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

Good morning, ladies and gentlemen, and welcome to the Flow Capital's Q2 2022 Earnings Call. [Operator Instructions] This call is being recorded on Wednesday, August 17, 2022. I would now like to turn the conference over to Mr. Alex Baluta. Please go ahead.

Thank you, Joanne. Good morning, everybody, and thank you 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 financial results for the second quarter ended June 30. Details can be found on our website or as filed on SEDAR. We had another excellent quarter, continuing the progress that we made last year and in fact, over the last 3 years. By almost all measures, we had a record quarter. Here are some of the financial highlights. Recurring revenue just under $2.1 million in the quarter was the highest quarterly revenue from investments over the past 4 years, and it was up over 23% year-over-year. Adjusted recurring cash flow of nearly $1 million in the quarter, $1.6 million year-to-date and $2.1 million over the past 4 quarters marks a record in free cash flow generation for us. Total assets just crossed $50 million -- $51 million, and that's compared to $44 million at the end of the year of 2021, another record. Cash on the balance sheet currently stands at $8.8 million. That compares to $4.1 million at the end of 2021. And importantly, book value per share is up to $0.91 per share, that's up 22.4% year-to-date. And that's on top of the 33.7% increase that we saw in 2021. Please note that the numbers I just quoted are our adjusted numbers, which really focus on recurring revenue and operations related to recurring revenue. IFRS numbers, which as we file our financial statements, can be volatile due to unpredictable timing under unrealized fair value changes and FX adjustments. Given that, our perspective as management is that recurring revenue is a much more informative metric to track. I will not be going through the financial statements in detail on this call, but I'm going to focus on the business highlights. If you'd like more details, I strongly urge you to download our financial statements either from our website or from SEDAR. And if you have any questions, feel free to call. If you've been following Flow for any length of time, you'll know that in 2021, it was a transition year for us on the back of several years of preparation as we changed our focus during '21. We experienced a very rapid transition in our business away from royalties, which is our legacy business investment structure and firmly into venture debt. And we define venture debt or more appropriately, growth debt as much lower risk, higher quality senior and secured debt investments into high-growth companies, primarily into SaaS software technology companies that represents well over 50% of our portfolio. And this is in contrast to the unsecured perpetual royalties or quasi equity that the company focused on from 2014 to 2018. This transition to higher-quality investments with equity participation upside has been our strategy for well over 3 years now. In the quarter, as I mentioned, we reported $2.1 million of recurring revenues from royalties and interest income. Now I only see royalties because that's the legacy stub of our business. The vast majority of our revenue now is from loans and interest income. For example, last year at this time, in Q2, loan interest represented 36% of our recurring revenue while royalties were 64% of our recurring revenue. This year, recurring revenue from loans was 83% of our total recurring revenue, while royalties represented just 17%. So in fact, we really have only one significant royalty remaining, and we expect that by this time next year, our royalty revenues will likely be below 10% of our overall recurring revenues. And to be clear, we offer royalties when we speak to clients, potential investee partners. If they need it, if it's the right fit, I mean we do pride ourselves on providing a financing -- minimally dilutive financing solution to our partners that fits their needs, but most times when we issue term sheets, it's for debt. In fact, I don't think we've issued a royalty term sheet for several years now. It just doesn't fit the risk return profile that we're looking for, and it tends not to fit the profile of the type of investment that the companies that come to us are looking for. So we firmly transitioned away from royalties. Turning to book value. Honestly, I could not be more proud of our performance when it comes to book value and by extension, shareholder value over the past 4 years. Flow had another phenomenal quarter in terms of book value growth, as I mentioned, up 22% year-to-date. Book value now stands at $0.91 a share, that's up from $0.75 a share in December of 2021. But more importantly, it's up 22% year-to-date, it's up 63.6% from year-end 2020, and it's up 101.8% from the year-end 2019. That means in 10 quarters, we've increased book value per share by over 100%, and I challenge you to find any other comparable company that's had the same increase in book value per share over the same period of time. As I said, the team has worked hard to achieve that. I'm very proud of our performance, and I look forward to growing that going forward. Relating -- regarding free cash flow. In the quarter, we generated almost $1 million of adjusted free cash flow from recurring revenue. As I said, we manage our business based on recurring revenue and adjusted recurring revenue. And so just to help me understand what that means, our adjusted free cash flow metric is simply recurring revenue, less cash expenses, less interest expense. That's it. Clean, simple, very easy to track, very easy to analyze, very easy to perform against. On that basis, we generated $2.1 million of adjusted free cash flow over the past 4 quarters. As I mentioned, that's a record for us. In terms of new deployments, we deployed $3 million in the quarter. This was a third tranche investment into one of our strongest portfolio companies, a company called Echobox. Echobox is MRR. This is a software-as-a-service company based in Europe. The company's monthly recurring revenue is up over -- well over 200% since we made our first investment in the company. At $6 million, that is our largest investment to date. While I'm very glad of this investment and our track record with that company, I am a little disappointed that we did not make more investments in the quarters, but more on that a little bit later in my commentary. We had no exits booked in the quarter. However, Performio, which we spoke about a lot in the last conference call, was booked in the last quarter did -- that did contribute a residual $250,000 to our results in the current quarter. As I mentioned last quarter and it's worth reiterating now, Performio represents an example of a key part of our business model and strategy. In all of our loans, while we focus on recurring revenue, that's only manage our business, we also take a small upside participation right usually in the form of warrants or what's called a success on exit bonus, which is in lieu of warrants. If we've helped the company grow its equity value by using our capital, there's a small -- when they exit our loan, there's a small bonus on that increase in equity value. And that's, in fact, the structure that we have with Performio, and Performio is so successful for us because of the gains that we crystallize on our bonus position. What's important, I think, for us is that we're not just a company that generates recurring revenues in senior secured loan positions in high-growth companies, but over time, each one of those investments provides a potential for a bonus on exit either through warrants or a bonus success on exit type structure. And that represents, I think, significant upside to our book value and actually protection to our downside over time. As we reach $100 million in assets, we expect it should be over 25 to 30 of these positions. In fact, right now, we have 13 warrant/bonus positions plus 3 common equity positions. Sometimes our warrants, as you know, will convert into common equity. So we have 16 non-loan positions on our books, and I expect that this will continue to be an important part of our value generation strategy going forward. In fact, we don't generally do any loans without some form of bonus participation right. Turning to assets. A quick mention on our asset base, which is now over $51 million. It's a small -- passing $50 million is a small meaningful milestone. Our objective is to get to $100 million then $200 million then $500 million over the next several years. Book value and asset gains in the quarter were driven by free cash flow, FX and book value increases in our warrant portfolio. In particular, in 3 of our companies, we saw a material increase in valuation. As I mentioned, book value per share is $0.91. Book value in terms of cash is over 28 -- almost $29 million. In terms of capital structure, at the end of the quarter, we had well over $8 million in cash during the quarter. We did close our first tranche, which was $1.2 million of our preferred share offering. It's a 6-year term preferred share that yields [ 22% ] in terms of eligible dividend yield. We will be raising an additional $4.5 million in that structure up to a limit of about 5.5, and we expect we'll be raising that money over the several quarters as we need it. Currently, we're not capital constrained for the near term. However, we continue to work on long-term capital solution that will help us scale from where we are now to that $100 million to $250 million to $500 million capital mark, as I mentioned earlier. In terms of our pipeline, it remains at a very similar level to last year. This year, we've seen about 1,000 deals per year at the top of our funnel consistently for the last several years, and year-to-date, we've seen about 600 leads very, very similar to the number last year. But I am disappointed with a number of deals that we've closed. We're not closing as many deals as we expected year-to-date, and it's not -- again, it's not for the lack of deals, I think there's -- we're tracking similar levels of last year. But I think it's -- there's a lot of volatility in the markets right now. Equity markets, both public and private, are shut down. And we expected to see a significant inflow of deals related to that as companies bridge to their next round or bridge to cash flow breakeven. But I think a lot of companies prior to the bubble that -- or the burst of the bubble that we've seen topped up their capital, and we are starting to see some of these deals come in that are related to the lack of their ability to raise equity, but we're not seeing as many as I thought we would. This is a lumpy business by nature, and to be honest, from our perspective, the solution of that lumpiness is simply to see more deals. I can increase the number of deals at the top of the funnel. So this is, has been and continues to be a focus for us. So we're trying to grow that 1,000 per year to 2,000 to 3,000, which is, at the end of the day, the ultimate solution to this problem is see more deals and choose the best deals amongst those that you do see, and so stay tuned for that. We're working on more initiatives ramping up our marketing, ramping up our referral networks, and I expect that, that should continue. While it's shown great progress to date, there's more to do and that is the focus that I have and the team has going forward. And with that, I'll end my prepared remarks and hand it back to the operator for questions.

[Operator Instructions] First question comes from Ed Sollbach of Spartan.

Great quarter, Alex. Have you guys given any thought to -- given the improved balance sheet to return to capital options, given that with the tremendous growth in book value, it seems like one of the -- I like buying quarters for $0.10. So if you could put some of that capital into your own shares, that would be a great deal seems to me.

Ed, thanks for being a long-term support. I really appreciate that support. And yes, of course, I mean, you know that historically, we've been strong advocates of buying, as we say, dollars for $0.50 quarters for dime. And in fact, if you look back at our history, we went from 44 million shares outstanding, again, to 30 -- low 30 million through various mechanisms, all of which was buying our book value at somewhere between 40% to 60% discount to then price either through an NCIB. And normal course were a bit of a substantial issuer bid or consolidation and buying out fraction of shareholders. So I believe in that -- and yes, with the capital that's on our balance sheet today, we have sort of a direct automatic [indiscernible] in place. That needs to be renewed. That will be renewed. It's a function of us getting out of a quiet period, and so you -- we will be as appropriate buying shares with our excess capital in the marketplace. I'm not going to commit to a value or a number, only point to the history that we've already bought back 10 million, 15 million shares, and that's proven to be probably one of our best investments is, believing in ourselves given the growth in book value we've had since that time. So yes, that will happen over time. I appreciate the question. And as I said, I appreciate the support.

No, it's been -- you're welcome because I like buying quarters for dime, too. So that's how I think of the shares. And I don't know if you can talk maybe about -- if you think about your funnel, if there's certain areas that seem to be more, I don't know, software or whatever. If there are certain areas that you see more opportunity versus other areas? I know generally, you're tech focus, but is there anything in terms of subsectors maybe that would give us some insight?

Yes. So let me start by saying what we don't do. We don't do real estate. We don't do primary resources -- resource extraction either energy or mining. It's just not our specialty. There's plenty of specialty funds out there and specialty investors to do that really, really well. Our primary objective is growth and growth self-selects for technology very often, but we're pretty agnostic when it comes to the business that the company is in. As I mentioned, our portfolio really is over, I don't remember, the exact number is, I think, well over 70% now in terms of a tech exposure. But within there having been a tech analyst and our team, by the way, as you probably remember, is highly skewed to tech background. There are multiple subsectors within tech. So when you say you're tech analyst, that literally could mean 20 different sectors. And so there isn't -- SaaS software is the sort of trend of the day over the last 5, 10 years, and I think it will continue to be there. So as a broad sector, we look at SaaS, but within SaaS, the subsectors that they perform in or that they live in could be different. And one could be B2B, one could be B2C, et cetera. So tech teams drive most of our investments. Growth is the overriding characteristic that's most important to us, and then we do deep dive due diligence. We do equity level investment due diligence on all of our investments because while we don't take equity level risk, our backgrounds are all equity investors, and we feel that's the best way to know our company is just to do that deep due diligence. So we invest in companies that have potential to scale rapidly. That tends to be technology companies because technology drives scalability, but within that, I wouldn't say that there's any one sector that stands out as being particularly interesting or important to us. It's more of a broad growth focus that we drill into as the opportunities come our way.

Okay. So -- but I noticed, I think you like the SaaS companies because they have recurring revenues, which helps pay back the loans, right?

Yes. Is that a simple way to think of it? Sure. Absolutely.

And so on that generally growth because I always think of it more as tech, but growth is really the -- so if I had like a growing pizza chain, would -- could I quote Flow and look for a loan?

Yes, we consider it. Maybe openly -- we consider roll-ups. One of our investment -- investees is a tech-based roll-up that company called Kovo that does -- that focuses on health care billing in the U.S., and they're rolling up. They have a tech platform, and they roll up on top of that tech platform. Other builders in a very fragmented industry in the U.S. So the concept of a roll-up isn't foreign to us. The concept of a franchise isn't foreign to us. There's still in our pipeline right now that we're looking at the franchise deal, but they have to be well managed. They have -- so as a minimum, if it's SaaS revenue, they need to be generating $3 million to $5 million in SaaS revenue. If it's non-tax revenue, they need to be generating more than $5 million in revenue. They need to be at or near breakeven on a cash flow basis. So a little bit about the credit box. They have to -- we have to have -- our funding needs to get them to a cash flow breakeven or we have to have very, very strong conviction that their venture investors and partners will be there to -- we're basically bridging to the next round in this current environment with the uncertainty in the equity funding marketplace. We're really bridging to breakeven, if not already breakeven. So there's a lot of things that we look at beyond just the sectors that they're in, but yes, we will look at a growth company even if it's not tech related. We don't have as many of those in our portfolio, but we're relatively open to good management teams with really strong business fundamentals that are trying to fund their growth in a minimally dilutive way.

Okay. Last question. So just in the macro environment, like it's getting tighter with rising rates and stuff. So in terms of your hurdle rates, like as interest rates climb, does your hurdle rate climb? Or are you still happy with what it was?

Yes. So our -- the loans that we do to date are generally fixed, they're not a variable rate. We are adding variability to our term sheets that we're issuing now. I'm not really worried about the existing portfolio. The relative term on the portfolio is relatively short, and I don't see there's a lot of risk. Going forward, we are adding a variable mechanism in there. It's not one that kicks in day 1, there's going to be a hurdle and above the hurdle, it floats. So we're conscious of that risk, and we're working to minimize it in terms of -- when we look at future investments. But I'm not -- it's not something that concerns us, to be honest, at this point in time. We recognize it. We're managing to solve it going forward, but it's -- I don't feel it's a high risk in our business right now.