Gladstone Capital Corp (GLAD) 2003 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the third-quarter conference call for Gladstone Capital. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session, and instructions will follow at that time. (OPERATOR INSTRUCTIONS) As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Mr. David Gladstone, Chairman of Gladstone Capital. Mr. Gladstone, you may begin.

All right. Thank you all for attending. Sorry to be so late in having this conference call. We were on the roadshow for Gladstone Commercial, and that finally got done, and we are off and running with that, but it got us a little bit behind on getting this conference call set up and also filings. First thing to talk about, of course, is net investment income. It's what we pay our dividends from. It is the lifeblood of our all our holders, of course. And for the June '03 quarter we were at 31 cents. That is up from last year at 22 cents and up from the prior quarter of 29 and prior quarter to that, of course, 24. So as you can see, we're moving things along.

For the nine months we were at 84 cents. That was up from prior year 48 cents, so our ability to pay dividends seems to be increasing, and we continue to move the company along in that direction. For net increase in shareholders equity, which is includes the appreciation and depreciation, which is really not part of our dividend-paying ability but gives you some focus on our portfolio. We moved from last year on June from 22 cents to only 23 cents, and that has won depreciation in there, and we'll come back and talk about that.

And then for the nine months ending we went from 47 cents last year to 83 cents this year. So pretty much on target for this year in terms of trying to make that number go up. Now what's in that depreciation number is for the three months we had a depreciation of about $745,000. That's a large number, but for the nine months it's only $2000, so it's more or less breakeven for that number or at cost it would be a better way of stating it. One company made up most of that depreciation, and that was a company called Kingway/Inca or Inca/Kingway. It is a merger of two companies, one Kingway and one called Inca. Inca/Kingway is a company that is owned by American Capital. They have invested about $40 million in either equity or subordinated debt below us, and we in the bank are in the senior position. We had some difficulty with the numbers that we got from American Capital, and as a result when we talked to them about it, they informed us that they would buy us out. And so we've been valuing the loan based on American Capital's offer to buy us out. But for some reason, even after the Board had approved it and after the bank had approved the sale of our piece, they declined to buy it. I'm not sure why, and I don't know what action we will take, but we'll have to do what we need to do in that situation.

Meanwhile, the company, that is Inca/Kingway, is paying, as agreed, it has paid us and the bank as a senior lenders, as agreed. And the bank is -- we are all looking at the company. It is profitable according to the numbers we've been receiving from American Capital, and things seem to be on par in terms of them bringing the company along. It has been in a weak segment of the economy. So right now in seems to be, in terms of paying us, in a good position. And we probably shouldn't complain given all the problems that are out there in the world today. But that is what it is.

So we downgraded that since American Capital declined to go forward with its purchase, and so at this point in time we've downgraded it. I don't know if we'll downgrade any more. That was also one that was done by Standard & Poor's. They did the valuation there. So that's their value as -- and we at the Board level accepted that. So that's the one item on the list that is not exactly what it should be.

On the other hand, the quality of our assets remain strong. We are still at a 7.7 in terms of the overall grading system. That is about somewhere between a BB and a BB- if you want to think about that in terms of national rating organizations. Of course, it is not exactly that because these aren't really rated by the folks at the rating agencies. But this is our rating system based on what we've been able to put together based on working with the national rating agencies.

As most of you know, the best middle market companies rated by these national rating agencies like S&P and Moody's is about a BBB, and so being in the BB category is quite good for us since we are in the middle market. It means we are at the very near the top of the scale. So we feel good about that. So the quality of the assets remains what we consider strong at this point in time at a 7.7 and hasn't scaled down. What we'll probably do at the end of the year in take the portfolio that we've got now and start to track it as the '03 portfolio. We didn't do that for '01 because we have so few in it, but we will start tracking that as a separate portfolio, as well as the overall portfolio. And we will start doing that to give you a better feel for how portfolios performed based on their vintage years and give you a flavor for that as we go forward.

Expenses are a bit too high. We've been running a little bit high as we brought people on board for this year. It is the very difficult thing to do. When you're doing a buildup of a new business you get a little ahead of yourself sometimes in expenses. But we will, I think as '04 comes in expense ratios will get back in relationship to where they should be. Some of it we will be helped somewhat by Gladstone Commercial as we begin to share some of these expenses, the general overhead expenses such as insurance and office space and those kind of things, as well as salaries. Those will help us some there. But nonetheless, it is what it is at this point in time.

We did have one loan, 5.5 million new loan. Fugate came on board. Round numbers it is in the range of our normal interest rate, although we did a portion of that loan as the senior. We did the senior and the subordinated or last out tranche there. So we have one small piece of that is in the senior category, which is a little lower than our normal. It's around 9 percent. So that pulled down our overall average in Fugate a little bit, although gave us full control over the company.

And they are a good company. They recycle or they aggregate, that is, meaning they collect print cartridges, as well as toner cartridges really all over the United States and all over the world. And then they inspect them, and then they sell them to people like NCR and others who refill those cartridges and sell them. And if you went to say Staples or Office Depot, you would see two groups of sales there, one being to the new ones that are coming straight from the factory and then the refilled ones that are about half the price of a new one. So it is quite a savings for people to buy those.

And we are not in -- this company is not in the refill business, but it is in the gathering business. If you go to our website there is some information about Fugate there. Not in the report is the loan that we closed just a few days ago, and it's not actually in our Q either. We closed a $15 million to a company called Mustras (ph), and that company is a testing company. And they have proprietary methods for testing bridges and water towers and oil tanks for possible leaks or cracks or problems, and the company is owned in part by an LBO group called Thayer Capital here in Washington, D.C. And in that one we did a senior, a small senior piece and a subdebt (ph) piece, as well. So we have a blend. That all in blend on that one -- it's a fairly strong company -- is probably around 11, 11.5 percent. So it's a good company, and we look forward to them doing a good job for us. Also we got repaid one of our deals, ARI Holdings $8.6 million. I hate to see a good loan go, but they purchased another large company, and they did it through merger with another LBO group, and it was all equity coming in. So there was no debt on the company that was merged in. So as a result, their equity base went up substantially, and their lender was able to give them a much lower rate loan than they were getting in a blend with us, and I think it was GE Capital at the time.

The interesting thing about that is we did have about $600,000 worth of paid in kind interest. It was one of our few companies that we have had on the books that had a PIK interest, as it's called, which is some kind of phantom income. That was about 600,000 that was paid at closing. So that will knock -- we had on our balance sheet, I think at June 30 about $1 million worth of paid in kind interest. So that eliminates most of that. As you know, those of you who tuned in many times before, we don't do those anymore. Those were some early deals that we did early on. We have gotten away from paid in kind interest, and so we only have -- is it Harry just one loan we have left now, or is there two?

There are two, Marked Markal (ph) and Coring (ph).

So we have a little bit of paid in kind interest on both of those that is accruing, but we've gotten paid off with ARI, the one loan that had the most paid in kind interest. On the positive side we were able to launch our REIT. Most of you who are out there listening probably know about it, but that got done. We can't talk about it. We are in the quiet period now, but it is good to have that. As most of you know, the more you are able to do for your customer, the better off you are. And with Gladstone Commercial, our REIT, we will be able to the real estate transactions in these companies, so we will be able to offer a lot more. And as they say in this business, deals beget deals. So you can do one transaction for them and then have another product to do a second type of transaction. It should help us.

The pipeline has gotten very strong. As most of you know, the LBO business has been going strong now. First quarter ending March was a relatively strong quarter, and the one ending June has been even stronger. We have been a little bit reticent. I may be the last bear in the woods, as they say. I've been very bearish on the economy, so the hurdle rate for a company to get financed here at our company has been quite high because our outlook has been so dim.

But now that the economy seems to be turning around, we are starting to see both LBO funds become much more active, as well as many more companies looking for financing because they have a growth picture that not only do they believe it and they're out, but we are beginning to believe many more of the growth pictures than we did in the past.

Certainly six months ago we were pretty negative, as all of you know. But we are seeing a pretty dramatic pick up in backlogs in some of the companies that we have investments in. And we are also seeing a good deal of strength in the economy and the industrial sector, which we like. So we are expecting the next six months to look pretty strong, and we are expecting '04, quite frankly, to be a booming year for both LBOs and for the economy. So we are, as they say in our business, we've got our track shoes on, and we are out running now. So we are actively working all of our sources, and we would expect by the end of the year to be pretty strong in terms of number of deals we are putting on the books.

I'm not sure there is much else. I could ramble on through some of this stuff, but what I think I will do now is open it up for questions. And if we could have our -- Paula, if you could come back on the line and queue people up for questions and answers that would be good.

(OPERATOR INSTRUCTIONS) Our first question is from Eric Swergold (ph).

David, could you tell us what percent of your current portfolio is floating rate loan versus fixed, and then what your intentions are on a forward basis, and then (indiscernible) the floating versus fixed?

Harry, you know the percentage? I know the answer to the second part of that is that we are doing all of our loans on floating-rate basis now so that future we won't have a problem as this interest rate moves up. But Harry, I don't think we have -- what do we have --?

We have -- well, the new loan, Mustras, that is a floating-rate. But right now the floor is at like 11 percent. It's like --

But what's the percentage?

The percentage is probably, I'd say 30 or 35 percent is fixed.

So we've still got a good chunk of our portfolio is fixed, but it will go down as we get pay-offs, as well as as we do new loans.

So two-thirds if it's floating?

Pardon?

Roughly two-thirds of the portfolio is floating?

Yes, and what we'll do is Harry will get that percentage, and we'll put it on our question-and-answer section in our site so that you can look it up then in the next day or so.

Thanks very much.

Our next question is from Rick Shane (ph).

Two questions. One is, you are describing that your outlook is becoming more positive, and a lot of that is being driven sort of by forward-looking prospects. What are you seeing sort of in terms of fundamental performance within portfolio companies? Are you already starting to see that turn around, or is that something that we should anticipate over the next couple quarters? And then also, with your new $100 million facility, what is your expectation as to when we would see you tapping into that and -- I guess I would tie that into perhaps where you see origination sort of going for the remainder of the calendar year?

Okay, taking the first one, performance outlook, we do -- we follow that obviously every month. And while the companies, as you would expect in many cases, are not performing to their projections, they are now at 98 percent of what we projected them to be when we did the loan. Some of you know because I said over and over again at these meetings is that when we do a transaction, we project ourselves and it's usually -- well, 99 percent of the time, lower than what management or the LBO fund projects only because they tend to be more optimistic than we are. But we do our projection, and it becomes frozen in time until there's a merger or a pay off or something happens to make us want to change it. But none of those have been changed.

So we are running at 98 percent of what we projected them to be, which we find very, very strong. We didn't -- we always make a projection, but are nervous about it and worry about it. So we feel very good about our portfolio today. The only one in the portfolio that's not really tapping the numbers we thought is the one we mentioned before, which was Inca. But the others, obviously some are performing better, but overall the portfolio is good. As to tapping in the $100 million facility, I believe that we'll be there by our fiscal year end, September 30. So we are actively pursuing deals, and I think we'll be drawing it down. This latest $15 million was just an example of things that are in our pipeline. And again, no guarantee that we're going to do this but that's my best guess in terms of forward-looking.

Lee Carter.

Thanks for a little previous action and success to you on that one. That worked out good. The only criticism I have, and it's not really a criticism, is most companies are judged by how they report and when. Why does it take 45 days to report for you and longer on year-end? Just checking.

Lee, that was my fault. I was on the roadshow for two weeks. We were pretty much ready when I began the roadshow, which was the end of July, and unfortunately I just couldn't get the time to review it and I like to read through it before it goes out. I did make several changes, and it was really driven by me. There are two things going to happen, first of all we'll be quicker as quarter goes on. But second of all, as you probably know, all the rules are changing and everybody is going to have to be within 30 days anyway. As you know, Sarbanes-Oxley is coming forward and I don't know what the date is for that, but the 45 days is going to be out the window soon and the 30 days will be in so we'll all have to report so it won't matter what you're doing, you'll have to get it out.

We're a little shop over here. We don't have the big bureaucracy that a lot of people have so they can get that stuff out. So it was really on my back. We do have a person on board now that is helping Harry out with the reporting. She comes from a background of doing the reports, and she is excellent. And she was ready and I wasn't and so it was my fault this time, but I think the September 1 of course is our year-end, so it's going to take us a little longer to get that done because we don't release it until PricewaterhouseCooper signs off on it. So hopefully that'll be in about 45 days rather than 90, which is still the amount of time you have doing your year-end. I think last year we were out, Harry, what about December 6, 7 somewhere along there? Early December. I'm hoping to make it before Thanksgiving this year. So we will work on that and we can get the auditors in here and get them cranked up we'll get that done. But again, my apologies, and the fault is mine, not hers.

Your idea of going with standard (indiscernible) for appraisals is outstanding. I like your rating system, it's super. Going back to the question that was just asked previous to mine, the $100 million facility, what you just said is you mean you will use it all or is that your intent as our outlook?

Lee, if I could use $100 million between now and September that would be wonderful, but I think his question was Rick asked when did he think we were going to start tapping into it and start to draw it down. We will start, my guess is end of September, beginning of October we may be able to draw down that and put it to work. And as any line of credit works, we will draw it down as needed. We won't take down that whole $100 million. I don't know if you picked up on it also that that credit was joined by KeyBank so we have two large banks that are providers, and they have already indicated that we can go to 125 if we want to go there. So we could be at 125 in terms of borrowing, (indiscernible) one. I don't want to add that to it now because they have an unused line fee, that is we paid for the money -- pay a little bit of money for not using it, so I don't want to add anything to that. But I would expect sometime next year as we're getting up close to the top of that list of the $100 million that we'll draw down that extra 25 as well and then the fully 1 to 1 leverage. So it's a good thing to have.

Keep up the good work, and thank you David.

You're welcome, Lee. And the S&P rating has worked out very well for us. And while it does take a great deal of control away from us, that is we sometimes disagree with the folks at S&P, we have, at least the Board has adhered to following the S&P guidelines. And what it brings to the floor (ph) is two things. First of all independence, obviously our Board is very independent and we trust them, but also having S&P provide input is invaluable in terms of what the market is for these loans. We think we know what we could sell them for in terms of if you give us three months or six months to sell them we think we could sell them for certain amounts. The people at S&P are pegging this to a real-time market, and so this is what they think we could sell it for if it was -- if we had to market it in the market today sort of instantaneous.

So we're getting much better execution in terms of having S&P do these valuations than we could ever hope to do. They have a database of some 20,000 loans that they track. So these guys are on top of the market much better than we are. So you're getting a much better market valuation of these loans than we could ever provide, even though I have great confidence in our independent directors and their knowledge of the world, they just can't compare to S&P. So we're delighted with S&P on the one hand and sometimes we get a little frustrated with them because they don't see the world the way we do. But we are every case following S&P. It does take us about a -- one quarter so the first valuation that comes out of the box, and you'll see it probably in Mustras when we do that valuation is probably going to be our independent directors and then the quarter after that will be S&P. It just takes us a long time to set it up in S&P only because they have a very, very detailed process that we need to go through in order to get it set up. But anyway, that's a little background on using S&P to do our valuations.

It takes the wind out of the short sails.

Those short boys can find any number of reasons to do what they do, but I guess that's one less reason that they could beat up on us.

Thanks for the other business. Appreciate it, David. Thank you.

(OPERATOR INSTRUCTIONS) David Miezaki (ph).

Can you guys calculate the -- you put a maturity schedule in your release but I was wondering do you have an average maturity or duration for your portfolio that you calculate?

Harry, do you do that someplace in the Q?

Yes, average duration --.

He's looking up the footnote. Do you have any other question, David, while we're waiting?

Sure. My second question is a little more squishy. I was curious what makes the last bear in the woods come out and what is it -- have you talked to companies or do you look at sort of economic indicators? I think you've been right with your call on the economy thus far, I was just wondering what kind of prompted the change in view?

It's not a 100 percent change and I'm not out of the woods completely. There are still negatives in the economy, I don't mean to say that we're completely out. But what we're seeing in companies that we see new ones coming in as well as in our own portfolios, that people actually have backlogs which is one thing. We also see some of the indicators that are out there in the marketplace turning positive. I think the sales figures that we see in the industrial side now are starting to perk up all across the industrial base. And so as a result we're getting our legs back in terms of getting ready to run and feeling much better about what we see in the economy. We also see the LBO funds, which have been relatively dormant during the last couple years. They've been licking their wounds of their problem portfolio companies. They seem to have gotten a number of those straightened out now. We're not seeing nearly as many people come in with crippled companies needing extra financing and so that's a good sign for us.

And in addition, we're seeing the LBO funds put an enormous amount of money out now. The quarter ending March was a strong quarter. We were wondering if that was a fluke. It wasn't. June has been a very strong quarter if you followed any of the surveys and magazines that have information on what the buyout funds are doing you'd know that both quarters were very strong quarters. We now believe the September quarter is going to be another booming quarter. And so what we're seeing is the LBO funds putting a lot of money to work. Now there is one caveat in that money going to work, and we don't mean to throw disparaging words the way of our brethren in the LBO business, but they have to use their money or lose it. That is they have the ability to draw money down from their limited partners, and if they don't drawn down within a certain period of time, which they call their invest up period, then they don't have the right to draw it down.

So there's a bit of nervousness from us in feeling that some of these folks may be using it so they don't lose it, and we're watching that carefully. But so far the deals that we've seen coming in have been very fair-minded deals, very straightforward deals and we just feel a lot better about it. And what that does for us, David, is that it makes us feel like the hurdle rate for people to do a transaction with us is not as high as it used to be. We used to take a very dim view of projections and cut them back substantially. We're not cutting them back as much as we used to because we're buying into some of their rationale of why they think they're going to meet their projections. And again, as I mentioned, our portfolio is about 98 percent of projections. We feel good that the future looks a lot brighter, but it's still not bright lights and all good things happening. It is still a lot of worrisome things still in the portfolio and in the economy.

Great.

And what about your average duration?

We don't actually do the average in the (indiscernible), but back under the liquidity and capital resources of MD&A we disclose by fiscal year the principal balances at (indiscernible).

Why don't we do that? We'll put that in the Q&A, David. We'll put that on our web site, we'll look that up and do an average duration. My recollection was it was about 4.5 years, but that's been a while since I've looked at it. We'll go back and do that for you.

That's great. Thanks a lot.

We'll try to put that from now on in our MD&A, the average duration so that you can see that. Any other questions, David?

No, that's everything. Thanks a lot. Great quarter.

Vernon Plack (ph).

You talked about the fact that your outlook from a big picture perspective has improved and that your willingness to do deals has improved, but could you address the level of deal flow? Are you seeing a lot more deals than you've seen in the past, or is you're just more willing to do deals at this point?

The deal flow has been strong and, as you know, our turndown rate has been much higher. We took the changes with a grain of salt during sort of the March time frame. But as this quarter has worn on, we've been more and more willing to look at deals that probably we'd have passed on a year ago because the projections look more realistic. Now we may be fools, so we're still being careful, but I would say the deal flow, first of all, has picked up, but it has picked up with higher quality as far as we're concerned only because the quality of those companies coming in has been better. And we just changed our perception of what the economy looks like right now. It looks better than it did six months ago, and certainly a little better than even it looked three months, although three months ago it was starting to perk up.

So I think there are more deals coming in, and we're more open to look at them than we were before. I think both of those are adding to our -- what we call our real deal flow, that is things we're really looking at. I mean, we've had from day one a substantial deal flow, but again many of them have been things that we just wouldn't consider and have turned down. But I think it's both of those things you mentioned.

Thank you.

At this time, sir, I am showing no further questions.

We'll give you one last chance if someone has a question. All right, Paula, that sounds like we're not going to get any more questions. Thank you all for participating, and we'll get those two questions up on our Q&A section and try to put those in the Q from now on. Thanks much. Good-bye.

Ladies and gentlemen, this does conclude today's conference. Thank you for your participation. You may disconnect at this time, and have a great weekend.