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 September 30, 2021. [Operator Instructions] I would like to remind everyone that today's discussion 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 November 11, 2021, which is available on SEDAR. Today's call is being recorded on November 12, 2021. I would now like to turn the meeting over to Alex Baluta, Chief Executive Officer of Flow Capital.

Thank you very much, operator. Good morning, everybody, and thank you again for participating in today's call. I'm joined by Gaurav Singh, our Chief Financial Officer. After the close of market yesterday, we released our Q3 '21 unaudited financial results. Details can be found on our website or on SEDAR. Our total IFRS revenue for the 3-month period ended September 30, 2021, was a negative $170,000, 104.7% decrease from $3.8 million in the 3 months prior period ended September 30, 2020. Year-to-date revenues under IFRS are $7.1 million, a 4.7% increase from $6.7 million in the 9-month period ended September 30, 2020, this year over last. Note IFRS numbers can be volatile due to the unpredictable nature and timing of buyouts and/or realized fair value changes in FX adjustments. So for example, we had the buyout of our Inner Spirit position in the quarter, which yielded almost $5 million in cash, yet under IFRS rules, that event led to negative revenue. Given that, recurring revenue is a more informative metric that we use to track our business. Our recurring revenue from loans and royalties in Q3 2021 was $1.2 million, representing a 26.6% decrease from the $1.6 million earned in the 3 months last year. Year-to-date, our recurring revenue was $4.5 million, a 17% increase from the $3.8 million earned in the 9 months last year. Q3 was unusual in that we experienced a significant impact -- the significant impact of a number of repayments, primarily of legacy royalties that were clustered together in a short period of time. Specifically, most of the buyouts and repayments we experienced this year were clustered in Q2 and early Q3. The impact of an influx of $12 million of repaid capital, combined with our measured and conservative approach to new investments, had a temporarily negative impact on recurring revenue. In our Q1 and Q2 quarterly update calls, we highlighted that revenue and free cash flow would be lumpy for a few quarters as some of our high-yielding legacy deals were repaid and were eventually replaced with lower-risk but lower-yielding new investments. And that's exactly what you're seeing in Q3. This year, we saw the repayment of royalties in Spiridon, Stability Health, InteriorMark, ConnectAndSell and Bluedrop. We have been expecting all of these to be bought out at some point as they were all performing well, and they were all approaching the buyout trigger. But to see them all happen in a [indiscernible] of our control and a surprise. And it give us a bit of a hill decline in terms of revenue. These 5 buyouts repaid $12 million in cash, and they were generating over $3.5 million in aggregate revenue for us. However, given the strength of our pipeline and the high quality of opportunities we are seeing and continue to see, we've been quickly redeploying our capital. The effort we put into improving our origination efforts in 2019 and 2020, many of which I discussed in prior calls, are paying off today -- to date, including our most recent investments that were in Q4 in AskVet and Kovo HealthTech. Kovo closed 2 days ago. We've invested over $21 million in calendar '21, replacing most or almost all of the revenue that was being generated from the aforementioned repaid royalties. As such, we expect this drop in recurring revenue from the repayments to reverse in Q4 as revenue from new investments replaces the revenue from exiting investments. Continue on with some of the financial details, in Q3 2021, Flow continued the strong trend of increasing transaction activity that we've been witnessing over the -- earlier in the year, closing over $14.9 million in transactions in the quarter. In the 9 months ended September 30, Flow Capital had closed over $35 million in transaction value in aggregate, including 5 new investment loans for $15 million, 5 royalty repayments for $12.1 million and equity sales totaling $5.5 million as well as some partial redemptions and recoveries from previously distressed legacy investments. The significant increase in transaction throughput in 2021 has accelerated the transition in our investment portfolio from the legacy royalty warranted portfolio to a predominantly loan-centric portfolio. This also reflects our focus on moving down the risk curve in the later stage and typically larger and secured investments, layered with additional upside potential to the warrants and/or exit fee structures in all of our recent deals. In Q3, net income was a negative $1 million for the quarter and 3.3 -- a positive $3.3 million year-to-date compared to a positive $1.8 million and a positive $1.5 million for the corresponding period last year. Adjusted EBITDA was a positive $5.4 million for the quarter and a positive $11.5 million year-to-date compared to $1.5 million and $2.4 million for the corresponding period last year. Again, this highlights the challenge of IFRS reporting as we had negative revenues in the quarter, but positive EBITDA of over $5 million. Nevertheless, the year-over-year increases were driven by realized gains in sales -- sorry, from the sales of investments -- sale of investments, higher royalty and loan interest income, lower operating costs and movement in noncash items, including fair value and foreign exchange. In Q3 2021, Flow generated free cash flow of positive $4.5 million. And year-to-date, our free -- IFRS free cash flow was positive $9.3 million. We ended Q3 with a strong balance sheet with over $30 million in our active investment portfolio that's generating recurring revenues and an additional $2.2 million in equity holdings across both public and private investments and over $8 million in cash. And much of that cash has now been redeployed in Q4 in new investments. We're quite pleased with Q3 numbers as it reflects the strength of our core recurring revenue-generating investment portfolio business model complemented by notable examples of substantial gains from portfolio exits. As some of you may have observed, our stock trades at a discount to book value, a significant discount. We believe this offers a compelling opportunity to purchase high-quality, undervalued stock. Year-to-date, until the end of Q3, Flow has repurchased about 915,000 shares of our own shares under the ongoing NCIB, normal course issuer bid, at an average price of $0.42 per share. Our book value as at September 30 is $0.674. So we were buying back our own stock at a significant discount to book value. Our Q3 financial results are summarized in our press release. And the details can be found in the full financial statements and the MD&A on our website and on SEDAR. I encourage you to review those and email us if you need more information. There's a few additional items I'd like to highlight. As of today, including our 2 most recent investments that closed in Q4, our portfolio of loans and royalties is now over $33 million and is generating almost $6 million in recurring revenue. We've been cautiously moving down the risk curve and increasing the size of our transactions in order to help us scale. We now have 5 deals that are over $3 million in size. And in several of our deals, we have the opportunity to deploy an additional capital. We'll deploy up to $7 million in any individual deal. This has been a cautious effort on our part to increase the size and the quality of our deals to help us scale, as I mentioned. I also mentioned earlier that we're transitioning to loans and away from royalties. This is really a function of the quality of the companies that we're targeting, and they themselves are self-selecting into loans. Today, over 80% of our portfolio of investments are in debt instruments, which are almost always senior, top of stack and secured. Our warrants and our equity portfolio in aggregate now hold 12 warrant positions, which -- including the 2 most recent deals, 2 bonus exit fee positions. And I should explain a bonus exit fee is like a warrant with a payment above a fixed value of equity -- fixed equity value. But it's not quite structured like a warrant. It's actually nondilutable and doesn't cost us any money. But we have 12 warrants, 2 bonus exit positions and 3 publicly traded common equity positions. I want to linger on this point here for a moment. These warrants and equity positions represent a significant potential upside to our long-term business model. We take warrants on almost every deal we make or investment we make. I can't see us making an investment in the future where we don't take a warrant position. When we reach our target of $100 million in invested assets, we expect to have over 20 to 25 warrant positions. On average, these warrants give us somewhere between 0.5% to 4% ownership position in the companies that we invest in. And remember, we lend money to high-growth companies, where if they are successful, the increase in equity value over time can be significant. While we don't expect all of our warrant positions to generate upside, a meaningful portion should over the medium term. And that's really the nature of the venture debt business. Finally, and most importantly, we continue to generate positive free cash flow from our recurring revenue. As I've mentioned in the past, one of our key metrics we track is recurring revenue from interest and royalties and adjusted free cash flow from recurring operations. And you can see, given the somewhat confusing nature of our IFRS reporting, this is why we focus on recurring revenue as a metric. The calculations are simple. It's revenue from interest and royalties less OpEx, less interest. That's how we define adjusted free cash flow. I'm very pleased that during Q3, in spite of significant loan repayments, we generated almost $170,000 in positive adjusted free cash flow, marking the sixth quarter in a row of positive adjusted free cash flow. To me, this demonstrates the resilience of our business model and is the outcome of all of our efforts over the past 3 years, including improving our deal origination, reducing our costs, streamlining operations, increasing investment quality and size, simplifying our deal structures and cleaning up our balance sheet. And with that, I'll pause and turn it over to the operator for questions.

[Operator Instructions] The first question comes from the line of Ed Sollbach with Spartan.

Congrats on the many buyouts in the last few months.

Thanks, Ed.

Just digging into -- there's some fair value adjustments. So it looks like one of your loans went delinquent in the quarter. And the Mera Group, $1.9 million? Am I reading that correctly? And what's the outlook for recovery on that one?

Sorry, Ed. I heard the word delinquent. And then I missed the second part. What was the $1.9 million?

Well, I -- if I compare the 2 quarters, it looked like it was $1.9 million extra this quarter that was classified as -- in terms of fair value adjustments for the...

Got it, Ed. Gaurav will answer your question.

Thanks, Ed. So just to explain the first part of your question about the investment that went delinquent, we had an investment that ran into some trouble and is exploring a merger with another company. We don't have details to -- final details or discloses yet. So as a conservative approach, we have written down that investment. That investment was on our books at under $250,000 and is down -- now down at less than $100,000. So it's more of a conservative approach to accounting as per IFRS, and we expect to have a more definitive number by the end of the year. But that should not be representative of the $1.9 million. The $1.9 million that you're referring to in the movement in the fair value is really coming from some of the buyouts. We had a buyout in our investment in Bluedrop in the quarter. And that investment because of fair value movements up was at close to $1.9 million on the books. And when that gets bought out, the cost and the fair value movement away is what represents that $1.9 million, most of that $1.9 million.

Yes, Ed, it's really a function of -- it fits back to the movement on IFRS. Basically, we didn't have too many things that were negative in the portfolio. It's a function of the accounting rules and changes in what's -- to be honest, this is why Gaurav's here. I don't even understand if it's IFRS. IFRS Is so complex. It's not a very good representation of our business, which is why we look at recurring revenue from recurring operations less OpEx, less interest cost as a metric for how our business performs.

Okay. So $1.9 million because there was one extra delinquent company in the quarter, right? And is the $1.9 million...

Yes, there was. Sorry to interrupt you, Ed.

Yes.

There was one investment that went delinquent in the quarter for 1 month in the quarter. And that investment represents a write-down of less than $250,000. The balance of the fair value movement is because of the buyout.

Okay.

So the other thing to know about -- sorry, Ed, one thing. The other thing to note about DirecTech is the initial investment was, I think, USD 250,000. I mean, it was -- it's a legacy deal that we just -- I mean, we're trying not to do investments below 250 -- sorry, $2 million, let alone $250,000. So there's an earlier smaller investment, arguably not material, but nevertheless, yes, it was a write-down in the quarter.

Okay. Okay. No, it's just -- like it looks like a good quarter or I mean, decent. I mean -- but if I look at the 3 months, there's a $6 million, $6.1 million adjustment to fair value. And so is that -- so the way to think of that is it's that some of the stuff that you had marked -- because you mark a lot of stuff to market, right? So is it that some of your equity investments that you didn't crystallize yet were [ performing ]?

Yes. So again, this is what I mentioned in my commentary. We had a really positive event with the buyout of Inner Spirit, right? We made literally liberated $5 million in cash. And yet somehow in the quarter, we have a negative $100,000, $170,000 in revenue. So it's -- the movements in IFRS do not -- I understand why they're there, but they don't really fairly reflect the ongoing nature of our business. So maybe what we can do is we can have -- why don't we have a call after this, and we'll go literally line by line with you [ to go through ] the movement in fair value. That might help explain why when you have a gain of $5 million in cash, you end up with negative revenue.

Okay. Okay. No, it's just people -- I guess, I'm worried that it's about the delinquency. So -- but just to understand, when you have a delinquency, do you write that investment off right away? Or how -- what's your approach to that?

So when there is a potential decline in future expected revenues, we will write down that investment, but not write it off yet. We would initiate proceedings to make recoveries. And actually, in this quarter, we also have, although relatively nominal, a couple of recoveries from previously delinquent deals as well. So that's a process that continues. And the investment is written off only when there is no further expected recovery or when we have recovered the investment in full. A couple of cases in point, we've had investments that were held in the books or carried on the books at 0 values, which we went on to recover the full investment as an example was in Q4 last year, which is why we saw that significant jump in Q4 last year.

Right.

It's a part of following conservative principles of accounting to make sure that we recognize losses early, but write them up only when we are sure we're going to achieve them.

The next question comes from Akiva Dubrofsky, a private investor.

Yes. So I have 2 questions. One is last quarter, I was asking about your debt to equity and if you guys want to increase your leverage ratio to improve returns. And I think out that you guys had some efforts underway to open up a new credit facility, where it was less focused on royalties and more focused on loans. So I'm wondering how have you guys progressed with that? And do you foresee that over the next few quarters you'll actually have more leverage in the books?

Yes. Akiva, yes, look, we have $21 million, $22 million in book value of our equity. We have a portfolio in our assets in aggregate approaching $42 million. And so we do carry a little bit of debt. And yes, we want to increase our leverage. And yes, we've been speaking to senior strategic lenders to try and set up a relationship where somebody gives us a, say, senior ranking over our balance sheet and then give us a loan to value in our portfolio between 50% to 70%. i.e., if we had a $100 million portfolio and $30 million in equity, they would give us $70 million in debt as an example. We have been in discussions. We had some term sheets. We haven't finalized anything with anybody. I suspect that part of all the efforts that we do to improve our business, improve our performance, reduce our cost, streamline our operations, reduce our cost of capital, it's literally a function of what we do every day. So we haven't gotten anything -- we do not have anything to announce. We have been working on this. When we find that senior partner, we'll obviously announce it, and it will be part of the way we continue to scale our business. So we're working on it. Nothing to announce, but over time, that's how we'll grow.

Yes. And just to add to that comment, you'll notice that we do -- we did end the quarter with significant cash on our balance sheet. Most of these credit facilities would load up further cash on the balance sheet till we deploy it, and we like to time our debt raises along with our investment outlays. And as a result, we're on track with what we have in mind to meet our investment outlay targets for the year. We do have facilities that we are considering. And when we have something finalized, we'll come out and make an announcement. We do also have the supplement of the PRF, which gives us a lot more flexibility in when and how we raise the capital because that's a lot more in our control as opposed to a credit facility, which is somewhat negotiated in a larger number all in one go.

Yes. And by the way, Akiva, that Priority Return Fund has a preferred unit structure that pays 9.25%. So if anybody is interested in participating with us in a priority structure that helps us grow our business, you can earn 9.25%. We'd love to have you as a unitholder in that structure.

It is, unfortunately, open to credit investors only.

Right, for credit investors. Thank you.

Another question is on -- you said in the last quarter that when you record your warrant and your royalties on your book, you try to keep it very conservative. Like you try to -- it's almost like you record them in a way that's less than what they get bought out for. But I'm wondering, is this quarter different because like it kind of seems like you guys got bought out for less than you were recording it on your books? Unless there's something I'm reading wrong here, kind of seems like you guys are too optimistic in the valuations you apply to your royalty and warrants.

That is actually not true. So just to take an illustration, [indiscernible] was recorded on the book, let's say the investment is $1 million, and the buyout is $2 million. The investment would be on the books at the $1 million cost plus the fair value or the fair market value of that investment till it is bought out. Now that estimate for the fair market value may not be the full $2 million and maybe at $1.7 million or $1.8 million, and that's a function of the discounting that goes into future cash flow. So you wouldn't -- if it's a $2 million exit, it wouldn't be carried at $2 million because there would be a discount factor applied to the money that you're going to get on exit. So it will be somewhat lower than the $2 million based on the time left on the expected buyout and the discount. So there is potentially a small difference between the 2, but there isn't a significant difference between the 2.

That's a royalty, though.

Yes. And...

Is it direct?

And the corresponding explanation for a loan, a loan is carried at amortized costs. So that would reflect the value of the loan, including the amortization walk up towards the end of the life of the loan. So at the end of the life of the loan, you would reach the face value of the loan. But when you're starting the loan, you would be making a walk up to the amortized value.

Let me try to give you my version of a -- sorry. We make $1 million loan. We get -- we have a loan, and we get warrants. You have to subscribe some value to the warrants. So it goes on our books at $950,000 in loan and $50,000 in warrants as an example. The warrants stay there at $50,000 until such time as is either a revaluation or an exit. The loan walks up from $950,000 to $1 million over the life of the loan. So it's not that we -- and this is approved by our auditors and a third-party valuator over time. So you take $1 million, you split it reasonably between the loan and the warrants. The loan goes from $950,000 to $1 million, and the warrants stay at the $50,000 until such time as there's another event that gives us a reason to revalue. That's really the way accounting forces us to account for our investments when we get a warrant as part of an investment. Does that answer your question?

I think so, yes. I think [ we can go over it ] later.

Yes. I don't think it was any warrant write-ups in the quarter to be specific.

Not in this quarter. We had new warrants that came in along with the new investments we made, but not...

No write-ups.

Existing warrants were written up right.

So one of the things you will see is that our equity portfolio went from somewhere in the $7 million down to $2 million, and that's a function of Inner Spirit being in our equity portfolio then being liquidated to cash. So the -- it exited our equity portfolio and translated into cash on the balance sheet.

So is there a time lag between when you -- like when the buyout happens and when you actually get the cash, and you have to apply a discount factor to that future cash? Is that it?

No. If we get -- if there's a buyout, they buy us in royalties. The loans have a maturity date. The amount due is due on the maturity date. The royalties, and in the case of the 5 buyouts we had this year, they're all optional at the company's option, which is why we can't forecast when -- we had a cluster of 5 royalty buyouts. We had -- we could have come a month earlier or 2 years later. It's up to the company and a royalty to decide when they want to buy us out. It just all happen to buy out in Q2 and Q3. And they literally call us, tell us they're going to buy us out. They sign a buyout paper, and they have 3 days to deliver the cash. That's how royalty buyout works in our business. So there's not a lot of visibility on those -- what does happen in a typical royalty, and again, royalties are less than 20% of our portfolio now. But in a historical royalty, they had a trigger. They had to achieve some -- they had to pass a certain level of royalty payments before they then had the option to buyout the royalty. We knew these buyouts were coming because all of them had hit their trigger, but we didn't know when they were going to be triggered. It's up to the company. So to give you an example, if we gave a company $1 million and they had the option to buy us out after they paid us $1 million, all of those 5 investments had hit that $1 million trigger. Then it was up to them to decide when to buy us out. And it just so happens that in Q2 and Q3, all 5 of those said, "Yes, we're going to buy us out -- we're going to buy you out." So it's different than the -- so now in our portfolio where it's all loans, we have a lot more visibility in the maturity dates. It's a 3-year loan that matures on November 2024. Perfect. We know that. We expect the money to come in, and we plan our deployments accordingly. With our legacy royalty portfolio, it was harder to do that kind of forecasting and planning. And so what you're seeing is we got paid back an awful lot of loans and royalties, which is excellent. And as we deployed, we didn't -- our deployment speed didn't match the repayment speed. And so you have to drop -- look, here's the thing. If 100% of our portfolio is repaid tomorrow, we'd have 0 revenue because our business is based on deployed investments. So as an investment gets deployed, we -- or repaid, we then need to redeploy it. And so all you're seeing in Q3 is the timing difference of repayments coming on to the balance sheet and us not deploying those at the same time.

So you guys need to make sure that you would redeploy quickly?

No. We're going to make sure that we redeploy in safe investments that are of the type that we're looking for. And I said this in prior calls, if I have excess cash on my balance sheet, that's fine. I don't want to have any defaults. So our -- my -- our primary objective when we make a loan is we target zero 0s. We target 0 defaults. It's an aspirational goal, but it is kind of something that we live by. So I'm not going to just deploy -- if I have $8 million on the balance sheet, it's not randomly deployed in the next deal that comes into our pipeline because I want to make sure that we are making the best investment that we can out of the opportunities that we have.

And there are no further questions at this time. And I'll turn the call back to...

Thank you, operator. Look, I'll summarize that I feel we had a really good quarter in spite of the clustered repayments that I just explained. We remain cash flow positive, marking the sixth quarter in a row that we're cash flow positive. We've made over $20 million in new investments this year. Our pipeline continues to be very robust, and we're seeing no shortage of excellent investment opportunities, although they do take time to close. Our warrants in our equity portfolio of high-growth companies continues to grow, and we have the team in place to scale our business dramatically without increasing cost significantly. And so we feel good about our prospects. Thank you very much for your time. Feel free to call us if you have any additional questions, and I look forward to speaking to you after next quarter. Thank you.

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