Gladstone Capital Corp (GLAD) 2006 Q4 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Gladstone Capital fourth 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 of Gladstone Capital. Thank you, Mr. Gladstone, you may begin.

All right. Thank you, Dan.

Today is December 7th and I hope you all take a moment to remember all those brave men and women who died in the attack on Pearl Harbor, as well as all those who have died fighting for freedom in America and all those who have been injured and take a moment to remember all the efforts of those in the military service today, especially those in harm's way in places like Afghanistan and Iraq.

This is the quarterly conference call for shareholders and analysts for Gladstone Capital, trading symbol GLAD. We thank you all for calling in. As you know, we enjoy these calls, wish there were more of them.

And we'd like to invite you all to come McLean, Virginia, sometime and stop by and say hello. You have a personal invitation. Come by and say hello to us when you get a chance.

Now I'm going to read a statement. This report that I'm about to give may contain forward-looking statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Security Exchange Act of 1934 including statements with regard to the future performance of the Company.

These forward-looking statements inherently involve certain risk and uncertainties, even though they are based on our current plans. We do believe these plans to be reasonable.

There are many factors that may cause our actual results to be materially different from any future results that are expressed or implied by these forward-looking statements, including those factors listened under the caption, "Risk Factors" in our 10-K filings as filed with the Securities and Exchange Commission and, by the way, those can be found on our Web site at gladstonecapital.com.

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

Well, the quarter ending September 30, 2006 had some good points and some not so good points. It was a good quarter in many regards. Let's start with the lowlights, if we will.

We invested about $31 million in new loan originations in eight companies. And for us, that amount of production was okay, but it's not as much as I'd like.

However, during the quarter we received repayments of about $16 million of our loans including normal amortization. So loan payoffs were heavy and net new production was about $15 million.

After the close of the quarter, we made about $36 million in new loans and were repaid about $22 million. So repayments continue to be part of the process and they are very strong at this point in time.

At the end of the quarter, our investment portfolio was valued at about $218 million and our cost was about $216 million. It's always a good sign to have the value above the cost.

During the last five years, we've made loans to about 66 companies and have also been repaid about 29 of those. The average return of the exits has been 15%.

At the end of the quarter, we had no loans past due. All payments are current. To date, all of our investments have had a positive IRR.

This all leads me to say the program that we set up years ago is working as planned. It's just that we haven't been able to find as many loans and investments as we'd like, so there's no need to change the strategy at this point in time.

It is a difficult time for finding good loans and investments, a lot of money chasing deals. We could change our business model and make more risk-oriented loans and show more growth in our assets and perhaps even more profits, but that would mean exposing our shareholders to more risk.

There are plenty of investment companies making loans with more risk, so shareholders do have an opportunity to go buy into those companies if they want to, but for us we like the lower-risk profile and are willing to give up some profit and some growth in order to keep a good, solid portfolio going.

Our balance sheet is strong at quarter end. We had approximately $50 million borrowed on our line of credit. We have $173 million or so in equity, so we're less than 1-to-1 leverage.

This is, by all means, a very conservative balance sheet and I think the risk profile is reasonably low. So on a risk-adjusted basis, we think we're doing fine.

Now for the income statement for the September quarter, net investment income which is before appreciation, depreciation, gains or losses, was about $4.9 million versus $3.8 million for the quarter last year at this time. That's an increase of about 29%.

You'll notice in our financial statements a line for stock option expenses. The deduction for this quarter was $5700 and for the whole year it was about $285,000.

That is a deduction for GAAP reporting, but not for tax, so if you're looking at how much we have available to pay dividends for it, you have to look at our tax returns. So that $5700 for the quarter and the $285,000 for the year in expenses would have to be added back in order to determine taxable earnings. That's about a penny a share, I think.

This is the last deduction for stock options. We have, since October 1st, canceled our stock option plan and all the options have been exercised. So from October 1, 2006 there'll be no more dilution of shareholders' earnings from stock options.

In this presentation, all the time we're talking about weighted average fully diluted common shares, so when I use that term, that's what we're talking about.

Net investment income is about $0.42 per share for the quarter as compared to $0.33 for the same quarter a year ago. That's a nice increase of about 27%.

And now I'm turning to unrealized and realized gains. This is a mixture of appreciation, depreciation, gains and losses, and for the quarter ending September, we recognized $14,000 in realized gains and about $133,000 in unrealized gains.

The unrealized gains reported during the quarter is primarily determined using the opinion of the value of our loans that we receive from Standard & Poor's loan evaluation service or S&P. We think they're very conservative in their valuations of our loans and using the market test for our loans is the way that we do that.

I think they follow thousands of loans and I think they have a good view of that. We ask S&P to value all of the loans in our portfolio that don't have a ready determinable market value every quarter, so we're going to them with a large chunk of our portfolio.

We're the only BDC that does this. Others have various consultants that give some oversight, but that's just oversight.

The evaluation service of S&P gives us an exact dollar value for each of these loans that we ask them to review. This eliminates the worry, we believe, that our shareholders may have that we're not writing down poor-performing loans.

We think it's good for shareholders to have an independent party that gives you, our shareholders, the value of our loans rather than us trying to come up with a value that might be somewhat slanted towards something that we feel is appropriate. And of course, our Board is overseeing all of this.

The evaluation service of S&P has that for our Board of Directors and they make the ultimate decision on fair value and to date, they've accepted the S&P values. So a lot of folks involved in determining the most accurate value for our private portfolio of loans and we're very happy with the results that are coming out now.

Now let's turn to the bottom line. Net increase in net assets from operation. This is a term that combines net investment income, appreciation, depreciation, gains and losses, so it has it all in there.

For the quarter, this number was about $5.1 million versus $2.3 million last year this time. This September quarter we were about $0.43 per share versus last year's $0.20 per share.

That's a whopping increase of 114%. It's extremely good showing and I don't think you should expect us to do that every year.

For the year ending, this number was about $24 million versus $15 million last year, so the September 2006 year-end, we're about $2.10 per share versus last year's $1.33 per share. That's an increase of 58%. Again, that's a strong showing that will be hard to beat next year.

Paid in kind, or PIK interest, or OID, all of that is non-income producing, non-income in terms of cash. We didn't have any paid in kind income for the quarter ending September 2006, and as of April 1, 2006 we don't have any loans with PIK income or original issue discounts. So both of those are non-cash income.

We think this is a very important point because there are others with a very large portion of their income coming from non-cash sources and non-cash income has to be paid out as dividends even though you don't have the money in hand. So they must borrow from a bank to pay their dividends and thank goodness we don't have to do that, we have the income coming in.

So just remember, the money we receive from interest payments is the money that we have available to pay our dividends and this is a very conservative way to run a business like ours.

All our portfolio companies are paying on time, as agreed. The value of our loans are now higher than its costs so all of this shows good strength in our portfolio.

As many of you know, we do our own loan ratings. We have our own loan ratings system that we set up. We tried to mimic many of the larger rating companies and our average loan rating for the quarter remains relatively unchanged.

The risk rating system that we use has produced an average of 6.9 for the quarter versus the average of 6.8 for the June30 ending quarter. So it was up a little bit.

This risk rating system gives you the probability of default on the portfolio. We have a scale of zero to 10 with 10 being the lowest probability and zero representing the highest probability of default. So 6.9 is a pretty good number for us in this and we are quite satisfied with our current portfolio mix.

Since I last talked to you last quarter, the senior and sub debt marketplace for middle market companies has continued to be very robust. It's highly competitive. There are a large number of folks bidding on loans and investments.

This larger loan marketplace, we call it the capital markets, it's run by Wall Street investment bankers, saw a little bit of a crack in the marketplace in June, but it has come roaring back in July and has continued to be exceedingly strong. Companies that are getting ratings from the rating agencies have continued to get very good financing.

For example, a syndicated loan of $200 million or larger, rates have continued to be strong at about 2.5%. All of them range in the 2 to 3% over LIBOR. Even some of the ones that we passed on are as low as 3% over LIBOR.

This is a two-tier marketplace with the junky ones having to pay a little bit more. This is normal, I guess, in terms of the trend that we're in today.

This may be the top of the market, spreads may widen over the next six months. We just have no way of knowing that. We'll just have to wait and see.

LIBOR, of course, is the London Interbank Rate, which is recognized as the leading indicator of short-term rates. LIBOR, I guess, is about 5.3% today. So when you add 2.5 points to it, borrowers are really getting financing at about 7.8% today.

Debt money is right at the norm, I think, today. The norm for LIBOR has traditionally been 5 to 6% and then if you add 2.5 to that, you're in the 7 to 8% range.

So today, the interest rates that you see out there, that's pretty much the norm. What's unusual is the amount of leverage that's being placed on some of these companies as well as those that are getting the large amount of leverage.

Demand for loans in the big capital marketplace by non-bank lenders like hedge funds and bond funds for rated loans is just astronomically high. We see transaction being four and five times over subscribed.

The equity markets, as they become stronger, may change this but right now the debt demand, or demand for debt securities, is very strong and I don't see it receding over the next six months or so. Demand for senior paper is high, but so is the demand for second lien loans in that category so we see no let up in that marketplace.

In the other part of our marketplace for our small companies, these are companies that are certainly borrowing less than $100 million. It's very hard for the syndicated loan marketplace to go below $100 million, although we see one or two now and then coming into 75 or 80 or $100,000. We're not sure how long all of this craziness is going to last, but I don't think it's going to come into the sub $100 million market.

However, the 5 to $15 million transactions are certainly not in the syndicated area, but it's a small marketplace but there's still plenty of competition there. Some of it from banks, but most of these small loans tend to have more risk and banks typically stay away from that.

We have to compete for loans in the smaller marketplace from small private lenders like mezzanine loan funds, some small business investment companies. There are a few hedge funds there, but not a lot. And some of the smaller BDCs.

Our loan request pipeline in this area is still strong. We see just about everything that's coming along, but our criteria for loans remains very fixed on solid fundamentals and so we also turn down quite a few loans.

We don't want to alter our lending credit standards just so we can make our loan production better. Our goal, as we've stated over and over, is to be a strong, profitable company, not necessarily the biggest company.

We are concentrating on variable rate loans so that we're not hurt if the Federal Reserve intends to increase interest rates. We're happy to see that the new Fed Chairman is not talking about interest rates being increased.

We don't have any fixed rate loans today, but we may do a few as time goes on now. So we don't worry about rising interest rates in our portfolio and we do, normally, in our smaller loans, have a floor on those loans so that if rates started to go down, they would stop at a certain area and not compress our profits.

All our old fixed rate loans have been paid off now and our loans are now variable rate so we feel very good about the position that we're in.

As we look out at the economy today, we still worry about the cost of oil. It has a tremendous rippling affect through the economy.

Natural gas, of course, has the same impact on just about all parts of the economy and it takes money out of the middle class pockets and then they don't have money for buying durable goods or non-durables or even visiting restaurants. So we worry how much oil prices are going to continue to increase from where they are today.

We're no longer worried about inflation. I think it may come back next year, but right now I doubt it.

But we do worry about the money being spent on the war in Iraq. It is hurting us, obviously, and we support the troops in Iraq and we want the money to keep being spent as long as we have soldiers there, but the war is draining our economy.

Even worse, is the pork barrel spending by federal, state, and local governments. They just seem to be completely out of control. I think Congress is continuing to act irresponsible of the excess spending.

This excess spending, of course, will lead to excess taxes and cause a great deal of dislocation in the economy. It's absolutely killed the dollar in terms of other currencies like the euro. I think we're trading -- our dollar is trading at the lowest point since the beginning of trading in the euro.

Trade deficits with countries like China and some of the other nations is just terrible. That continues to hurt and just makes us very non-competitive when we have to have a trade deficit like that. We worry that the Chinese will continue to subsidize their currency and not let it float and that, of course, will continue to have this trade deficit that's doing so much damage to many small businesses.

And we continue to wonder about the impact of the downturn in housing industry. This housing bubble has, of course, burst, and it may cause an entire economy to come down.

I think housing prices have a long way to go before they turn up again. They're down about 15% from when they started to come down and that's just for the houses that have gotten sold.

Today, of course, there are more houses on the market than ever before, so the housing downturn is not over and that, of course, in certain parts of the economy and certain geographic areas like Detroit with the downturn in GM and Ford are also hurting that part of the economy.

So we're just not sure where that's all going and how much it's going to hurt, but we keep our eyes open. We have one small exposure to the housing area and it seems to be holding its own right now.

In spite of all those negatives and the worries that we have, the industrial base of the U.S. is continuing to be strong. Small businesses have kept their costs low and profits are improving. We do see some of the small businesses out there missing their projections, but manufacturing is not operating at full capacity.

They're not loaded up with people. They've been hiring some people, but not staffing up too much and they've been building their backlog, so all in all, we see most of the small business customers that we see are in pretty good shape. And we think these factors should continue during the next six months or so and that's about as far as we can look out.

I do want to warn you and to tell you that we anticipate that we'll update our shelf offering. We don't have any plans for making an offering in the near-term, but you'll see that come through. We try to keep that updated.

And as far as dividends, we did increase our dividend from the director's dividends at $0.14 per month. Our run rate's $1.68 and at the current price, that's about 6.9% in terms of yield.

Please go to the Web site and sign up for our e-mail notifications. And if you'd like to read our newsletter, you have to go to gladstonemanagement.com. We have them all there and if you sign up there, you'll get those newsletters as well.

You know, as far as we can see out now, six months or so, a couple of quarters, we think things are still looking pretty good. We want to be careful, though.

We know that the credit cycles come and go and we're certainly at the top of any credit cycle that anybody's been looking at these days, so we worry that when the downturn comes, there'll be some real difficult times. So we're remaining conservative and on course.

And with that, operator, I'll close down and let the folks ask some questions.

[OPERATOR INSTRUCTIONS] Our first question is coming from Vernon Plack of BB&T Capital Markets. Please proceed with your question.

Thanks and good morning, David.

I have a question about interest and dividend income. I know from the third quarter to the fourth quarter interest and dividend income increased 23%, yet the portfolio grew less than 7. I'm assuming there's a mix and some timing issues there and was just hoping that you could perhaps provide more color on that.

Yes, I think some of it has to do with the portfolio payoffs. We've had some payoffs and we've had some extras. So if you look up there in the revenue section, you'll see some extra revenue that came in.

Every time one of these loans pays off, if it's a smaller loan, there's some prepayment penalties and so as a result, we get some extra income. So we had some extra income from that.

I'm not sure what else there is. We've gotten, the portfolio hasn't changed that much so you're right to question why it's moved up so much.

Great. Thank you.

[OPERATOR INSTRUCTIONS] Our next question is coming from Rick Sheen of Jefferies and Company. Please proceed with your question.

Hi, David. It's actually Ro [Hit] in for Rick today. Thanks for taking my question.

Looks like there's about a million shares more outstanding at the end of this quarter than at the end of the last quarter. Could you maybe talk about that and sort of what the -- what your outlook is going forward for the capital structure?

Sure. We had, I know we've announced it many times that we were getting rid of our stock option plan.

So what we did is we vested all the options and said, not only are we vesting them all, we're terminating as of September 30. So this is people exercising their stock options.

Some of them exercise and sold their shares. Some of them exercised the employees who were not officers and borrowed from the Company, so they're holders of them. And some people just paid cash and exercised their shares and there was a mixture of all of that, but that's the reason the number of shares went up.

Okay. Great. Thank you.

[OPERATOR INSTRUCTIONS]

Just to remind everybody, we've gotten rid of our stock option plan completely. There will be no stock options going forward.

I know the press is loaded with discussions about stock options and people who have backdated stock options and there's a lot of criticism of folks who have a lot of stock options outstanding. We've seen companies, even in our industry, with 20% or so of their shares under option, meaning that shareholders are going to take a 20% dilution over time with those stock options.

Now, we're not against rewarding management and folks for their work and certainly we're not criticizing the point that they're doing it with stock options, because we had a plan as well, but I wouldn't say that now that we've eliminated the stock option plan, it will be much easier for folks to determine exactly what we're getting paid, because it will be on a performance base.

And so you'll see it come right through the P&L in a cost and it won't be some evaluation of what the value of a stock option is, it will be the actual cash that's going out. So, again, I think transparency for us has improved as we've moved away from stock options and gone into this fee for service and performance fee basis.

So are there any other questions?

We do have one more question coming from Everett [Beverly] of Davenport and Company. Please proceed with your question.

Good morning, David. It's Dave West here with Davenport.

Wondered, you previously had announced that the Boards of GLAD and GAIN had announced that you would potentially share and join investments. Has that happened at this time?

Yes, we've done a couple those and those are all in the syndicated loan marketplace. We don't do it in those where we might have some control.

But in a situation where you're actually offered participation in a deal and you have no control over what the terms or conditions are, that is you either buy or you don't buy, then we felt there was no real conflict of interest with participating in.

As you know, there are many, many mutual funds that buy the same stocks and share in purchases of shares of stock as well as bonds and transactions and that's pretty well-recognized in the marketplace that mutual funds under common management can do that. And we felt that was okay to follow the lead in the mutual fund marketplace when we don't have ability to price or control terms so we have started doing that and I'm not sure how many dollars, but we've got a few dollars and I guess at some point, somebody will sit down and look at our Ks and Qs and compare and see which ones we're in.

We do the allocation between those based on the assets of each of the funds. So if one fund had 60% of the total assets between the two, they would get 60% of that transaction and the other fund would get 40%.

So we make it a non-management discretion kind of situation so that we can't load it up on one fund versus the other. So it's pretty well hardwired in and, of course, the Board reviews that every quarter to make sure we haven't done anything out of line with their instruction.

Very good.

And then as a follow-up, I read into your comments on the syndicated loan market that that's obviously the primary way to try to leverage out the balance sheet a bit and it sounds like you feel there's sufficient deal flow there to allow for perhaps modest balance sheet growth absent an unusual increase in repayments.

Yes, I think we're going to get pretty good traction there. We've zeroed in on that and, as you know, we've reduced the fee. As those people who have looked at that marketplace, if you're doing a senior transaction there, 250 over LIBOR is where it is.

But we couldn't charge 2% on that a management fee and make any money for the funds, so we've cut that to a half a percent in terms of our management fee there.

So we think all in all, it's a way to make the assets grow and in securitization, when we finally get time to do that, they're very well received in securitization of these loans and we should get a very good price in terms of our securitization model when it comes time by putting these into the mix.

Okay. Thanks, David.

Any other questions out there?

We show no further questions in the queue at this time, sir.

All right.

Well, we thank you all for tuning in. It was a great quarter for us and we're off to a good running start in this quarter, as you can see by the numbers, and I think this is going to be a good quarter for us, and quite frankly, I think the year ending September '07 will be a good year as well. Thank you for all tuning in and we'll talk to you next quarter.

This concludes today's teleconference. Thank you for your participation.