 million. Interest income rose during the quarter to $11.6 million, up 6% over the prior quarter, with the increase in average investments. The portfolio yield remained unchanged at 10.9% since most of our investments are well below the applicable LIBOR floors. Prepayment and dividend income was nominal, leading to investment income overall up slightly to $11.7 million. Borrowing and administrative costs fell in the period due to lower LIBOR rates and unused commitment fees. However, net management fees rose by $900,000 due to the reduction of incentive fee credits, resulting in net investment income of $6.1 million or $0.195 per share. Net assets from operations rose to $15 million or $0.48 per share, which included $9 million of net unrealized portfolio appreciation as the reduction of market-based spreads and strong performers offset weakness in our energy and auto-related investments. For the period, NAV rose to $7.27 per share, an increase of 4% from the previous quarter. Regarding the portfolio, our diversity limited exposure to consumer, retail, or travel sectors affected most by the COVID-19 pandemic. Throughout last quarter, we focused on working with our companies to ensure appropriate actions were instituted to adjust costs and bolster liquidity, including supporting their access to PPP funding. We did not experience any payment defaults in our sole non-accrual investment. Our non-accrual investments declined to 1.5% of the portfolio at fair value. Notably, we moved one investment to pick for the upcoming quarters in connection with the PE sponsor contributing new equity to bridge the disruption in order flow from the auto manufacturers it serves. Valuation-wise, the top three companies that increased were driven by improved operating performance. Several of our broadly syndicated investments also recovered an average of about 60% of last quarter’s depreciation, thanks to the reduction in applicable market spreads. Much of the unrealized appreciation this quarter stemmed from our auto and energy sector exposures. Auto plant shutdowns and subsequent ramp-up of order flow hampered recovery in this sector, representing about 4.2% of our investments at fair value. However, both companies are on attractive high-profile vehicle platforms, continue to win business, and have sufficient liquidity, so we expect improvement in the next couple of quarters. On our energy sector exposures, production volatility last quarter impacted our investment in an oilfield chemical distribution business. This company has dealt with energy swings in the past, and the team has adapted its cost structure, but the speed of the production curtailment in the Permian was unprecedented. Fortunately, many shut-in wells have already restarted with improved crude prices, and we expect revenues to have bottomed in May, trending up this quarter. Lastly, extreme price swings disrupted the volume of energy property and lease sales last quarter, negatively impacting our investment in a leading broker of government and auction services for these properties. That company has taken significant cost reductions, bolstered liquidity, and is well-positioned for future government sales and auctions of distressed properties. The asset mix at the end of the quarter remained steady, with first lien loans dropping to 47% and second lien loan exposure rising to 43% at cost. Our only non-earning asset is a $7.2 million debt investment in B&T, a wireless engineering and contracting business, representing 1.5% of assets at fair value. B&T is well-positioned to benefit from the increase in wireless 5G expenditures, which we're starting to see. Since the end of the quarter, our investment in Survey Healthcare of approximately $14 million was prepaid at par, plus a prepayment fee of $300,000. We also sold a $6 million portion of our second lien exposure to Lignetics at par, which represents a significant gain over where this position was marked last quarter. Looking ahead to the remainder of 2020, despite the unprecedented challenges presented by COVID-19, we feel we've weathered much of last quarter’s difficulties. Our portfolio's composition, diversity, underwriting discipline, and active management position us well for growth. Concerning new deals, we remain cautious about lasting COVID-related financial impacts, but we have recently seen a pickup in deal activity. Given current market dislocations and limited competition, we expect these opportunities to involve modest leverage levels and improved yields. We aim to manage our investment capacity proactively by selling existing assets to support new investments while maintaining our targeted leverage level. And now, I’d like to turn it over to Nicole Schaltenbrand, the CFO of Gladstone Capital, to provide details on our financial performance for the quarter.

Thanks, Bob. Good morning, everyone. During the June quarter, total interest income increased by $600,000, or 5.7%, to $11.6 million, primarily due to an increase in the average balance of our interest-bearing investments. The investment portfolio's weighted average balance increased by $24.7 million, or 6.1%, to $429 million, compared to $404.3 million for the quarter ended March 31. The weighted average yield on our interest-bearing portfolio remained unchanged at 10.9%, as the decline in LIBOR had a minimal effect due to interest rate floors impacting our predominantly floating-rate assets. Other income decreased by $400,000 compared to the last quarter, attributed to lower prepayment fees and dividends, resulting in total investment income for the quarter increasing by $200,000, or 2.1%, to $11.7 million. Total expenses increased by $700,000, or 4.2%, quarter-over-quarter, primarily due to a $900,000 decrease in the incentive fee credit granted by the Adviser, coupled with small reductions in interest expenses and fees. As a reminder, we continue to credit closing fees received directly to the manager, totaling $675,000 last quarter, and we continue to provide a credit to reduce management fees on broadly syndicated investments to 50 basis points, which amounted to $92,000 last quarter. Net investment income for the quarter ended June 30, 2020, was $6.1 million, a decrease of 7.1% compared to the prior quarter, or $0.195 per share, and covered 100% of shareholder distributions. The net increase in net assets resulting from operations was $15 million, or $0.48 per share for the quarter ended June 30, compared to a decrease of $27.8 million, or $0.89 per share for the previous quarter. This increase was driven primarily by $9 million of net portfolio appreciation, as Bob mentioned earlier. Regarding the balance sheet, as of June 30, total assets were $458 million, comprised of $447 million in investments at fair value and $11 million in cash and other assets. Liabilities rose to $231 million as of June 30, consisting primarily of $133.5 million in borrowings on our credit facility, $57.5 million of 6.125% Senior Notes due 2023, and $38.8 million of 5.375% Senior Notes due 2024. Net assets rose by $8.9 million from the prior quarter-end with $9 million of net realized and unrealized portfolio appreciation. NAV increased from $6.99 per share at March 31 to $7.27 per share as of June 30. Our leverage, as of June 30, increased from the prior quarter-end to 102% of net assets from 86%, due to net origination for the period. As of the quarter’s end, we had over $53 million in current investment capacity and available credit. In April, we successfully extended the revolving period ending on the credit facility by six months, now set for July 15, 2021. Our overall leverage compares favorably, and we believe we have sufficient liquidity to support our existing portfolio companies as needed while selectively deploying capital in new investment opportunities. Concerning distributions, Gladstone Capital remains committed to paying its shareholders a cash dividend. In July, our board declared monthly distributions to common stockholders of $0.065 per share from July through September, equating to an annual rate of $0.78 per share. The board plans to meet in October to determine monthly distributions for the following quarter. At the current distribution rate for common stock and with a price around $7.31, the distribution run rate produces a yield of 10.7%, which continues to be attractive relative to the exceptionally low yields generally available in the market today. I will now turn it back to David to complete the presentation.

Super, Nicole. Very nice. Good presentation, Bob and Mike, keeping us all up to date. It's a challenging quarter for participants in the leveraged lending marketplace, and Gladstone Capital is no exception. We performed well in delivering numbers for this good company. We originated $56 million, had about $17 million in paydowns, resulting in about $39 million of asset growth, and hopefully all of those will generate good income over the next six months, allowing us to report positive developments on that front. We are diligently working with our portfolio companies to maintain non-performing assets at approximately 1.5% and enhance total investments. Higher assets led to a nice increase in the company's core net interest income of approximately $8.9 million. We've maintained a strong balance sheet, including existing assets that make additional capital available for more loans to middle-market businesses. That's our core business, the original business I started out in many years ago. In summary, the company continues to invest in mid-sized private businesses under solid management. Many of these situations are supported by private equity funds, which foster our relationships in providing necessary debt for acquisitions. This enables us to offer attractive interest-paying loans while continuing our cash distribution commitments to shareholders. As mentioned earlier, forecasting is quite challenging today, given the uncertainty surrounding state, local, and national government actions. The environment is unpredictable, as evidenced by boarded-up streets in Washington, D.C., raising concerns about future developments. The government now possesses significant power under the pretext of COVID-19, resulting in both positive and negative repercussions. Let's stop here and allow the operator to explain how participants can ask questions regarding the company.

Our first question comes from Mickey Schleien of Ladenburg. Your line is open.

Yes. Good morning, everyone. First of all, congratulations on what appears to be a very strong quarter given how difficult the environment is, so well done. I see that your investment activity was much higher this quarter than in previous quarters. I'd like to understand how much of that was from deals in the pipeline that you have been working on for a while and came to fruition now, versus opportunistic investing during a period of high dislocation?

Good morning, Mickey. Both of those investments typically take a while to materialize. Therefore, both transactions actually pre-dated the quarter and were adjusted slightly due to the activities during the quarter, but we feel very comfortable with both deals as they are relatively low leveraged, more akin to twos versus fours in terms of leverage. We are satisfied with those investments - yielding nice returns with lower risk exposures.

Thank you for that. That's helpful. Bob, I see that your weighted average risk rating on proprietary investments improved, which certainly reflects the trend I’ve observed in the sector. Were there any specific outliers that influenced that rating?

Some of those numbers are somewhat lagging. The financial results for the second quarter reflect 630 numbers. We don't have complete 630 numbers for all companies just yet. The second reason pertains mostly to newly closed deals. When we finance deals that are leveraged below three, that will certainly improve the overall rating. Thirdly, three historical companies dramatically improved their financial performance, contributing to this rating. It may appear a bit anomalous given the timing, but there were good assets involved, and notable improvements in some core positions.

I appreciate the insight, that's really interesting. Bob, your leverage, at least in terms of debt-to-equity, is now within your target range; last time I checked, you mentioned it was 0.9 to 1.25. From your prepared remarks, it sounds like you’re not inclined to exceed that target range, considering current market conditions. Is that correct?

That's correct. We are currently at around a 1-to-1 leverage net level now. We had some subsequent prepayments that brought us down and provided approximately $20 million in additional capacity. We will certainly consider increasing leverage, but as we surpass 1-to-1, we will thoroughly assess our existing assets to gauge how much further we are comfortable going. Historically, we've maintained a cushion to handle any portfolio-related matters. Typically, we've stayed below 80%, despite a rule indicating a 1-to-1 limit. We'll maintain this cushion to 1.25 moving forward and also factor in marginal funding costs while managing closely.

I understand. Based on your previous answers, it sounds like the strategy would be to rotate the portfolio, perhaps as repayments come in or from lower-yielding investments to higher-yielding ones as you identify them, all while keeping leverage constrained amid uncertainty. Is that a fair summary?

That's a good re-characterization, Mickey. Every day brings different management needs. Regarding equity issuance, we need to anticipate the market trends. We are already observing some price compression and competition as the market normalizes. Therefore, we won't rush to issue equity based on anticipated spreads in the marketplace.

That's all my questions for this morning. I appreciate your time.

Thanks for calling in.

And I hope everyone on the team stays healthy. Thanks.

We're all in good shape so far. Michelle, please come on and get the next question.

Our next question comes from Henry Coffey of Wedbush. Your line is open.

Good morning, and I wanted to follow up on Mickey's questions. Currently, when new loans are presented to you, who’s seeking capital in this market? Is it primarily for growth or survival?

Henry, there are many individuals looking to recapitize existing lenders. Some are under stress and have reached the end of their five-year hold period. We remain cautious with such situations, as they suggest caution in terms of their inability to deleverage or pay out. There are also some new transactions beginning to emerge as we explore diligence in a COVID environment. Travel is resuming, and individuals are even contemplating remote diligence calls. These transactions are gradually coming to life, though they have been stagnant for the past three to four months. Additional opportunities typically arise in some add-ons, for businesses looking to acquire growth-compatible entities. Overall, it still leans towards sponsored financing transactions, but the flow is just beginning to re-emerge.

You mentioned spreads tightening. How do real-life business trends correlate with trends in bond values, spreads, and loan values? Are those two aligning or is there disconnect?

I see it in two contrasting ways. In the broadly syndicated marketplace, we hold several investments in our portfolio that remain marked well below where I’d expect them to be. This reflects how the leveraged loan market hasn't fully normalized. The CLO market condition and the flow of investor funds haven’t reflected the bonds' true value, as evidenced by assets still trading in the 80’s, indicating some divergence at present. There’s also the aspect of higher leverage and instruments lacking necessary controls that we prioritize. However, the more active area for proprietary investments sees many insurance companies and others looking for yield in the current environment. This presents valuable opportunities to place unitranche pieces into their portfolio, generating high returns due to the attractive yields in direct origination markets compared to the less liquid leveraged finance syndicated loan market.

Will this present a challenge for you when it comes to deploying your funds? Are you competing against insurance companies due to their larger bids, or does this create more opportunity because of the comparative liquidity?

Even with significant funds available, competitors new to the market lack the necessary reputation and flexibility to truly engage effectively. Our primary focus remains on the lower middle market, thus the barriers to entry remain substantial. While they may become a factor as the companies grow, we’re positioned well to enter and execute unitranche investments. Should these businesses expand, we may require partnerships to accommodate their growth. Starting from valuations of $8 million to $20 million of EBITDA allows us to effectively manage a path where we can operationally grow the business together.

Good. This has been incredibly helpful. Thank you for your insights.

Thanks for calling in.

There are no further questions.

No further questions.

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