OFS Capital Corporation (NASDAQ:OFS)
Q2 2016 Earnings Conference Call
August 5, 2016 11:00 AM ET
Steve Altebrando – Vice President of Investor Relations
Bilal Rashid – Chairman and Chief Executive Officer
Jeff Cerny – Chief Financial Officer and Treasurer
Mickey Schleien – Ladenburg
Terry Ma – Barclays
Christopher Testa – National Securities Corporation
Good morning and welcome to the OFS Capital Corporation Second Quarter 2016 Earnings Conference Call and Webcast. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.
I would now like to turn the conference over to Mr. Steve Altebrando, Vice President of Investor Relations. Please go ahead.
Thank you. Good morning everyone, and thank you for joining us. With me today is Bilal Rashid, our Chairman and Chief Executive Officer; and Jeff Cerny, our Chief Financial Officer and Treasurer.
Please note that we issued a press release this morning announcing our second quarter results. This press release was subsequently filed on Form 8-K with the SEC. Both documents can be obtained under the Investor Relations section of our Web site at ofscapital.com.
Before we begin, please note that the statements made on this call and webcast may constitute forward-looking statements within the meaning of the Securities Act of 1933 as amended. Such statements reflect various assumptions by OFS Capital concerning anticipated results are not guarantees of future performance, and are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from such statements.
The uncertainties and other factors are in some ways beyond management's control including the risk factors described from time-to-time in our filings with the SEC. Although we believe these assumptions are reasonable, any of those assumptions could prove inaccurate and as a result, the forward-looking statements based on those assumptions also could also be incorrect.
You should not place undue reliance on those forward-looking statements. OFS Capital undertakes no duty to update any forward-looking statements made herein. All forward-looking statements speak only as of the date of this call. Our comments may reference adjusted net investment income and non-GAAP measure. Please refer to our earnings press release for reconciliation.
With that, I'll turn the call over to our Chairman and Chief Executive Officer, Bilal Rashid.
Thank you, Steve. Good morning and welcome. The second quarter of 2016 was another strong period for us. OFS Capital has continued to deliver earnings growth and a stable net asset value.
This quarter, our net investment income has once again exceeded our quarterly distribution, and it is the fifth consecutive quarter our adjusted net investment income and non-GAAP measure has exceeded our distribution. Our net asset value increased compared to the first quarter of this year as well as the second quarter of last year.
Our adherence to strict underwriting standards, our focus on the credit quality of our portfolio and our diligence in sourcing quality investments has proven to be the right strategy.
Our net investment income grew to $0.36 per share this quarter. Over the last 12 months, our adjusted net investment income per share was 114% of our distribution. Given the ample amount of dry powder available to us, we believe we have significant room to continue to grow our earnings.
Our net asset value was stable at $14.76 per share, compared to $14.65 per share in the prior quarter and $14.66 per share at June 30, 2015. We have generated strong total return for our shareholders as measured by distributions plus the change in our book value.
Over the last two years, our total return has been 23%. Since the beginning of 2011, we have invested $618 million and had a cumulative net realized loss of just $600,000, which is less than 1/10th of 1%.
We credit this strong track record and our stable net asset value to the strength of our team and the close alignment of interests of our shareholders and our external manager, which owns more than 30% of the company.
We remain satisfied with the overall credit quality of the portfolio. As we have mentioned on our prior calls, OFS Capital does not have any investments in the oil and gas sector and we have focused on sectors that are less cyclical and have a track record of performing throughout an economic cycle.
Our focus on the underserved lower middle market especially in the non-sponsored segment has also given us an edge. We have longstanding relationships in this segment. And we continue to believe that our best opportunity to generate strong risk adjusted returns is in this part of the middle market.
OFS Capital also benefits from the broad expertise of its experienced external manager, which has an approximately $1.6 million credit platform and has successfully navigated multiple credit cycles since its inception in 1994. Our team has the size, relationships, and breath of expertise across all parts of the leverage loan market to provide us with considerable capital markets intelligence as well as industry expertise.
This allows us to see a broad array of potential transactions and to be highly selective in making investments. Given the overall market conditions in the beginning of the year, our originations to-date have been lower than our expectations. However, we remain committed to growing our originations.
As always, we remain highly selective and focused on capital preservation. We believe our focus on credit quality has led to long term stability in our net asset value, low loss experience, and a strong investment track record.
Looking ahead, we will continue to focus on what has benefited our shareholders over the past several quarters. One, maintaining a strict underwriting standards. This has resulted in low loss experience and an avoidance of portfolio companies in the highly cyclical oil and gas sector; two, being responsive to our borrower's needs by providing flexible capital solutions. This has led to repeat business, a reputation as a reliable partner, and ultimately good quality deal flow. Three, always focusing on the best risk adjusted returns for the long term. We have been able to finance our origination activities with very attractive long term financing.
As you know, we have a $150 million in fixed rate SBA debentures through the SBIC program with a weighted average coupon of 3.18%, with no maturities until 2022. This continues to have a meaningful positive impact on our return on equity, especially given the size of our portfolio.
In addition, our portfolio is positioned to benefit from a meaningful increase in interest rates if and when that would happen. Nearly two-thirds of our loans are floating rate while our debt is 100% fixed rate.
In terms of investment capacity, we have significant capital resources on hand as well as several additional sources to raise new capital to grow net investment income and our distribution.
As of the end of the second quarter, we had 45 million in cash, 20 million invested in the senior club loan portfolio that can be redeployed in higher yielding investments and untapped 15 million revolving credit facility, the ability to raise additional capital in the bank loan or the bond market. As a reminder, SBIC debt does not count towards the BDC leverage test, so we have not tapped any of our available statutory leverage.
And finally, our second SBIC license was submitted last year. If approved, we would have access to additional capital through SBA debentures. We will continue to finance the company in a thoughtful manner and only raise additional capital if it is accretive. Our job is to generate long term value for our shareholders through strong current cash flows and stability in the value of our portfolio.
At this point, I'll turn the call over to Jeff Cerny, our Chief Financial Officer.
Thank you. We are pleased with our second quarter results. As Bilal just mentioned, we continue to focus on the credit quality and stability of our portfolio, which has resulted in a stable net asset value over time.
We have 31% of our net asset value in cash and the potential to borrow additional capital. As you also just heard, our only debt is long term fixed rate SBA debentures with a weighted average coupon of 3.18%. This debt does not count towards our leverage test and coupled with our cash position gives us flexibility and room to grow our net investment income.
Turning to our portfolio at quarter's end, we had investments in 37 companies, totaling $248.8 million on a fair value basis, which is above our cost. The debt portfolio is at 99.4%, and the equity portfolio is at 111.4% of cost.
The fair value of our loan portfolio increased primarily due to tightening market based credit spreads this quarter. As a percentage of fair value, our investments were approximately 66% senior secured loans, 21% subordinated debt, and 13% equity.
As a percentage of cost, our equity investments were just under 12%. It is important to note that approximately one- third of these equity investments produce investment income due their contractual coupons.
Our portfolio remains diverse with an average investment size in each portfolio company of $6.7 million or 2.7% of the total portfolio. The overall weighted average yield to fair value on our debt investments remains strong at 11.84%.
At the end of the quarter, 64% of our loan portfolio had floating rate coupons. Non-accruals consisted of two loans: Phoenix Brands and Community Intervention Services with a total principal balance of $7.7 million and a total fair value of $6.6 million.
On Phoenix Brands, interest payments resumed on a cash basis during the quarter and we expect a near term resolution. Community Intervention Services went on non-accrual in the second quarter due to the company senior lender blocking our payments due to covenant defaults.
We are involved in ongoing negotiations with the senior lender and the company to reach a resolution that will allow interest payments to resume. However, at this point, we cannot predict the timing of the resolution.
Total investment income was consistent with that of last quarter. We derived approximately $7.7 million in total investment income in the second quarter compared with $7.8 million in the first quarter.
Total expenses were essentially unchanged. Expenses totaled $4.2 million for both this quarter and last quarter. Net investment income for the second quarter was approximately $3.5 million or $0.36 per share, exceeding our distribution of $0.34. As Bilal previously mentioned, we have more than covered our distribution for five consecutive quarters and over the last 12 months our adjusted investment income was 114% of our distribution.
As far as deal activity, during the second quarter we closed transactions with an aggregate invested amount of $17.6 million. With approximately $45 million of cash, $20 million remaining in lower-yielding assets and the potential to borrow significant additional capital, we continue to have the flexibility to execute on our investment strategy.
We remain selective on credit structure and pricing. We will continue to prudently deploy capital and generate liquidity on a timeline that allows us to maximize our interest income for our shareholder. We will only sell lower-yielding assets or otherwise raise capital and we believe it is accretive and can be deployed in a timely manner.
With that, I will turn the call back over to Bilal.
Thank you, Jeff. We are pleased with the value we have created for our shareholders since our initial public offering in 2012. Our recent results demonstrate the strength of our investment platform and our increased band awareness among borrowers. Our investment track record has been solid, and indicated by a strong earnings and a stable net asset value.
This highlights the strength of our underwriting capabilities and the long-term alignment of interest between our shareholders and our external manager, which owns more than 30% of our company. We also benefit from the strong value-added origination capabilities of our external manager. Our focus has been to deliver capital to the lower middle market, especially to the loans sponsored community.
This underserved segment requires specialized expertise and a network of sourcing relationships. This is where we continue to find attractive risk-adjusted returns compared to other parts of the middle market. Our team's underwriting expertise and sourcing relationship have enabled us to successfully participate in that part of the middle market.
In terms of our balance sheet, we have attractive long-term fixed rate financing through the SBIC program that positions us well for an eventual increase in interest rates. In addition, we have significant capital available to continue to grow our earnings.
OFS Capital remains committed to providing long-term value to all its stakeholders, including both shareholders and borrowers. As a lender, we remain focused on being responsive to the needs of our borrowers by providing them flexible capital solutions.
With that, operator, please open up the call for questions.
[Operator Instructions] The first question comes from Mickey Schleien with Ladenburg. Please go ahead.
Yes, good morning Bilal and Jeff.
My first question is, given the rally in second-lien middle market loans in the quarter, I thought your NAV would possible increase more than you reported, and as we don't have the Q or the Investor Presentation yet, could you tell us whether there are any material markups or markdowns on specific investments other than the two non-accruals?
[Indiscernible] two non-accruals. Yes, I would say the second-lien loans as a group did increase. They are just not a material part of our portfolio, and we did see an overall increase in the entire debt portfolio primarily due to you know, taking credit spreads over the past quarter. So you did an overall uptick in the debt portfolio, and as you mentioned, with the non-accruals we did have an unrealized loss on Community Intervention Services.
Right. Okay, thank you. Just a couple of more questions. Do you generally use one, two, or three-month LIBOR as the index for your floating rate loans?
Typically, I would say three months.
Three months. And lastly, of the cash on the balance sheet how much is in the SBIC?
I think it's -- I don't have those numbers right in front of me, I think it's about 30 million.
Okay. So, most of it's on the SBIC?
Most of it's in the SBIC. That is correct.
And if I recall correctly off the top of my head, that was also the case in the first quarter, right?
So, is that a function of difficulty finding deals that fit the SBIC profile, whether it relates to the size of the deal or underwriting criteria or something else, keeping that -- keeping you from putting that money to work?
No, I just think it's -- that's where the majority of our portfolio is, quite frankly, and it's just prepayment. So, yes, not - challenge is finding SBIC eligible credits.
Okay, very good. Those are all my questions this morning, thank you.
You are welcome, thanks Mickey.
[Operator Instructions] The next question comes from Terry Ma with Barclays. Please go ahead.
Hey, good morning. Can you guys just maybe talk about the investment environment right now? You guys mentioned that deal flow was a bit slower earlier this year, how is that shaping up now and what do you see in the pipeline further down later this year?
Yes. Terry, I would say that the first half of the year was slower than usual, and we're seeing that across the industry, but as it relates to the future, we believe that the second half of the year is going to be stronger than the first half, and that's really born out by some of the deal flow that we are seeing right now in our pipeline. So I would say the first half has been slower than expected, but the second half is shaping up to be stronger as indicated by our pipeline.
Okay, and what are you seeing in terms of pricing and just structures, has the pricing gotten more competitive and structure is looser in general, or how has that trended?
Yes. I mean, I would say that the part of the middle market that we play in which is the lower middle market and specifically the loan sponsored part of the market, I think that the pricing and the structures have been relatively stable there, and that really is the main reason that we are playing in that part of the market. So I would say that we are not seeing any meaningful changes there.
Okay, got it. And can you just talk about the underlying trends for your portfolio companies and maybe if you can, just talk about the EBITDA growth year-over-year and also revenue growth trends you are seeing?
Yes, I would say that both with respect to the revenue and EBITDA I think we are flat to slightly up, compared to last year and also compared to the last quarter. So I would say it's stable to slightly up, both on the revenue and on the EBITDA front.
Okay, great. Thanks. That's it for me.
Next question comes from Christopher Testa with National Securities Corporation. Please go ahead.
Hi, guys, good morning. Thanks for taking my question. Just going back to Terry's question a bit on volume, just curious as to your thoughts on whether you need to kind of build out more of an infrastructure if you need to hire people or if you know, potentially doing some more club deals there to boost volume is on the table?
No, we really don't think that is necessary. We have very strong and deep bench of [regulators] [ph] and underwriters. I think the first half of this year really has been slow not -- I believe not just for us but I think across the industry. I think some of it is seasonality. I think the second half of the year tends to be stronger than the first half. So, as I mentioned that earlier on the second half of the year looks much stronger than the first half just based on the pipeline that we have right now.
And the deal volume in terms of M&A for the lower middle market fell off significantly from the first into the second quarter. Just being curious what trends you are seeing in M&A in the lower middle market in the second half of the year?
Yes, I think that the first half of the year, there was definitely lower trend with respect to M&A activity. Second half of the year, we are actually seeing that activity picking up. So, I think that is going to be one of the main drivers there with respect to higher deal volume.
Okay. And what the NII per share -- I know last quarter you guys had guided it to be down a bit this quarter. It's relatively pretty much flat, what is the, I guess, surprise there or something that you didn't necessarily expect that kept NII per share up like that?
Yes. Chris, I would say that we did have some prepayments, so we had some acceleration of income and prepayment fees, but those fees were not inconsistent with prior quarters. In fact, they were dead on with the first quarter. So, we always see a portion of our earnings each quarter related to prepayment fees, OID acceleration and the like, and it is no different this quarter, and it is something that paid off late in quarter.
Got it. And can you provide what the debt to EBITDA on the portfolio is?
Yes. So fully consistent quarter-over-quarter, I would say the median continues to be running about 3.5 times and the weighted average [indiscernible] the four.
Got it. Okay. And you guys just remind me have applied for another SBIC license which if granted that will give you another 75 million in debentures, right?
That's correct. That is correct.
Okay. And when was that applied for?
We applied for it last year.
Okay. And have you received a Green Light Letter for that yet?
No, we have not, but if and when we receive it, we will make a public announcement in respect to that.
Okay. Great. That's all from me. Thank you for taking my questions.
This concludes our question-and-answer session. I would like to turn the conference back over to Bilal Rashid for any closing remarks.
Thank you all for joining us all today. And we look forward to speaking with everyone again next quarter. Operator, you may now end the call. Thank you.
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.
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.
THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.
If you have any additional questions about our online transcripts, please contact us at: firstname.lastname@example.org. Thank you!