Earnings Call Transcript - VBNK Q3 2022

Operator, Operator

Good morning, ladies and gentlemen. Welcome to VersaBank’s Third Quarter 2022 Financial Results Conference Call. This morning, VersaBank issued a news release reporting its financial results for the third quarter and year-to-date ending July 31, 2022. That news release, along with the Bank’s financial statements and supplemental financial information, are available on the Bank’s website in the Investor Relations section, as well as on SEDAR and EDGAR. Please note that in addition to the telephone dial-in, VersaBank is webcasting this conference call live over the Internet. The webcast is listen-only. If you are listening to the webcast but would like to ask a question in the Q&A session following Mr. Taylor’s presentation, please dial into the conference line, the details of which are included in this morning’s news release and on the Bank’s website. For those participating in today’s call by telephone, the accompanying slide presentation is available on the Bank’s website. Also, for today’s call will be archived for replay, both by telephone and via the Internet, beginning approximately one hour following completion of the call. Details on how to access the replays are available in this morning’s news release. I would like to remind our listeners that the statements about future events made on this call are forward-looking in nature and are based on certain assumptions and analysis made by VersaBank management. Actual results could differ materially from our expectations due to various material risks and uncertainties associated with VersaBank’s business. Please refer to VersaBank’s forward-looking statement advisory in today’s presentation. I would now like to turn the call over to Mr. David Taylor, President and Chief Executive Officer of VersaBank. Please go ahead, Mr. Taylor.

David Taylor, President and CEO

Good morning, everyone, and thank you for joining us for the Q3 call. With me today is Shawn Clarke, our Chief Financial Officer. Before I begin, just a quick reminder regarding the adjustments we made last quarter to the way we are describing our business and our quarterly results. These include breaking out non-interest expense into its components, Digital Banking and DRTC parts, to provide a clear picture of the individual performance of each of the operations and enabling better comparison to our peers in each sector. In addition, within our Digital Banking operation, we now present net interest margin based on both total assets as this convention with publicly traded banks in Canada, as well as excluding cash securities and other assets from total assets as is the practice of U.S. banks. Finally, we began reporting our efficiency ratio for only our Digital Banking operations, which excludes the impact of DRTC. Now onto the results for the quarter, which are reported and will be discussed on this call in our reporting currency of Canadian dollars. I will note that we provide U.S. dollar translations for most of our financial numbers in our standard investor presentation, which will be updated and available on our website shortly. The third quarter saw outstanding loan growth in our core Digital Banking operations as a 75% year-over-year and 24% sequential increase in our Canadian Point-of-Sale financing business drove our loan portfolio to another new high at more than $2.8 billion. And I will note that 75% year-over-year growth betters the very healthy 51% year-over-year growth in the Canadian Point-of-Sale portfolio last quarter. It is worth mentioning here that we fed this growth with essentially no impact on our interest margin and without relaxing our stringent credit. The continued growth in our loan portfolio drove record quarterly revenue for the third quarter, both for Digital Banking operations and on a consolidated basis. We achieved near-record profitability as we returned to both year-over-year and sequential growth in net income, even with net income being dampened by transitory non-interest expenses related to strategic growth initiatives that we believe will accelerate our growth in both the near and long terms. Specifically, we continue to incur short-term costs related to our acquisition of a national U.S. bank, which I will discuss more in a moment. Development of the equivalent of our highly successful point-of-sale financing solution for the U.S. market, continued preparation for the launch of our Canadian dollar version of our revolutionary digital deposit receipts, as well as incremental costs associated with listing on NASDAQ last September. Combined, these transitory costs approximately $3 million to our Q3 non-interest expenses. We expect these costs to dissipate over the fourth quarter and return to normalized levels for 2023. Without these transitory costs, third quarter 2022 net income would have been by far our best quarterly profitability in our history. Shawn will discuss the financials in more detail in a moment. In addition to our strong financial performance, the major highlight for the third quarter was the announcement of our signing of a definitive agreement to acquire a fully operational, OCC-chartered national U.S. bank, Minnesota-based Stearns Bank Holdingford. This is a transformational next step in VersaBank’s long-term growth strategy. The U.S. market has been a priority for us for several years, and one of the key reasons for our NASDAQ listing. We are steadily progressing towards closing the transaction, which we expect by the end of the calendar year. To be renamed VersaBank USA upon closing, Stearns Bank Holdingford will provide VersaBank with a platform from which to roll out our immensely successful Canadian Point-of-Sale financing model to underserved U.S. markets. While substantially the same as our Canadian Point-of-Sale offering going forward, you will hear us refer to the U.S. version of this program as our U.S. receivable purchase program, which is terminology that is more consistent with the U.S. market environment. We are currently enjoying working with the teams holding for parent companies Stearns Financial and look forward to exploring future opportunities for collaboration to our mutual benefit. On our Q2 earnings call, I discussed having signed up our first customer for the limited early rollout of our receivable purchase program in the U.S. That customer is a large North American commercial transportation financing business focused on independent owner/operators. They are a great example of the inherent value of our offering, addressing an unmet need in the market by providing a highly flexible and economically superior, technology-based alternative. They have already significantly expanded their business with us. The U.S. customer and small business Point-of-Sale financing market is massive, at $1.8 trillion, and growing rapidly. Our unique and attractive solution arrives at a time when one of the two primary sources of funding for Point-of-Sale business in the U.S., the public market, has all but dried up. We continue to be very encouraged by the discussions we’re having with potential partners in the U.S. and very much look forward to closing our U.S. bank acquisition to fully capitalize on this opportunity. I’d now like to turn the call over to Shawn to review our financial results in detail. Shawn?

Shawn Clarke, CFO

Thank you, David. Before I jump in, folks, just a quick reminder that our full financial statements and MD&A for the third quarter and year-to-date 2022 are available on our website under the Investor Relations section, as well as on SEDAR and EDGAR. And as David mentioned, all the following numbers are reported in Canadian dollars as per our financial statements, unless otherwise noted. Starting with an overview of the balance sheet, total assets at the end of the third quarter surpassed the $3 billion mark for the first time, at $3.1 billion, up 35% from $2.3 billion at the end of Q3 last year and up 14% from $2.7 billion at the end of the second quarter of this year. Cash and securities at the end of Q3 were $218 million or 7% of total assets, down from $297 million or 13% of total assets at the end of Q3 last year, and up from $198 million or 7% of total assets at the end of Q2 of this year. These trends resulted from the bank deploying cash into higher-yielding lending assets and low-risk securities over the course of the quarter. Our total loan portfolio at the end of the third quarter grew to another record balance of $2.81 billion, an increase of 44% year-over-year and 15% sequentially. Book value per share increased 8% year-over-year and 2% sequentially to $12.14, which is also a record for the bank. These trends were both a function of higher retained earnings resulting from net income growth, partially offset by dividends paid with the year-over-year increase also being impacted by our common share offering in the U.S. last September. Our CET1 ratio was 12.51%, up from 11.94% at the end of Q3 of last year and down from 13.6% at the end of Q2 of this year. While the leverage ratio at the end of Q3 was 10.38%, up from 9.99% last year and down from 11.63% at the end of Q2 of this year. Both our CET1 and leverage ratios remain well above our internal targets. Turning to the income statement, total consolidated revenue increased 35% year-over-year and 14% sequentially to a record $21.2 million, with the increase driven primarily by higher net interest income from our digital banking operations resulting from the strong growth in our loan portfolio that I mentioned earlier. As David noted previously, we returned to both year-over-year and sequential growth in consolidated net income in Q3, increasing by 5% and 16% over the respective periods. Net income for Q3 was $5.7 million and, as with the case in Q2, was driven by a number of transitory costs related to critical investments in several strategic growth initiatives, including the U.S. bank acquisition and the launch of the U.S. version of our Point-of-Sale offering, as well as preparation for the launch of our Digital Deposit Receipts, all incurred in advance of these initiatives generating incremental profitability for the bank. The transitory costs also included certain elevated costs resulting from our listing on NASDAQ, which we’ve been able to reduce substantially since early August. As David noted previously, these transitory costs totaled approximately $3 million for the current quarter. Earnings per share for Q3 was $0.20, which is down 20% year-over-year due to the higher number of shares outstanding resulting from the issuance of 6.3 million common shares under our U.S. IPO in September of last year. Earnings per share was up, however, sequentially by 18%. I want to reiterate David’s comments earlier, that we expect the costs associated with the strategic business development initiatives to mitigate somewhat in the fourth quarter and return to normalized levels for 2023. The strong growth in our overall loan portfolio was driven by our Point-of-sale financing business, which increased 75% year-over-year and 24% sequentially, reaching the $2 billion mark. This growth continues to be driven mainly by strong demand for home finance, home improvement, HVAC, and auto receivable financing. Our Point-of-Sale portfolio continues to expand as a portion of the overall portfolio, and per our strategy, now represents 71% of our total loan portfolio as of July 31, up from 66% last quarter. Our commercial real estate portfolio increased 1% year-over-year and decreased 3% sequentially to $804 million at the end of Q3. As we noted last quarter, management has taken a more cautionary stance with respect to the commercial portfolio due to expected volatility and valuations within this asset class in a rising interest rate environment, and the potential impact of the same borrower's ability to service debt, as well as concerns related to higher commodity prices attributed to current global supply chain disruptions and a very tight labor market, both of which have the potential to drive higher construction costs. Notwithstanding our cautious approach, we remain very comfortable with the risk profile of our commercial real estate portfolio, which has been established through our work with well-established, well-capitalized development partners. Additionally, we maintain modest loan-to-value ratios on individual transactions. Turning to the income statement for our digital banking operations, net interest income for this segment for the third quarter increased 38% year-over-year and 16% sequentially to a record $20.1 million. These increasing trends were primarily a function of loan growth in the respective periods. Net interest margin on all interest-generating assets for Q3 was 2.76%, essentially unchanged from the second quarter of 2022 and up from 2.61% from Q3 of last year. The year-over-year increase was primarily a result of higher yields earned on loans and liquid securities. Net interest margin excluded the impact of cash, securities, and other assets for Q3 was 3.07% compared with 3.43% for the same period last year and 3.11% for Q2 of this year. These modest decreases are primarily the result of changes in the bank’s funding mix. Non-interest expenses for the quarter totaled $13.2 million compared to $8.2 million for Q3 of last year and $11.8 million for Q2 of this year. Both increases were due primarily to higher costs, approximately $3 million of which were of a transitory nature related to strategic growth initiatives and the NASDAQ listing, which we discussed earlier this morning. The year-over-year increase was also a function of higher salary and benefits expense attributable to higher staffing levels to support expanded business activity across the bank, as well as increased costs associated with employee retention and higher office and facility-related costs attributed to the implementation of the bank’s return-to-work strategy. The cost of funds for Q3 was 1.94%, which represented an increase of 53 basis points year-over-year and 56 basis points sequentially, primarily due to a higher interest rate environment and changes in the Bank’s funding mix. Notably, this increase was significantly less than the Bank of Canada’s benchmark increase, which is up 50 basis points during the quarter as a result of our continued focus on ultra-low cost funding sources, primarily derived from insolvency professional deposits. Insolvency professional deposit balances contracted slightly in Q3, despite adding more partners, as we experienced the lag effect of the government of Canada’s COVID-19 financial support and historically low bankruptcy activity. Despite recent increases, bankruptcy activity is still well below pre-pandemic levels. As a result, our insolvency professional deposits comprised a smaller portion of our overall deposit base this quarter. We do, however, expect a return to growth in our insolvency professional deposits in early fiscal 2023, driven by an anticipated increase in the volume of consumer bankruptcies, which historically accompany a rising interest rate environment and as we continue to add new insolvency professional partners. Our provisions for credit losses in Q3 once again reflected the prudent risk mitigation strategies inherent in our lending models and outstanding credit quality of our loan portfolio. For Q3, we recognized a provision for credit losses (PCL) in the amount of $166,000, compared to PCLs in the amount of $96,000 in the same period a year ago and $78,000 in Q2 of this year. PCLs as a percentage of average loans were 0.03% this quarter, compared with a 12-quarter average of negative 0.01%, which continues to be amongst the lowest of the publicly traded Canadian federally licensed banks. Gross impaired loans at the end of Q3 stood at $1.4 million, with $1 million of that amount having been repaid two days after the quarter end and the remaining $400,000 scheduled to be repaid in early September of this year. Turning now to DRTC, our cybersecurity services and banking and financial technology development operations. Revenue and gross profit generated entirely by the cybersecurity services component of the business increased by 7% and decreased by 2% year-over-year to $2.1 million and $1.2 million, respectively. Revenue and gross profit were down 12% and 17% sequentially. The sequential decrease was a function of lower engagements over the course of Q3. However, on a year-to-date basis, both revenue and gross profit were up 27% and 26%, respectively. Importantly, the DRTC cybersecurity services business continues to be profitable, despite incurring higher salary benefits and business development costs. DRTC, on a consolidated basis, reported a net loss of $0.7 million compared to net income of $0.2 million in Q3 of last year and a net loss of $0.5 million in Q2 of this year, with the losses being driven by costs outside of the cybersecurity services business related to work on strategic growth initiatives, including DRTC's work on the Bank’s Digital Deposit Receipts, as well as other technology development initiatives that are not yet contributing to revenue. I’d now like to turn the call back to David for some closing remarks. David?

David Taylor, President and CEO

Thanks, Shawn. Finally, before I open the call up for questions, a quick update on our Canadian Digital Deposit Receipts, which I know is of great interest to many of you, and which represents a significant opportunity with our low-cost deposit funding strategy. But before I do that, I want to be clear with respect to VersaBank’s exposure to the so-called cryptocurrencies. Quite simply, we have not. We hold no such assets. We never have. Accordingly, our balance sheet has in no way been impacted by the meltdown in the cryptocurrency market. If anything, we expect to benefit from this meltdown. Our Digital Deposit Receipts represent an attractive alternative to the unregulated stablecoin market, with the goal of providing individuals and businesses with a highly encrypted, interest-earning digital deposit with a federally regulated bank that can also be used for transactional purposes. Recently, the Canadian Office of the Superintendent of Financial Institutions published an advisory entitled 'Interim arrangements for the regulatory capital and liquidity treatment of crypto asset exposures.' VersaBank applauds OSFI’s leadership in this regard, as we fundamentally believe that a regulated industry is in the best interests of the users of digital currency. We are confident that our Digital Deposit Receipt model is consistent with the content of OSFI’s advisory as we continue to evolve our model amidst the changing macro environment. We look forward to providing updates on our progress towards commercial launch as we continue our constructive discourse with OSFI to ensure their prudential comfort. Our cybersecurity business and DRTC continue to contribute positively to the Bank’s overall earnings, although it remains a relatively small part of our P&L. DRTC overall plays a critical role in our competitive advantage as a digital bank, combining technology development for our own internal benefit with a significant growth opportunity in a rapidly expanding market. The third quarter of 2022 was strong evidence of the ability of our digital banking operations to generate outsized growth as we continue to grow our loan portfolio, led by the continued success and expansion of our Canadian Point-of-Sale financing business. We expect continued momentum throughout the remainder of the year and into 2023, as consumer spending is expected to remain robust, albeit likely somewhat moderate from 2022 levels due to the Bank of Canada’s actions. Our unique solution continues to be a very attractive source of financing for our partners. We expect this to support increased volumes, contributing to continued strong growth in the Point-of-Sale portfolio. Our success and growth in our Point-of-Sale solution in Canada gives us great confidence regarding our opportunity in the significantly larger U.S. market. Upon closing our U.S. acquisition, which will provide access to ample U.S. dollar deposit funding, we expect to significantly ramp up our U.S. receivables purchase program, signing up new partners and expanding business with existing partners. With each passing month, we see even more potential opportunity for our unique solution in the U.S. as an attractive option for consumer and small business point-of-sale finance firms. At the end of the day, our business is very simple. The larger our loan portfolio, the greater our profitability. And with the anticipated continued strong growth in the Canadian Point-of-Sale portfolio and the significant opportunity presented by our U.S. receivable purchase program, the potential for outsized net income growth has never been better. With that, I would now like to open the call to questions. Operator?

Operator, Operator

Thank you, Mr. Taylor. Ladies and gentlemen, we will now begin the question-and-answer session. Your first question comes from Greg MacDonald, LodeRock Research. Please go ahead.

Greg MacDonald, Analyst

Thank you. Good morning, David. Good morning, Shawn. How are you guys?

David Taylor, President and CEO

Pretty good. Thanks, Greg.

Greg MacDonald, Analyst

Hey, I just have two questions, and then I’ll pass it on to the others. First is on DRTC. You talk about a sequential decline in revenue and then the press release itself talks also about growth continuing to be expected in that business, specifically benefiting from investments made in 2022. Can you just talk overall about the business outlook there? And is that specifically the issue; it’s getting a number of products in the suite that kind of sets that business up for growth? Is that still a business that we should expect double-digit growth on a sustainable basis? And then I have a second.

David Taylor, President and CEO

Well, there is some seasonality in the DRTC’s business, particularly with DBG our digital penetration tester. So we expect towards the end of the year it’ll come back as it does normally. Some of the new products that we’ve been working on have now been launched and have been quite well received. I think we’ve got at least one contract signed and maybe two more to go. So we’re pretty excited about that progress and that some of these products took a little while to develop. There’s another aspect to the testing we do that we’ve been engaged by a very large Canadian corporate, and there’s a lot of revenue associated with that. So generally speaking, what we’ve been working on, namely the skunk works has now come to market ready products. And in fact has been contracted by some parties already. So it looks very good for DRTC.

Greg MacDonald, Analyst

And is pen testing still the major demand in that business?

David Taylor, President and CEO

It is now, but there’s another aspect to pen testing, app testing is an area that we’re growing in quite rapidly. And then this compliance with anti-SPAM legislation software that we developed is very popular too. So that’s something we developed internally and seems to be very well received by the marketplace.

Greg MacDonald, Analyst

Okay. Thanks for that. And the second is on the insolvency deposit strategy. This is something that’s interesting to me. I would’ve expected more small business failures to drive more insolvency growth. And we haven’t really seen that, but increased interest rates are certainly – almost certainly going to drive consumer insolvency. Can you talk, you stated specifically that you expect growth in early 2023, which suggests to me that you’re getting some signals from the market. I know you’re adding partners, but can you talk generally about what you’re seeing there, and the level of growth you expect in that part of the deposit structure?

David Taylor, President and CEO

Well, we are still the first – Statistics Canada’s reporting, we’re still about 10% less than normal insolvency in Canada, but that’s often at a 35-year low. So the 10% less tends to dampen the deposits that we raise in that area. And also there’s quite a lag effect. So we’re still seeing a little contraction in our deposits, even though we’ve signed up some new partners. The 35-year low is still sort of impacting our deposits now. I expect, I think as most people do, increasing interest rates going to create a fair amount of hardship for people and small businesses living on the edge. And that’s – there’s 10% below normal insolvencies, and proposals will probably get up to 10%, 15% above normal, with a lag of about six months leading into 2023, with significantly increasing deposits.

Greg MacDonald, Analyst

Okay. That’s helpful. Thanks, David. I’ll pass it on.

Operator, Operator

Your next question will come from Bradley Ness of Choral Capital. Please go ahead.

Bradley Ness, Analyst

Hello, gentlemen, can you hear me?

David Taylor, President and CEO

Sure, we can, Brad.

Bradley Ness, Analyst

Great. I just wanted to delve a little bit into these $3 million of the transitory costs. Can you break that down for me a little bit?

David Taylor, President and CEO

Yes, certainly, Brad. About 60% of it would be legal and consulting primarily to do with the Stearns acquisition and the refinement of the U.S. receivable program. That’s about 40% or so that’s associated with savings we got from the renewal of our directors and officers liability insurance. But when we listed on the NASDAQ, we agreed to our premium of about $3.6 million per year for that insurance, and we subsequently renewed it with about a $2.1 million savings in August just now. So those are real – they’re really transitory costs and certainly, we can look forward to about a $500,000 per month reduction in D&O expenses from the NASDAQ. There were also some NASDAQ costs that we had used to pay outside parties to conduct the reporting, and now we’re doing that internally.

Bradley Ness, Analyst

Okay, great. Thank you. And I’m just trying to look at my math here. You said the $500 reduction per month, so that’s $3 million right there. And that just related to the D&O expense?

David Taylor, President and CEO

No, sorry. That’s $500 per quarter. It was $2.1 million.

Bradley Ness, Analyst

Oh, you said per quarter.

David Taylor, President and CEO

Yes.

Bradley Ness, Analyst

Okay. Per quarter. Got it. So that should fall off in August. And would the other 60% of that $3 million basically fall off once you complete the acquisition, you think?

David Taylor, President and CEO

Absolutely. Yes. It may tail off a little bit in the quarter room now, and that we’re very close to submitting the application, the OCC in the Fed for the acquisition. But I can’t say for sure with legal expenses we know what will occur a little bit, but we believe we’re sort of at the tail end now of the creation of the application and the consulting fees and the legal should tail off and diminish in the first part of 2023.

Bradley Ness, Analyst

Okay, great. Thanks. And regarding the DRTC, it seems like revenue has been flat, but expenses have grown $1 million versus the year ago quarter. It does seem like you’re incurring some VCAD expenses in there. Is that correct?

David Taylor, President and CEO

VCAD expenses and expenses related to the sort of skunk works type projects that we’ve got going on in DRTC. So yes, we’ve got some – we think some exciting projects, but we’re not ready yet to reveal it.

Bradley Ness, Analyst

Okay. And when I think about how you divided up the bank with the digital bank and DRTC and financial reporting, if you’re incurring a fair amount of costs from VCAD in DRTC, is that where the VCAD is going to show up entirely, is in DRTC or is it just going to be partially in DRTC?

David Taylor, President and CEO

It would show up in the bank; it’s a bank product, but DRTC is providing the service. So there’ll be a service agreement between DRTC and the bank. Basically, DRTC owns what we call VersaVault, and VersaVault is a key technology for the issuance of these Digital Deposit Receipts.

Bradley Ness, Analyst

Okay. Okay. Maybe as a recommendation, if you could break out kind of the VCAD related expenses from DRTC, it would clean it up for me, it would definitely be appreciated. But let’s see two more, and then I’ll open up to someone else. So what is the balance of the U.S. Point-of-Sale loans now?

David Taylor, President and CEO

I think it’s $39 million right now.

Bradley Ness, Analyst

$39 million. Okay. Thank you. And lastly, here on the VCAD commercial launch, now that you are totally within the OSFI guidance, what’s the timeframe then, as you’re thinking about that launch?

David Taylor, President and CEO

Well, I’m thinking about it before the end of our fiscal year, which is October 31. And yes, as I said in the presentation, I was very pleased that OSFI came out with the definitive guideline, because it’s now fairly easy for us to check the boxes with our Digital Deposit Receipt. They’ve given a nice list of a group one crypto asset, they call it, but from our perspective, it’s crypto liability. So we’re very pleased to see OSFI come out with that clear direction. So presently we’re just going over our product and ensuring that it meets OSFI’s guidelines completely.

Bradley Ness, Analyst

Okay. You think that’s a two-month process? I know you guys were ready to go six months ago or so, maybe even longer.

David Taylor, President and CEO

It might be less – we’re working with OSFI, FINTRAC, and CDIC to ensure they’re comfortable with it. And some say with the wine, no wine before it’s time; for who said that, I’d like to go, of course a lot faster. I live in a fast-paced world, but we think it’s a wonderful product. It’s that product that the market wants; definitely wants since the stablecoin industry meltdown. And we think it also provides huge increases in the security of a bank's deposits utilizing distributed ledger and encryption. So it’s a quantum leap, I think, in the banking industry over what is presently being used. So, I mean, I’d love to go faster, but hedge my bet a little bit by the end of the year.

Bradley Ness, Analyst

Okay. Thank you, gentlemen.

David Taylor, President and CEO

Thank you, Brad. Look forward to seeing you sometime.

Operator, Operator

Mr. Taylor, there are no other questions from the phone line, sir. I’ll turn the call back to you for closing remarks.

David Taylor, President and CEO

All right. Well, I’d just like to thank everybody for dialing in and those who asked me questions, and I look forward to talking to you again at the end of our fiscal year. Thank you.

Operator, Operator

Ladies and gentlemen, this does conclude your conference call for this morning. We would like to thank everyone for participating and ask you to please disconnect your lines.