Gladstone Investment Corp (GAIN) 2010 Q2 法說會逐字稿

Good morning and welcome to the Gladstone Investment Corporation's second-quarter ending September 30, 2010, shareholders conference call. (Operator Instructions). Please note this event is being recorded.

I would now like to turn the conference over to David Gladstone. Please go ahead.

Well, thank you, Amy. Thank you for that nice introduction, and hello and good morning to all of you out there in radio land. This is David Gladstone, Chairman of Gladstone Investment. And the symbol on our stock is GAIN.

Thank you all for calling in. I am always very happy to talk with shareholders. If you are ever in the Washington DC area we're in a suburb of McLean, Virginia. And if you want to come by and say hello, we will be glad to say hello when you come by this area.

Now I need to read the statement about forward-looking statements. This conference call may include statements that constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934, including statements with regard to the future performance of the Company.

These forward-looking statements inherently involve certain risks and uncertainties. Even though they are based on our current plans, we believe those plans to be reasonable. There are many factors that may cause our actual results to be materially different from any future results that are expressed or implied by the forward-looking statements, including those factors listed under the caption, Risk Factors, in our periodic filings with the Securities and Exchange Commission. And those filings can be found on our website at www.GladstoneInvestment.com and also on the SEC's website.

The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

First up for your talk today is David Dullum, President of the Company. He will cover a lot of ground, including view of the future of this fund. David, head out.

Thank you, David. Good morning to you all. To review briefly, your Company, Gladstone Investment, or GAIN, is an investor in buyout transactions of lower middle-market businesses. We partner with the management teams and private equity sponsors in these transactions to facilitate the necessary leverage and best financing solutions.

We also may find opportunities to provide capital in support of owners and management teams who wish to achieve partial liquidity by selling a portion of their business.

[Our] primary investment types are subordinated debt, which we combine with preferred stock or common stock and sometime with warrants to buy common stock. This approach allows us to generate income for dividend distributions on a current basis, and the opportunity for future capital gains.

We demonstrated actually that the benefits of this approach is our sale of our portfolio companies, A. Stucki, in the second quarter. And we have reported on this in the last earnings call. We are currently, we believe, in a favorable investing environment for our type of financing and are seeing increasing new deal activity.

Returning to the fund activity, for the quarter ended September 30, 2010, we invested about $3.6 million in some of our existing portfolio of companies. We did not make any new investments during that quarter.

As a result of those activities at the end of the September quarter we had $182 million invested in 13 buyouts at cost, and $5.4 million invested in one syndicated and one non-syndicated loan, for a total portfolio cost of about $187.4 million and total assets of approximately $213 million.

However, subsequent to the quarter end, actually on October 29, we closed on and invested $25 million in a new buyout. The company is called Venyu. It provides disaster backup and recovery of data and information, as well as manage data hosting for midsized enterprises.

This investment was in support of the management team where we provided a financing of subordinated debt and the equity to supplement the management's equity contribution. We are very excited about this opportunity going forward.

In terms of our portfolio companies, in general the portfolio companies are performing well and we are seeing improvement in spite of the current economic environment. We continue to emphasize the portfolio management activity, which is one of our strengths, and an important part of our investment management approach of working to limit losses and preserve cash flow from our portfolio companies. This is important, and I do keep referring to this in quarterly calls, as limiting losses sometimes can be as important as actually making gains.

The portfolio management team continues to provide value-added services such as strategic and business planning, operating management support, and facilitating interaction between portfolio companies management teams. This allows for an exchange of ideas such as best practices in purchasing pricing and manufacturing disciplines.

As far as the marketplace opportunity for us, we are seeing a pickup in activity and improvement in quality of the transactions that we are looking at. Key factors contributing to this are the economy and financing availability. The current economic conditions still create uncertainty around earnings and cash flow of the lower middle-market companies, though we are starting to see some stability in this area.

Those companies that have been well-managed and made it through the downturn, thereby proving their resiliency, are actually those that are contributing to this increase in merger and acquisition activity.

Additionally, senior secured loans, and some what we call cash flow loans, are becoming more available with attractive interest rates. As a result of these factors the good companies are attracting the attention of buyout funds and also themselves looking for some liquidity.

So while the buyout funds are providing around 50% of the equity in the capital structure of these transactions, they still need the subordinated debt and the equity investment, which we provide.

As far as new deals are concerned, having successfully navigated the many challenges of the past year we have been able over the past few quarters to turn our attention to increased marketing and more serious investment analysis. As a result, we are experiencing an increase in the flow of both the quality and the number of new opportunities for our type of financing, and as I previously mentioned, our recently closed new buyout transaction, Venyu.

We also have a number of other very good prospects where we have issued Indication of Interest Letters. These Indication Letters are actually the beginning of our review process on new investment activity and building a pipeline.

We do continue to be cautious about the economy, and will be diligent in our pursuit of new investments. And we have very good capacity for new investments resulting from the funding availability of our two-year line of credit and the cash receipts from the sale of the last quarter of A. Stucki, as previously mentioned.

Nothing has changed in our goal and outlook for this fund, which is to maximize our monthly distributions to shareholders, while achieving solid growth in the portfolio of proprietary investments in the lower middle-market buyout area. We are well-positioned to follow this path.

David, this concludes my part of the presentation.

All right, thank you, Mr. Dullum. We are excited about the future of this fund. But now let's hear from our CFO, David Watson, on the fund's financial performance this quarter. David.

Thank you, David, and good morning everyone. Before I go through the financial statements, I would like to highlight several key points for this quarter end. First, we believe our portfolio is generally performing well. This is reflected in the net increase when one excludes the unrealized depreciation related to Galaxy, and the valuations during the quarter of $5.8 million, which followed the net increase from the prior two quarters of $19.4 million. The good performance is also reflected in that all but one of our companies are current with interest and principal payment.

Second, at the time of this call we have nothing borrowed on our line of credit. And we have about $15.2 million in cash.

Third, at quarter end we purchased $25 million in short-term US treasury securities through the use of borrowed funds to satisfy our asset diversification requirements. This amount was $50 million less than in the previous quarters.

Fourth, net investment income increased 3% over the prior-year quarter and is on target to cover 100% of our dividend.

Lastly, subsequent to quarter end we made a new debt and equity control investment of $25 million in Venyu, which Dave touched on earlier in this call.

Now for the details, and I will start with the balance sheet. At the end of the September quarter we had $213 million in assets, consisting of $142 million in investments at fair value and $71 million in cash and other assets. Included in the cash and cash equivalents is $25 million of US Treasury securities, which I previously mentioned.

Therefore at September quarter end, and we had $25 million borrowed via the short-term loan, nothing borrowed on the line of credit, and had $186 million in net assets. So we were less than 1 to 1 leverage on our senior secured borrowings.

We had a net asset value of $8.43 per share. Currently we have $166 million in investment at fair value, which reflects the recent $25 million we invested in Venyu, cash of $15.2 million and no outstanding borrowings. We believe this to be an extremely safe balance sheet for a Company like ours, and we believe our overall risk profile is low.

Moving over to the income statement. For the September quarter end total investment income was $4.3 million versus $4.9 million in the prior-year quarter, while total expenses, including credits, were $1.9 million versus $2.6 million in the prior-year quarter, leaving net investment income, which is before appreciation, depreciation gains or losses, of $2.44 million versus $2.37 million for the quarter last year, a slight increase of 3%.

Primarily due to additional other income resulting from the prepayment of a success fee by Cavert and reduction in interest expense and amortization of deferred financing fees during the current quarter, partially offset by reduced interest income due to a smaller portfolio.

Let's turn to realized and unrealized changes in our assets. Realized gains and losses come from actual sales or disposals of investments. Unrealized appreciation and depreciation comes from our requirement to mark our investments to fair value on our balance sheet, with the change in fair value from one period to the next, getting recognized in our income statement. Unrealized appreciation and depreciation is a non-cash event. For the September 2010 and 2009 quarter end there were no realized gains or losses.

For the September 2010 quarter end we had net unrealized depreciation of $9.3 million over our entire portfolio, which included unrealized depreciation of $15.1 million on Galaxy, primarily due to a restructure resulting in the conversion of $12.1 million of debt at fair value as of June 30, 2010 into preferred equity, and the subsequent application of the total enterprise valuation methodology resulting in a nominal fair value as of September 30, 2010.

As of June 30, 2010, the Company's fair value Galaxy debt using pricing obtained from Standard & Poor's Securities Evaluations Inc. So excluding Galaxy, we had $5.8 million in unrealized appreciation for the current quarter. The remaining net appreciation was primarily due to increased multiples and, to a lesser extent, performance in our portfolio companies.

Our entire portfolio was fair valued at 75.6% of cost as of September 30, 2010. The cumulative underlied depreciation of our investments does not have an impact on our current ability to pay distributions to stockholders, but does indicate that the value is lower, and there may be future realized losses that could ultimately reduce our distribution.

Now let's turn to net decrease in net assets from operations. This term is a combination of net investment income, unrealized net appreciation or depreciation, unrealized gains and losses. For the September 2010 quarter end this number was a decrease of $6.9 million or $0.31 per share versus a decrease of $18.1 million or $0.82 per share from the prior-year's September quarter.

The year-over-year change is primarily due to the $20.5 million in unrealized depreciation recorded in the quarter ending September 30, 2009 when compared to $9.3 million recorded in the current-year quarter.

While we believe our overall investment portfolio is generally stable, as demonstrated by three consecutive quarters of gains when one excludes Galaxy and continues to meet expectations. With the continued investor uncertainty in the current economy and credit markets, investors should expect continued volatility in the aggregate value of the portfolio.

Regarding our loan ratings, the risk rating system we use sets our proprietary loans, which represents over 96% of our portfolio, at a weighted average of 6.6 for this quarter, which is up from 6.0 during the prior quarter. Our risk rating system gives investors a probability of default rating for the portfolio with a scale of 0 to 10, with zero representing a high probability of default. We see the weighted average risk of our portfolio staying relatively the same as prior quarters.

Historically we had concentrations of variable rate loans in the syndicated markets, but we have sold or exited all but one syndicated loan.

Some of our buyout loans have variable rates. But we almost always have a minimum or floor in the rate charged, so if interest rates decline it will minimize the impact on our ability to make distributions.

We have $126 million at cost in fixed-rate loans or rates with a fixed floor, all in our buyout deal. In other words, 97% of our debt investments at cost have a floor or are fixed.

In addition, we purchased an interest-rate cap on $45 million of the debt on our credit facility in order to have some protection on our cost of funding when drawn if interest rates rise over the next two years.

As of September 30, 2010, we do not have any loans with paid-in-kind income or original issue discount income. PIK income would result in recording non-cash income from which we would have to distribute out to our stockholders under tax rules.

Currently all of our portfolio companies are paying, except for ASH, which remains on nonaccrual this quarter. In addition, we applied the interest payments that we did receive from ASH against our cost basis in the investment.

With that, we look forward to maintaining momentum in fiscal year March 2011. And now I will turn the call back over to David.

All right, thanks David Watson. That was a good report. That was a good summary of our financials. And I hope each of the listeners out there will read the press release and also obtain a copy of our quarterly 10-Q, which has been filed with the SEC. That can be accessed on our website at www.GladstoneInvestment.com and also on the SEC website.

I think the big news this quarter is that we have recovered from the recession and on the way back up. It is nice to have a positive outlook for change. We have had so much negatives over the past years. Earnings at the Company seem to be very strong today. We have a nice line of credit with BB&T and KeyBanc and room to borrow under the line.

We have a lot of cash to invest, although with this new investment of $25 million, we have about $15 million in cash and then $50 million on our line of credit. So we have room for another three or four good investments like we just made in Venyu.

At the end of last quarter we sold one of our good investments, obviously A. Stucki, for a very strong profit. We believe we have a few more of those coming along. And we are not looking to sell any of them until we have redeployed a little more of the capital that we have from this one.

But there are a lot of equity money out there looking for deals these days. The LBO world has about $462 billion worth of equity to deploy over the next three years, so we are getting phone calls and we are working at some of our portfolio companies and thinking about some sales.

But please know that some of the portfolio companies are doing very, very well, and that we may end up selling something, maybe not this year, but certainly next year in order to redeploy that money and go out and make additional investments.

As we redeploy the cash, you should see a much more in the way of income as we fund those new transactions with higher and stronger income components to them. While we can't make any promises or any guarantees about the future, I think as this fund continues to fund new deals with the excess cash and the borrowings it will be a really a fabulous fund with a great opportunity for the future.

There are still some things to worry about in the economy. We still spend some time at night worrying about these things. Of course, the cost of oil continues to stay around $80 dollars some a barrel. We think that is going to go up over time, because as the economy comes back out of this recession the United States will need more and more oil to run its factories.

And the United States is still much too dependent on foreign oil, and one kind of catastrophe in the Middle East could turn things upside down. So we do need to increase our own domestic energy sources, such as coal, natural gas, and my favorite, of course, is nuclear. We could build another 100 nuclear plants and pretty much eliminate the need to import any oil.

The trade deficit with China and other countries continues to drain the economy. As you all know, China subsidizes their businesses and then sells the products to us under the Free Trade Agreement. China has destroyed thousands of businesses in the United States. If you look at Southern Virginia or North Carolina, all of the furniture factories have now been destroyed down there, and most of them have had to move to China in order to keep up with the competition.

This causes great number of losses of jobs in the United States. And I think it is very difficult for me, and I hope for many other Americans, to watch these jobs disappear to places like China and Vietnam.

We are now worried about inflation. We continue to see the government print more and more treasury bills, borrow more and more money. We know the dollar is continuing to drop. We see big depreciation over the next 18 months as the federal government continues to print more money. Right now our government is out of control. And while we saw it change at least in the House of Representatives, I have no idea whether they will be able to stop printing so much money, and that is going to continue to destroy the dollar.

The amount of money being spent on the wars in Afghanistan and Iraq continue to hurt us. Again, I want to say we support our soldiers. We think they're wonderful. They are laying down their lives for us every day, and all we can do is hope that the war ends soon and they come home. And the bottom line is, of course, the war is draining our economy and we just hope it ends soon.

Even worse, of course, is the excessive spending by the federal government. They call it a stimulus, but government is spending trillions of dollars on wasteful projects. The so-called stimulus things that they are doing are filled with projects that have very little impact on job creation.

State and local governments are still in shock in terms of tax income. They are grossly over leveraged. There has got to be at least 40 states that are in deep trouble today. And as a result, they're going to have to work through that over the next six months to somehow turn that around.

Of all the money that is being spent to all of our consternation very little of that money is being aimed at small businesses. This is one of the biggest mistakes of the current administration, as well as the people in Congress.

Small businesses create 80% of all the new jobs. If they really wanted to create a lot of new jobs they would put a lot of money into small businesses. They are just missing a great opportunity to stimulate the small business area and thereby create a lot of jobs.

The Congress just says they are going to help small business, but they almost never do. And we really do need some kind of term limits on Congress to get a new team in there and somehow turn the stimulus bill that they are passing into long-term employment creation.

In other ways the US economy is still very strong, still moving along. If you're not in the housing business or not in the auto business or not in some of those that are related to that, the businesses continue to hum along.

But all the industries have suffered due to the bad acts of a few. And even though some of the companies -- I know we mentioned Galaxy a few minutes ago, backlogs there aren't as strong as we have seen them in years. The plant is flat out running at full speed in two shifts, trying to think about a partial third shift now.

It will take some time for us to get through these difficult times, but I am sure over time we can work our way out of the recession. I just wish we had more cooperation from our federal and state government.

We had this Company are very, very lucky that so many of our portfolio companies are still doing well. Even the one that we talk about, ASH, is paying. It is just that we have kept them on nonaccrual, and we are applying their payments to principal rather than interest. So as a result the principal payments that we get in are making that loan lower and lower, and our investment there smaller and smaller. And every day that Company continues to get better.

Employment is worse than we had forecast. We never expected the employment rate -- the unemployment rate to get as high as it is today. The government reports that it is 9% or 10%. In essence it is probably double that. And many states and certainly throughout the country it has to be closer to 15%, rather than the 10% that is reported by the government.

There are many things out there that we think are just continuing to hurt the economy. And the many aspects of the recession continue today, and are likely to continue for the next six months to a year.

I believe we are on the way back up. And we are certainly looking at companies that we think are on the way back up. And there are many companies that are showing very good signs in our portfolio. But I've got fooled by this before, in which I looked at the portfolio and didn't look at a lot of the surrounding companies and got fooled by how deep this recession was going to be. So we are not -- even though our companies are doing well, we are still looking at a lot of companies out there that are having problems.

Just to mention again our distribution is declared by the Board. And October we are $0.04 per month, so October, November and December. This is a run rate of $0.48 a year. The Board next meets in January and considers a vote of the dividend. We just have to get busy and build our income back up and hopefully get our monthly distributions back up.

Distributions today based on the price of $7.42 is the closing price yesterday, still extremely high. We have no plans to reduce the dividend. In fact, you should note that earnings for this year are outpacing dividends, and so we are in no danger of having to reduce the dividends, certainly for this year. This really means the buyers of the stock today are getting a fabulous return, and I hope more people will sign up to buy stock.

I keep doing dividend reinvestment. I know you would like to know how many more shares I am buying, and I'm trying to figure out how to report the dividend reinvestment that I do. It is substantial in all three of our companies.

Please go to our website today and sign up for our e-mail notification service. We send out no junk mail, and just news about your Company. Our website is www.GladstoneInvestment.com.

You know, folks, as far as I can see, the rest of the calendar year, certainly 2010 and the first part of 2011 looks much better than anything we saw in 2009. But we can only see a couple of quarters out, and we just want to be careful.

We are, of course, stewards of your money. And I think the worst is behind us today. And we are looking for -- we certainly have a good base to build on today and we are looking forward to some new investments -- some good new investments that will happen during the next three to six months.

With that I will stop and let the operator come on and field questions from those of you who have dialed in.

(Operator Instructions). Ross Demmerle, Hilliard Lyons.

Say, could you talk a little bit about the success fee that was paid this quarter, the timing of that? It looked like the Company didn't actually pay down the debt this quarter. I'm trying to figure out how that works.

Yes, Cavert made a payment on the success fees that they have accrued on their books to date of approximately almost $800,000. Even though there wasn't a change in control of the Company, we record success fees upon receipt into income. So you're correct that no additional investments were made into Cavert.

I think Ross is also asking the question, why would they do it. And the reason they do it is because they've got a tax deduction for paying it. They had a lot of surplus cash. They were in a good position. So they thought they would go ahead and pay some of the success of either they're going to have to pay at the end of when we exit the firm and pay it now and take the tax deduction of $800,000.

I see. Okay, thanks.

Let me add to that a little bit. I mentioned from time to time we keep thinking about our portfolio in a broad sense, how to best manage the various pieces and these are the sort of things we look at. Obviously consistent with continuing with good earnings growth and the right things to do for the businesses, so it's not just all about either taking a gain, selling a company and/or making new investments. We really actively manage the pieces of the portfolio.

Okay. And then the latest investment that you made subsequent to quarter end, can you give us a breakdown of how much of that was debt and how much of that was equity?

Sure. Roughly $19 million is subdebt, about $6 million is the equity. And as we typically do, that is consistent with sharing the equity interest with management. We actually in this case will have a controlling interest in the business.

Then can we expect some kind of upfront, I guess, other income in this quarter because of that investment?

Yes.

Thank you.

(Operator Instructions). John Rogers, Janney Montgomery Scott.

I just had a question on Galaxy Tool. I think you said in your comments that they're having a strong year. I am just wondering what led to the restructuring? And also looking at the fair value marks, the debt on this was at -- the fair value was 98% of cost. And it was surprised to have that sort of transition quarter-to-quarter.

Again, as David said, the backlog in the business is doing very well. As I mentioned, again, we actively manage our portfolios and go on and do the right things. And sometimes on a, say, temporary basis we might have to restructure the balance sheet for the right reasons. And over time we would potentially look to possibly even reverse that.

We have the flexibility given the capital structure. We like the business very well. And we did it, frankly, just to provide some flexibility in the business, allow the management team to have the cash flow necessary to build back up. As you know, that is in an industry where the commercial and the private aircraft industry had a downturn, but it is moving in the right direction.

So we feel very good about the business. The management is very good there. We are actively managing it, and right now we don't certainly see any major issues with that company.

Just so you know, we are always extremely conservative in terms of the valuations. We always err on the side of conservatism there just to make sure that we don't send a signal to somebody that something is doing well, when in essence it needs money to grow.

That is what we did here. Galaxy is now needing working capital to build back its cash that it has on the balance sheet. And so as a result the best way to do that is for us to take a back seat on part of our notes. And we did that, and we will -- probably at the end of the summer, we will look at this again next summer and say to ourselves that we want to put some of that back into debt and start getting paid down or maybe even pay the dividend on the preferred stock. There is lots of flexibility when you have control of a company.

I guess looking at the other parts of the portfolio, where you've got no value in the preferred and less than 100% of par, I guess, on the subordinated debt there is a Tread Corp., I guess, Country Club and Noble and Quench. It looks like those companies -- are those companies at risk that we might see something like this restructuring happen inter-quarter in the near future?

Surely there can be one or more of those doing it. My doubt is you will not see anything this quarter that we are in, but who knows. And sometime in the future you have to do those kind of things in order to build companies back up that have been through a difficult time.

But remember how we do our valuations on the equity side. The debt, of course, is done by Standard & Poor's. And we can argue all we want to, but they give us a number and that is what goes in the balance sheet.

But we do this idea of matching it with multiples in the marketplace. So as multiples have come down we have had to reduce our valuation of our equity and our preferred stock based on the total value of the company. And then as multiples are going back up, as they are right now, you probably will see some appreciation in the equity side of the portfolio. And certainly some of the subordinated debt and preferred come back into the money.

But we are pretty religious about following the multiples in the marketplace, and using those as adjustments to the price that we pay for the business. So if we used a multiple of 4.5 or 5 to buy a business, we adjust that 4.5 or 5 by whatever the changes going on in the marketplace.

Right now the marketplace is going up. As I mentioned, somewhere in my talk there is about over $450 billion of equity money out there buying businesses today. And those guys have got to get rid of that money -- get rid of is the wrong word -- invest the money in the next three years in order to make that not have to go back to the people that they got it from. So as a result they're busy buying.

As you see, the marketplace is extremely busy in the higher end or larger companies, and it is filtering down to the smaller businesses now. We are getting phone calls about portfolio companies, so don't be surprised if you hear some announcement from us of somebody coming in and wanting to pay a decent price for one of our portfolio companies.

Great. I guess along those lines it looks like Chase II Holdings had a pretty big increase in fair value of the equity piece. Is that multiple or increases -- or increases on the (multiple speakers).

(multiple speakers) multiples that are going on there, but also that company has done extremely well. A lot of their competition have faltered, and hats off to the management team there. They have done a great job of running that business -- that is in the business of selling doors -- through the recession. Not doors to homeowners, but doors to manufacturing facilities.

So we think there is a great management team there. And that was primarily due not only to their efforts of building the returns that they've got going in that company and the earnings going up, but also some multiple movement.

Okay, great. Thanks a lot. Thanks for taking my questions.

There are no further questions at this time. I would like to turn the conference back over to David Gladstone for any closing remarks.

Well, thank you all for tuning in. We look forward to giving you some good news next quarter. And that is the end of this conference call.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.