Capital Southwest Corporation [CSWC] Conference call transcript for 2021 q2
2021-08-03 16:10:53
Fiscal: 2022 q1
Operator: Thank you for joining today’s Capital Southwest First Quarter Fiscal Year 2022 Earnings Call. Participating on the call today are Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, VP Finance. I will now turn the call over to Chris Rehberger.
Chris Rehberger: Thank you. I would like to remind everyone that in the course of this call, we will be making certain forward-looking statements. These statements are based on current conditions, currently available information and management's expectations, assumptions and beliefs. They are not guarantees of future results and are subject to numerous risks, uncertainties and assumptions that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Capital Southwest's publicly available filings with the SEC.
Bowen Diehl: Thanks, Chris and thank you, everyone, for joining us for our earnings call for the first -- for the quarter ended June 30, 2021 which is the first quarter of our 2022 fiscal year. We are pleased to be with you this morning and look forward to giving you an update on the performance of our company, our portfolio and our progress on executing our investment strategy as stewards of your capital. Throughout our prepared remarks, we will refer to various slides in the earnings presentation, which can be found on our website at www.capitalsouthwest.com. We'll begin on slide 6 of the earnings presentation, where we have summarized some of the key performance highlights for the quarter. During the quarter, we generated pre-tax net investment income of $0.45 per share, which more than earned our regular dividend paid for the quarter of $0.43 per share. Total dividends for the quarter were $0.53 per share, which included a $0.10 per share supplemental dividend. Total dividends paid during the quarter, represented an annualized dividend yield on our stock price as of the last day of the quarter of 9.1% and an annualized yield on net asset value per share of 12.8%. I am pleased to announce that our Board of Directors has increased our total dividends per share to $0.54 for the coming quarter ending September 30, 2021 consisting of a regular dividend increase from $0.43 per share to $0.44 per share and a quarterly supplemental dividend of $0.10 per share. Our decision to increase the dividend emanates from our continued confidence in the current earnings power of our portfolio as a result of portfolio growth continued, reductions in our cost of capital and our ability to improve our operating leverage efficiency by actively managing operating costs, while growing the asset base. During the quarter, we grew our investment portfolio on a net basis by 16% to $799 million. Portfolio growth during the quarter was driven primarily by a total of $138.9 million in new commitments to eight new portfolio companies of which $102.6 million was funded at close offset by $1.6 million in proceeds from the exit of one equity co-investment.
Michael Sarner : Thanks, Bowen. Specific to our performance for the June quarter, as summarized on Slide 17, we earned pre-tax net investment income of $9.4 million or $0.45 per share. We paid out $0.43 per share in regular dividends for the quarter an increase from the $0.42 regular dividend per share paid out in the March quarter. As mentioned earlier, our Board has again this quarter increased the regular dividend declaring a quarterly dividend of $0.44 per share to be paid out during the September quarter, up from $0.43 per share paid out in the June quarter. Maintaining a consistent track record of meaningfully covering our regular dividend with pre-tax NII is important to our investment strategy. We continue to maintain our strong track record of regular dividend coverage with 110% for the last 12 months ended June 30 2021 and 107% cumulative since the launch of our credit strategy in January 2015. During the quarter, we maintained our supplemental dividend at $0.10 per share. And again our Board has declared a further $0.10 per share supplemental dividend to be paid out during the September quarter. As a reminder, the supplemental dividend program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our UTI balance. As of June 30, 2021, our estimated UTI balance was $0.83 per share. Our investment portfolio produced $18.6 million of investment income this quarter, with a weighted average yield on all investments of 10.1%. Investment income was $1.4 million higher this quarter, due primarily to an increase in average credit investments outstanding, as well as an increase in cash dividends paid from our equity portfolio.
Bowen Diehl: Thanks, Michael, and thank you everyone for joining us today. Capital Southwest continues to perform well and consistent with the vision and strategy we communicated to our shareholders six-and-a-half years ago. Our team has done an outstanding job, building a robust asset base, deal origination capability as well as a flexible capital structure that prepares us, for all environments throughout the economic cycle. We believe, that our performance continues to demonstrate the investment acumen of our team at Capital Southwest and the merits of our first lien senior secured debt strategy. We feel very good about the health of our company and portfolio and we are excited to continue to execute our investment strategy going forward. Everyone here at Capital Southwest is totally dedicated to being good stewards of our shareholders' capital by continuing to deliver performance and creating long-term sustainable value for all our stakeholders. This concludes our prepared remarks. Operator, we are ready to open the lines up for Q&A.
Question-and:Operator: Thank you. Our first question comes from Devin Ryan with JMP Securities. Your line is open.
Kevin Fultz: Hi. Good morning. This is Kevin Fultz on for Devin. First question, dividend income was elevated in the quarter, due to dividends received from portfolio companies of roughly $1.1 million. Can you provide some color on the source of that dividend? And then also confirm whether that should be considered recurring or nonrecurring?
Michael Sarner: Yeah. So a portion of that is recurring or received from our shareholders -- from our portfolio companies held in our blocker. On a quarterly basis, I think the level is around call it $300,000 to $350,000 is what we're receiving. And then some of those tend to be one-time in nature from dividend income coming from portfolio companies of distributions.
Kevin Fultz: Okay. That's helpful. And then, looking at the expense side, G&A tracked a bit higher this quarter than last quarter. Is that increase driven by one-time expenses, or is that reflective of higher G&A due to increased scale of the business?
Michael Sarner: Sure. So some of this is related just to the seasonality, this is our -- our annual meeting is in July. So we incurred some audit costs and 10-K. So that's a few hundred -- that's about $200,000. And you'll see that on -- every year in the 6/30 quarter. We also noted we had $100,000 one-time costs for a headhunter for a new principle that we hired, which obviously is one-time in nature. And then, we did increase -- we had one new board member and that's increased professional expenses by $100,000. And so that will be recurring going forward.
Kevin Fultz: Okay, got it. That makes sense. And thanks for taking my questions.
Michael Sarner: Well thanks.
Operator: Thank you. Our next question comes from Kyle Joseph with Jefferies. Your line is open.
Kyle Joseph: Hey. Good morning guys. Thanks a lot for taking my question. In terms of other income, it was light in the quarter. I would guess that has to do with the lower prepayment activity in the quarter. So -- and I think from your comments, it sounds like you expect prepayment activity to pickup, as the year goes on. And therefore should we expect a pickup in other income?
Michael Sarner: So I mean, we're looking probably at maybe somewhere in the $30 million to $60 million in potential prepayments between now and the end of the year. Now some of those have make-wholes so the newer companies that maybe have been with us a year or two, they'll have either 102 or 101. But there's, others that potentially come back and don't have a make-whole. So I'm not sure that it's going to be elevated beyond somewhere in the 500,000 range.
Kyle Joseph: Yeah. Okay, got it. And then, I just want to get your high-level thoughts on credit. Obviously the ratings were positive. There were some unrealized depreciation, but we did see two investments go on non-accrual. Just broadly, talk about the, -- whether its revenue or EBITDA growth trends you're seeing across your portfolio?
Bowen Diehl: Yeah, I'd say across the portfolio EBITDA is -- from an LTM perspective is growing slightly. As we move forward, each quarter we're progressively further across the calendar. So we start losing some of those COVID months of last year. So yeah I think generally EBITDA is kind of flat to slightly up across the portfolio.
Kyle Joseph: Okay, got it. And then last one for me, osbviously a good quarter on the origination side. Can you give us a sense for the cadence of originations throughout the quarter whether that was front weighted or back weighted? Just help us figure out modeling yields going forward.
Michael Sarner: Yeah. I'd probably say it's in the middle. I think we had some very early and then probably like 40% very early, and 60% very late. So it sounds like, it's a fairly evenly weighted.
Bowen Diehl: Yeah. I think that's right.
Kyle Joseph: Okay, great. All right thanks so much for answering my questions.
Michael Sarner: Thank you.
Operator: Thank you. Our next question comes from Bryce Rowe with Hovde Group. Your line is open.
Bryce Rowe: Thank you. Good morning. Good morning Michael.
Michael Sarner: Good morning.
Bryce Rowe: Wanted to ask you make note of I guess the additional employees their Capital Southwest. So, maybe you could speak to the principal that was hired and how that might impact kind of deal flow going forward and the investment funnel?
Bowen Diehl: Yes, we're very excited about it. You'll see Laura Zengilowski on our website. Very excited. She joined us from AllianceBernstein, obviously, another competing credit shop down in Austin. We're very excited for her addition and she comes with very robust underwriting track record and she gives us more horsepower to originate deals so to put out in the market. So, pretty excited about her joining.
Bryce Rowe: Great. Okay. And then Bowen you make -- you guys made mention of the impact of appreciation within the equity portfolio on NAV for the quarter. Can you speak to kind of how broad based that was? Was it again driven across multiple investments or really just concentrated in a couple?
Bowen Diehl: No, it's a pretty -- I mean I'd say if you looked at the list of investments, it's probably almost -- maybe 40% of them had appreciation and -- just thinking of the list I don't have the list in front of me, probably 20% of them had some kind of depreciation with the appreciation being higher than that small -- the 20% of the companies that were depreciated and a bunch of them that were basically flat. So, I'd say slightly less than half of the companies had appreciation. And then what you have the--
Michael Sarner: Yes, I would just say on the equity side, we had four companies.
Bowen Diehl: That's pretty material.
Michael Sarner: Material appreciation that are just performing tremendously. And on the debt side the $0.5 million of appreciation though it's small, it was very granular and it's these are some--
Bowen Diehl: On the debt side--
Michael Sarner: On the debt. So, to some degree, it's just like the companies that were struggling during COVID are starting to come out from that and you're starting to see some granular appreciation on those assets that they reappreciate.
Bryce Rowe: Okay. Okay. And then maybe following up on Kyle's question there around yields and pricing. It looked like spreads have kind of been relatively stable quarter-to-quarter. Are you seeing that within the pipeline that you described as robust? And just trying to get a feel for how you think about portfolio yield as we move forward here?
Bowen Diehl: Yes, I mean the portfolio -- or the deal pipeline has been strong. We're pleased by that. The yields I mean clearly they've retraced the COVID move and the market is obviously very competitive. We just have people out in the market and we're widening that top end of our deal funnel, so we can have a greater percentage of the deals that we're looking at in the market. We think that's pretty critical to maintaining our track record. But I think over time yields -- our average yield in our portfolio maybe comes down a bit, but not a ton, but a bit. Yields right now in the market seem to be -- as you noted, seem to be pretty stable from what they've been in the last quarter or so.
Michael Sarner: Yes. And so obviously this quarter it dropped from due to our non-accruals, but we also saw probably like 20 basis points of reduction through lower-yielding assets. We think that's probably going to come back up a bit in the coming quarters. And then on the hopeful side, I think we think that the two credits that are on non-accrual have a very high likelihood of coming back on accrual and those are higher yielding assets that would bring the yield back up.
Bowen Diehl: Yes, we have a pretty long dialogue back and forth about -- with one of the questions last quarter about the kind of my analogy of the deep end of the pool and shallow end of the pool. So, as we've gotten our cost of capital down and we've increased our operating efficiency meaning that our assets are growing faster than our operating costs are growing. Our cost of doing business is dropping from that perspective, obviously offset by non-accruals. And I'd love to tell you all that this is a non a zero defect business as much as I want it to be it's not. But as we -- as our cost of delivering the investment strategy to the shareholders comes down, we can compete in a safer end of the lower middle market that tends to price at slightly lower spreads. And whereas like three years ago, two years ago, that was really -- those were deals that we really couldn't compete for we could but we just -- our net interest margin wasn't attractive. And so, now you'll see deals that have LIBOR 6.50%, LIBOR 6.25%. Those are -- our net interest margin on those deals are -- as we've gotten -- as our business has evolved, it's very attractive. And so we can compete for those deals. And so, some of the rating -- some of the yield migration is not necessarily the same deal that was higher yield two years ago. It's a different safety lower LTVs type deal flow. And so, you'll see that. And we talked about that for the last couple of quarters being a dynamic in our business, which I think is a very attractive piece of our story going forward.
Michael Sarner: I mean -- so, I mean Bowen makes a good point, because on the net interest margin perspective, so yields may come down, maybe from the 10.7% down to 10.25% over the next six and 12 months. But our SG&A or operating leverage is going to go to 2% and probably hold around 2%. You didn't ask the question, but we did -- we are in the process of amending our credit facility, which we think is going to have a significant reduction in cost as well. So you couple that with us starting to draw. We've already drawn $7.5 million on our SBIC and that should be up to $25 million by the end of the quarter. So as those get drawn, so we're borrowing at sub-3% and our SG&A at 2%, I think you'll see an expansion of our NII even with the reduction in the yield.
Bryce Rowe: Great. That’s a good detail, and really nice to see the dividend increase, and you all continuing to execute. Appreciate.
Bowen Diehl: Thanks, Bryce. Appreciate it.
Operator: Thank you. Our next question comes from Sarkis Sherbetchyan with B. Riley Securities. Your line is open.
Sarkis Sherbetchyan: Hey. Good morning and thank you for taking my question here. I just wanted to see if I can get some more color on the pipeline share quarter-to-date as well as the activity that you're seeing. And then, just if you can kind of pair that up with your expectation for the repayments to come in as the balance of the year progresses?
Bowen Diehl: Yes. So, if I look at our pipeline right now and I add up the deals that are either, we've either closed quarter-to-date or are signed up and working due diligence at $60 million to $70 million in that range. And so -- and six new companies. And so, the quarter is far from over. So, candidly we probably expect additional deals to close before September 30. But that gives you an idea. So, $138 million in a quarter is obviously a heavy quarter. I'm not sure that replicates in the next quarter or two, but the originations are -- continues to be very strong. And then, if we think about repayments, looking down our portfolio names and the dialogue we're having with the companies, add up kind of the names -- the capital that we would put a pin on saying, okay, that's something that very likely would prepay before the end of the calendar year and that number is about $50 million. And from a timing perspective, we control that obviously less. But, generally speaking, it wouldn't surprise me as that's pretty evenly distributed between the next two quarters September, December. So, if you're modeling you might say $50 million or $25 million a quarter in prepayments.
Sarkis Sherbetchyan: Understood. Thanks for that. And I think another one is a little bit more, I suppose of a hypothetical question, but just want to kind of understand with your cost of debt capital and just kind of the overall cost of doing business coming down for you. If there is, let's say, a change in interest rates, it seems like maybe the first 125 basis points might be a little bit of an NII headwind. I guess, how do we think about that? Is there a way to kind of parse through that in the event that happens, or do you think you're kind of insulated from any of the potential changes that may come about there?
Michael Sarner: Yeah. I mean I think the way we think about it is, we've looked into hedging but it's -- that's a really difficult concept, because you're spending a lot of dollars to predict the timing for when how quickly you're going to -- that first 100 basis points is going to go up. So we don't think that that's really an option for us. So quite frankly, the way we're looking at it is with our originations and our cost of debt and cost of operating leverage coming down, if and when the rates start rising for the first 75 basis points, you'll see our growth on NII slow, but you -- essentially once you get past that 75% then you're going to see an acceleration. So you won't see a reduction in NII or a dividend, you'll see slower growth and then an acceleration once it's done. Obviously, on that I mean the cost of debt with the SBIC just to be clear on I think you guys probably have other BDCs you look at cost of debt right now on the pooled debt is 2% -- really about 1.65%. But on the debt that you draw before pooling and pooling happens twice a year, the actual cost is about 60 basis points. So just giving you a sense as rates go up I think that gets offset by extremely cheap capital that we're going to be drawing from. So that's why we feel pretty confident we'll continue to grow the dividend while interest rates rise.
Bowen Diehl: Okay. You also have to keep in mind that that interest analysis on that last slide is a static analysis. So it seems like nothing else happens like new portfolio originations, portfolio growth and that kind of thing. So the 120 -- the slide illustrates a headwind, but it's not a -- it's not a one-to-one math as we continue to evolve and grow the portfolio. So...
Sarkis Sherbetchyan: No, I understood, it’s dynamic. Just wanted to get a sense for the changing dynamics there. And obviously you'll be originating and you'd probably get some repayments and what have you back. But I just wanted to get a sense for the NII and dividend, and how insulated the business is. That's all. Very helpful comments. Thank you, guys.
Bowen Diehl: Great. Thanks. Good questions.
Operator: Thank you. Our next question comes from Matt Tjaden with Raymond James. Your line is open.
Matt Tjaden: Hi, all. Good morning and appreciate you taking my questions. First one for me following up on the equity book. Can you give us a sense of how much of the appreciation was a function of improved performance or kind of expanded market multiples? And if it was some combination of the two kind of what proportion was which?
Bowen Diehl: Yes. The vast majority of it is I'm just looking down the names so a vast majority of it is company performance. I mean a pretty robust performance. So…
Matt Tjaden: Got it. And, I guess, as a follow-up apologies if I missed this. With the receipt of the first SBIC license can you remind us whether or not you have a target leverage range both in an economic sense and on a regulatory level?
Michael Sarner: Yes. We've kind of said this before. We're -- our economic leverage is going to be somewhere in the 1.2 to 1.3 range and our regulatory leverage will be around -- between 0.9 and 1.1. We actually think that with the pace of originations and the draws of SBIC we should be near 1 times in the next six months.
Matt Tjaden: Got it. That's helpful. Last one for me on PIK income. So looks like over the last four quarters, PIK income both nominally and as a percentage of total investment income has fallen pretty materially. Any color you can give on how much of that is purposeful? Is that a kind of a concentrated effort to steer away from PIK income? Is that just how the docs are being signed? Any high-level color there?
Michael Sarner: Well, I would tell you it's actually kind of concentrated. The company -- one of the lower middle market company we put on non-accrual it had essentially converted from cash to PIK and then we obviously inevitably put it in non-accrual this quarter. So there was sort of a write-up of PIK for that company over the last two quarters and then it was reserved against this quarter. So therefore it's -- what you're seeing now is actually the normal run rate of PIK income.
Matt Tjaden: Got it. That’s it from. I appreciate the time.
Michael Sarner: Thank you.
Bowen Diehl: Thank you.
Operator: Thank you. I'm not showing any further questions at this time. I would now like to turn the call back over to Bowen Diehl for closing remarks.
Bowen Diehl: Great. Thanks, operator and thanks everybody for joining today. We appreciate your time and we certainly love talking about our business and giving you all updates on the business. So appreciate it and have a great week. We look forward to talking to you next quarter.
Operator: And this concludes today's conference call. Thank you for participating. You may now disconnect.
