Fidus Investment (NASDAQ:FDUS) Q3 2013 Earnings Call November 8, 2013 9:00 AM ET
Ed Ross – President & Chief Executive Officer
Cary Schaefer – Chief Financial Officer & Chief Compliance Officer
Stephanie Prince – LHA (NYSE:IR)
Robert Dodd – Raymond James
Bryce Rowe – Robert W Baird
Good day, ladies and gentlemen, and welcome to the Fidus Investment Corporation Q3 2013 Earnings Conference Call. (Operator instructions.) As a reminder, today’s conference is being recorded. I would now like to turn over today’s conference call to Ms. Stephanie Prince. Ma’am, you may begin.
Thank you, Kevin, and good morning everyone. This is Stephanie Prince from LHA. Thank you for joining us for Fidus Investment Corporation’s Q3 2013 Earnings Conference Call.
With me this morning are Ed Ross, Fidus Investment Corporation’s Chairman and Chief Executive Officer, and Cary Schaefer, Chief Financial Officer and Chief Compliance Officer.
Fidus Investment Corporation issued a press release yesterday afternoon with details of the company’s quarterly financial and operating results. A copy of the press release is available on the Investor Relations page of the company’s website at www.fdus.com. I’d like to remind everyone that today’s call is being recorded.
A replay of today’s call will be available by using the telephone numbers and conference ID provided in the earnings press release. In addition, an archived webcast replay will be available on the Investor Relations page of the company’s website at www.fdus.com following the conclusion of this conference call.
I’d also like to call your attention to the customary Safe Harbor disclosure regarding forward-looking information included in the earnings release. The conference call today will contain certain forward-looking statements including statements regarding the goals, strategies, beliefs, future potential, operating results and cash flow of Fidus Investment Corporation.
Although management believes these statements are reasonable based on estimates, assumptions and projections as of today, November 8, 2013, these statements are not guarantees of future performance. Time sensitive information may no longer be accurate at the time of any telephonic or webcast replay. Actual results may differ materially as a result of risks, uncertainties, and other factors including but not limited to the factors set forth in the company’s filings with the SEC. Fidus undertakes no obligation to update or revise any of these forward-looking statements.
I’d now like to turn the call over to Ed Ross. Ed?
Thank you, Stephanie, and good morning everyone. Welcome to our Q3 2013 Earnings Call. Today I’d like to begin by discussing our Q3 financial results and the special dividend that we announced yesterday. After that I’ll discuss the Q3 investment activity, the performance of our investment portfolio, and current market conditions. I’ll then turn the call over to Cary who will go into more detail about our financial results and l liquidity position before we open up the call for questions.
Turning to our Q3 results our investment portfolio delivered a high level of performance during Q3. We generated net investment income or NII of $5.3 million or $0.38 per share. Our adjusted NII, which we define as net investment income excluding any capital gains incentive fee attributable to realized and unrealized gains and losses was $0.37 per share. Last quarter we began to report adjusted NII as we believe it better reflects our core earnings.
And importantly, as we mentioned on our last call we recognized long-term capital gains of $24.6 million during Q3. These gains were primarily the result of a successful exit of our investments in Worldwide Express Operations, LLC, in connection with the sale of the company including payment in full on our subordinated notes and a realized gain of approximately $22.1 million on our equity investments.
In addition, we recognized a net gain of approximately $2.5 million on the sale of our warrants to Goodrich Quality Theaters in connection with the company’s partial repayment of our subordinated loan investment.
At September 30 our net asset value, or NAV, was $15.98 per share compared to $15.27 at September 30, 2012. In light of our Q3 realized capital gains we are very pleased to announce a special cash dividend of $0.38 per share in addition to our regular quarterly dividend of $0.38 per share. This follows the Q3 special dividend of $0.04 per share. Both of the Q4 dividends will be paid on December 20, 2013, to stockholders of record as of December 6, 2013.
These special dividends are a result of our performance to date and in particular the cumulative year-to-date $25.7 million of capital gains. Our approach reflects the Board’s balancing of several primary objectives, including delivering long-term value for shareholders in the form of stable and growing dividends, managing the business with a high margin of safety, and growing our net asset value or NAV on a per share basis over time.
During Q3 we invested a total of $20.3 million in three existing portfolio companies, including an investment of $15.0 million in debt and equity securities in support of the change of control of Worldwide Express. In addition, we also closed investments totaling $28.1 million in three new portfolio companies during the first two weeks of October. These new portfolio companies fit well with our investment criteria, advancing our goal of constructing a well-diversified portfolio of debt and to a lesser extent equity investments that we believe will perform well over the long term and can withstand the challenges of the current economic environment.
During Q3 repayment and investment realization proceeds totaled $53.6 million from five of our portfolio companies. In addition to the Goodrich and Worldwide transactions mentioned earlier, we also received payment in full of our subordinated loan in Anthony’s Coal Fired Pizza – however, we continue to hold our equity investment. In connection with Anthony’s strong financial and operating performance the company was able to lower its cost to debt capital.
As we mentioned on our last two earnings calls we have been expecting a higher level of refinancing and realization activity this year. This is a consequence of the natural maturation of our portfolio combined with an active financing market. So far this year we have received repayments and realizations totaling $90.3 million and have invested $107.7 million, including the three new investments that closed the first two weeks of October.
As of September 30, 2013, we had approximately $86 million of cash on hand, of which we invested approximately $28 million in early October, 2013. In addition, we have access to approximately $80 million of attractive, low-cost, long-term debt through our two FDIC licenses. With these available funds we believe that we are well positioned from a capital standpoint to continue to grow and diversify our portfolio.
As of September 30, 2013, we had debt and equity investments in 34 portfolio companies with a total fair value of $277.4 million. As of the end of Q3, the fair value to cost ratio of the portfolio was approximately 99% and we had no loans on nonaccrual status. While the broader economy continues to face certain headwinds and broader uncertainty we continue to be pleased with the overall stability, quality and performance of our investment portfolio.
This can be seen in the quality measures we track which includes the portfolio’s weighted average investment rating based on our internal system. Under our methodology 1 is outperform and 5 is an expected loss. As of September 30, 2013, the weighted average investment rating for the portfolio was 2, generally in line with prior periods.
The credit performance of the portfolio remains sound as well. At September 30, 2013, our portfolio companies had a combined ratio of total net debt through Fidus’ debt investments to total EBITDA of 3.8x which we believe reflects a prudent level of risk for our portfolio. Lastly, our portfolio companies have a combined ratio of total EBITDA to total cash interest expense of 2.8x, which we believe provides a significant cushion for them to meet their debt service obligations to us. These metrics reflect our cautious and deliberate approach which remains intensely focused on capital preservation.
Market conditions have remained stable for the past several months with a healthy amount of activity. For us deal flow is very steady and ample enough to maintain our selective stance as we strive to make progress on our growth and diversification goals. We currently believe that market activity will remain at these levels for the balance of 2013.
And due to the sheer size and fragmentation of our target lower-middle market, this end of the market continues to be attractive and generally less competitive than the broader markets. In this segment of the market, relationships, industry knowledge, and the ability to offer flexible capital solutions are key drivers of our success.
Looking ahead, we remain focused on our highly selective investment approach, emphasizing quality over quantity. Our strategy is to build a well-diversified portfolio of debt and to a lesser extent equity investments in high-quality, lower-middle market companies that are market leaders in their respective niches. We seek to invest in businesses that we believe will perform well over the long term, with an emphasis on companies that operate in industries we know well that generate excess free cash flow for debt service and investment and have positive outlooks.
In executing this strategy we will maintain an acute focus on capital preservation as we strive to generate attractive risk-adjusted returns. I’ll now turn the call over to Cary to provide some details on our financial and operating results. Cary?
Thank you, Ed, and good morning everyone. I’ll now review our Q3 results in more detail and close with comments on our liquidity position.
Total investment income was $10.3 million for Q3 2013, an increase of $1.3 million or approximately 14% over the $9.0 million recorded during Q3 2012. This increase was primarily driven by the increase in average outstanding debt investments in Q3 2013 compared to Q3 last year.
Dividend income increased $0.3 million in Q3 compared to the prior year primarily due to a higher amount of income-producing preferred equity investments. Fee income, which may fluctuate from quarter to quarter depending on the level of new investments and/or prepayment activity, was $516,000 for Q3 2013, consistent with the $514,000 in last year’s Q3.
Total expenses for Q3 2013 were $5.0 million, essentially flat with Q3 2012. Interest expense on our SBA debentures was approximately $1.8 million for Q3 2013 compared to $1.7 million for Q3 2012, an increase due to a slightly higher average level of outstanding debentures. As of September 30, 2013, the weighted average fixed interest rate on our SBA debentures was 4.6% before fees.
Administrative service expenses, professional fees, and other general and administrative expenses totaled approximately $737,000 for the quarter, 28% higher than Q3 2012 which totaled approximately $576,000. The increase was primarily due to an increase in professional and administrative fees associated with our growing portfolio as well as additions to the Finance and Accounting Department staff in July, 2013.
The base management fee increased $0.2 million due to higher average outstanding assets net of cash, and total incentive fees decreased $0.5 million due to a reversal of previously accrued capital gains incentive fees which was partially offset by higher income incentive fees.
The capital gains incentive fee decreased $0.6 million due to a reversal of accrued fees of $0.1 million for Q3 2013 compared to a $0.5 million capital gain incentive fee expense accrued during Q3 2012. The income incentive fee increased $0.2 million to $1.3 million for Q3 ended September 30, 2013, due to higher net investment income. And as a reminder, the capital gains incentive fees are only payable annually and only to the extent that cumulative net realized capital gains are in excess of gross unrealized depreciation.
As a result of these operating activities, net investment income for the three months ended September 30, 2013, was $5.3 million, an increase of 31.8% compared to the $4.0 million reported in Q3 2012. On a per share basis, NII was $0.38 per share for Q3 2013 compared to $0.40 for Q3 2012.
Last quarter we introduced the non-GAAP measure of adjusted NII defined as NII excluding capital gains incentive fees. We continue to believe adjusted NII better reflects our core level of earnings, and during Q3 2013 adjusted NII was $5.1 million, an increase of approximately 14% from the $4.5 million of adjusted NII in Q3 2012. On a per share basis, adjusted NII was $0.37 in Q3 2013 compared to $0.45 in Q3 last year. A reconciliation of NII to adjusted NII can be found in our earnings press release that was issued yesterday afternoon and is also posted on the Investor Relations page of our website.
As Ed has discussed, Fidus reported realized gains on investments of $24.6 million in Q3 2013 resulting from the sale of control investments in one portfolio company and a sale of non-control non-affiliate investments in another portfolio company. The net change in unrealized depreciation was $25.4 million for Q3 2013. This was comprised of $23.6 million of net unrealized depreciation on equity investments and $1.8 million of net unrealized depreciation on debt investments.
The $23.6 million of net unrealized depreciation on equity investments included $23.1 million of reclassification to realize gain on investments which resulted in the unrealized appreciation. Currently, the $1.8 million of net unrealized depreciation on debt investments included $0.2 million of reclassifications to realize gains on investments. These activities resulted in a net increase in net assets from operations of $4.5 million or $0.33 per share for Q3 2013 compared to $6.6 million or $0.66 per share for Q3 2012.
The income per share numbers above reflect a 38% year-over-year increase in our weighted average shares outstanding due to follow-on equity offerings in September, 2012, and February, 2013, both of which were completed at offering prices accretive to NAV. And after our $0.04 per share special dividend plus our $0.38 per share regular dividend for Q3, net asset value as of September 30, 2013, was $15.98 per share.
Turning now to portfolio statistics, as of September 30, 2013, our total investment portfolio had a fair market value of $277.4 million, approximately 99% of costs. Consistent with our debt-oriented investment strategy, portfolio on a cost basis was comprised of approximately 71% subordinated debt, 13% senior secured loans, and 16% equity and warrant securities.
Our average portfolio company investment on a cost basis was $8.2 million at the end of Q3. We have equity investments in approximately 85% of our portfolio companies with an average fully diluted equity ownership of 8.1%. Weighted average effective yield on debt investments was 15% as of September 30, 2013, and we continued to have no investments on nonaccrual status.
Regarding our liquidity position and capital resources, as of September 30, 2013, total cash and equivalents were approximately $86.0 million, and combined with our remaining unfunded SBA commitments of $30.5 million we believe that Fidus has ample capital available for additional investments and operations.
Now I’ll turn the call back to Ed for concluding comments. Ed?
Thanks, Cary. Before opening up the call for questions I’d like to thank the outstanding team at Fidus for their great work and our shareholders for their continued support. I’ll now turn the call back over to Kevin for Q&A. Kevin?
(Operator instructions.) Our first question comes from Robert Dodd with Raymond James.
Robert Dodd – Raymond James
Congratulations on the quarter. A couple questions: first on the dividend and spillover capacity, what is your current spillover income at I guess at the end of Q3 or pro forma for the special at the end of the year? Do you have that number handy?
I’ll let Cary take that one.
Sure, good morning, Robert. The spillover income as of the end of Q3, as of September 30, was $21.5 million so after factoring in the special dividends planned and before any potential activity through the end of the year, that would bring it down by about another $5.2 million.
Robert Dodd – Raymond James
So that would put you at about nine months’ worth of regular dividend in hand in spillover, and of course you’re earning regular dividend. Obviously the dividend policy is up to the Board but can you clarify for us… I mean as far as I understand the, and of course this is obscure now – the IRS starts to look and goes a little funny if you’ve got more than nine months in regular dividend spillover on hand given that you only have technically until four (inaudible ) give or take to distribute the spillover in the following year. So is that spillover getting a little too high and is that going to affect dividend policy going forward? I mean it’s a good problem to have obviously, but…
[laughing] Right. Well, your question’s a very good one, Robert, and it’s obviously the whole dividend question and dividend policy question is one we spend a lot of time thinking about and thinking through, and talking to the Board about. And let me try to go through the whole situation to give you a sense of our approach. To start with, our top priority is to perform well for our shareholders over the long term.
Our ultimate goal is to deliver stable and growing dividends to our shareholders while also growing our portfolio value and our NAV over the long term. We also however acknowledge that uncertainty continues to be a common theme in today’s world and we continue to make these types of decisions as a Board with a conservative bias; and intend to maintain a high margin of safety as we move forward.
You know, as it pertains to excess current earnings and our net realized long-term capital gains we will continue to evaluate some complement of the following distribution options. Number one would be to periodically make special cash dividend declarations but on a periodic basis as we see fit. Number two would be to utilize our ability as a BDC RIC to have spillover income which is defined as current year… [technical difficulties] …whereby Fidus Investment Corporation would retain a portion of our long-term capital gains.
In light of the first point I just made, in terms of special dividends, I think we’re extremely pleased to announce and distribute a special cash dividend of approximately $5.2 million or $0.38 per share. [technical difficulties] …total retention for growth.
…special dividends to stockholders we are equally as pleased that our platform continues to generate significant new investment opportunities that should create longer-term shareholder value. So hopefully that kind of spells out the thought process that we have, and as we move forward we’ll continue… [technical difficulties]
Robert Dodd – Raymond James
I’m sorry, you were breaking up a little bit there, I don’t know if it’s on my end or yours. I got most of that and I appreciate the color there. If I can one more question – your commentary on obviously the subsequent events where you’ve deployed a considerable amount of capital relatively early in the quarter. Your comments to the effect of you expect market activity to continue at elevated rates. I presume you don’t want us to take the $40 million that you’ve done so far and run rate that in terms of originations, not net, and run rate that for Q4. But can you give us a little more color on maybe what the pipeline is shaking out as in terms of originations, and if you’ve gotten any indications so far that you’re going to have more prepayments in Q4?
Sure. You broke up a little bit there, I’m not sure why. But I think I know what the question was and I’ll try to address it.
In terms of market activity, I think market activity continues to be pretty good – I wouldn’t say vibrant but it’s healthy. And for us it’s been a healthy year of originations. Just to go back to Q3 for a second, it was an interesting quarter. We were very busy but we actually had, depending upon how you look at it at least three and some would say four deals that actually fell apart once we were anointed and started working on kind of going towards closing. So it was kind of an unfortunate quarter from that perspective.
Having said that we did get a good start to Q4. We continued to be very busy both on the new investment front as well as managing the portfolio but I don’t want to extrapolate given what happened last quarter at all to say “Expect more originations.” I just don’t think that is… It’s just deals take on a life of their own and they’re just very hard to predict. But we are very busy and we’re seeing good deal flow.
With regard to debt repayments, one of the subsequent events was a small debt repayment that we actually just received yesterday. And I think what we would expect for the quarter as we sit here today, and again, we’ve been surprised here recently on a couple, is probably another deal with a repayment on the debt side of things – but not anywhere near what happened in Q3 or even in Q2.
But I do think repayments is a continuing theme, and 2014 will also have I think a reasonable level of repayments though I think, as I look at it today it’ll be less than this year. So it’s just kind of one of the things we’re dealing with. Companies are lowering their cost of capital tot eh extent they can and there’s also M&A activity at a high level, especially for very good companies.
Robert Dodd – Raymond James
Thank you very much, very helpful.
Yep, sure. Nice talking to you, Robert.
The next question comes from Bryce Rowe with Robert W. Baird.
Bryce Rowe – Robert W Baird
Thanks, good morning. Just a couple questions, and I agree with Robert there, Ed, that there was some breakup when you were talking about the special dividend. So those of us on the phone might have missed a little bit of your comment around the special divided, so maybe you can repeat those. But I wanted to ask a little bit about the activity subsequent to Q3. As Robert pointed out it’s been pretty strong activities since Q3. You made a mention of use of cash to help fund that activity. I wanted to get a feel for whether or not you would take advantage of the commitments that are available to you through the SBA or whether or not we should expect continued cash usage.
Okay, good question, Bryce, and it’s one we look at quite often. I think right now given the level of cash balances it’s more accretive if you will or profitable for shareholders, for us to invest the cash. I think that we’ll get down to a level where it makes sense to keep some cash in reserve and start using the SBA commitments. So I would expect incremental investments in portfolio growth to initially be funded with cash, and then when we get down closer to reserve levels or even $10 million above reserve levels we will start using the SBA debentures primarily.
Bryce Rowe – Robert W Baird
Okay, that’s helpful. And then I guess one other question, and we’ve talked about this on the Q2 conference call – and I certainly don’t mean to harp on anything negative because you guys have certainly produced a lot of positives since your IPO. But we continue to see a little bit of degradation in one of the investments, I guess Avrio from a fair value to cost perspective. And obviously that investment is also 100% pick in terms of the accrual, or the interest accrual. I just wanted to get a feel for one, if that company is progressing towards a nonaccrual status, and then two, how do you determine nonaccrual status for a company like that when you aren’t in fact receiving any cash interest.
Okay, good question – very good question, and you know, I’ll take this one holistically and then come down more to Avrio. Number one, just to talk about the portfolio for a second I think we continue to feel very good about the overall health of the portfolio. I would characterize it as being in a slow growth and stable mode, so we’re pleased with the overall performance. And I’ve mentioned this before and it’s what I would expect is that we have a lot of companies performing to expectations, but as we’d expect we have a few companies that are exceeding expectations and we have a few companies that are underperforming. And that is what we would expect as we go forward. And it’s one of the reasons continuing to diversify our portfolio is a big goal of ours.
I think with regard to the portfolio, just to hit it there, it is an uncertain environment. There are a couple trends in the industry. I think overall the economy continues to be in a slow growth mode. There’s a few sectors that are getting I think hit a little tougher than others. One would be on kind of the consumer side of things – discretionary spending I think is under pressure a little bit with the higher tax rates and whatnot. So I think that’s one sector that we’re focused on, and then other end markets that are effected by sequestration is something that we continue to be focused on and I think is also impacting some portfolio companies.
With regard to Avrio, obviously this company has not performed to our expectations. There’s clearly a higher level of risk and that’s reflected in the valuation, and in this case sequestration has not helped this company’s performance. But having said that there is a new CEO that joined the company in February; we are very pleased with the progress that he has made but it’s in the face of a pretty tough environment. We continue to believe in the value proposition of this business and the opportunities that the markets provide over the long term. Having said that the valuation reflects a high level of risk with regard to this.
We also have a lot of support from just the overall equity group for this company so that is also a factor in how we’re kind of looking at the business holistically. I don’t know if you want to add anything to that, Cary?
Yeah, the only thing I would add there, Bryce, is regarding your question around the nonaccrual approach with respect to the pick. And I think what you’re seeing in the valuation is a lot of our methodologies for fair value driving really based on yield and kind of yield comparison to market. And at 100% pick this security is definitely not a market piece of paper, nor given the situation would we expect it to be and that’s reflected in the fair value.
I do however think that when we look at nonaccrual and pick, as mentioned there has been and there continues to be a fair bit of equity support below our debt securities. And so when we’re evaluating nonaccruals even in a 100% pick situation the determination is our belief system around recovery of that pick – will that pick be paid to us? And that’s what you’re seeing reflected currently in our nonaccrual status for, by not having that on nonaccrual status. It’s our belief system that that will be collected, including the pick amount.
Bryce Rowe – Robert W Baird
Okay, great. That’s helpful. Thank you.
Let me come back to your first request, Bryce, real quickly and just touch on dividend policy again. I’m sorry I was breaking up; I’m not sure what happened there. I think just to hit the top, our focus is on performing over the long term for shareholders. Our goal is to deliver stable and growing dividends to our shareholders while also growing our portfolio value and our net asset value over the long term. At the same time we acknowledge that uncertainty continues to be a very common theme in today’s world so we’re going to continue to make things like dividend distribution decisions with a conservative bias, and we intend to maintain a high margin of safety as we move forward.
With regard to excess current earnings and net realized long-term capital gains we will continue to evaluate some complement of the following distribution options: one is to periodically make special cash dividend declarations; number two would be to utilize our ability as a BDC RIC to have spillover income which is defined as current year taxable earnings that can be spilled over and distributed in the future. And number three would be to make a deemed distribution whereby Fidus Investment Corporation would retain some portion of our long-term capital gains.
So in light of those three options we’re pleased to announce and distribute a special cash distribution. And you know, as we move forward I think there’s going to be a balance between return of capital, i.e. distributions, and capital retention for growth and investment. But we’re pleased to be in a position to provide that special dividend. At the same time we’re very pleased with the investment opportunities that our team continues to generate. So hopefully that’s helpful from a thought process perspective.
Bryce Rowe – Robert W Baird
Thank you for restating that.
(Operator instructions.) I’m not showing any further questions at this time. I’d like to turn the conference back over to Ed Ross for closing comments.
Thank you, Kevin, and thank you everyone for joining us this morning. We look forward to speaking to you on our year-end call in early March. I hope everyone has a great day and a great weekend. Thanks again.
Ladies and gentlemen, that does conclude today’s presentation. You may now disconnect and have a wonderful day.
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