NewStar Financial, Inc. Q1 2009 Earnings Call Transcript

| About: NewStar Financial, (NEWS)

NewStar Financial, Inc. (NASDAQ:NEWS)

Q1 2009 Earnings Call

May 6, 2009 10:00 am ET

Executives

Colleen M. Banse – Investor Relations

Timothy J. Conway – Chairman, Chief Executive Officer

John Kirby Bray – Chief Financial Officer

Analysts

Sameer Gokhale – Keefe, Bruyette & Woods

Brian Hagler - Kennedy Capital

Operator

Good day and welcome to the NewStar Financial first quarter 2009 earnings results conference. Today’s call is being recorded. At this time, I’d like to turn the call over to Ms. Colleen Banse. Please go ahead ma’am.

Colleen Banse

Thanks Patrick and thanks to everyone for joining us for our earnings conference call, where we will be discussing our first quarter 2009 results. With me today are Tim Conway, Chairman and Chief Executive Officer of NewStar Financial; and John Bray, our Chief Financial Officer.

Before I turn the call over to Tim, I want to remind you that we have posted a presentation on the Investor Relations section of our website, www.newstarfin.com. Also available on our website is our financial results press release, which was filed on Form 8-K with the SEC this morning.

This presentation and our financial results press release contain additional materials related to this conference call that we may refer to during our remarks today, including information with respect to certain non-GAAP financial measures. This call is also being webcast simultaneously on our website and a recording of the call will be available beginning at approximately 1:00 PM Eastern Time today.

Our press release and website provide details on accessing the archived call. Also before we begin, I need to inform you that statements in this earnings call, which are not historical facts, may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All forward-looking statements including statements regarding future financial operating results involve risks, uncertainties, and contingencies, many of which are beyond NewStar’s control and which may cause actual results to differ materially from anticipated results. More detailed information about these risk factors can be found in our press release issued this morning and in the Risk Factors section as updated on our quarterly reports on Form 10-Q.

NewStar is under no obligation to and we especially disclaim any such obligation to update or alter our forward-looking statements whether as a result of information, future events or otherwise, except where required by law. NewStar plans to file its Form 10-Q with the SEC on or before May 11 and urges its shareholders to refer to that document for more complete information concerning the company’s financial results.

Now I’d like to turn the call over to NewStar’s Chairman and Chief Executive Officer, Tim Conway.

Timothy Conway

Thanks Colleen and thanks for joining the call today to discuss our first quarter results. I will begin my remarks by providing my perspective on current market conditions and by highlighting key aspects of our performance in the first quarter. I will also comment on the status of our proposed acquisition of Southern Commerce Bank, which we continue to believe will factor prominently in our plans for the future.

After I hand it over John Bray, to provide additional detail on our first quarter results, I will recap what we have discussed and take some questions. So let me begin with my perspective on market conditions and on our first quarter results.

The economic downturn continues to post significant challenges to our industry and to NewStar as persistent weakness in the economy has contributed to deterioration in overall credit quality. Recessionary business conditions that had a negative impact on the financial performance of many of our borrowers, in some cases impacting their ability to meet their obligation to us.

Stress in the financial system also contributed to dislocation in the capital markets constraining access to credit. Although we maintained very strong and constructive relationships with our banks, our credit facilities are becoming more expensive and have less favorable terms and conditions.

In this environment, we remain focused on executing a plan with four essential elements: managing credit, restructuring our warehouse facilities to better match our liabilities with the maturity profile of our assets, managing expenses and maintaining an adequate liquidity buffer during this period of uncertainty. I’ll touch on each of these elements as we turn to our Q1 results.

For the quarter, the company posted an adjusted loss of $2.9 million, or $0.06 adjusted loss per share. On a GAAP basis, we lost $5 million, or $0.10 per share. Outstandings on the balance sheet were down slightly to $2.3 billion in the first quarter, compared to $2.4 billion in Q4, which reflects typical run-off and the intentionally slower pace of new loan origination.

Non-interest income of $6.3 million in the first quarter was driven primarily by the sale of an equity co-investment and the repurchase of some of our debt, complemented by asset management income and agency fees. Q4 and Q1 were clearly challenging quarters as credit conditions worsened and made a sharp decline in the economy. We continue to experience weakness in sectors I have highlighted on prior calls including building products, transportation, consumer, advertising-based media and commercial real estate.

Current market conditions have had a pronounced impact on commercial real estate as liquidity in that market has dried up and refinancing alternatives for all types of real estate loans have been very challenging.

We have 40 loans totalling approximately $390 million in our commercial real estate portfolio. The vast majority representing 95% of outstanding balances are senior and we do not have material exposure to construction, land or the cyclical hospitality sectors. We stopped making real estate loans 15 months ago as the economy declined. The real estate securing our portfolio relies on absorption rates and new leasing activity has slowed significantly.

Many of our borrowers are at the point where they have occupancy rate sufficient to cover debt service. Some are not there yet and we are spending considerable time on those properties. We established new specific reserves totalling $26.7 million in the first quarter compared to $13.2 million in Q4. More than a quarter of these new specific reserves can be attributed to commercial real estate portfolio.

Allowance for loan losses increased to 281 basis points, or $65 million, up from 225 basis points, or $54 million at the end of Q4, due primarily to a higher level of specific reserves. Non-performing assets increased from six loans in Q4 totaling 60.6 million to 10 loans in the first quarter with an aggregate outstanding balance of 88.9 million, or approximately 3.84% of total loans.

Non-performing assets in Q1 were comprised of approximately one-third consumer related industries including restaurants, roughly 20% commercial real estate, 20% publishing, 15% transportation and a little more than 10% manufacturing with the remainder in building products.

Net charge-offs for the quarter were 14.3 million, or 250 basis points on an annualized basis, up from 8.9 million, or 147 basis points in Q4. In this type of environment, we take comfort in the quality of our credit management and the fact that our middle market transactions have meaningful financial covenants, which get us to the table earlier.

We believe that our credit strategy differentiates us for many players in the market and should allow us to outperform peers and market averages over time. However, given the current level of stress in the financial system, we continue to expect loan delinquencies non-accruals and charge-offs to increase in the near-term.

At this point in the cycle, new loan origination is secondary to managing credit performance and liquidity. We originated three loans in the first quarter. Slower pace of new origination coupled with our strategic intent to extend the maturity profile of our warehouses to better match our loan profiles, contributed to the restructuring of two of our existing credit facilities during the course of the first quarter.

In mid-April, we extended our agreement with Wachovia to June 1, 2009 and reduced the size of the facility from $350 million to $200 million. The advance rate was also reduced from 70% to 65%. We are currently engaged in negotiations with Wachovia, which we believe will result in a longer-term facility, which better matches our assets and our liabilities.

In January, we also amended our term debt facility with Deutsche Bank, which reduced the commitment amount from $400 million to $250 million. The term structure of the facility closely matches the maturity characteristics of the assets its finances. It would begin to amortize for a three-year period beginning on May 7, 2009.

We continued to be excited about the proposed acquisition of Southern Commerce Bank, which I discussed in detail on last quarter’s call. This combination would allow us to capitalize on our core strength in commercial lending and enter the traditional banking business at the time when commercial banks have reemerged as the leading providers of senior capital to smaller midsize businesses.

Although our time line has extended, we remain engaged in constructive dialog with the Federal Banking Regulators, regarding important aspects of our application to acquire Southern Commerce Bank and to become a bank holding company. Our discussion is centered on certain aspects of the business plan, we submitted in connection with our application including the size and nature of a proposed balance sheet restructuring.

As a result, we have extended certain dates in our purchase and sale agreement with Dickinson Financial to allow us time to complete these discussions. We believe that we will be able to address the aspects of our plan that are under discussion and remain committed to reaching an agreement that meets the objectives of all parties involved.

While developing the commercial banking platform remains central to our strategy, it is not an essential element of our plan for managing our commercial finance operation.

Approximately 70% of our existing portfolio continues to be term funded by stable securitized long-term debt at attractive locked-in spreads. We have a term debt facility with one bank, Deutsche Bank and two major bank warehouses. We have one remaining renewal within our capital structure left to complete with Citibank this year, which matures in November. We have no other debt or funding maturities.

Importantly, we have the ability to reinvest run-off from two of our three securitizations. We believe our CLOs representing an enduring source of funding and a valuable asset.

Finally, we continue to aggressively manage expenses to ensure that the company is poised to operate efficiently during the downturn. We will continue to aggressively manage staffing and compensation levels to optimize performance during this cycle.

With that, I’ll turn the call to over John to provide more detail on the quarter and then I’ll wrap up with comments and outlook for 2009. John?

John Kirby Bray

Thank you Tim. My presentation will follow the slide that we put out on the website, and I’ll begin on the slide called summary of Q1 2009 financial results. As Tim said, adjusted net loss was $2.9 million for the first quarter Adjusted net loss for the first quarter’s GAAP net loss excluding after tax non-cash compensation expense of $2.1 million related to the restricted equity grants made in connection with our initial public offering.

The $2.1 million adjustment is a combination of $1.5 million tax effect on a discrete item relating to the expiration of an exercised stock options grants and remaining $600,000 of adjustment related to restricted equity grants made in conjunction with the initial IPO. This resulted in adjusted basic and diluted loss per share of $0.06 in the quarter.

On a GAAP basis, net loss was $5 million, or $0.10 per diluted share for the first quarter. Our results included $745,000 of expenses related to the proposed purchase of the bank. Accounting rules changed as of December 31, 2008 and requires institution when acquiring other institutions noe expense those transactions as incurred and not roll them into goodwill or purchase accounting.

Our share count on a weighted average basis was 48.8 million shares for the quarter, at the end of the first quarter, our book value per share was $11.76.

If you turn to the funding and liquidity slide, you can see we’ve reduced certain credit facilities by entering into amendments to our facilities with Wachovia and Deutsche bank. Given our capital conservation strategy, we’re not using excess availability and we did not want to continue to pay the related unused fees.

As our credit facilities mature, we believe we’ll continue to re-price at current market rates. As such the information presented in these slides is presented as if Wachovia amendment had occurred at quarter-end.

As you can see on the bottom right hand chart, our diversified funding source totaled $2.7 billion at quarter-end, pro forma for the Wachovia amendment. In addition, we had $40.2 million of reinvestment capacity in the existing CLOs at attractive locked-in spreads as of March 31.

In the first quarter, we were able to reinvest approximately $18 million in our CLOs. Our CLOs have reinvestment periods that are significant. Our $600 million CLO from 2007 has a six-year reinvestment period and our $500 million CLO from 2006 has a five-year reinvestment period. We had $109 million fund of restricted cash in our balance sheet at quarter-end, including $45 million of restricted cash available for reinvestment and another $19 million of restricted cash available for debt service.

Taken together with our unrestricted cash of 58 million, this cash can be used to fund loan originations, pay debt service, operating costs and credit cost of NewStar Financial. The funding model slide, which is the next slide, gives you a detailed look at our borrowing funding capacity, our pricing, our leverage by term debt and warehouse lines. At the end of the first quarter more than 70% of our loans were funded with term debt at very attractive, locked in prices with long-term maturities. Total funding capacity was $195 million at the end of the quarter, if we optimized advance rates in each facility.

If you turn to the core business performance slide, you'll see that our managed loan portfolio was roughly $2.9 billion, down slightly from levels for the recent quarters.

Our adjusted revenue reflects the slower pace of managed asset growth for the first quarter was $28.5 million, net interest income declined to $22.2 million from $24.4 million in the fourth quarter of 2008.

I’ll explain the factors affecting the net interest income and the net interest margin in greater detail later.

Non-interest income was $6.3 million in the first quarter compared to $8.6 million in the fourth quarter of 2008. The next slide, the loan origination slide describes the amount and composition of first quarter originations and related revenue that the origination volume drives. As Tim mentioned earlier, we kept close eye on liquidity during the first quarter. Originations totaled $18 million, $7 million was retained on the NewStar balance sheet, and $11 million was booked for the NewStar Credit Opportunities fund.

Credit spreads and amortizing fees on new loan originations in the fourth quarter were roughly 810 basis points over LIBOR, up from 355 basis points in the first quarter of 2008. We continue to get LIBOR floors on all of our new transactions and approximately 27% of our portfolio now includes them. The floors give us a natural hedge against our equity-funded loans, if the interest rates moved downwards.

In the next slide that deal for the net interest margin, gives you a detailed look at our net interest margins. The net interest margin was 3.58% for Q1 down from the last quarter’s number of 3.79. During the quarter, we lost approximately 47 basis points from decreasing LIBOR as more customers moved into one-month LIBOR contracts where our borrowing are three-month spread between the two widen with one month dropping faster than the three-month LIBOR.

We also lost 14 basis points due to increasing non-performing loans. This was partially offset by an increase loan spreads due to the pricing of loans and new originations in the portfolio. In the quarter we real estate-priced approximately $350 million worth of loans, which we re-priced by an average of 150 basis points upwards due to the pricing grids and amendments.

The next page loan and investment portfolio slide shows again how diverse our loan portfolio really is, we had purposely built our portfolio to be a balance across industry sectors. The credit performance slide, which follows it details our credit results, as Tim highlighted in earlier discussion. We increased our allowance to credit losses to 281 basis points on period end loans, compared to 225 basis points at 12/31.

Non-accrual loans increased $28 million in the quarter and came in at $88 million.

Credit remains difficult given today’s economy and charge-offs maybe lumpy quarter-to-quarter as the table shows. We expect credit performance to continue to deteriorate in 2009 in line with economic conditions. Our delinquent loan rate at quarter end was 2.65%, and our delinquent loan rate for accruing loans 60 days or more past due was 0.09%.

The next slide highlights our income statement for the quarter. As I mentioned earlier adjusted net loss was $2.9 for the quarter and GAAP net loss was $5 million. I’ll now drill down on the different components of the income statement. Net interest income was $22.2 million for the first quarter compared to $24.4 million in the fourth quarter, and as I said early in the March came in at 358.

Provision increased $7.4 million for the quarter from $17.9 million for the fourth quarter, primarily due to increased specific reserves. Non-interest income decreased to $6.3 million this quarter from $8.6 million last quarter, as we had $3.3 million solid gain on repurchase of debt and it’s $3 million monetization of net gains on sale of equity co-investments along side our loans.

Our asset management fees were down quarter-over-quarter slightly. Expenses increased to $9.9 million in the first quarter from $7.9 million in the fourth quarter, primarily due to three reasons. First, we have $350,000 of severance expense in Q1. We had $750,000 of expenses related to the potential acquisition of the bank and in the fourth quarter of last year we had a reversal of equity compensation expense.

Our Q1 balance sheet is shown on the next slide and as you can see NewStar’s book equity value at quarter end was $578 million, and book value per share was $11.76.

Now, I’ll turn it back to Tim.

Timothy Conway

Thanks John. Clearly, Q1 and Q4 were very challenging quarters as the economic downturn weighed heavily on credit performance and on our results as well. In this environment, we believe that our direct origination model, and senior debt focus high diversification and strong ongoing credit monitoring and management will differentiate our performance through this cycle.

But our management team that has worked the leading banks through previous cycles, and we built the company to perform in a range of conditions including periods of severe economic stress. We are actively focussed on positioning the company to capitalize on shifting market conditions including reduced reliance our bank and capital market funding.

That concludes my remarks. And I’m happy to open it up for questions.

Question-and-Answer Session

Operator

(Operator instructions). We will take our first question from Sameer Gokhale with Keefe, Bruyette & Woods.

Sameer Gokhale – Keefe, Bruyette & Woods

Hi, thank you, and good morning.

Timothy Conway

Good morning Sameer.

Sameer Gokhale – Keefe, Bruyette & Woods

Just had a few questions, the first one was, when I looked at your managed loan portfolio and your originations and charge-offs, I estimate that the actual pay down of the portfolio was somewhere in the ballpark of about $91 million just till this quarter, and that was up from $37 million last quarter, it stood below kind of the run-rate that you had in the first three quarters of ’08 but the question I have is the period on amount seems to have picked up relative to last quarter. Is there anything to be between from that? Why do you think that may have occurred?

John Kirby Bray

Sameer, the one thing, your 91 is pretty much right on, the one thing you also have in there is the charge-offs increase, which is about $14 million. So, if you take that $14 million out, we’ve came in at our pay off is about $77 million.

Sameer Gokhale – Keefe, Bruyette & Woods

I think, I’d actually thought to back out to adjust for that charge-off number now still coming up about $91 million. But, if you are saying that if you …

John Kirby Bray

So, basically, where it comes down to this for the quarter we ran just about little lower 13% of the amortization and prepayments. If you look back over NewStar’s history it’s been roughly somewhere between 15 to 18%. Q4 was a little bit lighter, what picked up in Q1 was that we had a couple of payoffs and loans. We’ve normally run about 10% of amortization on the portfolio that was where it came in and we - so the increase from Q4 was really just increase for the couple of loans that paid off.

Sameer Gokhale – Keefe, Bruyette & Woods

I guess is that there isn’t much to be gleaned from that in terms of the payoffs for those borrowers that refinanced elsewhere or did they just payoff your debt. I mean can we see that as a sign of kind of the broader improvement and greater availability of credit in the markets in general or we can’t do that in your view?

Timothy Conway

I think that the amortization is very positive right, because we have scheduled amortization and excess cash flow we capture and so and our companies are paying down or delevering when they pay down bank debt towards and that's a positive. And the fact is there is not a lot of M&A activity in the markets. So not many of the properties we financed are being paying sold but there is some liquidity in the market and if there is an M&A transaction done, they can get financed in fact spreads have tightened up and the loan market has firmed pretty significantly in the last few months. So, deals can get done and they aren’t a lot getting done but there is capital our there to refinance a good property and we’ve had some very positive developments where we’ve been working with a credit to reduce the facilities as well for an reason or other we’ve been able to do refinancing that resulted in the reduction of our outstanding for those credits and so those all are our positive developments, so frankly that’s a lot of our focus is on as opposed to new origination at this point.

Sameer Gokhale – Keefe, Bruyette & Woods

Okay that’s helpful color. And then another question, then I’ll get back in the queue. But in terms of loss provisions so would you characterize those provisions as having peaked this quarter or are you looking for provisions to continue to increase and in some companies suggested that Q1 maybe the peak, what’s your view on that?

Timothy Conway

Yeah I don’t think that, I can’t say I know, and but I would say at this point, I would be reluctant to say that we think it’s peaked, I think there are some positive signs in the economy, and we think there are some positive signs in some of the companies that we financed. But my sense is that while we appropriately reserved, that for the next few quarters, we’re going to see increase in credit cost including reserves but and then we believe that later in the year and certainly beginning in next year, we’ll begin to come out of this and hopefully reserves are going the other direction. But I would not say that although I would like to call the bottom and say it’s peaked, I am not ready to do that.

Sameer Gokhale – Keefe, Bruyette & Woods

Okay, thank you.

Operator

(Operator Instructions) We’ll go next to Brian Hagler with Kennedy Capital.

Brian Hagler - Kennedy Capital

Hey, good morning.

Timothy Conway

Good morning.

Brian Hagler - Kennedy Capital

Sorry, I had signed on late and then actually right when the Q&A, so I missed your commentary. I was hoping I could get first of all your outlook on the net interest margin, I don’t know if you’ve discussed that at all?

Timothy Conway

John

John Kirby Bray

Basically, what you see it is came down in this quarter, and it really came down for a couple of reasons, one was an increase in non-accruing loans, which costs us about 15 basis point in the margin. The other big drop was that our customers were actually do the right things, which is they shifted from being in prime based contracts and three month LIBOR into one month LIBOR and we’ve got hurt a little bit because one month LIBOR decrease much quicker than three months LIBOR, we are most of our funding is done. So as those rates kind of come back in line, and the relationship between the margin will grow, I think it will improve slightly but it will be somewhere kind of where it is now.

Brian Hagler - Kennedy Capital

Okay and then also can you guys just talk about the outlook for the completion in the bank acquisition, and I know you move, I guess the date back a month, can you just talk about what you’re doing with the regulators to get that deal closed?

Timothy Conway

That I can’t provide a lot of detail, but we have a very constructive dialogue going with various regulators, we believe that we will be able to address issues that have come up and they have raised with respect to our plan. It’s a very involved process and lot of the issues are interrelated but we continue to work on it and have a very good dialogue and we believe we have a very good plan, we have a great teamwe think to operate our commercial banks, the traditional commercial banking operation. And so it’s clearly taking no longer than we had hoped, and there are some issues to work through with the plan with the regulators, but I remain optimistic that we can work through those issues.

Brian Hagler - Kennedy Capital

All right. And then currently are you guys with, I guess without the bank currently would guys be eligible to participate in the PPIP or would that require you to acquiring the bank and then maybe becoming eligible, and would you be even interested?

Timothy Conway

We would have to acquire the bank in order to be eligible. We have not assumed or included that in our plans at this point.

John Kirby Bray

Now maybe certainly we’ll look at it but right it’s more, we are spending more of our energy just trying to get the bank and all that stuff and then we will see, if those things make sense after.

Timothy Conway

And there are the number of things that maybe attractive, if you’re bank holding company, but I would say that none of those are crucial or essential to the plan that we have put forward at this point.

Brian Hagler – Kennedy Capital

All right, great. And then finally, can you just discuss maybe you mentioned pricing on new loans, although I know that there isn’t a lot of demand out there today, but can you just talk about how much it has improved maybe on the last year, and how maybe the competitive environments are also changed?

Timothy Conway

Well, if you just look at the industries for non-investment grade loans, and don’t hold me to these numbers but I would say December of last year, we are looking at secondary prices in the 60’s for single B loans. And depending on which indices you look at, some of those have rallied into the low 80’s and as of today, so significant improvement in secondary loan prices, spreads and new issues widened from what might have been 350 or 400 out to 750. And I would say that in the last month or so, there are couple of large players in the middle market who have been pretty aggressive and there is not much volume in the market so we’ve seem some deals actually get in priced at 650 or 700 over LIBOR floors. The deals that we did in the fourth quarter were something closer to something like 800 over, so we think there are still a lot of opportunities at better spreads but there are some big players that are putting out some capital that’s slightly lower spreads in that now.

Brian Hagler - Kennedy Capital

All right, great, thanks guys.

Timothy Conway

Thank you.

Operator

And we have follow-up question from Sameer Gokhale with KBW.

Sameer Gokhale - Keefe, Bruyette & Woods

There is a couple of ones, you purchase some debt end of the quarter and booked a gain. How much debt did you purchased, and what was the gain as a percentage par if you will?

Timothy Conway

Hold one second. We purchased $4 million of debt and the gain was $3.2 million.

Sameer Gokhale - Keefe, Bruyette & Woods

Okay, that’s helpful. And then you had mentioned John, the 14 basis points impact on your net interest margin due to the increase in non-accruals, how much was that impact on the (inaudible) last quarter, if you could just refresh my memory?

John Kirby Bray

Probably the way to look at it, if I can answer this question for you, is the total non-performers now if you looked at our margin is costing us about 28 basis points. So we had a increase of 14 this quarter to bring up to about 28, so back the 14 out. I mean that happened overtime, but that’s the non-performers are costing us now.

Sameer Gokhale - Keefe, Bruyette & Woods

Okay, and then related to the bank acquisition I understand that your limited in what you can say, but your referenced, Tim, the discussions about the bank restructuring, so I am assuming that relates to the 23A and the transfer the assets into bank. So, is the discussion centered around figuring out, which assets are eligible to go into the bank and is there is back and forth around that or is it just more of a procedural thing where they said okay come back to us with what assets would be eligible based on certain criteria and you guys work that out and then got back to them. And it just kind of that back and forth that's taking time as opposed to any concern of the regulators may have about putting assets into the bank. And can you just give us some color around that?

Timothy Conway

I would say, number on, that we do have a good dialogue back and forth and we are obviously taking their input, I’d say that any 23A wavers are on issue. In general in the marketplace and that's one of the issues that's part of our application. But, beyond that I really, I can’t comment on any of this specifics of it and I would say that my sense of it is the regulators are appropriately looking at the overall plan and a variety of different issues and that's one of the issues that factor into it

Unidentified Analyst

Okay, Okay, thank you.

Operator

And with no further questions, I’d like to turn the call conference back to you Ms. Colleen Banse for any closing remarks.

Colleen M. Banse

Thanks Patrick, and thanks everyone for joining us first quarter earnings call today. That will conclude our comments, have a great day.

Timothy J. Conway

Thank you.

Operator

That thus conclude today’s conference, we thank every one for their participation.

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