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Edited Transcript of BANX earnings conference call or presentation 30-Oct-19 9:00pm GMT

Q3 2019 StoneCastle Financial Corp Earnings Call

New York Nov 11, 2019 (Thomson StreetEvents) -- Edited Transcript of StoneCastle Financial Corp earnings conference call or presentation Wednesday, October 30, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Joshua Stuart Siegel

StoneCastle Financial Corp. - Chairman & CEO

* Patrick Joseph Farrell

StoneCastle Financial Corp. - CFO

* Rachel Schatten

StoneCastle Partners, LLC - General Counsel and Chief Compliance Officer

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Conference Call Participants

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* Brian J. Mckenna

JMP Securities LLC, Research Division - Associate

* Christopher Thomas O'Connell

Keefe, Bruyette, & Woods, Inc., Research Division - Assistant Analyst

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Presentation

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Operator [1]

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Greetings, ladies and gentlemen, and welcome to the StoneCastle Financial Corp. Q3 2019 Investor Conference Call. (Operator Instructions)

It is now my pleasure to introduce -- to turn the call over to your host, Rachel Schatten, General Counsel of StoneCastle Financial. Please go ahead.

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Rachel Schatten, StoneCastle Partners, LLC - General Counsel and Chief Compliance Officer [2]

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Good afternoon. Before we begin this conference call, I'd like to remind everyone that certain statements made during the call may be considered forward-looking statements based on current management expectations that involve substantial risks and uncertainties. Actual results may differ materially from the results stated in or implied by these forward-looking statements. This would depend on numerous factors, such as changes in securities or financial markets or general economic conditions; the volume of sales and purchases of shares of common stock; the continuation of investment advisory, administrative and service contracts; and other risks discussed from time to time in the company's filings with the SEC, including annual and semiannual reports of the company.

StoneCastle Financial has based the forward-looking statements included in this presentation on information available to us as of September 30, 2019. The company undertakes no duty to update any forward-looking statement made herein. All forward-looking statements speak only as of today, October 30, 2019.

Now I will turn the call over to StoneCastle Financial's Chairman and Chief Executive Officer, Josh Siegel.

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [3]

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Thank you, Rachel. Good afternoon, and welcome to StoneCastle Financial's third quarter 2019 investor call. In addition to Rachel, joining me today is George Shilowitz, President; and Pat Farrell, our Chief Financial Officer.

I would like to start the call today with an update of StoneCastle Financial's quarterly results and portfolio review. Then I will turn the call over to Pat, who will provide you with greater detail on our financial results before I open up the call for questions.

We are pleased to report that earnings for the third quarter were approximately $3.4 million or $0.52 per share. This figure was comprised of net investment income of $2.5 million or $0.38 per share and approximately $1 million in net realized capital gains of $0.14 per share.

Total assets were $169.2 million, and the value of the invested portfolio was $166.9 million. The net asset value at the end of the quarter was $21.75 per share, down $0.05 from the prior quarter. We believe no meaningful credit issues currently exist within the portfolio, and the majority of the underlying banks continue to be scored investment grade by Kroll Bond Rating Agency.

Now let me turn to the portfolio review. During the quarter, the company sold its equity interest in Happy Bancshares, a position held since 2014. While we typically seek income-producing investments, this was a case where we identified an attractive private equity investment in the common stock of the bank. The company invested $1 million in a privately negotiated transaction and sold the position for a realized capital gain of approximately $1 million. This was double our investment, resulting in an average annualized return in excess of 14%.

As expected, the company received full call proceeds of $10 million from Katahdin Bankshares and $4.5 million from Mercantil. The company also received principal amortization payments of $1.6 million during the quarter.

As we have been reminding investors on the past few calls, the company's strategic focus has been and will continue to be finding value in the banking sector. We have been in a market environment where bank sub debt issuance has been low and, in our opinion, current coupon rates are still not commensurate with the risk for these types of investments. However, during the quarter, StoneCastle invested in 2 interesting bank capital securities that are effectively a form of common equity. But unlike common equity, they are nondilutive to the bank. Further, these securities generate significant current income compared to the more traditional capital securities issued by banks. These securities also have some attractive features not found in traditional common or preferred securities issued by banks.

As bank investors, we believe these securities represent an attractive relative and absolute value. These securities are born from inefficiencies created by bank regulations such as Basel III. I recognize that not all of our investors are bank regulatory experts, so I'll do my best to describe the securities at a high level. Banks are required to maintain a certain amount of capital in proportion to their assets. However, not all assets represent the same amount of credit risk, and therefore, assets are risk-weighted by regulators to account for this fact.

The ratio of capital to risk-weighted assets can be improved by either increasing capital, issuing common equity or reducing the risk weighting of certain bank assets. Banks accomplish this risk reduction through the issuance of certain types of capital securities, which we refer to as alternative capital securities.

Although not widely known, these capital securities are not NOB and have been issued by banks for more than 2 decades. When bank valuations are higher, banks issue traditional common equity. When valuations are lower, such as now, banks are motivated to issue nondilutive forms of equity, such as the securities we purchased. Due to the reduced demand for new capital, sub debt yields compressing to 5% to 6% and the decline in bank equity multiples over the last several years, we think this is an ideal time to invest in alternative capital securities.

After several months of work to source, we purchased 2 such securities with a total face value of $15 million. Both securities carry a coupon of 3-month LIBOR plus 10%, and the current coupon for both exceed 12%. These securities were acquired at a slight discount to par. Although we hope to find more investments of this type, the challenge is that these securities are generally issued privately, usually in increments of $50 million or more and are typically done on a bilateral basis.

Due to the minimum issue size, investors active in the sector are significantly larger than StoneCastle Financial. That said, we will continue to look for additional opportunities.

Overall, the investments made during the period can increase our quarterly earnings potential. Factoring in the prepayments received this quarter, quarterly gross investment income declined by approximately $0.05 per share. However, our new investments will generate quarterly gross income of approximately $0.07 per share for an incremental quarterly increase of $0.02 per share and $0.08 per share annually. Therefore, while we had roughly $18 million of investment proceeds received during the quarter, we put $15 million to work to generate the increase in quarterly gross income, using about 17% less invested capital. This investment efficiency results in increased income while using less of our revolving credit line. As a result, we can serve capital and stand ready to take advantage of a turn in the credit cycle and other new investment opportunities.

Overall, portfolio activity during the quarter, including the addition of our new investments, resulted in an increase in the estimated annualized portfolio yield from 9.16% at the end of Q2 to 9.55% at the end of Q3. The quarter end schedule of investments can be found on the company's SEC filings and on the company's website.

Lastly, we have a brief update to our disclosure from the June 30 semiannual report, wherein StoneCastle Financial Corp. was included as a named defendant in a lawsuit filed in May 2019 against StoneCastle Partners and its affiliates by one of its vendors. We believe StoneCastle Financial was mistakenly included in the lawsuit due to the similarity of company names.

StoneCastle Financial filed a motion to dismiss from the lawsuit, and we are awaiting the court's ruling in this regard. The company retained counsel to manage the company's efforts to be dismissed from the lawsuit.

Now I want to turn the call over to Pat to discuss the financial results and provide details on the underlying value of the company.

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Patrick Joseph Farrell, StoneCastle Financial Corp. - CFO [4]

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Thank you, Josh. As I do each quarter, I will present the financial results by going through the components of the company's quarterly results in detail. We are pleased that StoneCastle common stock continues to trade at or above net asset value. We ended the third quarter with the stock at a slight premium of almost 2% to NAV. The net asset value at September 30 was $21.75, down $0.05 from the prior quarter.

NAV is comprised of 4 components: net investment income; realized capital gains and losses, the change in value of the portfolio's investments; and lastly, distributions paid during the period.

Let's look at these components. Gross income for the quarter was $4 million or $0.60 per share. Net operating expenses for the quarter were $1.5 million or $0.22 per share, resulting in net investment income for the quarter of $2.5 million or $0.38 per share. We also had net realized capital gains of $0.14 per share, resulting in total earnings of $0.52 for the quarter.

Realized capital gains and losses in the quarter is the second component affecting the change in NAV. As I just mentioned, the net realized capital gains for the quarter were $923,000 or $0.14 per share. The majority of which was from the sale of Happy Bancshares.

The third component, changes in unrealized appreciation or depreciation of the portfolio, relates to how the value of the entire investment portfolio has changed from the previous quarter end to the current quarter end.

For the third quarter, the unrealized appreciation of the portfolio decreased by approximately $1.2 million or $0.19 per share. The majority of this decrease was the realization of the capital gain from the sale of Happy Bancshares.

The fourth component affecting the change in net asset value is distributions. The cash distribution for the quarter was $0.38 per share. The distribution was paid on September 27 to shareholders of record on September 23.

In summary, we began the quarter with a net asset value of $21.80 per share. During the quarter, we generated net income of $2.5 million, net realized capital gains of approximately $923,000, and the unrealized value of the portfolio investments decreased by $1.2 million. The sum of these components, offset by distribution of $0.38 per share, resulted in a net asset value of $21.75 per share at September 30, down $0.05 from the prior quarter. As I do every quarter, it is worth noting that the vast majority of the portfolio continues to be independently marked from broker-dealer quotes. For the quarter, approximately 87% of the portfolio prices or marks reflect a minimum of 2 quotations or actual closing exchange prices. These quotations represent an independent third-party assessment of the current value of the portfolio. This differentiates StoneCastle from certain publicly traded closed-end funds and BDCs that self-mark their portfolios.

Quarter end, the company had total assets of $169.2 million consisting of total investments of $166.9 million, cash of $118,000, interest and dividends receivable of $1.5 million and other assets of $653,000 representing prepaid assets. Our dividend yield at the end of the quarter was approximately 7%, which is over 2x higher than that of the average financial institution available in the public markets.

Now let me update you on the balance of our current credit facility. At September 30, the company had $25.2 million drawn from the facility. Based on regulated investment company rules, we may only borrow up to 33.3% of our total assets.

Now I want to turn the call back over to Josh.

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [5]

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Thank you, Pat. Now operator, we would like to open up the call for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Devin Ryan with JMP Securities.

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Brian J. Mckenna, JMP Securities LLC, Research Division - Associate [2]

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This is Brian Mckenna for Devin. So first one from me, so I appreciate the commentary around the 2 investments you made during the quarter. But I'm just curious what else you're seeing in the backdrop today in terms of additional investment opportunities and related yields as we head into year-end. And then last quarter, you mentioned that the pipeline was starting to build a bit. So I'm just curious if there's any update to that commentary as well.

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [3]

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Yes, sure. Yes, the pipeline, we're definitely getting more inquiry. We're chasing a few transactions. It's still slow. Q4 historically tends to pick up pace as people want to do some, before year-end, capital planning for their final audited financials. So we'll see what comes out of it. But we're definitely seeing a bit of pickup. CECL is more and more becoming a talking point. I think people realize it's not going away and not going to be sidelined by Congress. It doesn't seem to be in anybody's menu of focus. There was a moment a few months ago where there was some saber-rattling in Congress about it, but they moved on as usual.

So yes, I think we're seeing a little bit of pickup. We're still finding interesting transactions. They take time to find. And obviously, we always try to have a little positive surprise when we can create them. But yes, I mean I think we're still feeling good about what we see, still feeling good about the earnings and have really no deviation of where we're going.

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Brian J. Mckenna, JMP Securities LLC, Research Division - Associate [4]

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Got it. Okay. That makes sense. And then just my follow-up here, kind of bigger picture, obviously the macro backdrop is pretty fluid right now and there's quite a bit of uncertainty in the market. So I'm curious what you're seeing and hearing from some of the community banks you talk to. Are there any new trends or interesting trends out there that you're starting to see? Or anything on that front will be helpful?

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [5]

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Well, on the credit side, still not seeing any particular hotspots, either by geography or major asset classes. I mean, obviously, used auto, which is not a community bank sector and an unsecured consumer seeing increased past dues, but that's more a credit union issue not a bank issue. And of course, it's also a more traditional consumer lender that can cap on one kind of profile.

Outside of that, no, nothing interesting. I'd say the general trend across the banks is they're moving to a hunker-down mode. And maybe that becomes some tea leaves to what happens in the economy. But from the benefit of our deposit side of our -- of StoneCastle Partners, there's definitely been a pullback in the want for funding, which then obviously is telegraphing they want to make less loans. So I do see that happening across the whole country, including some of the larger regional money centers, where they seem to have an insatiable appetite 6 months ago for funding, they've cut back. So I think that telegraphs some worry about what's coming in the economy and the credit, as you just mentioned, but it seems to be realized by the banks.

I'd say the greatest focus because lending isn't where a lot of banks want to be extending aggressively is really an increased focus on how do I add new technology to make me more competitive in the market? How do I add more products and services? How do I find a way to even further reduce my expense load by outsourcing or bringing in new software to make the processes more efficient? You saw some interesting transactions. There was a company called PrecisionLender that just got acquired by a big technology services company to help consolidate the view of a given bank that's using this platform. They say, okay, I'm making the loan, let's factor in everything we do with this customer to see what the global profitability is. Well, that sounds like common sense, banks historically don't have an easy way to do that. Their cores don't permit that. This system connects to all of those different subsystems and gives a holistic view of the value of a client.

So kind of a long answer to your question, but that's kind of what we're seeing. I mean really nothing giving us any particular pause. But I would say the crystal ball says, lending is going to slow a little bit.

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Operator [6]

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Our next question comes from the line of Chris O'Connell with KBW.

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Christopher Thomas O'Connell, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant Analyst [7]

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So it sounds like the pipeline is still looking healthier, kind of, looking into the fourth quarter. But I was hoping you could provide some color on potential call proceeds coming into the fourth quarter, whether that be how much you've seen so far? Or if you don't want to comment necessarily on that, maybe what percentage of the portfolio is availably called out compared to in the beginning of the year, say?

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [8]

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Sure. I mean I'll tag team this with Pat. We really haven't gotten anything to the fourth quarter, anything material other than some scheduled principal am and probably not expecting anything. I mean it doesn't mean we can't be surprised, but there's also just less and less available to call out before at least 12-plus months from now. And Pat will...

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Patrick Joseph Farrell, StoneCastle Financial Corp. - CFO [9]

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Yes. I mean it's only about $15 million that's available right now. In addition, I'd point out that if you look back, surprisingly, 2019, we have had a lot of calls. And in spite of that, I think we've held up extremely well with our earnings. We've had $48.5 million this year alone as compared to last year, which was only $4.4 million. So certainly, a lot of calls this year, but we have put that money to work very smartly, I would say. So -- but looking forward, we don't really see a lot on horizon. Obviously, it's kind of kept close to the vest by the community banks until the time that they tell us, but nothing on the horizon, as Josh said.

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Christopher Thomas O'Connell, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant Analyst [10]

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Got it. And you have mentioned CECL and the implementation of that. And there's definitely been a lot more chatter and talk about it, especially as there's been some more disclosures coming into this quarter from the banks. But can you maybe comment on the delay for some of the small banks out to 2023? I believe the adoption for and just whether you see that delaying some of maybe the demand that you would see from the lending side, just from the small banks?

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [11]

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Well, to the smaller ones, it's going to give them some breathing room and granted. Once again, it's crystal ball. But regulators don't love having differential supervision. So I'll give you an example. So on capital ratios, right? It doesn't matter if you're Citigroup, JPMorgan or a tiny community bank, you have to comply with the same CET1 ratio, Tier 1 capital and total capital ratio. That said, why is it consistently that smaller banks are basically required to keep more capital than a larger brother. There's nothing in the rules that says that. But generally, that's just what the regulators want to see. I wouldn't be shocked if that's what happens with CECL, it's that once the CECL rule goes into effect for the larger banks, while technically, the small banks wouldn't be in violation, I would tend to think that a lot of regulators are going to say, well, show me that you're at least preparing. And if a bank can't basically show that it's about ready, it wouldn't be and probably could be put under unofficial memorandum of understanding regulatory agreement. So I don't think it's delayed, and that's the end of it for the small banks until 2022 and '23, I think they're going to be held directionally to that standard earlier. And if they can't demonstrate that they're making pretty significant progress, it's going to be problematic.

So direct answer to your question, for the smallest banks, yes, it might push back a bit what can come from those folks. But for the banks that are on the larger side and are being measured on compliance with larger bank standards, right, once you're sort of approaching the nonsmall bank holding company policy statement guidelines, yes, I think that's where they're still going to try to be ahead of it because they don't want to find that either the rules change or the regulators have to be thinking about everybody differently. So kind of a long answer, but I think that's pretty much the story.

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Christopher Thomas O'Connell, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant Analyst [12]

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Got it. No. Yes, that's very interesting. And then just last one, in terms of what you guys are seeing coming through the pipeline on originations, and just where you're seeing yields at versus kind of the current portfolio?

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [13]

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Yields for traditional product are still sub. We're seeing some things in the 8, 7, 6s, 5s, and I'm really not interested in the 5s, not terribly interested in the 6s. But obviously, we're pursuing a few deals in the 8s and high 7s, so I don't want to put a lot on there, but that's close to fair value for a strong credit.

So yes, that's kind of what's in the pipe. Usually, Q3 is on the slower side and Q4 is where banks make decisions. In fact, that's happening now because they're just finishing up their call reports, month end here. So we'll start to get an insight of what the year-end flow could be, but of course, those deals -- some will close by year-end, some are planning for Q1.

Going back to your first question, one other thing to keep in mind, which we've talked about before, is the community funding CLO. That comes up for refi for us next year. So a year and change from now. That -- if you remember from the terms, the debt on that steps from 5.75% to 6.4%, I believe. And of course, that's already been factored into our rate of return because the way we accrue it is assuming what the actual cash flows would have been for the life. That said, today, in the market, if we were going to refinance that senior piece, it wouldn't be 6.40%, color we get from The Street is closer to 5%. So that gives us a lot of interesting flexibility to be able to, a, generate additional -- pretty significant additional free cash flow on the piece we own, but also potentially entice the banks to hang around for an extended period by reprinting their rates at a lower rate than they're at now. So obviously, if we're saving just to use the simple math, 1.4% on our debt funding cost, if we passed even 1% through which -- I don't even know if we have to do that much or any, we'll see, depends where things are in a year. We make more money and they save money. And we extend the noncall longer. So there's a lot of interesting opportunities coming up next year on that.

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Operator [14]

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(Operator Instructions) It appears there are no further questions at this time. I would like to turn the floor back to Josh Siegel for any closing comments.

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [15]

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Thank you, operator. Well, everyone, thank you for listening. As always, we appreciate your interest in StoneCastle Financial Corp. Likely, we'll not speak to many of you until 2020. So on behalf of the entire management team, I may extend our best wishes for the holiday season. And see you next year unless we talk before that.

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Operator [16]

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Thank you. Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.