Pathward Financial, Inc. (NASDAQ:CASH) Q2 2023 Earnings Call Transcript

Pathward Financial, Inc. (NASDAQ:CASH) Q2 2023 Earnings Call Transcript April 26, 2023

Pathward Financial, Inc. misses on earnings expectations. Reported EPS is $1.99 EPS, expectations were $2.07.

Operator: Ladies and gentlemen, thank you for standing by, and welcome to Pathward Financial’s Second Quarter Fiscal Year 2023 Investor Conference Call. During the presentation, all participants will be in a listen-only mode. Following the prepared remarks, we will conduct a question-and-answer session. 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.

Darby Schoenfeld: 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 second 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 statement.

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 results to differ materially from the forward-looking statements. Additionally, today, we will be discussing certain non-GAAP financial measures on this 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.

Brett Pharr: Thanks, everyone for joining us today. We’re very happy to welcome Darby to Pathward. Please reach out to her to say hello, introduce yourself, and let her know what you might need. We thought this was a good opportunity and time to offer all of you a bit more context and detail than we have in the past about Pathward. We’ve taken advantage of the recent attention focus on our industry to assess our strengths, focus on the potential for new opportunities and more about these in a few minutes, and better communicate to you and others, why Pathward is uniquely positioned for a strong and stable future. I’m going to start today with an in-depth look and how Pathward is different. Our business is unique and how we differentiate ourselves from traditional banks.

And more importantly, why we think that differentiation matters and how it offers our investors and customers a better value proposition. Financial inclusion for all drives our actions and our strategy. We want to be a leader in providing access to unreserved banking markets. Why? Three reasons. The unreserved gap that’s in the marketplace for both consumers and commercial small business customers is significant. We can help close that gap. Second, we believe our approach to inclusion generates a unique value for our shareholders. And three, we believe it offers valuable and meaningful career opportunities for our employees. We continuously strive to provide financial inclusion by positioning ourselves at the hub of the financial ecosystem, where financial technology and banking intersect.

Sitting at this intersection gives Pathward and you our investors multiple advantages and opportunities. First off, provides us with strength, provides us with stability and it provides us with the ability to produce stronger capital returns. It also gives us the ability to innovate and disrupt creating more opportunities for growth. I want to share a bit about our business lines. We operate primarily through two businesses. Banking-as-a-service or BaaS and two, commercial finance. Our BaaS business focuses on underbanks and underserved consumers. It generates sticky, low-cost deposits and recurring fee income. Our commercial finance business lends these stable deposits to small and medium-sized businesses that may not have access to traditional forms of credit.

These two business entities form a particularly strong combination. The ability to deliver a diversified revenue base that provides recurring stable fee income and a high net interest margin. In BaaS, we operate primarily through a diverse net of work of partners who are proven established companies and long standing clients of ours. We generally sign long-term agreements and excluding the economic impact program or EIP deposits, no single partner constitutes more than 13% of our total deposits. Our BaaS business has four solutions issuing, tax, payment and credit. In addition to creating a strong deposit base, these businesses have the added benefit of generating recurring non-interest or fee income. And issuing solutions where one of the leading debit and prepaid card issuers in the country.

We are network sponsor and settle and hold funds and programs developed jointly with our partners. This allows the end consumer who may not have access to a traditional bank account to receive the protections and benefits of one. These partnerships combined with our purpose distinguished Pathward’s deposits from most traditional banks. 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 that we do have are typically cash collateral tied to loans within our commercial finance group. Due to these factors, our noninterest bearing deposits on the balance sheet have a weighted average life of over six years based on our case study. To contrast this with our loan portfolio’s weighted average life of about 2.5 years and our securities portfolio duration of around five years, you can really see the value of our unique deposit base, particularly in today’s high-rate environment.

Glen will give you a more detailed look at our deposits in a moment. Our second line of business within BaaS is tax solutions, where we offer refund transfers, refund advances and pre-season loan programs. Refund transfers allow consumers to have their tax return completed with no upfront cost, has any preparation fees are deducted from the refund. Additionally, refund transfers allow unbanked customers to take advantage of the speed and safety of direct deposit from the IRS. Refund advance enables consumers to receive an advanced based on their expected refund proceeds, allowing access to funds immediately while they wait for the return to be processed by the IRS. The pre-season loan program allows the consumer to borrow as early as November in anticipation of the refund, which may serve a more immediate end-of-year cash flow need.

For many of our customers, their tax refund is one of the largest financial events of the year. Our programs assist them by providing access to funds immediately or in some cases early, providing options for receiving their refund and helping to process the tax preparation payment. These tax surfaces are utilized by millions of consumers annually through a network tens of thousands of tax preparation offices nationwide. This year’s tax season has performed above our initial expectations through the end of March and we’re pleased with the results. Glen will dive into the details in his remarks. The main two businesses are payment solutions and credit solutions. Payment solutions, we offer merchant acquiring and money movement acting as a sponsor bank for our clients and moving our $2.5 billion in ACH and wire services daily.

We are also sponsoring bank on approximately 270,000 or two of every three independent ATMs in the nation. In credit solutions, we gave our partners the ability to offer lending solutions to a diverse credit pool. Importantly, our relationships are designed with a focus on credit protection, risk mitigation as well as liquidity. We earn a reasonable risk-adjusted return protected by certain layers of credit support. We may also choose to sell certain consumer loans to third parties. Total deposits both on and off balance sheet decreased $534 million or 6% from the prior year quarter to $7.9 billion. The drivers of this are continued decrease in EIP balances and the volume and timing of tax deposits at quarter end. From the end of last quarter, we saw a decrease in total deposits of $152 million or 2%, primarily due to run-off of seasonal gift card balances, partially offset by tax season deposits.

Pathward continues to be in a strong liquidity position. The recent financial industry issues have actually produced some new potential for Pathward. We this leadership took this new focus on the banking industry as an opportunity to take a closer look at our positions and strengths and how they might offer new value and potential, because of how our bank has positioned, our experience and our leadership in the BaaS industry, some of which I just described. Several new businesses have reached out to us and new partnership opportunities have developed. We and others see the benefit of our strength as a stable established partner. We will continue to be selective in our deals, ensuring the new relationships fits with our company’s purpose, risk profile and return aspirations.

Now I want to have a few words about commercial finance. We primarily offer financing to small and medium sized businesses. We operate in a unique position between traditional banks. We can offer better structuring to our clients and finance companies. We can offer better pricing. We generated new loans across the country through a combination of our in-house business development officers and referrals from other institutions. This portfolio is diversified across different asset classes and structured to provide opportunity regardless of where we are in the economic cycle. If we’re in a thriving economy, we expect to see increased originations in the equipment and insurance lines of businesses as our customers grow and expand. In the downturn, we typically see an increase in the working capital segment, as most businesses need our help bridging any gaps they may experience.

Regardless of the economic cycle, our leases and loans performance remained steady. There are two reasons for this. First, during a downturn, some of the additional volumes we underwrite are good credit companies have had a bad moment. And therefore have lost access to their original funding source. These companies are working to rebuild their credit profile. So they’re highly incentivized to work with us to fulfil their fiduciary responsibilities. Secondly, our loans are highly collateralized and underwritten to a discounted basis on that collateral. So that in the event of liquidation, our recoveries limiting losses we may experience. The higher yields we receive are primarily due to the human capital and due diligence performed on the collateral during the underwriting process and throughout the life of the loan and not necessarily an increased risk premium.

I’ll give you an example. During the underwriting process in the equipment finance line, we often receive several quotes from buyers on the equipment at origination. These quotes are part of what we base the value of the loan on. So that in the event of a default, buyers are pre-approved and prepared to transact with us. In our working capital business during underwriting, we researched and pre-approved the end client who is responsible for making payments for the company we’re financing. In addition throughout the life of the loan, we conduct onsite field examinations, test the collateral and books of our clients and we have dominion of funds. Should the client default for payment from their customer comes directly to us. The active management of our highly collateralized loan book puts us in a strong position to recover a significant portion, if not all the value of the loan even of a customer defaults.

This may cause peaks and valleys in our short-term net charge-off rates since the default may occur in one quarter and recover in another. However, as you can see on this slide, our annual net charge-off rates even throughout the global financial crisis are not significantly higher than those of larger banks. Total loans and leases were $3.7 billion as of March 31st, an increase of 6% from the linked-quarter. Commercial finance volumes and warehouse lending were the primary drivers of this result. This was roughly flat compared to the prior year as growth in commercial finance was offset by our decision to sell the student loan portfolio, pay downs and warehouse facilities and the timing of tax season loans. Our commercial finance portfolio totaled $3.1 billion, an increase of 7% from the year ago period.

During the second quarter, the company recognized a total of $6.8 million in pre-tax financial impacts. This was attributable to the disposal or change in depreciable life of mobile solar generators related to a single relationship. In fiscal year 2019, we incurred a large impairment expense associated with one company with which we had three legacy solar transactions that turned out to be fraudulent. The assets were written down to their market value and redeployed under an equipment lease agreements to new participants. The lease assets were returned, we performed a due diligence assessment. This led us to dispose of certain generators based on their condition and to adjust the depreciable life for the remaining mobile generators. That better reflected the service period based on market conditions and advancements in current technology.

This was an isolated event limited to unique equipment is not indicative of the remaining rental equipment or even the solar portfolio. Remaining value generated on the balance sheet is $1.3 million. Notwithstanding that unique situation, credit quality across the portfolio remains strong. Nonperforming loans of 0.76% were down from 1.16% in the previous quarter and our net charge-off rates remain stable. We remain confident in our collateral management and the quality of our portfolio. Finally, some news of which we are particularly proud. In the fiscal third quarter, we were awarded the Great Place to Work certification. We remain dedicated to Pathward’s culture and improving our employees’ work experience. We are extremely pleased with Pathward’s recognition as a Great Place To Work.

I know that’s a lot. Thank you for your patience and attention to this Pathward news and these interesting times. I look forward to your questions. Before yielding the floor to Glen Herrick, I’d like to express my gratitude to Glen for postponing his retirement and agreeing to carry the mantle of CFO, while we search for his successor. We have engaged an executive search firm for this position and Glen has graciously agreed to help in a transition once that person is on board. Now, Glen, will you take us through our financial results?

Glen Herrick: Thank you, Brett. Net income for the quarter ended March 31st totaled $54.8 million or $1.99 per share, an increase from $49.3 million or $1.66 per share recorded in the prior year quarter. When excluding the financial impact of the previously mentioned legacy mobile solar deal, a venture capital impairment and their corresponding tax impacts, net income was $60.3 million or $2.18 per share for the fiscal second quarter. The second quarter’s results were driven by the expansion of the net interest margin and increases in noninterest income, generating 11% GAAP net income growth and 16% adjusted net income growth. Continued expansion in Pathward’s net interest margin enabled net interest income to grow 21% year-over-year.

Total net interest margin for the fiscal second quarter of 6.12% increased considerably when compared to the 4.80% recorded in the second quarter of fiscal year 2022. We expect our net interest margin to continue to expand through the ongoing remix of our balance sheet and the repricing of our earning assets in today’s higher rate environment. Provision expense in the fiscal second quarter of $36.8 million represents a $4.5 million increase from the prior year. The primary driver of the increase is higher provisioning in tax products. Excluding the impact of tax, the provision expense was $5.3 million, a $2.1 million increase from the prior year. This increase reflects the shift in the overall mix of loans. Total noninterest income increased 16% to $127 million in the fiscal second quarter as compared to $109.8 million in the prior year’s quarter.

The large increase was attributable to revenues associated from off-balance sheet deposits servicing along with refund transfer product fee income, partially offset by a $2 million loss on the disposal of rental equipment related to the mobile solar generator activity, Brett mentioned. For the six months ended March 31, 2023, total tax services product revenue increased 2% when compared to the same period last year. This was driven by increases in revenue from refund transfers, which was partially offset by decreases in revenue from refund advances. Refund advance originations for the 2023 tax season were $1.46 billion as compared to $1.83 billion last year. When adjusting originations for the non-renewal of two previously announced partnerships during the first six months of 2022, refund advance originations would have increased $116 million or 9%.

Provision for tax services products increased when compared to the prior year’s tax season, primarily due to an expected shift in mix in refund advances from national franchise channels to independent tax providers. As Brett mentioned, we are pleased with the performance year-to-date. On the expense side, total noninterest expense of $127.1 million represents an increase of 23% from the prior year. This increase resulted primarily from $20.4 million in contractual card processing expenses, mostly attributable to the higher rate environment. On our balance sheet, our deposit base remains strong at $5.9 billion. And as Brett stated, consists of millions of retail cards and other small dollar accounts with an average balance less than $1,000. Our deposit base is also diversified on a client basis as we contract with over 50 program managers.

In all of our partnerships, consumer funds are held in accounts owned and controlled by Pathward. In the second quarter, off balance sheet deposits averaged $1.6 billion, earning revenue roughly equivalent to the effective Fed funds rate. At March 31st, we had $2 billion of deposits off balance sheet with program banks. For the quarter ended March 31st, we held approximately $1 billion in deposits related to government stimulus programs. As we move through the rest of 2023 and into 2024, we anticipate that our off balance sheet deposit balances and associated revenue seen in the card and deposit fee lines of noninterest income will likely decrease due to the continued rundown of our EIP balances. Not only will recipients continue to spend them, but we will also begin to return unclaimed balances to the United States treasury.

We expect the return of the unclaimed balances to be approximately $500 million in deposits over the next 18 months. This assumption is included in our guidance as we believe loan growth in the corresponding net interest income will offset this impact along with other growth. From a liquidity perspective, Pathward continues to remain in a robust position. Our balance sheet is strong and the company holds $2 billion in deposits off balance sheet. We have cash and cash equivalents of $433 million, unpledged investment securities of $85 million, Federal Home Loan Bank borrowing capacity of $755 million and funds available through the fed discount window of $195 million. When factoring in unsecured funding and other wholesale funding options, this gives us over $4 billion in available liquidity.

The company remains well capitalized by continuing to return value to shareholders. During the fiscal 2023 second quarter, the company repurchased 1.17 million shares at an average price of $46.60. We are reaffirming our guidance for fiscal year 2023, continuing to expect GAAP earnings per share between $5.55 and $5.95, despite the $7.3 million in adverse pre-tax items during the second quarter that were detailed in the press release. This guidance includes the anticipated impacts from the declining EIP deposit balances and assumes the federal funds target rate remains at 5% in the second half of fiscal year 2023. We also assume an income tax rate in the 12% to 15% range for the fiscal year. That concludes our prepared remarks. Operator, please open the line for questions.

Q&A Session

Operator: Thank you. We will now begin our question-and-answer session. Our first question will be from the line of Frank Schiraldi with Piper Sandler. Your line is now open.

Frank Schiraldi: Hi. Good afternoon.

Brett Pharr: Hi, Frank.

Frank Schiraldi: Glen, I wanted to ask, just off the bat, you just mentioned the guidance. You reiterated the guidance. And I know in the quarter, you talked about the adjusted earnings per share excluding the impairments and mostly on solar generators. And it seemed in the release that you talked about the adjusted earnings per share being in the range of $5.40 to $5.80 that would include the impairments this quarter though, right, given what you say in the release.

Glen Herrick: It did not, Frank. So the adjusted earnings would actually be higher if you’re going to adjust out the solar impairment. We use the same methodology when we first issued guidance, which was just for the rebranding gain that we had in the impacts from that.

Frank Schiraldi: All right. That’s what I thought. Okay. I just wanted to make sure. And then as far as these the mobile generators. I believe you guys, I mean, obviously, you’re not in that one partnership or that one relationship any longer. But I believe you basically exited that business following that issue. Is that the case or anything else that’s like that on the — in the loan book?

Brett Pharr: Yeah. Frank, this is Brett. That is the only mobile solar transaction set that we did with one borrower as we said turned out to be a fraudulent borrower. If you go back to 2019, you can read all the story about that, there were a number of lenders that got caught in that. But no, we don’t have anything else like that. All of our solar business is fixed panels, the things that are considerably different than that.

Frank Schiraldi: Right, okay. And then just lastly if I could, on the commercial finance side, we’ve talked in the past and then you talked a little bit about the detail there, Brett, on the call about the business in general. You’ve talked about pricing may be being impacted a bit by all the liquidity in the system. It seems like some of that liquidity has come out of the system over the last — certainly over the last few months. And just wondering, it seems like maybe you’re getting some better pricing there? Just curious, any color on both the pricing you’re seeing there and also maybe the opportunity is, as this seems like it’s the time where other more traditional banks kind of back off that business a bit?

Brett Pharr: Yeah. I think you’re right, Frank. We literally within the past couple of weeks are starting to see what you’re talking about as other banks begin to pull back, either because of their own liquidity concerns or any kind of view of a credit C&I kind of credit view. So we are just now starting to see that and that gives us an opportunity to get a higher yield on the kinds of transactions we’re comfortable with. So, I think, part of our guidance view is, we’re going to get the benefit of that through the next few months.

Frank Schiraldi: Got it. Okay, great. I appreciate all the color. Thanks.

Brett Pharr: Thank you.

Operator: Thank you. There are currently no additional questions registered at this time. There are currently no additional questions registered at this time. So I will pass the call back over to the management team for closing remarks.

Brett Pharr: Thank you, everybody for joining us today, and your interest in Pathward. Have a great evening.

Operator: That concludes today’s conference call. Thank you for your participation. You may now disconnect your lines.