Gladstone Capital Corp (GLAD) 2006 Q2 法說會逐字稿

Greeting ladies and gentlemen and welcome to the Gladstone Capital second-quarter 2006 earnings conference call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (OPERATOR INSTRUCTIONS) As a reminder this conference is being recorded.

It is now my pleasure to introduce your host, Mr. David Gladstone, Chairman. Thank you, Mr. Gladstone, you may begin.

Thank you, Jan. This is the quarterly conference call for shareholders and we thank you all for calling in. We love these times with shareholders and we give you all a special invitation that if you're in the McLean, Virginia area please stop in and say hello. You'll see a great team at work, the best team in the business.

This is the shareholder call for Gladstone Capital, symbol GLAD and I need to read the warning about forward-looking statements before I go on. This report that I'm about to give includes statements that may constitute forward-looking statements within the meaning of the Security Act of 1933 and the Securities Exchange Act of 1934 including statements regarding the future performance of the Company. These forward-looking statements inherently involve certain risks and uncertainties and even though they are based on our current plans, these plans we do believe are reasonable. There are many factors that may cause the 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 the 10-K filings that are filed with the Securities and Exchange Commission and can be found also on our website at gladstonecapital.com and also the SEC 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.

Well the quarter ending March 31st, 2006 was a good quarter for our Company in terms of strengthening the portfolio and a good number of loan originations. We did get a substantial number of payoffs. We invested about $38.5 million in new loan originations and we did some just participations as well during the quarter to five new companies, so our loan production was okay. At the end of the quarter our values stayed at about the same, a small decrease at about $16,000 in unrealized depreciation and our portfolio is very strong today. For all three months we're at about -- I'm sorry -- for six months we're at about $5 million in appreciation. So the portfolio over the last six months has done a good job.

During the quarter we received repayments unfortunately of about $24.8 million of our loans including normal amortizations. There were some prepayment fees involved in that as you can see in the numbers. So payoffs in sales of some of our loans were heavier and new production grew some but not enough. And the increase in the portfolio was a net amount of about $13.6 million as of March 31st.

At the end of the quarter our investment portfolio was valued at about $206 million and the cost was $206 million. So as you can see the portfolio has gotten very strong. Subsequent to the quarter end we received about $25 million in payoffs and we had about $15 million in new loans so we're down a little bit as we begin this quarter. But we have a good number of things in the pipeline. So I think we will be all right.

We have in our history invested in about $430 million since inception. We've exited from about 22 companies and the average return has been around 15%. We have no loans today that are past due that all have made their payments. Actually we've never had an investment that didn't return a positive IRR. And that gives you a lot of hope that and strength in the portfolio today that we don't really see anything in the near term that is going to change that.

A program we set up when we founded the Company is working so we don't feel it necessary to change our strategy. And for those people who want a very conservative portfolio of loans and investments, that performs very well and this time as well as in down times we think this is the right Company stock to own. Our balance sheet is strong. We have approximately $60 million worth of borrowed under our lines of credit at the end of the quarter so we have $156 million in equity. So we're much less than 1-to-1 leverage. This is very conservative for an investment company like ours.

The numbers for March quarter were a bit behind our desire but we are still building strength in the portfolio. I think the quarter ending June will be a good one. For the March quarter, net investment income which is before appreciation, depreciation, gains and losses was about $5.2 million versus last year at the same time of $4.4 million for that quarter ending. That's about an 18% increase.

During the quarter we had $31,000 of income from non-cash items like paid-in-kind interest or OID. That is the last of the pick income. I'll talk about that a little later. Net investment income is about $0.45 per share for the quarter versus $0.38 last year. That is about 18% increase. And this presentation all the time we're going to be talking about weighted average, fully diluted common shares when we use the per-share numbers which is the most conservative presentation you can make.

So we continue to grow and just need to put more loans on the books that don't have so many prepayments.

Unrealized and realized gains now I'm turning over to that section of the presentation. This is the appreciation/depreciation and gains and losses. This is where we continue to build strength. This quarter we increased that value a little bit for the quarter ending March unrealized and realized gains increased by $542,000 to $387,000 as compared to the same quarter last year which was a net loss, net downturn of about $156,000. This value that we present and tell you about is determined mostly by Standard and Poor's. They use a very conservative approach of evaluating our loans. They're using a market test for our loans as if we have to sell them. And this is based on about 20,000 or so loans that they follow.

We're the only BDC that I know of that has S&P come in and value their loans. Others have various consultants like a Duff and Phelps or Houlihan Lokey give some oversight but it's just oversight they don't give them an actual number to put into their balance sheet. S&P gives us the exact dollar value of each one of our loans so shareholders don't have to worry about that inherent conflict of interest of us making a loan and then turning around and setting the value. We do have this outside third party, Standard & Poor's, that does that.

Now turning to the bottom line. We're turning to net increase and net assets from operation. This term is a combination of net investment income and the appreciation/depreciation gains and losses and for the quarter this number was about $5.6 million versus $4.3 million last year at this time. So this March quarter we are about $0.48 per share versus a last year's $0.37 per share and that's about a 30% increase. So continue to add strength to the portfolio.

Our paid-in-kind interest has continued to decline and we're now down to zero. It was about 31,000 for the March quarter. This is the last of the loans with paid-in-kind interest attached to them as paid off and as of April 1, 2006, we don't have any loans with paid-in-kind income. So we're not accruing anything that is this phantom income.

Both of these things paid-in-kind interest and the original issued discount income are both non-cash incomes but you've got for tax purposes you've got to pay them out in order to qualify as a pass-through company and we're very happy now to be through with that. We don't have any of this non-cash income coming out. It's very important because some of these other investment companies have a large portion of their income from non-cash sources. So the money we get in is from interest payments and that is the money we have available to pay out as dividends. We don't have to borrow money or raise equity in order to meet our dividend. This is a very conservative way to run our business and we like having a very high-quality of income.

Remember this is the portfolio that went through the last recession without a hitch. So we are building our Company in a strong way because we know the credit cycles do change.

All of our companies are paying on time as agreed. The portfolio keeps getting better and stronger as the economy gets better and stronger. The value of our loans is now at the same price we paid for them. Usually you have some problems but right now we don't have any.

Our loan rating for the quarter remains relatively unchanged. The risk rating system that we use for our loans was at 7.1% for this quarter versus 7.2%, 7.2 last time. This risk rating system gives you a feeling of how we see our portfolio not necessarily how S&P or how other rating agencies might see it but this is an internal rating and right now we're quite happy with the portfolio. Both for existing loans and the new ones that we're putting on.

The marketplace, the middle market for loans is still -- the senior and subdebt marketplace -- is still very strong. Companies continue to be able to raise large amounts of money. This larger loan marketplace that is run by Wall Street money continues to flow in and driving rates down. Companies are getting ratings from rating agencies and then have a very good chance of raising money through the syndicated loan process. And if you are looking for $200 million or larger rates continue to be about 2 to 2.5% over LIBOR. LIBOR is the lender and interbank rate which is recognized as a leading indicator of short-term rates.

LIBOR is now around 5%. So when you add 2.5% to it, that means the borrower is paying about 7.5%. So debt money is still relatively cheap and we're really back at the norm because LIBOR has traditionally been about 5 to 6% range. So today the short-term interest rates are about average. And that means that businesses are paying about 7% or 8% for their traditional financing and that is right in line. So this economy is going along at a good pace and interest rates still are in the zone of the normal zone.

The larger companies are getting these kind of things but as we look at the demand for loans out there in the marketplace, our small business area is not in the syndicated loan marketplace. It's really hard to syndicate a loan of less than $100 million. So there's little likelihood that this syndicated loan market which is run by Wall Street is going to come down and do small loans of 5 to $15 million. Small loan marketplace that we invest in doesn't see much competition for banks mainly because small loans tend to have more risk. So the typical small lender is not being able to get his money from a bank loan source because banks are held in bay by the regulators.

But we do compete for our loans in the small private lender area from the small private lenders, the mezzanine loan funds and some of the smaller business development companies as well as the smaller SBICs. Right now our pipeline in the small area is very strong. It is still strong but our criteria for loans remains fixed and we look at solid fundamentals before we make a loan. And I want to assure everyone out there that we're not going to alter our underwriting standards to make our loan production better. Our goal is to be a strong profitable company, not necessarily the biggest one.

We are reluctant to make fixed-rate loans in this environment. We are concentrating on variable rate loans so that we are not hurt by the Federal Reserve as they continue to increase interest rates. I personally don't understand why the Fed chairman increased interest rates again this time but that is the federal reserve and they seem to overshoot the market every single time that they go through this cycle. But hopefully this new head of the Fed will stop raising rates somewhere along here.

As you know, we put an interest rate cap in to cover all of our fixed-rate loans. Some people call this a derivative and you see that in our analysts is on our P&L. We don't worry much about rising interest rates now because quite frankly all of our old fixed-rate loans have been paid off and all of our loans now are in a variable rate. And even though we have this cap in place we're not interested in going out and doing fixed-rates until we see some settling down in interest rates.

So we're well protected today against any rates rising and we will do some fixed-rate loans because we have the cap in place as long as we see rates starting to stabilize and they are not quite there yet.

We continue to worry about the cost of oil and gas out there. It has a ripple affect through the economy. There are some commodity prices that continue to creep up where productivity of the small businesses continues to be strong so they are able to take on these other cost. I'm assuming at some point in time we're going to have a problem with that but it doesn't seem to be quite the time yet to worry about inflation.

The money being spent on the war in Iraq continues to hurt. We all support our troops over there of course but the war is definitely draining us and certainly the pork barrel spending by the federal and state governments is just way over the top and we wish there was some way that they could get a handle on spending so that they'd stop acting so irresponsible. During this period of wartimes we would hope that people would curtail some of the pork barrel spending. But the excess spending continues to cause the federal government to put too many dollars or T-bills into that world system and it's hurting our economy and it's hurting our businesses here in the United States.

The trade deficit with China certainly is still something to worry about. It's just terrible and China continues to subsidize all their industries to be the disadvantage of our businesses. I know the larger retail giants in the United States are lobbying Congress not to act against China but if something isn't done soon they are just going to continue to decimate our manufacturing base. The retail giants get about 80% of their production from China now so they don't want to see anything happen there because it would raise their cost of goods and certainly they are fighting against that. But hopefully our congressmen and senators will at some point in time stand up and do something about that.

The industrial base of the U.S. continues to get much stronger; productivity is stronger. Things continue to go along at a very good clip. Small businesses have kept their costs low and their profits strong. Manufacturing operating companies that are here that have some niche against the Asian onslaught have -- they are just running at full capacity now. They are hiring people and building backlog and I'd say 2006 looks like an extremely strong year this year, much better than '05. And I think that will translate into it good loans for us in this environment.

We do anticipate updating our shelf offering so watch for that. It's not that we need capital today but we always want to keep that shelf offering in good stead in case we need to go back to the market. Our dividend has remained steady at 13.5 per month; [13.5 cents] per month that's $1.62 run rate a year. That's a good run rate for us right now at 2150 yesterday's stockprice the yield is about 7.5%. So it is a very good yield and for those of you who are out there who bought on the offering you're getting about an 11% return now. So that is a great return in this environment.

The stock price did come down last quarter as many of you noticed, the short sellers did gang up on the stock. We know the borrowers of our stock and we know that they borrowed it just before the analyst report came out that said to short the stock. They seem to be working in concert. Shorts always borrow the stock and then the stock and then they short the stock and then the analysts comes out and tells everyone to go short. It's one way of making money I guess. But it does make a great buying opportunity for everybody to jump in and get a 7.5% yield and you still have our desire and promise that we're going to go out there and do our best to continue to increase the dividend.

Please go to our website and sign up for our e-mail notification. We don't bombard you with junk mail, just news about the Company. And if you want to get our free newsletter, go to Gladstonemanagement.com and sign up and you'll get the free newsletter as well.

In summary, we think 2006 is going to be a great year for Gladstone Capital. We're pretty sure about over the next twelve months increasing the dividend again. No guarantees but that is our goal.

And with that, Jan, I will stop and take some questions from the folks that are listening in.

(OPERATOR INSTRUCTIONS) David West with Davenport & Company.

Good morning David. I wondered if you could -- I know there's probably nothing overly specific you can state, but your continuing negotiations on your line of credit I suspect you hope to wrap that up fairly shortly. Do you remain optimistic about renewing that facility?

Yes, we do. We've gone back and forth a couple of times. They've made a very strong proposal back to us much better terms quite frankly than we have today. So they are being very aggressive I think. And we like the working relationship with them and I think the next step is for us to get the lawyers involved. So we're moving right along on that and I expect it to be in place sometime this month.

Okay, great. And if I read the disclosure correctly on your new plan to basically remove the current options outstanding to go to the new management plan the shareholders have approved. Is that estimated to only incur a $13,000 cost? Did I read that correctly?

That is the additional cost of that was the accelerated vesting. What we did to everyone we said we want you to -- we're going to vest all your options so that if you want to exercise and buy you can. And that caused us to accrue another $13,000 of cost under this new regulation in which we have to expense stock options.

The FASB 123?

Yes, that is 123(R). And just so you know we haven't cut over to that plan yet. We have to get with a tender offer that's just out to all of the people who hold the options and hopefully that will be wrapped up this month. It may take a little wonder. And then we won't put that in place until October 1st. So we will go through this fiscal year under the old plan and assuming everybody tenders their shares, their options, we will start the new plan on October 1st.

It seems though of late that some of your investments have been more in loan participations area. An example was the John Henry loan that appeared to have paid off and then you reinvested in that it seems through a loan syndication. Is that likely to become a bigger part of the portfolio over time?

I don't think so. We've found some good second liens in that marketplace. And we continue to find a few here and there. But by large that second lien marketplace is enormous and it's very efficient. And most of the rates of return are below what we think is fair. And it's been driven mostly by the hedge funds. They seem to like those kinds of loans. And so we will stay looking at those but I don't think that is going to be our dominant part of our market over time. We still like the small loan marketplace and still have good opportunity they are.

Okay, thanks very much.

Henry Coffey, with Ferris, Baker, Watts.

David, it's actually Henry Coffey, how are you?

Fine, Henry.

I always enjoy listening to your conference calls. You seem to blend optimism with pessimism. But before we begin, I was running some numbers last night on a second project and just for your information the internal rate of return on holding your stocks as the IPO has been 15% a year which is obviously pretty respectable. Looking at your loan yields which appreciated nicely, I assume that is tied to the fact that everything is hooked to LIBOR now. But you did have a nice uptick in loan yields.

Yes, that is correct. There is sort of wonderful thing when the Fed increases the rate because we get more money. On the other hand our expense side is variable as well. Borrowing money from Deutsche Bank and KeyBanc is variable.

But the uptick is simply tied to increase in LIBOR not a change in any kind of the structure the sorts of lending you are doing?

No, we haven't changed the structure and probably never will unless something dramatic comes along.

And can you -- we've seen a wild flood of not only money into the private equity market but a very aggressive taste for investments and have seen some among some of your competitors some fairly outsized, very quick gains. How do you navigate around that? Obviously that creates challenges but what kind of positive opportunities does this market create for you?

Well I think there are two things to look at there. Of course we spend most of our time when we're doing equity transactions in Gladstone Investment -- that's gain and (multiple speakers) you know more about that than a lot of folks do. But it's a great little company that is just sort of building its portfolio now. And Gladstone Capital that is our lending company and we spend most of our time thinking about how to make loans to leverage buyouts. The more money that comes into the buyout marketplace really the better we are in finding opportunities and the marketplace is very robust now. The transactions that we see where people are triggering huge capital gains is because the economy is so robust right now. Obviously at some point in time the credit cycles change and you can't trigger big capital gains. And that puts a crimp in your ability to pay dividends if you are basing your dividends on capital gains.

We on the other hand in this Company which is easily our most conservative Company in terms of analysis, have a very pure approach in that interest income coming in is what's going to go out in terms of the dividend. And it's a really solid portfolio. So for us to take advantage of the marketplace some of the time we have to go out and really reach for a deal and we're just not going to do that. That is the pessimism in the marketplace. At the same time there are an enormous number of transactions occurring.

It is -- we were equating it the other day and good news bad news it's like the late '80s in which it was a kind of wild time in terms of transactions. And what we have to remember here is not to lose our head and go off the deep end and change our underwriting standards and start doing things that are going to come back to hurt us when the credit cycle changes. That is the challenge that we have. Lots of opportunities but you don't want to reach too far for some of these deals. And quite frankly there a lot of people that are in the business today that never went through a credit cycle before and they just don't understand that you don't leverage up a cyclical business at five or six times EBITDA when you're at the top.

We were looking at one the other day which was negative during the last recession and they're going out at five times EBITDA, and that is just the loan part of it. Then there's equity on top of it and it's a recipe for disaster unless you believe we're going to run this economic cycle for another two or three years and you can get it paid down. But again, the risk reward is not there for lenders at this point in time.

Just one last question. Given will you be making sort of moving up the balance sheet and increasingly making more senior loans like you did this quarter?

Yes. You are going to see us move into more senior area because in the small end of the spectrum we can do the senior and the second lien and some of the even a little bit of the mezzanine all at one stop. And that helps us in our marketing to be able to do a one-stop loan like that. So yes, you will see more senior stuff as we go forward now.

Thank you very much.

Joel Houck with Wachovia Securities.

Good morning, David.

Good morning, Joel.

I'm wondering if you could maybe give us a sense of have you had more success in negotiating prepayment fees in some of newer loans last year? So I mean it seems like obviously prepayments are part of the business but the fees that we see from time to time tend to be lumpy. It's kind of hard to model if you will to get a sense for how much excess return you get from prepayment penalties.

We go through the same analysis. And in some cases most of the syndicated loans may have in the first year or two have some prepayments in it. But by and large the syndicated loans don't have prepayment penalties. And so you are sort of at the mercy of them getting their first audit after the buyout and then looking to the senior loan marketplace to knock out the second liens and that is what has happened to us. It does in essence all of these payoffs do verify our underwriting skill of picking the best loans. Unfortunately picking the best loans may not be the best way to keep a lot of loans on the books. But again, it verifies our underwriting skills here.

In the small loan marketplace we are able to put prepayment penalties and other things and income enhancements in virtually every loan that we do. And it's rare that we don't have something there. That is because those loans are probably not going to pay off in the first couple of years and so they don't mind giving you prepayment penalties. I think it has not changed really in my way of thinking about it in the last two or three years in terms of the way prepayment penalties and fees are being generated in these companies.

Okay, that is helpful. And then you made a comment earlier about you were kind of reluctant to see the Fed continue to raise rates. I'm wondering given that your portfolio is all variable and you tend to be less leveraged than most companies, it seems like at least from a margin perspective, you would benefit. I'm wondering if your concerns are more credit quality related down the road or just what is behind those comments?

Well you benefit. Yes, we benefit but we want our companies to be strong as well. And if they raise the rates beyond sort of the norm which is this range of LIBOR being between 5% and 6%, you start to get into the point in which it impacts the small business concern. And now they are paying out more interest so they have less money to reinvest into the company. And we'd rather see -- we'd rather have a nice regular interest rate marketplace in which we'd make a nice spread and very healthy businesses rather than making much higher spread and have the businesses not be as healthy.

So we're just in the same camp as our customer right now of hoping that the Fed won't raise rates and in keeping our customer healthy, we always have to balance our desires between wanting more interest for our shareholders and also wanting our customer to be very healthy and strong. So right now we're in the camp of keeping interest rates more or less where they are today rather than continue to raise it. But I've been amazed that the small business concerns and even the mid-sized guys have been able to either pass on the expense or through just tremendous productivity been able to maintain their profits and continue to grow their business. It as a testament to the small and medium-sized businesses in the United States.

Thanks, David.

(OPERATOR INSTRUCTIONS) [Lee Carter] with Oppenheimer.

Good morning, David.

Good morning, Lee.

A couple of questions. In your travels I noticed you've been down in Florida, and Vegas or wherever. What kind of comments do you hear? Are most of the people you meet have not heard of Gladstone or are they?

Well we go to some of these retail shows that you mentioned, one was in Florida and we're going to one in Las Vegas and we invite you all to come out to Vegas and see us. We have a pretty good following at these shows mainly because we are very dividend oriented and income oriented. And I would say that most of the folks who come to these shows and not to be negative in anyway are toward the retirement age and they're looking for income. So we get a tremendous amount of people. I think at the last meeting we had round numbers 1000 or so people that came to our workshop in which we talked about the Company and got a good showing there.

I'd say there's obviously in the crowd of some people who don't own the stock and just interested in listening and I think there is at a lot of fans that join us there and we them there every couple of years. And it's a good relationship.

Okay. In your opinion, three years down the pike you're changing on your companies from the option return to the employees to the hedge fund metrics. Where do think the stockholder will be stock-wise? Is one better than the other for the stockholder or both about the same when you go down the pike three to five years?

You know it's always hard to evaluate those. We feel like that the price that we're charging on the performance fee is about equal to the cost of the stock options that we've had to get rid of. And, Lee, as you probably know the problem with stock options is that we're -- we can't borrow money or we can't exercise them with a loan anymore. So as you look at that method of rewarding people before what would happen is an officer would get some stock options, they would exercise the stock option and own the stock and they would have a full recourse note against them. So they were in the same position as the shareholder. They could lose on the downside and not make any or on the other side they couldn't make any money until they increased the dividend. So they were well-suited and all interests were congruent.

And what happened under Sarbanes, is they took away the ability for an individual to have a loan with a company so now people have stock options but they can't exercise them and own them unless they have a lot of money and you can buy them for all cash. And so as a result you've got people that have stock options who are not really in favor of paying a big dividend because it would be better to keep that dividend inside the company and grow the company and make the stock go up that way.

So as a result of that -- I don't know, it's not directly one-to-one in terms of disincentivizing management but it certainly hurts. We decided to go to the incentive comp which pays on a performance fee. And now there's a one-to-one correlation if we can raise the dividend to shareholders, it means more money coming into the management company that we can put around to all of the individuals. And I think it's going to be tremendous and, Lee, proof will be in the pudding as we go down the road. But my bet is that rather than stock options having this performance fee and being able to reward managers as they build their portfolio of high-income paying investments, they're going to get a one-to-one relationship and as a result of that I think were going to see some pretty tremendous deals and some pretty good growth in the dividend. No guarantee of course but that's the motivation that is out there for everybody under this performance fee.

I understand. I appreciate the call (indiscernible) because I'm thinking we're in a wild market right now, David, with what is going on with all these hedge funds.

Well the hedge funds are definitely in the senior syndicated loans and some of the second lien loans that we see. Hedge funds probably dominate 70% of that marketplace. But in the small end we really don't see them down at the small end of the spectrum. So as time goes on, I think we will get more and more deals in small end and not rely as much on this craziness that's going on in the hedge fund marketplace.

We were paid a complement at one of the conventions by being one of the founders of the second lien marketplace in the syndicated loan world. And having originated that and of course you only get to exploit a marketplace that you create for maybe six months or a year in the financial world. And then everybody else understands it and comes rolling in and that is what's happened to us here as the hedge funds have come in and made it a gargantuan marketplace rather than just a small marketplace that we started out with.

Well thank you, David. I appreciate it.

Mr. Gladstone, there are no further questions in queue at this time.

All right. Again, thank you all for participating. We look forward to next quarter and we will do our best to push the earnings up some more. Thanks again. Bye.

This concludes today's conference. Thank you for your participation. You may disconnect your lines at this time.