Capitala's (CPTA) CEO Joe Alala on Q2 2016 Results - Earnings Call Transcript

| About: Capitala Finance (CPTA)

Capitala Finance Corp. (NASDAQ:CPTA)

Q2 2016 Results Earnings Conference Call

August 10, 2016 8:30 AM ET

Executives

Joe Alala - Chairman and Chief Executive Officer

Jack McGlinn - Chief Operating Officer, Treasurer and Secretary

Steve Arnall - Chief Financial Officer

Analysts

Mickey Schleien - Ladenburg

Jonathan Bock - Wells Fargo

Chris Kotowski - Oppenheimer

Ryan Lynch - KBW

Christopher Nolan - FBR & Co.

Michael Del Grosso - Jefferies & Company

Operator

At this time, I would like to welcome everyone to the Capitala Financial Corp’s Conference Call for the Quarter Ended June 30, 2016. All participants are in a listen-only mode. A question-and-answer session will follow the Company’s formal remarks. Today’s call is being recorded and a replay will be available approximately three hours after the conclusion of the call on the Company’s website at www.capitalagroup.com under the Investor Relations section.

The hosts for today’s call are Capitala Finance Corp’s Chairman and Chief Executive Officer, Joe Alala; Chief Operating Officer, Treasurer and Secretary, Jack McGlinn; and Chief Financial Officer, Steve Arnall. Capitala Finance Corp issued a press release on August 9, 2016 with details of the Company’s quarterly financial and operating results. A copy of the press release is available on the Company’s website.

Please note that this call contains forward-looking statements that provide information other than historical information including statements regarding the Company’s goals, beliefs, strategies, future operating results, and cash flows. Although the Company believes these statements are reasonable, actual results could differ materially from those projected in the forward-looking statements. These statements are based on various underlying assumptions and are subject to numerous uncertainties and risks, including those disclosed under the sections titled Risk Factors and Forward-Looking Statements in the Company’s quarterly report on Form 10-Q. Capitala undertakes no obligation to update or revise any forward-looking statements.

At this time, I would like to turn the meeting over to Joe Alala.

Joe Alala

Thank you, operator. Good morning everyone. Thank you for joining us. Our second quarter results, Capital covered the distance producing with net investment income for the fourth consecutive quarter.

The manager continues to waive incentive fees to support net investment income and distribution coverage. The waiver amounted to $800,000 for the quarter and totaled $2.4 million as announced earlier this year demonstrating manager and shareholder alignment.

Net asset value per share of $16.28 unchanged from the first quarter. We are hopeful that the net asset value has stabilized. Having been negatively impacted by valuations related to our energy investments. However, our energy exposure is now approximately 5% based on fair value at June 30, compared to 12% at the end of 2014.

No real investment activity during the quarter. This was driven by two things, one modest liquidity and two, our commitment to not chase yield, in fact provides partly investments.

Looking ahead, we did have an successful exit of MTI Holdings. The debt was repaid at par while the equity generated a realized gain of $8.6 million or a cash on cash return of 5.3 x. Redeployment of these proceeds into a yielding investment will help reduce our alliance on the incentive fee waiver.

We also continued to work towards the first close on our private credit fund which will provide additional liquidity to the platform and allow the company to co-invest with affiliates having received a co-investment order from the SEC during the second quarter. We continue to focus on our direct origination platform to seek out lower middle-market investments with proper risk-adjusted returns and pricing.

At this point, I would like to turn the meeting over to Steve and Jack to provide additional comments on our operating and financial performance.

Steve Arnall

Thanks, Joe. Good morning. As previously mentioned, on August 9th, we filed a press release with our second quarter 2016 earnings. I would invite you to visit the Investor Relations portion of our website to learn more about the company, review quarterly investor updates and to automatically receive email notifications of company financial information, press releases, stock alerts and other corporate filings.

During the second quarter of 2016, total investment income was $17.0 million, an increase of $1.9 million over the same period last year. Total interest fee and PIK income was $1.5 million higher in the second quarter of 2016 compared to 2015, driven by a larger investment portfolio. All other income increased by $0.4 million.

Total expenses for the second quarter of 2016 net of incentive fee waiver were $9.6 million, compared to $9.8 million in 2015.

There are no material variances to report. Net investment income totaled $7.4 million or $0.47 per share for the second quarter of 2016, compared to $5.3 million or $0.33 per share for the same period last year. Net investment income and the coverage of quarterly distributions continue to be a high priority for management.

Net realized losses totaled $5.6 million or $0.35 per share for the second quarter of 2016, compared to net gains of $15.8 million for the same period in 2015. Jack will provide more about our net unrealized losses in just a moment.

Net unrealized depreciation for the second quarter of 2016 was $5.4 million, compared to depreciation of $16.2 million last year. The net increase in net assets resulted from operations during the second quarter of 2016 totaled $7.3 million or $0.46 per share, compared to a net increase of $4.9 million or $0.31 per share for the same period last year.

Total net assets of $257.5 million at June 30, 2016 equates to $16.28 per share, compared to $17.04 a share at December 31, 2015.

From a liquidity standpoint, we have cash and cash equivalents of $20.1 million at June 30, 2016, compared to $34.1 million at December 31, 2015. SBA debentures outstanding at March 31 – excuse me at June 30, 2016 totaled $182.2 million with an annual weighted average interest rate of 3.34%.

In addition, the company had $113.4 million of notes outstanding bearing a fixed interest rate of 7.125%. Lastly, the Company has $69 million drawn and $51 million available under its senior secured revolving credit facility and a regulatory leverage ratio of 0.71 x at quarter end.

At June 30, 2016, the Company’s balance sheet and future net investment income will not be materially impacted by changes in short-term interest rates. Please see Form 10-Q for detailed information about the Company’s interest rate sensitivity.

At this point, I’ll turn the call over to Jack.

Jack McGlinn

Thanks Steve. Let me first comment on market activity. As it’s been commonly reported, the M&A market activity is well off the historical pace over the last several years. While we continue to see ample deal flow, many of the deals we saw in the second quarter were credits and we have to miss these opportunities.

Further with our lower liquidity, we were not aggressively pricing potential investments. This led to no new platform investments in the second quarter. We recently have been seeing an uptick in market activities as summer comes to an end and this coupled with our increased liquidity will lead to more investments for the second half of the year.

As of the end of the second quarter, Capitala’s portfolio consists of 54 companies with a fair market value of $595.1 million on a cost basis of $576.8 million. Senior debt investments represent 36% of the portfolio, senior subordinated debt 43%, senior liquid loan fund 3%, and equity/warrant value of 16.8%.

In regards to portfolio quality, we continue to maintain a sub two internal weighted average risk rating at 1.81. Weighted average yield on our debt portfolio continued to be strong at 12.5%. Realized losses of $5.6 million were recognized during the quarter mostly related to $6.6 million recognized loss from Abutec, one of the energy investments and formerly a non-accrual asset.

Net unrealized appreciation was $5.4 million, which included a $5.7 million reversal on Abutec. Depreciation on several investments that help to offset the further $5 million depreciation in the oil and gas services business TCE Holdings. That now has no remaining fair value.

As a further update on investments in the energy space, the four remaining investments to fair value totaled $32.4 million or 5.4% of the portfolio. At the end of the quarter there were three debt investments on non-accruals with fair value and cost basis of $9 million and $37.2 million respectively, a continued improvement from the prior quarter.

As mentioned, we have had significant subsequent repayment activity with the $5 million repayment of Maxim Crane Works, $18.4 million of Merlin International, and $18.6 million from MTI Holdings that excluded a $10.6 million payment for our $2 million equity investment.

With that, I will turn it back to Joe.

Joe Alala

Thanks Jack, thanks Steve. So, we want to reemphasize that we continue to focus on distribution coverage with NII, the fee waiver commitment from the manager has assisting that. We do expect stability due to the reduction of energy and non-accrual investments and with our improved liquidity, we will continue to focus on directly originated lower middle-market investments with proper risk-adjusted price.

And with that operator, we are ready to address questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Mickey Schleien with Ladenburg.

Mickey Schleien

Yes, good morning everyone. Hope you are all having a good day. First of all, can you please update us on the exit of Abutec which was on non-accrual, I just like to understand the reasoning for that exit.

Jack McGlinn

Yes, I mean, with the – as with some of the

Mickey Schleien

And Jack, by the way, it’s really hard to hear you.

Jack McGlinn

Sure. As with some of the other oil and gas services deals, I mean the prolonged downturn in pricing gone on for over 18 months. Abutec was a smaller company. We had couple different opportunities to look at restructuring on that none of which were really appealing as it involved further investment into the business without great visibility and the long-term viability of the business. So we passed on that and wrote off the investment.

Mickey Schleien

I understand and that’s a good segue into my next question and I do have a couple more on energy. So, TCE was completely written down. Can you update us on that company? Is it in bankruptcy or are they restructuring? Where are they in the cycle?

Jack McGlinn

It’s kind of a similar story. We are – they are looking to restructure and I can’t comment too much on that individual investment, but, at this point, we don’t think it was appropriate to have any value recognized on that.

Mickey Schleien

Okay, and my last energy question, is the Sierra Hamilton loan a second lien?

Jack McGlinn

It is a first lien behind some working capital revolver.

Q - Mickey Schleien

Okay. And that’s valued at 50, but it’s current. So, I am curious what strategies they are using to remain current given where you value the investment.

Jack McGlinn

Yes, they continue to maintain a pretty good availability as far as their working capital goes. They continue to perform. So, they were able to burn down some ARs at the beginning of the downturn of pricing. So, we are optimistic that they will continue to perform, but we are also being cautious with the valuation.

Mickey Schleien

All right, I understand. I just want to confirm with Steve that most of the dividend income this quarter was from the senior loan fund. Is that correct?

Steve Arnall

That is correct.

Mickey Schleien

So, taking that into consideration and the equity portfolio has almost no – or generated almost no dividend this quarter. So, I’d like to understand what the outlook is, if you could give us some more specificity on monetizing some of the larger positions like Medical Depot or MTI or City Gear or Navis which you control?

Steve Arnall

MTI, we actually, this we reported that in the earnings. Beyond that, as we’ve talked about in the past, Mickey, we wish we could give you some more clarity on all that, but it would just be inappropriate to do so. When those events happen, we will certainly be sharing that news with the market, but, to do so ahead of time, which is not be appropriate.

Mickey Schleien

Okay, and a couple modeling questions. G&A fell pretty meaningfully from $1.2 million to $0.9 million. Can you tell me what accounted for that?

Steve Arnall

Nothing specifically, just some lower expenses and some of the timing related to some professional fees.

Mickey Schleien

So, is $0.9 a good run rate number or could we expect that to turn back up?

Steve Arnall

I think this is a range in there that makes sense, $0.9 maybe on the low end, Mickey to think, again some of the professional fees related to year end hit in the first quarter and so the second quarter might be a slight decrease. But I wouldn’t look for a substantial change from that, maybe just saying range of $0.9 to $1.2 would be appropriate.

Mickey Schleien

Okay. And Steve, if I recall correctly, one of your SBA debentures is due soon. So how much of your cash is within the SBIC subsidiaries?

Steve Arnall

The majority of our cash including the repayments that we’ve already reported out is in the subsidiaries. To your point, we’ve got $11.5 million maturing on September 1 and that’s the highest price money we have with all-in cost of over 6.5%. So we will be repaying that on 9/1 and going forward, that really has a pretty immaterial impact to our future financial statements.

Mickey Schleien

Okay. My last question is, we saw pretty sharp decline in portfolio net leverage. Could you give us some sense of what caused that to occur?

Jack McGlinn

Yes, I mean,

Mickey Schleien

For instance the presentation…

Jack McGlinn

With this some EBITDA improvement, some and just the maturing of the portfolio with no real significant investments over the quarter in this one in the first quarter. As the portfolio matures, and it will be – first get into obviously the leverage us usually higher at a transaction multiple and companies have been paying down debt and improving EBITDA. So that’s part of it. So that’s just some of the exits that we’ve had.

Mickey Schleien

Okay, thank you for the – thank you for that. So, those are all my questions today. I appreciate your time.

Operator

Our next question comes from Jonathan Bock with Wells Fargo Securities.

Jonathan Bock

Good morning and thank you for taking my questions. Joe, Steve, if we look at the BDC space broadly, we’ve seen a series of dividend reductions in some cases these are reactive post-losses, post-portfolio underperformance, in some cases, they are proactive in order to realign according to a better improved cost to capital to originate high quality deals that generate good risk-adjusted returns.

And the $64,000 question just we want to ask here would relate to your dividend policy, right, because today, at now I think you are offering a yield at 11.5% and again that’s all based on a NAV basis and if you kind of plug in the math of fee structure before the waiver, we are arriving at a required portfolio ROA of about 12.5%, 13%.

Now Joe, clearly you can waive your fees and bridge to the other side, but the question is, how confident are you in the ability to bridge to the other side because to the extent that you couldn’t get there any way, it would seem that the market is allowing you a prime opportunity to reduce the dividend inline with a number of your other peers.

So that you and Chris and Jack and the team can originate high quality and I’ll emphasize, safe, although that’s kind of a tough word in this environment, safer risk-adjusted return.

So, your policy in the phase of what you are originating and the safety level at which you are originating it, not exposing the industrial losses, that’s really the key question I think kind of faces the shares and faces the opportunity and the uncertain time is how long you would want to waive that fee and its effect on your business and more importantly your partners and yourselves?

Joe Alala

This is Joe. One is the Board determines the dividend and we review that with them every quarter before announcing. Two, what we commented on early in the year is, we need the time to rotate out some of these equity positions, get that liquidity and redeploy into yields.

Now part of your question is that yields you are redeploying into does it cover that 12.5-ish percent to get to where you are covering NII with that fee waiver through redeployment in that yield. And I think, what we have now is we’ve created the liquidity, especially, over the past two or three weeks we’ve created the liquidity, we will actually forecast increased liquidity in the near term future from more repayments.

We will also have parallel liquidity we forecast for the private credit funds. So then we have to go back to our investment strategy of direct origination with all this liquidity with the monetized equity position. And Steve, where we can deploy that without having to chase yield, I think that is a very important question and that will be answered over the next quarter or two to see how we deploy all this liquidity that we are about to have, but we will not chase yield.

We will continue to focus on direct originations. And I think we will be realistic in presenting to our Board and our Board considering all these factors to set its dividend and distribution policy.

Jonathan Bock

That’s very helpful. And so, and I appreciate it, because at the end of the day, look, the alignment is apparent in your past decisions and we know it’s certainly there in future ones. Then the question just relates to the underlying risk levels at which folks are deploying at in the middle-market and how you would gauge kind of the overall competitive dynamic and my apologies, I know this always gets touched on, but how would you describe the competition for the first lien, second lien kind of product you could offer – a general unitranche you could offer and then finally a first Mez which we understand the first Mez option has really become a bit in vogue as second lien pricing now effectively – there is no difference between the second lien and the Mez piece. So would you give us a sense of just the all-in kind of levels of risk? I don’t want to just describe it by leverage, but risk in either first, second/unitranche/first Mez options that you are exploring for sponsors?

Joe Alala

Well, I just want to reiterate, we are not going to chase yields. And we have a unique origination platform that we do both sponsor and non-sponsor activity. And I think, on a transaction by transaction basis, we move around the capital structure. I know, we will not chase yield and take on higher risk deals just to make that yield work.

But we are still finding some very attractively priced opportunities in the market. Now having said that, we haven’t done a lot of deals lately, but we’ve changed that dynamic that now we do have the liquidity, so the quality of deals are picking up. We do have the liquidity.

So it really goes back to what’s the rest of the year hold for us and that’s what we are eager to pursue. We think, we call it hunting season. We think that starts September, when everyone sort of gets back from their August vacations and kids get back to school.

We will enter that season with a significant amount of improved liquidity. We have a motivated origination platform and underwriting and portfolio resources. So we will really be able to answer that question better as we go throughout 2016.

Jonathan Bock

Got it. Well, we know, one, we appreciate the waivers in the alignment, two, understand that you certainly can deploy and also are going to be conservative and, three, I appreciate you’ve taken the time to answer my questions this morning. Thank you.

Joe Alala

Thank you.

Operator

Our next question comes from Chris Kotowski with Oppenheimer.

Chris Kotowski

All right, yes, I was looking at number of your values on the equity positions and I noticed couple of them were written up nicely like LJS and Nth Degree, STX and I am wondering, does that just reflect good markets or does it reflect company fundamentals or does it reflect a process underway to monetize those investments, if you can say?

Jack McGlinn

Yes, this is Jack. I can’t say specifically, but it’s – all those factors as we look across the portfolio, LJS had improvement in performance. So each one of those factors you mentioned applies somewhere in the portfolio, but don’t want to be too specific about transactions that are going on, but some of that does impact our valuation as something moves towards that, but, Joe likes to say, a deal is not done until the cash is in the bank, so.

Chris Kotowski

Okay. And then, obviously, since the beginning of the year, energy prices have improved and those stalled out in the last couple of weeks again. And I am wondering, just in general, for some of your energy credits, is it kind of too little too late to help you resolve or to help the companies resolve the situation or is $40-ish oil sufficient to what the companies work through the remainder of the cycle?

Jack McGlinn

Yes, I mean, from what I’ve heard in the market, the 2016 budgets were pretty well set. So, the fluctuations that were going on in oil prices really haven’t impacted the market all that much. The rise back into the 50s gave hope for 2017, I think this backs down – the hope isn’t as strong that the budgets for 2017 are going to show a lot of new rigs.

So, and TCE and Abutec have been our ones that are most heavily impacted by the oil prices and their valuations reflected that there is not a lot of optimism for growth in those markets. There are other energy investments are more first lien in nature and we’ve had better luck better optimism on those companies, so. I don’t think $30, $40, $50 of oil is making much of a difference at this point.

Chris Kotowski

Okay. All right.

Jack McGlinn

But again, that’s for more related is more related to Abutec and TCE.

Chris Kotowski

Okay. That’s it for me. Thank you.

Joe Alala

Thank you, Chris.

Jack McGlinn

Thank you.

Operator

Our next question comes from Ryan Lynch with KBW.

Ryan Lynch

Good morning. My first question, just following up on Mickey’s question on Sierra Hamilton, that investment, it remained pretty steady quarter-over-quarter from a fair value market – obviously marked down quite a bit, but it was steady quarter-over-quarter. Does that fair value mark for flat just the general uncertainty surrounding that company or is there any sort of balance sheet restructuring talks going on with that?

Joe Alala

No on the latter, and again, we’ve kept it steady, just because there hasn’t been anything pointing in either directions. It was part of our visibility on it, so.

Ryan Lynch

Okay. And then, just one, kind of general question. So, spreads have been coming down across, basically all yield products, certainly, broadly for all the syndicated loans. So, because of that spread compression, have you guys been seeing any increase in your portfolio of companies come to you with a potential discussing repaying your debt now that credit spreads and interest rates are compressing more than we’ve seen over the last couple of years?

Joe Alala

Well, we’ve reported some repayment activity. I am not sure that was really driven by the spreads at all. So I would generally answer your question as no, we haven’t seen that kind of activity or pressure.

Ryan Lynch

Okay. That’s all from me. Thanks.

Joe Alala

Thanks, Ryan.

Jack McGlinn

Thank you.

Operator

Our next question comes from Christopher Nolan with FBR & Company.

Christopher Nolan

Hey guys. Given the $11.5 million in SBA paydowns on 9/1, is that funding going to be replaced with additional SBA borrowings?

Joe Alala

Not at this time, no.

Christopher Nolan

Okay. And so, I estimate it sort of impacts EPS roughly by $0.03 or so. Is the plan to take the realized equity gains from MTI Holdings and just roll that into offset that EPS impact from the SBA roll off?

Joe Alala

Yes, maybe we can talk it offline about your calculations when you factor in management fees and all that and I am not sure I get to the same spot, but absolutely related to monetizations and redeployment. That has been our strategy for the whole year and will continue to be for the rest of the year.

Christopher Nolan

Okay. Could you explain a little bit how the private credit fund is going to co-invest with the BDC? And how do you reconcile you are basically – how do you reconcile potential conflicts between the BDC and credit fund?

Joe Alala

Well, we do have SEC approval to co-invest and that approval is publicly out there in the filing. So, the fund’s five private credit fund went online will offer the BDC the opportunity to co-invest in the deals pro rata and you take that through a process with the Board and they sort of determine co-investment ratios and actually approve or disapprove of the deals.

So, that’s really, it’s very similar to the other ones in place. There is nothing sort of out of the ordinary with it and our focus now has been to have that private credit fund come online to really give a sort of investment strategy liquidity over the next several years. So you know how to continue running your business.

Christopher Nolan

So the private credit fund essentially enables you to invest more into particular portfolio company, the overall Capitala organization?

Joe Alala

Yes, I mean, if you raise a private credit fund, that liquidity comes into that strategy. So that increases your sort of liquidity along the same investment strategy so you can do larger deals, but more importantly for us is, over the past few quarters at the BDC, the inability to raise debt and/or equity capital creates a unforecastable liquidity position and it’s been hard to run a business when you have all these five origination offices out there sourcing deals and we as a firm do not know our liquidity in the BDC, because it’s not predictable.

This will have predictable liquidity and that way you can continue running your business and not be subject to the sources as the capital markets than our BDC as it’s subject to in the past couple quarters.

Christopher Nolan

Okay, and the waiver, am I correct that the waiver expires in the fourth quarter of 2016?

Joe Alala

When we announced the waiver 1st of 2016, that included Q4 of 2015. So we’ve been waiving for, what, three quarters now. We feel that waiver should be in place for all of 2016, because when we announce the waiver, we really wanted to have time to rotate out these equity positions generate liquidity through that and redeploy and see how that affected our NII. So, part of our strategy was to do that. We will reassess management fee waiver of 2017 in the future.

Christopher Nolan

Okay, but the philosophy is really to protect the dividend, number one, so, going to 2017, so we could see a renewal of the waiver.

Joe Alala

In 2017?

Christopher Nolan

Yes.

Joe Alala

We will reconsider at the time. We are really focused on, I think our real focus now is finishing out 2016.

Christopher Nolan

Okay, thanks for taking my questions guys.

Joe Alala

Thank you.

Operator

Our next question comes from Mike Del Grosso with Jefferies.

Michael Del Grosso

Good morning guys. Thanks for taking my question. Most have been asked and answered, but I did want to touch on origination activities and deal activities you saw during this quarter. What trends were at play there? And more importantly, what’s your outlook for the remainder of the year?

Jack McGlinn

Well, I think, we always have a pipeline. I think, in the quality and the type of deals sponsor versus non-sponsor always varies. We do think we were primarily focused on creating liquidity and that liquidity is now in place. It’s hard to run your business with modest liquidity when you are not able to speak for an entire deal and you haven’t shared deals or co-invest with other groups to complete a deal and then there is a, maybe a competitor that can hold it without syndication risk.

That’s a hard position to be in. So, we have addressed the liquidity issues. We are going to enter into September and the rest of 2016 with materially increased liquidity and we believe that the quality of deals will increase, it will match our liquidity and we expect to have a very strong origination pace between September 1 and end of the year.

We have shown over time that when we do raise capital, when we did the bond offering, when we did a subsequent equity offering that the quarter following or the quarter up, those offerings that we were able to deploy capital. We just really have had very modest liquidity most of this year and it frustrates a origination platform that tries to directly source and underwrite and hold all of these loans and investment positions we take.

Michael Del Grosso

Understood, appreciate that. Thank you.

Operator

And I am not showing any further questions at this time. I would like to turn the call back over to our host.

Joe Alala

Like to thank you everyone for their time. We’re around all day. Please give us a call for any more questions. And we look forward to a very active rest of 2016. Have a great day.

Operator

Ladies and gentlemen, this does conclude today’s presentation. You may now disconnect and have a wonderful day.

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