May 6, 2010: Gladstone Capital (GLAD) reported earnings for the period that ended March 31 2010. Just for the fun of it, we read the Earnings press release, perused the 10-Q and read the transcript of the Conference Call. We came away impressed with the Company’s financial strength at this critical time in the markets brought on by the Greek crisis, but are underwhelmed by the prospects for significant increases in earnings per share or the dividend in the near term. Gladstone is still getting its capital structure straightened out.
Here are the main take-aways :
Earnings are in a holding pattern. For example, Total Investment Income was $9.804mn at December 31, 2009 and $9.814mn at March 31, 2010. Net Investment Income went from $4.428mn to $4.474mn.. That’s a 1% increase. However that’s being generous. If we deduct out unusually high prepayment fees from repaid loans, Net Investment Income would have dropped 10%.
Notwithstanding Gladstone’s renewal of its $127mn Revolver for one year (with a one year pay-off period) Gladstone ‘s investment asset base (and its borrowings) are dropping. Despite adding a smattering of new assets, repayments are far outstripping new loan formation. At year end GLAD had $347mn in investment assets at cost. Three months later the balance had dropped to $330mn. The Revolver balance is down in the same three-month period by $21mn to $53mn.Moreover, the pay-offs have continued in the current quarter. The Revolver is down to $28mn, mostly thanks to the repayment of a loan to a company called VanaCore (which, coincidentally, is a portfolio company of another BDC, Kayne Anderson Energy).
As a result of the above, the immediate outlook for GLAD’s earnings remains cloudy. We’ve been worried about the Company’s prospects of materially boosting earnings per share for some time.
Management appears to be hanging much of its hope for higher earnings on turning round the new loan origination trend by tapping the unused Revolver capacity.
…we do feel very comfortable about putting $50, $60 maybe even $70 million of new loans on the books using our line of credit
However, the yield on these new loans will have to be substantial to offset the incremental interest and operating expenses from adding new investments. Gladstone’s Revolver debt is expensive for short-term money: 6.5% per annum all in, plus 0.5% on any unused capacity. Likewise, operating expenses are high, running over 5% of new investment assets at cost. Combined that’s 11.5% in expenses on any new dollar of loans made. Given that average yield at March 31, 2010 was 10.9% it seems unlikely to us that earnings can increase much from this source. There might be a slight pop from upfront fees, but that’s a one time source of profits.
Management continues to pine for long term insurance company financing. We’ve been hearing for several quarters that Gladstone wants to match its assets with its liabilities and wants to raise either Preferred stock or long term debt from an insurer.
Our plan today is to seek long term debt for our fund. That’s the next goal and objective on the right hand side of the balance sheet. Obviously on the left hand side of the balance sheet we need to put more money to work. We’d like to borrow long term again because we’re making long term loans and we want to match the book as they say in the business and make sure that we don’t have short term borrowing problems as all of us did during this last part of the recession.
To date, neither has happened, and GLAD has had to renew its 1 year Revolver, as mentioned above. Now Gladstone envisages using the Revolver as a warehouse facility and the still undetermined insurance company debt as the take-out. We applaud the motivation, which shows that the Company learned from the Great Recession when assets had to be dumped in a hurry when Revolver lender Deutsche Bank cut and run unexpectedly. The rub is that more time has passed and no progress seems to have been made.
This is what was said on the Conference Call in response to a question from one of the veteran BDC analysts:
Vernon Plack – BB&T Capital Markets
A quick question for you David regarding long term debt, could we expect an announcement on that from you within the next quarter?
I don’t know. We’ve engaged a placement agent, they are working on our behalf. We have had several sessions with insurance companies, I just don’t know. As you probably know better than I do, most of the insurance companies have for at least the last 18 months have said no to everything in the finance sector whether they’re finally now interested in the finance sector I can’t answer but we are able to talk to them which I say one quarter ago you couldn’t even reach them on the telephone, they wouldn’t talk about it. So, I think they’re coming back. Whether we could announce something in the next quarter I don’t know, it’s too early to tell”.
We’re also disappointed that GLAD seems unable to snag a SBIC license, which so many other BDCs have managed to do (PennantPark is the latest candidate). David Gladstone is clearly unenthusiastic and gives all the arguments on why it’s not worth the effort. That’s $150mn of potential long term financing at a rate lower than any insurance company is likely to charge going to waste.
Despite asking shareholders for the right to raise equity below NAV, GLAD says they are not interested in doing an equity offering at this stage. Most likely management would like to resolve the long term debt funding issue before proceeding.
Credit quality remains only so-so. A new company was added to the non-accrual list, but this entity was already unofficially on non-accrual, so there was no change in income. However, a telling metric everyone uses: non-accruing loans to total debt investments jumped from 8% (or $26mn) from 3.7% in the prior year. There are six companies on non-accrual, 5 of which are “fallen angels” which GLAD has taken control of and is seeking to turn around. We don’t know if this strategy will work out or not.
The credit underwriting scorecard for GLAD remains about average for the BDC industry. The Company has written off $26mn in Realized Losses to date and has $38mn in Unrealized Depreciation. Together that represents about 20% of initial capital. However, if Gladstone can nurse its fallen angels back to health the damage could be lower.
The Company’s Liquidity is in fine shape. That’s worth mentioning right now with the Greek crisis causing a massive sell-off of most BDC stocks. Even without any new equity, preferred or insurance company debt Gladstone’s weakness in terms of earnings generation (i.e. ever lower assets) means it is under-leveraged. With just $28mn borrowed as of the Conference Call and with $300mn in assets the Company is unlikely to face the same problems that occurred during the Great Recession.
Author's Disclosure: No position GLAD