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Executives

Colleen Banse – Investor Relations

Tim Conway - Chairman and Chief Executive Officer

John Bray – Chief Financial Officer

Analysts

Sameer Gokhale - Keefe, Bruyette & Woods

Operator

Good morning and welcome to the NewStar Financial Q2 2010 earnings call. [Operator instructions.] I would now like to turn the conference over to your host for today’s call, Ms. Colleen Banse. Ma’am you may begin.

Colleen Banse

Thanks everyone for joining us for our earnings conference call where we will be discussing our second quarter 2010 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 web site, www.newstarfin.com. Also available on our web site 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 web site and the recording of the call will be available beginning at approximately 1:00 p.m. Eastern Time today. Our press release and web site 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 August 9 and urges its shareholders to refer to that document for a 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.

Tim Conway

Thanks Colleen, and thanks for joining the call today. I’m pleased to report that our operating performance continued to improve and that we returned to profitability in the second quarter. We generated adjusted net income of $5.9 million, or $0.11 per diluted share, driven by significantly lower credit costs and margin improvement.

A return to profitability at this time is a reflection of the many steps we’ve taken over the past few years to anticipate and mitigate credit losses, add to the maturities of our assets and liabilities, enhance liquidity, and reduce costs. Our ability to preserve book value through the crisis is the result of our direct origination platform, senior debt focus, highly selective credit process, and a granular portfolio.

Q2 performance was in line with our expectations and consistent with what we began signaling in the fourth quarter of last year. Despite the increasing likelihood of a slow recovery from the recession, we expect our default rate and credit costs to continue to moderate, and we still expect to be profitable for the full year.

Of course, given the lack of vigor in the economic recovery, our earnings will remain vulnerable to potential negative credit events or a slowdown in economic growth. Conversely, as the economy improves, we would expect to see some positive credit outcomes that could provide cushion against unanticipated weakness in individual names.

In addition to posting a profit, there were several other positive developments in the second quarter. We made significant progress on our key initiatives that will drive growth and improve profitability by increasing lending activity and beginning to execute on our plans to expand the business.

Origination volume more than doubled to $123 million, compared to a plan of $55 million. Our quarterly origination volume was the highest it’s been in nearly two years. These volumes reflect the shift in our focus, from protecting the balance sheet to building the franchise, as well as a pickup in overall loan demand.

We also renewed our credit facility with Natixis and for the first time since the crisis began we were able to improve the pricing and other key terms on a bank facility. We generated substantial cash flow and enhanced our liquidity position. Unrestricted cash stood at $40 million at the end of quarter, which along with our undrawn $75 million corporate revolver represented $115 million of available liquidity.

We added staff for the first time since the fourth quarter of 2007, while continuing to effectively manage cost despite elevated workout expenses. As I mentioned on the last call, we provided long-term retention-based incentives to key personnel. These incentives are tied to performance criteria and are structured to vest at the end of a three year period. These grants are expected to replace annual grants to senior management during that time frame.

Following a surprising period of overheating during the first part of the year, resulting largely from light deal flow, loan market conditions improved in the second quarter. Volume increased due to an uptick in M&A activity and pricing improved as euro zone issues and concerns over slower economic recovery resulted in wider spreads in most of the fixed income markets.

Spreads in the loan market widened 50 to 100 basis points during the quarter. New lending opportunities are attractive with LIBOR spreads of 500 to 550 basis points, 1.5 to 2 points up front and LIBOR floors which lead to yields of 7% to 7.5%. We continue to be highly selective and the new loans we made in the quarter averaged senior loan to value of about 40% and debt to EBDA of approximately 3.25 times.

We now expect to generate between $400 million to $500 million of volume for the year, or about 4 times last year’s origination. As I mentioned earlier, credit costs were down again in the second quarter, but we continue to perform very well relative to our peers and to the indices. Revision declined 80% to $5.5 million, while new specific reserves, our best measure of quarterly credit costs, declined 36% from $22 million to $14 million.

NPA and charge off levels also improved, but remained elevated. We expect them to continue to decline as negative migration moderates and we resolve existing NPAs. Our NPAs are now held at an average of $0.43 on the dollar. Helping to drive this positive trend is the success we’ve had resolving NPAs.

Three loans totaling $30 million were returned to performing status when we sold a commercial real estate property at a price slightly better than our carrying value. We believe that commercial real estate has largely stabilized, but it is still the least certain of the sectors we lend to.

We continue to shrink our real estate portfolio, which at $300 million is down over 30% from its peak. After I turn it over to John to provide some more detail on the quarter, I will conclude with some additional comments on our strategic priorities.

John?

John Bray

Thank you Tim. My presentation will follow the slides we posted on our web site, and I’ll begin with a summary of the Q2 2010 financial results, starting with page 7.

As Tim mentioned, we’re pleased to report a return to profitability in Q2. Adjusted net income was $5.9 million for the second quarter, which is GAAP net income excluding after-tax, non-cash compensation expense of approximately $500,000 related to equity grants made in connection with our initial public offering. This resulted in adjusted basic and diluted income per share of $0.12 and $0.11 respectively for the quarter. The dilution for the second quarter resulted from a restricted share issuance in the quarter, which I will discuss next, and previously issued options.

On a GAAP basis net income was $5.3 million and $0.10 per diluted share for the second quarter. On May 19, we issued 2 million shares of restricted stock, as Tim mentioned earlier. These shares have both time and performance investing requirements. These shares are considered outstanding and are included in our book value per share calculation for the end of the quarter. However, they will not be included in basic EPS until investing requirements are met. They are evaluated for diluted EPS and included only if the performance vesting requirements would have been met for the reporting period.

In Q2, diluted EPS including approximately 935,000 of these restricted shares, which are as equal to the average number of these shares which were outstanding for the second quarter, were added in because they met the performance vesting requirements. Including the 2 million restricted shares our share count at the end of Q2 was 51.6 million compared to 49.8 million at the end of Q1. Additionally, these shares reflect repurchases of approximately 247,000 shares during the quarter that had an average price of $6.83.

If you turn to page 8, which talks about our capital liquidity position, you can see that we believe it supports a strong balance sheet and continued growth. As Tim said earlier, we renewed our warehouse facility with Natixis on approved terms. During the quarter we fully ramped at the 2009 CLO and reinvestment capacity in the 2006 and 2007 CLOs.

If you assume our current prepayment rate, we would have capacity to originate approximately $300 million in loans during the next 12 months under our existing facilities. We had $40 million in unrestricted cash, up from $18 million at the end of Q1. We had $27 million of restricted cash for reinvestment in the 2006 and 2007 CLOs. The $75 million fortress facility remains undrawn at the end of Q2, and if you add our unrestricted cash in the fortress facility we have liquidity of $115 million.

If you turn to the next slide, we get into talking about our securitization summary and these next three slides that we’ll walk through will talk about our securitizations, our CLOs, our bank debt, and our on balance sheet funding. 79% of our loans are funded through securitizations that track to locked-in spreads.

CLOs represent a stable source of our funding which are designed with flexibility to absorb non-performing assets. If there is a deterioration in an asset held in a CLO we have the option, but not the obligation, to purchase the assets and substitute collateral. If we choose not to repurchase, the CLO will trap cash in an account sufficient to pay down the debt.

Having impaired assets in the CLOs can be an effective liquidity strategy because in the aggregate we expect that the CLOs will generate over $60 million of excess spread per year that can be used instead of balancing cash to cover non-performing loans.

The next slide shows that we have reduced our short term debt by an additional 7% in the second quarter. We have net asset position or equity of approximately $140 million in our bank facilities. Including our CLOs and term debt, approximately 80% of our real estate loans are term funded.

If you turn to the next slide, the key takeaway here is that the new $75 million revolving credit facility provides management with the available liquidity that supports operating flexibility and we have actively used it to support our warehouses and our CLOs by repurchasing more than $100 million during the cycle. By repurchasing the credit repaired loans from the warehouses, the company has avoided the need to sell loans and to depress prices and preserve the value of residual interest in the portfolio.

The next slide talks about our managed loan portfolio. The managed loan portfolio is roughly $2.4 billion, down slightly from levels over recent quarters, while adjusted revenue increased $23.8 million. Net interest income increased $19.1 million from $16.1 million first quarter. I will explain these factors affecting the net interest income and the net interest margin in greater detail later.

Non-interest income was $4.7 million for the second quarter, reflecting a $3.8 million gain from the repurchase of our CLO debt. While we have continuously opportunistically repurchased our CLO debt as recent market prices reflect, the discount to par resulting in returns to our share holders, you should remember that we do not consider these gains as part of our ongoing revenue stream.

The next slide talks about our loan originations in the quarter and the amount and composition. Originations as Tim said were $123 million: $75 million was retained on NewStar’s balance sheet and $48 million was booked to the new StarCredit opportunities.

We continue to get LIBOR floors on all our new transactions and approximately 42% of our portfolio now includes them. These floors give us a natural hedge against our equity funded loans if interest rates move downwards and has resulted in increased interest spread.

The next slide deals with the net interest margin. The net interest margin was 3.75 for the second quarter, up from last quarter’s 3.03. As I mentioned earlier, in last quarter the interest expense included an additional $3.4 million of accelerating amortization of deferred financing fees related to our Citi facility and our Deutsche Bank facility.

Non-performing assets were a drag of 14 basis points to the margin this quarter. The total cost of our existing non-performers was approximately 53 basis points. During the quarter, though, we benefitted approximately 5 basis points from re-pricing new loans. We expect our net interest margin will run under 4% until we are able to move more loans off non-accrual.

The next slide shows the diversified loan and investment portfolio. At the end of the second quarter our middle market loans made up 83% of our portfolio and we had approximately $309 million of real estate loans.

If you turn to the next slide, which deals with our credit costs, credit cost decreased substantially in Q2 as the outlook for credit continues to improve. We decreased our allowance for credit losses to 553 basis points on period-end loans, compared to 604 basis points at March 31. The provision for credit losses declined 80% and new specific provisions declined 36%. Other real estate owned consists of one property carried at $3.4 million as of June 30.

During the second quarter we were able to return approximately $30 million in non-performing loans back to performing and we sold one of two commercial real estate properties previously classified as OREO at prices above its carrying value.

Our annualized charge off rate decreased to 4.6% of period end loans and these charge offs related to loans previously identified as impaired. While we believe the decline and specific provision signals an improvement in the credit environment, we expect the level of charge offs and NPAs to remain elevated for several quarters as our earnings remain vulnerable to potential negative credit outcomes.

If you turn to the next slide, it is a breakdown of our nonperforming assets. It shows it by industry and it shows that the nonperforming assets have decreased 10% from quarter one and the average carrying value of our nonperformers is at 43% of face value.

If you turn to the next slide, our Q2 2010 income statement, as I mentioned earlier adjusted net income was $5.9 million for the quarter and GAAP net income was $5.3 million. Net interest income was $19.1 million for the second quarter compared to $16.1 million for the first quarter.

As I said earlier, the margin was 3.75 versus 3.03. Provision decreased in the quarter from $27 million to $5.5 million. Non-interest income increased slightly to $4.8 million this quarter. Our asset management fees were slightly also up in the quarter. Expenses decreased slightly to $9.5 million in the second quarter, from $9.8 million in the first quarter, primarily due to lower payroll taxes and slightly lower occupancy costs. Head count was at 62 people at the end of the quarter.

The last slide that I’ll talk about is our 2010 Q2 balance sheet, which is shown on that next slide. Our book value equity at the end of the quarter was $544 million, up slightly from last quarter, and our book value per share, as of June 30, was $10.53. We’ve also added in our slides supplemental data that shows how our book value reconciles to last quarter, and what’s in our deferred tax assets.

With that, I’ll turn it back to Tim.

Tim Conway

Thank you John. So to summarize, our return to profitability marks a shift from defense to offense as we focus on our key priorities to generate better returns. Our strategy is straightforward. First, we plan to sustain income momentum as the portfolio improves and we increase volumes. Second, we will re-lever the balance sheet to fund growth and invest in new opportunities.

When we placed a deal in December of 2009 we were the first issuer to tap the loan securitization market since it closed as a result of the credit crisis. We are now having conversations with a broader range of credit providers who are interested in financing our lending activities. The key objective of re-levering is to redeploy existing capital to fund growth. Third, we plan to diversify the business in areas that are consistent with our core strengths in direct origination and credit management.

We are beginning to see many new opportunities in our core business, as well as in adjacent markets. We expect to see substantial consolidation among lenders of various types, from banks to finance companies, to asset managers and we believe we are well positioned to strategically capitalize on this trend by adding businesses or teams to expand our franchise.

We are evaluating several of these opportunities that have potential to generate attractive leverage and risk adjusted returns. For example, we are exploring the possibility of building a mid-ticket leasing business to complement our middle-market platform. We believe the segment represents an attractive way to diversify our revenue and funding sources while leveraging our core competencies in origination and credit. We expect to discuss it in more detail next quarter.

That’s the end of our prepared remarks and we’re happy to take any questions you might have.

Question-and-Answer Session

Operator

Thank you sir. [Operator instructions.] Our first question comes from Sameer Gokhale from Keefe, Bruyette.

Sameer Gokhale - Keefe, Bruyette & Woods

I just had a question about those - there seem to be those loans which had returned to performing status. Can you discuss what kinds of loans those were, and just to get some sense for maybe - is there a read into that from – into those broader sectors where those loans came from?

Tim Conway

Well those are all directly originated loans that we had on the balance sheet that were – obviously were NPAs.

Sameer Gokhale

And was there some grouping by industry type or something like that?

Tim Conway

One was media property, one was industrial property, and one was a restaurant and so three areas where, in particular media and retail and restaurants where we’ve seen elevated defaults and I think these are very positive developments. Media for example is a situation where a company put it on NPA, wasn’t paying interest in a timely fashion, and now their top line ad revenues operations have improved to the degree that they’re current and we feel as though it’s a performing asset. In the case of the restaurant, there was a lot of value in the franchise, so they had some cash flow issues in that case. That deal was refinanced. We got 100% of our capital out of that and refinanced as part of an acquisition of the restaurant chain by another company. And then the last one was a company that went through bankruptcy then emerged with a very strong balance sheet and position where we had taken a mark on that and didn’t put new capital in it but it’s now back on performing. I think actually in those you see some very positive trends that are indicative of what we’re seeing in the portfolio in general, which is by and large where we’re seeing improvement it really is in the fundamental operating characteristics or in the refinancing that reflects the value of a company that another company is interested in it.

Sameer Gokhale

Okay, that’s very helpful, and that’s exactly what I was looking for in terms of color. But now I’d like to just get your sense for reconciling the commentary. Even in your press release you mention that you remain optimistic about the positive trend in credit performance. You expect non-accruals to come down, charge offs were down sequentially, non-accruals were down, you expect non-accruals to decrease. But then you mention that you – earnings remain vulnerable to potential negative – potential credit surprises, and I was just wondering. It seems like you were a little bit guarded there but everything seems to be improving from a credit standpoint. So now are you just being a little cautious at this point, or is there anything specifically you’re seeing? Some area that you’re more cautious about that’s causing you to be a little guarded with your commentary? Just some thoughts there would be helpful.

Tim Conway

Well I think we are clearly- we’re bankers so we’re cautious by nature, but we’re being cautious although I think that there is uncertainty in the market and there’s a lot of concern about the economic recovery. What we’re – there are no specific things that we’re trying to foreshadow or indicate with that comment. We expect to - for the trends that we indicated to continue, which is lower reserves, lower charge offs, lower NPAs, and we don’t have any specific reason to believe that that won’t be the case. And I think we’re seeing in our portfolio on a bottoms up basis name by name and industry by industry by and large a significant improvement in the operating characteristics in these markets and the companies. So I think it is a note of caution, but it’s still a – I’d say - somewhat fragile economy and things could turn around. But what we see right now is not indicative of any specific caution that we should – that we’re trying to point out.

Sameer Gokhale

Okay, and then just my last question and I’ll hop back into the queue, but in terms of the staff that you mentioned you’d added, any specific areas that you can share with us where you’ve added staff, and then maybe is that an indication of the [unintelligible] areas in which you plan to ramp up originations a little further?

Tim Conway

Yeah we added support staff in origination and a little bit in credit, but really focused on origination. In fact we have some plans to do some more hiring in the – on the origination side because we’re seeing a couple things. Number one our – we have an opportunity to do more volume than we had anticipated. We think that’s going to increase even more over the next few quarters. We have, we’re seeing very attractive deals in the marketplace, and so we really need to add some staff where we see those opportunities and it’s really on the origination side.

Sameer Gokhale

Okay, thank you.

Operator

Thank you sir. I am showing no more questions in queue. I’d like to turn it back to Ms. Banse for final remarks.

Colleen Banse

Thanks operator, and thanks everyone for joining our call this morning. That will conclude our remarks for the day. We hope you have a great day.

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Source: New Star Financial Q2 2010 Earnings Call Transcript
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