Gladstone Capital Corp (GLAD) 2007 Q2 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Gladstone Capital second-quarter 2007 earnings conference call. (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, sir. You may begin.

Thank you, Donna, for that nice introduction. This is the quarterly conference call for Gladstone Capital for the March 31, 2007 quarter. We certainly thank you all for dialing in. We are happy to talk with shareholders, and I would like to see some of you come by and see us in McLean, Virginia. Please stop by and say hello next time you are in town. You will see some of the finest people in the business right here.

And now I need to read the statement 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 Exchange Act of 1934, including statements with regard to the future performance of the Company. These forward-looking statements inherently involve certain risks and uncertainties, even though they are based on our current plans, and we believe those 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 the forward-looking statements, including those factors listed 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 website at www.GladstoneCapital.com. The Company undertakes 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 March 31, 2007 was a good quarter for our Company in terms of increasing our assets. We invested $75 million in new loans and originations and syndicated loans. About 20 companies. For us that was a good production quarter.

However, during the quarter we received repayments or we sold some loans for about $38 million, $18 million of which were sales of our position in certain senior syndicated loans and $13 million was refinancings, and the rest was sort of normal prepayments. These sales are some of our senior loans that had the lowest interest rates, so we are replacing those with new non-syndicated loans that are at higher rates. Loan payoffs were large, including the sales for the net new production were $37 million.

For the six months ending March 31, 2007, we invested $127 million and received repayments of about $62 million, including the senior syndicated loan sales. And that meant that we had a net new production of $65 million. After the close of the quarter, we continue to sell some of our positions in certain senior syndicated loans and some scheduled repayments, and so we had another $24 million that paid off after March 31, 2007.

The reason we have been selling some of these syndicated loans is that we have needed the money to fund non-syndicated loans, and we're getting up close to the edge of our regulatory one-to-one debt to equity ratio. The pipeline is our possible non-syndicated loans continues to be strong and grow, and we needed to get more liquidity to fund them. And since they carry these -- new loans that we are doing carry a higher interest rate of return, it will be good for shareholders.

At the end of the quarter, our portfolio was valued at about $280 million, and our cost was about $281.5 million. So we're about even on the value versus the cost.

Since inception we have made loans to approximately 100 companies now. We have been repaid and exited from 46 of them. The average return on the exits has been around 15%. This past quarter we had no loans past due, and all payments are current. So the portfolio is in good shape.

Today all our investments had a positive internal rate of return, and as you know, we had one loss in the last five and a half years.

This all leads us to say that the program we set up when we founded the Company that is working as planned, and we don't feel it is necessary to change our strategy at this point in time. But I must remind you it is still difficult to find good loans and make and keep them on the books. We have seen a noticeable change in the opportunities coming to us, and I cannot explain why. I know we have not changed the way we see the marketplace and the way that we analyze things, but there has been some change out there.

Our balance sheet is strong. The quarter-end we had approximately $120 million borrowed on the line of credit. We obviously had to reserve for things that are in the pipeline. We have a $169 million or so in equity, so we are less than one-to-one in leverage.

And I should remind you that part of that $169 million is appreciation. So it is not cash that actually came in.

This is a very conservative balance sheet today, and the risk profile we believe is very low. In part of this presentation, we're going to be talking about per-share earnings, and here we are going to use weighted average, fully diluted common shares when we are talking about per-share numbers. That is the most conservative way of stating earnings per share. For the quarter ending March 31, 2007, net investment income, which is before appreciation, depreciation, gains and losses, was about $5.7 million versus $5.2 million for the quarter last year. That was an increase of about 10%. Net investment income was about $0.47 per share for the quarter as compared to $0.45 for the same quarter a year ago. This was a modest increase of about 4%.

The difference in the lower increase is the per-share numbers were increased this year versus last year. The exercises of stock options increased the number of shares outstanding. There are no more stock options in the Company now. We do not have a stock option plan, so stock options will not be a dilutive effect on earnings as we go forward.

For the six months ending March 31, 2007, net investment income was about $10.9 million versus $9.6 million for the same period a year ago. A nice increase of about 12.9%.

Net investment income is about $0.89 a share for the six months ending March 31, as compared with $0.83 per share for the same period last year. That is about a 7% increase.

As all of you know, this number that I talk about, net investment income, is the most important number to us because it is the number that is closest to our taxable income, and that taxable income is the income we use to pay our dividends. That is the number that we all focus on. So this is one of the most important numbers to watch.

Now let's change over to unrealized and realized gains. This is a mixture of appreciation, depreciation and gains and losses. We would like to talk about two categories in this section. The first, of course, is realized gains. For the quarter ending March, we had about $94,000 in realized gains. The unrealized depreciation during the quarter ending is primarily determined by our use of, as they say, the opinions of value on our loans that we receive from Standard & Poor's loan evaluation service or S&P. They do a good job of setting the price on these loans. They have a good experience in this area because they follow thousands of loans.

We ask S&P to value all of our loans in our portfolio that we don't have a readily determined market value for, and they do that every quarter. We're the only BDC that does this. Others have various consultants that give them some oversight, but that is just consulting type oversight. S&P actually gives us -- has an independent opinion and exact dollar value of each one of the loans we ask them to review every quarter. This eliminates we think the worry of shareholders that may have -- were writing down poorly performing loans. We think it is good for shareholders to have an independent party giving them an opinion on the value of loans, rather than us the advisor telling you the shareholders what we think those values are.

And, of course, our Board oversees the determination of fair value. So a lot of folks are involved in determining the value of our private portfolio. Because of this valuation from S&P, this independent third party, you are going to see a lot of valuation -- variations in the number. Last year was up a lot. Now it is going to come back down a lot for this quarter. The quarter ending March, our assets had a net depreciation of about $1.734 million as compared with the prior year that had an unrealized appreciation of $9000. And for the six months March 31, 2007, we realized a net gain of $109,000 and also recorded an unrealized depreciation in total of $2.748 million. As compared with those numbers last year, we had a net loss of $803,000 and an unrealized appreciation -- that is it went up by $4.981 million during the same period a year ago.

Most of the depreciation this quarter was from three portfolio companies. All of them are paying as agreed, but S&P thought they needed some depreciation. One loan was depreciated because the CEO was fired by the sponsor group that owns the business. They have since replaced him with a very nice person that we think will be better than the old CEO. Another was depreciated because the industry was having some slowness. And the third was depreciated because there had been a small fraud discovered in one of the divisions. But at that time S&P was doing the review, the forensic accounting report had not come in. Now that it is in, I think that loan will be back up in terms of its valuation.

As noted, all these loans are paying as agreed. I believe one of them will probably be refinanced and paid off in the near-term. We don't see any losses from them, but nonetheless I am sure there is some concern about the depreciation.

You know, folks, when you ask someone like S&P to value your portfolio, you should expect volatility. This is because the technique being used is the value -- determined the value of what the loan could be sold for on a single date. This is a much harsher technique than used by some other funds that use a liquidation analysis, and that liquidation analysis really says, if the business is sold, the whole business is sold, would the loan be repaid? This is also called enterprise value method of valuation.

We use enterprise value on our equity in our other fund, but we don't use it on the loans. And I think if we used the enterprise value here, the loans would be a different value. But all-in-all, folks, I'm not sure how you ever tell what the value of a loan is. We are all just guessing until one actually has to sell a loan. And the loans that we sold, we all sold them at premiums or a par on the syndicated loans, and that gives you some indication of where these things are going.

The bottom line -- let's go to the bottom line now. This is called net increase in net assets from operation. This term combines both the net investment income, which we think is so important with other items like appreciation, depreciation, gains and losses. This is kind of like adding up everything. It is kind of like putting apples, oranges and tomatoes in one bin and taking a look at it.

But for March quarter, the number was about $4.1 million versus $5.6 million last year this time when we -- last year, of course, we had significant appreciation. This March quarter we're about $0.33 a share versus last year at $0.48 a share, a decrease of about $0.31 a share. And for the six months ending March, this number was about $8.2 million versus $13.8 million last year or about $0.67 a share versus $1.20 per share. For both the quarter and the six months ending, this difference is related to the depreciation of the portfolio at this time versus the appreciation of the portfolio last time. And again, investors should expect this kind of volatility out of a portfolio like ours.

Now let me also mention that we did not have any paid-in-kind income. We call that phantom income. We did not have any of that from March 31, 2007. As of April 1, 2006, we had not had any loans with paid-in-kind income or original issue discount. We call this kind of income phantom income because the Company does not receive the cash, but then has to pay out the phantom income as if it had it. So you have to -- one would have to go to the bank and borrow the money to pay the dividend or sell some equity shares in order to pay the dividend.

We believe this is a very important point in the quality analysis. There are BDCs that have very large portions of their income from non-cash sources, and that non-cash income has to be paid, even though their money is not there.

The money we received from interest payments is the money we have available to pay dividends. This is a very conservative way to run a business like ours, and that is the way we are going to continue to run it.

Our average loan rating, we do risk-rate our own loans with our own risk rating system. We try to mimic some of the larger risk rating companies. Our average dropped from 1.7.2 to 7.1 in our proprietary or non-syndicated loans. Our syndicated loans are averaging about 6.2 for this quarter versus 6.1 at September 30. And for our weighted syndicated loans, we do have a few of those. The rating of B- to BBB for the quarter ending versus an average B or BB last September. So a little improvement in some of the portfolio.

Our risk rating system on the non-rated ones from the rating agencies is 0 to 10 with zero representing a high probability of default. And the risk here is staying relatively low at 7.1.

As most of you know, we sold an additional 2 million shares of stock on April 27 at $24.25 a share. We needed to increase the equity base, so we can continue to make loans as we believe we are getting very close to the one-to-one leverage ratio. It is very hard for a management team to sit and make a commitment if you don't have the money in place to fund the loan. We feel uncomfortable doing that. So we are never going to get exactly to one-to-one in terms of leverage until we can do some kind of securitization off-balance sheet.

But we will be expanding our line of credit, too, to match the equity that we raised. And while the underwriters have an overallotment of options for another 300,000 shares, we are hoping they don't sell them because we would like to put this money to work before we sell anymore stock. We, of course, will update our shelf offering as soon as we put the offering in place, and sometime in the future it will be available for other equity offerings should we need them.

Since I last talked to you last quarter, the senior and sub-debt marketplace -- that is the large middle market companies come to that marketplace to get financed. It has remained exceedingly liquid and highly competitive. As you know, we have over the last couple of years bought some first and second lien loans in that marketplace, but we have been selling those senior syndicated loans in the marketplace to make room for the non-syndicated loans right now. This will be a very positive over time.

We hope to have some of these senior syndicated loans until we can securitize, but given the time it takes for securitization, we needed the money now. So that meant we had to selloff some of these at par or better and use the cash to buy these higher interest rate loans that are coming on.

The senior syndicated loans of $200 million are larger. They just continue to get stronger and stronger. They are moving gradually from 2.5 over LIBOR down closer to 2% over LIBOR. This may be the top of the marketplace, but I know you've heard me say that before. So we will just watch the marketplace. We thought by today things would -- spreads would start to tighten, but we just have to wait and see which way the winds are going to blow whether they are going to loosen or tighten.

LIBOR is, for those who don't know about it, the London Interbank rate, which is recognized as the leading indicator of short-term rates. And LIBOR has averaged traditionally 5 or 6% range, and that is where it is today, and we feel very comfortable that that is an indicator of a good marketplace out there. Certainly the demand for loans in the big capital marketplace by nonbank lenders like hedge funds and bond funds for rated loans is astronomically high these days. And I personally remain astonished at how much money there is in the syndicated loan marketplace.

Turning to our preferred marketplace for our small companies and their loans, the world is certainly different there. It is very hard to syndicate a loan less than $100 million, and certainly the loans we're doing at 5 to $15 million are not being syndicated. Small loan marketplace is seeing some competition from banks, but mostly the small loans tend to have more risk. So they typically stay away from bank lenders. We have to compete for our loans in this marketplace with small private lenders like mezzanine loan funds and some small hedge funds and some smaller business development companies or BDCs.

Our loan request pipeline, as I have mentioned before, is exceedingly strong right now. We see a very strong outlook, and I am hopeful that all of this that is in the pipeline will materialize. You know, we will just have to see over the next 60 days what happens.

Please remember that we're not changing our criteria of making new loans. It is just we have that grounded in sound fundamentals we believe, and we're going to stick with that, but there is a pickup in the marketplace.

We are concentrating on variable-rate loans so that we are not hurt by rates if they increase. While our rates are variable, we most of the time have minimum rate charges in them. That is floors so that we don't have our interest income hurt by a declining interest rate environment. We do have in place an interest rate cap, and that is called a derivative.

All of our old fixed-rate loans have been paid off, and all of our loans are now variable-rate, except for one new loan that we did at a fixed-rate. The cap rate -- the cap that we have in place will help protect us in case any increase comes in that near-term. So we are well protected against rate increases, decreases as we go forward.

Just a quick note on the things that we are worrying about. We still worry about oil prices, you know the Middle East, Nigeria, Venezuela. There is so much activity going on. I think high oil prices are going to be around for awhile, and they are just continuing to take money out of the middle-class pocketbook. So they don't have the money to spend on things that we would like to see them spend it on.

I'm no longer worried about inflation. I think that's not coming back in the next six to 12 months. We will see whether that forecast is right or not. The amount of money being spent on the war in Iraq continues to have a tremendous effect on the economy. We are all in support of the troops, but it is draining our economy. Even worse I think, though, is the pork barrel spending by federal and state governments. They are just out of control.

The excess taxing and excess spending has caused a great deal of dislocation in the economy. All of this has just killed the dollar. As most of you know, the pound and the Euro are at all-time highs against the dollar, and that hurts in some regards and helps in others.

The trade deficit with China and other Asian nations continues to be just terrible. China continues to subsidize their industries to the disadvantage of our businesses. And we continue to wonder how much the housing downturn is going to have on the economy. I don't think we have seen the bottom. This is certainly a difficult market to predict. With housing sales down so much right now, it is just hard to know if this is the bottom or not. I just don't think it is going to change anytime soon.

Also much of the housing trade is out of work now, but many of them cannot apply for government help because, quite frankly, they don't have visas, so it is hard for them to go in and ask for unemployment help. So I'm really not sure if we have a good number on the unemployment rate today.

The default rate on subprime mortgages is going to reach probably 30% over the next year. We see that as a real disaster. The Alt-A, which is the next level up, my guess is they are going to hit about 10% in 30-day past-due within the next year. This will have a great impact on a lot of the banks and mortgage companies.

And we are afraid many of these defaults are going to come on up into the home mortgage area and then drift over into the credit cards and the loan business -- and the auto loan business. It has not happened yet, but if it does, it will mean the consumer is in trouble, and certainly the strength of the economy will go down based on that.

In spite of all of that, there are numerous indicators that the industrial base is still strong. Small businesses have kept their costs low. The profits are still there. Manufacturing is not operating at full capacity, and hiring is not over budget. So it continued to grow, and we are amazed at the resilience that is out there in the economy today.

Dividends. We have held our dividend at $0.14 a month. Run-rate is $1.68. We should declare a dividend in July or August -- in July for July, August and September. We will do that in the first week or so of July.

The extra shares we sold may have a lower -- may lower our earnings a bit. We think it is about $0.01 a share, so there's not a big danger that is coming in terms of the shares that we sold. We think things will continue to grow at a good clip. Our dividend rate now is yielding about 7.1% with the stock at 23.62 yesterday. The stock came down after we issued the new shares, and I am not sure who Mr. Market was listening to. I hope he listens to the good news that we have had in this call, and at least Mr. Market may hear the replay and get the shares back up.

Please go to our website and sign up for our e-mail notification. We don't send out junk mail. Go to Gladstonemanagement.com if you want to see our newsletter that we put out.

I also mention that we have some great job openings for both senior and entry-level positions at our Company, so please send over those resumes.

In summary, as far as we can see, things are looking good out there. We can only see a couple of quarters out, so we want to be careful. But right now we are stewards of your money, and we're going to stay the course and continue to be conservative in our investment approach.

And now if the operator will come on, we will open it up for some calls from all the folks that have been so good to listen in right now.

(OPERATOR INSTRUCTIONS). Richard Shane, Jefferies & Co.

Looking at the credit against the management fee, obviously that is very shareholder friendly, but you had a similar question yesterday on the good call. But I would describe the credit to the management fee today was even more extreme. Can you talk about employee compensation and what your staffing levels look like and how this impacts employees, and sort of what the sentiment within the firm is related to crediting back the management fees?

Okay. As I mentioned last time, yesterday and I think I have reiterated this before, the stock options that were given out before we believe brought us to a certain level of earnings. In essence, the Company, Gladstone Capital, has paid for that with those stock options. And now that we have exercised those stock options and they are out of the way, it is incumbent upon the team that is managing Gladstone Capital to increase the amount that is going to be coming in.

So our goal here is to go above what the dividend rate is. As you know, we're above the dividend rate for this quarter. It is a little banking of income to make sure that we are strong. The goal here is to get significantly above the dividend and payout that incentive fee. But until we get there, I think all employees realize that we have to get to that.

From the private equity standpoint, it is kind of like all of them joined a new private equity fund. You don't get a lot of payouts during the early years in a private equity fund. You get it in the later years. So they are all betting on it come as we all are that in '08 there's going to be a significant payout, and people are going to get a lot of money paid to them.

So that is the way we're looking at it today, Richard.

And that is fair, and again I would emphasize I think that it is shareholder friendly. But it's a pretty competitive market right now for labor, especially for talented investment professionals, and on the last two calls, you have made the point, hey, we are looking for folks. And this entity of the three public entities is the oldest. It went public in August of '01. So I mean it strikes me that this is not a story that is sort of on the [calm], but it really is -- it should be a more mature business.

Could you talk about staffing levels and across the three entities and almost help us understand what the org chart is and how you guys look at compensation all-in for employees? Because I'm assuming that employees probably spend time on different -- within the different organizations.

Yes, some do. There are some folks that don't do buyout. There are some folks that don't do real estate, and they spend most of their time here. We have brought three new people on managing directors who will most likely put most of their deals into this fund. That was another reason for raising some money. We think the ramp-up is going to be pretty significant.

So all I can tell you is three managing directors and one staff level person just joined the firm from another firm, and I think the compensation system is terrific. So, Richard, if you look at the growth of the Company, I don't know, what, three years ago, we were probably half the size we are today. We're at about 52 people today, and my guess is next year at this time we will be 75 people.

So we're having problems recruiting all of the good people we want, but we're still getting our share of the good folks who come on board and believe in it. And as to your point that this is a mature fund, the answer is, of course, it is a mature fund. But we changed the nature of the fund on October 1. So on October 1 it became a whole new ballgame, and no one who starts a whole new ballgame on October 1 expects a huge payout the next morning. They have got to work and grow the business in order to get the payout.

So again, I cannot argue with your statement that it is hard to get good people because it is. We will just keep working at it, and those who believe in the long-term prospects of the way we have got this setup will join us, and those who don't will join other firms.

A fair answer, David. Thank you very much.

Scott Valentin, Friedman Billings Ramsey.

Two questions. One, it was in the press release I guess you have hired a media and communications group. I guess, one, have you hired the staff there? And two, historically you have been more of a manufacturing type of lender. I am just curious as to what gives you the confidence regarding the media and telecommunications area. That is the first question.

And then secondly, maybe you can talk about the margin a little bit. I think you made a quick reference to it in that as you move away from syndicate loans to more non-syndicate loans and self originations, you expect the margin to improve. I just wanted to confirm that.

Taking the last question first, the marginal debt, obviously when you have your asset in 2.5 over LIBOR and you go to 12%, there is a big pickup for shareholders. And so that is what we have been doing is moving money out of lower yielding debt into higher yielding debt, mainly because we have got the capacity to do it.

As to the communications group, you probably don't know this, but I have probably financed 100 radio stations in my career. Probably I don't know how many TV stations and cable deals and magazines and newspapers. So I have a fairly good background, and so do a couple of other folks here.

We have been looking at that space, and what we have noticed is there was not a lot of folks in the lowest end. You ask plenty of people, you get to something that has 25 or $30 million in EBITDA, and there are lots of people notably in town here, and MCG Capital has a great record in that area. But we noticed that there are very few people doing the smaller transactions, and since that is an area that I know and since it was an area this group of three managing directors knew, we felt this was a good place for us to migrate into. And I feel very comfortable about the deals they are churning together now and hope to have some announcements about those at the next quarter.

Okay. And just one final question. Back to the credit or the management fee, so based on your comments just previously, there should not be any management fee paid by or paid I guess this year in '07, but expect the management fee to be paid in '08. Is that fair?

I think we'll have some in this year because, as we do our projections for the year ending September 30, our projections of that -- in fact, the first quarter we did have some available. But we are expecting as we look at year-end to make sure that year-end numbers are correct. That is going to be a pretty significant amount of money coming in in June and in September for the incentive fee. So employees will have a good time those two quarters.

Jason Funk, Ferris, Baker Watts.

The $75 million in deals that you did this quarter, what kind of pricing were you getting on those? Were they at 12%? I just have not had a chance to look at your queue.

I know the average on the portfolio is about 12.5, and I don't think we went down any on those transactions. So it is in the range, yes.

Okay. Secondly, you talked about your pipeline a little bit. Exactly how many deals are you looking at or dollar volume in the pipeline?

Jason, it would scary if I told you what the number was. I would rather not try to focus on that for the simple reason that I have no way of knowing at this point in time how many of those might make it all the way through. If we did all that is in the pipeline, I'm afraid we would have to come back to the equity marketplace relatively soon because I think we would run through the $100 million that we have gotten in terms of liquidity from this offering.

And let me just explain that. We got about $45 million worth of equity, and we will also get 45 or $50 million worth of loan availability out of that. So in round numbers we are near $100 million. We could run through that in 90 days if all of our stuff comes true. Of course, it will not. It will take us longer to nail that down. But we have seen a marketable change in the pipeline.

(OPERATOR INSTRUCTIONS).

Alright. Since there are no questions, no last questions --

Lee Carpenter, Oppenheimer & Co.

I was gone and I did listen in on your replays a quarter ago. Would you take a phone call from me as soon as we hang up here?

Sure.

What number can I use? 744-1165? Or is that an old one?

No sir, that is an old one. 703-287-5800.

5800. I will call you shortly.

Okay, Lee. Anybody else?

We're showing no further questions in queue at this time.

Alright. Let's adjourn this meeting. Thank you all very much for attending.

Ladies and gentlemen, thank you for your participation. This does conclude today's teleconference. You may disconnect your lines at this time, and have a wonderful day.