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

Good morning, ladies and gentlemen, and welcome to the Flow Capital's Q1 2022 Earnings Conference Call. [Operator Instructions] This call is being recorded on Tuesday, May 31, 2022. I would now like to turn the conference over to Mr. Alex Baluta. Please go ahead, sir.

Thank you, operator. Good morning, and thank you, everybody, for participating in this call. After the close of market yesterday, we released our financial results for the quarter ended March 31, 2022. Details can be found on our website or -- our website, by the way, flowcap.com, or on SEDAR. We had an excellent quarter, continuing the progress we made last year. Book value grew by over 10% in the quarter to $0.82 a share. That's on top of the 30 -- almost 34% increase that we saw in all of 2021. IFRS reported revenue was up to $3.9 million, up 55% year-over-year. And net income -- IFRS reported net income was $2.35 million, up 79% year-over-year. Note that, I say this on every conference call, IFRS numbers can be volatile due to the unpredictable timing of buyouts and/or unrealized fair market value changes in FX adjustments. Given that what we really focus on is simple recurring revenue from ongoing operations, i.e., interest and royalty income. And that's a much more informative metric for us to track. Recurring revenue from royalties and interest income grew by 10% to approximately $1.77 million. I'm not going to go through the full financial statements on this call, but I want to focus again on a few of the highlights. If you'd like more details, I urge you to download our financial statements from the website or from SEDAR. And we're always open for questions if you have any questions after reviewing these statements. In terms of highlights, if you've been following flow for any length of time, you'll know that 2021 represented a significant transition year for Flow. Basically, the culmination of 3 years' worth of -- more than 3 years with the transition efforts. During that year -- last year, we experienced a very rapid transition in our business away from royalties, which was our legacy investment structure going back almost 4 years now and firmly in the venture that -- redefined venture debt or growth debt that has much lower risk, higher quality, senior secured debt investments into high-growth companies. And primarily that's used into factors a service or other technology companies. Well over 50% of our portfolio is skewed to technology. When this is in contrast to sort of the 2014 to 2018 time period where unsecured perpetual royalties were the primary focus of the company, this transition to higher-quality investments with equity upside, I should add, has been part of our strategy, as I said, for last 4 years now. In Q1, that $1.77 million of recurring revenue had an interesting -- or sort of highlights an interesting transition. Last year, loan interest represented -- only last year in Q1 that it is, represented about 22% of our recurring revenue, while royalties represented 8% of our recurring revenue. If you recall, last year, we had 5 major buyouts of our very strong remaining royalty portfolio. And interestingly, this year, the percentages are reversed. The loans represent or loan interest income revenue represented 78% of the revenue in the quarter, and royalties were down to 22%. And looking forward, you'll gradually see royalty revenues essentially fade away. We rarely issue a royalty term sheet these days as we focus on much higher quality investments and the investee companies tend to self-select away from the royalties and into loan structures. So it's something we don't offer royalties. It's just that it's rare that the type of companies that we invest in today seek a royalty. Turning to book value. It's pretty evident, we had a pretty phenomenal quarter in terms of the growth in book value, up 10% in the quarter to $0.82, that's up from $0.75 in December. The numbers are -- they're pretty striking. I'm actually -- we're pretty excited about the performance over the last several years. They're up almost 38% last year on a year-over-year basis. And if you look back to mid-2019, our book value is up over 85%. I don't know anybody else in our sector who had that kind of performance in terms of book value growth. The growth in book value this quarter is driven primarily, although not exclusively by the exit in Performio. There were no other material changes in our portfolio, I should add. I want to highlight Performio for a minute. A fantastic company, and it was a fantastic deal for us. And it actually is a perfect illustration of our ongoing strategy and what we really should come to expect from us over time, Performio is the investment that we closed last year. They -- actually, it was an early buyout as they received a major equity infusion from a top-tier venture capitalist to use that capital device. So that also -- that investment also triggered what we call a buyout on exit successfully. So as I mentioned, we run our business on recurring revenue. So on a day-to-day, month-to-month, year-to-year basis, our primary focus is on ensuring we have strong recurring cash-based interest and royalties. But in all of our loans, we take a small upside participation right or a bonus, it's even in the form of the warrants what we call a success on exit bonus. That's generally a nondilutive small percentage of equity that is triggered on the change of control. Those success bonus on exits are generally smaller than warrants in terms of the representation, the size of the company that they represent for us. So our warrant positions will average 1% to 4% of the equity the company we invest in, success on exit will be a little bit smaller. Over time, we'll have a large portfolio of these bonus positions that are essentially tied to equity upside in our invested companies as we reach for the $100 million in assets. We expect that we'll have somewhere in the range of 25 to 30 positions. Right now, we're approaching almost 20 positions in terms of warrants, bonus on equity or common equity positions. And these bonus -- on actual, these bonus -- equity-related bonus position represent not only downside protection for us, but as you saw in this quarter, a material upside to our book value over time. Now as that portfolio of bonus positions grows, you'll see the cadence become a little bit more regular, but to be clear, it's really hard to forecast when. Usually, these -- our average loan ratio is in the range of 30 months. And every time we redeploy capital, we earn more warrants. We don't know the timing of those exits, generally, they will outlive the warrant positions if our -- or at least 2x the duration of our investment positions. And so it's hard to forecast. But as we grow that portfolio, we will, over time, expect to see a more regular cadence of exits and upside. And as I said, these are a meaningful contributor, both to our downside protection, but also to our upside. In terms of new deployments, we deployed only a modest $500,000 in the quarter. It's a little disappointing, but the pipeline activity remains very strong. Shortly after the end of the quarter, we did close a third tranche into Echobox. It's now our largest investment, it's one of our longest term investments now. Another excellent company. And again, it's part of our strategy that is we continue to invest in strong performing companies. We like to stay invested in those companies for as long as we can. Echobox is an example, their MRR -- it's software-as-a-service company, their MRR is up well over 200% since we first invested our first $1 million tranche in that company several years ago. At the end of the quarter portfolio, in aggregate, was $41.9 million, up from $29.8 million a year ago. We have 16 active investments, 13 warrant bonus on exit positions and for common equity positions right now. In terms of the pipeline, we continue to see good progress in our pipeline as our referral network continues to grow, and our internal efforts keep generating good deal flow. We're very encouraged about the future right now, though for a different reason, which is that the recent volatility that you're seeing in public markets. Two things have happened. One, technology valuations have come down, in some instances, collapsed. More importantly, though, so public equity markets are closed, but VCs, the venture capitalists, are also closed. And we tend to piggyback. Over 50% of our portfolio is in venture-sponsored, venture-invested companies. What VCs, there's lots of new stories out there. What VCs are saying to their investee companies is we're not funding anymore. You need to get the cash flow breakeven on the existing cash that you have. Some companies will make that, some won't. But what we feel is this is going to represent an excellent opportunity for us to see companies that we might not otherwise have seen as they would have used equity to fund themselves. Now we still have to make good investments, and we still have to focus on due diligence, but we're excited about the increase in opportunities that we expect we're going to see over the next 3 quarters for the rest of the year. From an available cash perspective, we have over $4 million on our balance sheet available to invest, and we expect that's going to grow as we continue to work on strategic initiatives to increase access to capital. In terms of recurring cash flow, again, it's a non-IFRS metric that we use to manage our business. It's defined as simply recurring revenue, less OpEx, less interest expense. They should say cash OpEx generally. Free cash flow in the quarter was over $630,000, that is the highest that it's been in at least the last 4 years and so now positive for the past 8 quarters in a row. Very proud of that number. We continue to focus on generating not only revenue growth and a strong portfolio with equity upside, but strong free cash flow and positive EBITDA. So with that, I'll pause and to summarize that we continue to see good deal origination and improving pipeline metrics. We have spent several years reducing our costs and streamlining our operations together to start growing our free cash flow. We're seeing a strong and reasonable on our portfolio. We expect to see more Performio-like exits over time as our equity-related bonus positions grow, and we look forward to the rest of the year. With that, I'll pause and hand it back to the operator for questions.

[Operator Instructions] Your first question comes from Ed Sollbach with Spartan.

Congrats on another great quarter.

Thank you.

So when you think about redeploying capital, it seems one of the best opportunities for Flow is your own shares, which are almost at half book value, and that book value has grown so nicely over the last year. So how do you and the board feel about share buybacks? What's the position?

Yes. Ed, thank you very much for that. I love that question. It's a bit of a softball. We, as you know, love buying dollar bills for $0.50 or $0.60, which is what we're effectively doing when we buy back on our shares and in particular, because we're very confident in our strategy and it's proven to be working. We have, in aggregate, over the last couple of years, reduced our share count from about 44-ish million down to about 31 million. That's a meaningful reduction in the share count. We continue to -- we haven't bought as much back in this -- in the last couple of quarters as we have in the past. That's simply a function of preferring to deploy capital into new investments, but -- and then we had some restrictions. But we intend to have our NCI, our normal course issuer, bid open in buying shares as we can. I want to set expectations like it might not be a dramatic reduction as you've seen in the past, but yes, we're strong believers in our own equity and have and will continue to buy shares back in the future.

Well, that's great. It's nice to have a management, the company aligned. And also because they have liquidity, it's nice to have a bidder in there sometimes, I think. The other thing I -- question I had is -- and I didn't realize that there have been such a dramatic reduction in the share count, which is totally the opposite of most TSX companies who are always diluting, diluting, diluting. So it seems to me that you're doing a lot of second and third tranches with companies that you're really familiar with and like. Is that a valid observation?

It is. It's actually, it's part of the strategy. So what happens when we do a follow-on tranche is, we generally -- Okay, take a step back. We invest -- if we invest $1 million, we expect that $1 million to be invested for an average term of about 30 months. It might be as low as 24, it might be as high as 36, but call it on average of 30. And then we earn, as I discussed in the call, warrants or just call it warrants along with that. So if we recycle every time we get paid back, when we recycle that money, we earn more warrants. So every 30 months or so for every dollar we invest, we should be earning some warrants. If one of our investee companies needs more money and they're performing strongly, as usually when we make a follow-on investment, we're happy to reinvest in that company, increase our investment. But what we do is we earn more warrants when we make that reinvestment. So from our perspective, it's -- we view it as a new deployment of capital. So a couple of things happen. One...

Because your paid back from the original tranche. Is that...

Well, yes. And we just -- our strategy is to earn more warrants every time we invest on a certain time scale. So therefore, we ask for warrants. But -- what we got is it's a high-quality company where we've got a multiple year track record to see how they report and how they perform. Where we feel strongly that, as an example, companies are up in their revenue sometimes hundreds of percent. It's about -- and generally, our rates or terms don't change. So it's a perfect scenario for making lower-risk investments in companies that we're very, very familiar with. So we'd love to do that. We try to manage exposure risk and concentration risk. But I do expect that over time -- I hope, actually, over time, and in our best companies, we get to see multiple opportunities to invest. Having said that, we do need to continue to build our portfolio with new investments. And as the last year, I don't know the exact number yet for this quarter, but last year, we saw just under 1,000 new opportunities and closed on less than 1% of them, which sounds like a low close rate. But as our objective with the team that we have in place is to increase the number of deals that we see, but keep the close rate relatively modest implying that we're investing in the best deals that we can find. So we continue to focus on finding new deals. That is always a challenge in this business. But I think as it's coming from you as an equity investor, once you've got that great company, we try to stay with it for as long as we can.

Oh, exactly, you want to stay with people you're comfortable -- really, people that have a track record of delivering, right? Because so many people don't. So...

Right.

Okay. And just I think a new topic is in terms of concentration exposure risk, what kind of parameters does Flow have in terms of those kind of metrics? Yes.

Yes. The one that's most meaningful for us is kind of an LTV ratio, loan to value. And we look at loan-to-value to what is the equity value in a company that is effectively subordinated to us as we're the senior lender on the balance sheet in most instances. And so we won't -- on average, our loan-to-value, so if you think of a company that I don't want to use specific examples because -- but let's say a company has a 100 -- $20 million market cap. It's a private company. It's got an equity value at some $20 million, we won't go higher than $4 million in terms of the amount of debt relative to the equity. And even then, the average across our entire portfolio is in the single digits is probably 8%, 9% of the -- our loan represents, let's say, 8% or 9% of the total equity value in the company. Now that will change those are private equity valuations. If we have a public investor in a public company that's subject to the volatility of a small cap company, let's say, on public markets. But in general, from a loan-to-value perspective, we're in the single-digit perspective from a risk of any individual investment relative to that company's equity value. From a diversification perspective, ourselves, we have some concentration risk, but we make those investments. The largest deals we have tend to be the companies that we know the best. And as we grow our portfolio, and I've mentioned to you and on this call before, we're trying to get to over $100 million in assets and then over $250 million, the concentration risk will naturally decline over time.

Right. But right now, if you think of the largest investment on, what does that represent in terms of the collectables? And what...

Roughly 16%, 17%.

Okay. So it's -- and I guess it's kind of like it's because the company has done well, right, that it's grown to that size. So it's kind of like when you buy Microsoft and it grows to 20% of your portfolio, that's actually a good thing. And...

Yes. the largest company in our portfolio today is a company that we've got 3 tranches and therefore, it is large. Most new investments are not that large.

Okay. -- but I guess, to your first point, these companies aren't very levered, right, because they have pretty limited debt on their balance sheet. So that makes it safer, too. Yes.

Yes. And that's -- again, where we play is between venture capital or piggybacking our venture capital and between bank debt. So it's in a market where these are high-growth, low assay companies, generally speaking. They don't do real estate. They don't do. They don't do asset-backed loans. And we're the senior secured lender on the balance sheet, where they want to extend an equity round and not suffer the dilution or loss of control through an equity investment, and banks just aren't interested. And so that's the space that we play in.

Okay. Congrats on another great quarter.

Thanks, Ed. Thanks for your support over time.

[Operator Instructions] There are no further questions at this time. Mr. Baluta, you may proceed.

Great. thank you very much, everybody. We appreciate your support and look forward to speaking to you in about 3 months' time with our Q2 numbers. That's it, operator.

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines. Have a great day.