Earnings Call Transcript - OPRT Q3 2020

Operator, Operator

Good afternoon, and welcome to the Oportun Third Quarter 2020 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Nils Erdmann, Vice President of Investor Relations. Please go ahead.

Nils Erdmann, Vice President of Investor Relations

Thanks, and good afternoon, everyone. Joining me today to discuss Oportun's third quarter 2020 results are Raul Vazquez, Chief Executive Officer; and Jonathan Coblentz, Chief Financial Officer and Chief Administrative Officer. Before we get started, let me remind you that some of the remarks made today will include forward-looking statements. Actual results may differ materially from those contemplated or implied by these forward-looking statements, particularly given the uncertainties caused by the COVID-19 pandemic, and we caution you not to place undue reliance on these forward-looking statements. A more detailed discussion of the risk factors that could cause these results to differ materially are set forth in our earnings press release and in our filings with the Securities and Exchange Commission under the caption Risk Factors, including our most recent quarterly report on Form 10-Q and our annual report on Form 10-K. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. Also on today's call, we will present both GAAP and non-GAAP financial measures, which we believe can be useful measures for period-to-period comparisons of our core business and which will provide useful information to investors regarding our financial condition and results of operation. A reconciliation of non-GAAP to GAAP measures is included in our earnings press release, our third quarter 2020 financial supplement and the appendix section of the third quarter 2020 earnings presentation, all of which are available on the Investor Relations website. In addition, this call is being webcast and an archived version will be available after the call on the Investor Relations portion of our website. With that, I will now turn the call over to Raul.

Raul Vazquez, CEO

Thank you, Nils, and thank you to everyone on the webcast and phone line for joining us this afternoon. I would like to start by highlighting our solid third quarter results, as evidenced by our quarter-over-quarter originations growth, our credit performance, our ability to access the capital markets to fund our growth and our positive adjusted EPS. While the environment continues to be dynamic, we believe we have adapted and identified a path to steady and sensible growth. During the third quarter, we grew aggregate originations 92% quarter-over-quarter. We generated $137 million of total revenue and $4.2 million of adjusted net income or $0.15 of adjusted EPS. Our managed principal balance at end of period was $1.84 billion. I am very pleased to share with you that at the end of October, our managed principal balance was $1.83 billion, largely in line with September, so we believe we have reached an inflection point where we will resume growing our receivables and revenue. Our credit performance continues to demonstrate the superior capabilities of our risk engine, particularly through this period of economic uncertainty. Our annualized net charge-off rate for the third quarter was 10.4%, which was lower than our second quarter rate of 10.6%. We saw our net charge-off rate further improve at the end of October to 8.9%, a 10 basis point improvement month-over-month. Our favorable charge-off trend was driven by decreasing 30-plus day delinquencies and fewer customers in deferral status. At the end of October, delinquencies were at 3.6%, about 30 basis points below last year's level. Jonathan will share additional credit details as well as our third quarter financials. But before that, I'd like to talk about our deliberate progress towards returning to growth. You may recall that prior to the pandemic, I outlined our 5 strategic drivers that create our company's growth flywheel. These were: number one, customer growth; number two, data and technology; three, new products; four, our omnichannel network; and five, geographic expansion. I'd now like to provide an update on 3 of these, namely: geographic expansion, new products and our omnichannel network. Today, we announced a partnership with MetaBank, National Association that sets us on a course to broaden our distribution by expanding across the nation. We currently offer personal loan products in 12 states, credit cards through an issuing bank in 24 states, and auto loans in 1. To accomplish this, we devote significant technology resources to build and maintain product terms that vary in each state. Partnering with a national bank will allow us to offer a uniform personal loan product across the nation, creating access to our responsible unsecured installment loans in over 30 additional states. This greatly reduces operational complexity and gives customers access to affordable loans in the new geographies that we will enter. Our nationwide product will be the same as our core state license products that are designed to help our customers succeed, with APRs capped at 36%. I am enthusiastic about our growth prospects in light of this announcement. It sets the foundation for Oportun to reach all of the estimated 100 million financially underserved low- and moderate-income U.S. consumers we seek to serve. We are currently working on the technology that will enable the rollout of our MetaBank partnership by mid-2021. Over the course of the next few quarters, we'll provide periodic updates on our progress. Turning to new products. We are seeing steady progress with both the Oportun Visa Credit Card issued by WebBank and our secured personal loan product. For credit card, our geographic presence continues to expand through marketing in multiple states, including those that are outside of our personal loan footprint. In the third quarter, we added 5 additional states, bringing our total credit card footprint to 24 states. For auto, we've been doing a lot of work on product market fit by using the data we've collected from our soft launch. Based on our learnings, we are now in the process of increasing the number of customers who are offered secured personal loans. Starting in a couple of weeks, our underwriting platform will begin offering all eligible customers a choice between our traditional personal loan or a personal loan secured by an auto with a higher loan amount and more favorable terms. This functionality is currently being rolled out everywhere we offer auto loans, and over time, we expect to make this available across additional states. Turning to our partner channel. We announced our strategic partnership with DolEx in August. We are currently developing the underlying technological capabilities required to enable our partnership and expect to soft launch in select DolEx locations in several weeks. These partnerships and new products, combined with our technology-focused and mission-driven culture, represent sustainable and compelling opportunities for us as a company. Our track record of delivering bottom line results while growing our business enables us to continue to empower low- and moderate-income consumers across the U.S. while generating significant value for our shareholders. I couldn't be more proud of what Oportun stands for as an organization or more optimistic about where we are headed. With that, I'll now turn the call over to Jonathan, who will walk you through a more in-depth discussion of our third quarter financial results, and then we'll open the line for your questions. Jonathan?

Jonathan Coblentz, CFO

Thanks, Raul, and hello, everyone. In addition to GAAP, we also evaluate our performance based on fair value pro forma results, which we believe present a more consistent view of the underlying trends of the business. Unless I state otherwise, all of the metrics that I will now share with you will be on a fair value pro forma basis for the purposes of comparison to prior year periods. A full list of definitions and reconciliations can be found in our earnings materials. As Raul mentioned a moment ago, we experienced steady improvement throughout the third quarter that continues into the current quarter. Aggregate originations in the third quarter were $302.4 million, nearly twice the level of our second quarter originations. We are also tracking our progress in returning to our 2019 level of originations, and our third quarter originations were up to 56% of last year's. In September, our originations improved to 67% of last year's, and in October, this improvement continued as we saw aggregate originations for the month increase to $133.6 million, 69% of last year's. As the overall economic environment has gradually improved, we have cautiously increased our credit decisioning. We remain thoughtful and deliberate in our execution of such changes. Given the encouraging indications we experienced throughout the third quarter and into October, we believe we are well positioned for further improvements, assuming the economy continues to improve. Total revenue for the third quarter was $136.8 million, down 11% relative to the prior year period. The decrease was primarily due to lower interest income during the period which was $128.7 million, down 7% year-over-year. This was due to a 3% decrease in average daily principal balance and a decrease in portfolio yield to 32%. Noninterest income, which includes cash gain on sale from our whole loan sale program, was $8 million. This was down over the prior year period, reflecting the lower volume of loans sold as well as lower gain on sale premium of 9.9% versus 10.1% in the prior year period. For the third quarter, net revenue, which is our total revenue after interest expense and net change in fair value, was $92.4 million, down 17% year-over-year. Net revenue was lower due to higher charge-offs, offset by lower interest expense and $10.7 million net improvement in the fair value of our loan portfolio and asset-backed notes. Interest expense of $13.2 million was down 13% year-over-year. The decline in interest expense was driven by a decrease in our average daily debt balance of 8% year-over-year as we have reduced our leverage as our portfolio is paid down and also the decrease in our cost of debt to 3.9% in Q3 relative to 4.2% in the same period a year ago. Net increase or decrease in fair value or net change in fair value includes our current period principal net charge-offs and mark-to-market of our loans and debt. We provide a summary of the net change in fair value in our third quarter 2020 earnings deck. As you'll see on Slide 15, the third quarter $31.2 million net decrease in fair value consisted of a $10.7 million mark-to-market net increase on our loans and our debt and current period charge-offs of $41.9 million. The mark-to-market adjustments consisted of a $29.1 million mark-to-market decrease related to our asset-backed notes and a $39.8 million mark-to-market increase in our loans receivable. Now, I'll walk you through the drivers of our fair value mark, starting with our asset-backed notes. As of September 30, the weighted average price of our asset-backed notes was 101.1%, up from 98.7% at June 30, reflecting a significant improvement in the prices of our bonds. The increase in the fair value of our bonds resulted in a $29.1 million decrease net change in fair value in net revenue. The improvement in prices is a positive indication of capital markets conditions and accessibility. The $39.8 million increase in fair value of our loans receivable was driven by an increase in the fair value price for our loans to 101.9% as of September 30 from 99.4% as of June 30. The increase in fair value was mainly driven by three factors: first, due to more customers returning to repayment, our remaining life of loan charge-offs decreased to 10.61% at September 30 from 12.73% at June 30; second, consistent with the weighted average decrease in yield on our bonds, the discount rate on our loans decreased to 7.84% as of September 30 from 8.84% as of June 30; third, fewer-than-expected emergency hardship deferrals resulted in a decrease in average life to 0.78 years as of September 30 from 0.8 years as of June 30. Additional supplemental information regarding our fair value assumptions is provided in the appendix section of our third quarter 2020 earnings deck. Turning to expenses. We have actively reduced discretionary spend across the company. For the third quarter, our total operating expense was $101.6 million, up 9% sequentially from the second quarter. However, excluding the impact of a net liability of $8.8 million in relationship to a legal settlement, our operating expenses were down 0.2% sequentially. By comparison, our operating expenses increased 20% from the second quarter to the third quarter in 2019. Operating costs associated with our auto and credit card products, which are included in our overall OpEx, were $4.2 million for the third quarter. These investments contributed to our year-over-year OpEx increase. Lower revenue in the third quarter led to adjusted operating efficiency of 63.3%, which was 540 basis points higher than the comparable quarter last year and 330 basis points higher than the second quarter of 2020. Our customer acquisition cost for the third quarter was $207, down from $413 in the second quarter. While our CAC was still elevated relative to the $128 in the prior year period, it is returning to normal levels as origination volumes normalize. As originations increased in September, CAC further decreased to $180 for the month. We are optimizing our marketing investments for the current environment, but we expect an increase in marketing in the fourth quarter as we return to growth and take advantage of the expected seasonal increase in demand. Our loss from operations on a GAAP basis was $6 million versus net income of $10 million in the prior year quarter. This equated to GAAP net loss per share of $0.22 versus a net loss per share of $6.39 in the prior year quarter. On a non-GAAP basis, our adjusted EPS was $0.15 based on adjusted net income of $4.2 million versus adjusted EPS of $0.64 and adjusted net income of $15.3 million in the prior year quarter. Adjusted net income is the numerator of our adjusted return on equity, which was 3.7% for Q3 versus 14.6% in the prior year quarter. Our third quarter adjusted EBITDA, which is our proxy for pretax cash profitability, does not factor in the 212 basis point reduction in our remaining cumulative loss estimate since the noncash impact of fair value accounting is backed out. For the third quarter, our adjusted EBITDA was negative $1.2 million compared to $18.6 million in the prior year quarter. Turning now to credit. Our performance in the third quarter and October showed notable improvements. We continued to see a significant decline in loans in deferral, and at the end of September, only 1.5% of our portfolio was in emergency hardship deferral status. By the end of October, deferrals had further decreased to 1%. Since the start of the pandemic, we have been able to help over 112,000 customers through our emergency hardship program and most have emerged from deferral and returned to repayment. Coupled with this positive trend is a reduction in our 30-plus day delinquency rate. At September 30, this rate had decreased to 3.5%, down 20 basis points quarter-over-quarter and down 30 basis points year-over-year. And as Raul mentioned earlier, the October 30-plus day delinquency rate was 3.6%, also 30 basis points better than last year's level. We regard this positive trend as an indication that our customers are currently managing through the crisis and returning to repayment status. At the same time, we continue to be extremely pleased with the credit performance of our newly originated loans. The loans we have originated since our credit tightening in mid-March have continued to trend better than 2019 levels. These results are a testament to the competitive advantage we have built through our proprietary underwriting models and technology platform. We do not need credit to be better than last year, however, and our risk team continues to analyze opportunities to open up in well-performing notes, as evidenced by the quarter-over-quarter growth we delivered in Q3. Our annualized net charge-off rate was 10.4% for the third quarter, down from 10.6% for the second quarter. Consistent with our policy and charge-off actions we took in the second quarter, we deemed certain loans impacted by the pandemic to be uncollectible prior to reaching 120 days past due. This led to $11.2 million of additional charge-offs in the third quarter. We continue to expect elevated levels of charge-offs. However, future accelerated charge-offs are expected to be lower than in the third quarter. Turning now to capital and liquidity. We continue to manage our funding program to maintain a liquidity runway of at least 12 months. As of October 31, total cash was $196.2 million comprised of cash and cash equivalents of $140.2 million and restricted cash of $56 million. Last week, we completed the sale to an institutional asset manager of Class C and Class D bonds that we had retained as part of our 2018-B and 2019-A asset-backed securitizations. The transaction provided us with growth capital of $39.8 million, net of fees and expenses, and reflected investor confidence in our collateral performance in our business model. We also co-sponsored a $188 million securitization by our whole loan buyer backed by loans they had previously purchased from us. While the whole loan buyer receives the economic benefit of the securitization funding, the strong investor reception the deal received pricing at 2.8% cost of funds also reflects asset-backed investor confidence in Oportun loans. I also want to update you on our plans for whole loan sales. We have extended our current whole loan agreement through December 10, and we'll continue to sell 10% of our loans at the same price as before. During this extension period, we will evaluate our future options for selling whole loans. Given we are coming up on year-end, we may decide to pause selling whole loans. If we decide to stop selling whole loans in the future, we are comfortable holding these loans on our balance sheet, and we expect the near-term reduction in the gain on sale to be more than offset by additional interest income over time. To evaluate our liquidity, it is also valuable to look at our cash flow statement. For the third quarter, our cash flow from operations was $45.4 million as compared to $68.6 million for the prior year period. We also continued to maintain a strong capital base and run our business at a low level of leverage. As of the end of the third quarter, we had adjusted tangible book value of $425.1 million or $15.41 per share. Our debt-to-equity ratio was 2.9x, a reduction from 3.3x the prior year. As of October 31, 2020, we had $208 million of undrawn capacity on our $400 million warehouse line that is committed through October 2021. We believe our warehouse line, combined with our demonstrated ability to successfully place both senior and subordinate bonds will support our return to growth. In closing, like Raul, I am very excited about the MetaBank announcement, and I'm extremely encouraged by the progress we're showing with our credit outcomes, the growth prospects of our products and the health and stability of our balance sheet. While I will not be providing financial guidance at this time due to the ongoing pandemic, our long-term outlook for Oportun remains optimistic, and we see a great opportunity for growth in the months ahead.

Raul Vazquez, CEO

I want to thank all of Oportun's employees for their efforts throughout the past year. Their actions and responses have been nothing short of fantastic, and I continue to be grateful for their commitment and dedication. Thank you all for your time, and now we welcome your questions and comments. Operator?

Operator, Operator

And the first question comes from Sanjay Sakhrani of KBW.

Sanjay Sakhrani, Analyst

I guess, 2 questions on future originations. As far as the rollout of auto to personal loan customers, can you maybe frame the opportunity here? Because I know some of your competitors did this in the past and it became a meaningful part of their portfolio. Maybe you could speak to the economic impacts and the trade-offs between credit and higher loan average sizes, et cetera, and sort of the economic returns. And then secondly, on the MetaBank deal, how quickly can you roll out personal loans to other geographies? And does Meta keep any of the loan?

Raul Vazquez, CEO

Sanjay, it's Raul. So I'll start with your question about auto and personal loans. So what we're going to do in the next few weeks is for customers who are eligible, they will, in essence, get a side-by-side offer. They'll be offered an unsecured personal loan and then they'll be also offered a secured loan or a personal loan secured by an auto. So it's a little early, we think, right now to talk about the economic impact, but I'll give you a sense of certainly what we expect. We would expect the average loan size to be larger. We would expect losses to be lower because of the fact that they are secured by the car. And to your point, we've seen this playbook run well by others. So we're bullish really about what this can represent over the next few years for our business as we continue to roll it out and continue to optimize product market fit. So let me pause there and see if you have any follow-up questions on that piece.

Sanjay Sakhrani, Analyst

So you're saying the ROAs are the same when you net it all out?

Raul Vazquez, CEO

I think it's a little early for us to really give you a sense of what that's going to look like. So far, we have about $4 million of auto loans so it's still really small relative to the size of our portfolio. And as a consequence, we don't really have a sense yet of what the steady-state ROAs or ROEs are going to look like for that product. But as we make more progress, we'll give updates to you and to others.

Sanjay Sakhrani, Analyst

Okay. Great. And then on Meta?

Raul Vazquez, CEO

Sure. So on MetaBank, we're really excited about the fact that we're now going to have a chance to offer our products across the nation. We do think we'll be able to offer to over 30 additional states relative to our footprint today. So our plan is going to be to get all of the new states up as quickly as possible, starting in the middle of next year, and we would hope to finish that initial rollout by early 2022.

Sanjay Sakhrani, Analyst

Okay. And just a final question on credit quality. Obviously, the trend seems quite positive. But I'm just trying to think through how you guys are planning for the lack of stimulus. I know Raul, you spoke last quarter maybe to the fact that many of your customers were impacted very early in the pandemic and many might have actually been reemployed as the reopenings occurred. How do you feel about the setup right here?

Raul Vazquez, CEO

We actually feel really good about the setup. So I think to your point, Sanjay, if you were to look at Page #10 of our earnings deck, what you would see is the percentage of customers who are not delinquent, right, that very top row of 0 days delinquent is now, as of the end of October, up to 91.3%, so it's the highest number of all the numbers that we've listed there in terms of prior periods. Early delinquencies look good, too. First payment defaults continue to look good so that's giving us confidence to go ahead and increase approval rates, which is part of what's driving originations. And the delinquency numbers themselves look good. So we think we're well positioned now to return to growth. And you saw that not only in the 92% quarter-over-quarter growth in origination but the fact that the October and September portfolio size is now stable. So we feel like we've turned the corner and we can get back to growth now.

Operator, Operator

The next question comes from John Hecht of Jefferies.

John Hecht, Analyst

The first question, Jonathan, you mentioned having $2.8 million in incremental charge-offs. If I recall correctly, that's related to late-stage delinquency buckets that originated around the start of the pandemic, and you've been providing guidance on that. How much more is left, and how did that impact the October or 3Q charge-off levels?

Jonathan Coblentz, CFO

Sure, John. Thank you for your question. I want to clarify one point. In the third quarter, we had $11.2 million in additional accelerated charge-offs. In October, we recorded $2.8 million in accelerated charge-offs, so those are two different figures. The reason for this is that when a customer comes out of deferral and we cannot reach them, our previous data and models indicate a high likelihood that they won't return to repayment, so we don't wait for 120 days to charge them off. Since we're down to only 1% of the outstanding portfolio in emergency hardship deferral, we anticipate future levels will be lower than before. Regarding the loss rate impact, there are some variables at play. We didn't provide a specific number because some of the accelerated charge-offs from the second quarter would have typically been charged off in the third quarter. However, the overall charge-off level is higher because we are recognizing these charge-offs to clear things out, as you mentioned.

John Hecht, Analyst

The remaining category is significantly smaller than it was a few months ago. Regarding your second question about growth opportunities with the rollout of DolEx and Meta, it appears there are chances to either cross-sell to larger loans or increase the loan sizes of your customers. It seems that during the tightening phase, you might have reduced the average loan size. Therefore, you have various opportunities for growth. However, there is also some uncertainty in the world due to several factors right now. I'm curious, Raul, how do you manage that? You must consider budgeting, capital expenditures, partner expectations, and so on. How are you approaching this wide range of opportunities while also factoring in global uncertainties? How will you prioritize these?

Raul Vazquez, CEO

That's a great question, John. Over the last 8 months, in light of uncertainties, we've tightened our approach. We've limited hiring to strategic projects, paused store expansion, particularly in Q2, and cut back on spending for professional services and outside vendors. Given the uncertainty, we've been very cautious with our expenses. In Q3, absent a legal settlement, our expenses would have actually decreased by 0.2% quarter-over-quarter compared to last year, while in the previous quarter, our expenses increased by 20%. This illustrates our commitment to disciplined expense management. We're currently excited about growth opportunities, particularly with DolEx, which is our closest project, and MetaBank, which will start to take shape mid-next year. Additionally, we are making progress with new products that we believe will drive further growth. The expenses we're incurring now are for teams focused on DolEx, MetaBank, and funding new products as they meet their milestones and show progress. We're maintaining deliberate expense control in our current business while also budgeting for the strategic projects you mentioned.

John Hecht, Analyst

Okay. That helps with the cadence of the rollout. I have one final question. Jonathan, you've had to adjust your liabilities significantly due to interest rate fluctuations. Given where your liabilities stand now and the minimal downside for benchmark interest rates, would it be accurate to say that the interest rate risk associated with the liabilities has been contained due to your pricing adjustments? Is there anything else we should consider regarding this?

Jonathan Coblentz, CFO

Yes. That's a great question, John. While I don't have a crystal ball with regard to markets, if you take a look at Page 15 of our earnings deck, where we have the explanation of net change in fair value, right, at the end of this quarter, the debt was worth 101.1%, and you go back a year ago in a strong normalized market, the debt was worth 101.4%, right? So we're very close to where we were just before the pandemic. So I would think that the amount of the debt can increase is certainly a lot less than it was from the prior quarter.

Operator, Operator

And the next question will come from Rick Shane of JPMorgan.

Rick Shane, Analyst

I hope everybody is well. Just wanted to talk a little bit about expenses as we roll into the fourth quarter. There was an uptick in the third quarter in terms of operating expense. I'm assuming that, that's a function of reopening and restaffing branches. Curious as we move into what is your busiest season, and that's coincident presumably with further reopenings and restaffing, how we should think about that. And I do apologize if you addressed this. We're bouncing around on calls today.

Raul Vazquez, CEO

No, that's quite all right. So in terms of expenses, the increase from Q2 to Q3, which is largely driven by an $8.8 million legal settlement, this was a case that we just decided with the Board that we wanted to put behind us when we looked at the expense related to continuing to try to litigate that. So we looked at the expense and management attention and decided that we were better off settling it. Absent those $8.8 million, Rick, expenses basically would have been flat compared to last year when they went up 20% quarter-over-quarter. As we look forward to Q4, you're right, there are some incremental locations that we've been able to open. These are co-locations. And as you've heard us describe in the past, we like co-locations because someone else is generating the traffic and it's a small footprint, so there is going to be some incremental staffing costs related to that. Probably the biggest increase in expenses from Q3 to Q4 is going to be marketing because now that we're starting to see the economy stabilize and given the great performance that we're seeing in first payment defaults and early delinquencies, we're really going to lean into the seasonal increase that we normally see as we go into Q4. So the marketing budget is going to go up in this quarter. That's probably going to be the biggest increase in expenses and then some incremental staffing related to the strategic projects that we talked about earlier.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Raul Vazquez for any closing remarks.

Raul Vazquez, CEO

I just want to thank everyone again for joining us on today's call, and we look forward to speaking with you again soon.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect.