FS KKR Capital Corp (FSK) 2016 Q3 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to FS Investment Corporation third quarter 2016 earnings call.

(Operator Instructions)

Please note that this conference is being recorded. At this time, Dominic Mammarella, Director of Investor Relations, will proceed with the introduction. Mr. Mammarella, you may begin.

Thank you, Crystal. Good morning and welcome to FS Investment Corporation's third quarter 2016 earnings conference call.

Please note that FS Investment Corporation may be referred to as FSIC, the Fund or the Company throughout the call. Today's conference call is being recorded, and an audio replay of the call will be available for 30 days. The replay information is included in a press release that FSIC issued on November 9, 2016.

In addition, FSIC has posted on its website a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended September 30, 2016. A link to today's webcast and the presentation is available in the Investor Relations section of the Company's website at www.fsinvestmentcorp.com under Presentations and Reports.

Please note that this call is the property of FSIC. Any unauthorized rebroadcast of this call in any form is strictly prohibited.

I would also like to call your attention to the customary disclosure in FSIC's filings with the SEC regarding forward-looking statements. Today's conference call includes forward-looking statements, and we ask that you refer to FSIC's most recent filings with the SEC for important factors that could cause actual results or outcomes to differ materially from these statements. FSIC does not undertake to update its forward-looking statements unless required to do so by law.

In addition, this call will include certain non-GAAP financial measures. For such measures, reconciliations to the most directly comparable GAAP measures can be found in FSIC's third quarter earnings release that was filed with the SEC on November 9, 2016.

Non-GAAP information should be considered supplemental in nature, and should not be considered in isolation or as a substitute for the related financial information prepared in accordance with GAAP. In addition, these non-GAAP financial measures may not be the same as similarly named measures reported by other companies. To obtain copies of the Company's latest SEC filings, please visit FSIC's website.

Speaking on today's call will be Michael Forman, Chairman and Chief Executive Officer of FSIC; Brad Marshall, Senior Portfolio Manager of FSIC and Senior Managing Director at GSO Blackstone, FSIC's Investment Subadvisor; and Jerry Stahlecker, President of FSIC. We will then open the call for questions. I will now turn the call over to Michael.

Thank you, Dom, and welcome, everyone, to FS Investment Corporation's third quarter 2016 earnings conference call. We appreciate your interest in FSIC.

On today's call, I will provide a summary of FSIC's key highlights and strategies, after which Brad will provide an overview of our investment activity, Then, Jerry will discuss our financial results in greater detail.

Corporate credit markets rallied in the third quarter of 2016 amid generally solid US economic conditions and stable commodity prices. As market sentiment and asset prices improved during the quarter, our primary focus was on leveraging the capital base of FS Investment's BDC platform and the resources and credit expertise of GSO Blackstone to improve the liquidity and operating efficiencies of our portfolio companies.

Net investment income for the third quarter of 2016 was $0.20 per share, compared to $0.23 per share for the second quarter of 2016, and $0.26 per share for the quarter ended September 30, 2015. The decline between the third quarter and the second quarter was largely attributable to reduced fee income, as the result of low direct origination volume, and the timing of certain prepayments that were pushed into the fourth quarter. Fee income totaled $4.2 million in the third quarter of 2016, compared to $16 million in the prior quarter and $3.3 million in the quarter ended September 30, 2015.

Adjusted net investment income for the third quarter of 2016 was $0.20 per share, compared to $0.24 per share for the second quarter of 2016, and $0.21 per share for the quarter ended September 30, 2015. As a result, distributions of approximately $0.22 per share were partially covered by accumulated undistributed net investment income. As of September 30, 2016, FSIC's total accumulated undistributed net investment income on a tax basis was approximately $0.63 per share.

FSIC's net asset value as of the end of the third quarter was $9.42 per share, compared to $9.18 per share as of June 30, 2016, and $8.82 per share as of March 31, 2016. NAV growth was driven primarily by unrealized appreciation in direct originations and opportunistic investments. It's important to note that we, along with our Board of Directors, work with independent third-party valuation service providers to mark 100% of the investment portfolio to market each quarter.

At September 30, 2016, approximately 97% of the fair value of the total investment portfolio was allocated to our core investment strategies. These strategies include direct originations, which generally offer the potential for higher yields and stronger covenant protections that may be found in the broadly syndicated markets, and opportunistic investments where we believe there is an opportunity to earn an attractive return on our investment by capitalizing on marketplace inefficiencies.

This is level investment in our core strategies has remained relatively unchanged for the past several quarters, and approximates our target allocations. We have also maintained a focus on investing in senior secured debt, which at the end of the third quarter represented approximately 72% of the portfolio based upon fair value.

With that, I will now turn the call over to Brad to discuss our investment activity during the quarter. Brad?

Thank you, Michael.

Given the continued strength of the credit markets and the materialization of some of our opportunistic transactions, we were a net seller of assets during the third quarter. On September 27, Caesar's Entertainment Operating Company announced it had reached a resolution with its creditors.

Our first-lien loan position on average has rallied over 40% since the start of 2016, and during the third quarter we began to opportunistically exit this investment. Other exits during the quarter were driven primarily by refinancings, and the prepayment of certain direct originations.

With respect to new investments, our primary focus during the quarter was in providing additional capital and operational support to our existing portfolio companies. Total purchases for the quarter were $217 million, 89% of which were first-lien senior secured loans.

Looking forward, given the overall strength in the credit market, we expect similar levels of activity in the fourth quarter of 2016. We will look take gains where appropriate, and continue to free up capital and take advantage of a very healthy new investment pipeline. We expect that we will be able to match our capital availability with new in investments during the fourth quarter.

We continued to use the size and scale of GSO's direct-lending platform and FSIC's capital base to identify, source and structure investments with attractive return profiles. As of September 30, 2016, the gross portfolio yield prior to leverage and excluding non-income producing assets was 10.2%, unchanged from the prior quarter. The average leverage for our direct originations through the respective tranche in which we invested, excluding equity and collateralized securities, was 4.8 times compared to 5.4 times as of June 30, 2016.

All of our directly originated portfolio companies have access to Blackstone's group purchasing organization program, which leverages the collective buying power of Blackstone's portfolio companies to reduce operating expenses. This potentially leads to improved EBITDA margins for the participants, and ultimately better credit metrics for our portfolio companies, and in turn stronger performance for FSIC. As of October 24, 2016, FSIC portfolio companies that participated in the program had average savings on addressable spend of 21.8%, increasing EBITDA for those companies by an average of 4%.

As of September 30, 2016, we had five investments on nonaccrual, which in aggregate, represents only 0.7% of the portfolio based on fair value and 2% of the portfolio based on amortized costs. We are working with all these companies to maximize our recoveries. Since quarter end, two of these nonaccruals, Sandridge Energy and Warren Resources, were restructured and exited bankruptcy. For our standard senior secured bonds we received convertible debt and common equity, and we exchanged our warrant first-lien loan for reinstated first-lien paper and common equity.

Since FSIC's inception, where FSIC's portfolio companies have defaulted on their debt, the fund's average recoveries have been in excess of their corresponding cost basis. Which means we have made money in aggregate when a company has defaulted. We work hard as an equity owner, and as GSO is part of Blackstone, we have many tools at our disposal in order to maximize our recoveries in the event a default. We are actively working to restructure a handful of portfolio companies, which may result in an increase in equity securities.

Equity comprised approximately 15% of the portfolio as of September 30, 2016 based on fair value, up from 14% as of June 30, 2016. This increase was largely due to appreciation in the value of the underlying equity securities.

Now let me turn to our energy portfolio. Energy-related investments as of September 30, 2016 comprised approximately 12% of FSIC's investment portfolio based on fair value, unchanged from quarter-end June 30, 2016.

As a whole, our energy portfolio continues to perform very well, as the net change in unrealized appreciation on energy investments during the third quarter of 2016 was approximately $9.2 million or $0.04 a share. On a year-to-date basis through September 30, 2016, the net change in unrealized appreciation on energy investments was approximately $72.2 million, which was partially offset by realized losses of approximately 1.8 million has contributed approximately $0.29 per share to NAV appreciation.

Since quarter end, it was announced that the parent of Plains Offshore intends to repay FSIC's preferred equity investment in the Company during the fourth quarter. As a result, our investments should be repaid at approximately 110% of par, despite having made the original investment in 2012 when oil prices were near $100 per barrel.

I will now turn the call over to Jerry to provide additional details on our results.

Thanks, Brad.

Net investment income for the third quarter of 2016 was $0.20 per share, compared to $0.26 per share for the third quarter of 2015. Adjusted net investment income for the third quarter was also $0.20 per share, compared to $0.21 per share for the quarter ended September 30, 2015.

As Michael noted, fee income during the third quarter was lower than the previous quarter, primarily due to delayed prepayments and lower direct originations. Lower fee income was partially offset by higher interest income, which increased approximately 2.2% in the third quarter as compared to the second quarter of 2016.

In the third quarter of 2016, we declared our regularly quarterly distribution of approximately $0.22 per share, which was paid on October 4, 2016. For the fourth quarter of 2016, we have also declared our regularly quarterly distribution of approximately $0.22 per share to be paid on or about January 4, 2017, to stockholders of record on December 21, 2016. Subject to the timing of expected prepayments and new direct originations, we expect to cover our fourth-quarter distributions from interest, dividend and fee income generated during the quarter.

NAV was $9.42 per share as of September 30, 2016, compared to $9.18 per share as of June 30, and $9.10 per share as of December 31, 2015. Resulting in a third quarter NAV return of approximately 4.8%, and a year-to-date NAV return of approximately 10.9%.

Net change in unrealized appreciation on investments during the third quarter of 2016 totaled approximately $62.9 million or $0.26 per share, which was attributable to broad-based appreciation across the portfolio. Net realized gains during the third quarter were $2.4 million or $0.01 per share.

At quarter end, FSIC's debt-to-equity ratio was 75.6%, compared to 76.4% as of June 30, 2016, and 82% as of March 31, 2016. Approximately 95% of FSIC's total borrowings were fixed rate as of September 30, 2016, with a weighted average effective interest rate of 4%.

I will now turn the call back to Michael. Michael?

Thanks, Jerry.

We at FS Investments believe our experience, scale and partnership with GSO Blackstone will continue to benefit FSIC investors. We are the largest manager of BDCs more than $18 billion in BDC assets under management as of June 30, 2016, and we believe our investment at FSIC -- we believe our investment in FSIC serves to further align our interest with our stockholders.

I would like to thank you for all joining us today. With that, we will now open the call for questions.

Thank you.

(Operator Instructions)

Your first question comes from the line of Jonathan Bock with Wells Fargo Securities.

Good morning. Joe Mazzoli filling in for Jonathan Bock. The first question relates to the dividend.

With NOI falling below the dividend in the quarter and leverage of 0.76 times, it appears that run rate NOI might hover just in line or even below the dividend at times. Now, of course, the market acknowledges that there are certain levers that you can pull to rotate out of equity or to originate at higher rates, but there are two questions here.

So the first, Brad, are you seeing higher new origination opportunities for unitranche, directly originated unitranche financings? And the second part is, what are the thoughts on the dividend policy going forward and the Company's ability to consistently meet the distribution?

Sure, thanks, Joe. This is Brad.

So to answer your question around origination, I'd say yes, we are seeing a lot of great opportunities. The pipeline is probably the fullest it has been in the past two years. So we are seeing a lot of good opportunities, and we are pricing those accordingly.

As it relates to the dividend, we'll fully cover in the fourth quarter. I think we had some deals that got pushed into the fourth quarter from the third quarter, and we were pretty busy selling assets just into a fairly strong market. But as you point out, we do have a fairly high equity balance, and if you look at those assets I think on average or on total they contribute about $0.07 to -- during the quarter in appreciation which is a good offset to the $0.02 of NII miss.

I think that's important to note, but we will be rotating it's probably about a half dozen of those names will be rotating out of equity, selling those positions, monetizing those positions and putting it into income producing assets. But at the end of the day, our goal is to maximize return to investors, and that's a combination of income and net asset value, and I think if you look over at this past quarter and the past two quarters FSIC has been a top decile or a top quartile performer, and I think the past two quarters it's over 11%. So we look at it on a combined basis, and we are seeing a lot of good opportunities in the pipeline.

Joe, this is Jerry Stahlecker. I think just to add to what Brad said, we've talked previously about the fact that the amount of fee income on a quarterly basis is going to be determined by the timing of expected prepayments. And those prepayments, the proceeds of which will drive our ability to redeploy that capital into new transactions of the type that Brad was talking about.

So we expect that fee income on a quarterly basis will be subject to fluctuation based on those timing factors, but over the course of a full year should approximate the normal range. And on a full-year basis, while we may undercover in one quarter on a full-year basis, we've historically more than covered which is why we have got $0.63 per share of undistributed income. Which we can use on a quarterly basis to the extent that timing causes us to underearn that quarter's distribution, we have got sufficient stop gap income that we can use until the next quarter when that fee income should return back to normal levels or flatten out over the course of the year.

Okay. I've got it, and that's very helpful and I certainly appreciate that combined perspective there. The next question relates to the investment portfolio.

So there was a very nice mark up in the New Star investment, the subordinated position. But it still held at 84. So could you provide some color here?

Was the mark up -- could you remind us, was the mark up related to improving technicals and NAV improvement at New Star, or is New Star working through some problem assets? What is the story there?

New Star continues to perform well. I think you can look at their earnings report. I think they reported this week.

They had one of their best quarters in a long time this past quarter. It continued to exceed our expectations from a portfolio performance standpoint, and I think the mark up in the securities during our mark up in our securities during the quarter was a combination of the improved valuation of the high-yield bonds. Which is a proxy for our security, and that's why the third-party valuation firm improved the value of those securities.

I think our view here and as we look at their portfolio, it's very, very strong. And we think it's a par asset once it gets repaid.

Okay. That is helpful. Thank you, Brad.

And now just the final question, obviously, the size and scale of the platform here is a significant benefit for FSIC shareholders. As there's substantial deal flow and lots of new originations in the pipeline here. And a lot of that is helped by the co-investment opportunities within the significant private funds.

So there is a lot of moving parts and changes to the business with DOL. So could you provide an update on the pace of fund raising through the private retail channels recently?

Sure, and this is Michael Forman. Certainly lots of change, regulatory change, and a lot happened this week as we all know. So you are in a period of uncertainty.

We continue to raise capital for FSIC III and FSIC IV in the markets. Perhaps not at historical levels, but still have by far the leading market share. We think over time as certainty returns to the marketplace, we will ramp up to historical levels.

So we think it's just a period of change. Commissions will likely come down, in any event, we will see what happens with the DOL fiduciary rule with the election of a candidate that may be opposed to it, but I think it's just great uncertainty. But we raised capital.

We also have fairly robust dividend reinvestment plans in each of our non-traded funds, and we take in a couple hundred million dollars or more in III and IV -- I'm sorry, in II and III, II is also private, which adds to available capital together with the turnover in the portfolio. So we certainly have opportunities. We have a very robust pipeline, and we have some capital coming in to take advantage of those opportunities across the platform.

Thank you very much, Michael, and thank you all for taking my questions.

Sure.

Your next question comes from the line of Terry Ma with Barclays.

Hey, guys, good morning. I just wanted to follow up on the equity investment for a second.

You guys mentioned you'll exit about half a dozen positions in the near term. Can you maybe quantify what the dollar value of that is? And also remind us how much of that is actually under your control versus market dependent?

Sure. So a couple of things, I think I said a half dozen names. And if I said half the names, I misspoke. About a half dozen names that are in the process of being sold. And a handful of those are in our control, but I think my reference is more to the fact that a process has started for a half dozen of those names which will conclude in the next 6 to 12 months.

Okay. Got it. Then, longer term, I think also from your prepared remarks, it looks like you were going to restructure some investments into equity. Longer term, is there a plan to reduce that exposure?

Reduce the exposure in some of the restructured equity positions?

Of just equity period.

Yes, I think the names that we expect to monetize in the next 6 to 12 months will get rotated into income producing securities.

Got it. Can you maybe give color on sequential [brands]? I think equity was guided down and stocks down 30%. What is your outlook for your investment in the debt?

Very strong. The stock was down 30% because they missed guidance, which is purely an equity issue in our opinion, given that there is over 50% subordination below our debt security. But the Company is a very, very strong debt story because the reoccurring revenue and contracted revenue nature of their assets.

The growth of those assets is more of an equity consideration. I think they have seen slower growth in some of their brands. But because it is a growth story, the equity markets are highly tuned in to the pace of growth.

But from a debt security, we are very well -- very comfortable with the asset. I think it's marked around 102% of par. So that is an indication of our belief in the asset.

Got it. And what is your outlook for any potential BDC legislation with the new congress next year?

So it's just probably a difficult time to predict what's going to happen in D.C. We continue to be very engaged through our D.C. office and our political affairs team, and we are monitoring it and leading the effort as the largest BDC sponsor.

So we are going to see how things shake out over the next couple of months. We will continue to push to move it forward if we think that the legislation will be constructive. So probably something we want to check back in on next quarter.

Got it. Then one last housekeeping question. Was there anything one time in the interest income line? It was higher Q over Q. And it looks like the portfolio size was lower and yield was also lower. So was there anything one time in there?

Maybe a third of the increase was from accelerated LID on some names that got pre paid or repaid. But beyond that, it was just incrementally higher income in this quarter over the prior quarter.

Okay. Got it. That's it for me. Thanks.

Sure.

Your next question is from the line of Arren Cyganovich with D.A. Davidson.

Thanks. Brad, you'd mentioned the pipeline is relatively full. We heard from some other BDCs that's somewhat conflicting I guess in this quarter, but we're hearing that it's a fairly frothy market in some aspects of the middle market. What are you seeing from a pricing and structure area that is enough for you to overcome those issues that you can fill your pipeline as full as you think it is right now?

I've got an exact opposite view. The pipeline is very strong, and it's not uncommon for this time of year for that to be the case because a lot of people want to get deals done before the end of the year. So things that may have pushed into the first quarter of next year are getting pulled forward a little bit.

I think that's why there's -- the pipeline has accelerated. And I would say from a pricing and structure standpoint, I would say that we are seeing better pricing this quarter than we saw last quarter. So some of the deal flow that is coming in is more proprietary relationships that we have, versus more auctioned broadly available opportunities than maybe the rest of the market is seeing.

Okay thanks, that's helpful. And then I saw a news article that said that GSO has raised a $6.5 billion mezzanine fund. Can you talk about whether or not that competes outside of the BDC, or is it something you can co-invest? I'm just trying to understand if there's any ways to work with them or conflicts of interest in that side of it?

Sure. So GSO did raise a large mezz fund. We had an existing mezz fund in place, so it's a continuation of that franchise which focuses on large cap companies at the bottom of the debt capital structure or in preferred equity.

So it tends to use no leverage in its structure, and takes a lot of credit risk versus the BDCs that are typically using leverage and taking less credit risk by being at the top of the capital structure. But they're complementary in the sense that as we go to market, we are more relevant to the Street, more relevant to sponsors, and it allows us to deepen our relationships with those groups. So I think it's very positive for the BDC franchise.

So it's not exactly the same credit, it's a little higher cap outside of the middle market?

Larger cap businesses. They are typically making a junior debt investment of, let's just say, $300 million. So that means it's probably a company that has EBITDA of $200 million to $300 million, so more large cap type companies.

Got it. Thanks. And then just lastly, the Plains Offshore repayment, is the premium associated with that going to be treated as a gain or is that treated as fee income for the quarter?

It would be a gain.

Okay, thank you.

Your next question is from the line of Rick Shane with JPMorgan.

Hello, guys, thanks for taking my questions this morning. Look, obviously the fee income fluctuates quarter to quarter, and it's one of the reasons that you have retained the spillover income.

When we think about it on an annual basis, so we can smooth out for quarters, what is a reasonable dollar target, or should we think about it perhaps as a percentage of the interest income? It looks like historically it has been around 10% of interest income. Is that a reasonable way for us to be thinking about it, and headed into 2017, any changes from that pattern?

So think at the start of the year, we guided in the market that we would have fee income that was in line with 2015 which was in the mid-$40 millions. So that is a number we feel comfortable for 2016. It's a little bit early to say, but it's probably a number we will feel comfortable for 2017. But that is a rough number to use.

And you are right, it does move around quarter to quarter. But I think for modeling purposes, you're typically going to see a lot more fee income in your model for FSIC than you would for some of the other BDCs.

Okay. That's actually good context. I had forgotten that comment. That would suggest that fourth quarter, given we are three quarters in and where you are to get back to the mid-$40 millions has to be probably your strongest quarter in two years, or your second strongest quarter in two years to get there in terms of fees.

Yes, that's a good question. We are roughly $22 million in fee and dividend income through the first three quarters of the year. I don't believe that we will get to mid-$40 millions this year, but I think we will get to the high $30 millions, $40 million on a full-year basis. And I think historically, we have averaged anywhere from the mid-$30 millions to the mid-$40 millions, and where we followed in that range is -- fluctuates year to year but it's typically been within that range.

Fair enough. I didn't want my model to get too ahead of itself based on that last comment about the mid-$40 millions. Okay, fair enough. That's it for me. Thank you, guys.

(Operator Instructions)

With no questions, I want to thank everybody for their attendance this morning, and we look forward to our next call with you all. Thank you, operator.

This does conclude today's conference call. You may now disconnect.