Earnings Call Transcript - CASH Q3 2025

Operator, Operator

Ladies and gentlemen, thank you for standing by, and welcome to Pathward Financial's Third Quarter Preliminary Earnings Conference Call. As a reminder, this conference call is being recorded. I would now like to turn the conference call over to Darby Schoenfeld, Senior Vice President, Chief of Staff and Investor Relations.

Darby Schoenfeld, Senior Vice President, Chief of Staff and Investor Relations

Thank you, operator, and welcome. With me today are Pathward Financial's CEO, Brett Pharr; and CFO, Greg Sigrist, who will discuss our preliminary operating and financial results for the third quarter of fiscal 2025, after which we will take your questions. Additional information, including the earnings release and the investor presentation that accompanies our prepared remarks, may be found on our website at pathwardfinancial.com. As a reminder, our comments may include forward-looking statements. Those statements are subject to risks and uncertainties that could cause actual and anticipated results to differ. The company undertakes no obligation to update any forward-looking statements. Please refer to the cautionary language in the earnings release, investor presentation, and in the company's filings with the Securities and Exchange Commission, including our most recent filings for additional information covering factors that could cause actual and anticipated results to differ materially from the forward-looking statements. Additionally, today, we will be discussing certain non-GAAP financial measures on this conference call. References to non-GAAP measures are only provided to assist you in understanding the company's results and performance trends, particularly in competitive analysis. Reconciliations for such non-GAAP measures are included in the earnings release. Finally, the financial information we will discuss is preliminary pending our previously disclosed restatement. These results incorporate our current view of the new accounting methodology under which we recognize certain relationships in the Credit Solutions business within held-for-investment loan balances on a gross basis. The company's actual results may differ materially from these preliminary financial results. All time periods referenced are fiscal quarters and fiscal years, and all comparisons are to the prior year period, unless otherwise noted. Now let me turn the call over to Brett Pharr, our CEO.

Brett L. Pharr, CEO

Thanks, Darby, and welcome, everyone, to our preliminary earnings conference call. The strategy that we set out to accomplish at the start of our fiscal year 2025, being the trusted platform that enables our partners to thrive, remains our main focus. We've made progress on many fronts, and I'm incredibly proud of what our team has been able to accomplish over the past 9 months. This strategy starts with balance sheet optimization where the assets that we choose to originate must have either a high risk-adjusted return or optionality that can also generate fee income growth and higher return on assets. The success of our commercial business lies in our ability to operate in niche markets or be creative with our loans due to our collateral management capabilities. Because of this approach, we operate in a unique position where we can offer structures to our clients that traditional banks may not have the ability to. This differentiation matters as our customers are able to receive the financing that meets their needs. And because of our stable deposit base, we are able to provide our clients, typically small- to medium-sized businesses, loans at attractive rates. These loans are originated across the country through a combination of an in-house business development team, referrals from other institutions, or through partners. In the third quarter, we continued to see strong originations within commercial finance at solid yields. The team has done a tremendous job redeploying the additional capital that was generated earlier in the fiscal year with the sale of some of our loans and securities. The funds generated were almost $1 billion, and we originally believed it would take us 12 to 18-plus months to redeploy the funds from just the insurance premium finance sale and corresponding security sale. I'm excited that we were able to accomplish it in a shorter time frame. In addition, credit sponsorship, which we have been providing since 2018, is another area where we are starting to see some additional opportunities. As we announced on our last earnings call during the June quarter, we signed a contract with a new credit solutions partner to originate loans through their lending marketplace. This business gives us an alternate way to leverage our balance sheet and generate sustainable fee income. With the second part of our strategy, we have been investing in technology to help us evolve and scale our product offerings. This gives us the opportunity to focus on delivering sustainable fee income growth since our ongoing investment in technology is particularly impactful when we think about partner solutions. We are building and scaling products that allow us to co-innovate with some of the largest players in the business. This approach has helped to fill our pipeline in Partner Solutions, which remains strong. This year, Pathward contracted for 11 opportunities to expand products with existing or new partners. One area where our investment has paid dividends is acquiring. This product has experienced triple-digit revenue growth year-to-date. After the quarter closed, we signed a multiyear deal with Checkout.com for acquiring sponsorship and are excited about the upcoming partnership. The progress both our partner solutions and technology teams are making is very important and is allowing us to bring multi-threaded solutions to our partners. We believe continued investments in technology will continue to drive growth with our existing partners and enable us to partner with new clients as well. Third, and something that I am incredibly proud of are our people and culture. Recently, Pathward was named one of the best companies to work for by U.S. News and World Report for 2025 to 2026 on the finance and insurance list and the Midwest list. Our culture is driven organically by a sense of purpose, financial inclusion, a belief in giving back to our communities and a desire to work for a Talent Anywhere company that can be a greater partner and solutions provider. This has also earned Pathward the Great Place To Work Certification for 3 years in a row. This type of recognition is humbling and a true testament to the strength of our people who continue to execute against our objectives and purpose. The final component is risk and compliance. As we grow our product offerings across the enterprise, we are able to showcase our experience and mature risk and compliance infrastructure that is supported by our three lines of defense. We understand the complexities of the industry and aim to remain nimble through the ever-changing regulatory environment while making the necessary investments in this area. It is our belief that strong execution of this strategy will continue to position the company well in future years and generate strong growth and returns for our shareholders. As a final comment, while we were very pleased with the performance of our tax team this year, they are already gearing up for next season. We have agreements with all of our tax software partners heading into the next tax season, including recently renewing our relationship with one of the largest tax software providers. The 3-year agreement lays the foundation for an expanded partnership. Overall, we believe that we have one of the most comprehensive product mixes in the tax industry and feel confident that we will continue to expand our network as we strengthen our relationships and continue our strong sales and marketing efforts. Now I'd like to turn it over to Greg, who will take you through the financials in more detail.

Gregory A. Sigrist, CFO

Thank you, Brett. As a reminder, all financial results shared today are preliminary pending our previously disclosed restatement. All results for comparison purposes reflect the new accounting methodology for the held-for-investment consumer loan portfolio with impacted balances totaling $191 million at June 30. We're very pleased with our third quarter results that show the impact of our strategy. Our focus on balance sheet optimization has contributed to increasing net interest income over the past few years. We are encouraged by the stability of our net interest income and net interest margin when compared to the prior year. Net interest margin in the quarter was 7.43% and adjusted net interest margin, which includes rate-related card expenses associated with deposits on the balance sheet, was 5.98%. Both of these expanded from last year's quarter, which were 7.26% and 5.76%, respectively, and when you compare them to the March quarter, which were 7.12% and 5.72%, respectively. Noninterest income grew 11% from the prior year. Tax solutions continued to produce results that outperformed last year's quarter and secondary market revenue and card and deposit fees were also higher. Secondary market revenue is benefiting from our balance sheet optimization strategy, part of which focuses on originating loans that have optionality and can generate fee income. As a reminder, we are generally targeting quarterly secondary market revenues in the range of $5 million to $7 million. Expenses in the quarter were elevated as we continue to invest in technology and compliance, which I indicated last quarter would occur in the back half of the year. This can be seen in the occupancy and equipment expense line, which includes our technology costs as well as legal and consulting fees. We expect legal and consulting fees to remain elevated in the fourth quarter and then to taper off into fiscal year 2026. Deposits held on the company's balance sheet at June 30 declined from a year ago, primarily due to the timing of when the quarter ended and the runoff of EIP deposits. Custodial deposits held at partner banks on June 30 were $431 million, an increase from $353 million a year ago. Loans and leases at June 30 increased when compared to last year. As Brett mentioned, this represents pretty significant growth since our prior year's total loan balance included insurance premium finance loans, which were sold earlier this year. Additionally, the yield on new originations on commercial finance loans during the quarter was 9.55% as compared to the March quarter yield on average balances of 8.24%. Our allowance for credit loss, excluding our seasonal tax service lending, was 160 basis points in the quarter with an annualized net charge-off rate in the quarter of 52 basis points. As we mentioned before, our NPL ratio can be a bit lumpy from time to time, but then recover in the next quarter or two as the loans either return to performing or we are able to recover the collateral. In the June quarter, the increase in nonperforming loans was driven by three loans in different loan verticals. One was related to fraud but is well-collateralized relative to carrying value. The other two we expect to either return to accrual status or to result in recovery that will cover the majority of, if not the full balance. This is what makes our commercial finance team so successful, how we remain comfortable with our credit book and why we focus on the net charge-off rate versus NPL ratio. Our liquidity remains strong with almost $2.7 billion available. This is higher than where we were last year at this time, and we're extremely pleased with our position. During the quarter, we were able to repurchase approximately 604,000 shares at an average price of $74.49. This brings year-to-date repurchases to almost 1.9 million shares. Based on our preliminary analysis, this accounting change should have a negative impact on net income in fiscal 2022 and 2023, primarily due to the increase in provision that will be recognized early in the life of the contracts as the portfolios ramp up. The inflection point appears to be 2024 when the impact of the recognized credit enhancements begins to flow through as the portfolios approach a steady state, thus producing higher net income. However, should these portfolios remain in this steady state, we would expect them to have a more muted impact on fiscal fourth quarter 2025 and full year 2026. Therefore, for fiscal year 2025, we are expecting a preliminary EPS range of $7.50 to $7.80. This includes the following assumptions: one rate cut in fiscal Q4 of 2025, an effective tax rate of 16% to 20%. For fiscal year '26, we are introducing a preliminary EPS range of $8.25 to $8.75, which includes the following assumptions: no rate cuts during the year, an effective tax rate of 18% to 22% and guidance for fiscal year 2025 and fiscal year 2026 includes expected share repurchases. I'd like to reiterate again that these are preliminary numbers pending the outcome of our restatement. This concludes our prepared remarks. Operator, please open the line for questions.

Operator, Operator

The first question comes from Joe Yanchunis with Raymond James.

Joseph Peter Yanchunis, Analyst

So it appears the accounting change is taking a little longer to remedy than expected. Can you discuss how much of a distraction this has been for management? And if you have a sense on when we could expect the new filings?

Gregory A. Sigrist, CFO

Well, I think the accounting methodology is up from a distraction perspective. We've got the lion's share of it behind us, Joe. There's a lot of processes though that go into working back through 13 quarters, which is what it takes and then redrafting a super 10-K and whatnot. So I would say we're probably in the middle to later innings in terms of getting it completely done and behind us. So we're obviously comfortable enough with the methodologies, and we're far enough along on all the quantifications that we felt comfortable putting out these preliminary numbers. And you probably have noticed in the IR deck itself in the back, we actually put in 8 quarters of the new balance sheet and income statement with the new accounting. So that should give you a sense of kind of where we are at the comfort level.

Joseph Peter Yanchunis, Analyst

Okay. I appreciate that. And kind of sticking on this topic and perhaps I missed this, but can you quantify the incremental expenses associated with the accounting change? And then can you give a sense for how much earnings will be pulled forward from prior periods to future periods?

Gregory A. Sigrist, CFO

So that was the origin of the 8-quarter table we provided. Unfortunately, you'll need to wait until we file the restated 10-K to see the complete figures for 2022 and 2023. However, as I mentioned, you should expect lower income in those years due to the provisions we established. As disclosed in our 8-K filing, we will not benefit from the contractual waterfall payments for credit enhancements until we actually receive them, which will significantly occur in 2024. When you review the quarterly numbers we shared in the investor relations deck and compare them to the reported figures, you'll notice additional income in 2024, after which it tends to stabilize. The impact over the last 3 to 4 quarters has been relatively muted and flat overall. Regarding your other question about expenses, analyzing the figures at a line item level will reveal the quarter-on-quarter impacts for that time horizon.

Joseph Peter Yanchunis, Analyst

Okay. I appreciate that. Yes, I haven't had a chance to dig through everything yet, just kind of given the restatements that were there. But kind of shifting over to credit quality. It looks like there was a little degradation in the quarter, and you attributed the increases in NPLs to the commercial and consumer finance portfolios. Can you provide a little more color on what occurred?

Brett L. Pharr, CEO

Yes, this is Brett. The situation we’re discussing involves three distinct events that arise occasionally across different areas of our business. These are not related to a broader portfolio issue; they are simply individual stories. As Greg mentioned earlier, one of these events was related to fraud, and we've taken the necessary measures to account for it. We are confident that we can manage our collateral to address this. The other two situations are actually showing positive trends and are well-supported by collateral as well. So, there is no overarching credit concern here; these are unique, separate incidents. We have experienced similar situations before, and we concentrate on the net charge-off rate because many of these instances can lead to recoveries, thanks to our strong collateral management.

Joseph Peter Yanchunis, Analyst

Appreciate that. And then kind of last one for me here. I just want to kind of zoom out a little bit. So AI has been a pretty big theme across the market over the past year or so. And as a tech-forward bank, can you discuss your strategy around AI and if that's something you're pursuing and how you think that could benefit, say, the P&L over the near to intermediate term?

Brett L. Pharr, CEO

Yes. Like many forward-thinking companies, we are exploring AI to improve efficiency in office tools and software engineering. Eventually, this may enhance our development capabilities, which is a common approach among innovative companies. In banking, it's crucial for us to carefully consider information security and ensure that our models are well tested. We are actively working on this, and we anticipate that it will lead to efficiencies over time. A particularly exciting aspect for us is the third-party delivery of banking services, which means we are accountable for our partners' actions that affect consumers. AI presents many opportunities for us to analyze full datasets more efficiently and swiftly, which should ultimately improve our cost structure. Regarding your question about its impact on the P&L, I don't expect to see significant effects in the next couple of years. However, we may experience a slower increase in costs as we handle more volume. That said, I don't foresee any dramatic changes in the near term.

Operator, Operator

There are currently no other questions in queue. The next question comes from Tim Switzer with KBW.

Timothy Jeffrey Switzer, Analyst

Just jumped over from another call. One of the questions I had, and apologies if you've talked about this, but I believe you guys maybe have one or two partners with some crypto-related partners. And I'd love to know kind of what products you're offering there, what your services are? And then have you guys explored any opportunities internally to develop any kind of crypto-related products on your side, maybe a stablecoin or anything like that, or how you could support the growth in this industry going forward?

Brett L. Pharr, CEO

You are correct in noting that we have been providing access devices in U.S. dollars to partners that offer crypto-related digital wallets for some time. This allows them to facilitate the onboarding and offboarding of assets from their consumers' or investors' wallets. This has been a significant part of our operations, and we are adept at it and enjoy doing it. Being in the payments industry, we are certainly exploring all these options, and there are numerous use cases that we could consider as a tech-forward bank, which may put us ahead on some fronts. However, there is a lot of change happening right now, so it will take time to see how everything develops. It’s important to note that our focus is primarily on consumer transactions, though we do engage in some B2C and limited B2B activities. The early use cases in this sector may lean more towards B2B or international transactions, which might not be our immediate focus. Nevertheless, we will continue to assess various use cases, collaborate with our partners and networks, and determine the best approach moving forward. This area is here to stay, and we will likely need to be involved.

Timothy Jeffrey Switzer, Analyst

Okay. Yes. Makes sense. And then can you provide an update on the credit trends you're seeing in the portfolio, particularly within the commercial finance? Is there any pressure at all from some of the macro uncertainty or anything like that, or higher rates? Or are most of your borrowers still doing pretty well?

Brett L. Pharr, CEO

They're doing very well. We noted in our comments that NPL bumped a little bit this time. You can go back and see that, but there are three credits that are episodic, and they're in different verticals that each have their own story, and we're handling those correctly, and they're collateral managed, and they're covered one way or the other. So we tend to manage that net charge-off line because even when there is a write-down, oftentimes because of our collateral managed approach, they go right back up. So no trends, no story, no industry that's in it. We generally do not do commercial real estate, which is important to note. So we're in good shape.

Timothy Jeffrey Switzer, Analyst

Okay. And then can you update us on the partner pipeline in your Banking-as-a-Service business? How is that trending? I assume, still pretty robust. And then what are some of the more near-term opportunities you guys are seeing within embedded finance specifically?

Brett L. Pharr, CEO

The pipeline remains strong. Following the recent industry reshuffle, many are seeking new primary or secondary banking partners. We are actively evaluating these opportunities. This year, we secured 11 contracts, either with existing or new partners. We are also exploring additional prospects. In terms of priority, I would rank our focus on consumer lending and marketplace sponsorship as very strong, followed by traditional issuing and payments. The emerging area of embedded financing is developing unique use cases that require careful navigation regarding funds flow. While these opportunities are promising, they may take longer to materialize compared to those in marketplace lending and issuing/payments.

Timothy Jeffrey Switzer, Analyst

Okay. Got it. And then the last question I have for you is your expectations to continue deploying capital through share repurchases?

Gregory A. Sigrist, CFO

Yes, nothing has really changed in that regard, Tim. As I mentioned in my prepared remarks, we've repurchased about 1.9 million shares this year, which is impressive. Given our ability to generate capital, we expect to keep buying back shares. However, I believe it will likely remain at a more subdued level next year. We still want to accumulate a bit more capital and be mindful of our share price. That said, based on the trends we've observed and our valuation multiple, we still feel optimistic about proceeding.

Operator, Operator

I'll now turn it back over to the management team for closing remarks.

Brett L. Pharr, CEO

Thank you, everyone, for joining our call today. Have a great evening.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect your line.