ArrowMark Financial Corp (BANX) 2020 Q2 法說會逐字稿

Welcome to StoneCastle Financial Corporation's Q2 2020 Investor Conference Call. (Operator Instructions) Please note, this conference is being recorded. I would now like to turn the conference over to Rachel Schatten, General Counsel of StoneCastle Financial. Thank you. You may begin.

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 this presentation on information available to us as of June 30, 2020. The company undertakes no duty to update any forward-looking statements made herein. All forward-looking statements speak only as of today, August 6, 2020. Now I will turn the call over to Sanjai Bhonsle.

Thank you, Rachel. Good afternoon, and welcome to StoneCastle Financial's Second Quarter investor call for 2020. Here with me today is Pat Farrell, our CFO. Like many organizations around the country, we continue to monitor the government response to the pandemic. StoneCastle Financial is now functioning in a hybrid environment of an in-office and remote workforce. The management and operations of the company continue to operate seamlessly between our Denver and New York City offices in the best interest of our shareholders and for the safety of our employees.

Now on to the second quarter financial results. During today's presentation, I will briefly comment on the banking industry and credit markets before commenting on the company. Then I'll provide StoneCastle Financial's quarterly results and portfolio review, and Pat will provide you with greater detail on our financial results before we open the call for questions.

In general, the banking industry remains cautious going into the second half of 2020, with many banks reporting increased loan loss reserves in anticipation of increased corporate default, particularly in industry sectors most affected by the coronavirus. Independent research in the banking industry continues to indicate that in general, banks came to the pandemic with adequate capital ratios, which is also reflected in our portfolio bank. Generally seeking, the banking industry is in a good position to withstand systemic risk in a prolonged economic recovery in both the global and US markets. Banks are also conducting stress tests for multiple economic recovery scenarios given the uncertainty of the pandemic. However, it is important to note that federal stimulus programs, including PPP, have been a positive for banks. Many banks are using the origination fees from the government programs to supplement loan loss reserves. As of this call, all of StoneCastle's underlying banks have reported second quarter results. Banks in our portfolios are reporting median net income up 9.3% versus the first quarter. In addition, our portfolio banks reported average Tier 1 capital ratios of 13.8%. Finally, StoneCastle's underlying banks reported change in median reserves of 16.7% and loan book growth of 13.7%.

Although we are cautiously optimistic about the banking industry, we are also guarded about the near-term economic environment as it will be dependent on the containment of the virus. Given this uncertainty, we have been proactive with our bank with increased communications in order to closely monitor the impact of the pandemic and any residual economic fallout. Based on this initial set of conversations, our banks are navigating the current challenge as well, but continue to be prudent going into the second half of 2020.

Now let me comment on the credit market for banks. During the second quarter, we saw credit spreads for banking-related strategies, recover to the mid-2019 level from the March decline. This was partly due to the Fed action, but also due to a competitive environment for attractive banking-related assets. Last quarter, we saw the secondary market active in both alternative capital security and community bank. In alternative capital securities, we are beginning to see a pipeline of primary issuance for the third and fourth quarters. In addition, we continue to see attractive yield for alternative capital securities in the secondary market.

Community banking origination in the primary market increased in the second quarter. The number of community bank issuances in Q2 were approximately 30, up from 6 in the prior quarter. Capital raise was $1.8 billion in Q2, up from $695 million in Q1. Banks were able to issue sub debt in the 5% and 6% range with some issuances in the 7%. With many banks' common stock trading below tangible book value, sub debt is a lower cost of capital when raising Tier 1 capital. This market activity continues to show the resiliency of the community banks.

Now I'd like to take a moment to review the investment characteristics of StoneCastle Financial. The company's investment portfolio primarily consists of investment-grade fixed rate assets. Our leverage remains relatively low. Also, StoneCastle Financial has a highly diversified community banking portfolio, as measured geographically across the United States and across large and medium corporations. Our largest state concentration is Missouri, with just over 8%. Generally, our community banks are in the rural markets. They cater to the local markets, primarily in real estate like multifamily or owner-occupied residential, C&I loans, and other small business loans. We see a new interest in people moving to suburban and rural locations and believe this will benefit our portfolio banks over the long term.

Now onto StoneCastle financial results for the quarter. We are pleased to report that net investment income for the second quarter was approximately $2.7 million or $0.41 per share, an increase of $0.02 per share or up 5% from the prior quarter. In the second quarter, the value of the invested portfolio was $165.8 million versus $132.9 million in the first quarter of 2020, an increase of 25%. The net asset value at the end of the second quarter was $20.27 per share, up $1.27 from the prior quarter.

Now let me turn to the portfolio view. During the second quarter, the company invested a total of $36.3 million in 4 alternative capital transactions, 1 common stock transaction, and 1 preferred stock transaction. The 4 alternative capital transactions contributed a weighted average effective yield to maturity of 8.4% and a weighted average yield to call of 18.5% to the portfolio. We were able to take advantage of the recent market dislocation in both community banks and alternative capital securities to add assets at a discount to par. For example, we purchased the 4 alternative capital trades at a weighted average price of $89.71 and the Community Bank preferred shares at a price of $93.50. We believe these types of transactions showcase our management's resourcefulness in providing attractive risk-adjusted assets for the company.

I would also like to point out that the $36.3 million of investments made in the second quarter was greater than the last 6 quarters combined. Also during the second quarter, the company received proceeds of $5 million from the partial sale of PFF and received a nominal amount of partial paydown. At the quarter end, the estimated annualized effective yield generated by the domestic portfolio, excluding cash and cash equivalents, was approximately 10.1%. The alternative capital securities were approximately 23% of the portfolio investment and community bank-related investments accounted for approximately 70% of the portfolio.

Since we added about $25 million of alternative capital securities in Q2, I want to spend a moment on the characteristics of these securities. The banks issuing these transactions are large global financial institutions, which are regulated in the U.S. The underlying corporate credits are primarily investment grade, U.S. large and medium-sized corporations, and to a lesser extent, multinational, large and medium corporations. The underlying corporate credits are highly diversified across industry sectors. With these securities, and in fact all our banking-related investments, the portfolio is managed for income generation and capital preservation. We also look at an investment capacity to offer total return to the portfolio. In alternative capital securities, we are seeing risk-adjusted total return scenarios between 12% to 13%.

Before I turn the call over to Pat, I want to touch upon the relative value of StoneCastle Financial's stock. At the quarter end, StoneCastle Financial stock traded at a 21.6% discount to NAV with a 9.6% dividend yield. This is in comparison to other vehicles, such as the financial sector SPDR Fund which had a dividend yield of approximately 2.6%, while the Invesco KBW index that traded at an approximate 3.5% dividend yield during the same period.

We believe StoneCastle Financial is also an attractive value relative to the Bloomberg Barclays U.S. Aggregate Bond Index, which traded at an approximate 2.2% distribution yield at quarter end. I would like to point out that as of June 30, StoneCastle Financial traded at approximately 680 basis points wide to the average dividend yield of the income-oriented vehicle peer groups I just mentioned. Now I want to turn the call over to Pat to discuss the financial results and provide details on the underlying net asset value of the company.

Thank you, Sanjai. As I do each quarter, I will present the financial results by going through the components of the company's quarterly results in detail. The net asset value at June 30 was $20.27, up $1.27 or 9.1% from the prior quarter, including reinvestment of dividends. The NAV is comprised of 4 components: net investment income; realized capital gains and losses; the change in value of the portfolio's investments; and lastly, distributions paid during the period. Let's review these components.

Gross income for the quarter was $4 million or $0.61 per share. Net operating expenses for the quarter were $1.3 million or $0.20 per share, resulting in net investment income for the quarter of $2.7 million or $0.41 per share. This compares to $0.39 reported in the prior quarter or up $0.02 per share. I would like to note that this quarter's net investment income of $0.41 per share provides adequate coverage to our $0.38 quarterly dividend.

Realized capital gains and losses in the quarter is the second component affecting the change in NAV. The net realized capital losses from investments were approximately $327,000 or $0.05 per share. Realized losses due to foreign currency transactions were approximately $437,000 or $0.07 per share.

Third component, changes in 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 second quarter, the portfolio recorded unrealized appreciation from investments of approximately $8.6 million or $1.32 per share and unrealized appreciation on written options of $287,000 or $0.04 per share. We are pleased to report that the total quarterly change in net unrealized appreciation on investments and foreign currency transactions is $8.9 million or up $1.36 per share. I want to point out, gains and losses from foreign currency hedging activities do not impact our net income.

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 June 26 to shareholders of record on June 19.

In summary, we began the quarter with a net asset value of $19 per share. During the quarter, we generated net income of $2.7 million, net realized capital losses on investments and foreign currency transactions of approximately $764,000, and the unrealized value of the portfolio investments and foreign currency contracts increased by $8.9 million. The sum of these components, offset by a distribution of $0.38 per share, resulted in a net asset value of $20.27 per share at June 30, which was up $1.27 from the prior quarter.

Looking forward, StoneCastle Financial will begin releasing a monthly net asset value, beginning with the month end of July 2020. We believe this reporting will allow investors a greater degree of intra-quarter transparency into the underlying value of the company's assets.

Turning to the valuations for our portfolio holdings, it is worth noting that a vast majority of the portfolio continues to be independently marked from broker-dealer quotes. For the quarter, approximately 84% of the portfolio prices or marks reflect a minimum of 2 quotations or actual closing exchange prices. These quotations represent an independent third-party assessment of the current value of the portfolio. This should provide a greater degree of confidence in the company's underlying value versus other publicly traded closed-end funds and BDCs that self-mark their portfolios.

At quarter end, the company had total assets of $174 million, consisting of total investments of $165.8 million and cash, interest and dividends receivable and prepaid assets totaling $8.2 million. Our dividend yield at the end of the quarter was approximately 9.6%.

Now let me update you on the balance of our credit facility. At June 30, the company had $33 million drawn from the facility or 19% of total assets, leaving $29 million available to draw. Based on regulated investment company rules, we may only borrow up to 33.3% of our total assets. Now I want to turn the call back over to Sanjai for closing remarks.

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

(Operator Instructions) Our first question comes from the line of Chris O'Connell with KBW.

I guess I just wanted to start with the investment pipeline. Obviously really strong growth this quarter, matching the past 6 quarters of growth in total. Is that pipeline still pretty full? It sounds like right now it's split evenly between the alternative capital investments and the traditional bank investments. Maybe just confirming if that's true, and then if you're seeing any stronger opportunities in one of the 2 kind of investment areas?

Sure. Thanks again, Chris. Yes. So we are very optimistic about the pipeline here in 3Q and 4Q. As it pertains to the community banking space, based on my previous remarks, the sub debt issuance market remains open for the community banks, and no reason to kind of expect a slowdown here going forward. A lot of that capital is helping shore up the balance sheet for the banks, so pretty happy to see that. And then in regards to the alternative capital space, traditionally speaking, 3Q and 4Q are fairly active quarters for the issuance. And based on what we see today, no reason to believe that's not going to happen. Actually, our pipeline looks fairly strong there. And so pretty excited about that also. And so we will -- as we have told you in our previous comments, we are very prudent and opportunistic as to how we kind of look at these investments from a risk-adjusted basis, and that was going to determine the mix going forward over the balance of 3Q and 4Q.

Great. And so you put on $25 million or so of the alternative capital investments. The near-term goal coming into the year for kind of the first half of '20 was about $30 million, so I'm sure there's at least $5 million more coming on in the back half of the year. Do you have a target for how much of the total alternative capital investments you're looking to put on in the second half of '20 or a general -- is there any limit to the amount that you're going to put on, either on a dollar basis or a percentage basis, in kind of the next 6 months?

Sure. So in short, we really don't have a dollar target for either community banking investments or alternative capital securities. Again, we look at each investment on a stand-alone basis and kind of measure their risk and rewards. So that's kind of how we look at it from an asset allocation perspective. In regards to the incremental $5 million, I'm fairly confident that we should get past that $30 million target during this quarter. And then we'll see kind of what the allocations look like between the 2 strategies going forward in the fourth quarter.

Got it. And I mean, just kind of going off that question, has there been any investments made already in the third quarter?

We are -- the short answer to that is yes. And we continue to grow that investment pipeline here during this quarter and next quarter.

Okay. Great. And then just a little bit more of a technical question. In terms of the realized losses from foreign currency transactions, is that -- I'm assuming that's related to the alternative capital investments?

That is correct. That is correct. And again, it's worth noting there that from a net asset value basis, it's basically neutral. And also, from a net income perspective, it's below the net income line. And I'll let Pat add a little bit more color to that. And we put those hedges in place basically to mitigate volatility and risk.

Yes. Let me jump in. So for those securities, it's through the hedging that we're doing there really is to mitigate risk and to have a neutral effect on the overall portfolio. The other side of those is on the actual (inaudible) portfolio of investments. So we have some very large unrealized appreciation on those securities that we purchased. It's actually about $150,000 in total. And roughly half of that or so has to do with the changes in the euro rate. And the balance of that being that those securities, we really did buy some of these at some very attractive prices, and that's the balance of that unrealized gain on those securities.

Got it. Makes sense. And then one final question, more I guess on the traditional bank investment evaluation. As you guys are evaluating the current portfolio credit quality as well as potential investments and their credit quality, I mean I know you have the rampart system with all the back data, but how are you guys evaluating kind of the nontraditional data that we're getting these days in terms of PPP investments maybe as a percentage of the provision or the reserve or as a percentage of loans and that fee income as well as the differences, whether somebody is already reporting on CECL or not as well as deferral. Loan deferral percentages and kind of the migration of those loan deferrals as we've only gotten about 2 data points here. But as we kind of look into the back half of the year?

Sure. So in short, it's nothing short of hard work, right? And so we roll up our sleeves and we start diligencing our portfolio companies, or banks here in this case, and it's great to be part of a diversified asset manager. And so from a resource perspective, we are not short of any. And also at a basic level, what we do is we pick up the phone and call our banks. And we have been, since the beginning of the year, we've spoken to a decent amount of portfolio banks and kind of understanding what's going on in the local markets. What's the composition of the bank loan portfolios? What is management's plan going forward? And I'll give you a couple of data points. Generally speaking, the PPP income during 2Q has, at least for our portfolio of banks, has almost mitigated the increase in the loan loss reserves. Number two, the deferrals that the bank saw during 1Q and in the earlier part of 2 Q, by time of June quarter were down like 80%. And a lot of the markets actually saw a pretty decent rebound. And again, remember, these are also rural communities that were not meaningfully impacted. And so from that, certainly we were pleasantly surprised, but in certain instances we kind of knew what would happen to these markets as the shutdown came to an end. And so we're using our S&L data, we're using data that we gather from talking to each one of our management teams to come up with a picture as to what the second half would look like.

Great. That's helpful. And one last small one, I think the monthly NAV disclosures will be great and helpful and I think investors will appreciate the transparency. Does that come with any substantial incremental cost?

It does not. Yes, it's no -- definitely not any substantial cost. There may be a small increase in custody and accounting fees, but we actually monitor the portfolio right now monthly already. We actually do our own internal NAV calculation on a monthly basis to monitor the portfolio. So in this case, we're just going to firm that up a little bit tighter and then publish that number. I'd expect to publish that probably around the third week after month end, except for like the semiannual and the annual report, where we have much more robust financials to put together. And in those cases, I think it might slip a little bit from there.

(Operator Instructions). As there are no further questions left in the queue, I would like to turn the floor back over to management for any closing remarks.

Thank you, Operator. Thank you all for listening. We appreciate your continued support of StoneCastle, and I look forward to speaking with you on the next quarter's call. Thank you, and have a great evening.

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