Earnings Call Transcript - TBBK Q2 2024

Operator, Operator

Good day and welcome to The Bancorp, Inc. Q2 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's remarks, there will be a question-and-answer session. Please note today's call will be recorded, and I will be standing by if you should need any assistance. It is now my pleasure to turn the call over to Andres Viroslav. Please go ahead.

Andres Viroslav, Moderator

Thank you, operator. Good morning, and thank you for joining us today for The Bancorp's second quarter 2024 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 available via webcast on our website beginning at approximately 12:00 p.m. Eastern time today. The dial-in for the replay is 1-800-934-5153. Before I turn the call over to Damian, I would like to remind everyone that when used in this conference call, the words believes, anticipates, expects, and similar expressions are intended to identify forward-looking statements with 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 such 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. Damian?

Damian Kozlowski, CEO

Thank you, Andres. Good morning, everyone. The Bancorp earned $1.05 a share, or $1.07 adjusted for interest on a residual security from the securitization business exited in 2020. With revenue growth year-over-year of 7% and expense growth of 3%. ROE was 27%. NIM contracted to 4.97% from 5.15% quarter-over-quarter versus 48% year-over-year. This contraction was primarily due to the purchase of $900 million of long-term fixed-rate securities in April at a 5.11% yield. These purchases have mostly been financed through ongoing FinTech program deposits with limited borrowings. Thus, the impact of NIM has been lower than anticipated. The FinTech Solutions Group continues to show significant growth momentum from the ramp-up and expansion of new and existing programs broadly across the portfolio, and especially in B2B payments. GDV increased 13% year-over-year and total fees from all FinTech activities increased 13%. This quarter is the first where we will begin to break out our credit sponsorship loan balances and fees in our financial reporting with balances reported as consumer FinTech loans. As a key strategic initiative of the bank and objective of our APEX 2030 strategy, we have spent the last few years building a platform that will enable existing and new partners to issue credit solutions to their customers. These loans will be generally short-term and mostly secured by our partners or distributed to investors. Over the next five years, we intend to build a diversified group of regulatory-compliant credit sponsor programs that will mirror our best-in-class innovative capabilities in our FinTech payments ecosystem. On the lending side, we had year-over-year growth across a portfolio of 6%, led by small business lending with growth of 16% year-over-year and 4% quarter-over-quarter. Most notably, our institutional book has continued to stabilize and showed incremental growth quarter-over-quarter of 1%. Concerning our commercial real estate portfolio of multifamily transitional loans, we continue to expect little or no losses due to the current portfolio and individual loan leverage and our underwriting standards for loans at their inception. We recently entered an agreement to sell our one OREO multifamily property expected to close in December ‘24 with a sales price to cover the current other real estate owned balance plus the forecasted cost of improvements in process. Lastly, with continued strong growth in our FinTech activities, including credit sponsorship and growth across our lending portfolio, we are lifting our guidance to $4.35 from $5.25 a share without the impact of $50 million per quarter of share buybacks in 2024. We intend to issue preliminary 2025 guidance in our third quarter press release.

Paul Frenkiel, CFO

Thank you, Damian. As a result of its variable rate loans and securities, Bancorp's performance continues to benefit from the cumulative impact of Federal Reserve rate increases. Additionally, as Damian stated, the purchase of $900 million of fixed-rate U.S. Government sponsored agency securities in April 2024 has significantly reduced exposure to future Federal Reserve rate decreases. Overnight borrowings for the quarter averaged $92 million as the majority of the purchases were funded by deposits. While deposits generally decline in the second quarter with continuing reductions in tax refund-related balances, this quarter deposits on average increased over $200 million, compared to the first quarter of 2024. At an estimated average 5.11% yield, the securities purchases had only a modest impact on current income, while significant prepayment protection is reflected in estimated eight-year weighted average lives. Additionally, the bank continues to emphasize fixed-rate loans to further reduce exposure to lower rates. In addition to the impact of the Federal Reserve rate increases, the company benefited from loan growth, with year-over-year decreases in S-block and I-block significantly offset by increases in other higher yielding lending categories. In Q2 2024, S-block and I-block reversed the trend from net quarterly decline since the fourth quarter of 2022 to net growth in Q2 2024, notwithstanding the persistence of higher rates. We believe that higher rates have resulted in payoffs from customer rate sensitivity. The impact of the aforementioned Federal Reserve rate increases on variable rate loans and securities and lesser increases in deposit rates with growth in higher yielding loan categories was reflected in an 8% increase in net interest income in Q2 2024, compared to Q2 2023. As a result, in Q2 2024, the yield on interest earning assets had increased to 7.3% from 7% in Q2 2023, or an increase of 0.3%. The cost of funds in those respective periods increased by only $0.1% to 2.5%. Those factors were reflected in the 4.97% NIM in Q2 2024. The provision for credit losses was $1.3 million in Q2 2024, compared to $361,000 in Q2 2023. The provision for credit losses in Q2 2024 reflected the impact of $1.4 million of leasing net charge-offs, while the majority of such charge-offs had been previously reserved. The largest single component of leasing charge-offs was local trucking, transportation, and related activities for which total exposure was approximately $34 million at June 30, 2024. As described in our press release, the company entered into a purchase and sale agreement with a year-end 2024 closing deadline, with a $39.4 million balanced apartment loan, which was reported as non-accrual last quarter and which now comprise the majority of other real estate owned. Non-accrual loans, loans 90 days still accruing and other real estate owned total $77.1 million at June 30, 2024, compared to $76.7 million at March 31, 2024. While a $12.3 million loan became delinquent during Q2 2024 after having been modified with a payment deferral, the as-is and as-stabilized LTVs for related collateral are 72% and 56%, based on a May 2024 appraisal. While the macroeconomic environment has challenged the multifamily bridge space, the stability of Bancorp's rehabilitation bridge loan portfolio is evidenced by the estimated values underlying collateral. The $2.1 billion apartment bridge lending portfolio has a weighted average origination date as-is LTV of 70% based on third-party appraisals. Further, the weighted average origination date as stabilized LTV, which measures the estimated value of the apartments after the rehabilitation is complete, may provide even greater protection. One of the accounting estimates as described in the notes to our financial statements as the allowance for credit losses, which is sensitive to a variety of inherent portfolio and external factors. Rebel may be one of the more sensitive portfolios to such factors. In the second quarter of 2024, rebel loans classified as either special mention or substandard increased to $177.1 million from $165.2 million at March 31, 2024. Each classified loan was evaluated for potential increase in the allowance for credit losses on the basis of third-party appraisals of related apartment building collateral. On the basis of as-is and as-stabilized loan to values, increases in the allowance for specific loans were not required. The respective weighted average as-is and as-stabilized LTVs of those classified loans were 81% and 69%. The current allowance for credit losses for rebel is primarily based upon historical industry losses for multifamily loans in the absence of significant historical losses within the company's rebel portfolio. However, as a result of increasing amounts of loan classified as special mention and substandard, the company will evaluate potential related sensitivity of that factor for rebel. This evaluation is inherently subjective as it requires material estimates that may be susceptible to change as more information becomes available. Non-interest expense for Q2 2024 was $51.4 million, which was 3% higher than Q2 2023. The increase included a 2% increase in salaries and benefits, higher FDIC insurance expense, reflecting higher levels of deposits and higher other real estate owned expense. Book value per share at quarter end increased 15% to $15.77, compared to $13.74 a year earlier reflecting the impact of retained earnings. In summary, The Bancorp's balance sheet has a risk profile enhanced by the special nature of the collateral supporting its loan niches and related underwriting. Those loan niches have contributed to increased earnings levels even during periods in which markets have experienced various economic stresses. Real estate bridge lending is comprised of workforce housing, which we consider to be working-class apartments at more affordable rental rates in selected states. We believe that underwriting requirements provide significant protection against loss as supported by LTV ratios based on third-party appraisals. S-block and I-block loans are respectively collateralized by marketable securities and the cash value of life insurance, while SBA loans are either 7A loans that come with significant government-related guarantees or SBA 405 loans that are made at 50% to 60% LTVs. Additional details regarding our loan portfolios are included in the related tables in our press release, as are the earnings contributions of our payments businesses, which further enhances our risk profile. The risk profile inherent in the company's loan portfolios, payments funding sources, and our earnings levels may present opportunities to further increase shareholder value, while still prudently maintaining capital levels. Such opportunities include the recently concluded share repurchases of $100 million for the second quarter of 2024 from the original $50 million.

Damian Kozlowski, CEO

Thank you, Paul. Operator, please open the line for questions.

Operator, Operator

The floor is now open for questions. Our first question will come from David Feaster with Raymond James. Please go ahead.

David Feaster, Analyst

Hi, good morning, everybody.

Damian Kozlowski, CEO

Good morning, David.

David Feaster, Analyst

I wanted to first touch on the rebel book quick. I was hoping to get a bit more update on that rebel OREO loan. It's great to see the buyer lined up. Still a decent amount of time for that to close though. I guess, could you talk about the plans in the intermediate term with the construction and timeline for that? And then just with the non-accrual migration you see more broadly, is there any commonality with where you're seeing that migration from a regional perspective or anything?

Damian Kozlowski, CEO

The first part is on track. It's the property in Houston, and we should be mostly finished with the work over the summer leading up to the closing. The buyer is engaged and has conducted due diligence on the property as well as being part of the planned strategy. The trends we’re seeing are primarily from the vintage of 2021 and 2022. There has been some stress due to rising interest rates and supply chain issues stemming from the pandemic. When we deviate from the plan, whether in time or cost, it can lead to weaknesses that might escalate the loan to substandard status. This is the credit migration we’ve observed. We are working closely with our sponsors to assist them if they deviate from the plan. Typically, if there's significant deviation, the sponsor will inject additional equity or we will hold back our own funds. Currently, we don’t have many non-paying cases, which is a positive indicator. There are definitely pools of capital and sponsors actively seeking these opportunities. With the low leverage levels, there is capital available to recapitalize these loans, as illustrated with the Aubrey loan. While more credit migration could occur, we are not seeing any losses at this time.

David Feaster, Analyst

Okay, that's helpful. And then obviously the regulatory backdrop is challenging. We've seen some competitors under pressure, but I'm curious how does this benefit you and your pipeline? I mean your understanding your pipeline is always full. We've talked about that in the past, but have you seen any shift? Are you seeing maybe stronger or higher quality partners come to you? And is this giving you maybe more pricing power, just kind of given the strength of your platform? Curious what you're seeing?

Damian Kozlowski, CEO

Yes, there’s no doubt that this is happening. We are unable to facilitate smaller programs due to widespread dislocation in the banking as a service space and increased regulatory scrutiny. Aspects such as third-party risk management, model risk management, fair lending, and compliance with BSA and AML regulations are all being closely examined by regulators. Over the past seven years, we have invested in developing a portfolio and completely overhauling our middle office, technology, and compliance framework to meet regulatory standards. However, we are not taking on smaller programs. We are seeing substantial interest and are collaborating with large partners who may be considering a move due to regulatory pressures. This situation is positively impacting our pricing, which has remained mostly stable over the past five years. Meanwhile, our costs have decreased thanks to our highly scalable platform, avoiding significant increases in our cost structure. Incremental programs significantly influence profitability because of our cost scalability and the larger size of the programs we are onboarding. Typically, these programs are also more profitable initially, covering implementation costs and being tiered, which allows pricing adjustments as they scale up in volume, leading to greater profitability owing to our platform's scalability.

David Feaster, Analyst

Okay.

Operator, Operator

Thank you. Our next question will come from Tim Switzer with KBW. Please go ahead.

Tim Switzer, Analyst

Hey, good morning. Thank you guys for taking my questions. I have kind of a follow-up on the Vast regulatory landscape here. So the Fed and some of the other regulators published a joint press release yesterday kind of discussing the risk of what they call third-party deposit arrangements and they requested additional information from participants? Can you provide your thoughts on how regulator expectations are changing for these Vast partnerships? And if you think there are any significant rule changes coming, particularly given the developments over, when you say the last year, but particularly with the situation, it's kind of gotten a lot of media headlines and might start to get some politician attention as well?

Damian Kozlowski, CEO

The regulatory expectation is that if you're doing these banking and service arrangements, that you have to validate the operations on a third-party basis. So, they really think of it as you running the business, that it's not outside of you. So you have third-party risk management, BSA, AML, consumer compliance, whatever it is, you have to overlook and assure that it's compliant. And I think that because the industry grew so quickly, there were a lot of small players, a lot of smaller players got into the market without building out sufficient infrastructure, that the regulators are now going back and ensuring that, that's true. And they've obviously gone back and there's been inadequacies and people's ability to demonstrate that validation. And so while we were under scrutiny, obviously years ago and under consent orders and we worked very closely with the FDIC and now with the OCC and the Novel Banking Group, I think we had a big head start on creating that compliant model and making sure that, that validation can happen. And that lowers, as far as the regulators view, you're more compliant and you're far lower risk. And so now, obviously, now that, that scrutiny has come to the industry, we are already at the finish line and people now have to catch up. The thing I would say is to be that compliant platform that can do that validation is incredibly expensive. So we have a fair amount of broad verticals. We have great positions across many industries. So we have the volume and the ability to invest in that platform. So it's unlikely that everyone in the industry would be able to do that, and some have exited. And so that dislocation will continue for some time.

Tim Switzer, Analyst

Okay, understood. That was a great summary. I guess just to be a little bit more specific to The Bancorp, do you think there's anything, because the regulators have kind of had this expectation for a while that just really cracking down on it? Do you think there's anything new that would maybe, I know you're continuing to invest part of it. There's anything new the regulators might come out with their change of expectation a little bit that will change how you operate or require a little bit additional investment to stay ahead of it?

Damian Kozlowski, CEO

We consistently prioritize our investments from the beginning. It took us years to establish our credit sponsorship, and we have been investing in that platform for a long time. We intend to approach embedded finance in the same manner as we start building that platform. We have collaborated closely with regulators to understand their expectations and continue to adapt to them. As leaders in this space, we will face increased scrutiny not only from regulators but also from competitors, both large and small. However, our multi-year head start in time and investment allows us to adjust more easily. This ongoing process has been in place for years. In the past, during our challenges with consent orders, there was a lack of consensus among regulatory bodies on how to regulate the validation process and compliant third-party risk management. Nowadays, there is a better contextual understanding among both the industry and regulators. This has resulted in difficulties for smaller players, who struggle to make significant investments given their lower volume and earlier stage programs. They are likely to experience a larger gap between what is expected and what is achievable. We do not anticipate facing a significant dislocation. We will continue to enhance our platform as regulators modify their expectations, investing any necessary resources to meet these expectations. If the changes are too drastic, it may impact others more than us since we are already aligned with those expectations on an ongoing basis.

Tim Switzer, Analyst

Okay, totally understood. Thank you. I'll jump back in the queue.

Operator, Operator

Thank you. Our next question will come from Frank Schiraldi with Piper Sandler. Please go ahead.

Frank Schiraldi, Analyst

Good morning.

Damian Kozlowski, CEO

Good morning, Frank.

Frank Schiraldi, Analyst

I think there's still a limited supply of new credit in this sector. Can we assume that Bancorp would be financing the sale of this property in Houston?

Damian Kozlowski, CEO

Oh, no, we'll be out of that property. There'll be new financing in place.

Frank Schiraldi, Analyst

Okay, great. Paul, you mentioned reviewing your criticized classifications, and considering that there haven't been any historic losses, would you think about reserve builds in that area? I'm curious how we should view this now. Is it something significant or just incremental? Could this pose a risk to the $4.35 target? I’d like to understand the potential for any reserve builds in the next couple of quarters.

Paul Frenkiel, CFO

We reviewed all of the special mention and substandard loans and found that none require an individual reserve. Therefore, as we have mentioned before, we do not anticipate any losses, despite an increase in classified loans. However, CECL requires us to assess sensitivity to various factors, and if there are loans with issues, we will closely monitor the trends and their potential impact on our allowance for credit losses. Consequently, it is possible that we may recognize additional provisions, which could affect our guidance. But again, we do not expect any actual losses. It is important to differentiate this point. If CECL suggests the need for a larger allowance, we will address that, but we do not foresee any losses occurring.

Frank Schiraldi, Analyst

Okay, I understand that the process is ongoing. Just one last question before I move on. Regarding the recent change in the share price and the current buyback plan, you've increased it to $50 million a quarter in the second quarter. Are you still confident in maintaining that buyback plan for the second half of the year?

Damian Kozlowski, CEO

Yes, we're very comfortable with the $50 million. The $100 million was a very unique opportunity. We bought the shares at $33, I believe. But we'll probably do the $100 million, unless the board decides otherwise, but I think it'll be $100 million. And then when we give guidance, we'll also mirror the buyback next year off the net income. Right now we have sufficient capital, even if the extra $50 million didn't really change our ratio that much in the Tier 1 leverage ratio and the other ratio. So, we're extremely strong capital position. And we pretty much have around the amount of capital we'll ever need, because of the Durbin Amendment limitation on the $10 billion bank. So we're in an incredibly good earnings and capital position. And we will continue to buy back the shares when they're undervalued, and we believe those shares are undervalued as of today.

Frank Schiraldi, Analyst

Great. Thank you.

Operator, Operator

Thank you. Our next question will be a follow-up from David Feaster. Please go ahead.

David Feaster, Analyst

Hey, thanks for taking the follow-up. You got a lot of pretty exciting initiatives going on. I was hoping to touch on some of them. We're starting to see the benefits of the credit sponsorship, which we talked about. You alluded to embedded finance, which you're rolling out. We've also talked about monetizing your risk and compliance functions. Just curious if you could give us an update on those and any other initiatives you're working on, and maybe how AI could play into that, because that's a pretty big buzzword these days. Just hoping to get an update on some of the things you're working on and what you're excited about?

Paul Frenkiel, CFO

You're correct about AI. We have a team dedicated to exploring how we will utilize AI in the future, along with a technological vision. We need to carefully consider this as we've made significant investments to completely overhaul our technology infrastructure, improve redundancy, and strengthen our cybersecurity. This work has been ongoing, but we are also focused on transforming the bank into a FinTech-centered platform. This is not just about being a significant part of our business but having a dedicated focus on it while considering our technology and AI needs. It’s very exciting. On the credit sponsorship side, our efforts are paying off. We have several programs and partners eager to work with The Bancorp. Currently, we are in the 70s in terms of our first tier, and it's growing. We anticipate this could reach between $300 million and $500 million on our balance sheet by the end of the year, with a possibility of hitting $1 billion next year. This business is highly accretive as it involves an ecosystem for payments linked to it. It's a very profitable venture, often with partners who already hold deposits at our bank. Effectively, we leverage our partners' liquidity to extend loans to their clients, which is very exciting. Looking ahead to our APEX 2030 balance sheet, we aspire to have 20 programs in five years, reflecting the size of banking-as-a-service models. Most of these will be balance sheet light, distributed yet secured by our partners who provide the deposits. This is also very promising, particularly as we work towards building embedded finance capabilities, which we don't currently offer. Retail companies that operate their apps require financial services integrated within them, and we would manage that aspect for them. This is anticipated to be a rapidly growing need across the economy. We believe we already have the best banking-as-a-service ecosystem, so implementing this will likely be straightforward for the marketplace. We've received significant inquiries about this service, indicating strong demand. In fact, we are already collaborating with others in the field to explore how we might provide this in certain contexts. These two areas alone represent substantial opportunities both in fees and on our balance sheet. When we discuss APEX, we envision growing our current fees of $100 million three to four times over the next five to seven years, which could mean an increase in spread revenue of $100 to $200 million. We are excited about the prospects for credit sponsorship in the near term, as we expect to see those balances grow significantly. For embedded finance, we will be patient and careful to ensure we deliver best-in-class capabilities to our partners. We are not rushing this process, and our core business is expanding rapidly, with leading players in the market expressing interest in joining our ecosystem. We're very enthusiastic about this.

David Feaster, Analyst

That's great. Thank you.

Operator, Operator

Thank you. We have a follow-up question from Frank Schiraldi. Please go ahead.

Frank Schiraldi, Analyst

Thanks. Yes, just back to the increase in guidance, is the primary driver of that credit sponsorship, and just when you talk about balances moving higher in the near term, is something along the lines of $0.5 billion in balances, a reasonable place to land at the end of this year? And I assume that would be more than one program?

Damian Kozlowski, CEO

Yes, especially with credit sponsorship. There's no doubt that if we're looking at $300 million to $500 billion in that area alone, we can anticipate an increase in balances. One aspect we may not have emphasized enough is the deposits. We're observing an increase in deposits across all sectors that we haven't typically seen during this time of year, especially when we exclude the impact of stimulus checks from the pandemic. This is crucial because it allows us to reduce funding costs over time by removing higher-cost deposits and borrowings from the balance sheet. With interest rates decreasing, there's potential for us to lower our bank funding even further by having more demand for non-interest-bearing deposits. This is very beneficial for profitability. Additionally, the incoming business from the FinTech sector is significant, and we expect the addition of more large programs in the next 12 months. All of this supports our guidance and indicates continued substantial increases in profitability over the next two years.

Frank Schiraldi, Analyst

Okay, great. And then as we think about just near-term trends you talked about the deposits being a bit higher than you would have thought based on previous seasonality, I guess, end of period. And as I think about, as we think about NII for the third quarter, kind of a good run rate, is it better to use kind of end of period balances or average balances for the court, any guardrails you guys can put around kind of NII expectations just because there's so many different things going on in terms of drivers?

Paul Frenkiel, CFO

Well, I'd go end of period and our NIM is going to be around 5% regardless of the loan type. So, it might even, it's going to be around, it could actually, we had that million dollars in there that we had to back out after tax, because of that one securitization that was a long time ago. And we do have plenty of coverage on that security, so we're not expecting a loss on that either. So 5-ish, it might take a little bit higher, depending on the class. But the issue with the loans that we're doing in certain cases on the FinTech side, some of that will be in fees, because of the way some of these loans work instead of in NIM. So you'll see some of the fees growing and some of that will actually be NIM related technically. But the 5% is I think a good, because we don't know exactly who's going to grow and in what cases, but in our modeling, that's kind of where it is.

Frank Schiraldi, Analyst

Great. Okay. Thanks.

Operator, Operator

Thank you. At this time, I would like to turn the call back to Damian Kozlowski for any additional or closing remarks.

Damian Kozlowski, CEO

Thank you, everyone. We appreciate you attending our conference call. Operator, you may disconnect the lines.

Operator, Operator

Thank you. This does conclude The Bancorp, Inc. Q2 2024 earnings conference call. You may disconnect your line at this time and have a wonderful day.