Pennantpark Investment Corp (PNNT) 2010 Q1 法說會逐字稿

Good morning and welcome to the PennantPark Investment Corporation first fiscal quarter 2010 earnings conference call. (Operator Instructions). It is now my pleasure to turn the conference over to Mr. Art Penn, Chairman and Chief Executive Officer of PennantPark Investment Corporation.

Thank you, and good morning everyone. I would like to welcome you to our first fiscal quarter 2010 earnings conference call. I am joined today by Aviv Efrat, our Chief Financial Officer. Aviv, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.

I would like to remind everyone that today's call is being recorded. Please note that this call is the property of PennantPark Investment Corporation and that any unauthorized broadcast of this call in any form is strictly prohibited. Audio replay of the call will be available by using the telephone numbers and pin provided in our earnings press release.

I would also like to call your attention to the customary Safe Harbor disclosure in our press release regarding forward-looking information. Today's conference call may also include forward-looking statements and projections, and we ask that you refer to our most recent filing with the SEC for important factors that could cause actual results to differ materially from these projections. We do not undertake to update our forward-looking statements unless required by law.

To obtain copies of our latest SEC filings, please visit our website at www.pennantpark.com or call us at 212-905-1000. At this time I would like to turn the call back to our Chairman and Chief Executive Officer, Art Penn.

I am going to spend a few minutes discussing current market conditions, followed by a discussion of investment activity, the portfolio, our overall strategy and then open it up for Q&A. As you all know, the economic signals are mixed with many economists expecting a flat to slightly growing economy going forward.

With regards to the more liquid capital markets, and in particular the leveraged loan and high-yield markets, the substantial rally that we saw in 2009 has continued in 2010. Yield-oriented investors have been investing in high-yield and leveraged loan funds as money market rates are at record lows. The cash flow into the market has been driving both secondary price levels and new issue activity.

We believe that the mixed economic conditions may last a while. As primarily a lender, a flat economy is manageable as long as the capital structure has appropriate leverage and interest coverage. We remain focused on long-term value and making investments that perform well over several years. We continue to set a high bar in terms of our investment parameters, and remain cautious and selective about which investments we add to the portfolio.

Our focus continues to be on companies or structures that are more defensive and have low leverage, strong covenants and high returns. As prior cycles have proven, our investments in this environment may end up being some of our best. With significantly reduced competition in the middle market, we are well positioned to take advantage of the 2010 vintage.

Since our inception three years ago we had become a first call for middle-market financial sponsors, management teams and intermediaries who want consistent credible capital. As an independent provider, free of conflicts or affiliations, we have become a trusted financing partner for our clients.

We have been active and are well-positioned. For the quarter ended December 31, 2010, we invested about $50 million at expected IRRs generally ranging from 13% to 18%. Average debt to EBITDA on these investments was below 4 times. We expect to continue to find investments with attractive risk/reward characteristics in this environment to grow our income.

Net investment income was $0.28 per share. We have continued to invest since quarter end to continue to grow income. Due to the stability and growth of our income, last quarter we increased the dividend to $0.25 per share. Yesterday we increased the dividend to $0.26 per share. Our run rate income continues to be higher than our newly increased dividend.

As a result of initiatives to focus on high-quality, new investments solid performance of existing investments, and continuing diversification, our portfolio is constructed to withstand market and economic volatility.

The credit statistics of the overall portfolio continue to improve. The cash interest coverage ratio, the amount by which EBITDA, or cash flow, exceeds cash interest expense, continues to be a healthy 2.8 times. This provides significant cushion to weather a weak economy and provide stable investment income.

Additionally, at cost the ratio of debt to EBITDA came down again this quarter to 4.0 times, and another indication of reduced risk in the portfolio. The portfolio is relatively low risk. It consists primarily of cash paid debt instruments, and only 5% of the portfolio is preferred and common equity.

Out of the 85 investments we have made since inception nearly 3 years ago, we have had only two companies on non-accrual, both of which have been subsequently reorganized. To the extent we have more non-accruals, which is probable in this economic environment, we have substantial cushion between our investment income and our dividend.

The statistics we have mentioned relating to interest coverage and EBITDA multiples highlight an important point about the vintage of our investments. At cost about 84% of our current core investments were made after June 2007, when the credit markets started to deteriorate. As a result, the investments completed after June 2007 tend to be in more defensive sectors, have lower leverage multiples, tighter covenants and better pricing. To date our investment thesis on those companies remains generally on track.

Now that it appears that we have come through the worst part of the recession, we can look back and analyze the actual performance of portfolio companies. The EBITDA of the core portfolio was down 7.2% from initial investment to its lowest point on a weighted average basis based on cost. Today that EBITDA number is up about 5.6% from initial investment.

We are in good shape from the standpoint of liquidity. As of December we had about $60 million of credit facility and cash available to us, in addition to our non-core first lien portfolio of about $35 million. We will continue to gradually sell down this non-core portfolio and rotate to higher-yielding assets.

Additionally, in January we filed an application with the Small Business Administration to form an SBIC. SBIC financing is attractively priced long-term debt, which can help us finance our growth. We do caution, however, that approval of a license is not assured, and the approval process will probably take at least a year.

We continue to be substantially matched from the standpoint of fixed and floating interest rates. 39% of the portfolio has an interest rate that floats, another 18% floats, but has the benefit of a floor, which protects income in this type of low base rate environment, and 43% is fixed-rate. As we add assets at attractive yields over the next few quarters, our net investment income should grow.

An inevitable part of our business, particularly in a soft economy, is defaults. The combination of our existing portfolio and new investments should position us to have a stable dividend, even if we experience non-accruals. That being said, to be clear we will do our best to maintain a stable dividend and potentially grow the dividend, but it is not guaranteed.

In terms of new investments we had an active quarter, investing in attractive risk-adjusted returns. Much of our activity continue to be driven by refinancing. In virtually all of these investments we have known these particular companies for a while, have studied the industries, have a strong relationship with the sponsor, or have proprietary information flow.

Let's walk through some of the highlights. We invested $10 million in senior notes at Aquilex, which is a leader in critical maintenance, repair and industrial cleaning solutions to the energy and utility industries. Teachers' Private Capital controls the company.

Columbus International provides wholesale broadband capacity services and retail broadband-enabled services to customers. We invested $10 million in senior secured notes. Fairway is a leading supermarket operator in the New York metropolitan area. We invested $10 million in a first lien senior secured loan. Sterling Investment Partners is the private equity sponsor.

We invested $11.5 million in subordinated debt on warrants of TRAK Acquisition, to finance the acquisition by private equity sponsor HIG. TRAK is an outsource provider of collection services through the legal recovery process.

We have also initiated small positions in Headwaters and Mohegan Tribal, while adding onto positions in QMG GuestTek and Transportation 100. We are also starting to see some positive early exits on core investments. Rex Air paid us back almost $7 million at par on an investment we made six months ago at around $0.77 on the dollar. Additionally, IBQ repaid $5 million of their $20 million loan at par, as that company continues to deleverage.

With regard to the outlook, we have continued to see activity levels pickup. New deals have primarily been driven by refinancing of existing capital structures, as companies look to extend maturities and replace lenders who are exiting the market. We have also seen a rise in the level of middle-market M&A, which over time should drive a substantial portion of our investment activity.

Much of our business will be driven by companies that need a financing solution and don't have many options as finance companies, CLOs and local banks have exited the market. Due to our strong sourcing network and client relationships, we are seeing tremendous deal flow.

Let me now turn the call over to Aviv, our CFO, to take us through the financial results.

For the quarter ended December 31, 2009, the investment income totaled $13.6 million, and expenses totaled $6.4 million. Management fees totaled $4.3 million.

General and administrative expenses totaled approximately $1.1 million. Interest and credit facility expenses totaled about $800,000, and excise tax totaled about $100,000. Accordingly, net investment income was $7.2 million or $0.28 per share.

During the quarter ended December 31, 2009, net unrealized change from investment was a gain of $23.9 million or $0.93 per share. Net unrealized change from credit facility was a loss of $5.8 million or $0.23 per share. Realized losses was approximately $16.6 million or $0.64 per share.

The dilutive effect of issuance of additional shares was $2 million or $0.08 per share. And excess net investment income over our dividend was approximately $800,000 or $0.03 per share. Consequently, NAV per share went from $11.85 to $11.86 per share.

As a reminder, our entire portfolio and our credit facility are marked to market by our Board of Directors each quarter, using the exit price provided by an independent valuation firm or independent broker-dealer quotations, when active markets are available under ASC 820 and ASC 825. In cases where broker-dealer quotes are inactive, we use independent valuation firms to value the investments.

Our overall debt portfolio has a weighted average yield of 11.3%. The non-core senior secured debt portfolio yielded 2.7%, and the core debt portfolio yielded 12.2%.

On December 31, 2009, our portfolio consisted of 44 companies and was invested 31% in senior secured debt, 29% in second lien secured debt, 35% in subordinated debt, and 5% in preferred and common equity.

Our core portfolio has 35 companies, with an average investment size of $13.7 million. Our non-core senior secured debt portfolio has nine companies, with an average investment size of $3.9 million.

With regard to the dividend, as of September 31, our run rate net investment income, assuming no changes, continues to be greater than our dividend. As you know, BDCs are obligated to pay out at least 90% of their net investment income. If we make no new investments and our portfolio continues to perform, our income will continue to be higher than our dividend.

Now let me turn the call back to Art.

To conclude, we want to reiterate our mission. Our goal is a steady, stable and growing dividend stream. Everything we do is aligned to that goal. We try to find larger, less risky middle market companies, companies that have high free cash flow conversion, capture that free cash flow primarily in debt instruments, and pay out those contractual cash flows in the form of dividends to our shareholders.

In closing, I would like to thank our extremely talented team of professionals for their commitment and dedication. Thank you all for your time today and for your continued investment and confidence in us. That concludes our remarks. At this time I would like to open up the call to questions.

(Operator Instructions). Sanjay Sakhrani, KBW.

Good quarter. I was wondering if you could talk about what kind of growth we should expect in the March quarter. I'm just trying to reconcile that with liquidity and potential capital needs.

As you know, we state this all the time, it is tough for us to predict with any accuracy quarter-to-quarter activity levels. We are value investors. If there is a good deal, we are going to try to do it, and if there is not a good deal, we are not going to do it.

So we do think overall 2010 should be an interesting opportunity. 2010 should be great vintage for what we all do for a living. So we are excited about the prospects for 2010.

But as you have seen, we have had quarters where we have done zero. We have had quarters where we have done $65 million. We have had quarters where we have done $30 million. It is hard to predict for us. It is hard to model. I know it is hard for research analysts to do that.

In terms of potential capital needs, we obviously feel like we have no immediate need for capital. We've got dry powder on our credit facility. We've got -- this non-core first lien portfolio which will dish off over time. We've got companies paying us back early, which happened last quarter, and we expect that to continue to happen. So we are in no rush to do anything other than find good deals.

Maybe I can ask that question a different way. Is there a strong pipeline of deals that may be completed in the March quarter?

It is a little too early to tell. There was a lot of activity towards the end of last quarter. People were trying to get deals done before year-end. It has gotten pretty active here in the last week or two. Frankly, the early part of January was pretty slow as people were probably just getting back from the holiday, and the wheels of commerce hadn't yet started. But we have been giving lots of interesting phone calls the last couple of weeks.

Again, tough to say what the hit ratio and that will be for the March quarter. And if those deals are deals that we are going to like. So, again, I am not giving you any guidance. It is hard for us to do that, but we do think 2010 will be a great opportunity, and we would expect to be active over the course of the year.

Okay, great. Then could you just quantify the impact of consummating some of the deals in the previous quarter late in the quarter? Was there a material impact to net operating income per share?

A lot of the deals, as I said, did close towards the end of the quarter. So you could -- indicating that the run rate might be higher than what we have been -- what we generated last quarter.

Maybe finally, could you just talk about how you feel about Pennant's position in the marketplace? And do you think you need to make any changes to fully capitalize on the opportunities out there? I understand the SBIC thing, but is there anything else that you guys could be doing to capture more deals flow, or do you guys feel pretty comfortable where you are?

Look, we think, as I said, 2010 will be a great opportunity. We are going to figure out how to judiciously take advantage of that opportunity. We like where we are positioned. It is nice to be an independent provider. We are unaffiliated, that provides a unique niche for us in the market where there is no conflict of interest with any other parts of a firm. We can be pure in our mission without having clients wondering about what our mission really is.

And we feel very good about the franchise we have built over the last almost three years in terms of client flow and client franchise. So there is no shortage of calls that we are getting. There is no shortage of opportunities. It is really for us to pick and choose which of those opportunities make sense and meet our risk/reward thresholds.

John Stilmar, SunTrust.

Two quick questions. The first one is as we start looking at the new investments, you made some investments in first lien debt, can you talk to me about the opportunity of first lien and where you are in the cap structure relative to maybe some other opportunities, if you were to go further down on the cap structure and capture higher yield, is there something that we are not seeing just as we look at the straight coupon that might be additional enhancements, or just that we may not be seeing in how you're thinking about where you want to play in the capital structure, given where we are in the capital markets and in the economy?

That is great question. Thank you. Look, we evaluate -- just in terms of how we evaluate reward for these deals, we are looking at not only the strict coupon or the yields we are looking at -- is there an upfront fee or are we buying it at a discount. What is the call protection. We were able to get some really nice call protection the last three quarters, where it is noncall three, noncall four, and in some cases noncall life. Which can be very attractive, particularly if you think the company is going to be deleveraging or growing. They are going to want to get out of a high cost pieces of paper, either through -- either if they deleverage or grow.

So call protection is something that doesn't show up in the actual numbers that are in the Q, but it does show up in our expected IRRs. And in some cases we get warrants. There was a deal that we did last quarter where we got warrants. Again, that doesn't show up in the actual yield, but to us that is an important part of IRR.

So to us, we look at it on an expected internal rate of return basis. We said that our IRRs are 13% to 18%, including our belief in either warrants or call protection or OID. So we look at it as an overall package.

With regard to first lien subdebt, secondly, whatever, unitranche, as you look at the 2009 vintage for us, the $150 million-ish that we did, a lot of it was first lien senior secured, whether that was new origination, whether that was buying investments in the secondary market at discount. It was a great time for us to move higher in the capital structure and get what we thought were heretofore mezzanine returns and being at the top of the capital structure.

So, of course, if you can get mezzanine, or even equity-like returns and be at the top of the capital structure, that can be wonderful risk/reward. We believe the other '09 vintage for us will continue to be wonderful risk/reward.

In terms of where the opportunity is going forward, as the markets have normalized, as secondary levels have increased, 2010 for us will be largely about origination of middle-market loans to either refinance companies or to finance an acquisition in conjunction with a sponsor.

It is either going to be what we would call stretch senior or unitranche financing, where you're doing a piece of paper at the top of the capital structure and stretching down into the middle, and getting a mezzanine type return. Or we are going to be doing traditional mezz or second lien in the middle of the capital structure and getting a mid-to upper teens return. That is going to be the bulk of what we do in 2010.

There still will be sporadically interesting secondary opportunities or more interesting on the [run] opportunities, but it is probably not going to be the bulk of what we are doing. I don't know if that answers your question.

It is perfect. Then secondly, moving more tactically to your portfolio, let's exclude the Questar refinancing, but Realogy, Jacuzzi Brands, Swift, were all things that looked to say you have certainly taken the lumps in the portfolio over a period of time. Those were really the big winners for this quarter.

One, can you talk about how much or what is changing in those businesses with regards to market appetite or capital structure or -- and then if you could shift to some of the ones that may not have performed this quarter as well, like EnviroSolutions or UP Acquisition, some flavor there for what might be some of the macro or micro drivers of those trends?

Swift continues to chug along and perform decently. As we said last quarter, they got an amendment done with the first lien. The bonds, which are illiquid, are trading around $0.90 on the dollar. So the value has substantially improved on Swift, and that seems to be chugging along nicely.

Realogy, as we said last quarter, did also a minor restructuring of their capital structure. Again, last quarter we sold off some of our subdebt position, rotated it into the second lien, a piece of paper higher in the capital structure, so we still have a piece of subdebt and we have a piece of second lien.

Both of those securities have traded up. The second lien that we bought last quarter at par is now 109. There you see the benefit of call protection. That is an non-call 3 on a 13.5% piece of paper. And the subdebt that we still own has traded up nicely from let's say $0.60 to $0.70 on the dollar over the course of the quarter. And there is some belief that the housing cycle is finally healing to some extent and that has helped the perception on those bonds.

Jacuzzi, we have seen a pop in the numbers. So that has helped that unit security trade up in value into the 70s. EnviroSolutions is a garbage company. And the trivia of fact of the day is this is the first time in history of people reporting the amount of garbage, garbage collection in the United States is down this year. That has impacted the results of that company. We are watching that company. We are on a first lien position. The paper is in the upper 70s right now in terms of where it is quoted. We bought it in the mid-90s.

In the upper 70s you are basically at about 5 times cash flow, which we think it is fairly safe from a value standpoint. Public comparables trade at much higher multiples than that. But that is one we are watching.

UP has gotten hurt. Their numbers are tied to natural gas to some extent, and natural gas prices are low, and that has hurt the company's EBITDA. We don't see any issue with the debt, but the equity co-invest has been marked down since last quarter.

Then the last sort of macro question for you. You talked about EBITDA being up roughly, I think, you said 5% from original investment. Can you talk to me about the relative momentum? Obviously an easy answer is things are getting better. But as you start looking at your -- as you start looking at that trajectory of EBITDA in your portfolio of companies, can you give me a sense for the relative degree of change that we have seen, let's say three months ago versus six months ago, sort of a progression? Are we starting to move to a higher growth rate or some sort of slope of that improvement would be helpful. Thank you.

That's a great question. It is hard, because obviously it is a lumpy thing, and we've got a pretty small sample set here. So the inflection point really was -- we are going to say mid-March to June of '09. That is when we saw the inflection point in some of that EBITDA.

Part of it was Lyondell, really the EBITDA there really improved pretty quickly. It is a cyclical company, but there was an inventory rebuild going on and that really flipped very nicely in mid-09. We have seen the rate of decline in, let's say, Realogy stock in that timeframe also. So those were just to indicate a sense for what was going on around that timeframe.

Scott Valentin, FBR Capital Markets.

Thanks for taking my question. Just with regard to interest-rate risk profile, I think you mentioned about 43% of the portfolio is fixed rate. There was a debate about where rates are going. I think people don't expect rates to go lower, but they may go up, and the timing of that is unknown. I am just curious, as you add new investments to the portfolio are you trying to add fixed-rate investment or is it more -- sorry, are you trying to focus on adjustable rates versus fixed-rate and preparing for maybe eventual rate increases?

Look, clearly -- and that has been a big theme. A lot of what we have bought over the last nine months has been floating. And it has been the best of all worlds, because it has floated and had a LIBOR or prime floor. So we get the best of both worlds. We get a pretty decent coupon now, and then if LIBOR or rates pop up we can pop up with that.

We like the way we're matched right now. It is -- there's a lot of matching focus for us as a company. But if you take the 39% that does -- that has no floor, but does float, plus the 18%, you're at like 57% that floats in some way, shape or form, that is fairly healthy.

Clearly we love to have our cake and eat it too, and have a minimum base, and an upside if we can negotiate it. Sometimes we can't. If we can't negotiate a floating and we do a fixed, we are going to be very comfortable that the company's credit characteristics, i.e., either its growth or its deleveraging, and combined with its call protection and potential upside, means that our internal rate of return is going to be at our mid to upper teens thresholds.

Then just in terms of dividend payout and capital management, I think you have roughly $0.10 of spillover. And then the excise taxes incurred this quarter, and you had a dividend increase. I'm just curious as to how you guys think about going forward, what is the appropriate level of spillover? I know you want to maintain at the very minimal a stable dividend, but hopefully a growing dividend. I am just curious as to how you manage those three factors, spillover, dividend and ability to pay an excise tax.

It is a great point. It is a balancing act that we have to balance. We do like having cushion. We do like earning more than our dividend. It is a safety valve for us; it is a safety valve for shareholders. We want people to feel very safe about our Company, and very safe about our earnings stream, and very safe about our dividend. So we generally like a little bit of cushion.

We like where our portfolio is right now. We feel very comfortable with our portfolio, and we have our arms around it. We feel good about our growth opportunity. I am not giving you an answer, because it is quarter-by-quarter, we analyze it and make a judgment call based on our backlog, based on our portfolio, based on our earnings power. But we generally like having a little bit of cushion between our income and our dividend.

Greg Mason, Stifel Nicolaus.

I want to talk about your future debt capacity. Obviously, with your current credit facility, two and half years left to go at a significantly low rate, it doesn't seem like you want to touch that. What are your plans for as you grow this business securing additional credit?

That is a really good question. It is something we think about a lot. And we are very methodically looking at all the options, whether that be SBIC financing -- as you know, we filed an application. Whether that be potentially at some point in the next quarter or two going into the rating agencies and getting a credit rating so that we could potentially issue either public or private debt. Whether it means continuing our very strong relationships with our existing lenders and developing options with them.

So, again, we have no immediate need for capital. But we are thinking about the future and working on creating as many options as possible for this Company, really to try to have several different sources of debt capital.

Then one final question. As you do new deals, can you talk about the upfront fees you're getting? And does it differ between doing a sole managed deal versus club deal, versus syndicated deal?

It is all case-by-case, as you know. There are some lenders who -- here is their formula. They always get X% fee and they always get Y% yield, or this type of call protection or whatever. For us we are looking at an overall IRR, and we are looking at is that a good risk-adjusted return for the particular deal. So to us it could be an upfront fee or OID. It could be better call protection. It could be either equity coinvestor warrants on the backend. So we come at it perhaps less formulaically than others.

In this market for originated deals, it is a 2, 3 point upfront fee is typical. But again, on TRAK Acquisition we are able to negotiate some warrants -- or a coupon, or you negotiate that versus call protection. So it is all part of the mix. We don't have a particular formula. For a company that we really think is a deleveraging candidate or a growth candidate, call protection can be a very powerful way to get upside. And we were able to negotiate some pretty good call protection last quarter.

Jim Ballan, Lazard Capital Markets.

I wanted to ask a little bit more about what you are seeing. It would be with -- you mentioned that the M&A market and the middle market continues to pick up. Can you talk about how that -- your experience of how that correlates with returned capital? And maybe talk also a little bit about your visibility into capital coming back to you. Do you have three months or six months of visibility on that capital coming back at you?

You think you do, but you know -- IDQ, as a great case study, that company just spews cash flow. And for them to pay us in 13s for a company that is less than 1 times levered, it doesn't make sense. They should pay us back. At some point they will say, you know what, we can just refinance you and take you out. And we shouldn't be paying you 13% plus for a company that is this lowly levered.

So it is hard to predict. You know which -- and you can see, and by the way everyone can see, pretty decently performance in the portfolio -- units where we have marked the debt or where we have marked the equity coinvestor. That is usually a leading indicator, but there is no assurance.

Look at the -- as an example, look at the IPO market right now. It is very choppy. Right? So you can't really count on IPOs. You can't count on M&A deals. It is just a lumpy unpredictable situation in terms of exit. All we can really underwrite to and count on is underwriting free cash flow and deleveraging. And in the long run that takes care of itself, if you do it right.

But last quarter the two deals that were repaid at the end of the quarter, Rex Air and IDQ, we weren't sure that they were going to happen then. They were just kind of -- they were two situations we knew were brewing, and they were able to pull it off by quarter end. But it was hard for us to count on it.

Got it. That's great. Thanks, Art.

It appears we have no further questions in the queue at this time. I would like to turn the conference back over to Mr. Penn for any additional or closing remarks.

Great. Thanks everybody. On behalf of Aviv and the rest of our talented team, thank you for your participation and interest in our Company. And we would be talking to you next in early May about our March results. Thanks again.

That does conclude today's conference. Thank you for your participation.