First Internet Bancorp Q2 FY2025 Earnings Call

Good day, everyone, and welcome to the First Internet Bancorp Earnings Conference Call for the Second Quarter of 2025. Please note that today's event is being recorded. I would now like to turn the conference over to Ben Brodkowitz from Financial Profiles, Inc. Please go ahead.

Thank you, operator. Hello, everyone, and thank you for joining us to discuss First Internet Bancorp's second quarter financial results. The company issued its earnings press release yesterday afternoon, and it is available on the company's website at www.firstinternetbancorp.com. In addition, the company has included a slide presentation that you can refer to during the call. You can also access these slides on the website. Joining us today from the management team are Chairman and CEO, David Becker; President and COO, Nicole Lorch; and Executive Vice President and CFO, Ken Lovik. David and Nicole will provide an update on credit in certain lines of business, and Ken will discuss some of the financial details for the quarter as well as an outlook for the remainder of the year and for 2026. Then we'll open the call to answer your questions. Before we begin, I would like to remind you that this conference call contains forward-looking statements with respect to the future performance and financial condition of First Internet Bancorp that involves risks and uncertainties. Various factors could cause actual results to be materially different from any future results expressed or implied by such forward-looking statements. These factors are discussed in the company's SEC filings, which are available on the company's website. The company disclaims any obligation to update any forward-looking statements made during the call. Additionally, management may refer to non-GAAP measures, which are intended to supplement but not substitute for the most directly comparable GAAP measures. The press release available on the website contains the financial and other quantitative information to be discussed today as well as the reconciliation of the GAAP to non-GAAP measures. At this time, I will turn the call over to David.

Thanks, Ben. Good afternoon, and thank you for joining us on the call today. In the second quarter, interest income was up, interest expense was down. Net interest margin on a tax-effective basis rose above 2%. These are all positive outcomes that we had expected and yet due mostly to credit issues and to a lesser extent, changes in noninterest income, we are reporting $0.02 of diluted earnings per share for the quarter. We're not happy about that, and we know you are not happy about that as well. To address your concerns head on, we're going to run this call a little differently than we have in the past. Rather than walk you through every element of our income statement in detail, we're going to start with an update on credit, then we'll walk you through our forecast for the second half of this year and all of 2026. Then we'll take your questions. There is a lot, a lot of detail in the deck that we don't plan to speak to today unless you have specific questions on it. So let's go to credit. For the third consecutive quarter, we are talking about elevated provision expense and nonperforming loans, once again in our franchise finance and small business lending portfolios. With other lending verticals that have a sterling track record like single-tenant, public finance, our overall credit quality is sound and is in line with industry norms. The Federal Reserve reported nonperforming loans to total loans for all banks at 1% at the end of 2024 and again, at the end of the first quarter of 2025, and that's exactly where we are. Across our loan portfolios, our delinquencies, which serve as an early warning indicator, declined to 62 basis points, a 15 basis point improvement in the last 90 days. I'll give you additional color on the franchise finance portfolio, and then I'll hand it over to Nicole to talk about what we see in SBA. In the second quarter, we moved $12.6 million of franchise finance loans to nonperforming status with related specific reserves of about $4.5 million. At the end of the quarter, 5% of the franchise portfolio was on nonaccrual, and about 1/3 of those balances are covered by specific reserves. So clearly, we still have some wood to chop, but we believe this portfolio, which consists of loans purchased from and serviced by ApplePie Capital, is headed in the right direction. There are 633 total loans in this portfolio, and as of June 30, none of them were on deferral and only 9 of them were past due. Additionally, the pace of new delinquencies has slowed, and with a now more active servicing role that we talked about last quarter, early intervention creates more opportunity for us to pursue solutions that minimize losses. We have had recent success in workout strategies with borrowers leading to improved recovery rates. We believe the steps we have taken and continue to take have resulted in significant progress towards derisking the portfolio. With a very small pool of delinquent borrowers and the slowing pace of new delinquencies, we see promising signs for improvement in future periods. The vast majority of the portfolio is performing well with an average yield over 7%. That has contributed towards our continued growth in net interest income and net interest margin. Now I'll turn it over to Nicole to talk about small business lending.

Thank you, David. Let's unpack what we're seeing in SBA. Since we entered the SBA lending business in earnest in 2020, we have originated $1.8 billion in small business loans. We have helped thousands of entrepreneurs achieve their dream of business ownership. Considering everything these business owners have had to react to in the last 5 years, from supply chain disruptions to inflation, tight labor markets, rising rates, uncertainty around government actions and taxes, we continue to feel positive about how our borrowers are navigating the current environment. It has been well covered by members of the media and members of Congress that the Small Business Administration has seen challenges across this portfolio. Because we are a nationwide generalist lender, our experience is likely to mirror that of the Small Business Administration's portfolio as a whole. In early 2023, we implemented the first in a series of adjustments to our approval criteria and to our processes in response to what we see in our portfolio, the SBA portfolio as a whole, and the economic outlook. We've added bench strength to our SBA teams, including our leadership team, servicing, credit, and closings. Closing is where guarantees are often lost, and we haven't lost one yet. And now we are seeing improvement in our portfolio consistent with our expectations. Loans on nonaccrual are down. Past dues dropped by 48% since the linked quarter. And the number of loans on deferral at the end of the second quarter was half the number at the end of the fourth quarter of 2024, and the dollar value is down by more than 60%. The improvement we are seeing in our portfolio is consistent with macro SBA program data. Over the past 2 years, there was a sharp rise in repurchase activity on the part of the SBA as well as lenders. Generally speaking, repurchases are due to a troubled or delinquent credit. The repurchase levels, which are published monthly, peaked in March of 2025, and are decelerating. For reference, June 2025 was back down to a level of April 2024. We see this as evidence that this cycle is winding down. The elevated level of prepayments has slightly tempered demand for SBA loans in the secondary market. So we are seeing softer premiums as we get back into the secondary market. Being one of the most active lenders in the SBA industry, we believe we have a responsibility to lead by example. As we noted for you last quarter, we implemented changes to our loan sale process to align with SBA's standard operating procedure. This is one way we can preserve shareholder value by protecting the guarantee on these loans. As a result, we held our originated loans for a longer period of time before selling them into the secondary market. You'll see this shows up in a few ways in our financial results. First, our SBA loans held for sale are up $92 million over the prior quarter. Holding these loans played a part in margin expansion. Second, we reported noninterest income of $5.6 million for the quarter, which is right in line with the $5 million to $6 million that Ken forecast in our last call. Included in noninterest income was $1.6 million on gain on sale of SBA loans, which was down about $7 million from the linked quarter while we held the majority of our originations. This was a 1-quarter impact for us to revise our processes, and we are back in the market now. In fact, we have already sold $52 million in guaranteed balances for a total of $3.7 million in gain on sale month-to-date in July, with more sales to follow this quarter. Based on the loans we have in our held-for-sale bucket, plus a strong pipeline behind that, we are forecasting gain on sale will propel meaningfully improved noninterest income in the second half of this year. All told, we find the improvement in our SBA results encouraging. I want to thank our entire SBA team for their tireless commitment to our borrowers, to each other, and to First Internet Bank. And now I'll turn it over to Ken for more on our 2025-'26 outlook.

Thank you, Nicole. Let me start by discussing some of the drivers of net interest income and net interest expense during the quarter. Net income for the second quarter was $28 million or $29.1 million on a fully taxable equivalent basis, up 11.5% and 11%, respectively, from the first quarter. Net interest margin improved to 1.96% or 2.04% on a fully taxable equivalent basis, up 14 and 13 basis points, respectively. The yield on average interest-earning assets rose to 5.65% from 5.57% driven by an 8 basis point increase in loan yields as rates on new originations exceeded 7.5% during the quarter. The cost of interest-bearing liabilities declined to 3.96% from 4.02% driven by a 9 basis point decrease in interest-bearing deposit costs as we continue to benefit from CD repricing and as we grew lower-cost fintech deposits. With lower CD pricing across the curve, we expect further declines in deposit costs throughout 2025 as higher-cost CDs mature and are replaced by lower-cost fintech deposits or new CDs. When combined with the higher loan origination yields, this should support ongoing growth in net interest income and margin, even assuming no Fed rate cuts. At quarter end, $1.8 billion or 33% of our deposits were indexed in some form to the Fed funds rate, offering additional cost reduction potential if rates decline. Now turning to future periods. I would like to provide some commentary on our outlook for the second half of 2025 and into 2026. Note that these estimates assume a flat rate environment; given the economic uncertainty, we are not going to attempt to predict the timing and magnitude of Fed rate cuts. We remain excited about our strategies in place to drive net interest income and net interest margin growth as loan yields continue to increase and deposit costs decline. For the third and fourth quarters each, we expect to grow our loan portfolio at an unannualized rate in the range of 2% each quarter. The impact of funding loans at higher origination rates in conjunction with lower deposit costs is expected to result in our fully taxable equivalent net interest margin rising to somewhere in the range of 2.20% to 2.25% in the third quarter and 2.30% to 2.35% in the fourth quarter. In dollar terms, we expect fully taxable equivalent net interest income to increase as well and be in the range of approximately $33.5 million in the third quarter and $35.5 million in the fourth quarter. With regard to noninterest income and expense, looking at the balance sheet, we have well over $100 million of guaranteed SBA balances that we expect to sell in the third quarter. And origination pipelines remain strong to support fourth quarter volume. As such, we expect to see noninterest income pick back up to around $13.3 million in both the third and fourth quarters driven by an increase in our gain on sale of loans. Furthermore, we expect expenses to land in the range of $27 million in both the third and fourth quarters. With respect to the provision for loan losses, we expect some tempering in the overall provision. However, it will remain elevated compared to historic levels. We anticipate the provision to be within the range of $10 million to $11 million for both the third and fourth quarters. Moving to our expectations for 2026, just as we are excited about the prospects for the second half of 2025, we are equally excited about the outlook for 2026. We anticipate continued growth in our income-generating loan verticals as well as our small business lending platform on a relatively stable expense base, which is expected to drive positive operating leverage for the full year of 2026. From an asset perspective, we expect to grow the loan portfolio somewhere in the range of 5% to 7% over the course of the year. While we do expect deposit costs to stabilize under a flat rate scenario in 2026, loan originations will continue to price upwards. We anticipate fully taxable equivalent net interest income in the range of $158 million to $163 million for the full year which reflects a fully taxable net interest margin in the range of 2.5% to 2.6%. Moving to noninterest income and expense, as we continue to bolster our SBA origination platform and expect originations to grow, we have modeled noninterest income in the range of $51 million to $54 million for the full year. On the expense side, we estimate expenses to be in the range of $108 million to $112 million, representing annual growth of around 8.5% to 12.5%. With respect to the provision for loan losses, we are going to take a conservative position and estimate the full year provision to be in the range of $37 million to $40 million. In terms of how this guidance translates to earnings per share, if you take an optimistic approach that is the higher end on revenue and the lower end on cost, you should arrive at around $6.30 per share. If you take a more conservative approach to the forecast, the low end of the range equates to about $5.20 in earnings per share, with a midpoint in the area of $5.80 per share. With that, I'll turn it back to the operator so we can take your questions.

And your first question will be from Brett Rabatin at Hovde Group.

I wanted to start on the provision guidance for the back half of this year and next year. I mean, if you just kind of think about the numbers, that's essentially a 90 to 100 basis point level through the end of next year. Can you just talk about that level and what you might be anticipating related to credit stress from here and where you think you guys are relative to working through the SBA and the franchise finance portfolios?

Quite honestly, Brett, we hope that we don't need that number, but we're tired of sitting here and telling you guys every quarter that we missed. So we pushed that up to what it's been for the last couple of quarters. As we stated and all the numbers we shared with you, the portfolios are headed in the right direction. It looks like the cycle is turning to our favor, but we don't want to short sight it again next year and/or in the second half of this year for that matter and wind up short. So we boosted it up. We hope that's a nice carryforward for us that will actually improve the bottom line because we don't need it. But we don't want to be in a position to underestimate and wind up short as we have in the last couple of quarters.

That's helpful. Regarding SBA, Ken, we had talked during the quarter about the decline in consumer spending, and it's clear that higher interest rates have affected some SBA industry loans. I would like to understand better what you are observing in the SBA sector. Additionally, I didn't fully grasp Nicole's comment about the changes to industry standards, which I assume refer to the updates that have occurred since the new administration.

Sure. I can clarify that for you, Brett. Yes, there have been changes to the SOP that were announced recently, and I think they were effective as of June 1. What we're really seeing is a reversal to the prior Trump administration in terms of some of the rules. And so that has changed the industry a bit. There were concerns that, that might soften demand for SBA loans either on the part of borrowers or in the secondary market, but that really hasn't shown up to us at all. We're seeing a strong pipeline continue.

But what those changes did do to, Brett, in the second quarter slowed down our sales in the secondary market. So as Nicole stated, we were down $7 million in what we had anticipated for the quarter, which was $0.70 worth of earnings for the quarter. So had those changes not taken place, we wouldn't have had a lot of the angst that we have today. But it is what it is. And as she said, we're back up and running over $3 million in gain on sale already in the month of July. So this quarter, we'll come back to normal, a little ahead of where we've been in the past.

It's quite typical for SBA loans to be sold immediately after closing into the secondary market. We ensure that we have all the necessary documentation, such as titles, licenses, and deeds, fully prepared before we offer those loans for sale in the secondary market.

Okay. And if I could sneak in one last one around credit. Just on the franchise finance portfolio. I know you've tightened up underwriting. Can you remind me, generally speaking, what the underwriting terms were for the franchise finance book?

What do you mean by underwriting terms in this case, Brett?

Well, just any metrics that you can give me related to loan to value, debt service coverage ratios, how you generally look at the different franchises and how you underwrite cash flow or real estate or how you...

Thank you for the explanation. Just to clarify, this involves cash flow lending, correct? That means you're assessing the underwriting based on the business's cash flows. I believe our minimum requirement is a 1.25 debt service coverage ratio, although we usually aim for something higher. Typically, in these deals, there isn't much real estate involved, but we do obtain personal guarantees and other forms of collateral, such as business equipment. That gives you a general idea at a high level.

And due to the changes going in the marketplace, Brett, we stopped originating or purchasing loans at the beginning of the year. We haven't purchased anything since January. Just too much uncertainty in the marketplace and concerns about consumer sentiment, tariffs, etc. So the portfolio has actually dropped outstandings by a little over 10% since the first of the year.

Next question will be from Nathan Race at Piper Sandler.

I appreciate all the commentary around the provision outlook. Just curious what's kind of underpinning that outlook in terms of how you're thinking about the charge-off trajectory going forward. I imagine it's not going to be as high as we've seen in the last handful of quarters, but just curious kind of the underlying charge-off assumptions and kind of what that equates to in terms of the reserve trajectory from here?

Yes. The charge-off number can sometimes fluctuate because it reflects whether there are specific reserves in place. For instance, during this particular quarter, over $7 million of net charge-offs had already been reserved for. A better approach might be to focus on the provision and its impact on the income statement, as predicting whether a charge-off will occur or a specific reserve is needed can be challenging. We do anticipate that the Allowance for Credit Losses (ACL) coverage will increase over time. While it dipped slightly this quarter due to the charge-offs I mentioned, which had full reserves, we expect the ACL coverage ratio to grow as we continue addressing the problem credits we've identified through the end of this year.

One of the issues out there, Nate, for example, the franchise finance loans, at the end of the year, we had 40 loans that had received some kind of deferment on them. Today, that number is 0. We haven't had any for several months. So we're getting comfortable that everything has crawled out from under the rug at this point, but we're still just being overly cautious, not knowing what might pop. We're in the same situation; deferrals are way down in the SBA world. So that's kind of a leading indicator that something is wrong with this loan, obviously, when they are asking to defer payment. And not only has delinquency gone down, deferments are virtually 0. We have nothing in either bucket that's over 90 days delinquent that we haven't already put in the non-performing. And as Ken said, about 40% of that has some form of specific reserve against them. So we think we're cleaning it up quickly, and the future looks a lot brighter than the past has, but we want to be quite honest, just conservative. We'd rather surprise you with lower numbers than continue to hit high numbers.

Yes. Understandably. Of the $33 million, $34 million in charge-offs over the last few quarters, do you guys have the breakdown of how much of that was SBA versus franchise?

I don't have the total number in mind right now. I'm going to speculate that it is likely a bit more weighted towards the SBA side, as some of the problem development and possibly some of the problem loans occurred there earlier than in franchise. It seems to be more of a timing issue. So I would estimate it's a bit heavier on the SBA side compared to franchise.

Okay. Got it. And then obviously, you guys had nice deposit growth in the quarter. Is deposits expected to slow in the back half of this year, just given maybe some excess cash on the balance sheet? Coming out of the quarter, how do you kind of think about the trajectory of deposits over the next couple of quarters?

I believe we are achieving significant success with some of our fintech partners in terms of deposits. We anticipate strong deposit growth for the remainder of 2025. This could allow us to lower our CD rates slightly and manage that aspect. For 2025, we have over $800 million in CDs maturing at a weighted average cost above 4.60%, giving us plenty of flexibility. Even if deposit growth from fintech exceeds our expectations, we can effectively manage our overall balance sheet growth by adjusting CD pricing.

And what rate are those CDs rolling into these days from 4.60% roll-off?

If we were doing it today, it would likely be in the mid-4.20s.

Okay. Got you. Just lastly for me, it seems like you guys are still expecting pretty decent loan growth. I think you mentioned around 8% annualized for the next couple of quarters. So just curious on maybe thoughts of perhaps slowing growth and maybe getting back in the market, buying back stock just given the valuation today?

Yes, we are excited about the opportunities for loan growth. We are seeing increased production in the SBA loans, but we are only retaining about 25% of that on average. If you look at our balance sheet, loans held for sale exceed $100 million. With our current model and selling process, we expect that average balance to be around $100 million per quarter. The benefit of holding these loans longer is that we are earning interest income at a higher rate. We have also experienced success on the construction side with originations, with much of the growth coming from unfunded commitments that are being drawn. Most areas of the portfolio are managing growth well, although there are a couple of portfolios, such as residential mortgage and healthcare, that are declining. We are committed to managing our balance sheet responsibly. Regarding capital ratios, while I would love to buy back stock at this price, we believe it is important to build our capital ratios. Once we start generating earnings at a higher rate than the overall balance sheet growth, we can focus on rebuilding capital ratios and consider share repurchases.

Regarding loan growth, it isn't significantly affecting our capital ratios since we maintain one of the lowest loan-to-deposit ratios in the bank's history. This allows us to capitalize on higher-yield loans without increasing the balance sheet or exerting pressure on equity. Currently, we're in a favorable position, as Ken mentioned, by adding loans at 7% to 8% as long as we ensure high quality. We also discovered that the loss distribution over the past six months was 54% franchise and 46% SBA.

Okay. Very helpful. I appreciate all that. And then Ken, just one last one, sorry. What's the tax rate assumptions you're assuming with all the specific guidance you laid out, which is very helpful, by the way.

For 2026, I anticipate a 15% growth as we begin to return to a stronger earnings trajectory. For the remainder of this year, I expect it to be in the 10% to 12% range. I might be slightly optimistic with that estimate, but that's what I'm incorporating into the model.

Next question will be from George Sutton at Craig-Hallum Capital Group.

My first question is around sort of a willingness to lend. Where are you really willing to lend right now? And in that context when we talk about the SBA side, David, you talked about kind of $600 million goals in the past. I assume those are sort of off the table as you're thinking about it today, but just wanted to clarify where are you willing to lend?

We're on track to achieve our $600 million goal this year and might even exceed it slightly. Looking ahead, with current trends and activity, we could reach between $650 million and $700 million next year. We're still comfortable lending in the SBA sector. Over the past 18 to 24 months, we've adjusted some of our underwriting criteria, stepping away from certain industries within the SBA space. The loans we are currently adding to our portfolio are of good quality. The challenges we're facing stem from the 2021 and 2022 vintages, which were affected during the COVID period. However, most of our loans involve existing business acquisitions, indicating that those buyers have weathered the storms. Although inflation is decreasing and interest rates haven't significantly benefited them yet, there is hope on the horizon. We're confident in our current underwriting standards and will continue to adhere to SBA guidelines. Remarkably, among the over $1 billion in loans we've issued and recent charge-offs, we've not faced any denials on insurance or cure requests, indicating the quality of our loans. Our commercial segment is robust, and our consumer segment remains strong. The only area we've reduced activity in is franchises, where we've adopted a higher rate standard, leading us to be priced out of some markets. Meanwhile, we're maintaining a super prime focus on the consumer side with credit scores above 770 and yields between 7% and 8%. On the commercial side, we're aligning with SOFR rates plus an additional margin. Overall, we're actively engaged in the market and have solid pipelines everywhere, with franchises being the only area we've significantly limited.

Got you. So other than Ken's very brief discussion on successful deposit growth with some of your fintech relationships. I wondered if you could just sort of update us on the Ramp and the jarises of the world in terms of how those programs are going? What your plans are to grow that part of the business?

It's going strong. Ramp in the month of June, we processed $10 billion worth of payments for them. In the month of June, our deposit base on their small business savings product is approaching $500 million. Our fintechs as a whole, we're north of $1 billion in total deposits. That's all below Fed funds, and it's also below the cost of our Federal Home Loan Bank borrowings. So as they've increased, we've been able to pay down a lot of that. Jaris is moving ahead, doing well. They've got a couple of really big opportunities. We haven't blown up the forecast on them. But I think this past month, we added about $1.5 million to our portfolio. So we're at $3 million to $4 million, and we're about $10 million in a loan pool with them. So it's getting bigger month by month, and we see a path with a couple of the people they're talking to that could take the roof off towards the end of the year or early part of '25. But we have settled down tremendously in the fintech space. We have counseled 4 of our clients off, and we have about 5 or 6 in the pipeline. We've got 10 active, I think, 4 in testing at the current time and certification. So it's been worth all the pain and agony. We grew revenue by 38% quarter-over-quarter. And we had forecasted, I think, initially about $4 million net there, and without anybody doing anything crazy, we'll probably be getting closer in the $5 million to $6 million range for this year. If a couple of them take off, we could get considerably higher than that. So it's been a good move, and we're seeing good results for all the work that we've done.

Last question, and I'm following up on a prior question that was related to the buyback that was answered by our CFO with the answer of capital issues. I'll ask the CEO the same question in a different way. So you've got a $44 book value and a $23 stock price. At what point does that equation just simply overwhelm the capital thoughts that Ken expressed?

I'll go back to the statement, I think I made last quarter. If we stay with the 2 handle on the front, we're not going to buy back, but God forbid, we fall into the teens; that overwhelms the capital constraints on my basis. So it's foolish to be at that level for a whole lot of reasons, and if we hit the teens, we'll be buying. If we stay above 20, we probably won't. But in the teens, we will be in the buyback position for sure.

And at this time, Mr. Becker, we have no other questions. Please proceed.

Thank you, Sylvia. Well, I guess we certainly appreciate you joining us for today's call. As we said, we've continued to deliver strong improvement in net interest income. The macro environment remains a little uncertain. Customer activity is a little destabilizing right now, but our lending teams continue to perform very well, as we just discussed, especially small business lending in the commercial side. We're also excited about the growth potential from the fintech that George just asked me about, and we will further diversify and strengthen our revenue base. With improvements in the loan mix and anticipated reductions in deposit costs, we're confident in our ability to deliver stronger earnings in the coming quarters. As stated, we might have padded just a wee bit on some of the reserves, but we feel it's smart for both of us. So as fellow shareholders, we remain committed to enhancing profitability and long-term value. And we thank you for your continued support, and have a great afternoon.

Thank you, sir. Ladies and gentlemen, this does indeed conclude your conference call for today. Once again, thank you for attending. And at this time, we do ask that you please disconnect your lines.