Bancorp, Inc. Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by. And welcome to the Q2 2020 The Bancorp, Inc. Earnings Conference Call. At this time, all participant lines are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. I would now like to hand the conference over to your speaker today, Andres Viroslav. Thank you. Please go ahead, sir.

Thank you, operator. Good morning. And thank you for joining us today for the Bancorp's second quarter 2020 financial results conference call. On the call with me today are Damian Kozlowski, Chief Executive Officer; and Paul Frenkiel, our Chief Financial Officer. This morning's call is being webcast on our website at www.thebancorp.com. There will be a replay of the call beginning at approximately 12:00 p.m. Eastern Time today. The dial-in for the replay is 855-859-2056 with a confirmation code of 2755988. Before I turn the call over to Damian, I'd like to remind everyone that when used in this conference call, the words believes, anticipates, expect and similar expressions are intended to identify forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to risks and uncertainties, which could cause actual results, performance, or achievements to differ materially from those anticipated or suggested by these statements. For further discussion of these risks and uncertainties, please see the Bancorp's filings with the SEC. Listeners are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Bancorp undertakes no obligation to publicly release the results of any revisions to forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Now, I'd like to turn the call over to The Bancorp's Chief Executive Officer, Damian Kozlowski.

Thank you, Andres. Good morning, everyone. And thank you for joining us. We have continued to experience momentum in our quarter earnings driven by higher interest income with falling interest expense, increased loan balances, and higher payment volumes. In the second quarter 2020, Bancorp earned $0.035 a share from both increased fee and spread revenue. Some of the highlights: Total loans increased 49% year-over-year, loan interest including loans held for sale increased 39%, total revenue increased 30% year-over-year with net interest income climbing 45%. Net interest margins increased quarter-over-quarter by 19 basis points to 3.53%. Payment card gross dollar volume, GDV, increased 43% year-over-year, while fees increased 18%. Non-interest expense was up 8% year-over-year as expenses continued to be tightly managed even as total revenue climbed 30%. Pre-tax income increased 91% year-over-year and 55% quarter-over-quarter. While the pandemic continued to be a significant source of market uncertainty, we have been able to achieve better revenue productivity and operating efficiency during this time. We also are making investments in our platform. In addition, the impact of Fed actions, the government’s SBA support, the macro retail trend from the physical to the virtual and financial services, and the removal of the BSA order restricting the bank’s activities have all provided additional tailwinds to our businesses. Moreover, our traditionally low risk business sites have continued to grow and gain momentum. This is apparent in our SBLOC, IBLOC loans, which grew 11% quarter-over-quarter and 50% year-over-year, as our digital Talea origination platform has enabled our clients to more quickly access liquidity from investment insurance assets. Our payments business also continued to experience GDV growth, significantly above the historical trends through increases in both existing and new programs across the payment spectrum. Our pipeline of new products and programs continues to be extremely robust compared to historical norms. Lastly, we are closely monitoring the fast-developing situation relative to COVID-19. We are emphasizing safety and implementing guidelines consistent with governmental agencies to reduce exposure and protect our staff. We are currently at approximately 25% staff levels in the office, with our remaining staff fully engaged in a work-from-home model. We are putting employee concerns first in determining when returning to our office locations is appropriate. I now turn the call over to Paul Frenkiel, our CFO, who will detail more about the second quarter.

Thank you, Damian. Return on assets and equity for the quarter were respectively 1.3% and 15.6%, which exceed both first quarter 2020 and second quarter 2019. The increases were driven by a $15.7 million increase in net interest income, and a $2.8 million increase in prepaid and debit card fee income. These revenue increases were partially offset by approximately $1 million in unrealized losses on commercial loans originated for sale, primarily on the small hotel and retail portfolio in that portfolio. The vast majority of that portfolio is comprised of multifamily loans with cumulative COVID losses estimated by a nationally recognized analytics firm at 1.2%. These loans generally are on our books at a $99 price net of fees and have a weighted average floor of 4.8%. Please see the new tables for CRE loans in the press release which provide a breakdown by loan type and other characteristics. If not sold, these loans will be retained as interest-earning assets. Commercial real estate loans originated for sale total $1.6 billion and represent the largest portfolio with the aforementioned 4.8% weighted average rate floor. The next largest portfolio is the combined $1.3 billion SBLOC and IBLOC portfolio, the yield for which is estimated at 2.5%. We generated $208 million of PPP loans with approximately $5.5 million to be earned as fees, which has been recognized over 11 months, beginning in April 2020. The actual recognition period may be less, depending on the completion of applications for forgiveness, and the timing of the SBA’s loan reimbursements. Including those short-term PPP loans, the small business loans substantially all SBA totaled $809 million and have an estimated yield of 5%. Leasing balances declined slightly to $422 million with an estimated yield of 5.8%. The decrease reflected the COVID impact of reduced new vehicle availability as vehicle production continues to be inconsistent. The $15.7 million increase in net interest income reflected increases in average quarterly CRE loans to $1.5 billion while related interest income increased by $11.3 million. Interest on SBA loans increased $2.2 million, including $1.2 million of recognized PPP fees. While combined SBLOC and IBLOC loans increased 54% over these periods, related interest income decreased $1.6 million, reflecting the impact of 75 basis points of Federal Reserve interest rate reductions in 2019 and additional historic reductions of 1.5% in Q1 2020. SBLOC loans are secured by marketable securities and IBLOC are secured by the cash value of life insurance, and credit losses have not been incurred. Interest expense was $7.9 million lower and the cost of funds was 12 basis points for the quarter, reflecting the impact of the Federal Reserve interest rate reductions. The vast majority of our deposit interest expense is contractual and tied to market interest rates. The provision for credit losses was approximately $1 million, compared to $3.6 million in Q1 2020, which was elevated as a result of leasing losses, because SBLOC and IBLOC loans are respectively collateralized by marketable securities and the cash value of life insurance and have not incurred losses. Management excludes those loans from the ratio of the allowance to total loans in its internal analysis. Accordingly, the adjusted ratio is 1.4%. Prepaid accounts, our largest funding source are also the primary driver of non-interest income. Fees and related income on prepaid cards were up 18% to $18.7 million in Q2 2020, compared to $15.8 million in Q1 2019. Card payment and ACH processing fees include rapid funds revenue and decreased $814,000 to $1.8 million, reflecting the answer of non-strategic higher risk ACH customers. Non-interest expense for Q2 2020 was $42.6 million or 8% higher than the prior year. The increase reflected higher salary, legal and FDIC expense. Salary expense reflected higher incentive compensation expense and higher business development, compliance, risk management and IT expense, primarily related to the payments business. Year-to-date non-interest expense was $81 million, so still in the $40 million average quarterly range. Book value per share increased to $9.28 compared to $8.07 at June 30, 2019, reflecting earnings per share and the increased value of the investment portfolio in the current rate environment. The Q2 2020 consolidated leverage ratio, which is based upon average quarterly assets, was approximately 8.5% and risk-based ratios approximated 15%. In closing, there are certain characteristics of our loan portfolios as shown in new tables in the press release, which I would like to highlight. As previously mentioned, the vast majority of our $1.6 billion of commercial loans held for sale are multifamily loans for which a nationally recognized analytics firm has estimated a cumulative loss of 1.2% in their COVID projections. Our next largest $1.3 billion loan portfolio consists of SBLOC and IBLOC loans, which have not incurred losses notwithstanding the recent historic declines in equity markets. Approximately half of the SBA loan portfolio is U.S. government guaranteed. And the U.S. government is paying principal and interest on those loans for a six-month period. The majority of the other SBA loans consist of commercial mortgages with 50% to 60% origination date loan to value. For leases which experience credit issues, we have recourse to the lease vehicles. While there is uncertainty related to the future, we believe these are positive characteristics of our portfolio, which demonstrate lower risk than other forms of lending.

Thank you, Paul. Operator, can you open the lines for questions?

Our first question comes from the line of Frank Schiraldi from Piper Sandler.

Just on the first topic regarding net interest margin. Clearly, we all recognize the sensitivity to interest rates, which have decreased, but the net interest margin increased compared to the previous quarter. So, Paul, could you discuss the sustainability of that and what we can expect moving forward?

Yes. So, the primary reason for that, Frank, is actually what we highlighted in the last call and in the first quarter too, which is that our CRE portfolio has interest rate floors. While they are rate sensitive, you're right, like the vast majority of our balance sheet is very sensitive, that particular portfolio has floors of 4.8% that was also highlighted in a table. Obviously, that floor is still in place. So, that speaks for stability within and maintenance of relative NIM that is comparable to the one we have now. On the other side of the coin, we have the SBLOC and IBLOC portfolios. They are at 2.5%. So, to the extent that portfolio grows faster than the higher yielding SBA and leasing, that could result in a slight decrease. But overall, I believe the NIM is relatively stable because of those floors.

Okay. And then, when you said the SBLOC is at 2.5%, is that fully captured in the average yields for the second quarter?

Yes. All the yields, if you recall, dropped in March, the Fed lowered, everything went down based on prime. So, it was in fact a full quarter.

Frank, we maintained our position as well. We're not anticipating any business-related reasons for that to decrease. In fact, the insurance and lines of credit are primarily starting at around 3%. Therefore, they are being generated at a higher rate. As a result, you might see the yield on that portfolio increase slightly over time.

And then, if you could just in broad strokes, I know you don't give detail on the breakout of these things. But, in terms of the 40% plus GDV growth year-over-year, could you maybe just kind of talk about the main drivers of that?

The primary macro driver is clear. Amazon's earnings from last night reflect a trend seen across retail, largely due to the pandemic, which has increased the use of noncash payment methods not just through FinTech companies but overall. This has resulted in high adoption rates, particularly in the FinTech sector, which is leading the charge. This quarter doesn't fully reflect some new products and programs, like SoFi, that are not yet fully implemented at The Bancorp. There’s a significant trend toward faster adoption. In fact, preliminary data for July indicates growth rates exceeding those of the second quarter, showing GDV growth in the low 50% range. This momentum appears to be sustainable; everything in our pipeline suggests that this trend will continue for an extended period, marking a generational change in how these products are utilized.

Great. Finally, you mentioned SoFi, which announced last quarter that they are pursuing a commercial bank charter. What are your overall thoughts on the challenger bank sector? How do you protect yourself considering that obtaining a bank charter can take a significant amount of time, potentially two to three years? Is this something you are concerned about, especially with the growth you are experiencing in other areas of your business?

Yes. There are very few programs involved. It's important to note that we operate in healthcare, as well as in government and gift cards and incentive cards, none of which are eligible for a license. You're correct in saying that it takes time. We support all our programs and aim to create a scalable, cost-effective, and top-tier consumer compliance and BSA platform. We believe this will attract interest, even if individuals are able to obtain licenses. They may find a lower-cost option available for purposes like lending, rather than using it for payments or deposits. Thus, we don't anticipate a significant impact on our operations. If anyone believes otherwise, they can pursue that; however, it is a challenging path. Valuations in the FinTech sector differ significantly from those in banking, so these factors need to be considered when seeking a license. As for Varo, they are still working on finalizing their license and have been an excellent partner. This does not preclude us from exploring other possibilities with them in the future. There are many greater opportunities available today, such as virtual credit cards, credit sponsorships, and expanding our BSA activities for partners who are not currently active. These prospects will easily offset any potential impact of one or two future programs on our volume. SoFi has yet to fully launch at the bank. We wish everyone success and support their strategies while also focusing on building the best scalable platform possible for BSA and compliance, which will encourage clients to choose The Bancorp as their BIN sponsor.

Our next question comes from the line of William Wallace from Raymond James.

Maybe start on the expense side. There was some commentary in the prepared remarks about some higher incentive compensation and then higher expenses on the payments business. Are those expenses that you anticipate come back out, so that $40 million run rate continues in the back half, or are these expenses, especially on the payments side, going to stay?

Some of these are one-time legal expenses. When you look at the year, it should be close to a $40 million run rate, maybe a little bit more, depending on revenue. We're experiencing an exceptional revenue trend, so we need to ensure we strengthen our platform while also compensating our employees. Last year, in the third quarter, we had a significant expense in that area. This year, we aim to be at or below that level in the third quarter, which may result in an expense increase of about 5%. You'll see substantial growth in our core revenue as well. Does that clarify things?

Yes, it does. In the CMBS portfolio that you've put on the balance sheet, there was commentary about if they don't sell. Is there still some expectation that you could package and sell those?

Yes, we're thoroughly evaluating our options. We have two main paths: we can either remain in the business while selling off most of our portfolio or we can keep the portfolio intact. We want to avoid being partially invested, so our decisions will lead us to either maintain the loans or divest most of them and proceed with the business. Currently, we believe that selling would not yield a good return, even though there's a possibility of getting to par if we sell a significant portion of the loans, which we find economically unfeasible. We believe those loans are valued at par or even higher. Our portfolio is recorded at 99, providing coverage against national credit and loss estimators. We are keen on making a well-informed decision, especially since we've faced external shocks that could change the market dynamics, similar to our exit from CMBS. We originate loans with the intention of holding them if necessary, particularly in cases of market disruptions or loss of gains, which would make holding the asset more beneficial. We've invested considerable effort in the last three years to position ourselves in this way. Our initial purpose for securitization was based on our community bank portfolio, which has now dwindled, so we are comfortable assuming the credit risk if we choose to do so.

Okay. And is that to say then that you are no longer originating loans in that business at present with these loans, as long as these loans are on the balance sheet?

Correct. We are not going to sell half the loans. It's either we keep the entire portfolio or, by the way, we have a moratorium until the end of this year, so there won't be any commercial real estate securitization loans done until then. We could distribute the loans in the first quarter of next year, but we won't distribute them unless we perceive gains. Not achieving those $10 million to $15 million gains on these portfolios significantly alters the economics of our business. If we aren't realizing $25 million a year in gains, then the spread revenue becomes much more appealing.

Yes, okay. And then, as you close the books each quarter, how are you determining the market value? Is it one external third-party or do you have two or three parties that are valuing these for you?

Yes. I’ll let Paul handle it.

Yes, we utilize various resources and depend primarily on the 1.2% estimate for most of the portfolio. For the small retail hotel, we outsource some valuations to a third party, while we also evaluate these loans internally for any potential issues. As you may recall, we recorded additional marks in the first quarter and another $1 million this quarter. Most of these marks are market-driven, largely influenced by interest rates, with some minimal credit impact, which you will find detailed in the 10-Q. We will continue this approach, and I believe we are doing everything we can to accurately assess those loans.

So, right now, there's really not much credit in that 1% discount?

Correct. Yes. That's about correct.

Yes. Currently, there are only a few hotels being affected, but overall, we are not seeing impacts from deferrals. We are working with strong sponsors, particularly on repositioning properties involving new investments and future funding. Real estate developers are typically reluctant to abandon properties they have recently invested in. Many of these sponsors manage significant multifamily properties that they have refinanced multiple times. Additionally, the markets we are operating in are largely insulated from the broader issues occurring nationwide. These areas are primarily located in the southern and central regions of the country, often near military bases and major auto manufacturing plants, where historical occupancy rates have been around 96%. I personally sit on the credit committee and have reviewed every deal in the portfolio alongside my Chief Credit Officer, and we both have a vote in these decisions. We feel confident about the portfolio we hold and believe it would not be wise to sell at this time, especially since if we entered the market now, we wouldn't achieve significantly better terms than we currently have. We could potentially exchange assets for deals that are not considerably more advantageous. However, no decisions have been finalized at this point. There is currently a pause on new originations, and we may reconsider restarting our business based on future market conditions. Holding onto the portfolio remains a viable option for us.

On the SBLOC and IBLOC business, is the demand a market share gain, or do you think there is just a lot more demand for that product in general?

It's definitely both because if you're growing 11% quarter-over-quarter and 50% year-over-year, there's likely some market share gain. I haven't calculated it, but there are only a few providers, like TriState and Goldman. I think having the right mix to provide the product seamlessly to clients is essential, and now we do with the Talea platform. We mentioned years ago that we were developing this platform and that it would change the way we operate, and it seems to be true because it has made it much simpler to access funds. With tax changes and second mortgages no longer being tax-efficient, it's easy to secure this money in just a few days, which appears to be supportive. The market is enormous, with penetration still in the single digits, under 5%. Thus, there is a vast market for these types of securities or investment assets as liquidity. I believe there is a long future ahead for this platform to continue experiencing rapid growth. By the way, our pipeline is stronger than ever. It's not just that we've seen this growth, but we're also getting GDV growth. We have more partners than we ever have before, and several providers of this product, some of whom are captive, have approached us wanting to rent our platform. Therefore, I think this particular business has significant growth potential in the coming years.

Okay. And just to be clear. So, you're not winning the business by undercutting on price. It's really a function of the ease of getting through the process for your product versus the competitors?

We are absolutely not cutting prices. We have established an economic floor and we won't go below that. There are a few cases where revenue share has led to slightly lower revenue shares with some clients on certain deals. However, if anything, you will likely see an increase in that portfolio over the next three to six months, not a decrease. We are firmly maintaining our pricing standards. I review all major deals as part of the credit committee and have turned down lower offers, which has frustrated my team, but we are not compromising on price.

One last question, Damian. This question that I've never asked before, but now that the order has been lifted, I guess, it can be a relevant question. You've always spoken about trying to identify low-risk businesses that Bancorp can be in that would help deploy your deposits with good risk-adjusted returns. Now that the order is lifted, does M&A come into the equation? Are there businesses out there that could be of interest that Bancorp might consider buying or would you think that order growth will be organic?

Of course. We don't

Could you talk a little about what types of business lines might...

Yes. There is a philosophy, but things evolve. We don’t just add core capabilities; we build them. We’ve acquired leasing portfolios and new technology that may enhance our payments. We are expanding our payments platform. Is there potential for growth with someone already involved in credit sponsorship, which is an area we are entering? Yes. We evaluate where our product services and core capabilities lie, and that guides our approach to mergers and acquisitions. Regarding M&A, we don’t purchase unrelated companies just to enhance our balance sheet. We avoid acquiring core capabilities that we don't manage as effectively as our other operations while depending on others. That’s our mindset. We are indeed accruing capital and aiming to bolster our capital base and broaden our scope. This is always part of our strategy. With the lifting of orders and maintaining healthy capital ratios, this should be a topic of discussion for any board and management team. We anticipate opportunities arising from the fact that not all companies are as well capitalized, which may lead to market dislocation. However, we will not pursue dilutive acquisitions that are not strategically aligned with our current strategy.

Thank you. At this time, I'm showing no further questions. I would like to turn the call back over to Damian Kozlowski for closing remarks.

Thank you for joining us today. We really appreciate all the questions. And we will talk soon at the end of the third quarter. Operator, we're all set.

Ladies and gentlemen, this concludes today's conference call. Thanks for participating. You may now disconnect.