Gladstone Investment: Earnings, Outlook Look Reassuring

| About: Gladstone Investment (GAIN)

Gladstone Investment (NASDAQ:GAIN) announced earnings for the fourth quarter and fiscal year ended March 31, 2010 [see call transcript]. We had a quick look, and listened to the conference call, and had a few comments:

1. With the current atmosphere of fear and panic about the future, and the prospect for a "double dip" recession (a concern we do not yet share), we thought it might be good to look at the Company's liquidity and capital structure. Of course, during the last recession, Gladstone Investment - like many other BDCs ("Business Development Companies") - was hit by lender defection. Specifically, Deutsche Bank (NYSE:DB) refused to renew the Revolving Line of Credit. This left GAIN with a smaller Revolver with 2 continuing lenders and a higher cost of capital. This is still on the mind of management, as the conference call showed. There were several references to the impact of that credit crunch. Most notable were the ($36mn) in Realized Losses the Company incurred from being forced to sell its low yielding syndicated loan portfolio to pay down the debt. That also caused a big cut in the monthly dividend.

However, there is no prospect of a replay should there be a second recession. Just look at the balance sheet. The Company has only $11.1mn outstanding under its $50mn Revolver, which was just extended for two years. Even better, GAIN has $7.7mn in cash and the prospect of a portfolio company soon to be sold, sufficient to pay off all debt. There are even a few saleable syndicated loans sitting around to aid liquidity. If GAIN lost its lenders in the next few months due to panic from a new recession, the impact would barely be felt in the short run.

Sadly, the Company still hasn't been able to locate any long term insurance company funding to provide debt financing that truly matches the maturity of the loan assets.

2. Another encouraging factor, not unique to GAIN, is that credit performance appears to have stabilized. A few months ago we were worried about a further deterioration in credit quality that might affect earnings and the dividend. In a company such as GAIN with only 16 core investments, all it takes is one or two companies going on non-accrual to have a resounding impact. For example, a hypothetical $10mn loan going on non-accrual at an 11% yield deprives the Company of $1.1mn of investment income, which equals 5 cents a share. Given that the Company is earning just 48 cents a year on an annualized basis (using the last quarter and multiplying by 4), that's a hit. Thankfully, GAIN has dodged that bullet for the moment. All the Company's remaining portfolio investments are current on interest and principal. GAIN has one company on non-accrual out of an abundance of caution, but interest is still being received. Unrealized Depreciation is reducing slightly and the fair market value of the portfolio now stands at 91% of original cost.

Of course GAIN's portfolio is not completely recovered, and a second recession would probably result in some credit deterioration. How much is important for anyone to tell. Nonetheless, the current trends are encouraging , as is the Company's policy of "working out" troubled companies rather than closing them down. It's a long process with no guarantee of success but it leaves the prospect of a return to profitability down the road.

3. Risk number three that is the current talk of the market: a LIBOR rate increase. As we all know from the news shows, 3 month LIBOR has been ticking up, to 0.5% last time we checked. For companies which use LIBOR as a borrowing reference point, the risk is higher cost of funding. For GAIN, wth only $11mn borrowed (and the prospect that's going lower in the next few weeks), the impact will be academic. Moreover, under its funding arrangement with its banks, GAIN is subject to a 2% LIBOR floor so the reference rate has a long way to go before making any impact on the bottom line. Even looking further ahead, GAIN is protected by its $45mn interest rate cap, intended to protect against higher rates.(On the other hand don't expect much of a benefit from the LIBOR increase either. Most of the Company's investment assets are fixed rate ($152mn of $196mn), and those that are not largely have LIBOR floors of their own.)

4. So we've discussed all the conventional risks that GAIN could face and come away reassured. What should we be worried about ? In the short term the dividend seems secure as Net Investment Income equals the 12 cent a quarter pay-out. However, the Company is constrained by its lending arrangement to only pay dividends equal to what is being currently earned. With the prospect of one of its portfolio companies being sold, there is a possibility that recurring earnings might drop if GAIN does not find any new deals to add to its books. Again this last quarter the Company made very few new advances, all to existing portfolio companies, and continued to receive a modest flow of principal repayments. After quarter end, one of its syndicated loan investments was repaid, bringing in $6.8mn.

Presumably management is on the hunt for new buy-outs or recapitalizations. On the conference call, GAIN mentioned that multiples for "good" companies were at multiples of 6-7X EBITDA (preparing us not to expect bargain hunter prices). The good news is that senior lenders making asset secured advances are topping out at 2.5X EBITDA and equity sponsors are putting up 50% of 3-3.5X the EBITDA. There is a gap in there for GAIN's mezzanine product and management hopes to fill it as well as make equity co-investments.

Recently, GAIN has had the luxury of not needing to add new deals, but if repayments occur, the pressure will be on. Unlike some BDCs, GAIN is seeking to take controlling stakes in the deals it books and this can be time consuming and episodic. Nonetheless, it's a good quality challenge to have, and suggests GAIN might be at a turning point. Unfortunately, management did not hint on the conference call that there was anything imminent pending in the new deal category, so we may not see any increase in GAIN's total assets or earnings until the third quarter of 2010.

Disclosure: No Position GAIN

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