Main Street Capital Corp (MAIN) 2018 Q4 法說會逐字稿

Greetings, and welcome to the Main Street Capital Corporation Fourth Quarter 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mark Roberson, Investor Relations for Dennard Lascar. You may begin.

Thank you, operator, and good morning, everyone. Thank you for joining us for Main Street Capital Corporation's Fourth Quarter 2018 Earnings Conference Call. Joining me on the call today are CEO, Dwayne Hyzak; President and Chief Investment Officer, David Magdol; and Chief Financial Officer, Brent Smith.

Main Street issued a press release yesterday afternoon that details the company's fourth quarter financial and operating results. This document is available on the Investor Relations section of the company's website at mainstcapital.com.

A replay of today's call will be available beginning an hour after the completion of the call and will remain available until March 8. Information on how to access the replay was included in yesterday's release.

We also advise that this conference call is being broadcast live through the Internet and can be accessed on the company's homepage. Please note that information reported on this call speaks only as of today, March 1, 2019, and therefore, you are advised that time-sensitive information may no longer be accurate at the time of any replay listening or transcript reading.

Today's call will contain forward-looking statements. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may or similar expressions. These statements are based on management's estimates, assumptions and projections as of the date of this call, and there are no guarantees of future performance. Actual results may differ materially from the results expressed or implied in these statements as a result of risks, uncertainties and other factors, including but not limited to the factors set forth in the company's filings with the Securities and Exchange Commission, which can be found on the company's website or at sec.gov.

Main Street assumes no obligation to update any of these statements unless required by law. During today's call, management will discuss non-GAAP financial measures, including distributable net investment income. Please refer to yesterday's press release for a reconciliation of these measures to the most directly comparable GAAP financial measures. Certain information discussed on this call, including information related to portfolio companies, was derived from third-party sources and has not been independently verified.

And now, I'll turn the call over to Dwayne.

Thanks, Mark, and thank you all for joining us today. Joining me for a call today with prepared comments are David Magdol, our President and Chief Investment Officer; and Brent Smith, our CFO. Also joining us for the Q&A portion of our call are Vince Foster, our Executive Chairman; and Nick Meserve, our Managing Director and Head of our Middle Market Investment Group.

On today's call, I will start by providing a recap of our overall performance in 2018 and in the fourth quarter, commenting on the performance of our investment portfolio, discussing our recent dividend announcement and a few other recent developments. And I will conclude by commenting on our investment pipeline.

Following my comments, David and Brent will provide additional comments on our financial results, recent originations and exits, our current liquidity position and certain key portfolio stats, after which we'll be happy to take your questions.

We're very pleased with our full year and fourth quarter operating results. Periods during which we again increased our total investment income and our distributable net investment income, our DNII per share compared to the same periods in the prior year and for the fourth quarter on a sequential basis over the third quarter. We also generated an increase in our net asset value per share for the full year in 2018, maintaining our favorable historical track record of consistently generating annual growth in our regular monthly dividends, DNII and net asset value per share.

As a result of this positive performance, we generated DNII per share that exceeded the regular monthly dividends paid during the fourth quarter and for the full year by approximately 20%. We also closed the year with continued favorable investment activities in the lower middle market, which continues to be our primary area of focus, allowing us to close the year with approximately $350 million of lower middle market investments funded in 2018, representing our best year ever for lower middle market investment activity.

We believe the combination of these positive results continues to highlight the advantages of our differentiated investment strategy and operating structure and have us very well positioned for continued success in 2019.

Looking specifically at the performance of our investment portfolio for the fourth quarter, our lower middle market portfolio appreciated by $18 million on a net basis during the quarter with 29 of our investments appreciating and 12 depreciating during the fourth quarter. Our lower middle market companies continue to collectively exhibit very conservative credit profiles on a relative basis, which David will cover in greater detail.

Our middle market and private loan portfolios collectively depreciated by approximately $45 million on a net basis during the fourth quarter due to a combination of market factors, which caused credit spreads to increase significantly in December, and certain specific credit issues in these portfolios.

We finished the year with a net asset value per share of $24.09, an increase in our net asset value per share for the full year of $0.56 per share and a sequential decrease since the third quarter of $0.60 per share or a decrease of $0.33 per share, excluding the impact of the December supplemental dividend.

Earlier this week, our board declared our second quarter 2019 regular monthly dividends of $0.20 per share payable in each of April, May and June, $0.005 increase per month from the first quarter of 2019, which is consistent with our guidance from last quarter.

As we previously announced on our last conference call, we are in the process of transitioning our semi-annual supplemental dividends into our monthly dividends over several years, and this dividend increase for the second quarter represents the beginning of this transition. As part of this transition, we expect to recommend that our board declare a supplemental dividend payable in June of $0.25 per share, down from our historical semi-annual supplemental dividend rate of $0.275 per share.

We continue to expect that this transition will take several years, and we remain confident that by the end of this transition period, we'll be successful with our long-term goal of delivering growth of our total annual dividends at a level consistent with the historical growth we have delivered to our shareholders.

We ended 2018 with continued momentum in our lower middle market investment activities and completed lower middle market investments of $60 million in the fourth quarter.

Since year-end, we have completed an additional $36 million of lower middle market investments, and as of today, I'll characterize our lower middle market investment pipeline as average. We continue to seek and receive significant equity participation in our lower middle market investments. And as of year-end, we owned an average fully diluted equity ownership position of 40% in the investments in which we currently have equity exposure.

We also had continued success in 2018 and our efforts to focus our non-lower middle market investment portfolio growth on our private loan portfolio ending the year with net growth in this portfolio of $35 million in the fourth quarter and $60 million for the full year.

As of today, I'd characterize our private loan investment pipeline as above average. And in closing, our officer and director group has continued to be regular purchasers of our shares, investing approximately $1.6 million during the fourth quarter and owning total Main Street shares valued at well over $100 million at year-end.

With that, I'd like to turn the call over to David.

Thanks, Dwayne, and good morning, everyone. We're pleased to report a strong fourth quarter, another year during which we grew our total investment income and distributable net investment income, or DNII, both in total and on a per share basis. We also continued to achieve our important goal of generating DNII in excess of our monthly dividends.

As a result of our core strategy in the lower middle market to focus on both debt and equity investments, during 2018, we were able to generate approximately $14 million of net realized gains in this segment of our business and also grow our net asset value per share for the year.

Our full year 2018 operating results provided a return on equity, or ROE, of 11.7%, results that are at the low end of our long-term goal of producing an ROE in the low to mid-teens for our shareholders. Our ROE in 2018 was negatively impacted by the significant unrealized appreciation in the fourth quarter in our middle market and private loan portfolios, partially due to the impact of changes in market interest rate spreads.

Looking forward, we continue to be confident in our ability to generate an ROE in the low to mid-teens. We believe that our long-term results illustrate the significant benefits of our lower middle market investment strategy, which combined with our efficient operating structure, other complementary debt investment strategies and our asset management activities, continue to provide a value proposition that differentiates Main Street from other yield-oriented investment options. This has been demonstrated through our consistent ability to generate premium total returns for our shareholders through growth in our dividends per share, our increased net asset value per share and our stock price appreciation.

The year-end provides a good opportunity to look back at our history and recap the benefits of our unique investment strategy and efficient operating structure and how they have enabled us to deliver attractive returns for our shareholders.

Since our IPO over 11 years ago, our operating performance has allowed us to grow our declared recurring monthly dividends per share by 82% and paid cumulative total dividends to our shareholders of over $25 a share or over 169% of our IPO's price of $15 per share.

Our shareholders have also benefited from significant stock price appreciation since our IPO. These benefits have allowed our shareholders to achieve an annual rate of return of 18% per year during the 11 years since our IPO, which we believe compares very favorably to other investment options over the same period of time.

As we've discussed on previous conference calls, we believe that the primary driver of our long-term success has been and continues to be our focus on the underserved lower middle market. This strategy provides attractive leverage points and yields on our first lien debt investments, while also allowing us to act as sponsor and partner with the management teams of our lower middle market portfolio companies.

In short, we believe we have significant downside protection through our first lien debt investments, while still benefiting from significant upside potential with our equity investments. Given our success in the lower middle market, we are pleased that we have continued to find attractive investment opportunities in this segment of our business. We attribute this success to our ability to customize capital solutions for the predominantly family-owned businesses that exist in this marketplace.

As Dwayne already stated, 2018 represents Main Street's strongest lower middle market year in our history as far as originations of approximately $350 million.

Turning to our most recent operating results, the contributions from our lower middle market portfolio continue to be well diversified with 41 of our 69 lower middle market companies having unrealized appreciation at year-end. Additionally, 30 of these companies contributed to our dividend income during 2018. So far in 2019, we successfully exited 1 lower middle market portfolio company. This investment was in Boss Industries, and it generated a realized gain of approximately $4 million and IRR of approximately 38% or 4x our money invested return and is yet another example of how valuable our lower middle market strategy is in supporting Main Street's stated goal of increasing our NAV over time.

Now turning specifically to our investment activity in the fourth quarter and our investment portfolio at year-end, our investment activity in the fourth quarter included total investments funded in our lower middle market portfolio of approximately $60 million, which after repayments, resulted in a net increase in our lower middle market portfolio of approximately $25 million. We had a net decrease in our middle market portfolio of approximately $6 million and a net increase in our private loan portfolio of approximately $35 million.

As of December 31, we had investments in 184 portfolio companies spanning across more than 50 different industries. Our largest portfolio company represented 4.9 of our total investment income for the year and 2.7% of our total investment portfolio at fair value at year-end. The majority of our portfolio investments represent less than 1% of our income and of our assets.

Additional details on our investment portfolio at year-end are included in the press release that we issued yesterday, but I'll touch on a few highlights. In our lower middle market portfolio, we included investments in 69 companies, representing approximately $1.2 billion of fair value, which is approximately 21% over our cost basis. At the lower middle market portfolio level, the portfolio's mean net senior debt-to-EBITDA ratio was a conservative 3:1 and the total EBITDA to senior interest ratio was 2.8:1.

As a complement to our lower middle market portfolio, our -- in our middle market portfolio, we had investments in 56 companies, representing approximately $577 million of fair value. And in our private loan portfolio, we had investments in 59 companies, representing approximately $508 million of fair value.

As we've discussed on previous conference calls, given our favorable view of the lower middle market and private little -- private loan opportunities that exist today, we've been working to focus our investment activities primarily in these segments of our business with our middle market investment activities focused on an opportunistic approach instead of an approach focused on growing the middle market portfolio. As a result of executing this strategy, during 2018, on a cost basis, we increased our lower middle market investment portfolio by $215 million or 28%, increased our private loan portfolio by $64 million or 13% and decreased our middle market portfolio by $21 million or 3%.

Our focus going forward will be to generally maintain the current amount invested in our middle market portfolio as it continues to be an important part of our investment strategy, but we do intend to decrease middle -- our middle market portfolio on a relative basis compared to the lower middle market and private loan portfolios.

The total investment portfolio at fair value at year-end was approximately 108% of the related cost basis. We had 6 investments on nonaccrual status, which equals 1.3% of the total investment portfolio at fair value and 3.9% at cost.

In summary, Main Street's investment portfolio continues to perform at a high-level and deliver on our long-term goals.

With that, I'll turn the call over to Brent to cover our financial results, capital structure and liquidity position.

Thanks, David. We are pleased to report that our total investment income increased by 6% for the fourth quarter over the same period in 2017 to a total of $59.3 million, primarily driven by an increase in interest income of $2.3 million and an increase in dividend income of $0.9 million.

Our total investment income includes a decrease of $1.6 million related to lower levels of accelerated income for certain debt investments and a decrease of $2.7 million related to nonrecurring interest income when compared to the same period in 2017.

The fourth quarter 2018 operating expenses, excluding noncash share-based compensation expense, decreased by $0.9 million over the fourth quarter of the prior year to a total of $14.9 million. The decrease was primarily related to a $2.8 million decrease in compensation expense, partially offset by a $1.9 million increase in interest expense.

The decrease in compensation expense was primarily due to $1.9 million in non-recurring expense reductions or benefits to income as well as lower overall incentive compensation accruals in the fourth quarter. The nonrecurring reductions included the conversion of $1.5 million of cash bonus into a noncash restricted stock grant and a $0.4 million reduction in compensation expense relating to the decrease in fair value of our deferred compensation plan assets. The ratio of our total operating expenses, excluding interest expense, as a percentage of our average total assets was 1.4% for the full year 2018 compared to 1.6% in 2017.

The combination of our unique investment strategy and leverage of our efficient operating structure resulted in 11% increase in distributable net investment income for the fourth quarter of 2018 to a total of $44.4 million or $0.72 per share or $0.69 per share after excluding the nonrecurring benefit relating to compensation expense, which exceeded our recurring monthly dividends paid for the quarter by approximately 18%.

The activities of our External Investment Manager and its relationship with the HMS Income Fund benefited our net investment income by approximately $2.6 million in the fourth quarter through the allocation of $1.4 million of operating expenses for services we provided to it and $1.2 million of dividend income.

We recorded a net realized loss of $1.4 million during the fourth quarter primarily relating to the realized loss from the exit of a lower middle market investment. And as Dwayne discussed, we recorded net unrealized depreciation on the investment portfolio of $32.4 million during the fourth quarter, primarily resulting from $27.3 million of net depreciation on our middle market portfolio, $17.7 million of net depreciation on our private loan portfolio, $4.4 million of depreciation on our External Investment Manager and $1.2 million of net depreciation on our other portfolio.

With this, net depreciation partially offset by $18.2 million of net appreciation on our lower middle market portfolio. Additional details for the net unrealized appreciation can be found in our earnings release.

Our operating results for the fourth quarter resulted in a net increase in net assets of $9.5 million or $0.16 per share. On a capital resources front, our liquidity and overall capitalization remains strong. At the end of the fourth quarter, we had approximately $54 million of cash and $404 million of unused capacity under our credit facility for total liquidity of $458 million.

Currently, we have approximately $40 million of cash and $370 million of unused capacity under our credit facility for total liquidity of $410 million.

Due to the stock market volatility in December, we limited our activity under our ATM equity issuance program, raising approximately $6 million in net proceeds during the fourth quarter with an average sale price of $38.47 per share.

As we look forward to the first quarter of 2019 and taking into account the impact from 2 fewer days of interest income during the first quarter when compared to the fourth quarter, which we estimate has a $0.01 to $0.02 negative impact to net investment income per share, we expect that we will generate distributable net investment income of $0.64 to $0.66 per share during the quarter. This estimate is $0.055 to $0.075 per share or approximately 9% to 13% above our previously announced monthly dividends for the first quarter of $0.585 per share, maintaining our conservative approach to our monthly cash dividends.

With that, I will now turn the call back over to the operator so we can take any questions.

(Operator Instructions) Our first question here is from Robert Dodd from Raymond James.

On the market, just wanted to know, can you give us any color because I was trying to think you characterized the lower middle market pipeline as average, but the private loan as above average. Are there any dynamics going on in terms of -- particularly on the lower middle market and the small business side that's driving people to be less eager to sell a stake in the business at this point?

No, Robert. I would say it's more just a fact that we had a very robust amount of activity in the fourth quarter and all of 2018, and we've already had a couple of closings in Q1. So it's more just a timing issue than a change in the marketplace. Our view is that we continue to find our value proposition both in terms of structuring flexibility and being a real partner to the management teams of these companies continues to have a very good place in the market. So there is nothing other than just where we are in executing on the pipeline as opposed to there being something that changed.

Okay. Got it. And then kind of a related follow-up. On -- the first time, I think that I can recall your average position on the lower middle market -- the average equity stake has hit 40%. If we go back a few years, it tended to be more in the low 30s. It's definitely been trending up. Is that an appetite from the lower middle market business owner to sell more? Or has it been obviously your equity positions on the lower middle market side of a large part of how you generate that higher-than-average ROE long term? So has it been a decision to increase the size of the equity position to try and manage the ROE by you? Or is it just opportunistic from the seller?

Yes. I would say it's more just -- it comes down of the type of deals we've seen recently. I think over the last couple of years, we have had an appetite or willingness to take larger equity positions. And the key for us is just making sure that the -- either the former owner, or more importantly, the operator manager of that business that he or she has a significant stake in the game. What you've seen in some of the more recent transactions is, while they are increasing their equity stake, they're starting with something less than 100%. So they just don't have as much equity to roll over into the new transaction and that results in us having a larger ownership position as a result of that transaction. But we continue to believe that the types of transactions we're executing are very consistent with what we've done in the past. It is just that the person that's our partner doesn't own 100% of the company proud us transacting with them.

Got it. Just one housekeeping one for Brent. On the DNOI (sic) [DNII] guidance, I mean, will we expect the stock comp share to still average kind of $0.04 a quarter going forward? Obviously, you give a little bit of color about some things that changed in the fourth quarter. So is that kind of -- the right kind of ballpark?

Yes. I think $0.04 is a good number. I mean, I think, technically, the number is 3-point something cents, but typically rounds up to $0.04.

Our next question is from Tim Hayes from B. Riley FBR.

Just following up on the growth question there, I just want to clarify, it sounds like you expect continued growth in the lower middle market portfolio and that the downgrade, so to speak, in your outlook from above average to just average reflects a more near-term view. So do you think the lower middle market portfolio could -- growth there could outpace last year? Or do you expect it to moderate a little bit?

What I would say is that last year, as I think we said in our comments, was our best year ever. So when we look at the marketplace, part of the pipeline is what I said earlier in response to Robert's question, just a timing issue as opposed to something changing. We do expect that the lower middle market will continue to be our primary focus, and we do expect to grow it. If you would have looked at our 2019 budget, it would not be at the 2018 level just because that was a robust year with it being our best year on record, but we absolutely expect it to grow and it'll -- the level of growth there will just be dictated by the attractiveness of the opportunities that we see.

Understood. Second question. How much of the unrealized appreciation of the middle market and private loan portfolios was attributable to market volatility and spread volatility, and I guess, broker quotes versus company-specific credit? And how much of that market-related weakness do you believe has been recovered so far in the first quarter?

Yes. I would say that when we look at that type of question because we're in the middle of the quarter, it's always tough to try and kind of split it or separate it between the 2 with any precision, our best estimate would be that if you look at the depreciation we took in the fourth quarter, it would be roughly 50-50 between market-related purely, and then combination of market and credit. When you look at the recovery in the first quarter, we do think that market spreads have improved significantly. So a significant portion of the market-related piece only. We do expect it to recover in Q1. When you look at the credit-specific piece, it will come down to how those individual companies or those credits end up working through the issues that they've had on their individual case.

Got it. Okay. That's helpful. And then my last question, just noticed you placed another investment on nonaccrual having been able to dig into that without the K out. Can you just give a little bit more context around which company that is, what's going on there and the risk rating it held at the end of 3Q?

Yes. The new nonaccrual was MH Corbin, which is a lower middle market investment. So there's been certain specific performance issues at the company, and we're currently actually working on a resolution related to that company. I think we expect that to occur in the near term. So hopefully, that will be coming off nonaccrual, if not, by the end of the first quarter, shortly thereafter.

(Operator Instructions) And our next question here is from Christopher Testa from National Securities Corporation.

Obviously, lower middle market, you guys have had a record year. Just wondering as you guys have grown in size pretty substantially over the last several years, if you're starting to get approached by larger size borrowers and if you think that there is also a pretty significant opportunity set there for Main Street?

Yes. So this is David Magdol. We do see some more attractions, especially as we're entering the private loan market and more with some opportunity to increase our size on transaction. We're still very much focused on where we've been and where we've made good investments historically. We stated our range of $3 to $20 million EBITDA. A substantial portion of our deals were really done in the $5 to $12 range, and we think there is lots of growth to continue to focus in that area. There is no question if you look at the average size of our investments, ones that we're doing 4, 5, 7 years ago, they are still on our balance sheet. They are smaller than some of the investments we're doing today, but there is no question, it's a very attractive market for us out there. And we can continue to grow where we have been focused going forward.

Got it. Okay. And kind of sticking with that theme, I know that you have a very small joint venture with Capital Southwest. Just wondering, if you guys think it makes sense to potentially use the 30% basket more either through upsizing that JV or entering into another one to potentially take advantage of market dislocation faster when it occurs like it did last quarter?

Yes. I would say that in specific reference to that joint venture, I think we've been very happy with the way it's performed. And we think it continues to have a very positive outlook as we look forward continuing to maintain and potentially grow that with Capital Southwest. As you've heard us reference in prior quarters, I think we continue to look for opportunities to grow our business. One of the ways we're looking to grow is the asset management side of our business that continues to be a very big focus area for us, and we'll continue to look for opportunities there. So when we look at that, it is something that we would find very attractive and think it could be a great place if there is a market dislocation to have another pool of capital that we could deploy in that type of situation.

Got it. And last one for me, just wondering for your lower middle market book to the middle market book and private loan book, if there is any difference in the kind of the biggest concerns from the borrowers within each of those books, whether it's a slowing economy or trade war, I'm just wondering if there is a difference in the concerns expressed by those borrowers? Or if you guys yourselves have different concerns for most of the companies that are in each of those segments?

Yes. I would say based upon what we hear from the companies, we don't see really material or big differences between the different groups. I think, obviously, when you look at the middle market, I think we've had some more retail exposure and a couple of names there that just like you've seen across the retail industry as a whole have underperformed, but that's just more of an individual company or industry as opposed to something broader based that we're hearing across the different portfolio companies.

Great. This concludes the question-and-answer session. I'd like to turn the floor back to management for any closing comments.

Well, thank you, everyone, for joining us today. Thank you very much for the questions, and we'll look forward to talking to everyone again in a couple of months.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you, again, for your participation.