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NewStar Financial, Inc. (NASDAQ:NEWS)

Q3 2010 Earnings Call

November 03, 2010 10:00 am ET

Executives

Colleen Banse - Managing Director

Tim Conway - Chairman and CEO

John Bray - CFO

Analysts

Sameer Gokhale - KBW

Operator

Welcome to the NewStar Financial Q3 2010 Earnings Conference Call. At this time, all participants are in listen-only mode. (Operator Instructions) As a reminder, this conference maybe recorded.

I would now like to turn the conference over to today’s host, 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 third 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 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 recording of the call will be available beginning at approximately 1 pm Eastern Time today. Our press release and website provide details on accessing in the archived call.

Also before we begin, I need to inform you that statements in this earnings call, which are not historical facts, maybe 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 or required by law.

NewStar plans to file its Form 10-Q with the SEC on or before November 9th, and urges its shareholders to refer to that document for more complete information concerning the company’s financial results.

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

Tim Conway

Thanks, Colleen, and thank you all for joining the call today. I am pleased to report that we had another very good quarter. Our operating performance continued to improve, volume and yields increased and we made significant progress executing on our strategic plan. The strategic plan is straightforward, our number one priority is to build income momentum as credit costs normalize and we increase the volume of new business with attractive deals.

Our second priority is to begin to re-lever the balance sheet and free up excess capital to fund growth. Thirdly, we want to broaden and diversify the existing platform into markets that are consistent with our core strengths and generate solid double-digit after-tax returns.

During the quarter, we generated net income of $6 million, or $0.12 per diluted share. Book value per share increased $0.21 to $10.74. Origination volumes again exceeded our plan increasing to $145 million and we put on the new loans at attractive deals. The average yield on loans booked in the third quarter was 7.1%, up meaningfully from 6% in the second quarter.

We believe the 7% yield on senior secured debts are attractive relative to other fixed income asset classes and highlight the value of our direct origination capabilities. Comparably rated public high yield bonds for example, which have longer tenure and are typically subordinated to senior loans, are trading at about 8%.

Although we have seen some tightening in loan spreads over the last month or so, we expect pricing to be attractive for the foreseeable future as a way of refinancing roles and at a time, when CLO capacity begins to run off.

As we build volume, we continue to add origination staff, we recently hired 20-year middle market veteran Jeffrey Catrett, who is a Managing Director on our Chicago office. I now believe that we are well positioned to maintain the momentum we have established in origination and continue to increase volumes into 2011.

Credit continues to improve in the third quarter, but at a slower pace that we had seen in the first half. We expect to see continued firming in the portfolio performance, but the recovery will be slower in past recoveries given the persistent unemployment and housing problems associated with this cycle.

We believe the commercial real estate is largely stabilized. We are paid out three real estate loans totaling $26 million in the quarter; one was paid at par and the others at levels above, where we had them reserved.

As always, we point out that our credit cost could be lumpy. While the economy is still fragile, the credit markets have stabilized to the point, where we are in a position to evaluate, how our credit perform to the cycle. We continue to believe that our track record has outperformed the industries as well as our peers.

During the six years we have been in business, we made 281 middle market loans of which 28 or about 10% have become NPAs over that period. This track record, which we think is excellent, will serve us well as we look to take advantage of more opportunities to grow the business in the coming period.

Our second strategic initiative is to free up excess capital on the balance sheet. In the third quarter, we restructured our corporate debt facility. We increased the size of the facility from $75 million to $100 million, extended the average life from 2.5 to 4 years and reduced pricing by 200 basis points to LIBOR plus 700.

We also improved financial flexibility by narrowing the pool of assets that secure the facility. At the end of the third quarter, we had $129 million of unrestricted cash and availability to fund growth.

We have also made exciting progress executing on our third strategic priority of broadening the platform into complimentary businesses with solid returns on equity. This week we announced that we had acquired CORE Business Credit from ACAS in a cash transaction valued at $25 million or $22 million net of cash in the balance sheet.

CORE which will be renamed NewStar Business Credit, is an asset-based lender led by industry veteran Michael Haddad. Michael and his team bring an outstanding track record to NewStar.

We plan to retain 16 of 22 CORE employees including five originators located in offices across the country. CORE will service a foundation for us to offer asset-based loans to midsized companies on a national basis and there will be significant opportunities to cross-sell with existing customers.

As result of the purchase, we have acquired a portfolio with total commitments of $164 million of which $73 million was funded as of yesterday. The average yield on the loans in that portfolio is higher than existing loans on our balance sheet today at about 8.5%.

We also assume the $225 million warehouse facility with DZ Bank. The facility has an advance rate of 75% to 80% and pricing of CP plus 200, which will enable us to profitably grow the business and matures in 2013.

Given the size of the portfolio, we are able to re-underwrite each of the loans; we are very comfortable with the credit profile of the portfolio. We paid a purchase price of 90% of the prior amount of the loans outstanding minus advances under the warehouse line. As a result the transaction is not expected to generate goodwill.

Part of the discount could be recognized as a gain in the fourth quarter and remaining balance of the discount will be accretive into income over the remaining life of the loans.

We are also pleased to announce that we are planning to launch NewStar Equipment Finance, a mid-ticket leasing business, which we have been building for several months as we mentioned on the last call.

We have assembled an experience leasing team and have also put together a national network of lease originators, who will operate under contract with NewStar’s independent agents.

We expected to attractive yields in this fragmented market, the availability of favorable term funding will enable the business to be profitable in 2011 and to generate very good returns as it grows. We expect to announce the launch of the business in the fourth quarter and I will provide more detail on our next call.

With that I will hand it over to John to take us through more detail on the quarter. John?

John Bray

My presentation will follow the slides posted on our website. I will begin with our summary of financial results. As Tim mentioned, we are pleased to report quarterly and year-to-date profit.

Adjusted net income was $6 million for the third quarter and $2.6 million for the year. This resulted in adjusted basic and diluted income per share of $0.12 for the quarter and $0.05 for the year.

On a GAAP basis, net income was $5.5 million and $0.11 diluted shares for the quarter and $900,000 and $0.02 for the year. Our Q3 diluted EPS does not reflect $2 million restricted performance shares that was awarded in Q2. We expect these shares to be included in the Q4 diluted EPS calculation.

Our outstanding share count at the end of Q3 was 50.9 million shares compared to 51.6 million at the end of Q2 reflecting repurchases of approximately 696,000 shares during the quarter at a weighted average price of $6.93.

If you turn to the slide titled strong capital and liquidity position, what this slide we believe demonstrates the strong balance sheet with liquidities to support continued growth. We amended our corporate debt facility on more favorable terms as Tim mentioned, increasing the size to $100 million consisting of a $50 million revolving credit facility and $50 million term loan facility and extending the maturity to August 31, 2014.

If you assume a pre-payment rate between 25% to 30%, we would have capacity to originate approximately $450 million over the next 12 months with existing credit facilities. To exceed this pace, we would need to add new facilities or add new funding sources. This analysis excludes the impact of core acquisition and the related DZ credit facility, which has the capacity to originate $240 million of loans. It also does not include capacity we may get to originate new business under our leasing initiatives.

We had $29 million of unrestricted cash at September 30th, down $40 million at the end of Q2. We had $31 million of restricted cash available for reinvestment in our 2006 and 2007 CLOs.

A $100 million of corporate debt facility remain undrawn at the end of Q3, as part of the restructure of the facility we are required to draw the entire $50 million term facility by November 29th. On October 29th, we drew $20 million to help finance the core acquisition. We plan to draw the remaining $30 million before November 29th.

In addition, if you add our unrestricted cash and corporate debt we have liquidity of $129 million at the end of the quarter. Our funding profile shows that substantially all of our outstanding debt is classified as either long-term or medium term.

The next three slides show how the company funds its loan portfolios, lending operations through a combination of CLOs medium term debt in large banks, were outlined in credit and equity. 78% of our loans are funded through securitizations attractive locked-in spreads.

Our securitization cost of funds was 1.1% over the LIBOR at quarter-end. Our CLOs represent a stable source of funding, which are designed with flexibility deserved non-performing assets.

The next slide shows that we have reduced our short-term debt by an additional 10% in the third quarter. We have a net asset position of approximately $141 million. Including our CLOs and term debt approximately 80% of our real estate loans were termed funded.

If you turn to the next slide, the key takeaway here is that our corporate debt facility provides management with ample liquidity that supports operating flexibility, which allows us to actively support our warehouses in CLOs.

If you now turn to the managed loan portfolio slide, you can see that our managed loan portfolio was roughly $2.3 billion, down slightly from levels of our recent quarters, while adjusted revenue decreased to $20.3 million.

Net interest income decreased to $17.8 million from $19.1 million in the second quarter, I will explain the factors affecting the net interest income and net interest margin with greater detail later.

Non-interest income was $2.5 million in the third quarter reflecting increases in fee and asset management income.

The next slide, the loan originations describes the amount in composition of third quarter loan originations and relative revenue drive from the volume. Originations totaled $145 million, $97 million was retained on NewStar’s balance sheet and $48 million was booked for the NewStar Credit Opportunities Fund.

The weighted average spread for new loan originated in Q3 was approximately 710 basis points as Tim pointed out. We continue to get LIBOR floors on all our new transactions and approximately 49% of our portfolio now includes them.

Before it give us a natural hedge against our equity funded loans, if interest rates move downwards and as a result it increased interest spread. If rates move upwards we cannot re-price and we cannot re-price. Spreads will compress until the rates are above the floors.

The net interest margin slide highlights that the net interest margins 3.63 for the quarter, down from last quarter’s 3.75. The drag on the margin from NPAs was approximately 65 basis points.

During the quarter, we put one loan on non-accrual status retroactive to the beginning of the year which had a detrimental impact to the margin of 16 basis points, but Q3 margin benefited by approximately 7 basis points from repricing on new loans. We expect our net interest margin to exceed 4% pro forma for NPAs as we resolved non-accruing loans.

If you look at the slide stable diverse loan and investment portfolio, you can see that our portfolio continues to be diversified. At the end of Q3 , our middle-market corporate loans were 84% of our portfolio and we had approximately 284 million of real estate loans which was $26 million less than last quarter and down from a high of 414 million. The reduction this quarter was primarily due to the pay out for three loans, real estate loans, as Tim said, one was at par and two were previously reserved levels.

The credit performance slide shows if credit costs have continued decline substantially in Q3, as the outlook for credit continues to improve. We decreased our loans for credit losses to 520 basis points on period-end loans compared to 553 basis points at June 30. The provision for credit losses declined 79% and new specific provision declined 78% from last quarter.

Moreover, our non-performing loans declined to 12% to $128 million. While we believe the decline in specific provision continues the signal an improvement in the credit environment, we expect levels of charge-offs and NPAs to remain somewhat elevated for several quarters and our earnings remain vulnerable for potential negative credit outcomes. Our annualized charge-off rate was decreased to 2.4% of period-end loans. Our other real estate owned consists of one property carried at 3.4 million as of September 30.

The next slide breaks down our non-performing assets by industry and shows that NPA has decreased 12% from Q2 and the non-accrual rate decreased 75 basis points to 729 as I mentioned earlier. On average, we are carrying our NPAs at 40% of face value.

If you now turn to the income slide for the quarter, as I mentioned earlier, adjusted net income was $6 million for the quarter and GAAP net income was 5.5 million. Net interest income was 17.8 million for the third quarter compared to 19.1 million for the second quarter; the margin came in at 3.63.

Provision decreased in the quarter from 5.5 million in the second quarter to 1.2 million in the third quarter. Non-interest income decreased to 2.5 million this quarter. Our fee income in our asset management fees, were up quarter-over-quarter and we did not record any gains from debt repurchases in Q3. Expenses increased slightly to $10 million in the third quarter from 9.5 million in the second quarter primarily due to strategic initiatives occurred from the acquisition of CORE our head count was 63 at the end of - people at the end of the quarter.

If you look at our balance sheet, shown in the next slide, our book equity at quarter-end was 547 million up slightly from last quarter. Our book value per share as of September 30 was 10.74. The primary drivers were Q3 net income of $0.11 and the share repurchase was $0.05 accretive.

I’ll now turn it back to Tim.

Tim Conway

In summary, we had a very good quarter and we’re beginning to really focus on building on the growth momentum that we’ve already established. I think we’ve clearly navigated very well through the prices that we’ve been through. I think we can execute equally well in the strategic plan as we start to focus on growth adding businesses, adding volumes.

In the fourth quarter, we’re going to add two very complimentary and profitable businesses to then platform and we say profitable, I think we’re going to be able to be demonstrate solid and double-digit after tax returns in those business, importantly having those products will enable us to offer more products to our existing customers and also enable us to allocate capital amongst products where we see the best returns on investment. Combined with the two new business, we think will represent up to 20% of our new volume in 2011.

Finally there are business that are clearly consistent with what we do which is direct origination credit expertise and management and I’m highly confident in our ability to integrate the business and then to grow them as part of NewStar.

With that, I will open the line up for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from Sameer Gokhale from KBW.

Sameer Gokhale - KBW

It’s a good quarter. The question I had was, is on this acquisition of CORE Business Credit. Tim is it reasonable to assume that the accretion in ‘11 is going to be on the order of like around $0.04 or $0.05 per share or do you think it could be higher than that?

John Bray

Sameer, this is John. What it really come down is during the process of share value and the assets and it will come down to how much of the assets that we have to take a gain in this year versus how much of that is the share value mark in next year, so we have to - we’re still in the process to bring that out.

Sameer Gokhale - KBW

Okay and then as far as this facility that you acquired, the DZ facility as part of that acquisition, you know what kind of assets can be funded in there, is it only that the CORE assets that can be funded in there or could you put other types of equipment finance assets in there or cash flow loans in there as well?

John Bray

That facility was put in place for CORE to support asset-based lending, so it’s really customized for asset-based lending business, so we plan to continue to use it that way. There obviously are deals that we may do with existing cash flow loans or certainly with existing customers that would be structured as asset-based loans that would go into that facility, but we plan to use that to grow what is now called the CORE business.

As John mentioned and I mentioned that we’re talking about leasing, we would expect to have a separate line for - to grow and build the leasing business as well.

Sameer Gokhale - KBW

As of now do you have some, like an originations target for that mid-ticket equipment leasing business and then the CORE business that you can share with us?

John Bray

The answer is yes, we do, but I don’t think we’re prepared to share the forecast on it, we can give you some more sense if it is over the next few periods, but I think all we would say at this point is we think we can grow them pretty meaningfully and that, as I said, we think they would represent up to 20% of our volume next year.

Sameer Gokhale - KBW

Well, I’ll get back into the queue. Thank you very much.

Operator

(Operator Instructions)

I am showing no more questions in queue. I would like to turn it back to Ms. Colleen Banse.

Colleen Banse

Thanks everyone for joining our call. That will conclude our remarks for the day. Have a great day.

Operator

Thank you ladies and gentlemen. This does conclude your call. You may now all disconnect. Thank you very much, and have a wonderful day.

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Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

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