Gladstone Capital Corp (GLAD) 2004 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Gladstone Capital Corporation quarterly conference call. (OPERATOR INSTRUCTIONS). As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. David Gladstone, of Gladstone Capital Corporation.

This is the quarterly report, and of course I need to read the obligatory warnings about forward-looking statements. This report that I'm about to give may include statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Act of 1934, including statements with regard to future performance of the Company.

These forward-looking statements inherently involve certain risks and uncertainties, and although they're based on the Company's current plans that are believed to be reasonable as of today. Factors that may cause the Company's actual results to be materially different from any future results expressed or implied by such forward-looking statements include, among other things those factors listed under the caption, Risk Factors, in the Company's 10-K filings as filed with the Securities and Exchange Commission that can be found at the SEC or our website at www.gladstonecapital.com. And the Company undertakes no obligation to publicly update or revise any of the forward-looking statements whether as a result of new information or future events or otherwise.

Well, welcome to the call. The quarter ending March 31, 2004 was okay, but we certainly have to do better. New loans, we had two new loans on the books, Woven Electronics for 14.5 million and net assets for 6 million. Woven is a company that makes harnesses, or wiring systems, for the U.S. government bombs. That is these are the smart bombs that the military has developed. And a wonderful small business company in the south that was purchased by an LBO fund that we like and we provided their subordinated and senior debt.

Medassets is a group purchasing organization. It is a group purchasing organization for hospitals and medical practices that aggregates the purchases, and then goes to the suppliers and negotiates, hopefully, better prices. They're backed by a very successful buy out group, and we like that group, and so we backed that.

New hires, we have one new person on board on the capital side, Bob Pierce. He is out of Chicago. We going to open a small Chicago office. Bob used to be a person with GE. He was on their loan origination and loan maintenance side. We look to hire a real estate person in Chicago for commercial later on, and that will staff up that office.

So we're optimistic that we going to get some good loans out of Chicago area as well. The numbers were not as good as I want, but okay. Net investment income was for the quarter was up a penny to 30 cents a share. It was 29 cents last year at this time. And net investment income for the six months was up 6 cents, up from 53 to 59 cents. Net investment income is the number that we pay taxes from, or pay our dividends from. That is the taxable number. So it is the most important number that we look at out from that standpoint.

Professional fees were just too large. We had lawyers and accounting fees that came through this time that just are much too much. We've got to work on getting those down. The net increase in stockholders equity speaks more to what we did on appreciation and depreciation. For this quarter end we had depreciation from Standard & Poor's who does the evaluations on our loans. They valued it down by about $300,000 as opposed to last year we had about 700,000 of appreciation, so that was like $1 million swing between the two quarters.

And this brings up again the discussion that we have from time to time with some of our shareholders on the market value set by S&P, and the health of the companies. I just want to reiterate all of our companies are fine. Everyone is paying as agreed on time. We don't have any defaults, that we are in good shape. We saw S&P devalue one or two of our loans by about $305,000. And quite frankly I can't explain all the things they go through, but they do have 20,000 loans that they track and they determine that our loan, if it was publicly traded like the loans they track would have depreciated by a small amount.

One interesting thing happened. They did value one of our loans, Wingstop, down from the 5.5 million that we paid for it. And then Wingstop paid off during the period, so you will see that run through in the next period. Anyway, we are quite happy with all the things that are going on in our portfolio. It is up much stronger. You can actually feel and see the economy improving in our portfolio.

After the quarter we did have Wingstop pay off, as I mentioned. The success fee and the prepayment fee totaled $467,000, so that income will come rolling through. That is about 4.5 cents. That will come rolling through in the quarter ending June. And that will be ordinary income. Total IRR on that loan was around 20 percent. And that is a good number. It helps show that our portfolio is doing as we have projected.

This is our fourth exit since going public. And all our exits have had IRRs in the range of 15 to 20 percent. And this is before any leverage, so our program is working. We feel very comfortable with the program that we set out. We just need to put more loans on the books at a little faster pace.

We haven't closed any loans since the quarter end, but we do have about $30 million in letters for closings. We have one closing due, I think, Tuesday of next week, and one right behind it for 6 million. So that 6 million that we feel very comfortable is going to go on the books for this quarter. And we have, as we mentioned, about $30 million total. So we will see how many of those close during the quarter.

Marketplace now, since I last talked to you in February the senior and subdebt marketplace in the middle market, these are larger loans than we typically do, has continued to strengthen. There is some reluctance by any of the lenders to do fixed-rate loans. And we too are concentrating on variable rate loans, so we don't get hurt when the Fed increases interest rates.

As many of you know, we put a hedge in place last quarter to fix our loan rate spreads, that is our fixed-rate loans that we have we put a spread -- put a hedge in place that will take care of that in case rates go up. We did that last quarter, so we feel pretty comfortable right now that if Mr. Greenspan decides to raise interest rates we won't get damaged.

The marketplace does continue to get better. Companies that can get ratings out there are continuing to raise money in the senior syndicated loan at 150. If they have $150 million that they're trying to raise, they can raise it at 2.5 to 3.5 over LIBOR. That means that LIBOR is about 1.1 percent. They are borrowing money at around 3.6 percent. And even though it is variable it is a very good rate.

That is obviously not going to last. LIBOR is going to go back to its traditional 5 percent range over probably the next 12 months, so we will see borrowing go back to the traditional 7, 8 percent. I don't think investors should fear rates going back to the norm. After all rates are at 40 year lows, so when they go back to the norm it will mean that the economy is humming along. And since our Company is stressing variable rate loans we don't really worry about the rates going back to the norm.

The Fed survey this last time out did say that banks are loosening credit standards on commercial and industrial loans, but as of yet we have not seen it. What we have seen is that many of the banks are willing to actually make revolving lines of credit loans to commercial concerns. The terms are still relatively tight. In the past three years most banks, as we have said before, have placed little emphasis on commercial loans. And since the small business area produces 85 percent of all the new jobs, I guess there is no wonder that we're having a jobless recovery in the economy these days.

Leverage ratios for bank lending is still in the range of 2 times free cash flow, or EBITDA they call it. And businesses must have collateral. We aren't seeing much change from that. Demand by non-bank lenders for good loans is still high, but we see some of the hedge funds that have done some of these larger loans go out of the marketplace. And there has differently been a drop-off in second lien loans -- the demand by the same lenders for second lien loans. So that may give us some opportunities to participate in some of the larger loans that we have not participated in.

We watch these big capital markets because it is an indicator of where the markets are going, and it is likely where our market is going. We're not seeing a great deal of improvement in the lending standards in our small market area, but that is likely to change over the next year.

Strength, we're seeing very great strength in our portfolio. The industrial base is obviously changing in the United States. It is coming back at a pretty brisk pace. By summer I think we're going to see a great deal of changes in marketplace. I think by fall the economy will be flying at a very rapid pace with these businesses borrowing money and growing at a pretty good clip.

Companies today are actually showing up on our doorstep with a backlog. So you can actually project that they're going to make the sales that they project because their backlogs are good. We haven't seen that -- that started really at the end of the year, and we haven't seen at in probably three years now.

Inflation unfortunately is going up. That will benefit some of our companies. Marcal intends to follow the paper industry with its 6 percent increase. They are under the umbrella obviously of larger paper producers and they will benefit from that. Any paper increase price was just unheard of three months ago, so inflation is probably on the way.

Our portfolio company that makes racking systems for warehouses has gotten some big orders from some large people. So it is obvious that these large retail shows are building more distribution centers. And this is really another positive sign that people are more bullish on the economy.

Our credit line, we're into the credit line about $20 million. That should move up to hopefully 50, $60 million by the end of this summer. We're expecting to go into that line. We did refile the shelf registration statement, and that is being updated with our year-end numbers, so don't be surprised when you see that get filed.

And I know many of you have called me with the rash of new filings of business development companies that are in our same format. Most of them that have filed have been mega format funds. These are billion dollar funds that are making loans that are 50 to $75 million in size. I don't think they're going to be in our size range. I don't see any of those guys making $10 million loans. I think you'll see them competing with some of the larger BDCs.

But it is good for our stock. We had an analyst in our office last week that was making the rounds of BDCs because he's looking to write on BDCs because of all this activity of business development companies. And this is a great positive for our stock in the marketplace as it will introduce business development companies to more shareholders, and hopefully should be good for us.

We only see some of the subdebt funds that we compete with over the past fifteen years in our space. We haven't seen many of them. A lot of them were hurt by the downturn in the venture business. They had strayed off into Internet and into some of the esoteric telecom deals. So there are about 100 subdebt funds out there that are private that we see around. About 25 of them as large as the ones that are going public in the BDC space. Goldman Sachs and Lehman have these large subdebt funds, and they will duke it out with the larger BDCs.

The others that run the gamut from small SVICs that have very small aperture for size of deals. On the other hand there's a half a dozen to a dozen that we see from time to time. I haven't really seen much change in that marketplace. So from our standpoint competition hasn't ballooned up yet, although, I guess that could be a rash of BDCs later on.

Inflation is still relatively strong out there. We're seeing some of that come back. It is in a lot of the commodities that we see out there. We're somewhat worried about that, but I don't see inflation going up greatly unless this war in Iraq continues for the next couple of years. And quite frankly, I don't see the deficit ballooning up the way most of the economists are saying. My guess is that it is going to be much less than before, because the tax breaks that have been given have been sparking businesses to grow. And I think people are more interested in paying their taxes now that they are low since it is easier to pay your taxes than it is to hire a bunch of accountants and try to beat the tax rap. So we don't really see -- worry about the tax situation making the deficit balloon up.

Please go to our website and sign up for our e-mail notification. We're going to be more active now. We won't bombard you with a lot of junk mail, but we are going to start putting things out a little more about our Company, so go to gladstonecapital.com and sign up on that first page. We do believe 2004 is going to be a good year, and we look to increase the dividend again.

And Elizabeth, if you want to come on now, we will go into the question-and-answer period.

(OPERATOR INSTRUCTIONS).

Any questions out there or did we answer all your questions that easily?

Sir, it looks like your first question comes from Joel Houck.

Good morning. David, with the economy improving and certainly M&A activity coming back, we're still not seeing a ton of originations out of Gladstone Capital. Can you talk about the -- just talk about the pipeline, and if you're making any enhancements to your model? I think you referenced a couple of new hires. What is the plan to get originations a little more robust?

Well, we haven't changed our criteria, Joel. As you know we're relatively conservative when compared to some of the others in the business, and as a result have gone slower because the companies that came in haven't met our criteria for credit. That shows up in our portfolio of not having any defaults or any problems in the portfolio. We like it that way. And if it meant the world was going to say as it is today, we would probably continue to go slow. But seeing the robust change in the economy that is coming through and seeing our pipeline that continues to build and get stronger, I can only say that I am forecasting higher closings. No guarantee, of course, but we do see a lot more opportunities that meet our criteria as these companies becomes stronger.

The basic problem with most of the companies that have come in is that we just didn't believe their forecasts and their projections, and historically we have been correct. We are now believing a lot more people as they come in. And quite frankly now that the economy has perked up more people are coming in. So you had a lot of entrepreneurs that in essence said, I'm not going to do anything when the economy is this bad. And we have of course those who had problem situations and needed someone to come in and fix their problem. We're not in the problem fixing business, per se.

So I just think the general upturn in the economy is going to run through to our portfolio and make it stronger, as well as sending us a lot more deals that we can put on the books. So there is no big change in the plans, I just think the economy is going to do it for us.

Okay. And just kind of a follow-up. Are you concerned that leveraged debt multiples might go higher and force returns down, or is there enough room there for multiples to expand and you guys still to get decent returns?

Well, I think I mentioned on a prior call multiples changed at the larger business area, those companies that are $1 billion in sales and borrowing $250 million in the syndicated loan environment are -- we saw rates change from 450 to 500 over LIBOR, or really high rates compared to historicals down to 300 or 358 over. And as a result of that change, you have seen some people that in the non-bank area move away from it.

As far as moving back to 150 over LIBOR the way it was 3, 4 years ago, I don't see anyone moving in that direction right now. As as far as our space is concerned, which is the $10 million loan, we haven't seen much change in that. It is still rides in the area of -- the high end best credits are 600, 650 over LIBOR. And the credits that are second lien are 10 to 12 over LIBOR. So again no change in that area.

Now the Fed did say that banks are emphasizing -- or have loosened the credit for commercial industrial loans. We just haven't seen it. They are still sticking with 2 times EBITDA. They haven't moved to 2.5 or 3 times over. No doubt some day they well; right now they haven't. So for us it is a good time to be in the business.

Henry Coffey of Ferris Bank.

Can you comment really on one real quick thing. You mentioned that you had two loans closings, one was 6 million, and you didn't put a size on the other.

The other come, I'm sorry, was 10 million.

Okay. And would you care to put any numbers to the likely level of originations either for the rest of the year or for the pending quarter?

I would not, but it is much stronger than -- it gets stronger every quarter now. So you should see a material change over the next six months.

Good. And then on the S&P underwriting process, how much of that is driven simply by the fact that rates are up, and therefore the perceived value of a loan is less? And how much of that is driven by the fact that they, for example, are looking at historical cash flows or something and are unhappy with the coverage of the credit?

I would like to answer that with a detailed answer, but when I ask the same question of how S&P did it, they told me that they spent $200 million to build their model and they weren't about to give me the secrets to how they do it. I can tell you that they have 20,000 loans and that they go out and they track them. And I suspect that some of the depreciation of our loans was due to the fact that interest rates have gone up. But I don't know what quantity. I do know how much of that is in there. Some of it has to do with industries that they track as well, and I just can't give you a good flavor for that, Henry, I wish I could.

Well, as an analyst, nobody is going to complain if your balance sheet is undervalued. So it is probably in the end a good practice.

Yes, I think so too. And after all the appreciation, depreciation only affects the net asset value. We really don't trade on net asset value like a (multiple speakers) fund, and we trade on yield. So as we jack up the dividend over time I think it just materially, that goes away.

Any comment on your outlook for the dividend for the rest of year?

Rest of the year, might go up. Certainly next year it will go up.

John Maier of UBS.

You said that you valued down, or S&P valued down Wingstop, but then Wingstop completely paid off. So the next quarter that should reverse that?

That's right. The way it works, and it is an odd process, but you actually appreciate the loan back to its cost, so you get unrealized appreciation running through. And then you -- and so that will go through. Now had we sold it at a premium, you would've gotten a capital gains. As it was we had a success fee and a prepayment fee, so that is just ordinary income that will come in off of that.

And that is one question. Your cost on your leverage, where is it approximately?

What's the cost of leverage? 2.5 percent.

Lee Carter of Grand Rapids, Michigan.

You just answered the one interest on borrowing. Are you borrowing at 2.5 percent?

Yes, sir.

That's not too shabby. On your -- outside management that is one criticism we hear of the Company. Didn't you have now the management of public company back at Allied (ph)?

Yes, we did that before and it worked exceedingly well. And, Lee, just so you know, we're trying to cut over as of July 1st. We haven't really cut over yet. We got shareholder approval, and to move 401(k) plans and all those kinds of things it takes us a little while, so we haven't cut over yet.

Actually I think the amount that the Company is paying will go down when we cut over. No guarantee, but that is my guess. So hopefully shareholders will applaud that that their management fee has gone down as we go into external management. But I understand, and I think some people believe that we're getting rich over here on the management Company when in essence we're not. And I have told everybody that even though we're externally managed, I will publish in the proxy every year or someplace my salary so you can know exactly what I'm making. Right now, just so you know, I'm making twice as Warren Buffett. So Warren is only making 100,000 year and I'm making 200. So I'm feeling very good.

Well, I will tell you what, if they're complaining just tell them to look at the fees that the big boys are going to get out of theirs.

Well, I have looked at some of my competition with a great deal of envy, we're in it for the long haul. I have, between the two companies, around 1.5 shares that I own. So I am in it with you, and I want the dividend to go up, not as interested in personal gain. I can get it on the dividend side.

Are you actually taking money down now on a line of credit, or how to --?

Yes, we're into our line of credit about 20 million. I hope to be somewhere in the 50 to 60 million borrowed by, say, late summer.

Okay. And you're doing at 2.5 percent?

Well, that is the current rate. Obviously it is a variable, but we're lending variable as well, Lee. And quite frankly since we're lending variable and borrowing variable, it doesn't make much difference what your friends over at the Fed do.

Okay. I'm very happy with what is going on. I just wanted -- glad you're doing so well.

Well, we're doing well.

Dee Miasuki (ph) with A.G. Edwards.

I just had a question regarding sort of the interaction. As you are beginning to draw down on your revolver, the interaction of your existing cash -- you say you're going to take your revolver up to maybe 50, $60 million by summer hopefully. And then I guess also are you going to utilize your repo agreements at all? And how are you going to manage the balance sheet here going forward?

Yes, the line of credit is set up to do our securitization. That is why we set it up. We probably set it up a little too early, but now it is in place and it is good. But the bottom line is what will happen is we will borrow on that. We'll get ourselves up, hopefully, to around $200 million total portfolio. And then our choice will be do we ou want to have a securitization at that point in time, or do we want to raise equity.

And we will have to cross that bridge when time comes. If the stock is trading at a high enough price, we might choose to raise a small amount of equity, say 30 or $50 million, and then use that to level to leverage up some more. That is we pay down the leverage that we've got - the bank loan, the leverage -- and then use that money to borrow -- we borrow again in order to make the next loan. And the lenders have already said they would be glad to increase the line of credit if we want them to. So we've got plenty of room here to borrow and continue to grow. We're not quite ready to do an equity offering. Does that answer your question?

Yes, yes it does. And how does -- how does the interaction of the repro agreement play into that?

I'm sorry. You're talking about the repro that we --.

Well, no, you answered the quarter, but I was also kind of wondering --.

I was thinking you were going in a different direction. I apologize. The repro is not related to our borrowing. It sounds like it is, but it is not. We borrow on the last day of the quarter and buy treasury bills with it. And then that helps us qualify under Subchapter M of the tax code. And what happens is we need to gross up our total assets so that some of our loans qualify. Any loan that is over 5 percent of your total portfolio doesn't qualify under Subchapter M, and you can only have so many that don't qualify. So we go through that little rigamarole at the end of the quarter. It was invented by a guy named Bill Thomas down at Cap Southwest years ago. We used it at American Capital during the early years.

When you finally get big enough, it doesn't matter. And hopefully by the end of the summer we won't be doing that. We may have to do it until at end of June, and we may have to do it at the end of September, but I think we will grow our way out of it by then.

But there is no intention longer term to utilize repro at as a source of capital?

No, it is not a source of capital. In fact is just an overnight transaction.

Okay. Could you give a little bit of color on the professional fees that you alluded to? You made a few comments on that that you're going to try to work to bring that down.

Well, they are just too high. And we have toyed with the idea of bringing on a General Counsel here, and that would cut in. I mean some of these lawyers have billing rates that are $5, 600 an hour, these senior partners, which would mean that they are worth, if they billed out all their hours, $1.8 million a year. It sounds a little absurd even though they are my friends, that they would be worth $1.8 million in billing fees.

But nonetheless, we're currently considering just bringing on a junior lawyer that would be General Counsel for the firm. And then we wouldn't have to go out and ask some of these questions. A lot of it is driven by Sarbanes-Oxley, all of that compliant stuff that we now have to do. Some of it is related to deals. And we could certainly cut into that greatly by not using our outside lawyers for some of the things that we ask.

Again, it is something our minds, and it is too high. Our accounting fees are relatively high as well compared to where they use to be in the past for the simple reason that we have Section 404 under Sarbanes-Oxley we are going to have to comply with. And we've got just lots of things that are changing. The regulatory environment is thrashing around with lots of pronouncements. And we need help there. So probably can't cut into that too much. We are going to need to work with our accountants on that.

Okay. Last question. Your cost of borrowing at 2.5 percent, is that off of a LIBOR?

It is. It is off of 1.5 over LIBOR. LIBOR is about 1 percent now.

(OPERATOR INSTRUCTIONS).

Well, Elizabeth, it looks like we did a good job.

Yes, I'm showing no questions at this time.

All right. Thank you all. We are adjourning the meeting.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may all disconnect.