Gladstone Investment Corp (GAIN) 2017 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Gladstone Investment Corporation's second-quarter earnings conference call. (Operator Instructions) As a reminder, today's conference may be recorded.

I would now like to introduce your host for today's conference, Mr. David Gladstone, Chairman. Sir, please go ahead.

All right. Thank you, Liz; nice introduction. And good morning to all of you. This is David Gladstone and this is the quarterly earnings conference call for the shareholders and some of the analysts that follow Gladstone Investment. Common stock traded on NASDAQ, symbol GAIN.

We also have some preferred stock out there, GAINO and GAINN and GAINM. You can remember it easy enough by saying "gain" and then the first three letters of "money," m-o-n. Then you just plug it in on the end of GAIN and you can look at the preferred stocks.

Thank you all for calling in. As always, we're happy to talk with loyal shareholders that like to listen to these calls and potential shareholders. We like to give updates on the Company and its investments and we like to give you a view of the business environment. Wish we could do this more often; try to do this in some of our press releases.

Also, you have an open invitation. We're here in McClean, Virginia, located just outside Washington DC, so if you are ever in the area and you want to stop by and see some of your team in action -- there's about 60 people now; I think they are the finest in the business.

You're going to begin to hear from our General Counsel and Secretary, Michael LiCalsi. Michael is also the President of Gladstone Administration, which serves as the administrator to all of the Gladstone public funds and related companies. He will make a statement regarding forward-looking statements and some other information. Michael, go ahead.

Good morning, everyone. This conference call may include statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933, the Securities Exchange Act of 1934, including statements with regard to the Company's future performance.

Forward-looking statements involve certain risks and uncertainties and other factors, even though they are based on our current plans, which we believe to be reasonable. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may, and similar expressions.

There are many factors that may cause our actual results to be materially different from any future results that are expressed or implied by these forward-looking statements, including information listed under the caption Risk Factors in our Form 10-Q and 10-K filings and in our registration statement, all as filed with the SEC, which can be found on our website, www.GladstoneInvestment.com, or the SEC's website, www.sec.gov.

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 after the date of this call except as required by law. Please also note that past performance and market information is not a guarantee of future results.

Please take the opportunity to visit our website, GladstoneInvestment.com, to sign up for our email notification service. You can also find us on Facebook under the keywords Gladstone Companies and on twitter @GladstoneComps.

The call today will be an overview of our results through September 30, 2016, but for more detailed information we ask that you read our press release issued yesterday and also review our Form 10-Q for the quarter ended September 30, filed yesterday with the SEC. You can access the press release and 10-Q on our website, GladstoneInvestment.com.

Now let's turn to David Dullum, President of Gladstone Investment, to get an update on the fund's performance and outlook.

Thanks, Mike. Good morning. I generally like to give everyone a quick refresher on who we are and what we do.

Gladstone Investment is a publicly-traded business development company, otherwise known as a BDC. And of course, we are focused on buyouts of US businesses in which annual earnings -- which means EBITDA, which is earnings before interest, taxes, depreciation, and amortization. Generally the range for these earnings or this EBITDA is between $3 million and $10 million; that's our area of interest.

The financial structure that we use for funding our buyouts usually consists of a secured first- or second-lien debt instrument in combination with a direct equity investment for a significant ownership position. So this combination of debt and equity in the individual transactions that we do produces our portfolio of assets. That gives us current income for monthly distributions to our stockholders and potential capital gains and other income upon the sale of a portfolio company, which then may be distributed to shareholders in the form of incremental dividends.

How are we different from other BDCs? Well, I wish to highlight that GAIN is not managed as a traditional credit or debt-oriented BDC. And so what does that mean? Well, we invest in operating companies and when we make an investment in a company, we take a significant equity position in that company as a component of a management buyout.

Now this differs from other public BDCs that are predominantly debt-focused and generally referred to as credit-oriented BDCs. For example, the current proportion of equity to debt, say, for the investments in our portfolio is approximately 28% equity and 72% debt at cost. Most other BDCs' portfolios are around 10% equity and about 90% debt, so pretty significant difference.

And this is intentional on our part as our strategy and the shareholder value proposition really are different than most other BDCs. In that, first of all, we want the debt portion of our investments to provide income to pay and over time grow our monthly distribution. Now this is similar to other BDCs.

However, along with the debt investment, we want to own significant equity positions which -- looking for an increase in value to provide the capital gains and the other income on it when we do make an exit. Now as we execute this strategy, these potential gains and other income may then be distributed to our shareholders in the form of incremental or special distributions. Clearly, with the underlying equity we hopefully and expect and will see an increase in NAV, which indeed is tied to these underlying equity values.

A further advantage to this approach is that as a provider of the equity and a majority of the debt in the transaction, we do have flexibility in the term and the interest rate on the debt and an influence over the downside protection, if necessary. Again, this strengthens our position in a particular portfolio company and provides an added level of protection, if you will, for our debt investments.

Now if we make investments, we also exit so what's our strategy there? Well, as our fund matures and we continue with new buyouts, we should expect turnover in the portfolio consistent with the strategy. Of course, we will generally be governed by market conditions and an assessment of the risk and return in continuing to hold an investment versus exiting.

What are results like? Well, since inception we have achieved eight buyout liquidity events, which in the aggregate have generated about $88.4 million in net realized gains and about $18.9 million in other income upon these exits, which is resulting in an aggregate cash on cash return on the exit of just the equity portion of those investments of approximately 3.8 times, which had an increase to our total net assets of about $107.3 million over time.

I should note that over the past 5 1/2 years we have also increased our NAV per share by about $0.27 per share, or approximately $8 million in total, even while increasing our shares outstanding from about $22 million to about $30 million through this period in the quarter end. Now consistent with these previous comments, we will continue to evaluate the sale of portfolio companies to the extent that market conditions remain favorable and company-specific performance will dictate such.

Now as we have done from time to time, we also may have to right-size the capital structure in a particular portfolio company, which would provide operating flexibility and improve the Company's future success. Again, we tend to try to keep our companies operating well and over time find exits and minimize the downside on these companies.

In this regard, and subsequent to quarter-end, we did restructure our investment in DPMS and we did this by exchanging our existing debt for a new term loan of the company which we will pay currently. We did relinquish our preferred equity and we did reduce part of our common ownership, allowing a significant upside for the management team.

So by relinquishing this equity, what we did was give it -- basically allowed the management to have a significant ownership position. This will also help the upside for our remaining common stock investment, which is still a pretty significant position in the Company. So while this transaction resulted in a realized loss, there was no impact or is no impact on NAV, given that we previously had unrealized depreciation on DPMS.

Now in terms of doing new deals, deal origination is very important. And we are mindful that whenever we sell a portfolio company it of course may reduce our income-producing asset base and income is very important to maintain our monthly distributions. Therefore, our deal-generation activities must have a high priority.

We have continued to increase our presence in the marketplace in many geographic areas. This will help us to generate new investment opportunities where our team is calling on folks such as independent sponsors, middle-market investment bankers, and other sources which will help to create a proprietary-type investment opportunity.

We do not depend on others, of course, to negotiate or structure our investments. Generally though, our investments do include partnering with the management teams, and as in the case of our investment early this year, The Mountains, we had management and sometimes we may have other sponsors in the purchase of a particular business. So our strategy of providing a financing package which includes both secured debt, the majority of the equity gives us a competitive advantage as it gives the seller or the independent sponsor, if one is involved, and the management team a high degree of comfort that the purchase will occur, at least from the financing perspective.

We believe that our strict adherence to investment fundamentals and our thorough due diligence process have enabled us to provide shareholder returns in both our consistent regular monthly distributions, as well as incremental distributions from time to time. We do continue to build our pipeline of opportunities and while we made no new investments in this quarter, we are actively reviewing and conducting due diligence on a number of potential investments.

And I should say that the current market valuations for buyouts is still pretty challenging and, again, our business is one where we have to -- we make investments and looking to acquire these businesses and it's not a consistent process. Now when we do make investments, the target for the equity portion of our investments is generally a minimum of 2 to 3 times cash-on-cash returns and indeed, based on our exits as we mentioned earlier, we seem to have been able to maintain those levels of returns.

For our secure debt investments, we -- primarily our first-lien loans, we typically carry a cash yield in the low teens which balances the equity portion of our investment; thereby producing a blended current cash yield which supports our shareholder distribution expectation.

Typically we also have what we call success fees, which are generally due upon a change of control. But these may be paid in cash in advance in limited circumstances at the portfolio company's option.

Now what is our investment focus? Generally, we invest in companies with consistent EBITDA and operating cash flow, which generally have a potential to be expanded. Areas of interest that we like are the sort of light and specialty manufacturing in companies such as G.I. Plastic in our portfolio falls in that category. Specialty consumer products and services. Examples of those would be Brunswick Bowling and The Mountain, which were recent acquisitions.

Industrial products and services. Examples there would be Counsel Press, a company in New York, and Nth Degree, a company in Atlanta. And from time to time, aerospace and energy and, frankly, historically we've really had minimum exposure here and right now we are not necessarily considering investing in this area, other than opportunistically if it really were to make some sense.

So with all of this, our activity this quarter, second quarter ending September 30, we only invested about $[2.2] million in existing portfolio of companies and we received about $[2.2] million in repayments and sales. I would add also that we were able to, and we previously announced, the successful issuance of our Series D term preferred stock in September, which generated net proceeds of $55.4 million. And this was to redeem a $40 million preferred which was coming due in February 2017.

So we are very excited about that because it showed an oversubscription to our efforts and also locked in a reasonably good long-term rate, given that this is a seven-year term preferred.

So what is the outlook? Our goal is to continue strategically, add accretive investments and position our existing portfolio for potential exits, thus thereby maximizing distribution to shareholders, with solid growth in both the equity and income portions of our assets.

And I will say that we are going to continue our diligence. We are going to continue our consistency in the way in which we think about new investments. We may have to go a period or two where we make no new investments, but at the same time we keep very concentrated on our current run rate of income, which thereby continues to produce the efforts we need and the levels of capital and income to pay our distributions to shareholders.

So with that I'm going to turn this now over to our Chief Financial Officer, Julia Ryan. She can give some more details.

Thanks, Dave, and good morning, everyone. As Dave just touched on, the fund had a strong quarter with the successful issuance of our new Series D term preferred stock and the generation of about $5 million in net investment income.

At the end of September we had over $499 million in assets, consisting of approximately $486 million in investments at fair value, $5.1 million in cash and cash equivalents, and about $8 million in other assets. Our portfolio's approximate allocation between debt and equity securities was 72% to 28% at cost. Our liabilities and equity at the end of the quarter consisted of $63.5 million in borrowings on our line of credit; $139.2 million in term preferred stock at liquidation value, which includes the new Series D; about $9 million in other liabilities; and about $292 million in equity.

Our net asset value per share was $9.65 as of September 30, which was down $0.19 from the prior quarter and which primarily resulted from net unrealized depreciation of $5 million this current quarter. This decrease was principally due to a small decline in the operating performance, such as EBITDA, of certain portfolio companies. However, overall RFI value to cost remains at over 90%.

Consistent with the previous six quarters, we continued to use an external third-party valuation specialist to provide additional data points regarding market, comparables, and other information related to certain of our more significant equity investments. We plan to continue this practice and update the externally-provided data on an annual basis for all of our significant equity investments.

Moving over to the income statement for the September quarter, total investment income was $11.7 million compared to $14.4 million in the prior quarter. Total expenses net of credits were $6.6 million versus $7.6 million in the prior quarter, leaving net investment income of about $5 million compared to $6.8 million in the prior quarter.

The decrease in total and net investment income was primarily due to little dividend income received this quarter versus the $2.8 million of dividend income received in the prior quarter related to our exit of Acme.

Other income was less than 1% of total investment income in the current quarter as compared to the 19% in the prior quarter. As we have mentioned on previous calls, we expect other income, which is primarily composed of success fees and dividend income, to remain meaningful but variable between quarters.

Net expenses increased by $1 million in the current quarter, which was primarily driven by a $1.2 million reduction of the incentive fee as a result of lower pre-incentive fee net investment income due to the decrease in other income as previously discussed. As a result of these factors, our net investment income per share was $0.17 per share in the current quarter compared to $0.23 during the June quarter.

Consistent with previous quarters, our current-period net investment income, together with undistributed net investment income from the prior period, or the spillover amount, more than covered our quarterly distributions to shareholders of $0.1875 per common share. Our distributions coverage ratio was more than 230% this quarter, which means that distributions were covered by current or prior-period income by over 230%.

As of September 30, total undistributed income was$[7.7] million or $0.25 per common share. We continue to actively manage our undistributed income with the ultimate goal to cover and over time increase distributions to shareholders. This may take the form of incremental periodic distributions.

Let's turn to realized and unrealized changes in our assets. Realized gains and losses generally result from sales of investments. Unrealized appreciation and depreciation is a non-cash event and is driven by the requirements to mark our investments to fair value with the change in fair value from one period to the next recognized in our income statement.

For the quarter ended September 30, 2016, realized activity was minimal. During the previous quarter, we recorded net realized gains of $18.6 million primarily related to the sale of Acme. We recorded $5 million of net unrealized depreciation in the current quarter, which was principally due to a decline in performance of certain portfolio companies and which we do not believe to be indicative of a permanent decline in value.

At September 30, our entire portfolio was fair valued at 93% of costs, which compared to 94% in the prior quarter. One portfolio company continues to remain on nonaccrual, representing less than 1% of the fair value and cost of all of our debt investments at quarter-end. Our debt portfolio is well-positioned for any interest rate increases with about 90% of our loans having variable rates with a minimum or a floor and the remaining 10% having fixed rates.

The weighted average yield on interest-bearing debt investments remained relatively consistent quarter over quarter at about 12.5%. This strong yield excludes success fees in our debt investments. It also does not include any paid-in-kind, or PIK, income as we do not currently have any debt securities with this feature.

Success fees are yield enhancements that are generally contingent upon a change of control, such as an exit or sale, although there are certain circumstances when the portfolio company can elect to pay it earlier. We recognize success fees in our income statement when they are earned, which generally coincides with the receipt of cash. For comparison purposes, if we had accrued these success fees, as we would if it was paid-in-kind interest, like many other BDCs do, our weighted average yield on interest-bearing assets would approximate 13.4% during this past quarter.

And at the end of the quarter, the success fees that are accruing off-balance-sheet totaled about $31 million, or $1 per common share. There is no guarantee that we will be able to collect any or all of these success fees or have any control over the timing of collection.

From a credit priority perspective, 100% of our loans are secured with 75% having a first-lien priority and the remaining 25% having a second-lien priority in the capital structure of the respective portfolio companies.

Overall, Gladstone Investment had another quarter of strong operating performance and financing success. We have maintained our distribution rate while remaining committed to covering our distributions with income, as we have done consistently in the past.

Now I will turn the call over to David Gladstone.

All right. Thank you, Julia; nice report. Good report from Michael and Dave. We are still on track to continue the strong results.

During this past quarter, we reported some of the great accomplishments and I think the Series D was a good indication that the market likes what we are doing. Additionally, we have certain portfolio companies on the path to being positioned for sale. We have offers on one and we are moving it along. Hopefully that happens in this quarter we are in.

We also have one that became public during the quarter -- right after the quarter, not in the quarter -- and this particular portfolio company, we don't have a significant impact on our portfolio but it's nice to have some publicly-traded shares in our portfolio. Lots of activity going on in the portfolio and I think you will be pleased that we will show some good success going into the third quarter of December 31, 2016.

Some of the people say we may be entering into a recession. We don't quite see it that way today. Our company is well-positioned. For example, we have a good diversification of deals across many different areas.

And some people ask me then what are you worried about? I have to go through this each time. Like everybody else, we are still watching which direction the Federal Reserve, or Fed, is going to go with its monetary policies. We have variable rates on most of our loans, so increasing rates is not going to hurt us, but it's really not good for the economy.

However, I doubt the Fed will raise rates again until there is a much stronger signal that the economy is improving. And even if they do it in December, as people keep talking about, probably only going to be 0.25% so it's more of a psychological rate rise than it is a big impact on us or many other people.

I think the reason that Janet Yellen at the Fed keeps pushing for higher rates is because she has to find buyers for all the money that she's borrowing using Treasury notes and T-bills. And to get people to buy these US Treasuries you have to have a good high rate to get people to buy them.

Anyway, turning over the volatility then in the oil and gas industry is one that we watch. Low oil prices, terrific benefit to the consumers in many businesses. We don't have investments in the oil and gas industry. They are not significant.

On the other hand though, you have to realize that the oil and gas industry is an integral part of the US economy and losses there will equal a lot of pain to the economic activity. I'm just glad that this Company doesn't have a lot of investments even related to oil and gas.

Then we worry about the federal deficit. No one seems to talk about that much anymore. $19 trillion at the end of the year that we've just started in September for the government; probably going to go well past $20 trillion. This spending is just putting pressure on the Fed to find more ways to bring money into the government so that they can meet their goals and objectives. But they are certainly borrowing at a furious rate and spending at a furious rate.

On another note, many of the private companies, like those we invest in, feel there is far too much regulation around all of those areas that are going on today. First of all, healthcare. A lot of activity in healthcare, it's hurt a lot of small businesses. Financial services, like our companies, are constantly seeing changes in regulation and increasing regulatory environment.

Energy emissions and now one that has popped up is minimum wages. We just see this hindering the performance and expansion of job growth, especially from the small business community.

We understand why big businesses move their operations out of the United States to places like Latin America and Asia, where there's less regulations and very low taxes, but midsized businesses then, similar to the ones in which we invest, end up having to hire manufacturing operations outside the United States in order to stay competitive. This is not good for our economy.

In light of these concerns, our Company, Gladstone Investment, has continued to be very selective in investing in new business we will keep [a] very conservative orientation.

In October 2016, our Board declared our monthly distributions to our common stockholders of $0.0625 per common share for each of the months of October, November, and December. It's an annual run rate of $0.75 per common share, which is consistent with prior quarters.

Just as a note, there are some number of BDCs now who have cut their dividend. We are not one of those, so don't look for us in that category. As mentioned before, we have about $7.7 million in our spillover reserve that we could use. We also, as many of you know, have cut our incentive fee in the past in order to cover the dividend, so don't look at us to be one of those that cuts the dividend. We're in a very strong position today.

Through the date of this call we have made 136 sequential monthly cash distributions to our common stockholders and additionally have made some special distributions in prior years. As of September 2016, we have distributed a total of $179.5 million at $7.92 per share of common shareholders. That's a great long-term record that we have out there.

The current distribution rate of common stock, which is common stock price about $8.40 yesterday. The current distribution rate is about 10.2%. That's a ridiculously high rate for a Company that's doing so well.

And if you don't like the 10.2% on the common stock, you can always switch over to the Series B. They are getting a 6.6% return today, so if you bought that. The Series C is running at about a 6.3% and the Series D is running about a 6.2%. So you've got your choice of preferred stocks if you want a lower yield, but to be in a preferred stock status.

In summary, Gladstone Investment is an attractive investment for investors seeking continuous monthly distributions and increased distributions over the potential capital gains that we should get. We expect a good quarter for December 31, 2016, and hope to continue to show you strong returns for the coming years.

Liz, if you will come on now, we will have some questions from the analysts and some of the loyal shareholders; start that up now.

(Operator Instructions) Mickey Schleien, Ladenburg.

Good morning, everyone. Dave, a question for you -- and I apologize, you may have commented about this in your prepared remarks, but I'm juggling a couple of calls at the moment.

But Danco Machine was extended, if I recall correctly, in the first quarter of 2015 and now it has been restructured. I was just hoping you could review what the issues are that are confronting them.

And I understand you have given management an equity stake. What are the strategies that they are pursuing to improve the performance of the company?

First of all, Mickey, the good news is that since 2015 they actually have improved the performance of the company. That's going -- back then we took the -- we made moves regarding management, improved the management team. We have a really strong management team now; it has taken us about this past year to work it through.

This was also a company that was made back in the sort of 2007-2008 timeframe, so it's been in our portfolio. While it's one that we had to essentially take more control over, if you will, it's one that was done with a smaller private equity firm. So that's just historic.

The business, though, it's a fundamentally good business and so with a good management team and with the progress they have made, we felt that we had reached a point where we don't have to put any more money in and we wanted to actually give incentive to the management team to really drive the business. So by restructuring it we've helped to reduce some of the burden on the business. The EBITDA has picked up nicely and looks to continue.

They've just recently done some interesting things, which I really can't talk about, with some major customers so we feel like the future looks very good and this is a chance now for management to be incentivized. At the same time, it gives us a solid base on the debt that we now have with them that they current pay and also opportunity for the significant equity position that we retained.

Appreciate it. Those are all my questions this morning. Thank you.

Laura Engel, Stonegate Capital.

Good morning. Thanks for taking my question. I wondered, given all that you discussed and the trends you are seeing in the industry and the potential rate changes, how that might affect your rate of these deals going forward. And if you are factoring in changes in maybe the size of the deals, being at the location or just the general mix of industry types to keep that diversification but keep the risk low as well.

Laura, Dave here. So you are referring to what we are seeing in terms of valuations; is that what you're touching on?

Well, yes. What you're seeing in the industry as far as going forward, your historical rates of doing these deals; how do you see that increasing or decreasing?

Then what you're looking at as far as steering clear of certain industries. I know there are some that historically you've stayed away from. But just looking forward if there's ways you're going to change the search for these companies and how quickly you move the deals through the pipeline?

Right. Okay, got it. No, we're not going to change anything. We think we've got a good model. We go out, we search. As you know, we have offices in a couple of the spots, LA and New York. We cover the Midwest from this area.

So we think we've got very good coverage and our managing directors and directors are out doing all the right things, beating the bushes. Our discipline around the industries and the areas that we like, as we mentioned in the script, we are not going to change that. And as far as the, I call it, production rate, we have to keep working hard to find companies that we think have the value that are necessary.

So what we are not going to do is make an investment at some silly or try to make an investment at some silly multiple of EBITDA, which is not going to either give us the return or, more importantly, might have to have it so highly levered that it puts it at a risk.

And this is not unusual. We've been through these sort of periods before and we just keep with the discipline of making the investments we make. We keep balancing with our current portfolio base, generating the income stream that we generate and we feel good about where we are. We just have to remain disciplined and, as I say to our team, a lot of shoe leather.

Right. Then I guess you referenced you are looking at several things right now and then specifically some comments about the upcoming quarter. Are there -- would you say there's deals in the pipe that are close to closing, even having just finished the sale of Acme and the purchase of The Mountain? Would you say -- can you give us any additional color on that or any further thoughts on that?

No, I would rather just say what I said. The pipeline is what it is; we are working hard. You know this business: you can get close on a deal and then something falls apart at the last minute, so I would really be remiss in making any predictions in that regard. We just got to keep working the pipeline and again keeping the discipline.

Perfect. I had to try, but I appreciate the information and thanks for taking my follow-up. I will hop back in the queue.

No problem, thanks.

(Operator Instructions) I'm not showing any further questions in queue. I would like to turn the call over to Mr. Gladstone for closing remarks.

Thank you, Liz, and thanks to all of you calling in. Mickey and Laura, we appreciate the questions.

We will see you next quarter. Thank you very much. That's the end of this conference.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program and you may now disconnect. Everyone, have a great day.