Consumer Portfolio Services, Inc. Q3 FY2020 Earnings Call

Good day, everyone, and welcome to the Consumer Portfolio Services 2020 Third Quarter Operating Results Conference Call. Today's call is being recorded. Before we begin, management has asked me to inform you that this conference call may contain forward-looking statements. Any statements made during this call that are not statements of historical facts may be deemed forward-looking statements. Statements regarding current or historical valuation of receivables because dependent on estimates of future events also are forward-looking statements. All such forward-looking statements are subject to risks that could cause actual results to differ materially from those projected. I refer you to the company's annual report filed March 16 and its quarterly report filed May 5 and July 31 for further clarification. The company assumes no obligation to update publicly any forward-looking statements, whether as a result of new information, further events or otherwise. With us here now are Mr. Charles Bradley, Chief Executive Officer; and Mr. Jeff Fritz, Chief Financial Officer of Consumer Portfolio Services. I will now turn the call over to Mr. Bradley.

Thank you for joining our third quarter conference call. In light of the pandemic and other global issues, it's encouraging that we had a strong quarter, indicating we're doing something right. Despite the challenges, we achieved solid earnings. We have shifted our focus more towards profitability rather than growth during these uncertain times. A few months ago, we decided to prioritize profitability over growth while navigating through the pandemic. We're beginning to see growth again, and we hope to accelerate that in the coming quarters. For now, concentrating on profitability has been effective, and we've made significant progress in reducing costs and strengthening our departments. The performance of our portfolio has been exceptionally strong, with our paper quality high and collections doing well. Both our charge-off and delinquency numbers are at their best in a long time. Wall Street is performing well too, and we recently completed a securitization at the lowest rates we've seen in six years, which benefits us broadly. Additionally, despite concerns about auction prices, we've experienced one of our best auction recovery quarters in years. Overall, many factors are aligning positively for us, including the quality of the paper we're originating and our strong access to Wall Street funds. I will provide more details after Jeff covers the financials.

Thanks, Brad. Welcome, everyone. Let's begin with the revenues. $70.7 million for the quarter reflects a 5% increase from the June quarter this year and a 17% decrease compared to the third quarter of 2019. The revenue for the first nine months of this year is $208.7 million, down 20% from the same period in 2019. We are continuing our transition to the fair value portfolio, which now makes up about 74% of the total at $1.7 billion, yielding 10.4%. Please note that this yield accounts for losses that are included in that figure. We recorded a $3.1 million markdown on the fair value portfolio, essentially an estimate of higher future credit losses due to the virus. Moving to expenses, we reported $64.8 million for the quarter, a 4% increase from the June quarter this year, but a 22% decrease from $82.7 million in the same quarter last year. For the first nine months, expenses totaled $195.1 million, a 23% decrease year-over-year. The most significant drop in expenses year-over-year is in the provisions for credit losses, along with notable reductions in most core operating costs, including employee expenses and interest expense, showing improvements and efficiencies across the board. Regarding provisions for credit losses, we booked $7.4 million on the legacy portfolio this quarter, an increase from $3.1 million in the second quarter this year but a decrease from $19.9 million in the third quarter last year. For the year, we’ve reported provisions for credit losses of $14.1 million, a 78% increase over $64.3 million for the first nine months of 2019. We adopted the CECL accounting method for the legacy portfolio in January, establishing an allowance for lifetime losses. The $14.1 million in recognized losses this year are considered COVID-related. Our pretax earnings for the quarter are $5.9 million, a 28% increase from the second quarter and a 111% increase compared to $2.8 million in the third quarter last year. Year-to-date pretax earnings stand at $13.6 million, up 64% from $8.3 million for the first nine months of 2019. Our net income for this quarter is $3.8 million, a 27% increase from $3 million in the second quarter this year and a 111% increase from $1.8 million in the third quarter of 2019. Year-to-date net income is $17.5 million, a 224% increase compared to the first nine months of 2019. This year's net income includes an $8.8 million tax benefit recognized in the first quarter due to the CARES Act, which altered the value of our deferred tax asset. The diluted earnings per share for this quarter is $0.16, a 23% increase over $0.13 in the June quarter and a 100% increase compared to $0.08 earned in the third quarter of 2019. For the year-to-date, diluted earnings per share is $0.74, compared to $0.22 for the first nine months of 2019. Please remember that the tax benefit accounts for about $0.37 of this year's earnings per share of $0.74. Now, moving on to the balance sheet, we maintain a strong liquidity position, with significant increases in restricted cash both quarter-over-quarter and year-over-year. Approximately $60 million of this increase is due to our securitization in September, which was shifted from its usual schedule because of pandemic-related factors. Concerning finance receivables, the allowance for the legacy portfolio has risen to 16%, reflecting substantial lifetime losses. On the debt side of the balance sheet, warehouse balances have decreased due to lower usage from decreased originations and our solid liquidity. For performance metrics, the net interest margin for the quarter was $45.8 million, a 12% increase from the June quarter of $40.8 million, but a 21% decrease compared to the third quarter last year. The nine-month net interest margin is $130.4 million, a 26% decrease from last year’s first nine months. The transition to fair value is influencing these numbers significantly, particularly year-over-year comparisons. The blended cost of all ABS debt this quarter was 4.4%, down from 4.5% in the third quarter of last year. We have generally performed well in executing the coupons and achieving favorable blended costs of funds for our securitizations this year. The risk-adjusted margin for the quarter reached $38.4 million, a 2% increase over the June quarter and also a 2% increase from the third quarter last year. Year-to-date risk-adjusted NIM is $116.2 million, reflecting a 3% increase over last year, influenced by lower provisions for credit losses and reduced interest rates on debt. Core operating expenses for the quarter, $32.5 million is a decrease of 2% compared to the second quarter of this year of $33.1 million and a decrease of 7% compared to the third quarter of 2019. The year-to-date core operating expenses $102.6 million is a 2% decrease compared to the first 9 months of 2019. So our operating costs this year, they've been somewhat influenced by the low originations volumes, but also influenced by investments we made in technologies, which made us more efficient, particularly on the servicing side of the business. And we're really starting to see some benefit from those changes. As a percentage, the core operating expenses for the quarter were 5.7%. That's a 2% increase over 5.6% in the June quarter this year, but a 2% decrease compared to 5.8% for the third quarter last year. On a year-to-date basis, it's also 5.8%, which is about the same compared to last year. So this metric is showing a year-over-year improvement even though we have a slightly smaller portfolio due to the lower growth this year. The return on managed assets, pretax, 1% for the quarter. That's a 25% increase compared to the second quarter this year and 100% increase compared to 0.5% in the third quarter of last year. And on a year-to-date basis, 0.8% return on managed assets, pretax, compared to 0.5% for the 9 months ended September 2019. So this encompasses all these things, the better efficiencies and the core operating expenses, lower interest expense, and lower provisions for credit losses.

Brad mentioned the credit performance. We're very pleased with the credit performance over the last two quarters, particularly. The delinquencies were 10.3%, which is nearly a 500 basis points reduction compared to September 2019. The net losses for the quarter were 6.4%, again, a significant reduction from 8.07% in September 2019, and the year-to-date losses were 6.9%, down from 7.9% for the first nine months of 2019. Brad also spoke about the auctions. Generally, dealers are finding it hard to obtain inventory, which has increased values at the auctions. We achieved a return of 45.1% of our collateral at the auctions this quarter, up from 34% in the second quarter and also up from 34% a year ago. I calculated that if the auction values this quarter had matched the historical average of around 34%, we would have faced $2 million more in charge-offs this last quarter. Even though these numbers are remarkably good and may revert to the average at some point, that's $2 million saved that we won't have to give back. Regarding the ABS market, we recently completed our securitization, the 2020C, which was a $252 million deal. There was strong demand across the capital structure, with all classes of bonds significantly oversubscribed. The combination of low benchmarks and tight spreads resulted in a blended yield of 2.39%, which is the lowest since 2014. Additionally, we managed to structure a Class F single B bond in this recent deal, which improved the leverage in the advance rate to preferable levels. With that, I'll turn it back over to Brad. Okay, let's discuss a few key points. As I mentioned, sales originations are performing very well. We've focused more on quality than on growth, although we are starting to grow again. It's been challenging to determine the right timing for growth given the pandemic and its uncertain developments. Nevertheless, I believe we've handled it quite well by increasing profitability and tightening operations. We've reduced our workforce by 20% and cut expenses significantly. These measures have worked effectively while still maintaining the performance we desire. Our APR has exceeded 19% again, and we have strong origination fees, indicating solid profitability. The loan-to-value ratio is down to about 113%, which is the lowest it's been in a long time, suggesting good quality in the loans we are purchasing. We have shifted somewhat towards higher-tier loans and may balance that out towards our usual mix. Regardless, production is strong, and our metrics are solid along with good collection rates. Collections are performing very well nationwide, with no gaps in our coverage. We've also added some near-shore collections to complement our efforts, which have favorable cost implications. Although the winter season may bring some changes, we are currently experiencing strong performance in collections across all segments in the U.S. It's all looking very positive. Some have suggested that collections are being boosted by the CARES Act, the stimulus package, and increased unemployment, but that trend has mostly ended. Unemployment benefits ceased in July, yet we continue to see remarkable collection performance. While those factors may have contributed, the quality of the loans we're collecting and the effectiveness of our collection strategies are truly what matters. If another stimulus package is introduced, that would be beneficial, but we don't necessarily rely on it to maintain our current performance. However, we do need to address the shrinking portfolio. Since reaching our peak size, our portfolio has decreased by nearly $200 million. The fact that we’re still performing well despite this reduction is encouraging. We aim to stabilize our portfolio and halt its decline, and we expect to achieve this over the next two to three quarters, after which we'll continue to monitor the market before deciding on further growth. As for Wall Street, conditions are stable, with very low costs for the ABS markets and strong credit lines in place. We have solid access to capital when needed. Lastly, we received an unsolicited offer for the company, which we disclosed in a press release. The Board will consider it carefully, and we plan to respond by the deadline of October 30. I have not yet spoken to the offering company, but we will evaluate the proposal. Overall, the company is performing excellently, and we hope someone recognizes our success. Now, let's open it up for questions.

Brad, a couple of things. The first is just to, maybe, get a little more color on maybe the near- and medium-term outlook in terms of just competition because it seems like there are a lot of competing factors. You noted how robust the ABS market is and that’s sort of reminiscent of when the industry became so competitive after the last financial crisis and rates came down. But at the same time, it looks like your yields have trended up, both within the legacy and in the fair value portfolio. Are you seeing more pricing flexibility? Or is that just a reflection of more caution and a little higher FICO focus given the pandemic?

That's a great question. We're definitely pleased with the higher pricing. I think there is more pricing flexibility available. The strong ABS market and the overall cost of funds for warehouse lines and borrowing money are beneficial for everyone. If companies were facing challenges, better access to capital is likely helping them. Some non-prime companies are quite aggressive, but we haven't noticed too much of that in our sector. Our access to capital and funding costs are supporting those who are struggling, but it seems many are adopting a cautious approach, similar to ours, trying not to overextend in case conditions change. While our numbers and performance are strong, we aren’t rushing to accelerate without careful consideration. Most in the industry probably share this sentiment, which may explain the increased pricing flexibility. We believe our business model is effective, but others might make similar claims. It’s unclear if some competitors have pulled back or if smaller players were more affected, but there haven’t been any notable exits among larger companies. Overall, it does seem there is more pricing flexibility in the current marketplace.

Okay. But just to be clear, I'm not getting a strong sense that we ought to be thinking about gross yields trending higher from Q3 levels. Is that fair?

Yes, that's probably fair. We're probably, give or take, if it gets better than this, then something is changing. So…

Certainly. Throughout the pandemic, a consistent theme in the industry has been the shortage of used vehicles among dealers, which has led to increased prices. It appears that new vehicle sales are starting to pick up again as the manufacturing bottlenecks from the pandemic are easing, which should increase trade inventory or volume. Do you believe that the previous quarter reflects the peak of collateral value we should expect? You've mentioned that the recovery rate was unusual this quarter, which was clear, but more generally, we might have already seen the peak of auction values.

I agree with you. I think new car production is starting to increase. I've long believed that new car production had moved too fast. Some manufacturers may feel the pandemic actually benefited them, as it allowed them to slow down and let the market catch up. I’m not sure they will come back very aggressively. While they certainly want to produce cars and profit, this break will likely strengthen the market for them in the future. The numbers were quite high in the third quarter, so it might be the peak, but I wouldn't be surprised if the fourth quarter holds steady and we see a gradual return to normal. If I were in their position, I wouldn't rush to flood the market with new cars. All the dealers need new inventory, and they will try to supply it, but I doubt they will aim to create another surplus of new vehicles. If that's the case, it could help keep recoveries a bit higher than usual for another quarter or two before returning to what we consider normal.

I just wanted to get sort of your thoughts on how the different portfolios are performing? Obviously, this quarter, we saw a smaller fair value mark on that portfolio, but a larger provision. And then we can see the legacy charge-offs are running higher, but at the same time, you talked about a better yield in there. So just kind of walk us through the differences in the performance between those 2 portfolios.

Overall, the legacy portfolio is older, which means it may not perform as well over time since older paper tends to incur higher losses. We are being very cautious with both portfolios. While we seem to be faring well during the pandemic, unforeseen circumstances may arise, so we're approaching this with caution until things stabilize. The performance levels in either portfolio might not be especially meaningful at this point. It's clear that the legacy portfolio is unlikely to perform as well as the fair value portfolio. We would likely agree that fair value is currently outperforming expectations, even amidst the challenges posed by the pandemic.

Got it. There's a lot of uncertainty regarding the stimulus right now. Delinquencies are still significantly down compared to last year, which is positive. They have increased slightly sequentially, which is expected from a typical seasonal perspective. Can you walk us through how delinquencies changed month by month throughout the quarter? Did they decrease again in July and then rise after the stimulus, or what is driving that?

After the June quarter, we observed slight month-to-month increases in delinquencies throughout the third quarter. As mentioned, this aligns with the typical seasonal trend we expect, as the third quarter usually sees an uptick in delinquencies due to vacations and back-to-school activities. This year, however, the increase was modest, likely because people are not traveling as much as usual. Even though stimulus and additional unemployment benefits may have ended during this time, it seems that individuals have more disposable income due to reduced activities. Our collection teams have effectively managed customer accounts, resulting in a seasonal increase in delinquencies, but not as significant as in previous years.

Got it. And I know you addressed the offer on yourselves. So I think thinking about it more broadly, can you give us your sense for potential consolidation in the industry that at this point, no one's really struggling because there was so much stimulus? But going forward, as losses really manifest, do you see some potential consolidation opportunities for the industry?

Well, I always say, yes, when we have that question, and I've been mostly wrong. So I think you're still going to have some folks out there who aren't doing exactly what they're supposed to be doing. I think probably you might have had a bit of a reckoning for some of the really smaller guys over the last couple of quarters. I mean, the larger people, sort of us and bigger, I don't really see too much going on there, because certainly, the lower cost of funds and the access to capital probably has helped everyone, what we'll call, medium to large size a lot. And so I think there's still a decent chance you'll have some consolidation. You’re still going to have the PE guys. They're still sitting in those same companies they probably don't want to be in. Maybe they're feeling a little better about the company, but they still, at some point, got to get out. So I don't know how that plays, but yes, I think there'll be consolidation. I think maybe after the election, you see how that shakes out, what happens. But the easy answer is, low-cost of money is going to be there now for a while, and that's going to help a lot of folks. And I don't know that it'll cause anybody to come into the market. So it's kind of a weird setup because you have a whole lot of people because of all the low-cost and stuff access, they're all going to probably hang in there. It doesn't mean the PE guys still don't want to get out. So at some point, something is going to happen. But given the current access to capital, I'm probably not thinking it happens very soon, which means it will happen tomorrow, which would be great. So there you go.

I wanted to focus on something specific. You mentioned that you reduced your workforce by 20%, but employee costs have decreased by less than 1%. I'm curious about how much of that reduction is variable, especially since you're clearly purchasing fewer contracts than last year. While there has been a slight increase recently, it doesn't appear that the full 20% reduction has significantly impacted your employee costs.

It will likely impact us more as time goes on. This isn't something we just implemented in this quarter. Part of the reason is the new accounting standards.

We had a slight reduction in staff, laying off about 10% of our workforce midway through the second quarter. Additionally, we've experienced some attrition due to consistently low volumes. As a result, I believe the comparisons from quarter to quarter or even year-over-year may not fully capture the situation, but our headcount has decreased by approximately 20%.

Okay. I mean, what's a good run rate going forward? I mean does it continue to trickle down? I mean, obviously, if there was attrition or people let go in 2Q or in 3Q, do we continue to see a reduction in employee costs going into the end of the year?

Well, we expect things to remain steady at these levels until the end of the year. We are focused on growing the business again. As origination volumes increase, our variable employee costs will also rise since most salespeople work on commission. If there is significant growth in originations, we may need to hire additional staff in the credit departments. However, we anticipate continued efficiencies in servicing, even as the business expands, due to our recent technological investments and changes. We plan to utilize our resources much more effectively in the future than we have in the past, which makes us feel optimistic about managing operating expenses and employee costs as the business begins to grow again.

Okay. Moving on, so I was a little surprised to see the provision for the legacy portfolio. I mean, is that just a function of the change in the allowance? I mean, going forward, if you don't have to make adjustments to the allowance ratio, should we not have any provision in the runoff portfolio?

Theoretically, when we adopted CECL in January, had it not been for the pandemic, there likely would not have been any provisions for credit loss at that time, as it was meant to be a lifetime allowance based on our calculations. However, the pandemic has negatively impacted our seasoned portfolio more than the less seasoned fair value portfolio. We have taken significant losses on the 2015 and '16 receivables, and even though these receivables are nearing the end of their lives, the incremental losses are not decreasing as we had anticipated. Therefore, we want to remain cautious and ensure the numbers accurately reflect true performance. At some point, we believe that as the economy begins to recover, we will feel more optimistic about the legacy portfolio, which we hope will eventually pay off. We are hopeful that the most substantial provisions for credit losses in the legacy portfolio are behind us.

Well, okay. So that leads into my next question because credit obviously improved, except in the legacy portfolio, where charge-offs increased year-over-year. Is that simply a result of the portfolio maturing and focusing on the vintages where you've experienced some challenges?

Well, like I said, yes, those underlying vintages, primarily '15 and '16. Although 2017 is in the legacy portfolio too, which is a little bit better. Those pools started out at higher losses earlier in their lives, and they’ve just continued to run hotter, even though they're, like I said, approaching the end of their lives. And so the other thing, too, is like even though we've seen improvement at the auctions this quarter, these last 6 months, those cars in the legacy portfolio are much older. And so they're probably not benefiting from those better returns at the auctions as much as the fresher portfolios and the fair value segment are. And so it's just because of the age of the portfolio, the legacy portfolio and the relatively weaker performance from the start of those portfolios, they're just really kind of stumbling to the finish line a little bit, but we're comfortable that we have sufficient allowance against them now.

Okay. And just last question. Kind of housekeeping. I just want to make sure I'm calculating it correctly, am I right, there was about $11.8 million of actual dollar value charge-offs in the quarter.

On the legacy portfolio?

Just the charge offs would be related to the legacy portfolio, yes.

Yes. That sounds right for the legacy portfolio, yes.

At this time, I'd like to turn the call back over to Mr. Bradley for any additional or closing remarks. Sir?

Thank you. Again, we appreciate you all joining us for the call. We had a real nice quarter. Certainly, fourth quarter is always challenging from a collection point of view with the holidays and all and given the election and all these other sort of wild little variables and the pandemic and vaccine and whatever else you want to put on the list, we're still in interesting times, which is, again, why I'm glad the third quarter was so good. We're going to hope to keep that trend rolling, but you never know what's going to happen next. I wish we did. But we like what we're doing fundamentally. We like what the future holds. I think most everyone wants to get out of 2020, and we do, too. So we're looking forward to 2021 and having a real good year. So thanks for attending, and we'll speak to you, well, next year. Thank you.

Thank you. This concludes today's teleconference. A replay will be available beginning 2 hours from now until October 27, 2020, by dialing (855) 859-2056 or (404) 537-3406 with conference identification number 2265436. A broadcast of the conference call will also be available live and for 90 days after the call via the company's website at www.consumerportfolio.com. Please disconnect your lines at this time, and have a wonderful day.