First Internet Bancorp (INBK) Earnings Call Transcript & Summary

Good day, everyone, and welcome to the First Internet Bancorp conference call to discuss the acquisition of First Century Bancorp. [Operator Instructions] Please note that today's event is being recorded. I would now like to turn the conference over to Mr. Larry Clark from Financial Profiles, Inc. Please go ahead, Mr. Clark.

Thank you, Ian. Good morning, everyone, and thank you for joining us to discuss First Internet Bancorp's proposed acquisition of First Century Bancorp. The company issued a press release earlier this morning and is available in the Investor Relations section of the company's website. In addition, the company has included a slide presentation that you can refer to during this call, in which you can also access on the website. Joining us today from the management team are Chairman and CEO, David Becker; and Executive Vice President and CFO, Ken Lovik. David will provide an overview of the acquisition, and Ken will discuss the financial aspects of the transaction in more detail, and we'll open up the call to your questions. Before we begin, I'd like to remind you that this conference call contains forward-looking statements with respect to the future performance and financial condition for First Internet Bancorp that involve risks and uncertainties. Various factors could cause actual results to be materially different from any future results expressed or implied by such forward-looking statements. These factors are discussed in the company's SEC filings, which are available on the company's website. The company disclaims any obligation to update any forward-looking statements made during the call. At this time, I'd like to turn the call over to David.

Thank you, Larry, and good morning, everyone. Thank you for joining us on this momentous day for First Internet Bancorp. We are very excited to be with you to discuss the acquisition of First Century Bancorp, which we announced earlier this morning. As many of you are aware, the team at First Internet has worked tirelessly to strengthen our leadership position in digital banking. In recent years, this includes acquiring and scaling our SBA lending platform as well as partnering with fintech lending platforms provided at ApplePie. The acquisition of First Century Bancorp will solidify our position as the technology-forward, growth-oriented financial services company operating under a bank charter. First Century has developed key relationships with industry-leading partners across the country while maintaining a minimal physical footprint. Its banking platform offers 4 scalable business lines that bring fee revenue and access to the very attractive, low-cost deposit base. Each of these business lines bring significant potential for future growth, which is by far the most exciting piece of the story. First Century's lines of business are generally not capital-intensive. As Ken will talk about further, we view our $80 million purchase price as only a $21 million capital investment as measured by the premium paid to the $59 million in tangible book value expected at closing. We believe the business can contribute approximately $11 million of after-tax earnings in 2023 with a long runway for growth in the coming years. This translates into about a 21% earnings per share accretion and further enhances the profitability profile of First Internet. As a reminder of who First Internet is today, as shown on Slide 4, we are a pioneer in the digital delivery of banking and financial services, opening our virtual doors in 1999. The combination of highly scalable, technology-driven business model and collection of nationwide deposit and asset-generation platform has enabled us to achieve extraordinary balance sheet growth over the last several years. We have continued -- we have worked hard to diversify and grow our revenue through noninterest income, building out nationwide SBA and direct-to-consumer lending platforms that have contributed significantly to much stronger earnings and profitability. Now let us discuss our new partnership. Slide 5 provides an overview of First Century, including its key lines of business: Payments, Tax Product Lending, Sponsored Card Programs and Homeowners Association, or HOA, Services. Let me give you a brief overview of these businesses, starting with First Century's Payments solution. Over the past 12-plus years, First Century has developed a Payment-as-a-Service platform that has evolved in scope and importance each year since inception. First Century's bespoke solutions enable payments processing for some of the largest online retail companies in the world. And First Century has processed $13.1 billion in ACH volume and a staggering $32.5 billion in virtual lockbox payments since 2018. First Century's tax product business is another important service of fee-based revenue. The bank partners with 2 large national tax preparers and earns fees to provide tax anticipation loans to customers using the partner's tax preparation software. Over the past 5 tax seasons, First Century has funded in excess of $1 billion in tax anticipation loans. This is a seasonal business with the majority of the revenue earned in the first quarter of each year. Turning to the sponsored prepaid card business. First Century is ranked as 1 of the top 15 commercial prepaid issuers in the U.S. and currently processes Visa and Mastercard prepaid cards for 5 program managers. Each program is unique in nature, demonstrating First Century's ability to provide program managers a fast and effective way to service their clients' cash needs. Since 2018, the program partners have totaled approximately $1.2 billion in card spends. In addition to the prepaid card programs, First Century has recently introduced a virtual card product built on the Mastercard credit rail. Therefore, this product is widely accepted, and interchange fees are more profitable than traditional prepaid card programs. This product is being targeted to merchants participating in online marketplaces to pay for social media advertising campaigns. The program was strategically rolled out in advance of the holiday season. Early reviews from the merchant customers are encouraging, and we anticipate this product being a key source of revenue going forward. The Sponsored Card Program generates revenue through fixed fees and interchange fees. It also provides noninterest-bearing deposits equal to the balances on the prepaid card. And finally, First Century has developed a substantial niche in the HOA Services sector. Through a software licensing agreement, First Century delivers deposit services that are integrated with a cash management and accounting solution tailored to this industry. This provides the ability to gather relatively low-cost deposits in an efficient and scalable manner. Now that I have outlined First Century's primary lines of business, let me briefly touch on the truly exciting part of this partnership, the growth potential we see in the First Century platform as outlined on Slide 6. I'll start with the Payments business, which encompasses ACH origination and processing support as well as virtual lockbox and direct mobile check clearing services. We see tremendous opportunity to deepen and expand First Century's existing relationships given our larger balance sheet and greater resources. Additionally, we have the ability and scale to leverage the platform First Century has built to partner with additional payments providers to achieve further market penetration. Tax Product Lending is another attractive business line that we believe has tremendous potential for future growth. First Century already has a strong presence and deep experience in this space, working with prominent national service providers. This experience can be leveraged to add additional tax preparation firms wanting to offer competitive refund anticipation loan product. Due to balance sheet constraints, First Century has been limited in its ability to both capture all the economics in this line of business and onboard tax preparation partners. With our much larger balance sheet and access to greater sources of liquidity, we will have the ability to aggressively pursue new opportunities with additional national tax preparers, particularly given some of the recent market disruptions. Sponsored Card Programs also provide several new avenues for growth. First Century's existing card programs have been built through relationships with a limited number of program managers with no real outbound sales efforts, so there's plenty of opportunity to take First Century's capabilities and expertise to the next level and scale this business. Similar to the tax product business, First Century's balance sheet has been a constraint on growth in its prepaid card program. With our larger balance sheet, we have the ability to provide new program solutions for existing partners, while we also leverage First Century's enterprise to pursue new and larger partner opportunities. The HOA platform First Century has built also provides significant opportunities for growth. First Century currently has relationships with over 20 HOA management companies that service more than 1,500 HOA accounts. Most of these are located in the southeastern part of the United States. Earlier this year, First Century made 3 strategic hires to jump-start this growth. These individuals have over 50 combined years of experience in HOA Services and responsible for over $2 billion in deposits at a predecessor bank. With additional dedicated resources, coupled with First Internet's nationwide presence, we see enormous potential to expand this business across the U.S., creating a national low-cost funding vehicle. HOAs also represent a potential lending opportunity. Given the recent emphasis on repairs and replacements in the homeowners and condominium owners association world, First Century has leveraged its existing relationships and recently launched the specialized area focused on the expanding market for HOA lending. Again, with our larger balance sheet, greater resources and credit administration and real estate expertise, we have the potential to build out another specialized nationwide lending platform similar to our single-tenant lease financing program. When we look at the combination of the 2 organizations, as shown on Slide 7, the result is truly dynamic. As a technology-forward, growth-oriented digital financial services provider, we will have a tremendous range of diversity in our revenue-generation channels, have a nationwide asset generation platform to a collection of resilient fee-based sources of noninterest income. Our balance sheet will be funded by a deposit base in which growth will come from lower costs and less rate-sensitive sources, helping drive increased profitability. And all products and services will be supported by the innovative technology and exceptional customer service that allow First Internet, through its digital delivery model, to thrive over the past 2 years despite the operational and economic challenges posed by the COVID-19 pandemic. With that, I'll turn it over to Ken to discuss the financial aspects of the transaction.

Thanks, David. As David noted, we are extremely excited about joining forces with the talented and experienced team at First Century Bancorp. We believe this is an incredible opportunity to advance our strategic vision of building a technology-forward, growth-oriented digital bank. This acquisition offers compelling economics, and we expect it to be immediately accretive to our earnings and key performance metrics. As David has outlined, First Century's revenue is largely generated by diverse fee-based business segments. They also have a very attractive low-cost deposit base sourced from their specialty business lines. Additionally, the company is currently sitting on a substantial excess liquidity position with almost $300 million in cash on the balance sheet. We intend to deploy and utilize this excess cash as I will discuss further here in a few minutes. Turning to Slide 8, you can see the considerable impact First Century's lines of business will have on our total fee-based income. Year-to-date through September 30, 2021, on a stand-alone basis, approximately 26% of our total revenue has come from noninterest income. For those of you who follow the First Internet story, you know that we have made a concerted effort to increase and diversify noninterest income over the last 2 years as evidenced by the build-out and continued expansion of our SBA platform. Looking at First Century's numbers, you can see that almost 80% of its revenue is derived from fee-based sources. On a pro forma basis, our effective noninterest income would increase to 33% of revenue with added diversification coming from revenue channels that have tremendous growth potential. Additionally, these lines of business are not interest rate-sensitive and are expected to perform well regardless of the interest rate environment. Turning to Slide 9. And as David mentioned earlier, another powerful aspect of this combination is the ability to drive growth of lower-cost deposits. First Century has 4 main areas of deposits: prepaid card balances, which are noninterest-bearing demand accounts held by the program managers; HOA, these are generally comprised of operating accounts which are noninterest-bearing and reserve accounts which are held in attractively priced money market products; Payments, these are also noninterest-bearing accounts held by First Century's ACH and lockbox partners; and lastly, a portion of First Century's deposits come from its local consumer and small business deposit base and are largely comprised of traditional checking and savings products. In total, as of September 30, First Century had $330 million of deposits with an all-in cost of 6 basis points. We believe that with the scalable fintech partner platforms in the HOA Services business, there's a tremendous opportunity to grow this low-cost deposit base, thereby, lowering our overall cost to fund and ultimately expanding net interest margin. Over the next 2 years, we are conservatively estimating an additional $500 million of deposit growth from the Payments, cards, and HOA lines of business, of which $350 million is projected to be noninterest-bearing. For discussion purposes, the diagram at the bottom of Slide 9 demonstrates the impact of First Century's current deposit base and growth potential on a combined basis. As you can see, noninterest-bearing accounts increased 17% of total deposits. And on a pro forma basis, our all-in cost of deposits would decline 16 basis points from 87 basis points to 71 basis points. Or looking at it a different way, if we were to replace a like amount of First Internet CDs with First Century's deposit base, plus the expected near-term growth, again, using third quarter deposit balances on a pro forma basis, our all-in cost of deposits would drop to 54 basis points. Moving to Slide 10, let me review the key transaction terms and assumptions. We are acquiring First Century for $80 million in cash, consisting entirely of cash on hand with no financing requirement. The purchase price represents approximately 1.36x the expected tangible book value at closing, which we believe is very attractive based on the compelling growth opportunities the combination provides. Effectively, we are paying a $21 million premium to tangible book value expected at closing for a platform that will contribute $11 million in after-tax earnings in 2023, which is a very attractive return on our investment. Given the strong profitability of First Century, we anticipate approximately 21% earnings per share accretion in 2023. Because we are financing the transaction with all cash, the tangible book value dilution is expected to be approximately 7%. However, this is expected to be earned back in around 3 years as calculated using the crossover method. From a capital perspective, at close, our total risk-based capital ratio is expected to be 16.9% at the holding company level, and our tangible common equity to tangible assets will be approximately 8%. Although this is a cash transaction, we expect our capital ratios to be robust and should allow us continued capital flexibility after closing of the acquisition. Due to the relatively small loan portfolio on First Century's balance sheet, the gross loan credit mark is only expected to be around $200,000. Other purchase accounting adjustments are relatively immaterial to the overall economics. Because First Century operates a branch-light business model, we are buying the company for its talent and platform. The economics of this transaction are not driven by cost savings. We do, however, anticipate approximately $1.8 million in annual pretax cost savings or 15% of expected 2022 operating expenses primarily comprised of savings in professional and regulatory fees and duplicative technology and corporate expenses. As I highlighted earlier in this presentation, First Century is expected to have approximately $300 million in cash on the balance sheet at close. Our modeling assumes that we deploy approximately $150 million in securities with a 1.5% pretax yield, and that the other $150 million will be used to replace higher-cost CD funding at First Internet. This results in an additional $2.1 million of after-tax income for 2023. We have estimated a onetime pretax restructuring charge of $6.5 million. This charge has been fully reflected in the pro forma tangible book value at close and is -- and, therefore, is also fully reflected in the earn-back calculation. And finally, while the modeling presented here today assumes a March 31, 2022, close, we are planning to close the transaction as soon as possible, hopefully, very early in 2022, so that we can benefit from the 2022 tax lending business to be earned in the first quarter. Without the benefit of the tax lending business in the first quarter, we expect modest 2022 EPS accretion, excluding transaction-related charges, but this accretion could increase significantly within an earlier closing date as highlighted on Slide 14 in the appendix. Turning to Slide 11. In summary, we believe the financial impact of this transaction is extremely compelling as the strong earnings accretion will help drive higher profitability in a sustainable and resilient manner regardless of interest rate environment. I'm now going to turn it back over to David to wrap up our prepared comments.

One aspect I want to touch on is that from the very beginning of looking at this partnership, we have always viewed this as a people transaction, not a typical bank acquisition. These technology-forward, fee-based and deposit-focused lines of business have been built by a highly experienced senior leadership team with a proven track record of success and extensive background in technology and software development. This is truly an ideal fit, both strategically and culturally. We gained new lines of business that complement our existing model as well as talent that will help drive additional revenue as we diversify and expand the franchise. With the addition of First Century's talent and platform, we will be able to leverage our scale, capital and expertise to drive growth opportunities and to deliver strong long-term returns for the shareholders. With that, I'll turn it back to our operator, so we can take your questions.

[Operator Instructions] It looks like our first question today comes from Michael Perito of KBW.

I wanted to start -- I had a few things I wanted to hit. First, on the prepaid card side, I think you said there are 5 kind of large program managers right now. A fairly new line of business for you guys, but one that I think seems pretty logical. I was just curious if you can maybe outline a little bit further what do you think the growth potential and -- but also kind of the road map from your perspective of how to achieve that growth in that business could be. And how much of that kind of contributes to the $500 million of incremental deposit growth versus the HOA business? I wonder if you could maybe slice that for us a little bit more in terms of where you think the biggest opportunities are.

On the card side of things, I'll let Ken talk a little bit about the deposit side, they have 5 kind of B2B groups that they're working with today. Within each of those groups, Mike, there's additional opportunities to add more services and program. The virtual card that was just released here in the fourth quarter has taken off with gangbusters. It's a tremendous opportunity. And as we stated in the comments, it runs down the Mastercard credit card rails. So it's not only a fee income, but it also has a better interchange model. This is one they've been in for a long time. They're one of the largest producers in the country. And really, the only constraint from growing it pretty exponentially has been balance sheet capacity. So the deposit side of things, they've actually been in a position over the last couple of years. The institution has had to run off deposits, so they kind of capped at what they're doing. Again, with our balance sheet and capacity, we can ratchet this up quickly. And as stated, it's not direct out to consumers; it's a B2B process. So by working with one organization, we can pick up tremendous card-based penetration on an overnight basis. Ken, you can talk about the deposit side.

Yes. On the deposit side, I think, as we talked about in the comments, we're modeling $500 million of growth over the next couple of years. I think we're trying to take a very conservative approach on that. I would say that, that estimate is probably split in half, about half coming from the HOA business and the other half coming from a combination of the cards and the payments business.

Helpful. And then on the tax business, specifically, I guess, one, that's where the balance sheet constraints come in that you guys mentioned, right? Because at a point of time, it looks like they have plenty of capital and cash, but a lot of that has to be held for when those seasonal loans come on balance sheet. Is that true? And then second, can you maybe just try and give us a ballpark of maybe what the expected tax revenues from the refund loans will be in the first quarter and just so we can kind of seasonally get the revenue flow of the model kind of close to correct for next year?

Yes, you're exactly right, Mike. It is a -- it's a first quarter activity. Last year, the numbers were down. If you go back and look at the reports, they were up and close to $500 million in -- let me give my years right here, in 2020. It fell off in 2021, in part as the whole tax business fell off. Because of all the government subsidies and cash that were going to consumers, there wasn't tremendous demand. One the organizations they worked with has already talked to them about this season of tripling down the number of loans coming through the door. So we're anticipating at least somewhere in the range of $500 million could go up to $1 billion in this tax season. So the consumer -- depending on what federal government does again, as long as they're not handing out checks every other week, the consumer will come back to normal. And again, these are very large growing programs. So we could see some exponential growth here in 2022 and 2023. But we're kind of forecasting at least $500 million for 2022.

Got it. And that's -- and just to confirm my first question, that's the constraint, right? Is that the biggest constraint rather on their balance sheet pre-merger? Is that they had to hold all that liquidity and cash for when those loans were on the books in the first quarter?

Yes, and it actually exceeded and knocked up their capital ratios as well. Last year, they outsourced some of the loan production on most -- I think it was 8 -- what was -- what did they outsource last year?

About -- probably about $100 million.

Yes. About $100 million went outside their organization last year that they lost the fee revenue on because they couldn't put it on their books. They also had to run off about $80 million in deposits over the last couple of years because of exceeding their capacity to hold that as well.

Got it. And then just lastly, and then I'll step back, is just you guys talked about kind of that initial $300 million of liquidity. But I guess, how do you guys think about the net balance sheet growth versus the remix of funding opportunity from here? And any kind of general thoughts around what type of size of balance sheet we could expect moving forward as those $500 million of deposits come on?

Well, as we talked at the last earnings call, we anticipate getting back into low double-digit growth next year. We've announced some of the fintech partnerships with ApplePie, Finzly. We've got a couple more we hope to announce here before year-end or very early in January. So we've got some good asset generation, some additional deposit generation capabilities. So we're not going to grow by $1 billion in assets outstanding next year, but we could easily grow the assets by at least $0.5 billion.

Our next question comes from Mr. Nathan Race, Piper Sandler.

Congrats on what appears to be a very complementary and compelling deal on a number of fronts. I was hoping to maybe just start on the payments side of the FCB franchise. It seems like there are some synergies that you guys can generate over time just with the pieces that you guys have put in place with Finzly more recently and just leveraging that product across the small SDA unit that's been built out over the last couple of years. So I was just hoping you could expand on that first in terms of that opportunity set in those revenue synergies that may not be factored into the EPS accretion expectations.

Yes. You hit the nail on the head, Nate. The Finzly partnership we just signed up will totally revolutionize our Payments service team on the back end. To date, Bill and his team are phenomenally nimble, great people, really understand the industry. The way they've won some just keystone accounts is by being able to bring services to market much faster than anybody else. Finzly will allow us even a better back-end settlement engine to expand geometrically, do it electronically, not involve a lot of manpower. So all of 5 of the programs they have today have additional opportunities for growth within them. And the servicing side of it with Finzly on the back end will be minimal. So it's a great, great go-forward opportunity. Obviously, in prepaid cards, a lot of the stuff we're doing, the real key to success there is the compliance side of things. And Bill and his team have built out -- the biggest single department in the organization is compliance. And they have done a great, great job for years of being on top of all the regulatory issues and they got a clean bill of health from the regulators from the beginning of time in this business world. So with strong compliance built in, with some of the new tools we're bringing to the table with Finzly, we think we could double-down over this whole business over the next 2 to 3 years very easily.

Got it. Makes sense. And just going back to the last question from Mike, just in terms of the moving pieces with the deposit mix with FCB coming on. I guess how quickly can we run off the brokerage CDs? There's still a decent component of the overall funding base and replace those with the lower cost deposits, which, obviously, I'd imagine would really improve the interest rate sensitivity of the overall balance sheet as the Fed potentially starts to rate -- increase interest rates sometime next year and forward into 2023.

Yes. I mean I think it's probably similar to like what we talked about on the earnings call when we kind of give that forward look on CD maturities over the next 12 months. We're still kind of, I think, beholden to that schedule because of the maturity schedule. But I think if you think about bringing on $330 million day 1 and scaling that to $500 million conservatively enough, we got $700 million to $800 million of CDs maturing over the next year and then probably another -- that cuts the balance by well more than half. And we probably have another $3 million to $4 million -- excuse me, $300 million to $400 million maturing the year after that. So I mean, I think, over time, the deployment of these deposits, again, to David's point earlier, some of it's going to go towards funding balance sheet growth in a much more cost-effective manner, and some of it's going to go towards just replacing higher-cost CDs that won't necessarily renew and come back on the balance sheet.

The other play, Nate, that I talked about a second ago, we've got a couple of other fintech opportunities that are asset generators that we're taking a hard look at right now. And if we get this additional capital at a cost of 6 to 10 basis points, we can get pretty aggressive on pushing out some new loans and really increasing net interest margin significantly. Instead of staring at 89 -- 80 to 90 basis point cost of funds, we're staring at 6 to 10. It really makes some of these lending opportunities extremely attractive for us.

Got it. And maybe just one last one just in terms of how the capital stack looks going forward and just within the context of the buyback authorization that was announced a couple of weeks ago. I guess how does this deal and the pending nature of it perhaps impact your ability to remain in the market buying back stock? And I'm not sure if this kind of changes the parameters in terms of your appetite to affect the buyback if the stock were to move above tangible book bill. I think in the past, you guys have been -- communicated that you're more than willing to buy back the stock out of below tangible book. But I'm not sure the multiple accretive nature of this transaction potentially changes kind of how you guys think about the right thresholds to be buying back stock going forward.

I would say if we get north of 1.5x book, we'll probably stop buying shares. But up until that point in time, we continue to be in the market buying. So we think we're undervalued tremendously at this point. We still have plenty of cash and capital capacity to be in the market of acquiring shares, and we'll continue to do that until we see significant expansion in the price.

Our next question comes from George Sutton of Craig-Hallum.

In all honesty, the deal sounds like too good a business, too good a price, too good a fit, which my natural skepticism I struggle with. But it does sound like their balance sheet was a constraint on growth. So you talked about your scale, your capital, your expertise and what you can bring to this. As you laid out the numbers going forward in terms of accretion, were you assuming the benefits of your scale, your capital and your expertise? Or would that give us upside from there?

I would tell you, it'll give us more upside from there, George. We're trying to wrap our arms around it. I've known about Bill and his organization for about 3 years. The advantage of being privately held and privately owned, he can fly under the radar screen. I've been absolutely amazed at the things that he and his team have been able to accomplish. It's kind of like talking to myself, bill has 40 years-plus experience in computer services, kind of a reluctant banker as myself in the beginning days. And so he's just built a phenomenal tool set. We're still trying to run down all the rabbit holes and look at all the opportunities. Every time we talk to him, there's another opportunity on the table. So I think our skill set, combined with the great track record in history that his organization has in all of these industries, is going to be a match made in heaven. Like you say, I pinch myself at times thinking how are we so fortunate to line this thing up. But I think it's going to be just a tremendous, tremendous opportunity for us going forward. And with Bill and his team, the expertise, the reputation they have in this market, under the radar screen, to some respect, and so -- and our resources, our talent and the HOA lending business with our FPL program, we've got a national real estate lending mechanism already set up and in place. We know the underwriting. We've got all the connections to all 50 states, a tremendous asset and add-on to this HOA program that they're just trying to get off the ground. So every day we talk to them, it's more opportunities. And I'm like a kid in a candy store, I'm going to start all over again with a big balance sheet, a great team, both there and here in our organization. And I think we've got a chance to set the world on fire.

[Operator Instructions] At this time, it looks like we have no further questions. I would now like to turn the call back to Mr. Becker. Please go ahead.

So again, ladies and gentlemen, we appreciate you joining us early here in the morning and helping us launch this great, great opportunity for First Internet and First Century. We have a tremendous opportunity out here to really move this forward tremendously over the next year to 2. And we're glad you're along for the ride. Thank you very much for your time. And if you have any further questions, you know how to find us. We appreciate it. Thanks.

The conference has now concluded. Thank you for coming to today's presentation. You may now disconnect.