Gladstone Capital Corp (GLAD) 2007 Q3 法說會逐字稿

Greetings ladies and gentlemen and welcome to the Gladstone Capital third quarter 2007 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.

Alright, thank you, Jackie. This is the quarterly conference call for shareholders and analysts of Gladstone Capital, trading as symbol GLAD. We thank you all for calling in. Always happy to talk with shareholders, especially when we have good news like this and we're still looking forward to some of you coming by and seeing us in McLean, Virginia. Please if you're in this area, you have an open invitation to come by and see your team in action.

Now I need to read this 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 risk and uncertainties, even though they may be based on our current plans. 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 these forward-looking statements, including those factors listed under the caption Risk Factors in our 10-K and 10-Q filings, as filed with the Securities and Exchange Commission. Those can be found on our website, www.GladstoneCapital.com. They're also on the SEC's web site.

The Company undertakes obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Before we begin, let me make something perfectly clear. We do not invest in home mortgages. We're not in any way buyers and holders of sub-prime (technical difficulty) or prime mortgages. It's just not our business. And for three years now, we've been advising folks to stay away from the housing industry so we have minimal exposure in the housing marketplace and have little or no exposure to the home mortgage marketplace.

Okay. For the quarter ending June 30, 2007, it was a good quarter for us. The Company in terms -- four our Company in terms of (technical difficulty) our assets. We invested about $126 million primarily in loan originations and syndicated purchases in about 20 companies. This included purchases by us in June of approximately $63 million of senior term debt to 16 different media companies. However, during the quarter, we did receive some repayments, about $37.6 million and about $19 million of which of that were sales, as well as forward payments of our position in certain syndicated investments. And about $14.6 million were repayments in full of loans originations and the rest was sort of normal amortization.

The syndicated sales were some of our senior loans that had the lowest interest rate, so we replaced them with loans that have much higher interest rate.

And we're very happy with the production this quarter. Net new production was about $88.5 million. For the nine months ending June 30, we have invested $253.7 million and received payments of about $100 million, including syndicated sales, repayments and scheduled amortizations for net new production of just shy of $160 million. The reason we've been selling some of our syndicated loans was that we needed the money to fund non-syndicated loans. The pipeline for non-syndicated loans is so strong that we needed to get more liquidity to fund them. And since the non-syndicated loans carry a higher rate of return, that's certainly good for shareholders to do.

At the end of the quarter, our investment portfolio was valued at about $369 million, and our cost was about $370 million, so we're about even on that number. Since inception, we have made loans to 120 companies. We have also been repaid and exited from about 58 companies, and the average return is about 15% on those exits.

In connection with the purchase of the 16 senior loans to media companies, we did acquire one loan that was already past due. It was part of the portfolio. It had been on non-accrual by the seller, and likewise, we placed that loan on nonaccrual. We're currently working toward assuming the ownership of that business, and so we're in the process of doing that. We did discount the note. The note was $4.4 million and we paid $800,000 for the note. I think we can make some money on this one, time will tell. We'll let you know where we come out on that one as time goes forward.

To date, all of our investments have had a positive IRR, so we're very proud of that. This leads me to say that of course that the program that we used in founding this company seems to would be working pretty much as planned, other than the fact that we have not put as many deals on the books as we'd like to put on it. So it's still difficult to find good loans, to keep on the books, but the market seems to be turning our way.

On the syndicated loan side, we haven't been buying a lot of those in Gladstone Capital. Most of them have been going in Gladstone Investment. But on July 20 was Black Friday in the syndicated loan marketplace. We saw a lot of loans that we passed on in prior months take a 2% hit in value.

The market, the syndicated loan marketplace, is in transition, and while the loans are all paying as agreed, liquidity for some of the sellers just doesn't exist. The market is turning to be a buyer's market rather than a seller's marketplace. There are more changes to come, I believe, and it would be very good for us. Some of the issues we hold do not have a market. The marketplace kind of shut down. That is, there's no bid and ask, and that's fine for us. We're long-term holders anyway. I guess -- my guess today is that we have had depreciation of about $3 million in that portfolio of syndicated loans.

The market's now a buyer's market. This happened because supply of new loans coming to the marketplace doubled from the spring to the summer. So given the upper hand, lenders demanded better pricing, and they got it. Prices moved from about L plus 250 -- that's LIBOR, that is the London Interbank Rate -- L plus 250 to L plus 350, 375; it may go even higher.

There has been some original issued discounts also placed on that, meaning that the buyers of the notes have paid like 98% of the face, but the offer was good enough for some deals, so underwriters and borrowers [pulled] some of those issues when so much came to the marketplace and the lenders were demanding more for it. So as you read in many of the newspaper articles, a lot of the deals did not get done. They are sort of stuck out there, and that puts an overhang on the marketplace. And since prices went up, that meant that the value of the existing loans went down. Some went down a lot. So many of the hedge funds that were highly leveraged had to sell to pay down the leverage. Many of them were leveraged 9 to 1.

Meanwhile, bond mutual funds saw redemptions increase by 2 to $3 billion over the last couple of weeks, so they had to sell some of their holdings. And the CLOs, the loan origination pools, we saw them stuck. And that is, they might have $300 million or $400 million worth of loans trying to get to $1 billion so they could carve it up and sell it off. CLOs got stuck and the prices went down. So all of these groups came to market trying to sell some of those, and of course the window was quite small to begin with and this caused what is classical in the business of a panic. It was a great opportunity to buy. We may step in and buy some yet. No loans were in default, but it was just a liquidity squeeze and reminds one of the panic of 1907, if you've ever read about that.

So here we are in a marketplace that is going to settle down over the next couple of months, and we think that all of our loans are paying as agreed, so we don't really have to worry about it.

The non-syndicated marketplace; that is, the loans to small businesses that we do and we like so much, is coming our way. We're very excited about that. We see a lot more loans for us over the next six months. Whether we close them or not is always the question, but we are getting good traction in the marketplace. We believe that there's plenty of opportunities to grow. So stayed tuned. Things look pretty bright for us right now and we will see where we go from here.

Our balance sheet is strong. At quarter end, we had approximately $120 million borrowed on the line of credit and we have about $215 million of equity at June 30. So we're less than 1 to 1 leverage. We have room to grow, and this is a very conservative balance sheet at this time and the risk profile is low.

On the income statement, in this presentation, we're always talking about weighted average fully diluted common shares when we use the per-share numbers. That of course the most conservative way of stating earnings. And for the June quarter, net investment income, which is before appreciation, depreciation gains and losses, was about $5.7 million versus $4.8 million for the quarter ending last year. That was an increase of about 19%.

Net investment income is about $0.42 a share for the quarter as compared with $0.41 for the same quarter a year ago. This was a modest increase of about 2%, and this is before the big asset purchase came on and added to the earnings. So you didn't see that since the purchase and addition of those assets was near the end of the quarter and the share increase was toward the middle of the quarter. You just didn't see the benefit of that in the June quarter, and hopefully you will see it in the September quarter.

As mentioned in May, we issued about 2 million shares in connection with a shelf offering which caused a modest dilution at the time in earnings per share, but we put all of the money to work before the end of the quarter and you should see the results of that next quarter.

For the nine months ending June 30, 2007, net investment income was $16.6 million versus $14.4 million for the same period one year ago. Nice increase of about 15%. Net investment income was about $1.31 per share for the nine months ending June 30, 2007, as compared with $1.25 per share for the same period, and the per share increase is about 5%. Again, the dilution from the offering hurt us a little bit there, but should show some good fruits in the September quarter.

As all of you know, net investment income is the most important number to us because it's this number that's closest to our taxable income, and that taxable income is the income we use to pay our dividend. So keep watch on this number as we continue to try to build it up.

Now turning to unrealized and realized gain. This is a mixture of appreciation and depreciation gains and losses, and we like to talk about it in the two categories. First, about gains and losses, because that is real cash coming in or going out. Second, about appreciation and depreciation, which is non-cash changes in the portfolio. In the first order -- the quarter ending June, we recognized about a $3000 net realized gain, so not much to talk about there. On the appreciation and depreciation reporting side during the quarter, all of this is determined primarily by the use of the opinions of value of our loans that we receive from Standard & Poor's loan evaluation service who does a good job of setting the price on our loans and their prices. They have a good experience in this area because they follow really thousands of loans.

I'm going to skip over a little bit of this. Because these valuations are from independent third party, you will see a lot of variation as this comes on; not much this quarter. The quarter ending June, the net assets had a net unrealized appreciation of about $256,000 as compared quarter the prior year where we had a net unrealized depreciation of $854,000.

We also used the bid and ask price averages on these loans, these syndicated loans, and the price volatility is -- again, my best guess is that the depreciation, if you had to do it today, would be about $3 million. And we are not trying to sell our loans right now, but all are paying as agreed, so we will try to hold onto those and see where the marketplace goes.

Now let's look at the bottom line. Net increase of net assets from operation, this is a term that combines net investment income appreciation, depreciation gains and losses. It adds up everything, kind of like adding apples, oranges and tomatoes together. They're all in one basket. And for the June quarter, this number was about $6 million versus $5.5 million last year this time. This June quarter, we're about $0.44 a share, and last year, we were about $0.48 a share. That is a decrease of about $0.08 a share, and that's mostly because of the huge increase in appreciation last year versus this year.

For the quarter, the earnings per share difference is largely attributable to the shelf offering also, the 2 million shares of common stock, and the appreciation that we had last year this time. We did not have any phantom income for the quarter ending June 30. As April 1, we have not had any loans with paid in kind income or original issue discount. We always call this income phantom income because the Company does not receive the cash but has to pay out the phantom income. We always think this is very important because a lot of other companies tend to have a lot of phantom income, and of course you have to borrow from the bank to pay your dividend when you're paying out those phantom incomes.

All the portfolio companies again are paying as agreed on time, except the one loan that we bought for about $800,000. So this shows good strength in the portfolio. The average loan rating for the quarter remains relatively unchanged. The risk rating system is set out an average of about 7.1 for this quarter versus last quarter of the 7.2 for September 30 ending quarter. The risk rating we use for unrated syndicated loans was an average of 6 for this quarter versus an average of 6.1 for September 30 quarter end. So a little bit going down there. And our syndicated loans that have an average rating are all in the CCC or CAA1 for this quarter on average versus an average of about a B/B2 for the September 30 quarter ending.

We sold off some of our higher rates, lower paying syndicated loans. That is loans that had low interest rates on them, we sold them off at par. So this made the average rating drop a little bit. Our risk rating gives you probability of default on a scale of zero to 10, with zero representing almost certainly of probability of default. Risk here has stayed relatively low, so we're quite satisfied with our current portfolio mix.

During the quarter, we also increased our borrowing capacity for our line of credit to $220 million. We have also updated our shelf offering to give us the potential to issue an additional 300 million of common stock over time. I don't know how much of that we will use. But subsequent to the end of the quarter, we just had some borrowing on our existing revolver of under $1 million. We didn't have any repayments, just a scheduled maturity of about $1 million.

Stock sale in July, we did issue 400,000 shares of common stock in connection with a direct share purchase to an institutional investor, and that raised about $8.1 million of proceeds, all of which we used to pay down our debt. As I mentioned, we have a tremendous log that we're working on and the need for equity is probably going to go up during the next three to five months.

Now let's turn to the type of loans that we're doing. We're doing mostly variable rate loans. We're concentrating on variable rate loans so that we don't get hurt by any rate increases. And while our rates are variable, we often have minimums in the rates charged so that we don't have a declining interest rate hurt our ability to pay the dividends. We do have an interest rate cap. You will see that going through our P&L from time to time. All our old fixed-rate loans have been paid off and all our loans are now variable rate, except one new fixed-rate loan that we just put in place.

The cap on rates will help protect us against any increasing interest rates on that one fixed-rate loan, and we're well protected against any further rate increases.

I usually talk about our worries in the marketplace, and I will just mention a few of them briefly. We still worry about the cost of oil. It's having a very big impact on the ability of middle-class families to have money in their pocket to buy things like durable goods or nondurable goods and money for restaurants. And they certainly have no money to save. We have the lowest saving rate on the planet today. We are no longer worried about inflation. It may come back next year, but I doubt it. We could I suppose see a small turn around and miss this, but right now, we are thinking that inflation, at least the way the government defines inflation, is probably not going to happen in the near-term.

The amount of money being spent on the war in Iraq of course hurts. We certainly support our troops, but we hope that that expenditure can go down over the next couple of years. Even worse, of course, if the pork barrel spending by federal and state governments. They're completely out of control and this excess spending causes excess taxes and a great deal of dislocation in the economy. It's already really killed the dollar in terms of other currencies like euro or any of the Asian currencies.

The trade deficit with China continues to hurt this country because China continues to subsidize their industries, and to the disadvantage of our businesses. We of course continue to worry about the impact of the downturn in housing, that's somewhere between 15% and 20% of our GDP. So it has a big impact on what we're seeing out there.

I don't think we have seen the bottom. This is a difficult marketplace to predict with housing sales down so much. It's really hard to know where the bottom is, but I'm not sure we're anywhere close to it. Perhaps another year of decline before we see some turnaround there.

Also, much of the housing trade is out of work but probably can't apply for government help, so we're missing the real impact there in terms of what's going on in the marketplace. Many of the workers in the housing business were undocumented, and so as a result, they have no ability to go in and register as unemployed. I'm really not sure that there's a good number out there for the unemployment rate today.

The default rate on sub-prime mortgages, some people are predicting they reach 30% over the next year. That would be a pretty big hammering to many of the financial institutions. And certainly, the all-day loans, which is the next step up in quality, have hit some very high default rates as well. This will have an impact on many banks and mortgage companies. Many of the banks of course sell off their mortgages, and about one in four is now kept by the banks and the rest are sold off. So there is -- a lot of the tranches in those pools of sub-prime loans are now below 50%, so it's a pretty big disaster in terms of how much pain and suffering people are going to go through and invest it in that area.

My worry now is that the default in home mortgage area may drift over into the credit card business and the auto loan business. It hasn't done so yet, but if it does, it means the consumer is definitely in trouble. Today, credit card loans and auto loans seem to be fine.

In spite of those things, many of the small and medium and even the large businesses, those negatives, has not invaded the industrial base of the US. Still relatively strong. Small businesses kept their cost down. I don't think the profits are going to go up much this year, but the bottom line is, they have good profits already. Manufacturing is not operating at full capacity. I don't think we'll see that in the next year either. We do see a slowdown in hiring, both of some of our companies as well as companies that come to see us, and backlogs are coming down in some of the businesses. I don't see a recession yet, but it could come if corporate earnings start to slide down.

Our dividend is $0.14 a month, run rate $1.68. The extra shares we sold lowered their earnings a little bit, maybe $0.01 a share, but I think with all of the assets we put on the books, there's no danger of the dividend being cut. And the extra shares we sold should put some money into our pocket to put to work as well. At this dividend rate, with the stock priced at $19.26 close yesterday, you've got a yield of about 8.7%. The stock came down to a new low and -- because of this panic in the marketplace. And so there's a lot of good news that I'm telling you about your company, and hopefully Mr. Market is listening to this and we'll get some movement up today in the stock. I usually don't tell you when to buy or sell the stock, but this is probably one of the best buying marketplaces for this stock. In fact, my statement is, it's a screaming buy right now. All our loans are paying as agreed, and so the market is good. All of the Gladstone companies are doing well. Gladstone Capital, Commercial, Investment -- they're all in very strong positions.

So please go to our web site, sign up for our e-mail notification. We don't send out any junk mail. If you want to see the newsletter we put out from time to time, that's at GladstoneManagement.com. Also, we have some job openings were trying to [field] on both the senior side as well as entry-level positions. So please have folks send over their resumes.

In summary, as far as we can see, things look good. We can only see a couple of quarters out, so we just want to continue to be careful. We are stewards of your money and we want to stay the course and continue to be conservative in our investment approach.

With that, I will leave it open now for your questions. So Jackie, if you will come back on, that would be great.

(OPERATOR INSTRUCTIONS). Vernon Plack, BB&T Capital Markets.

Looking at the portfolio, could you tell me, was the majority of the growth in the portfolio near the end of the quarter?

It was, Vernon. That's when we -- toward the end of the quarter is when we closed the large transaction, so most of the activity was at the end of the quarter.

Okay. So that was not necessarily reflected in the second quarter, given the fact that it was weighted so (MULTIPLE SPEAKERS).

That is right.

And am I to understand you correctly -- did you that if you had to mark the portfolio to market today, it would be your guessing a $3 million decrease?

That's best guess. And Vernon, I just use some -- some of the marketplaces are closed right now. There aren't any bids in ask. But I did sort of look at -- I was just looking for my calculation -- I used about a 2% depreciation on the senior debt and a 5% depreciation on the second lien debt, even though that may have been pretty harsh on the second lien stuff. And so that's where I came out when I did the analysis.

Help me to reconcile that with -- I think we've talked about and we have seen, at least the market has (inaudible) differently, about LIBOR plus 250 to LIBOR plus 350, 375. Wouldn't that suggest a larger decrease in price?

Well, it hasn't, because all of those loans are paying as agreed. So people don't tend to discount a lot of the loans that are paying as agreed. But Vernon, the marketplace is not really open today. The difference between the bid and the ask is, in some cases, nonexistent. There isn't any, but in others, it's very wide. I don't know how you could get to a market at that point in time.

I understand it, I was just trying to understand your rationale regarding your statement in terms of where you thought the portfolio would be marked today. So, thank you.

I have not tried to equate that to the rate. I've just been going to the marketplace and looking at where things are trading. Some of the larger, more highly leveraged transactions have traded down even more. We're not in those, we have avoided those. But it's still a very -- I think it's going to take all -- as you know, most of the bond traders go on vacation in August, so I think we won't see this clear up until September.

Thank you.

Scott Valentin, FBR Capital Markets.

Just kind of commentary we've heard on some of your peers' calls. It seems that the middle market is slower to react in terms of credit spread widening versus the larger, more liquid market. One, is that true, and are you seeing that? And two, would you pull back on originations for a quarter or two and wait for spreads to widen and then reengage?

I think what they're talking about is the difference between a marketplace such as the syndicated loan marketplace versus the private marketplace where there is no syndication of the deal. That is, whoever is buying the loan buys the whole [long]. It might be a $15 million deal or a $35 million deal. Those don't get syndicated. You have to get up to $100 million or so before syndications take on. And so I think what they're differentiating and talking to you about are those two marketplaces. It's true that while the syndicated marketplace is kind of crazy right now in terms of trying to figure out which way it's going to go and liquidity and all of those kinds of things, the lower middle market where you have the smaller transactions and the small business deals has not really changed that much. And so from last year this time to this year this time, I think it's more or less the same. Why we're getting much more traction now in that marketplace, I don't know. Maybe it's just we're out there hustling harder and getting better transactions, but I haven't really seen, Scott, that much change in that marketplace. The change that we have been talking about most has been in the syndicated loan, the larger loans where we have been buying small pieces of those transactions.

Okay. That color is helpful. Can you address the management fee? I think shareholders are obviously very happy that you're rebating part of the management fee, but wanted to think about that going forward. How should we think about when modeling some of the numbers in terms of NOI, whether there will be waivers or fees going forward or not?

We've committed to the concept that we won't cut the dividend. First of all, you can be assured that we will waive part or all of the management fee if it meant the dividend couldn't be paid. That's the first order of business. And here, we are talking about two waivers. One of course is the waiver for the incentive comp, and we committed to you on that that we would not take the incentive comp until we increased the earnings of the Company, which I think you're going to see come forward in the next quarter. But certainly in the year ending September 30, '08, you're going to see pretty good traction there.

The second waiver is one that we did voluntarily when we were doing senior syndicated loans. Those were 250, 350 over LIBOR. The Company wouldn't make very much money if we charged the full 2% for managing those, and management is not nearly as in-depth as it would be for a loan that we made by ourselves. So we cut the management fee on that, and we have waived that every quarter and are committed to waive it going forward from 2% down to 0.5%. I know a lot of the other BDCs that buy into that marketplace as well continue to charge 1.5 and 2% on those. We just didn't think you made any money for the shareholders doing that. So we've waived a lot of that fee. So you should look at the portfolio, single out the syndicated senior debt pieces which you can identify pretty easily. And those you should weight as 0.5% in the management fee, and then the rest of the assets in the portfolio, including the second lien -- second lien syndicated loans, at 2%. And then, you should, on the incentive fee side, should model in that we're going to waive that as long as it's needed in order to make the dividend. And we're trying to work out some formula whereby that we will share that for awhile in terms of what goes on the books and what doesn't go on the books so we can increase the dividend this year.

Thanks, that was very helpful.

[Lee Carter], Oppenheimer & Company.

Good morning David. I bet the West Coast is happy with your timing of your meeting.

Well, they can always listen.

That is true. Last quarter, you used the word scary. I assume it meant what was being shown to you was considerably being increased.

I told you, the marketplace is getting crazy in syndicated loans, and sure enough, it blew up.

The loans you got from Wells Fargo, $63 million. Can you describe those in length and interest rate?

Yes, they're all prime based loans, so they're a little higher rate. They're to usually small radio stations or small newspapers or people in the media area. There was a team that came along with that, we picked up three managing directors and one person in portfolio management, that came on board with that. So we got the team and their assets. And I think Wells Fargo was just not interested in investing in these very small loans. They are part of a big bank, I mean, they're part of -- what is the name of the company that they joined? I'm trying to remember. But they are a very large organization now. So I think they were just trying get away from the small loans. So we brought the team over and the assets, and they are setting us up for some additional loans in that area.

Very good. The average rate was prime plus a little bit then, in other words? How -- length of the loans -- five years or less?

Yes. They're usually five, six years, and they're usually prime plus 4, prime plus 5.

And no recourse back to Wells Fargo?

No. We brought them. They're ours.

Looking forward to the next question quarter. Thanks, David.

(OPERATOR INSTRUCTIONS). Rick Shane, Jeffries & Co.

My questions have all been asked, and Lee, out on the West Coast, it's not so bad for us. We will take the good weather. Thank you, guys.

Rick, does that mean that your questions were answered and we're to get a buy recommendation from you now?

My phone just went dead, David.

Okay, next question.

Mr. Gladstone, there are no further questions at this time. I would like the hand the floor back over to you for any closing comments.

Thank you all. It's always nice to have good news. The Company is growing well, strong, and we continue to go forward. So we will see you next quarter. That is the end of the meeting.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.