Earnings Call Transcript - AGM Q1 2022

Jalpa Nazareth, Director of Investor Relations and Finance Strategy

Good afternoon, and thank you for joining us for our First Quarter 2022 Earnings Conference Call. I’m Jalpa Nazareth, Director of Investor Relations and Finance Strategy here at Farmer Mac. As we begin, please note that the information provided during this call may contain forward-looking statements about the Company’s business strategies and prospects, which are based on management’s current expectations and assumptions. These statements are not a guarantee of future performance and are subject to risks and uncertainties that could cause our actual results to differ materially from those projected. Please refer to Farmer Mac’s 2021 annual report and subsequent SEC filings for a full discussion of the Company’s risk factors. On today’s call, we will also be discussing certain non-GAAP financial measures. Disclosures and reconciliations of these non-GAAP measures can be found in the most recent Form 10-Q and earnings release posted on Farmer Mac’s website, farmermac.com under the Financial Information portion of the Investors section. Joining us from management this afternoon are our President and Chief Executive Officer, Brad Nordholm, who will discuss first quarter business and financial highlights and strategic objectives; and our Chief Financial Officer, Aparna Ramesh, who will provide greater detail on our financial performance. Select members of our management team will also be joining us for the question-and-answer period. At this time, I’ll turn the call over to President and CEO, Brad Nordholm. Brad?

Brad Nordholm, CEO

Thanks Jalpa, and good afternoon, everyone. I’m really pleased that you’re able to join us today. I’m happy to report a very successful first quarter 2022. Our financial results are strong as we’ll be discussing, and we also are working to build upon a solid foundation for our future growth. We’ve provided a gross $3 billion in liquidity and lending capacity to lenders serving rural America in the first quarter 2022. This resulted in outstanding business volume of $24.2 billion as of March 31st. We generated consistent core earnings, and most importantly, our portfolio remained strong and credit performance continued to be stable with 90-day delinquencies and substandard asset ratios improving relative to the same period last year. The Agricultural Finance line of business, which is approximately 75% of our total outstanding business volume and comprises all products secured by first liens on agricultural real estate plus all USDA guaranteed loans grew approximately $500 million this quarter, or roughly 3%. And this is primarily due to our AgVantage securities, and Farm & Ranch loan purchase programs. We are pleased to see our strong institutional relationships and the overall dynamics of the macroeconomic environment that have resulted in our ability to return as an invaluable partner in the wholesale financing space. At the onset of the pandemic, opportunities for new business volume and our AgVantage securities program were limited, as liquidity support provided by the Federal Reserve Bank resulted in the tightening of investment grade credit spreads to historically low levels and increased competition. Net Farm & Ranch loan purchase volume was strong during the first quarter, despite its seasonally large number of payments. That’s because most of our Farm & Ranch loans have annual and semiannual payment terms with January 1st payment dates. During the first quarter, markets experienced the disruption caused by a combination of factors, including inflation, a federal funds rate increase, expectations of future increases, as well as the conflict in Ukraine. Farm expenses are rising in nearly all categories with higher grain, fertilizer, energy and labor prices driving the trend. And the impacts of these increases will vary by operation and commodity type. We believe the sector’s operating expense ratio is likely to increase back towards a historically high level. However, firm commodity and food prices do leave room for farm profits this year. The USDA is forecasting record net cash incomes for 2022. While production expenses are forecast to increase and government payments are expected to fall, rising cash receipts should offset these changes with recent commodity price data suggesting that even stronger incomes are possible. In terms of our portfolio, while we anticipate that lower financings could result in lower levels of new loan purchases in some of our Farm & Ranch and USDA products, it could also result in lower portfolio prepayment speeds. Our pipeline in this line of business remains strong. And we will continue to be adaptive as we navigate through this environment that is characterized by significant uncertainty. Our Rural Infrastructure Finance line of business grew nearly $150 million this quarter or 2%, primarily due to our loan purchase product. This growth was fueled by a competitive, but increasing interest rate environment, resulting in demand for long-term financing solutions for planned maintenance and capital expenditures. Also, contributing to growth this quarter in our rural infrastructure line of businesses was a $35 million commitment to a large solar project. As I’ve said on prior calls, renewable energy is both an important economic development opportunity for rural America, and it’s a business opportunity for us. Another business opportunity for Farmer Mac is our securitization program. As mentioned in our last earnings call, over the last few months, we’ve been focused on enhancing our infrastructure to support a securitization program, and we are closely monitoring a changing market dynamic. The market for newly issued securitizations was challenged during the first quarter, as the volatility in the debt capital markets resulted in somewhat of a slowdown in securitization markets. We remain committed to being a regular issuer in the market, with a diverse set of securitized products that align with our investor interests. With that said, in the near term, our plan is to slowly ramp up the number of issuances each year as we focus on building a strong foundation for the program. Farmer Mac continues its measured and thoughtful investment in people, technology and business infrastructure to improve our capacity and efficiency. We believe these will help us deliver on our long-term goals. We set meaningful market share goals for ourselves in our strategic plan. And to achieve these goals over the long run, we need to be able to achieve gross annual business volumes that represent growth over our current asset levels. That’s an example of our efforts to upgrade our technology platform, including doubling the eligible loan size for AgXpress scorecard products from $1.5 million to $3 million. This upgrade and enhancement of our underwriting solution will require appropriate investments. Another initiative currently underway at Farmer Mac is our rebranding efforts, which are in early stages. We recognize that we have grown significantly in size over the last few years. As a result, we are reaching a larger set of audiences and stakeholders with different profiles, but all with a shared passion for rural America. We hope that through our rebranding initiative, we’re able to gain deeper insight from each of our stakeholders in order to continue to build on our strong reputation as the nation’s key trusted secondary market for credit to rural America. The continuity of our culture and business model continues to deliver consistent, positive results. With the support of our Board, we believe that our unified commitment to Farmer Mac’s strategic plan in conjunction with the organization’s talented and committed employee base is enabling us to take Farmer Mac to the next level. Now, I’d like to turn the call over to Aparna, our Chief Financial Officer, to discuss our financial results in more detail. Aparna?

Aparna Ramesh, CFO

Thank you, Brad. And good afternoon, everyone. Core earnings for first quarter 2022 were $25.8 million, or $2.37 per diluted common share, compared to $30 million, or $2.75 per diluted common share in fourth quarter 2021 and $25.9 million or $2.39 per diluted common share for the same period last year. The sequential decrease was due to the non-recurrence of the fourth quarter 2021 $5.2 million after tax gain on sale of mortgage loans, a net change in our total allowance for losses of $1.1 million after tax and a $0.7 million after tax increase in operating expenses. These factors were partially offset by a $2.8 million after tax increase in net effective spread. The year-over-year decrease in core earnings was primarily due to a $2 million after tax increase in operating expenses and a $1.5 million increase in preferred stock dividends. These factors were partially offset by a $3.1 million after tax increase in net effective spread. Net effective spread for first quarter 2022 was $57.8 million, an approximate 7% increase compared to fourth quarter 2021 and the same period last year. The sequential and year-over-year improvement in net effective spread was primarily driven by net new business volume and cash basis interest income. Also contributing to the year-over-year increase was an increase in net coupon yields related to the acquisition of loan servicing rights in third quarter 2021. Our liability side of the balance sheet remains strong as we continue to benefit from our dynamic funding strategies that we’ve outlined to you in the past, and we’ve continued to maintain our disciplined asset liability management. Additionally, we continue to very carefully analyze our duration and convexity matches, especially in this rising rate environment to minimize our interest rate risk. Last quarter, we introduced operating segments to allow us to offer more transparency into the various contributing components of our portfolio’s net effective spread. We’ve implemented a funds transfer pricing, or FTP methodology. This process allows us to allocate interest expense much more accurately to each of the operating segments. Since funds transfer pricing or FTP assumes a matched-funded asset liability management approach, it allocates both the benefits as well as the cost from the funding and hedging strategies to the funding segment. This also allocates the results of the investment portfolio that we primarily hold for liquidity purposes. We believe that the new segment reporting construct provides shareholders and other stakeholders with clearer insight into the benefits of our disciplined ALM practices and dynamic funding strategies and how they ultimately contribute to enterprise profitability. The successful execution of a $299.4 million agricultural mortgage-backed securitization in October was a key contributor to our core earnings results in the fourth quarter of 2021. While we have spent the last few months identifying ways to potentially execute these transactions more efficiently and we hope to return to the market this year with another securitization transaction, we are taking a more measured approach in the short term, just as Brad mentioned, recognizing that current market dynamics are resetting credit market perspectives and outlook. First quarter 2022 was extremely challenging for the securitization market, as the evolving macro rate environment has contributed to spreads that are widening and interest rate volatility that is increasing throughout the quarter. We are, however, still committed to building a robust securitization program, which we believe will provide Farmer Mac with an opportunity to diversify funding sources and fulfill our mission of delivering low-cost liquidity even more effectively. Our current focus therefore is strengthening the platform and remaining opportunistic in terms of timing and structure to ensure we are not issuing in the face of volatility and uncertainty and that we continue to create value for our shareholders with these and other transactions. Operating expenses increased by 13% in the first quarter of 2022, compared to the first quarter of 2021. This was primarily due to increased headcount, including 10 new employees in connection with the strategic acquisition of loan servicing rights in the third quarter of 2021, increased staff compensation, and increased spending on software licenses and information technology and other consultants to support growth and strategic initiatives, some of which Brad mentioned earlier. The increase in loan servicing expenses is expected to be offset over a multiyear period by additional revenue that will be reflected in higher spreads in our Farm & Ranch segment, where we will not be paying a third party for servicing the loans that we will now service, making the initiative neutral to accretive for us in momentum. The remaining hires were brought on to drive additional volume growth and support our long-term technology strategy. We plan to continue our investments in both headcount and technology through 2022 and into 2023. This will primarily modernize and mitigate risk in our infrastructure, enhance the technology platforms to support our revenue and hedging strategies, and add relevant talent across the organization, especially as we scale and enter into new areas of business such as renewable energy and telecom. Over the next 12 to 18 months, we’ll continue as we’ve done before to closely monitor our efficiency ratio, which ended March 31, 2022, at 33%. Going forward, we expect operating expenses to increase commensurately with revenue growth. But as we noted previously, we expect to stay within an annual range that is consistent with our historical averages and below a 30% operating efficiency level. Our credit profile continues to be strong. As of March 31, 2022, the total allowance for losses was $16.3 million, a modest decrease from year-end 2021. This decrease was primarily attributable to a risk rating upgrade on a single loan related to the borrower’s successful securitization of a large payable that was incurred as a result of the Arctic freeze that struck Texas in February of 2021, and this was partially offset by new loan volume. Turning to capital now, Farmer Mac’s $1.2 billion of core capital as of March 31, 2022, exceeded our statutory requirement by $489 million or 66%. Core capital modestly increased from year-end, primarily due to an increase in retained earnings. Our Tier 1 capital ratio improved to 15% from 14.7% as of December 31, 2021. Subsequent to our February earnings call, the outlook for interest rates has changed materially. Low levels of unemployment and continued supply chain disruptions exacerbated by the situation in Ukraine have pushed inflation to levels not seen since the early 1980s. Interest rates began to rise even before the Federal Reserve raised its Fed Funds target in late March. Rate hikes are predicted to occur more quickly than we anticipated at the beginning of the year. We locked in low fixed-rate funding over the past two years, and that has positioned us extremely well to withstand either a rising or flattening rate environment. Despite rising rates and higher input costs that are experienced by our borrowers, credit quality remains strong, given the increase in commodity prices that has outpaced the increase in input costs. We’re managing expense growth thoughtfully as mentioned before and commensurately with revenue growth as we navigate this volatile rate environment and our opportunities. We are, however, overall very well positioned for the future and excited about the opportunities ahead of us. And with that, Brad, I’ll turn it back to you.

Brad Nordholm, CEO

Thank you, Aparna. We experienced a strong start to 2022. We are delivering well on all of our initiatives. And we believe we’re well positioned to deliver strong financial performance and consistent returns to shareholders over the rest of 2022. Farmer Mac has significantly increased its profile and name recognition over the last few years, and we believe this will help us as we bring new capital to agricultural and rural communities of America. And now, operator, I’d like to see if we have any questions from anyone on the line today.

Operator, Operator

And the first question will come from Marla Backer with Sidoti. Please go ahead.

Marla Backer, Analyst

Could you provide more insight into how the current geopolitical and economic situations are influencing grain prices? You mentioned in your prepared remarks that these factors are affecting the credit quality of your overall portfolio. Do you anticipate this having an effect on increasing your business volumes in the future?

Brad Nordholm, CEO

Yes. Marla, thanks so much for that question. And obviously, this is an extremely volatile environment in which we’re operating. Not only are we dealing with increases in interest rates, but the global events are having a significant impact on commodity prices, including agricultural prices and the inputs into agricultural production. I’m going to ask Zach Carpenter to comment on the business outlook and how we’re seeing the combination of rising interest rates and volatility, as well as generally good conditions in American agriculture impact originations. I’m also going to ask Marc Crady to comment a little bit on credit quality. But let me begin by saying that the overall condition of American agriculture, while these price changes are unnerving, the outlook, as I said, remains generally quite positive with anticipated record levels of earnings in American agriculture in 2022. So, if you look at the commodity sheets, we’re seeing corn approaching $8 a bushel, we’re seeing wheat over $10 a bushel. But at the same time, we’re seeing natural gas at $7.50. We’re seeing global oil at over $100 a barrel. So, agriculture has the effect of rising costs of inputs, but it also is seeing a level of agricultural commodity prices that we haven’t seen, frankly for about 10 years, and that’s both on a real as well as nominal basis. But let me turn it to Zach and let him add some color on how we’re seeing that translate into ebbs and flows in demand for credit. And we’ll carefully distinguish between demand for short-term operating credit, which may be a function of commodity prices for inventories, and longer-term trends as it relates to land. Zach?

Zach Carpenter, Analyst

Thank you, Brad and Marla, for your great question. Brad explained it very well. The many components entering the market are causing some hesitation. Record grain prices are benefiting farmers financially, allowing them to continue with real estate transactions. However, we've experienced the fastest rise in interest rates for our products in many years, leading to significant sticker shock from the increase. This, along with ongoing market uncertainties, contributes to the hesitation. In the food and agribusiness sector, we’ve seen a noticeable decline in transaction volume compared to the first quarter of 2021, mainly due to uncertainty and the need to ensure transactions occur at the right time. Overall, our borrowers are in a strong position. Historically, even with a significant rise in interest rates, debt remains relatively affordable. As Brad and Aparna mentioned, we had a solid quarter in Farm & Ranch loan purchases in the first quarter of 2021. We are evaluating the market and aiming to be flexible and competitive with our rates, supporting sellers, lenders, and their borrowers during this challenging period. Once again, we are assessing the market conditions and uncertainties while continuing to support our customers in a strong economic environment for commodities and agriculture with our products and services.

Brad Nordholm, CEO

Marc, could you add anything relative to credit quality and what we’re actually seeing in the numbers right now?

Marc Crady, Analyst

Yes. Let me start off by saying that current credit quality is fairly strong, as evidenced by strong farm incomes over the last year. Going forward, as mentioned, volatility has been very high, input costs have been very high, but we expect farm incomes to continue to be strong in 2022. So, from an overall credit quality perspective in the portfolio, we expect it to continue the strong performance. That doesn’t mean that there may be some operators, some producers, some farmers and ranchers in some commodity sectors that won’t experience some level of distress. But generally speaking, we’re optimistic in terms of continued high-quality credit performance.

Marla Backer, Analyst

Okay. Thank you for that comprehensive answer, or those comprehensive answers. And then, just one follow-on, which is a lot of the factors that you noted, we’re seeing, obviously, uncertainty impact a lot of sectors and a lot of general demand for financing and for transactions. Given where you sit and how you have access to capital, that certain other institutions don’t, how do you see this playing out in terms of perhaps providing some opportunity for market share gains, or do you see it playing out that way?

Brad Nordholm, CEO

There are opportunities, and they’re in different corners of our portfolio and our lines of business, I think, Marla. For example, right now, one of the impacts that the rapid run-up in commodity prices is happening is that farmers are drawing on their operating lines of credit heavily. That is resulting in banks that have agricultural concentration, including farm credit banks, experiencing rapid and, in fact, quite unexpected run-ups in asset levels. In some cases, this is putting some pressure on capital. So one, not the only driver, but one of the drivers of the increase in AgVantage activity at the very end of the quarter was because of just that. So interesting to think about how it translates into new opportunities. With the steepening of the yield curve, it is a bit distracting from one of our real core competitive advantages, which is at the long end of the curve, very long-term fixed-rate mortgages. But we have the ability, and in fact, our rate sheets publish offerings across the full curve, and we do short-term variable-rate financing as well. So, we may see some pickup there, and that may be a second example of the kind of opportunity that you’re alluding to. The third thing I’d just mention is that we are extremely disciplined in how we price our loans and our asset liability management. We’ve talked about that on numerous occasions before, but we pretty much match all of our business activity to current, meaning real-time, this minute, this hour, this day debt capital market conditions. So, when we first saw the rapid run-up in interest rates, that was reflected immediately in our rate sheet. Some of our competitors like the market a bit. That was a little bit of a disadvantage for us. But as they catch up, it then begins to translate more into an advantage for us. So, those are three specific ways that we could see some increasing demand per product amidst this unprecedented volatility that you’re referring to.

Operator, Operator

The next question will come from Gary Gordon, investor. Please go ahead.

Unidentified Analyst, Analyst

Okay. Thanks a lot. I appreciate your taking my questions. A couple about interest rates, first, on your existing portfolio. Obviously, you’ve got a variety of hedges to limit interest rate risks due to obviously dramatic market shifts in Q1. Did that cause any adjustments to the hedges or anything needed to be done to maintain the stability in the portfolio?

Brad Nordholm, CEO

Gary, one of the benefits of having the kind of volatility is that we are going to prove to you what we’ve been talking about for years, and that is the discipline of our asset liability management. And so, I think the short answer is no. But let me turn to Aparna to give you a little color on just exactly why that is.

Aparna Ramesh, CFO

Yes, Gary. You can actually see some of this volatility reflected positively in our net income profile. We don’t hold derivatives for speculative purposes; rather, our focus is on managing our asset liability management effectively. In response to Brad and Marla's earlier questions, it comes down to our pricing strategy. We have significant advantages as we don’t assume any basis risk or underlying interest rate risk, which we manage through our derivative activities. This allows us to align our funds and issue positions that help us nearly eliminate our interest rate risk. When you consider all these factors, it may seem complex, but we're actively evaluating it. We have gained benefits from some decisions made in the last two years, particularly in the current rising rate environment. There's a lot to discuss, but the short takeaway is that it remains an advantage for us in how we fund and manage our balance sheet through our portfolio.

Unidentified Analyst, Analyst

Okay. Thanks. Second one is typically in volatile markets, spreads widen out. You can discuss a minute your own funding costs versus treasuries and then maybe more importantly, available spreads for new investment?

Aparna Ramesh, CFO

Sure. Let me take that first part of your question in terms of our funding costs. And we are seeing definitely a widening of our funding. But I will say that when we look at where we are relative to our competitors, and by that I mean the Farm Credit Funding Corp or other GSEs, we typically on the long end of the curve maybe been somewhere between 5 to 10 basis points on top of that. So, everyone is seeing widening across the board relative to what’s happening. But I think also as a GSE, maybe from a credit standpoint, credit spreads widening out, we are not seeing as much relative to other issuers. But, we are seeing the same dynamics that we’ve seen in the past two years relative to other GSEs. We’re not seeing anything very different. As far as it relates to us specifically and again. I’ll reiterate this. Over the last two years, we’ve really been very opportunistic, whether it’s on our capital stack through preferred issuances or whether it’s been through extending our debt funding. I think the treasury team has done a very, very good job of really extending our liabilities. Now, we can be very opportunistic in terms of when we want to go out there and fund at the long end of the curve. So, we have a little bit of a bias not to do that until the volatility settles down, but we have an abundant amount of really debt funding at all points on the curve. So, we can really manage our interest rate profile and our debt profile fully opportunistically.

Unidentified Analyst, Analyst

Okay, good. One last question on the net interest margin. You said it was 97 basis points operating basis this year, the same as last year. The servicing business, obviously, the expenses of it run through operating expense, the revenue, is there a way to estimate how much of an impact it had or benefit to the net interest margin?

Aparna Ramesh, CFO

Yes, we can revisit this topic. It’s still early to provide a clear sense of the situation. About a third of the Farm & Ranch portfolio is expected to go back into the servicing business. When examining our incremental volume, particularly in the first quarter, we are experiencing some shifting dynamics influenced by additional fee payments related to Farm & Ranch. Therefore, the impact on the reported 97 basis points may be minimal at this point. However, over time, you should expect to see an increase of around 18 to 25 basis points on one-third of our net incremental volume. That’s likely how to approach this.

Unidentified Analyst, Analyst

Nice. And one last question on operating expenses. You mentioned your efficiency ratio is 33% today, and you have spending plans for the next 4 to 6 quarters. Ultimately, you aim to achieve an efficiency ratio below 30%, which is a significant target. Is this a long-term goal or is there a three-year plan in place to reach 30%? How should I approach this?

Aparna Ramesh, CFO

Yes. Let me jump in, and I’m sure Brad or others might want to add to this. In the first quarter, revenue typically exceeds 30%. Historically, we've seen this in the first quarter of last year and the quarter in 2020. One factor we've observed is that compensation often stands out. We believe we've effectively managed our compensation run rate and kept it reasonable, consistent with last year and the year before. As we normalize toward historical averages for the rest of the year, we expect to continue investing in technology and headcount, which will maintain a high efficiency ratio. Additionally, there will likely be an increase in loan activity in Q1 due to typical seasonality in prepayment, which also tends to elevate that efficiency ratio. However, we anticipate a slight decrease without significant changes, despite potential for large fluctuations. Another point to consider is the seasonality of compensation that will carry into the remaining quarters. The acquisition of servicing, which generally has higher efficiency ratios compared to our other operations, will likely continue this trend. Regarding your earlier question about experiencing those spreads as we service that volume and gain additional spread, all of this will positively impact the denominator of that efficiency ratio. We are optimistic about managing our efficiency ratio to stay below 30% on an annualized basis.

Brad Nordholm, CEO

Yes, Gary, to elaborate on that, in Q1 2021, our efficiency ratio was between 32% and 33%. In Q1 2020, it was between 22% and 23%. While this current figure is slightly higher, it is not significantly outside the norm. Specifically, our goal for fiscal year 2022 is to reduce the efficiency ratio to 30% or below.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Brad Nordholm for any closing remarks. Please go ahead, sir.

Brad Nordholm, CEO

Well, thank you, operator, and thank you all for participating in the call. As always, with follow-up questions or things that you’d like to have clarified, please get in touch with Jalpa, and we’ll put together the right people to answer your questions. This is the time of great volatility. But I think you’ve heard optimism on this call today, and you also heard confidence. That real confidence comes from Farmer Mac’s business model. It is designed from an asset liability standpoint, from an origination standpoint to be highly resilient. While we don’t know exactly where commodity prices and interest rates will be 6 months from now, we do know that the way we’re structured, we’re positioned to continue to deliver steady results and to fulfill our mission of serving American agriculture. So, I’ll just leave you with that thought. Thank you very much for participating, and I look forward to talking to you all soon.

Operator, Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.