Pathward Financial, Inc. (CASH) Earnings Call Transcript & Summary

Ladies and gentlemen, thank you for standing by, and welcome to Pathward Financial's Third Quarter Fiscal Year 2023 Investor Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference call over to Darby Schoenfeld, Senior Vice President, Head of Investor Relations. Please go ahead.

Thank you, operator, and welcome. With me today are Pathward Financial's CEO, Brett Pharr; and CFO, Glen Herrick, who will discuss our operating and financial results for the third fiscal quarter of 2023, after which we will take your questions. Additional information, including the earnings release, the investor presentation that accompanies our prepared remarks and supplemental slides may be found on our website at pathwardfinancial.com. As a reminder, our comments may include forward-looking statements, including with respect to anticipated results for future periods. Those statements are subject to risks and uncertainties that could cause actual and anticipated results to differ. The company undertakes no obligation to update any forward-looking statements. Please refer to the cautionary language in the earnings release, investor presentation and in the company's filings with the Securities and Exchange Commission, including our most recent filings for additional information covering factors that could cause actual and anticipated results to differ materially from the forward-looking statements. Additionally, today, we will be discussing certain non-GAAP financial measures on this conference call. References to non-GAAP measures are only provided to assist you in understanding the company's results and performance trends. Reconciliations for such non-GAAP measures are included in the appendix of the investor presentation. Now let me turn the call over to Brett Pharr, our CEO.

Thanks, Darby, and thanks, everyone, for joining us. As we start today, not news to anyone, the banking industry as a whole has come through some turbulent times. Last quarter, we talked about how our business model differentiated us, especially in these times. This quarter, I really want to share how those differentials translate into our strengths. Just a few examples. The industry suffered from unstable deposits, we have not. Compression on net interest margin from rising interest rates throughout the industry, but even counting the increase in card expenses, we have a growing net interest margin, not a lower one. There are general loan-related concerns, both demand and credit, but we have a collateral-managed portfolio with diverse asset classes built for whatever may come. And importantly, we typically do not do CRE purpose lending. During these times, our business model puts us in the envious position of allowing us to be defensive while still having increasing returns. More about some details of this in the next few minutes. But first, the third quarter. Pathward once again produced solid results, consistent with our performance so far in fiscal year 2023. Our net income for the quarter was $45.1 million or $1.68 per diluted share. Both were significant increases when compared to the same quarter last year. We did this by growth in both net interest income and noninterest income. Our net interest margin grew to 6.18%, an increase of 6 basis points from last quarter and a significant expansion, 142 basis points from the third quarter last year. While 6 basis points and sequential quarter NIM growth doesn't seem as large as you might expect, remember that last quarter includes the impact of our seasonal tax business, which can temporarily boost the net interest margin. Our adjusted NIM, considering rate-related card processing fees, was 4.88%. We are very pleased with this net interest margin performance and believe the steady trend upward will continue in 2024. Before I turn my attention to the loan side of the business, we have a history of delivering proven solutions to small- and medium-sized businesses and helping them meet specific financial goals. We also understand the challenges these businesses may face right now in efforts to secure the funding they need. How do we do that? We have a set of methods and controls that allow us to serve these clients safely, what I often refer to as collateral managed. We recently released a video on our LinkedIn page that we think tells the story well from the customers' perspective, so please take some time to check it out. Some specific asset highlights this quarter. We had significant growth in our insurance stream and finance loans. We had expansion in our term lending and SBA/USDA balances when compared to last quarter. We also saw an increase in the number of working capital originations. That's an area that we are especially optimistic about in this particular economic climate. I do want to make a comment on renewable energy loans. Recent times, we've had good demand and an increase in originations. But industry-wide, we are experiencing a slowdown in the pipeline as projects become less attractive due to rising interest rates. We expect this to continue into 2024, which will likely lead to lower originations and therefore, a higher tax rate next year. This is already factored into the guidance we are introducing today. That being said, our various asset classes provide us the diversity that is built for economic cycles. In order to deliver on our strategic initiatives of optimizing our earning asset portfolio, sometimes, we may grow working capital; other times will be equipment finance; others it may be insurance premium finance. It may even mean that if some of our securities mature, we may reinvest those funds in other securities since rates have increased significantly. This kind of optionality helps us meet our strategic goals in a variety of environments. Now a few words about BaaS partnerships and our deposits. If you listened to last quarter's call, you heard how we are different. Partnerships we have formed, continue to manage and continue to source are integral to our financial inclusion purpose, but also provide stable deposits and coveted fee income. As the banking industry is experiencing rising deposit costs and/or deposit outflows, this model is less impacted by the environment. We've built long-term relationships with a core group of companies that contribute significantly to our deposit stability. These partnerships are pivotal to our success. Importantly, we are very careful and diligent in who we decide to work with. This is called [ smart defense ]. For example, during the recent expansion in fintechs, we made sure that those we were partnering with had a strong understanding of regulatory requirements and could survive their cash burn phase. We added very limited partners during that time. And notably, we stayed away from concentrating in any one industry, even establishing internal industry-specific limits. This allows us to focus on our current partners, maximize those partnerships, strengthen and deepen the existing relationships and work together to expand and enhance product offerings. But we have added a few new partners and recently launched a few new programs or capabilities in conjunction with these new partners. We launched a new line of credit for consumers with Propel Holdings. We paired with Clair to offer spending and savings accounts as well as earned wage advances. I'd also like to mention that we announced a new relationship with Finix. We are their banking partner, supporting their launch as a payment processor. These new programs and associations may take time to deliver a meaningful impact to our deposit balances and revenue. This is why our model is built on long-term contracts. We are excited to strengthen our partnership network, and we continue to fulfill our purpose of increasing financial access for more Americans. And because of the partnerships Pathward has formed and nurtured, most of our deposits are held in millions of retail card accounts with an average balance of less than $1,000. We have very few institutional accounts, and those we do have are typically cash collateral tied to loans within our commercial finance group. As a result, our noninterest-bearing deposits on the balance sheet have a weighted average life of over 6 years based on our decay study. Just a comment on BaaS industry trends. The value of these deposits is significant, and we believe others in the industry are realizing that in the wake of recent events in banking. There are more banks entering the Banking as a Service space, but as recent news has reflected, they have not always invested in the regulatory framework needed. I believe there will be a bit of a regulatory cycle as these new entrants adjust to the third-party demand, the cost of which will eventually be included in pricing. However, at the moment, we are seeing more competition on pricing, and we've continued to work very closely with our partners. This may lead to slightly higher card processing fees in 2024, but we believe we can continue to grow both our GAAP net interest margin and adjusted net interest margin, which includes these costs in 2024. This is also included in the guidance we introduced today. Before I turn things over to Glen, I want to comment on our CFO search. We've made a lot of progress. We've had some very substantive discussions and have a strong candidate pipeline. It's our hope to announce something in the coming months. Now I'll turn it over to Glen to take us through our financial results.

Thank you, Brett. For the quarter ended June 30, net income totaled $45.1 million or $1.68 per share, an increase from $22.4 million or $0.76 per share in the prior year's quarter. Net interest income was $97.5 million for the third quarter of fiscal year 2023, an increase of 35% from the prior year quarter. This was driven by expansion in the net interest margin to 6.18% from 4.76%. NIM expansion was driven by 162 basis points expansion in loan and lease portfolio yields and an 82 basis point expansion in the yield on the securities portfolio. Remember, the bulk of our deposit costs are recorded as card processing expenses. If you include those expenses in our net interest margin calculation, our adjusted NIM would have been 4.88% compared to 4.89% last quarter and 4.62% in the third quarter of last year. Also keep in mind that the revenue we are earning on our off-balance sheet deposits is not shown in the NIM but in fee income. We expect our net interest margin to continue to expand as we deliver on our strategic initiative of optimizing the interest-earning portfolio and repricing our assets in the current rate environment, targeting appropriate yields. Provision expense was $1.8 million in the third quarter. During the prior year quarter, the business recorded a credit of $1.3 million to provision primarily due to releases in the commercial finance portfolio. As of June 30, the company had an ACL coverage rate of 2.01% compared to 2.04% at the same time last year. ACL coverage in our commercial finance group was 1.35% compared to 1.56% in the third quarter last year and 1.53% last quarter. The sequential decrease was driven by a mix shift towards insurance premium finance and SBA loans, which have a lower allowance rate. Noninterest income increased 25% from the prior year quarter to $67.7 million in the third quarter. This increase was primarily driven by $14.6 million of deposit servicing fee income associated with off-balance sheet deposits. Turning to expenses. Total noninterest expenses grew 19% or $18 million from the prior year quarter. The increase was primarily driven by $20.5 million of contractual card processing expenses related to the higher rate environment. Total deposits, including on- and off-balance sheet, increased $158 million or 2% from the prior year quarter to $7.1 billion. Total deposits decreased from the linked quarter, primarily due to a seasonal decrease in tax return-related deposits. During the third quarter, we maintained an average of $1.2 billion of deposits off-balance sheet, earning fee income roughly equal to the effective Fed funds rates. At June 30 period end, there were $781 million of deposits off-balance sheet. As mentioned last quarter, we serviced deposits related to government stimulus programs. That will decline over the fourth quarter and throughout fiscal year 2024. At June 30, roughly $970 million of these deposits remain. These deposits continue to be slowly spent down while unclaimed balances are being returned to the U.S. Treasury. Between July 2023 and the end of fiscal year 2024, we expect to return close to $450 million of unclaimed deposits. This reduction in our total deposit levels will lower the amount of funds we hold off-balance sheet and service for partner banks. Total loans and leases ended at $4.1 billion as of June 30, growing 9% from the last quarter and 10% from the prior year. The year-over-year increase was primarily driven by insurance premium finance, term lending and SBA and USDA loans. Credit quality across the portfolio remains strong. Nonperforming loans of 93 basis points were up slightly from 76 basis points in the previous quarter, and our net charge-off rates remain stable. We remain confident in our collateral management and the quality of our loan portfolio. From a liquidity perspective, Pathward continues to be in a good position. Our balance sheet is strong, and the company holds $781 million in deposits off-balance sheet. In addition, we have cash and cash equivalents of $515 million, unpledged investment securities of $124 million, FHLB borrowing capacity of $744 million and funds available through the Fed discount window of $234 million. When factoring in unsecured funding and other wholesale funding options, this gives us over $3 billion in available liquidity. Our strong balance sheet and return levels allow us to continue to return value to shareholders. During the fiscal 2023 third quarter, we repurchased approximately 490,000 shares at an average price of $43.83. An additional 249,000 shares of common stock at an average price of $50.23 were purchased in July through July 21, 2023. We are increasing our guidance for fiscal year 2023 to a range of $5.60 and $6 in GAAP earnings per diluted share. We also expect the effective tax rate to be in the range of 10% to 14%. We are also introducing fiscal year 2024 guidance of $6.10 to $6.60 per diluted share. This guidance includes the impacts from declining EIP deposit balances. Additionally, as Brett mentioned, the market has seen slowing demand for renewable energy fundings, which will impact tax credits and we expect them to be lower in 2024. As a result, we expect our annual effective tax rate in fiscal year 2024 will be in the 16% to 20% range. That concludes our prepared remarks. Operator, please open the line for questions.

[Operator Instructions] Our first question comes from the line of Frank Schiraldi with Piper Sandler.

Wondered if you could talk about in terms of the 2024 guide, the initial guide here. Can you share with us any sort of macro backdrop that assumes, including interest rate outlook? Do you just sort of follow the forward curve in terms of outlook here? And does it also include the potential for continued capital return through the buyback?

Frank, this is Glen. I could start. Yes, it does include generally the forward curve. We were anticipating today's action by the Fed as part of that. That obviously factored into our guidance. We talked about we're being a little cautious on investment tax credits in the renewable energy lending for next year. So we wanted to call off that component in our guide as well as then the other business conditions and macro events that Brett touched on in his section.

It's about capital and buybacks.

Yes. And our plan, you could assume, we continue to try to maintain or plan to maintain a consistent balance sheet. And so with the return levels that we have, we would look to do continued buybacks at these price levels.

Okay. And that's -- so that would be factored into guidance, whatever your plans are there on the buybacks?

Yes, that's correct.

Okay. And then just touching on a couple of things, the fewer renewable energy projects in 2024. I guess I understand the higher interest rates and what that does for demand. But I thought that there was this backlog maybe, given that there wasn't anything getting done for a while, that might sort of offset or overcome that. Is that -- just any more color on just your thoughts, what's driving you guys to decrease your expectations or give these expectations for decreased energy projects and tax credits next year?

Yes. Frank, this is Brett. I mean what we're seeing is a lot of these deals were funded with a mix of equity and debt, the tax equity components of it. And what's happening is because there are higher rates in the marketplace, they'd have to have a whole lot more tax equity in it. And investor capital is just not coming into it, at least at the size transactions that we generally operate with. So that's why the pipeline has slowed down. And these things, as you can imagine, they have a fairly long pipeline before they actually turn into a project. And so we're just looking at our pipeline and having sort of realistic expectations about how much of that's going to happen next year.

Okay. All right. Fair enough. And then on the interest rate outlook and the margin, just wondering if you can talk about what sort of things you're doing [ to effect the ] margin here from a potential down rate environment. Or are you at the point now with where the variable loan book is and where the floors are that you can get some additional NIM expansion even in some downward movement in rates if it comes to that next year? Just kind of any color on directionally if we do get the forward curve, that we do get rates sort of lining up with where the forward curve is now, what are your thoughts on margin?

Yes. So Frank, this is Brett. So one of the things that we like about our business model is we've got different asset classes, and those different asset classes have different duration elements of it. You'll note that we've been a little lean on the longer duration assets like equipment leasing. What I would expect to happen as we go into the year, we'll start trying to figure out how to do more of those because they have a longer life to do it. And keep in mind, I think round numbers, only about 25% of our assets reprice in a given year or less. And so you've got quite a bit of opportunity to bring on longer-term assets that have a longer duration to help. So we were pretty clear, we're slow on the way up in getting the margin and we should be slow on the way down on losing the margin. And so that's -- Glen, anything you'd add?

No. And then the other thing is recall, Frank, as if and when rates do come down, our card processing expenses that are rate related, those fall off immediately. So there's no lag to those. So those reset real time, which certainly give us a little tailwind as well.

Okay. Great. And then just lastly, if I could. Just trying to get a handle on loan growth here. I think the linked quarter growth in the commercial finance side was mostly insurance premium finance, which I assume that sort of growth rate isn't sustainable in that piece of the business. And we all hear about the manufacturing slowdown on the macro side. So how is that impacting the commercial finance business, your expectations are for growth here, particularly in that business going forward?

Yes. I think there's a few things. One is banks are pulling back, and we think of that as being an opportunity. So we are seeing a little bit of that. So hopefully, that's why I mentioned, for example, equipment leasing at the right time, we might be able to get into that a little more. I've been saying for some time, the working capital class should pick up as this slowdown goes on. And we're not seeing it in the pure numbers yet, but we're starting to see it in opportunities for origination. And those -- because of the diligence involved in them, it can take 90 to 120 days to start showing up as actual assets. So I mean I think there's some opportunity. The insurance stream and finance group did very well this time, very impressed with what they've done. That kind of growth, you're correct, it's not sustainable. But we'd like to -- particularly with the yield we're getting to stay at that level for what is such a low-risk asset class. So I think it's more of a steady as it goes. We'll be picking the asset classes where we can get the yield and get the business, and certainly thinking about that duration opportunity before rates start going down.

Okay. So it sounds like you still expect growth in the commercial finance business going forward. Is that fair on this level going next year?

I do, I do. I think that's right. I just don't know which asset classes it will be in. Yes, that's right.

The next question comes from the line of Michael Perito with KBW.

I had a couple -- a few things I wanted to touch on with you guys. Number one, I appreciate some of this color on some of these new partnerships that you guys are launching. I was wondering if you can maybe -- I realize this might be a little hard since there aren't a lot of them yet. But just on these -- the line of credit for consumers with Propel and just generally kind of on just credit agreements or contracts that you guys maybe are starting to consider a bit more than you have historically. Can you give us a sense of how you're trying to structure the credit risk within these? Is there like a lot of indemnification built in? Or should we expect kind of as these things ramp up over time, that there'll be some noise in the income statement in terms of maybe like higher yields on the NII, but then some indemnification on losses to like expense or fees? Like just trying to get a better sense of how you're structuring these and how we should think about them as they ramp, realizing there's some time, but just trying to get ahead of it.