Earnings Call Transcript - GLAD Q2 2024

Operator, Operator

Greetings, and welcome to the Gladstone Capital Corporation Second Quarter Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. David Gladstone, Chief Executive Officer. Thank you, sir. You may begin.

David Gladstone, CEO

Thank you, Latoya. That was a nice introduction, and hello, everybody. This is David Gladstone, Chairman, and this is the earnings conference call for Gladstone Capital for the quarter ending March 31, 2024. Thank you all for calling in. We're always happy to talk with our shareholders and analysts and welcome the opportunity to provide updates to the company. I hope we have some good questions today, but we're going to start off first with our General Counsel, Michael LiCalsi. He's going to make a few statements regarding forward-looking statements. Michael?

Michael LiCalsi, General Counsel

Thanks, David. Good morning, everybody. Today's report 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 that 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 in our Forms 10-Q, 10-K and other documents that we file with the SEC. You can find them on our Investors page of our website gladstonecapital.com. And while you're on there, you could also sign up for our email notification service. You can also find the documents on the SEC's website, which is 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. Today's call is simply an overview of our results, so we ask that you review our press release and Form 10-Q, both issued yesterday for more detailed information. Again, you can find them on the Investors page of our website. With that, I'll turn the call over to Gladstone Capital's President, Bob Marcotte.

Robert Marcotte, President

Thank you, Michael. Good morning, and thank you all for dialing in this morning. I'll cover the highlights for last quarter before turning the call over to Nicole to review the details of our financial results for the period. So beginning with our last quarter results. Fundings last quarter were modest at $45 million, given the traditionally slow first quarter and limited new deal buyout activity in the market. And like recent quarters, about two-thirds of the fundings were add-ons to the existing portfolio investments. Prepayments and amortization totaled $15 million, so net originations were $30 million for the period. SOFA rates were unchanged, so the weighted average yield on our investment portfolio was largely unchanged at 14%. However, average earning assets for the period rose 3.5%, resulting in a 3% increase in our total interest income to $23.7 million for the quarter. The combination of increased interest costs from higher average bank borrowings and an increase in non-earning assets offset the increase in earning assets and net interest was unchanged at $17.5 million for the quarter. Management fees rose to $5.7 million in the absence of new deal advisory fee credits and net investment income declined by 9.7% to $10.8 million. However, net realized gains rose to $2.2 million, and the combination totaled $0.298 per share or 120% of dividends for the period. In the aggregate, net realized and unrealized gains on the portfolio totaled $12.9 million, which lifted our ROE for the quarter to 22.3% and 17% for the last 12 months. With respect to the portfolio, our portfolio continues to perform well with senior debt representing 71% of the portfolio, and we ended the quarter with two non-earning debt investments, which represent $20.4 million at cost or 1.8% of assets at fair value. Appreciation for the quarter of $12.9 million was led by the appreciation of five equity positions driven by strong underlying operating performance or preferred share liquidation preference amounts and a $1.9 million realized gain related to residual interest associated with the sale of a former investment. Regarding our near-term outlook, I'd like to leave you a couple of comments. We continue to benefit from our incumbent position supporting growth-oriented businesses across a variety of industry sectors. And with PE sponsors facing extended investment hold periods, if they have not hired a banker to sell, they are continuing to seek ways to creatively grow and recapitalize their investments, and supporting these performing businesses we know well is a low-risk way to grow our assets. The syndicated loan market for larger well-established credits improved significantly last quarter, which has led to some spread compression for these companies, which we expect will trigger an uptick in prepayment activity for some of our larger positions over the balance of the year. We ended the quarter with a conservative leverage position at just below 89% of NAV and ample availability under our bank credit facility. So we're well positioned to grow our earning assets and fee income to continue to support our shareholder distributions in the coming year. And now I'd like to turn the call over to Nicole Schaltenbrand, the CFO of Gladstone Capital, to provide some more details regarding the fund's financial performance for the quarter.

Nicole Schaltenbrand, CFO

Thanks, Bob. Good morning, everyone. During the March quarter, total interest income increased by $700,000 or 3% to $23.7 million due to a rise in average earning assets. The weighted average yield on our interest-bearing portfolio remained stable at 14%. The average balance of the investment portfolio rose to $680 million, which was a $23 million or 3.5% increase compared to the prior quarter. Other income amounted to $300,000, and total investment income grew by $800,000 or 3.3% to $24 million for the quarter. Total expenses increased by $1.9 million, driven by a $1 million rise in net management fees due to lower new deal closings and advisory fee credits, along with a $700,000 uptick in interest expenses from higher bank borrowings. Net investment income for the quarter was $10.8 million, representing a decline of $1.2 million compared to the previous quarter, or $0.2475 per share. The net increase in net assets from operations was $23.6 million, or $0.54 per share for the quarter ended March 31, influenced by the realized and unrealized valuation depreciation mentioned by Bob earlier. Moving to the balance sheet. As of March 31, total assets rose to $812 million, comprised of $792 million in investments at fair value and $20 million in cash and other assets. Liabilities from net originations increased to $380 million as of March 31, mainly consisting of $254 million in senior notes. At the end of the quarter, advances under our $244 million credit facility stood at $117 million. As of March 31, net assets increased to $431 million from the end of the previous quarter due to investment appreciation. NAV rose by 3% from $9.51 per share as of December 31 to $9.90 per share as of March 31. Subsequent to March 31, we executed a 1-for-2 reverse stock split, resulting in an approximate NAV per share of $19.80, and our ongoing monthly distributions doubled to $0.165 per share per month. Additionally, after the quarter ended, we invested $7.3 million in a new proprietary investment, including senior debt and preferred equity. We also received payoff from our second lien debt investment in Giving Home Health, which included prepayment penalties of $900,000, along with a distribution on our warrant position of $2.5 million. We also received payoff from our second lien debt investment in Gray Matter Systems, which included prepayment fees of $200,000. As for distributions, we announced monthly distributions to common shareholders of $0.165 per common share for April, May, and June, equating to an annual run rate of $1.98 per share. The Board will convene in July to decide on monthly distributions to common stockholders for the upcoming quarter. At the current distribution rate for our common stock, with the stock price at approximately $21.77 per share yesterday, the distribution run rate yields about 9.1%. I will now turn it back to David to conclude.

David Gladstone, CEO

Thank you, and you did a great job, Nicole and Bob, on the earnings for that quarter. Michael, you did a great job, too, in letting our stockholders and the analysts know that they're following our company and all about our recent performance. Highlights to me would be the company continues to scale its investment portfolio and have eclipsed now the $800 million last quarter, which is over 37% in the past two years while maintaining the lower middle market focus. It's a different discipline than others might see, but this is a good yield for this kind of company with such a good track record. While we saw a small uptick in the nonperforming assets, the investment team is on top of the situation and otherwise, the portfolio continues to perform well, having supported significant net portfolio appreciation again this quarter, which lifted net asset values per share by 6.8%. And between the high rates and the portfolio performance, Glad has achieved a return on investment of about 17% for the past year, which puts the company in the top end of all the business development company peers that we compare ourselves to. In summary, the company continues to be well positioned as a portfolio and it's in good shape with a strong balance sheet, and I think that will support us well for further growth and hopefully, the growth orientation will increase our dividends as well. Many of these investments are in support of midsized private equity funds that are looking for experienced partners to support their acquisition and growth of their businesses in which they have invested a pretty substantial amount of equity. This gives us an opportunity to make attractive interest-paying loans to support our ongoing commitment and to pay cash distributions to our shareholders. So now, Latoya, if you'll come on, we'll get some good questions from the people that have called in today. Latoya?

Operator, Operator

We will now conduct a question-and-answer session. One moment while we poll for our first question. Our first question comes from Mickey Schleien with Ladenburg.

Mickey Schleien, Analyst

Bob, according to LSEG, lower middle market spreads have contracted about 50 basis points over the last year, but they're still above pre-COVID levels. So when you think about the supply and demand for lower middle market capital and the health of the economy, what's your view and the outlook for loan spreads in your business?

Robert Marcotte, President

Mickey, I think that indication of where the spread compression is coincides with what we're seeing. Obviously, that's a much lesser level than what is happening at the upper middle market realm, where, frankly, you have broadly syndicated loans in the CLO market, red-hot, and driving spreads down. That doesn't generally apply to credits where deals started under $10 million of EBITDA. You have to remember that most of our portfolio companies start under $10 million in EBITDA and grow over time. And it's only when they get to larger scale, do we see that price compression. So we're expecting some in the range of what you're outlining. But just to give you an example, the prepayment that we just disclosed in our subsequent events was a very large credit that we were opportunistically invested in several years ago, and the company's EBITDA was in the range of north of $100 million just for indicating purposes. And when it repriced, it priced at levels that just don't make sense for us. So we let that pay off. Going forward, we'll continue to focus in our market where we can think there's enough competition is less and the scale does not warrant the kind of price compression that you're alluding to.

Mickey Schleien, Analyst

I appreciate that. Bob, I realize they're relatively small investments, but could you give us a quick update on the outlook for DKI and B&T?

Robert Marcotte, President

DKI operates in the restoration sector, which encompasses a variety of players in the market, particularly related to events like storms and fires that occur frequently. The company is transitioning from a franchise model to a third-party administrator format, necessitating changes in marketing and cost structure. We are working with the team to expedite this process, and if we cannot achieve organic growth, we believe there are strategic exit options available due to the numerous competitors in the market. As for B&T, it serves mainly as an engineering platform with some distinct advantages, especially in the wireless engineering field. However, it operates in a market dominated by a few major players who generate most of the revenue. B&T can leverage offshore resources to provide cost-effective engineering support, but predicting capital expenditure cycles in this industry can be challenging. Updates in networks, cell site modifications, and spending on spectrum can lead to fluctuations. We are entering a new telecommunications spending cycle, with ongoing investments in 5G and companies like T-Mobile and Verizon expanding their wireless capacity for alternative internet services. Additionally, there is significant funding for broadband expansion as outlined in the Infrastructure Act, which has taken time to implement but is now showing progress. This quarter, the funds allocated to enhance broadband access in rural areas have increased significantly, with estimates of between $8 billion and $10 billion per year aimed at expanding these services across the U.S. We are beginning to see these funds being released, and we hope they will contribute to the growth of the engineering services that B&T offers.

Mickey Schleien, Analyst

Yes, I understand. That's really useful. Just a couple of housekeeping questions sort of trying to gauge the portfolio's risk. Can you give us a sense of the current average EBITDA, debt-to-EBITDA and cash interest coverage ratios?

Robert Marcotte, President

We cover a wide range in terms of overall EBITDA. It can typically start as low as $2 million to $3 million and reach up to $150 million. Therefore, an average may not accurately represent the situation. Most of our credits begin at around $10 million of EBITDA and grow from there. In terms of our overall leverage, I estimate it to be around 4 times, which aligns with our previous position. Interestingly, there seems to be a barbell effect; the more established businesses we’ve invested in tend to have slightly lower leverage compared to the early-stage credits that are still growing, which have a bit higher leverage, but both remain around 4 turns of debt to EBITDA. This generally supports the interest coverage we usually maintain. We typically have deals structured with at least two and often three covenants, most of which require debt service coverage between 1.10% and 1.20%.

Mickey Schleien, Analyst

I understand. Those are all my questions.

Operator, Operator

The next question comes from Sean-Paul Adams with Raymond James.

Sean-Paul Adams, Analyst

Could you add a little bit more color on the new nonaccrual WB Xcel? It looks like it's only been on the books for about three years. So I'm wondering if there was any residual impact from the buyers as well as providing a little bit more color on the origination outlook for the rest of the year?

Robert Marcotte, President

XL was one of the few credits that we have a little bit more consumer-oriented exposure than I would normally expect in the portfolio. Xcel, if you don't know, is a premium brand in the wet suit market. The business was doing fairly well, and we probably were a little bit more optimistic about where it stood. COVID certainly lifted the luxury and athletic activities that were going on in the marketplace, and it was fairly robust. Post-COVID, retail channels were reasonably full. The seasonality of those kind of offerings, combined with just a consumer-oriented pullback was more severe. As a result, we put it on nonaccrual. The company is in the throes of a new line launch, which is lined up and expected to occur as of the midsummer time frame. And I can say that we are very optimistic that the fall bookings are at a multiple of what they were last year. So we're positioned to restart it, but it was a little bit of a hangover situation between COVID retail channels, consumer and a refresh on the brand that we are working through at the moment. We have stepped in with a more significant involvement, and we've recruited external expertise to assist us in repositioning and taking advantage of the opportunity. This is a global business. It is selling in the U.S. and it is selling internationally. And so there's a lot of opportunity to go get in that business, and I think we've brought in some resources to help us with that process. Picking up on the originations for the back half of the year, that's the challenge for us. I will say that we are, as I mentioned, expecting an uptick in prepaid activities, and we're very much focused on sifting through and finding good growth opportunities to redeploy that capital. I will say that once the business has grown and it's got $20 million, $30 million, $40 million of EBITDA on sales, our exposure tends to be a little higher. And so when we restart the process and bring in earlier-stage younger businesses in the lower middle market, the initial exposures tend to be smaller, and it will take a period of time for those to grow and mature into credits of comparable size. So we are planting the seeds today. I think the deal that we referenced that has been closed is a nice transaction that is intended to be a roll-up or an add-on platform that is interestingly, in the elevator repair business. It's a fragmented market that there are plenty of opportunities to grow. And those are the kind of situations we're currently working on to expand. So I think we will continue to see add-ons to some of the younger companies in the portfolio, and we'll continue to see opportunities at the lower end of the middle market where we'll see that. In terms of overall, I think the challenge will be to drive net growth over the course of the balance of the year. I think given what could be $150-plus million of repayments, plus or minus, if we can originate and stay ahead of that curve, I think that's what we're currently shooting for, but it's not going to be a ton of net asset growth given what we're expecting to be refinancing activity because we're going to maintain our yield discipline. And we can certainly scale up, but our cost structure and our returns, it doesn't make sense for us to do that. I don't know if that helps.

Sean-Paul Adams, Analyst

Incredibly helpful. I really appreciate it.

Operator, Operator

Mr. Gladstone, there are no further questions in queue at this time. I'll turn it back to you for closing comments.

David Gladstone, CEO

Shucks. We wanted more questions. So you guys are not working very hard. So we're not getting enough questions. We want to get some more questions. Of course, we don't have a lot of problems in the portfolio, so I guess we're not going to get many questions. That's the end of this conference call, and we thank you all for calling in, and see you next quarter.

Operator, Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a great day.