Gladstone Capital Corp (GLAD) 2011 Q2 法說會逐字稿

Good morning and welcome to the Gladstone Capital Corporation second quarter ended March 31, 2011 shareholders conference call. All participants will be in listen-only mode. (Operator Instructions).

After today's presentation there will be an opportunity to ask questions. Please note this event is being recorded.

I would now like to turn the conference over to David Gladstone. Please go ahead.

Thank you, Valerie. Thank you for the nice introduction and good morning to all of you. This is David Gladstone, Chairman and this is the quarterly conference call for shareholders and analysts of Gladstone Capital, trading symbol GLAD, and we thank you all for calling in.

You know, we are always happy to have these talks with shareholders and we wish there were more opportunity to answer questions and get you interested in our Company. We hope you all will take the opportunity to go to the website, www.GladstoneCapital.com, where you can sign up for e-mail notices so you can receive information about the time -- about all the things that are going on here. And please remember that you have an open invitation, that if you're in the Washington, DC area and have an opportunity, you have an open invitation to come by and visit us here in McLean, Virginia. Stop by and say hello. You'll see some of the finest people in this business.

Now let me read the forward-looking statements. This conference call may include 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 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 (technical difficulties). Hello, are you still there?

Please continue.

Okay, I don't know what that music burst was all about, but sort of woke us all up. 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 particularly different from any future results that are expressed, implied by these forward-looking statements including those factors listed under the caption Risk Factors in our 10-K and 10-Q filings, and in our Prospectus that we filed with the Securities and Exchange Commission. They can all be found on our website at GladstoneCapital.com and, of course, on 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.

As usual, we start with our President Chip Stelljes. Chip is the Chief Investment officer of all the Gladstone companies and he'll cover a lot of ground here. So Chip, take us away.

Thank you, David, and good morning. We closed six new investments during the quarter totaling $35.2 million and we invested $5.6 million in existing portfolio companies in the form of additional investments or draws on revolver facilities. During the quarter we received repayments of approximately $22.8 million due to payoffs normally amortization and paydowns of revolvers and this included the full payoff of Tenneco Treatment Centers of $9.4 million and Urbana Network Solutions of $7.9 million.

So in total, we had a net production increase in our portfolio of about $17.8 million for the quarter and we funded the net increase in production from operating income and draws on our credit facility.

Since the end of the quarter, we funded three new investments totaling $17.3 million and $0.5 million in investments to existing portfolio companies. Additionally after the end of the quarter we received $1.5 million in repayments, mostly from scheduled principal amortization.

At the time of this call, we owe $47.2 million on our line of credit. But we continue to see new investment opportunities and while there seems to be a good deal of capital coming into the market for the right deals, we have availability on our line and are actively making and looking to make new investments.

At the end of the March quarter, devaluation of our investment portfolio was approximately $257 million versus a cost basis of $314 million or approximately 82% of cost. At the end of the quarter we had loans with six companies on non-accrual and a number of companies experiencing problems that may prevent them from making timely payments in the future; and we have taken operating control of several of these companies and we are working hard to fix the problems and improve profitability.

On a dollar basis, the loans classified as non-accruing have a cost basis of $30.4 million or about 9.7% of the cost basis of all investments in the portfolio. From a fair value perspective, the non-accrual spare value represents 2.4% of the fair value basis for all investments.

We continue to have a high concentration of variable rate loans so we should have higher income when rates begin to increase, and while our rates are variable, that usually have a floor so that declining interest rates are mitigated. Approximately 85.4% of our loans have floors. However, even with this high percentage of floating rate loans, having floors, the short-term floating rates remaining at all-time lows, we are still generating less income than in the past. 5.2% of our loans do not have floors and the remaining 9.4% of our loans have fixed rates.

Another measure of the quality of our assets is that our average loan rating for the quarter just ended remain relatively unchanged. Our risk rating system attempts to measure the probability of default, but the portfolio by using a zero to 10 scale. Zero represents a high probability of default and 10 represents a low probability.

Of significance, our risk rating system for our non-syndicated loans which constitutes over 82% of our loans showed a weighted average rating of 5.7% down from 5.9% in our prior year end. As for our rated syndicated loans which make up 15.2% of our portfolio, they had a weighted average rating of B, B1 for this quarter slightly down from B+ B2 at our prior year end.

In addition to the quality of our assets, the quality of our income continues to be good. As we've discussed in the past, we try to avoid income generated from paid in kind or original issue discount structures. These generate non-cash income which has to be accrued for book and tax, but it is not received until much later. And of course we know, sometimes, not at all. And this type of non-cash income is subject to our 90% payout requirement so we would be paying out cash that we have not yet received.

The senior and second lien debt market plays for larger middle market companies continues to improve. Our new investments this quarter come primarily from these larger middle market companies which is reflected in our cost basis of senior and second lien syndicated loans of $45.1 million at March 31, 2011, up from $18.7 million at December 31, 2010.

And we believe there are many attractive investments in this space, some with some level of decent liquidity.

Now the market for loans to companies at the lower end of the middle market in which we typically invest most of our capital is seeing more competition and most banks continue a policy of tightened credit standards, especially for companies at the lower end of the middle market. Currently many banks are not -- are only making asset-based loans, although we are seeing an increase in non-bank lending.

Net of all these conditions, we still feel we have a good market opportunity. Our loan request pipeline is still full and we should be able to show you some more good investments over the next six months.

With that, I will turn the presentation back to David.

All right, thank you, Chip. That was a good report and now let's turn to the financials, and for that we will hear from David Watson, our Chief Financial Officer. David?

Thank you, David. Good morning, everyone. Before I go through the financial statements, I'd like to highlight a few key points for this quarter.

First, during the quarter we made six new investments and three additional ones after quarter end. Our goal is to continue this disciplined approach and increase our investment activity. And second, at the time of this call we have $47.2 million borrowed on our $127 million line of credit. So the availability on our line of credit gives us the ability and the flexibility to deploy more capital for the right opportunity.

Now for the details, and I'll start with the balance sheet. As of March 31, we had $273 million in total assets consisting of $257 million in investments at fair value and $16 million in cash and other assets. We borrowed approximately $33 million on our line of credit and had approximately $235 million in net assets. Therefore, we are less than 1 to 1 leverage and in fact our leverage is less than 15%.

So we believe this is a safe balance sheet for a finance company which are usually levered much higher. We believe that our overall risk profile is low.

Moving over to the income statement, for the March quarter, net investment income was $4.4 million versus $4.5 million for the same quarter last year, a decrease of 1%. The decrease was primarily due to the decrease in interest income resulting from the reduction in the size of the Company's investment portfolio, subsequent to March 31, 2010, partially offset by reduced interest expense because of lower average borrowings outstanding.

On a per-share basis, net investment income for both quarters was $0.21 per share.

For the six months ended March 31, 2011, net investment income was $9.1 million or $0.43 per share as compared to $8.9 million or $0.42 per share for the prior year period, an increase in net investment income of 1.8%. Net investment income increased primarily due to reduced interest expense resulting from lower average borrowings outstanding and the reversal of related fees during the six months ended March 31, 2011, partially offset by decreased investment income resulting from the overall reduction in the size of the Company's investment portfolio subsequent to March 31, 2010. Though, it should be noted that the size of the investment portfolio did increase during the current quarter.

Let's turn to realized unrealized changes in our assets. Realized gains and losses come from actual sales or disposals of investments. Unrealized appreciation and depreciation come from our requirement to mark our investments to fair value on our balance sheet with the change in fair value from one period to the next getting recognized in our income statement. Unrealized appreciation and depreciation is a non-cash event.

For the March 2011 quarter end, there were minimal realized gains and losses. For the March 2010 quarter end, there was $0.9 million in realized gains primarily related to the -- to our of Ace Expediters Inc.

From an unrealized standpoint, for the March 2011 quarter end, we add net unrealized depreciation of $13.1 million over our entire portfolio. The decrease was primarily due, due to depreciation and the debt of certain of the Company's proprietary investments, both significantly Sunshine Media Holdings, which we took joint control of and restructured during the current quarter.

Our entire portfolio was fair valued at 82% of cost as of March 31, 2011. The cumulative unrealized depreciation of our investments did not have an impact on our current ability to pay distribution to stockholders but does indicate that the value is lower and there may be future realized losses that could ultimately reduce our distributions.

For the quarter, we had another component of unrealized depreciation which related to the fair value of our line of credit. For the quarter ended March 31, 2011, we recorded an unrealized depreciation of $0.3 million primarily based on estimates of value provided by an independent third party.

On our balance sheet, as of March 31, we had accumulative net unrealized appreciation on the line of credit of $0.4 million, down from $1.1 million at September 30, 2010.

Lastly, our bottom line is net decrease in net assets from operations. This term is a combination of net investment income, unrealized net appreciation or depreciation and realized gains and losses. For the March 2011 quarter end, this number was a decrease of $8.4 million or $0.40 per share versus an increase of $8 million or $0.38 per share in the prior year's March quarter. The year-over-year change is primarily due to the $13.1 million in unrealized depreciation and investments in the current quarter when compared to a $2.5 million in unrealized appreciation recorded in the prior quarter.

While we believe our overall investment portfolio is stable and continues to meet expectations, with the continued investor uncertainty in the current economy and credit markets, even though they are have been signs of recent strength, investors should expect continued volatility in the aggregate value of the portfolio.

Now I will turn the program back over to David.

All right, thank you, David Watson. That was a very good presentation. We encourage all of our listeners to read our press release and study our quarterly report called the 10-Q which is filed with the SEC. You can access that 10-Q as well as the press release on our website at www.GladstoneCapital.com and also on the SEC website.

I think the big news this quarter was that we continue to make progress with our portfolio companies. They are getting stronger and, certainly, as the economy progresses they are getting better. Also this quarter we see our backlog of opportunities to lend money to these smaller and midsize businesses increasing and I think that is going to continue and the wider that backlog gets more opportunities, we have to close transactions.

We also added a few new investments to our portfolio of loans and that will help us grow our assets and make more money. I'm -- just a side note here before and I promised shareholders the last time I'm going to go through this, but most of these new loans were syndicated loans and you will note that one of our syndicated loans that was made before the recession began recently paid off in full, and this exit demonstrates our ability to pick good investments in that segment, and most of the deals that we had before the recession started to all paid off and were in good shape.

Unfortunately, we had to sell them before then. We believe that if Deutsche Bank had renewed our line of credit in 2009 we would have been paid back with interest in all of our syndicated loans just like the one that paid off. But in order to pay off the Deutsche Bank loan, we had to sell our syndicated loans at a loss in the spring of 2009 just to repay them.

As a further side note it was recently reported that the US Federal Reserve purchased $280 billion of poor loans at par from Deutsche Bank in order to keep them afloat during the recession. And at the same time, the Fed loaned the bank -- that bank -- billions at the Fed window. So while the US taxpayers were bailing out Deutsche Bank, the bank still felt the need to liquidate our line of credit and cause our shareholders to have a big loss in the sale of our syndicated loans.

It really is too bad that the Fed would not buy any of our loans and bail us out the way they bailed out the foreign bank, Deutsche Bank. But I have recovered from all of that now and I won't be talking about that very disagreeable part of our history.

We do have plenty of room now under our line of credit to borrow. So there's plenty of room to grow our asset base and we certainly will do that.

Our biggest challenge today is long-term debt market -- is the long-term debt marketplace for our Company. We have a line of credit with supportive lenders and they are good to work with and that line of credit is working just fine and we believe it is sufficient for the near term. But the line of credit is a short-term line of credit coming due every two to three years, and so we have to find long-term funding solutions for our Company. In order to make a lot of long-term investments we need to raise long-term debt or a long-term capital such as the issuance of preferred stock or common stock.

Our new investments are long term. They are all long term and so we need long-term liabilities to match those durations. We can't rely on the short-term lines of credit. So our funds that we are looking for today are from insurance companies and other long-term lenders, but they are not there yet for smaller businesses like us.

The insurance industry is still not financing small companies like ours and certainly not small finance companies as they look at us. So we'll have to keep working on that until we come up with a solution.

For our portfolio companies, we're worried, too, that they are not able to get long-term senior loans at reasonable rates. The banks still aren't making those kinds of loans. There's a fair number of regional banks that make new loans, based primarily on assets of the business -- that is, short-term loans -- and these asset-based lenders are more plentiful than they were last year. So that is coming back to life in a very nice way.

So we are expecting that they will extend long-term loans to our portfolio companies somewhere down the road.

Our worries today about the future are still based on the ones that we mentioned last time. We worry about oil prices. As you know, we predicted oil prices to go up and begin oil is hitting all-time highs and will have a tremendous impact on all of the businesses in the United States.

Transportation prices are up 47% from last 12 months ago and that's just going to have a terrible impact on everybody. We are also worried about inflation. The decision by Congress and the President of the United States to expand the money supply is probably causing inflation to return and the government just continues to project to issue trillions more in T-bills and the government is really sopping up most of the credit of the banks and the other lending institutions.

The spending by the federal government is still just off the charts. We look at some of these stimulus packages that are out there. It's still with spending goodies for many of the supporters of the legislators, the government today is borrowing about 43% of every $1 they spend and that will have a tremendous impact and it may be of as much as 50% next year.

The amount of moneys being spent on the war in Iraq and Afghanistan is certainly hurting our economy. We all support the troops that are over there risking their lives for us today. They are the true heroes of this period of history. But we know the war is costing taxpayers a tremendous amount.

Certainly the cost is not much, considering all the young lives that have been lost in that war. So we wish they will come home soon and the war spending will be over with.

And of course, the government is talking about raising taxes. That is what they do at this period of time and I don't know how the economy can stand more taxes. We all know we have a spending problem and not a tax problem. Raising taxes will cause more dislocation and deter private businesses and individuals from investing and creating jobs.

We need more jobs. We certainly don't need any more taxes.

And I don't know when they are going to solve the trade deficit with China. It's terrible today. It is hurting us. China continues to subsidize their industries to the disadvantage of our businesses. For example they subsidize their oil prices significantly so that gasoline and oil prices in China are much reduced compared with us and this means our companies can't compete with theirs.

And so the jobs leave the United States and go to Asia and now China if you can believe this and not stop buying even the government paper that we're trying to issue to stay afloat.

It turned out the downturn in housing industry hasn't abated, and that was really the disaster, and home mortgage defaults that continues to hurt the economy. No one knows how many home mortgages will ultimately fail, but some estimates still put the number in trillions of dollars and that was the main cause of the recession and I think that is holding back their recovery pretty much even today.

In spite of all those negatives, the industry base of the US today is not a disaster. The lingering recession has had its impact on our portfolio of companies as well as many other businesses. But it is not the disaster that we thought it was going to happen.

Like most companies, the center of our portfolio companies have not seen increase in revenue or in backlogs. However, some others of our companies are saying good increases in their backlog and revenue. And a few of them are just spectacular, seeing great increases.

So it is a very uneven recovery. It is not across all the industries and we see it in our portfolio as well.

We believe that the downturn that began in late 2008 will continue well into 2011, perhaps all of 2011 and just won't see the growth that we all were hoping for at this period of time. However, we think the Company -- the economy has stabilized. It is at a low point today and I think it will stay there for a while. If that is true, though, if the economy doesn't recover very fast it will help us take advantage of this time in which other lenders aren't out there lending, and at the same time, people are worried about the future and at the same time not growing as fast.

Our dividend distribution is $0.07 a share for each of the months of April, May, and June. That is a run rate of $0.84 a share per year distribution rate for the dividend, and with the stock price now at $11.30 as it was yesterday, the yield on the distribution is now at a high point of 7.4%. We think that should be much lower and the stock price should be higher. So we are hopeful a lot of people will buy some more shares.

Please go to our website, GladstoneCapital.com, and sign up for e-mail notifications. We don't send out junk mail, just good news. And also you should know that we are now on Facebook under The Gladstone Company so you can follow us on Facebook and you can also follow us on Twitter under Gladstone Comps. That's another way to follow our companies.

So as far as -- in summary here, as far as we can see the economic conditions look like they will not sink any lower and could improve during the next quarter. We are certainly hopeful of that, but the next two quarters will be a telling time and we of course are stewards of your money. We are going to stay the course and continue to be conservative on an investment approach and the number of deals that we do.

At this point, will the operator please come on and we will open up for some questions from our shareholders who want to ask us some questions.

(Operator Instructions). Vernon Plack of BB&T Capital Markets.

Thanks very much. Chip, could you talk a little more about, you mentioned how higher interest rates will at some point have an impact on the portfolio. I'm curious as to the terms of where most of your LIBOR floors are.

Well, I guess there is a difference between what we would do today, you know, where LIBOR floors have come in to probably 150, but I would say our average LIBOR floor is at north of 200 right now and so we would have a period where we would not purchase a page in the upside without some hedging. But at some point, well, if we can move off over the floor to we would begin to participate.

I would argue that almost all of our loans, if not all of them, are at their floors today.

Okay. All right. And the other question involves Sunshine Media. I know that that company has been written down and a few quarters ago it was at 94% of calls and 75% of cost at the December quarter, 45% of cost. Today, I was hoping for some color. Just curious in terms of whether or not, where we are on that investment and concerns that it may wind up on nonaccrual.

The --. Yes, Sunshine has been a troubled situation for us for a while, but we are subject to a valuation on the debt by whatever S&P tells us it should be and they have their own black box that they use. I will tell you that we took over, as we announced last quarter, we took over from debt equity sponsor who did not want to continue to support the business.

It is -- so that was a change in the way we were managing it. We have now sold half of our equity position to the CEO, so we are partners with him now. And if you recall that business is two different businesses. One of which is a custom publishing business that would provide newsletters to hospital that they would send out as advertising. And the second is a group of B2B publications that really has been the problem and has suffered through the downturn.

The CEO who is running the company, we have a lot of confidence in. He ran the custom publishing business. And in fact, that business continues to do very well. And he has really been in charge of the turnaround of the B2B publications.

But the way these things go, things lag over time. I would argue that operationally, that company is in better shape than it was at this time last quarter when we announced it. But when we went in and sat down and took over from the equity sponsor, S&P looked at it and I know that they calculated the fact that the equity sponsor did not want to support it for whatever reason and that was negative.

And then we did restructure the deal during this quarter and gave the CEO some flexibility within some of the junior debt traunches in order to continue to improve the business. We are working hard not to have it go on nonaccrual and I don't think it will go completely on nonaccrual, but we may have some reduced income over time until we can get the B2B publishing units back to profitability.

Okay. That's helpful. Thank you very much.

Greg Mason of Stifel Nicolaus.

Good morning, gentlemen. David, as we look through your six new investments, I think on your Q, you have four of them labeled as syndicated loans. Can you talk about kind of why the focus on syndicated? Particularly kind of what we have been hearing about flows into high yield and bank loan funds that maybe that market is getting a little frothy.

What are you seeing there on the syndicated side?

Yes, the syndicated site is what I would call frothy as well. We are doing more of the club deals, they are smaller transactions that are going through there now but didn't go through for probably two, maybe three years now. And so these smaller club deals in which there might be four investors rather than 25 or 30 in these big transactions, you are probably referring more to the larger transactions that go through that might raise $1 billion or $1.5 billion. These are the smaller deals that might raise $300 million. Part of it senior and part of it second lien.

We have been participating in the second lien transactions as we do in our regular business, and we find that a very attractive area. As I mentioned as part of my presentation, the syndicated loan area is divided into lots of parts and sort of one of the divisions is between these smaller transactions that might come out from any number of LBO funds to the larger, huge transactions that you will read about in the Wall Street Journal.

So we've pretty much stayed with the smaller syndicated transactions that have higher -- higher interest rates and better terms than I think some of the large ones do. I hope that answers the question, Greg.

Yes, it does, David. And, Chip, you talked a little bit about --. It sounded, my interpretation is the lower middle market's kind of tougher to find deals. What would you say, is it a lack of financing that there are just not opportunities? Or you are seeing opportunities, but the coupons and leverage points aren't attractive? Which way would you characterize that?

I would say the latter. We have looked at situations that other folks are doing and have either lost out in a competitive situation or decided that the risk return was not quite right and so we've been sort of disappointed to date.

Now I think part of that is that there has been a good deal of money that has come into that market place. And I think secondarily, there hasn't been as much deal flow as I think a lot of people had hoped for. But clearly with the M&A trends in that sector picking up and with more financings coming, I think that in balance may turn, but we've looked at some and said, that's just the not the right pricing for that deal.

So we've not been as aggressive there as some other folks have been. I think we'll find some good opportunities, but we are going to have to just work hard to find situations that aren't completely competitive all the time.

Great. Then one last question. David, you talked about looking for long-term capital solutions. I know several of the BDCs have started to issue convertible debt and have you looked at that market? And what you think of that option?

We are not very fond of convertibles, mainly because it sets the Company up that if you don't refinance it about a year before it comes to due, you end up with the shorts using the convert to pound the common stock back to the price of the convert. So we have always avoided convertible features.

We are looking at a number of other ways of financing the business that will be new and hope you'll stay tuned and watch us try those out.

Great. Thanks, guys.

David West of Davenport & Company.

Good morning. First question may be a follow-up to the last regarding perhaps the issuance of common equity. Your stock is just around NAV. Your current leverage levels are very modest. Is -- what is kind of the threshold of leverage on your line of credit, where you feel comfortable and then where you may start to feel like the need to issue some common equity?

Yes. I'm trying to stay away from issuing common equity because I think the -- well, it's hard for me to say, but I think we are priced even though we are priced very well compared to other BDCs, I think we are still priced improperly in the marketplace, stock price should be much higher and the yield much lower, given the strength of the business.

But putting that aside, I think we've got plenty of room to run on the debt side. We are talking with some insurance companies. We -- they are not quite there yet, but I think we will get them there in the next year and, hopefully, we can issue some pretty straightforward debt, long-term debt and leverage up a bit more. We do have room on our line of credit and we have some other banks that wanted to join the line of credit.

As you know I don't want to get too heavy into the short-term line before we do something. We are looking at preferred stock, although it is a little bit high today. We could probably issue preferred stock at around maybe 9%. That would be a very difficult number to make work, but 9% may be better than shutting down operations.

And we've talked to a number of different people about different ways of leveraging ourselves up and I don't want to let the cat out of the bag, but we are still working on those and hopefully something will come along in the near term. But I am resisting, so you should know, resisting issuing any common stock at this price.

Is one of the options the [SBA] facility an option for GLAD at all?

No, we don't -- we are not in accordance with our friends at the small business administration, sorry to say.

Okay. And lastly, just go back to your comment, you David, I think you indicated you kind of said you felt good about your Company's -- portfolio companies are getting stronger. Can you reconcile that with the fact that your risk waiting did go down a little bit versus your fiscal year-end? Was that just you think overly impacted by actions relative on Sunshine?

I think it was a lot to do with Sunshine. We have changed our risk rating system from prior years so there's been a little bit of change. I think this quarter coming up in June we will be on the new system for both June last year and judiciary. So it should be a little bit different than you won't see. I think our old system was a little bit more liberal than we like.

The new one is certainly more stringent than we've had in the past and I feel more comfortable that it is a realistic approach to the probability of default.

Thanks very much.

Next question, please.

(Operator Instructions). At this time I'm showing no further questions. This concludes our question-and-answer session. I would like to turn the covers back over to David Gladstone for any closing remarks.

All right, thank you all for tuning in. We look for your next quarter and hopefully have some more good news for you then. That is the end of this conference.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect and have a great day.