ArrowMark Financial Corp (BANX) 2017 Q4 法說會逐字稿

Welcome to the StoneCastle Financial Corporation Fourth Quarter 2017 Investor Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

Now I'd like to turn the call over to Rachel Schatten, General Counsel of StoneCastle Financial.

Good afternoon. Before we begin this conference call, I'd like to remind everyone that certain statements made during the call may be considered forward-looking statements based on current management expectations that involve substantial risks and uncertainties. Actual results may differ materially from the results stated in or implied by these forward-looking statements. This would depend on numerous factors, such as changes in securities or financial markets or general economic conditions; the volume of sales and purchases of shares of common stock; the continuation of investment advisory, administrative and service contracts; and other risks discussed from time to time in the company's filings with the SEC, including annual and semiannual reports of the company.

StoneCastle Financial has based the forward-looking statements included in its presentation on information available to us as of December 31, 2017. The company undertakes no duty to update any forward-looking statement made herein. All forward-looking statements speak only as of today, March 1, 2018.

Now I will turn the call over to StoneCastle Financial's Chairman and Chief Executive Officer, Josh Siegel.

Thank you, Rachel. Good afternoon, and welcome to StoneCastle Financial's Fourth Quarter 2017 Investor Call. In addition to Rachel, joining me today is George Shilowitz, President; and Pat Farrell, our Chief Financial Officer.

I'd like to start the call today with a review of StoneCastle Financial's quarterly results as well as comment on the company's investment opportunities in the current market. I will conclude with remarks on the macroenvironment, including new developments and pending legislation, then I will turn the call over to Pat who will provide you with greater detail on our financial results before I open up the call for questions.

StoneCastle's total earnings for the quarter were approximately $3 million or $0.47 per share. Net investment income for the quarter was nearly $2.7 million or $0.41 per share. For the quarter, the company had net realized capital gains of $375,000 or $0.06 per share. The company's net asset value per share was $21.56 as of December 31, unchanged from the third quarter. Total assets were approximately $170 million and the value of the invested portfolio was $167 million. The estimated annualized portfolio yield was 9.05%, which was the fifth consecutive quarter of an estimated annualized yield over 9%.

During the quarter, the company invested $13 million in 3 investments and had 1 full call and 2 partial calls totaling approximately $23 million. However, subject to quarter -- or subsequent to the quarter end, the company made 5 additional investments totaling $36.1 million. Included in that number, the company invested $17.6 million in the preferred equity interest of a new pooled vehicle, whereby the company contributed $43.4 million in securities to date. The full schedule of investments can be found in the company's SEC filings and on the company's website.

At December 31, StoneCastle had a dividend yield of 7.6%, which continues to offer considerable relative value in the context of the market. At quarter-end, our shareholders realized a yield advantage of over 500 basis points above the 10-year U.S. Treasury and over 400 basis points above the Bank of America Merrill Lynch U.S. Corporate BBB Effective Yield Index. Even with the volatile markets in early 2018, StoneCastle's dividend yield continues to be 400 basis point above the 10-year treasury. The company currently pays a dividend rate over 3x higher than the average community bank dividend rate.

As we turn to market conditions, we believe investors rightly continue to focus on credit quality. I want to reiterate that StoneCastle has seen no material credit issues on our portfolio to date, and we continue to have the majority of the portfolio assets scored investment-grade.

Turning our attention to the environment for community banks, our adviser, StoneCastle Asset Management, continues to maintain its disciplined investment strategy, especially during these times of market uncertainty. We continue to utilize a patient, long-term view in the deployment of capital. Over the last 6 months, we have seen more banks taking advantage of high equity valuations by exploring equity transactions as a way to raise capital. In December, we saw the equity markets set new highs. As we mentioned last quarter, we had been seeing pressure on investment yields resulting in more aggressively priced transactions. However, over the past few months, we have seen rates become more attractive.

Now I'd like to take a moment to describe our investment in the new pooled vehicle. The new vehicle, community funding 2018, is comprised of 60% debt from a private domestic insurance group and a 40% preferred equity interest invested by StoneCastle Financial. We hope to scale the company's initial investment of $17.6 million of the preferred equity interests to $40 million. We expect this transaction to be accretive to net income per share.

Let me walk you through a few more details. The initial portfolio assets of community funding 2018 consists of 9 investments contributed by StoneCastle Financial valued at $43.4 million with an average investment size of approximately $4.8 million and an average coupon rate of 7.27%. The majority of the assets are scored investment-grade. In return for contributing the initial assets, StoneCastle received $17.6 million in a preferred equity interest and approximately $26 million in cash. The effective yield for StoneCastle Financial's investment will be disclosed once the vehicle is fully funded, but we expect it to be in excess of 9%. Additional details will be provided in our first quarter 2018 filings with the SEC. We continue to believe StoneCastle will have accretive opportunities to grow the company in 2018. As investors ourselves, we realize being good stewards of capital will create long-term value for our shareholders.

Now let me turn to the macroenvironment. Over the last several quarters, I've mentioned several considerations that might result in continued positive performance for community banks. Today, I want to focus on higher interest rates, developments in accounting standards and pending legislation.

Beginning with interest rates, banking is one of the few industry sectors that can typically benefit from rising interest rates, as lending rates increase faster than deposits cost. The difference between the loan rates and deposit rates is called net interest margin, or NIM, and is comparable to gross profits for a bank. Historically, NIM tends to increase in higher interest rate environments, even more so when the rate curve steepens. The Q3 FDIC quarterly banking profile showed that year-over-year, NIM for community banks widened 7 basis points from 3.58% to 3.65%. In Q3 2017, the NIM for community banks was about 35 basis points above all insured institutions. As interest rates move up, the health of banks historically tends to improve as banks generate more free cash flow and increase earnings potential. In addition, with an increasing rate environment, any new investments made by the company may have higher yields.

Another macro consideration is a new accounting rule issued by the Financial Accounting Standards Board, or FASB. Some of you may have read about this new accounting standard known as CECL, C-E-C-L, an acronym for Current Expected Credit Loss. I recently coauthored and copublished a white paper in conjunction with The Bank Treasury Newsletter on this very subject. This accounting measurement, effective March 2020, or March 2021, depending on whether the institution is an SEC filer or not, will require banks to increase their reserves to loan losses to now cover the life of each loan rather than a general reserve plus an incurred loss reserve. These increased loan-loss reserves will likely precipitate an increased need for capital in order for banks to maintain their well-capitalized status. Q2 sub debt is likely the most cost-efficient form for this additional capital.

CECL implementation may be negatively construed as reflecting on the health of the banks. Some have confused the need for high reserves with an increased risk in loan portfolios. This is not the case. CECL is a result of IASB, FASB, Basel III and Dodd-Frank regulations pushing the auditors and banks to think more conservatively about credit losses and related loan-loss reserves. Over the next several years, we believe there will be an increasing need for capital, most likely Tier 2, and StoneCastle stands ready to provide capital as a trusted long-term investor. We hope to capture a large part of these opportunities once banks begin implementing this new standard.

On the regulatory front, bipartisan legislation recently made its way through the Senate. In early December, the Senate passed the Economic Growth, Regulatory Relief, and Consumer Protection Act, sponsored by Sen. Mike Crapo of Idaho. This legislation seeks to ease the compliance and regulatory burden of small banks. Although the bill still faces hurdles to become law, we believe the Senate legislation is a big step in the right direction for small community banks and their overall profitability.

For the reasons highlighted in my comments, we continue to believe that an investment in StoneCastle Financial will afford shareholders a greater opportunity for capital preservation as well as a yield advantage over other income vehicles in the market, all while offering a high credit quality portfolio.

Now I want to turn the call over to Pat to discuss the financial results and provide details on the underlying value of the company.

Thank you, Josh. As I do each quarter, I will present the financials by going through the detailed components to help you understand the value of the company.

The net asset value at December 31 was $21.56, unchanged from last quarter. The NAV is comprised of 4 components: net investment income; realized capital gains and losses; a change in value of the portfolio of investments; and finally, distributions paid during the period.

Let me walk through these components.

Net investment income for the quarter was $2.7 million or $0.41 per share. Net investment income reflects gross income from dividends and interest received from our portfolio investments minus operating expenses. Gross income for the fourth quarter was $4.2 million or $0.65 per share.

Now I'd like to review the company's operating expenses, which are comprised of advisory fees, interest expense related to our use of leverage and other expenses.

Net operating expenses for the quarter were $1.6 million or $0.24 per share, which was down 10% from the prior quarter, primarily due to lower management fees and interest expense. I want to point out that the fourth quarter was the first full quarter of savings related to the renegotiated American Bankers Association contract, which started September 1, 2017, and will result in savings of approximately $0.015 per share annually.

The second component affecting the change in NAV for the quarter is realized capital gains and losses. The net realized capital gains for the quarter was approximately $375,000 or $0.06 per share, and was almost entirely related to a gain on the partial call of [MM] caps.

The third component, changes of unrealized appreciation or depreciation of the portfolio, relates to how the value of the entire investment portfolio has changed from the previous quarter-end to the current quarter-end. For the fourth quarter, the unrealized appreciation of the portfolio decreased by approximately $580,000 or $0.09 per share.

As I note this quarter, the vast majority of the portfolio continues to be independently marked from broker-dealer quotes. For the quarter, over 97% of the portfolio prices or marks reflect a minimum of 2 quotations. These represent an independent third-party assessment of the current value of the portfolio. At quarter-end, the closing stock price of StoneCastle traded at a discount of approximately 7% to the actual market value of the net assets of the company.

The fourth component affecting the change in net asset value is distributions. The cash distribution for the quarter was $0.38 per share. The distribution was paid on January 3, 2018, to shareholders of record on December 22, 2017.

In summary, we began the quarter with a net asset value of $21.56 per share. During the quarter, we've generated net income of $2.7 million. We realized capital gain of approximately $375,000 and the unrealized value of the portfolio investments decreased by approximately $580,000. The sum of these components, offset by a distribution of $0.38 per share, resulted in a net asset value of $21.56 per share at December 31.

At quarter-end, the company had total assets of approximately $170.4 million, consisting of total investments of $167 million, cash of $30,000 and other assets of $3.4 million, which includes receivables and prepaid assets.

Now let me update you on the balance of our current credit facility. At December 31, the company had $25.75 million drawn from the facility. In accordance with the regulated investment company rules, we may only borrow up to 33.3% of our total assets. Our leverage percentage at the end of the quarter was 15.1%.

Now I want to turn the call back over to Josh.

Thank you, Pat. Now, operator, we'd like to open up the call for questions.

(Operator Instructions) Our first question today comes from the line of Devin Ryan with JMP Securities.

Great. So first off, congratulations on the results and also on executing the pooled transaction. I guess, first question on that. And I know you guys are comfortable for good reason around the risk characteristics and the asset quality of the investments in the kind of pooled transactions. But just tried to think about, is there a level of maybe the overall equity base that would be kind of a limitation of how much you would be comfortable with on that front? And essentially, I'm just trying to think about how you think about the parameters to do those and especially if you continue to grow the equity base over time here, what that could look like, assuming that this capital is readily available.

Yes. There's always that. So in terms of how we think about the risk and exposure of the portfolio is I think as a percent of the -- sort of our net assets, probably aren't going to want to go much higher. But we do look through, because if you look at the first transaction that we invested in, it had about 82% debt and about 18-odd percent equity. This one has 60% debt and 40% equity. So the profile is quite derisked on the second one. And all we're really trying to do is find transactions like this that allow us to get just a little bit more yield and be able to go up to larger banks that won't pay our 8% or 9% rate straight, but we can get them at 6s or 7s, go for larger banks and be able to originate more and still end up with kind of a high 8s, low 9s or maybe even over 10 effective yield. And so we found this transaction as a more flexible solution than the first one as well as a derisked. But to your core question, we are very cognizant of the different risk profile on this one, although if you drill through, even though this is all nonrecourse financing, even on a blended basis, right now, we're quite likely levered. So we're monitoring that on sort of a drill-through basis, if that makes sense.

Yes, now that's really helpful color, just wanted to get some perspective. Maybe a bigger picture question just around the banking industry. Obviously, technology and kind of digital, if you will, is becoming a bigger theme across industries, and banking is no exception. And obviously, it's helping drive efficiencies and, I think, a better customer experience, but arguably could be disruptive due to certain models out there. And so I'm just curious how you guys are assessing in the technology capabilities of the banks you provide capital to. Is that something that's important? Or does this maybe even add a newer element to how you're thinking about the investment process? I know it might be kind of a longer-term play out for the industry, but I'm curious how that kind of plays in.

Well, it definitely plays in. It's a very good question with an answer that normally would last the space of dinner, but I'll try to do it short here. When we think about technology in banking, banking isn't one business. Every bank is 2 separate companies attached at the hip. One is a lending operation and then another side of the bank that actually doesn't talk terribly much to the other side is the deposit gathering organization. And so the old ING Direct, where you're basically just gathering deposits and you're not making loans, that doesn't work outside of having a bigger company behind it. And so you always have this double role. So when you say technology, the question is what technology related to what part of the bank. If it's for the lending side, you're looking at LendingClub and SoFi and people like that, I would probably take the under that those organizations are going to displace banks that are predominantly making nonconsumer loans, small business, low commercial real estate, 1 to 4 family prime home mortgages, that's not terribly where that's happening. But okay, fine. The flip side is the same forward-facing apps that the LendingClub and others created several years ago, now every small bank is finding quite cheap from more and more providers who I'm sure were out in force at the ABA Conference in Hawaii this week. So banks are now getting better technology to face up to their customers as well, quicker underwriting, quicker turnaround, et cetera. Then go to deposit side. I don't know of any fintechs that are really doing deposits. I think more are trying to find a way to do that. They are doing online savings, but those deposits tend up -- end up back at the banks anyway. And if it comes back to the bank to loan out, the banks are somewhat indifferent of how it got there. In fact, if they don't actually have to deal with the customer and just get the deposits, one could argue that's better. So again, I'll try to keep this to not-the-dinner discussion but the shorter answer on a public call. Yes, we're very cognizant of it. When we're evaluating a bank for investment, technology is part of it. On the other hand, if you have a bank that has a way below market cost of deposit funding, even if they're not super great on technology, and because of that huge price advantage, they can undercut lending, that works for us too. So technology is part of it, but it's part of a much larger discussion around the industry that I think becomes a more level playing field for small banks versus large and probably isn't terribly at a threat in the next few years to out-of-market disruptions to a regulated industry.

Okay. That's terrific, good perspective. Just one maybe quick modeling one, just if I may, then I'll hop back in the queue. If we operate under the assumption that new interest rates are rising, let's say across the curve, and I would assume there should be incremental pickup on the asset yields, and so there'll be income pickup there. How should we think about [absolutely] the credit facility floating? Any appetite to hedge that out? Or just how you're thinking about that because there is kind of you would see some impact on both sides of the balance sheet.

We would. Keep in mind, it's one thing that probably gets overlooked. Underneath community funding from 2015 and underneath the thing we just did is 10-year fixed rate debt. It's entirely fixed rate. So we've locked in the spread on that, right, which does comprise a good amount of assets. Yes, we have a floating rate facility, and Pat and I and the board talk about it each quarter, whether we do or don't want to term some out. But to term some out, you have to term it out. And right now, we have not a whole lot of leverage at the company. Now we're going to go into that over the coming quarter and quarters and we'd like to get to fully deployed. At that point, we should look at whether we term it out. But right now, we just have such little leverage it actually has very little effect on our sort of free cash flow because it's such a small percentage of our balance sheet right now.

Yes. Okay, great. That's very helpful and it's a good point on the pooled transactions.

Our next question comes from the line of Christopher Testa with National Securities.

Just touching a little bit on what Devin was just bringing up about the interest rate sensitivity of StoneCastle. Could you give us an idea of how much of the preferred securities that you guys own have a fixed to floating component?

Most -- well, the TARP Preferreds don't, but the direct preferred that we've done, they do have a float component to it above a certain threshold. So they're kind of fixed to a level, and then if floating rate goes above that, then they tend to float. So anything that's sort of past 10 years, we tend to want to have a float component to it, if we're doing it direct. That said, because you bring up the interest rates, I would be remiss if I didn't remind folks that when interest rates go higher, banks make more money. And so their credit quality improves, which one could argue spreads should tighten if a credit quality gets better. So banks are quite the opposite of most corporates in that their credit improves in a higher rate environment where most corporates, especially leverage credits, tend to get worse as rates move up. So there is that counterbalance of credit quality related to the rates. But of course, as we roll new investments, we should be able to benefit somewhat from those rising rates because if the 10-year is going higher, the 30-year is going higher, then we can even set the fixed rates higher.

Got it. And Josh, what's kind of a trigger for it to go fixed to floating? Is it just a set rate going above a certain level? Or is it if you structure 10-year paper after 5, it will automatically float? Just any color there is appreciated.

Sure. Each deal is different. Most of our 10-year Tier 2 capital is fixed rate. The market convention for larger banks tend to be fixed for 5 years and floating at LIBOR plus the spread. In our Katahdin transaction, which is one of these preferreds that has a float component, it's sort of every quarter, it's the greater of, the greater of LIBOR plus the spread or the fixed rate they're paying. So it's measured each quarter.

Got it. That's very helpful. And is that -- correct me if I'm wrong, but if a bank is basically taking the 10-year, perhaps that's very favorable from a Tier 2 perspective and then that benefit is effectively kind of goes away past 5 years or so? Is that correct?

If it's a 10 noncall 5, which is fixed for 5 and goes float, then yes. A lot of banks, right now, if they're given the choice, they prefer to lock in 10-year fixed. Their view is potentially higher rates. But that has also been lowering the capital cost of our banks, which makes them more competitive when they're making loans. So there is that sort of double play in that, okay, yes, maybe our borrowing costs, which can max out at 0.3, and right now it's well below that, will have a little of that effect. But it makes the bank that we're helping to provide capital to more competitive if they're locking in 10-year capital at a fixed rate. So we kind of like the benefits on both sides. If we have a bank that we do a fixed to float, then yes, they could call it out after 5 years, but then the spreads would have to have tightened otherwise they're indifferent anyway and then their capital goes up. So it's [6 on one and half a dozen] on the other. I would rather earn a little less and have a better quality bank than earn a tiny bit more and have a slightly worse risk profile. But that's just us.

Now those are great points. And looking at -- obviously, the CECL aside, just when we see kind of equity to assets at banks over 11%, it seems that they've been equity-heavy for quite some time here. Are you expecting increased debt demand relative to equity just for that reason, I mean, CECL aside?

Well, yes. I mean, if you look at the average bank ROE right now, it's a little over 9%, give or take, based on the most recent FDIC reports. And so if you raise, let's say it was even, our average rate, which is around 9%, which would be a little high on where the market is at this minute. After tax, that's like 5.5%, maybe 6%, right. So you could basically pay 9% and suffer dilution and be giving away the future book value and change in price-to-book or you can do a nondilutive after 6-ish percent, 5.5% after tax. That's kind of a no-brainer. As CECL comes into play within the next couple of years, Tier 1 capital, actually, you start losing capital above a certain threshold. I won't go into the details because it's lots of fun accounting math from FASB, but generally, over a 1.25% reserve for loan losses, you start deducting the excess from capital. I didn't write the rules, we're just living by them, and so are the banks. And so one thing that doesn't get deducted is Tier 2 capital. So you can raise more Tier 2 capital to solve this excess reserve that accounting is going to make these banks have. So why would you raise common equity dilutive when you can actually use it? It's exempted from the rule. So I think we're going to see more Tier 2 need there. We're also, depending on how overequitized banks are, because they haven't been taking losses, they've had good earnings, which means their Tier 1 capital ratios, as you just noted, are getting higher and higher. Eventually they're overcapitalized and they want to buy back some shares. Well, you wouldn't issue equity to go buy equity, you'll issue some tax-deductible Tier 2 to buy back some Tier 1 that you don't need.

Got it. Yes, now that's great color. And just kind of a more of a housekeeping item. Aside from the reversal of prior depreciation on the $375,000 gain, what else drove the unrealized depreciation during the quarter?

The big one this quarter was the [MM] caps position. So 2 things on that one. On that alone, the change in unrealized for that was $775,000. And basically, roughly half of that had to do with a gain that we realized for the quarter. So that gain came out of unrealized. And then the other piece of that was that position was marked down from September to December. And that just reflected the fact that, for that position that was called at par, one of the securities in there, one of the underlying banks paid off in full, so as a result, there was a decrease in asset coverage and interest coverage there.

(Operator Instructions) Moving on to our next question, it's from Bryce Legg with Robert W. Baird.

Josh, just curious in regards to CECL, I assume you've kind of taken that message to the banks that you talk with, the bank boards and bank management teams that you talk with. Is that -- is it resonating at this point? And are folks kind of trying to be early adopters and taking down some sub debt to supplement the Tier 2 capital loans?

Not yet. So there was an article written on SNL and there was a bit of a webinar that people can go look at publicly. I think they made it available to listen to around the topic. The American Bankers Association added that to their CECL repository and then folded that up to their banks and it was a write-up that isn't public. But ABA sent it to all of their banks, saying that, "Look, we looked at the paper that StoneCastle and Bank Treasury Newsletter wrote." And while there is some oversimplifications, you have to, if you're talking about the whole industry. They said, "We actually had a bank come in with their own specific case and the numbers were remarkably similar." I'm sort of just citing what they had said, which isn't confidential, but I don't know if its easy to see publicly. So it was serious enough and scary enough in terms of the change of what a bank will report as its capital ratio. Remember, this doesn't have anything to do with real losses. It's just accounting changes that I don't disagree with, which is we had a crisis, banks generally were underreserved going into the crisis, and even though things are hunky-dory right now, there will be another hiccup in the market, there always is, just a question of when. And so the accounting standards globally, truly globally, IASB and FASB, want banks to reserve more, and that more, with the air quotes, is for the life of a loan, not just the short-term reserve. And so that is going to compel banks to have to raise capital just to maintain their capital ratios. But I would say it's not accurate to say that we've scared them out of their wits and they're running to market. No, but we're -- look, we've been an inventor and an early visionary in the bank credit space for decades, personally and here at StoneCastle for 15 years, long before StoneCastle Financial went public. And so we were very involved with the Fed reserve in developing the community banks' stress testing models based upon the way we looked at credit before those were invented. And so I think we're early on this because the focus in the industry around CECL right now is how do I quantify it, like how do I calculate it, not what are the implications and we want us to be early in starting to get banks to be aware of. Look, you don't have to have a super sharp scalpel, a butter knife would work. Just start taking a general view of what would happen if you had to reserve for the life of loans based on certain assumptions, even if they're rough. And if they're enough to scare you, you need to be on this now. And the ABA's accounting policy folks agreed and said, "Banks should be thinking about this." So it's early, but we wanted to be early.

Got it. That's good, that's good. Good color, good commentary. Maybe one follow-up question. You noted the activities subsequent to year-end here in the first quarter of 2018. Just curious if you've seen any repayment activity thus far in the first quarter to go along with the origination activity.

Normally, we would sort of release that with the Q1 numbers, but I would just say, generally, there's nothing out of line with our historical trends. It's probably about as much as we should say right now.

Thank you. At this time, I will turn the floor back to management for closing remarks.

Thank you, operator. To our colleagues and shareholders, we thank you for listening, and we look forward to a prosperous and successful '18, and we'll talk to you soon.

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