Flow Capital Corp. (FW) Earnings Call Transcript & Summary

Good morning, ladies and gentlemen. Welcome to Flow Capital Corp.'s earnings call for the quarter ended on June 30, 2021. [Operator Instructions] I would like to remind everyone that today's discussions may contain forward-looking statements that reflect current views with respect to future events. Any such statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. For more information on Flow Capital's risks and uncertainties related to these forward-looking statements, please refer to the company's management discussion and analysis dated August 19, 2021, which is available on SEDAR. Today's call is being recorded on August 20, 2021. I would now like to turn the meeting over to Alex Baluta, Chief Executive Officer of Flow Capital.

Thank you very much, operator. Thank you, everybody, for joining and/or listening to the recording. Good morning. I am joined by Gaurav Singh, our Chief Financial Officer. After the close of market yesterday, we released Q2 unaudited financial results. Details can be found on our website at flowcap.com or on SEDAR. Our total IFRS revenue for Q2 was just under $5 million, up over 168% from $1.8 million a year ago. Year-to-date, revenue was $7.3 million compared to $2.9 million a year ago. Note that IFRS numbers may be volatile, due to the unpredictable timing and nature of unrealized fair value gains, buyouts and foreign exchange adjustments. Given that, recurring revenue is a simpler, much more informative metric that we track for internal purposes in terms of performance. Our recurring revenue in the quarter was $1.7 million, 31% higher than the $1.3 million a year ago. Year-to-date, our recurring revenue is $3.3 million compared to $2.2 million a year ago, up 48%. And more importantly, we're maintaining a recurring revenue run rate above $6 million. Net income, a gain under IFRS was $3.1 million versus breakeven a year ago. And net income year-to-date is $4.4 million versus a loss a year ago of $340,000. Again, to adjust for sometimes confusing nature of IFRS, we have an internal metric called adjusted free cash flow from recurring operations, which was a gain above $500,000 positive for the second quarter in a row. This now marks the sixth -- fifth quarter that we've had positive free cash flow from recurring operations. These numbers were driven by the strength of our portfolio through COVID, but on the recurring revenue side, but more importantly, several of our portfolio companies had exits in the quarter. I'll talk about that a little bit more. Adjusted EBITDA for the quarter was $4.1 million, an increase of 125%. And year-to-date, it's been -- it's $5.8 million compared to $700,000 a year ago. On an IFRS basis, free cash flow was $4.5 million in the quarter compared to negative free cash flow a year ago of $340,000. And again, this free cash flow is generated from realized gains on exits as well as strong operating performance from our recurring revenue. We ended the quarter with a very strong balance sheet of $25 million in our active investment portfolio, that's the portfolio that generates recurring revenues, an additional $7.2 million equity holdings across public and private instruments and nearly $11 million of cash. In July 2021, Sundial Growers and Inner Spirit completed a merger, by which Sundial acquired all the issued outstanding shares of Inner Spirit for a total consideration of approximately $0.39 per share. We owned just under 5% of Inner Spirit, which represented an approximate aggregate gain of $4.8 million for us. That position we've liquidated in terms of cash, we realized the gain during the quarter, but the cash was actually delivered early in Q3. And I'm very excited about that outcome because we can now reinvest that cash as opposed to it being a cash as equity holding on our balance sheet, you can reinvest that cash in the high-growth companies where we earn both an interest, yields and warrants. And I'm going to go through a business model in a bit more detail here in a moment. We're quite pleased with these numbers. They reflect strength of our core recurring revenue and our model and our strategy. And the numbers are very strongly registered there from substantial gains in exiting our portfolio. And we want to provide just 1 slight note of caution that the trajectory that you're seeing, the buyouts that we experienced were all buyouts in existing portfolio companies that have been in our portfolio for several years. Those buyouts -- as those companies that bought out were actually very high-yielding companies, in some cases, north of 20%. So what you'll see is a transition in our trajectory as we reinvest that capital into our current focused -- the type of companies that we focus on now, you'll see that our revenue -- the trajectory of our revenue growth will slow through a little bit as we replace the revenue from the companies who just bought out for a short time. Some of you have observed our stock trades at a significant discount to book value. We believe this is a very compelling opportunity from our perspective to purchase a high-quality undervalued stock. So year-to-date through the end of the quarter, Flow repurchased 915,000 shares under our ongoing NCIB at an average purchase price of $0.42 per share. Our book value as of the end of this quarter, $0.70 per share. I want to pause here and highlight that this has been a strategy of ours for 2 to 3 years now. We've taken our share count from close to 44 million down to 31 million shares, primarily by buying back our shares because as we like to say, we like to buy dollars from $0.50, and it has been a fantastic investment for us to buy our own stock and has had a positive impact from our shareholders. Our Q1 -- our Q3 financial results are summarized in our press release. And as I said, the details are on our website and on SEDAR. I encourage you to read those if you want more information. I'm going to transition and talk a little bit more about our business model and highlight the opportunity. The changes that we've implemented over the last few years and the opportunity that we face. I think one of the things I want to say, help us me is -- what exactly do we do? And certainly, we lend money to high-growth companies. But what is our -- how do I -- let me summarize for you what our business model is. First, we generate recurring revenue from that in royalty investments. And those recurring revenue investments, our first in high-growth companies with improving value propositions. So we don't do startups. We do companies that are scaling the business that are generating real revenues improving their value proposition. We like to say they've nailed their value proposition and result to scale it. We do that in the gap that exists between banks and VCs. Usually, these are asset-light companies, technology primarily that are too small or don't have enough an asset base or don't want to give a personal guarantee to a bank and may or may not be VC funded. In fact, there was a tremendous market there -- out there for bootstrap entrepreneur-founded companies that need growth capital. Our investments are secured and they're at the top of the stack. We try to focus on the appropriate risk return profile, which means that like risk and security with equity-like returns. Very certainly, and I think this is a new partnering model, people don't really understand. We do it with equity upside. We do that through warrants, and I'll talk about it a little bit more, but we own on average 2% of the companies we invest in through our warrant position. And that is a 2% warrant position in a very high-growth technology companies. And we do it in a scalable and repeatable way. We've built our platform to do this consistently so that when we do have buyouts like we had this quarter, we can quickly reinvest that capital and continue to generate both returns, recurring revenue, interest returns or royalty payments and we build our warrant portfolio. And this is a multibillion-dollar total addressable market on an annual basis. If you look at the venture debt market, which is usually the markets we're providing debt to venture-backed companies, that alone is $10-plus billion in originations on an annual basis in North America. We do sponsored companies. We like working with VCs, but we also do, as I just mentioned, bootstrap entrepreneur-founded companies. And that represents an additional probably double the addressable market that I just mentioned about. And so it's worth of that. So we focus on that gap between the VCs and banks. But what do we provide you, the investor? Well, what we give you is the opportunity to have lower risk exposure to high-growth businesses that are normally accessible on the venture capital investors. And we do it in a liquid public company, and we do focus on income on every one of our investments. And we add to that some equity upside. So if you think about a VC portfolio, the challenge investing in VC capital is you're usually in an LP structure locked up for 8 years, and there's no cash flow generated a while you're locked up. What we do is trade off some of that equity upside for ongoing cash flows, generally priced in the mid-teens, and we still take some equity upside through our warrant positions. And because of the type of companies and investments, we focus on the vast majority of our portfolio, north of 70% is in tech companies. We don't exclusively focused on tech companies. But that ended up self-selecting the portfolio, the type of companies that we do see the type of companies at the high growth level that we anticipate that have got that value proposition end up being tech companies. And as I said, the total addressable market is fairly significant. One of the key things that we look for in all of our companies is growth. Obviously, good. We do a lot of due diligence. It takes 3 to 6 weeks to complete an investment. We'll do very deep venture level due diligence. But the key priorities or the key statistics that we look for in selecting our companies is growth. And somewhat counterintuitively, growth actually reduces risk for the following reason: one, in a high-growth company, the equity because they're senior in the stock and we're a debt instrument, the equity below us generally in course increases disproportionately in value as the company grows, both through just the growth in revenue and earnings, but also through multiple expansion. So that means we have more downside protection on our investments. Secondly, these high-growth companies have more excel alternatives. As these companies scale, many different alternatives open up for them to buy out our investment either through cash flow, through refinancing, through lower cost of capital, i.e. banks through venture funding round -- or other exits. In fact, the 3 exists that we've had in the last 3 months have all been -- we've been bought out through the company's refinancing the forward cost of capital. And then important to our business model investing in these kind of companies when we have warrants represent significant upside to our future potential portfolio value through the recognition of those warrants turning into equity. So that's our business model. I want to talk a little bit about some of the changes that we've done in the last 3 years since I've been here, been here almost 3 years. It's important because I think it sets the stage for the growth opportunities that we see now ahead of us. So number one, we've increased deal size. On average, our deals now in the $3 million to $4 million. We're going to have 7 usually through multiple tranches. We've significantly increased the quality of our deals. We have an internal approach to targeting 0 defaults in our portfolio. We pivoted away from royalties, not exclusively, but away from royalties and warrant to loans. Part of that is a function of the self-selection in the company into a loan product versus a royalty product. The value add of the benefit of a royalty product to investee companies of a royalty allows the company to get off the refinance treadmill, i.e., they choose when they want to pay it back, which is more like equity. Most of the high-quality, high-growth companies we see now don't have a concern about refinancing, and so they're choosing the loan product. And part of our value -- our value proposition, the flexibility to clearly the solutions that the company need. We did warrants in every one of our investments. We now have a warrant portfolio of 12 companies. On average, we own 2% of these 12 high-growth companies. We changed almost the entire team. We have a great new team focused on, which experienced -- deep experienced in this industry and focus on finding us new growth companies. We've been focusing on profitability and free cash flow. We've now generated positive free cash flow for the last 5 quarters, and it's cash flow from recurring operations. And as I mentioned, we've been aggressively buying back our shares in the marketplace. So just on that warrant portfolio position, one of the things that I think people don't understand about -- or at least hasn't been properly communicated by our business model because it's a fairly new addition to our business model is the upside of that warrant portfolio. We have an internal target of reaching $100 million in revenue generating assets by the end of 2023, so call it 28 months from now. That should -- we currently have 12 warrant positions in high-growth companies. By the time we get to our targeted $100 million assets, we should have once in 25 to 30 companies. And while we can't predict the cadence not all those warrants to be in turn into value. But -- and we can't predict the cadence of when those warrants will be exited, but the average duration of those warrants is 5 to 6 years on initial investment. And we expect that the larger the portfolio warrants is, we shall start seeing a regular cadence of liquidity on some of those warrants in the coming years. And these warrants add torque to our business. So if you think about it, we provide you with strong cash flow, senior security and good protection, but we also add equity upside through those warrant positions. And I think with that, I'm going to pause my commentary and turn it over to the operator to see if there's any questions.

[Operator Instructions] Our first question comes from the line of Akiva Dubrofsky, shareholder.

I was wondering, is it possible that going into the future, there will be more the company directed towards PRF-style activities like because really that's where you get the better return on equity is through the residuals. Like the residuals is really the most accretive part of the business. So I'm wondering if you can -- is it possible that like as you go into the next 20 months and you try to target your $100 million, you could actually get -- you could actually do more PRF as a ratio of the total capital, and that will actually help you accelerate faster.

Akiva, thank you for the question. I think what you're asking is how much -- the PRF is a leverage structure that we use to help us access capital and grow our business. So just for everybody's understanding, we have 2 ways of funding our business. One is our common equity. We now have 21 -- just over $21 million in common equity, and we're trading at a significant discount to that common equity. But we then use some leverage, and we have a structure called Priority Return Fund, which is a private limited partnership where investors for every dollar, we raised preferred capital only by rolling in existing portfolio investments aside greenfield fund. So for every $10 million of assets that have been rolled into the Priority Return Fund, think of it as a securitization vehicle. Investors put in $8 million in Flow Capital. So we're providing 25% coverage with subordinated units, our units of subordinated units through our preferred unit Priority Return Fund investments that provide them significant downside. On the back of that, our preferred investors earn a 9.25% yield. And by the way, that yield is down from 12% a couple of years ago, and 10% earlier and down to 9% in the quarter. And one of our strategic effective is to keep bringing down our cost of capital. So the question is, what's a reasonable leverage ratio to have to help increase returns to equity holders. So the return on the Priority Return Fund is fixed is 9.25%. There's no participation in that. The gains all accrete to our equity shareholders. So the torque "in our model" flows down to the equity holders. But at the Priority Return Fund level, the preferred units what you said is very good. They have 2.4x interest coverage and had a substantial coverage on the invested principal. A responsible leverage on a loan-to-value basis in our business, given the types of investments we're making in security retake is probably between 50% to 80% loan-to-value coverage. We want to responsibly use the Priority Return Fund or similar structures, a strategic partnership, for example, with a large-scale funder, something we're working on. And that fund will take the returns under what's they feel comfortable from a loan-to-value perspective. And so the answer is yes. We're not going to be raising common equity at these levels, particularly as we trade below equity value. Our [Indiscernible] book value. That's irresponsible for us to raise any equity that leads common shareholders. We don't need to raise common equity at this point. We have excellent access to capital. We have enough both cash and additional headroom in our Priority Return Fund and other sources of capital that we can easily achieve our funding objectives for this year and fund a significant additional investment in the next year, right? We don't have enough capacity to get us to our $100 million AUM target, but we're not constrained for capital raising. So -- the answer is yes. It's a great structure. We really like it. It's excellent for preferred investors. But -- and I feel that we're using it responsibly. But the ratio is going to fluctuate somewhere between 50% to 80% loan-to-value coverage, and I don't think you'll see us going higher than that. I don't think you'll see us at least out for the near term, having very, very high leverage ratio. It's not how we fund the investment. I hope that answers your question.

Yes. That does. Yes, that's fine.

Yes. And I think it's key to know that -- the residual value accrues to our equity. And philosophically, I think it's important to understand how we view our equity. We take -- think of it this way, for every dollar I invest, I invest on average for 3 years. And when I get that money back, I then reinvest it. And every time I reinvest, every time I increase that turn, I want warrants and equity position in ultra high-growth companies. I can -- we have some portfolio examples companies in our portfolio where we did an investment at an initial valuation of $20 million. Then we did a follow-on tranche a company we had term sheet of $60 million and it continues to be on a very steep high-growth trajectory. That implicit -- there's been no funding in that rollout. So there's a reason for us to write up the value of our warrants and we're very conservative in our approach to valuing our warrants. But in some instances, when these companies exit 3 or 4 years later and even after our loan has been paid back, it could be just warrant value that is equal to or greater than the initial loan that we put in, simply because it's such a high-growth, well-managed company. So those are the types of companies we look for. That value of equity upside through this growing more portfolio accrues our common equity shareholders. And like the industry investment, while it's in equity, it's passive. I can't earn investment returns. Nothing making happier than having that exit cash coming on to my balance sheet. And now when I reinvest that cash, I'm making mid-teens interest rate plus or more every time I invested. So it's -- It's a bit of a flywheel once we start getting and we're at that stage where we're starting to get liquidity events. We're starting to reinvest them in other additional high-growth ectatic companies. We have a maiden portfolio, I should say, pipeline. In fact, one of the big changes in our business, operationally in the last 2 or 3 years has been our ability to generate increasing deal flow of these high-quality, high-growth companies. And the upside in that accrues to the equity, the common equity. I don't think that for the foreseeable future, you're going to see us paying a dividend only because not that we disagree with it philosophically. But it's the idea that I let us reinvest that money at mid-teens interest rates and earning warrants on it. And that will generate more returns for shareholders over the longer term.

I have another question. But I'm just wondering because you can keep the same LTV coverage, but just invest in more velocity of capital by getting more deal flow. And then the ratios are pretty much just as safe as long as everything is ring-fenced. So if you have like a ring-fenced different PRF and that could be really accretive.

Yes, I understand what you're saying. And again, it's coming down to the amount of leverage. And over time, as we -- as our longer-term growth strategy, as I said, is not seem to take a responsible levels of leverage. But to continue to grow our equity value, continue to grow our book value. Our free cash flow generates strong returns to our shareholders. And over time, we may raise common equity to help us add basically just more capacity. Just -- the opportunity here is we're growing responsibly. But the opportunity here is it's not just a $100 million AUM. We see a path to get to $100 million, then $250 million, then $500 million. And there's companies in our space that are doing billions of dollars of originations per year. We have a long way to go to get there, but the path for us there is a path to get there. So similar to the types of companies we invest in, we feel that we've nailed our value proposition, and that proposition we offer our customers. And we're just -- we're at the point now where we're sustaining our business.

At this time, I am showing no further questions. I would like to turn the call back over to Alex Baluta for closing remarks.

Thank you very much, operator. I think I've been not talking on this call probably our longest call to date. I appreciate everybody's time, and I look forward to speaking to you at the end of Q3. As usual, if anybody has any questions, please feel free to call myself or Gaurav at any time. Thank you very much for your time.

This concludes today's conference call. Thank you for participating. You may now disconnect.