Hercules Capital Inc (HTGC) 2005 Q3 法說會逐字稿

Good afternoon and welcome to the Hercules Technology Growth Capital Inc. third quarter conference call. (Operator Instructions). I will now turn the call over to Mike Knapp with Hercules Investor Relations Group to introduce today's speakers. You may go ahead, Mr. Knapp.

Thanks, Jen and thanks to all of you joining us today. I am joined today by Manuel Henriquez, President and CEO and David Lund, our Vice President of Finance.

The Company's third quarter results were released just after today's market close and can be accessed from our website at www.herculestech.com. I would like to remind everyone that today's call is being recorded. Please note that this call is the property of Hercules Technology Growth Capital and that any unauthorized broadcast of this call in any form is strictly prohibited. An audio replay of the call will be available through our website or by using the telephone numbers and pass code provided in our press release.

I would also like to call your attention to the Safe Harbor disclosure in our press release regarding forward-looking information. Today's conference call may include forward-looking statements and projections and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these projections. We do not undertake any obligation to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings please visit www.sec.gov or visit our website at www.herculestech.com. I will now turn the call over to Manuel Henriquez, Hercules' President and CEO. Manuel?

Thanks, Mike and thanks to everybody for joining us today. I want to spend a few minutes discussing our third quarter highlights and investment activities and then hand it over to Dave, which will take you through the third quarter operating results. After that, we'll be happy to take your questions.

Let me first start off by giving you some of the important highlights of the third quarter for 2005. New commitments totaled $30 million to five new companies. New debt fundings for the quarter totaled $43 million to nine companies. New preferred equity investments of $2.25 million to four existing portfolio companies, which include the exercise or conversion of $1 million of debt to equity. Total commitments since inception to companies was $152 million, representing 24 companies, and total (inaudible) investments were 134 -- $130.4 million based on fair value as of the third quarter.

Net income of $1.6 million or EPS of $0.16 per share based on 9.8 million weighted shares outstanding and taxable income of $1 million, which excludes the FASB 123, or $0.10 a share. Net investment income of approximately $900,000 or an EPS of $0.09 a share. Net asset value per share of $11.71, up from $11.55 the prior quarter. Net assets of approximately $115 million. Total unfunded commitments were $23.2 million.

And we also added two additional Managing Directors for targeting our late stage structured mezzanine investment opportunities. In addition, Hercules was added to the Russell Microcap Index during the quarter as well.

Turning to portfolio and investment activities in the third quarter, total new loan commitments represented $30 million to five new companies. We funded a total of $43 million in debt commitments to nine portfolio companies, which includes both companies that had signed term sheets in the prior quarter as well as the current quarter. We anticipate equity fundings -- sorry -- we participated in equity financing to three existing portfolio companies totaling $1.25 million and we also exercised an equity participation or conversion right of $1 million of debt into an equity financing Viscor (ph), it's a medical device company, which is in the middle of closing a $36 million equity round of financing through the quarter.

I would like to remind everyone that the third quarter is generally the slowest quarter of the year in terms of originations, while the fourth quarter is generally the most active. Also, we are seeing our average deal size stabilize in the 5 to $6 million dollar range. We don't expect our deal size to change significantly, however, as we expand our focus on the early stage and late stage companies, the size of the deals will fluctuate.

An important point of clarification is that although we may experience significant new investment activity during the quarter, we may not be able to publicly announce specific investment activity during the period. This is primarily driven by the private companies, who for strategic or competitive reasons, prefer not to bring attention to their expected capitalizations as they continue to build their companies and their product offerings. We need to be respectful of our companies' requests and not cause them any adverse effect as they build their companies. However, we will disclose such investments during our quarterly call.

We continue to see good capital inflow into private companies by venture capitalists who invested approximately $10 billion through the fist half of 2005, and this is according to Dow Jones VentureOne. Although the IPO market for technology companies remains selectively -- highly selective, M&A activities continue to be strong with many large companies seeking to acquire emerging growth technologies or customers, such as Oracle's recent acquisitions. We currently have two companies in our portfolio who are seeking or are in M&A discussion, with one company that may announce an agreement in the fourth quarter. We believe this positively reflects our ability to target and fund quality companies. Certain companies we were in negotiations with were acquired during the final documentation or due diligence process.

Our total investment portfolio at fair value was $130.4 million as of September 30, 2005 and our total debt commitments at inception (ph) was again, $152.2 million to 24 companies. We continue to see some yield expansion during the third quarter with our overall weighted average yield to maturity on our loan portfolio of 12.97. However, we believe that our yield to maturity may begin to stabilize in the near term in the 11 to 12% range, again, highly dependent on our portfolio mix of companies and the different stages of development these companies find themselves in.

In the coming quarter, we expect to expand our portfolio by providing growth capital to companies at various stages of development, specifically, we expect to increase origination efforts to early stage and late stage structured mezzanine opportunities. We were fortunate to add Ed Messman and John Hershey to the origination team for the late stage portion of our portfolio in the coming quarters.

The new funded investments during the third quarter for 2005 include $1.5 million to Adiana, including $.5 million of preferred stock investment, $2 million to Omrix Pharmaceutical, 1.5 million -- sorry -- $11.5 million to Ikano Communications, $8.5 million to AGEIA Technologies, which also includes $0.5 million of preferred stock investment, $2 million to Inxight Software, $4 million to Proficiency, $7.5 million to Luminous Networks, 250 million -- $250,000 to Affinity Express, a preferred stock investment, $4 million to Sling Media and $3 million to Interwise.

As I said earlier, we also converted $1 million of debt financing in Optiscan, an existing medical device company into preferred stock in connection with their financing round of $36 million of new capital that was recently invested in the company. In addition, in October, we recently received a payment -- a repayment of $7.5 million of principal and interest from Luminous Networks.

Turning to our portfolio grading, in the third quarter we had Grade 2 investments of approximately $119 million or 91% of the total investment portfolio. Grade 3 investments totaled $2 million or 2% of the total portfolio. And Grade 4 investments represented approximately $9 million or 7% of the total portfolio. As of September 30, 2005 our weighted average investment rating was 2.17, a significant -- a slight improvement from the second quarter rating of 2.19. Our company had no write-offs, no write-downs or non-accruals to report during the third quarter.

Our net paid earned dividend, as most of you saw today on our press release, we declared a dividend of $0.025 per share based on third quarter earnings, payable on November 17, 2005 to shareholders of record as of November 1, 2005. We intend to make a RIC election, a regulated investment company election, in the first quarter of 2006 at which time we anticipate declaring a special dividend to distribute any accumulated retained earnings. Now I'd like to turn the call over to Dave to review the Q3 operating results. Dave?

Thank you, Manuel. For the three months ended September 30, 2005 investment income was $3.7 million, an increase of $1.8 million or 95% from the $1.9 million in the previous quarter. In the third quarter interest income comprised $3.4 million and loan fees contributed $241,000 to investment income, as compared to $1.7 million of interest income and $192,000 of loan fees in the previous quarter.

Our accounting practice is to defer revenue related to loan commitments and amortize the fees over the life of the respective loans. At September 30, 2005 we had deferred revenue related to loan fees of approximately $1.8 million, a net increase of approximately $200,000 from the previous quarter. Operating expenses were $2.8 million, as compared to $2.2 million in the previous quarter. The increase of approximately $600,000 was primarily related to increases in legal and accounting costs related to being a public company and corporate structuring, as well as stock-based compensation expense in accordance with FAS 123R and compensation expense related to increased headcount.

Net investment income increased $1.2 million to $900,000, as compared to a loss of $300,000 in the second quarter of 2005. Basic net investment income was $0.09 per share based on 9.8 million weighted average shares outstanding, as compared to a loss of $0.07 per share in the second quarter on 5.1 million weighted average shares outstanding.

Net unrealized gains were $700,000 as compared to $1 million in the second quarter. Net income was $1.6 million, as compared to $700,000 in the second quarter. And basic net earnings per share was $0.16 per share based on 9.8 million weighted average shares outstanding, as compared to $0.14 per share in the second quarter on 5.1 million weighted average shares outstanding.

Basic taxable earnings per share, which includes -- excludes FAS 123R stock-based compensation expense, was $0.10 per share based on 9.8 million weighted average shares outstanding, as compared to a loss of $0.05 per share in the second quarter.

Moving on to liquidity and capital resources. September 30, 2005, we had approximately $10.6 million in cash. In addition, based on eligible loans currently in the investment portfolio and subject to the advance rate, we have approximately $600 million of borrowing capacity available under our existing $100 million credit facility with Citigroup. Advances under the facility bear interest at one-month LIBOR plus 160 basis points.

There were no outstanding balances under the facility at September 30, 2005. However, in October, we have drawn down $5 million under the Citigroup facility. We anticipate that portfolio investments entered into in succeeding periods will allow us to utilize the full $100 million borrowing capacity of the facility.

We anticipate that we will continue to fund our investment activities through a combination of debt and additional equity raises over the next two quarters. As a CDC, the company is required to maintain regulatory asset coverage of at least 200%. At September 30, 2005, the company's regulatory asset coverage was greater than 566%.

Now as to guidance, we anticipate the average loan size to be between $5 million and $6 million. We expect to recognize $175,000 of deferred loan fee revenue during the fourth quarter. Based on current option grants outstanding we expect to record approximately $210,000 in stock option expense in Q4. Weighted average shares outstanding for EPS calculation purposes will be $9.8 million for the quarter. We believe that approximately 75% of our commitment will be funded over the next two quarters. We expect to draw between 40 to $50 million on the Citibank facility by year-end. Cost of funds for Citibank will be monthly LIBOR plus 165 basis points and 9.76% on a $25 million loan with Fairlawn (ph). And the average yield to maturity on our loans will be between 11 and 12%.

Now for an update on our SBIC approval. We remain optimistic that we will receive final approval from the SBA some time in the next two to four months. Keep in mind that the SBIC process generally takes approximately 12 to 18 months and the SBI continues to work diligently in getting our application approved. Most recently during the third quarter, we received pre-licensing approval on two transactions from the SBA in anticipation of our final approval. In addition, we recently received a letter from the SBA requesting additional information in an effort to approve our application. We believe our association with SBA will provide an additional resource to capital and strengthen our financial position by giving us access to long term capital.

Operator, we are now ready to take questions.

Thank you, sir. (Operator Instructions). Your first question comes from Don Destino with JMP Security.

Hey, guys. I've got kind of a laundry list so feel free to stop me and I can get back in the queue.

Okay, Don.

First one. The equity investments during the quarter, is it safe to assume that those were not some kind of contingent investments, investments that were contingent on -- that investments, that those were arm's length, you decided that you liked the companies well enough to just make an equity investment in addition to your debt investment?

Absolutely. All the equity investments we make are not contingent upon any debt capital coming into the company. In fact, all of our -- I would say generally, all of our debt instruments by the company have the provision in the loan agreements, it gives us the right to invest in a company's next equity round of financing but we don't necessarily exercise that right all the time. And another point of clarification is that we only make equity investments in companies in conjunction with a new outside equity round being raised as well.

Gotcha. And then the re-payment of the Luminous loan, is it safe to assume that there was -- that there were warrants associated with that loan and would those still be outstanding even though there was the payback?

Yes. Even though when our loans are repaid early for whatever reason there may be, we actually -- the warrants associated with those transactions remain outstanding on our books for future, hopefully benefit, if they realize any gain. I would also tell you that, in conjunction with that same statement, that when a loan is repaid back early, any unrecognized -- unamortized fees are then recognized at the point of repayment of the loan entirely. So you'll see a slight spike in interest fee -- or fee income, I should say, during the quarter of repayment.

Got it. And then, there was 6 or $700,000 of unrealized gains. Can you characterize those? Were those associated with subsequent equity financings or with -- I know you've gotten a couple of investments in some public stocks with -- were those associated with public stocks or something else?

Sure. Well, I'll let Dave field that one.

Yes, most of the gains that we had on an unrealized basis were based on the portfolio companies, the two public stocks that we're holding.

Gotcha. And then, I guess another one for Dave, you said in the list of guidance that you expect a yield of between 11 and 12% but you also disclosed in the press release that the yield in the end of the quarter on the portfolio was 12.97%. I wasn't sure, am I supposed to assume that 11 to 12% is what you expect on incremental growth or is the yield going to come down so much on Q4 investments that it's going to drag down that 12.97% into the 11 to 12% range?

No, I think it's more of the former than the latter. I think that what we're saying is that in the fourth quarter and maybe the next couple of quarters on, as we begin to build out our early stage effort and our late stage effort origination, that that will have some in the yield distribution in terms of those facilities. Lastly, you also see a little more -- the reason why it's 12.97% is that we've seen higher fee recognition than we were anticipating on some transactions. For example, like -- well I'll just leave that -- from transactions. Either repaid or we've gotten higher fees than we anticipated

Gotcha. And then, can you give a brief explanation of what's going on in your Grade 3 and 4 investments?

Sure. We basically have one transaction right now in a Grade 3 level and that is a company that -- and let me just step back for a second and refresh people and everybody on the call what the different grade levels are and how we manage our transactions. We will always grade down a company as it approaches an imminent round of financing or when we anticipate a round of financing should be occurring. We invest in technology companies who are highly dependent upon their capital sponsors to continue to raise capital to operate their businesses and as we approach the period of time where these companies need to raise money, until they actually close a round of financing, in order to be cautious we actually lower the rating to a level three until an equity round in fact closes.

In the case of this particular company, this company has just closed a round of financing and you can anticipate that particular company to be risen to a higher grade level in the coming quarters. In terms of the two companies that we have currently in Grade 4, those are those companies that we alluded to in our opening comments, are in the process of completing or expecting to complete a M&A transaction. One of them in particular is fairly heavily in negotiations with multiple different interested buyers and we suspect that company will be acquired some time in the fourth quarter. It could spill over to the first quarter but we think so far, all the indications are it will occur in the fourth quarter. We tracked the companies at Grade level 4 fairly sensibly and as of right now we don't see any principal risk in those companies as of right now what we know and also the M&A activities and interest that those companies are receiving from their prospective buyers today.

Got it. Okay, I appreciate it. Thanks a lot.

Alright, Don.

Thanks, Don.

Your next question comes from Henry Coffey from Ferris Baker Watts.

Good afternoon, everyone. If I double over on some of Don's questions I apologize. I had to grab a call for just -- through his first question. On your grading system, we're talking about a 1 through 5 system?

That's correct.

Okay. And so the Grade 4 loans are no expected loss of principal?

That's correct.

That's correct.

And a Grade 3 loan would be no loss of principal but questions about the collectability of income, essentially is what a Grade 4 is?

A Grade 4 basically implies that we don't expect to see a loss of principal but the remaining stream of interest payments over the life of the loan may be at question.

And --

By the way, sorry to interrupt you, but it also means that the company is paying us currently.

And at this point you don't have any past-dues and you don't have any loans on non-accrual?

Absolutely not.

Okay. And then a Grade 3 is just as you indicated, there's some sort of external event going on that makes you want to be cautious.

That's right.

In terms of translating your guidance, I caught some of it and I didn't catch the rest. You indicated that you expected to close on a percentage of your current commitments. You've got $27 million of unfunded commitments right now, correct?

$23 million.

$23 million and your comment on guidance was that you'd be funding what over the next two quarters?

Approximately 75% of the commitments will get funded over the proceeding two quarters or so.

Plus new commitments, right?

That's right.

On average we'll fund 75% over the course of two quarters.

And can you give us some sense on the types of origination, what you're looking for in terms of originations over the next two quarters?

As I continue to say, we don't provide guidance in terms of origination. This is more of an investment function and a sales function. But the way we look at the world is that a Managing Director is expected to originate approximately 25 to $35 million of transactions on an annual basis. And today we have, effectively, six MD's -- Managing Directors -- and you really have a head count of MD's close to eight today. But on an effective basis, it's six.

And on December 31st you'll have eight? Because you're probably not giving full weight to the newer people.

That's correct, that's correct. We expect an originator to start contributing in a meaningful way generally at the beginning of their second quarter on the job.

And so if we're talking about '06 for a minute, about how many full-time bodies will you have in place?

What we said during our capitol raising initially that we expect to have 10 full-time head count originators in calendar '06, by the end of calendar '06.

Second question -- next question is on your dividend. If I understand you correctly, at the end of '05 you're going to declare the equivalent of an E&T dividend, you're going to distribute whatever retained earnings you have?

That's correct.

And when will you declare that dividend?

Probably in January once we've had a chance to close the financial records and have the audit completed with our auditors. And so we'll probably announce that at the same time that we do earnings call.

And that's going to be the -- is that going to be the policy, you're going to pay a fixed dividend during the year and at the end of the year have sort of a true up?

The answer is definitely that the Board has been contemplating but I don't want to step in and answer for the board, and certainly we've been looking at the normal practice and that's what they were looking at is paying a normal dividend as you said and then catch up at the end of the year.

Okay. Well that's good.

And the new dividend coming up, that's obviously significantly ahead of schedule.

The last question is probably more complex. Under the assumption that you don't raise any additional equity, your funding capacity in '06 would be somewhat limited, what would be the game plan? Can you give me some idea where the $25 million loan ends up, what you can do with Citibank and what other alternative funding sources you could bring to the table such as the SBA money?

Alright, so obviously we're looking to close the SBA financing. We anticipate that will happen in the next four to six months, two to four moths -- it just depends upon how quickly the government will get through that. We have $100 million available under the Citibank facility, which, depending upon how we continue to generate the loans and push them back into Citigroup, we believe that we will be able to access that full amount of capital by the end of the first quarter of next year. In addition, we are in discussions and we are working on new financings to work with the Fairrlawn loan and look at replacement or refinancing.

We're evaluating multiple different options and like I said, the important thing is that we're not in a capital need that we have to raise capital in the fourth quarter. With our partners at Citibank we have a sufficient amount of capital to continue to fund the business for the next two quarters and we are looking at multiple different options on continuing to raise capital as BBCs do in a normal course of business.

As -- you threw something off balance -- if you're excluding the SBA money you're in essence restricted to one-to-one, which means you're restricted to a balance sheet that's $228 million.

That's right.

And if you -- so we would expect to see with the additional, the current capital structure, about $220 million of on-balance sheet funding?

That's right. As you've rightfully pointed out, that excludes the additional leverage that we can receive under the SBA --

Then the SBA money can go beyond that?

Correct.

That's right. The SBA, assuming that we receive our order release from the SEC which we filed --

Right, you should. Everybody gets it.

Well, it's -- yes.

Right, I know. You can't say.

We anticipate that will occur, that would give us another borrowing capacity of approximately $120 million of capacity.

And what is the expected -- what is the approximate funding cost on that?

It is traditionally a 10-year Treasury plus a spread of anywhere between 160 to 180.

And the size of the loans you can make under that facility, are they within the range of what you're doing already?

We do not anticipate any significant change in our origination of practices today. From that, that will be investing in the SBA as well.

So the SBA will allow you to make how large a loan?

Well under the regulatory capital restriction under the SBA, we're able to do approximately a $12 million loan or so, under the SBA.

Well that's in essence a very flexible source of financing for you.

It clearly is a -- I wouldn't necessarily use flexible -- I think that the --

Friendly.

Yes, it is certainly friendly and there's corporate governances of underwriting criteria that one must be cognizant of when you're underwriting under the SBA program. The net worth of the company and other attributes in terms of where the company actually operates, its corporate offices, its employees and multiple other different things. But the answer is, we do not anticipate that to become a significant regulatory obstacle for us because our companies generally meet that profile.

So under the assumption that you raise no new equity over the next, we'll call it 12 to 16 months, you could still continue with your current business plan is what it sounds like.

I think that it is a safe assumption that we will probably look to raise capital some time in the next two quarters or so.

Right, right, we all know that. But I mean if you couldn't, how would that impact your funding capacity?

We would continue to rely on our Citibank facility.

Right. And the line with Fairlawn is structured to re-price in '06 but you're indicating that you think you can negotiate around that?

Well, we're working at looking at different alternatives to deal with the Fairlawn loan and it does get -- the interest rate does change on January 1.

Right, to 13.65%?

I think it's 13.5%

13.5%, okay. Alright well, thank you very much. Obviously a great quarter, lots of progress and I think the dividend is good news for everybody.

Thank you, Henry. I appreciate it.

(Operator Instructions).

Okay.

There are no more questions in the queue. We'll close this q-and-a session and I would like to hand the presentation back to Mr. Manuel Henriquez for closing remarks.

Well first of all, thank you everybody for your interest in Hercules Technology Growth Capital and we appreciate your questions and your investment in us, and we look forward to seeing many of you soon during our investor business over the next week or so.

Ladies and gentleman, thank you for your participation in today's conference. This concludes the presentation, you may now disconnect. Have a good day.