FinWise Bancorp (NASDAQ:FINW) Q3 2022 Earnings Conference Call October 26, 2022 5:30 PM ET
Company Participants
Kent Landvatter – President and Chief Executive Officer
Javvis Jacobson – Chief Financial Officer and Executive Vice President
James Noone – Chief Credit Officer and Executive Vice President
Conference Call Participants
Andrew Terrell – Stephens
Andrew Liesch – Piper Sandler
Operator
Greetings and welcome to the FinWise Bancorp Third Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder this conference is being recorded.
I would now like to turn the conference over to management to begin.
Unidentified Company Representative
Good afternoon and thank you for joining us today for FinWise Bancorp third quarter 2022 conference call. In addition to this call, we issued an earnings press release earlier this afternoon and posted it to the Investor Relations section of our website at investors.finwisebank.com. Today’s conference call is being recorded and webcast on the company’s website, investors.finwisebancorp.com.
On today’s call, management’s prepared remarks and answers to your questions may contain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ from those discussed today. Forward-looking statements represent management’s current estimates, and FinWise Bancorp assumes no obligation to update any forward-looking statements in the future. We encourage listeners to review the more detailed discussions related to these forward-looking statements contained in the company’s earnings press release and filings with the Securities and Exchange Commission.
Hosting the call today are Mr. Ken Landvatter, CEO and President of FinWise Bancorp; and Mr. Javvis Jacobson, Chief Financial Officer of FinWise Bancorp.
With that, I will turn the call over to Mr. Landvatter.
Kent Landvatter
Good afternoon, everyone, and thank you for joining us on our third quarter 2022 earnings conference call. Our differentiated business model allowed FinWise to generate solid top line results during the third quarter even as we faced an economic environment that is becoming increasingly challenging. We remain confident that our business model lends itself to flexibility in both weakening and strengthening economic conditions and we remain exceptionally proud of our team’s unwavering dedication to providing our clients and customers with best-in-class value and service, particularly during more challenging market conditions.
During the third quarter, we generated total revenue of $20.3 million led by loan originations of $1.5 billion. We also walked back 20,000 shares for a total of approximately $0.2 million as part of our previously announced share repurchase program. The company’s tangible book value per common share continued to grow increasing 32% year-over-year to $10.44 per share at the end of the third quarter. The overall environment for loan originations has decelerated this year across the industry and FinWise is not immune, even as the company’s relationships with existing strategic platforms and interest from potential new platforms remains strong.
Importantly, going forward, we expect to retain the guaranteed portion of certain SBA production, as gain on sale premiums have decreased and variable loan rates have increased. We expect to keep more of the guaranteed portion of certain SBA loans on the balance sheet to benefit the company through stronger government guaranteed held for investment loan growth and a higher recurring stream of interest income. Expenses remained well managed in the quarter.
During Q3, the efficiency ratio improved to 42.3% from 52% in the previous quarter. As we have publicly discussed, while our efficient ratio is likely to increase longer term as we invest for growth. Near-term, we will continue to be prudent with expenses in light of tougher economic conditions. We also remain pleased with the credit quality performance of our portfolio, which continues to move in line with our expectations for gradual industry-wide normalization of credit to pre-pandemic market conditions.
The company did not have any non-performing loans for the current quarter, compared to non-performing loans to total loans of 0.3% for the previous quarter and 0.3% for the year ago quarter. Certainly, if the U.S. economy were to experience further deterioration from current levels, the overall industry could experience faster than anticipated credit quality normalization.
However, as we noted during the past quarter, we slowed strategic program retention to better assess and manage economic risks and we remain confident in our ability to sustain sound credit quality through varying credit cycles given our prudent risk management approach and tight underwriting standards.
Additionally, as we have commented before, we have not adjusted our lending standards to reach for growth. We also remain significantly above well capitalized guidelines with a bank leverage ratio of 24.9%. Overall, while we manage the company for the long-term, we acknowledge the risk of further economic deterioration given headwinds, including inflation and rapidly rising interest rates.
However, given our cautious view on the direction of the economy, we have been proactively preparing for such a scenario in order to navigate a tougher environment as best as possible, while continuing to serve our clients. We will also continue to execute on items that we can control, including risk management, underwriting and expenses. And by doing this, we believe we will be able to capitalize on growth opportunities that emerge once the market environment stabilizes.
With that, I would now like to turn the call over to our CFO, Javvis Jacobson, who will provide you with more detail on our financial results.
Javvis Jacobson
Thank you, Kent. FinWise continued to move forward despite faster than anticipated deterioration in economic conditions during the quarter. The company’s loan originations were $1.5 billion during Q3 ’22, an average loan balances comprising held for sale and held for investment loans were $263.6 million during Q3 ‘22, as compared to $279.3 million in Q2 ’22 and $238.3 million in Q3, ’21.
Total average interest earning assets were $335.4 million during Q3, compared to $373.2 million for Q2 ’22 and $294.3 million for Q3 ’21. As we’ve highlighted on prior calls, our loan originations have generally followed typical industry seasonality, including a general rebound in the third and fourth quarters of the year. However, if the current challenging economic environment continues or deteriorates further, we believe loan origination growth on a sequential quarter basis could be pressured and the typical seasonal rebound in originations in the second half of the year could be negatively impacted.
Average interest bearing deposits were $104.8 million during Q3, compared to $127.2 million during Q2 ’22 and $112.2 million during Q3 ’21. The decrease from Q2 ’22 and Q3 ’21 was driven mainly by a decrease in certificates of deposits and money market accounts. As we have noted before, our non-interest bearing deposits have generally been highly correlated with our origination volume, due to the relationship between strategic platform deposit reserve accounts and total held for sale loans outstanding.
Turning to the income statement. Net income was $3.7 million in Q3, compared to $5.5 million in Q2 ’22 and $8.4 million in Q3 ’21. The sequential quarter change was primarily driven by a one-time tax expense correction, higher provision for loan losses and lower fee income, due primarily to lower strategic program origination volume, partly offset by a decrease in non-interest expense. Certainly, this one-time tax correction impacted some of our after tax metrics during the quarter.
The change in net income versus the prior year period was primarily driven by an increase in the provision for loan losses and non-interest expense and a decrease in gain on sale loans and interest income. Net interest income for Q3 was $12.5 million, compared to $12.8 million for the previous quarter and $13.5 million for Q3 ’21.
On a sequential quarter basis, net interest income declined primarily due to lower average loans held for sale balances, partially offset by higher loan yields and higher average loans held for investment balances. Relative to the prior year period, net interest income was lower primarily due to lower average loans held for sale balances and lower overall loan yield.
Net interest margin for Q3 was 14.93%, a 124 basis point increase from 13.69% in Q2 ’22 and down compared to 18.31% in Q3 ‘21. The sequential quarter increase was primarily driven by an increase in variable rates on SBA loans and a loan mix shift away from loans carrying lower yields within the strategic program held for sale portfolio.
The net interest margin decline from Q3 ’21 was driven mainly by a loan mix shift towards loans carrying lower yields. We continue to expect fluctuations in net interest margin from quarter-to-quarter, due to shifts in our asset mix. That said, our focus continues to be on generating strong and sustainable net interest income growth over the long-term, driven by continued growth in loan originations.
Non-interest income was $7.5 million in Q3 ’22, compared to $8.4 million in the previous quarter and $8.5 million in Q3 ’21. The sequential quarter change was driven primarily by lower strategic program fees due to a decrease in loan origination volume. The decrease compared to Q3 ’21 was primarily due to lower gain on sale of loans due to a decrease in premium receipt for SBA 7(a) loans sold.
We continue to expect quarterly fluctuations in the fair value of our investment in DFG, driven by general market movements. As Kent noted earlier, given our current plan to retain the guaranteed portion of certain of our SBA 7(a) production longer, due to suppressed gain on sale premiums and increasing variable loan rates, we would expect to see a continued decline on SBA gain on sale, which is a headwind to our fee income. Positively, however, we believe this should result in stronger held for investment loan growth and a tailwind to our net interest income over the long-term.
In terms of expenses, we held the line well in Q3 ’22 with non-interest expense of $8.5 million, compared to $11 million in Q2 ’22 and up from $7.4 million during Q3 2021. The sequential quarter decline was primarily due to the cessation in June 2022 of commission accruals related to the company’s strategic lending program and an impairment on the company’s SBA servicing asset in the previous quarter, which did not occur in the third quarter of 2022.
Compared to Q3 ’21, the increase was primarily due to higher other operating expenses, driven primarily by an increase in consulting fees, partially offset by the cessation in June 2022 of commission accruals related to the company’s strategic lending program. The company’s efficiency ratio improved significantly during Q3 coming in at 42.3% versus 52% in the prior quarter and 33.7% during Q3 ‘21.
As Kent mentioned, while we still expect to look for opportunities to invest for long-term growth, we will strive to be prudent with expenses given the tougher and macro environment. The bank’s credit quality remains solid and we did not have any non-performing loans at the end of this quarter, which compares to non-performing loans as a percent of total loans receivable of 0.3% for the previous quarter and 0.3% for Q3 ‘21.
The company’s provision for loan losses was $4.5 million for Q3, compared to $2.9 million for Q2 ’22 and $3.4 million for Q3 ’21. Sequential quarter and previous year increase in the provision is primarily driven by an increase in net charge offs and by unguaranteed loan growth. We also remain prudent as we continue to expect gradual normalization of credit quality throughout the industry, which is something we mentioned on prior earning calls.
Net charge offs for Q3 were $3.1 million, compared to $2.3 million in the prior quarter and $1 million for Q3 ’21. The company’s net charge off rate as a percentage of average loans for Q3 was 4.7%, compared to 3.3% for Q2 ’22 and 1.6% for Q3 ‘21. The change in net charge offs for Q3 ’22, compared to the prior quarter and Q3 ‘21 was primarily driven by higher net charge offs related to strategic program and SBA 7(a) loan balance that are not guaranteed by the SBA that have previously been held as classified assets.
As we’ve noted previously, back in March 2020, we proactively tightened factors that impact our reserve levels in conjunction with the heightened economic uncertainty at the start of the COVID-19 pandemic. We have not lowered these environmental factors since and do not have any current plans to lower them in the near-term, which is something that we believe should benefit the company as we enter a potential new credit cycle.
It’s worth reminding that reserve levels for our strategic programs are set according to high water charge-off rates by vintage and program, plus additional external factors. In fact, we made an adjustment to one of our platforms reserve with zero levels during the third quarter as a result of this high water charge-off rate methodology. The bank’s capital levels remained strong with a 24.9% leverage ratio, which keeps the bank significantly above the 9% well capitalized requirement.
Lastly, our effective tax rate was 48.7% for Q3, compared to 24.6% for Q2 ’21 and 24.5% for Q3 ’21. The current quarter’s increase in the effective tax rate over both prior periods is primarily due to the correction of an immaterial error in the calculation of the company’s tax provision.
With that, I would like to open up the call for Q&A. Operator?
Question-and-Answer Session
Operator
Thank you. Ladies and gentlemen, we will now be conducting a question-and-answer session. [Operator Instructions] Our first question is from Andrew Terrell with Stephens. Please proceed.
Andrew Terrell
Hey, Ken. Hey, Javvis.
Javvis Jacobson
Hey.
Kent Landvatter
Hey, how are you?
Andrew Terrell
Good. How are you guys?
Kent Landvatter
Great. Thanks.
Andrew Terrell
Good. Maybe just to start, just kind of housekeeping, Javvis, you have the amount of the tax expense, kind of, catch up this quarter. I know it was a bit outsized, do you have just what a normalized tax rate would have been this quarter? What the dollar amount of that impact was?
Javvis Jacobson
Yes, Andrew, let me give you some context for the correction right now, I think this will help. The matter stems from the Section 162(m) tax rule that applies to public companies and restricts the deduction of certain executive compensation over $1 million in the calendar year. That rule was not applicable to us as a private company, and was not incorporated in the provision calculations after we went public late last year. An understatement of 2021’s tax expense of approximately $939,000, which is less than 3% of the reported $31.6 million of net income for 2021 was identified when the reconciliation of our final 2021 income tax returns was made to the tax provision calculation for 2021.
Although the 2022 year is not yet complete, we expect that the impact of the 2021 correction in the 2022 year will be less than 5% on an annualized basis. We are also correcting an understatement of tax expense of approximately $108,000 from Q1 ’22 and $337,000 from Q2 ’22 in Q3. After discussing the issue thoroughly with our auditors and audit committee, we’re comfortable with the determination that this is an immaterial error corrected in Q3. The 2022 consulting fees paid to this executive will not be deducted for tax purposes. As a result, our effective tax rate is expected to be elevated for the rest of 2022, but come back to historical norms in Q1 of ‘23. Does that help, Andrew?
Andrew Terrell
Yes. No, that was a great color. I appreciate it. Okay, I want to move over to the — just the comments around retaining a higher portion of guaranteed SBA loans. I guess, I was hoping you could maybe size up the appetite and how should we think about what you might look to retain going forward? How that translates into loan growth?
And then I guess is it safe to assume that over the near-term just with this backdrop, there’s not going to be much in the way of, kind of, incremental SP credit retention or unguarantined SBA?
Kent Landvatter
Yes. Andrew, I’ll start with that one on the SBA retention. We don’t really have a specific target that we’re talking about, but we let the data guide us in this and where the SBA loan interest rates are increasing and the secondary market premiums declining. That’s why we’re talking about retaining more of the guaranteed portion for longer periods. We think it’s a good use of our capital and it’s important to note that the retention of this guarantee portion does not necessarily increase the credit risk of the profile of the bank. As far as we think that the amount that we intend to retain will be a meaningful amount. But again, we don’t have a target percentage.
Andrew Terrell
Okay, understood. And then outlook on the other portfolios as well, is it fair to think that we could see those, kind of, stable to generally declining at this point? Or is that an unfair assumption?
James Noone
Andrew, this is Jim. I think stable was probably the right way to look at it in the near-term. But there’s different ways that we’ve looked at monetizing the originations that come across our balance sheet. I think if you look at our history over the last few quarters, we’ve been very judicious in how we use that balance sheet, especially at a time of economic uncertainty. So we wouldn’t rule out the ability to retain in the right circumstances or with the right credit enhancements, but certainly in the current environment, it would have to be a fairly strong asset.
Andrew Terrell
Yes, understood. Okay, thanks, Jim. And I wanted to talk about I guess it’s good to see the HSA business contribute to growth this quarter. Do you have how much in net balances that contributed? And then do you think we can continue to see kind of net deposit growth into the fourth quarter and into 2023?
Kent Landvatter
So we haven’t broken that out, but it’ll be in the call report this week, Andrew. As far as the HSA amount, it’s a significant number in the $30 million range.
Andrew Terrell
Okay.
Kent Landvatter
As far as it growing in the future, it’ll have some fluctuation. But at this point, I don’t think unless conditions change, we’re going to expect to see much fluctuation in it on a material basis.
Andrew Terrell
Okay, understood. Alright, I’ll step back in the queue. Thanks for the time for the questions.
Operator
Our next question comes from the line of Andrew Liesch with Piper Sandler. Please proceed.
Andrew Liesch
Hey guys, good afternoon. Thanks for taking the questions. Just want to touch base on the expenses here for the cessation of the commission accrual. So this is not about $8.6 million run rate, is this a good place to build off going forward? Just recognizing there’s going to be more investments in the franchise?
Javvis Jacobson
Andrew, when you’re looking at that $8.5 million on a quarterly basis, I think you need to — we are looking at the contract with our former executive, that’s not an insignificant number in that figure. And as you know, the contract has been disclosed that — those payments will decrease quarter-over-quarter through the end of 2023. Does that help?
Andrew Liesch
Yes. Well, you’re saying that the line — that this $9.5 million can decline from here?
Javvis Jacobson
Yes. I think just by a function of that contract, with the former executive, it should decline.
Andrew Liesch
Okay, got it. And then just on the loan originations, the $1.5 billion you mentioned this quarter. Can you give us a sense on how that trended like where were originations in September versus August? And if we’ve started to see sort of a stabilization in monthly production?
James Noone
Yes. Andrew, this is Jim. So we understand the desire to have some, kind of, intra quarter visibility on origination levels. The issue is this figures are volatile. So we’ve taken note of the request. Right now, we would kind of point to the trend that you’re seeing across the last few quarters and we don’t think that the intra quarter figures are as useful.
Andrew Liesch
Got you, alright. I think that covers my questions, I’ll step back. Thanks.
Kent Landvatter
Thank you.
Operator
Our next question comes again from the line of Andrew Terrell with Stephens. Please proceed.
Andrew Terrell
Hey guys, thanks for the follow-up. Just to the last point on the originations, I guess we can make an assumption for the fourth quarter. I think, I heard your kind of prepared comments that maybe we shouldn’t see a stabilization or normal, kind of, seasonal rebound in the fourth quarter. So I guess I think about that heading into 2023, if 4Q because normally, seasonally a high point. Should we expect, I guess, flat to down, I guess, turning into the first part of 2023 as well? Is that a fair way to think about it?
Kent Landvatter
Yes. I think that’s a fair way to think of it.
Andrew Terrell
Okay. I guess barring an improvement in macro?
Kent Landvatter
Right.
Andrew Terrell
Okay. And then on the buyback, I saw there was a little bit done this quarter. Just wanted to get your thoughts on just appetite for the repurchase moving forward?
Kent Landvatter
Yes. As you’ve noticed, we did purchase shares in the third quarter. You still have significant number of shares you had to purchase under the recently announced program. And given the current market conditions, we’ll certainly look at continues to continue our buyback, particularly given the stock has been trading below book value, Andrew.
Andrew Terrell
Yes, makes sense. Okay, and if I could just ask one more. I saw the charge-offs stepped up a bit in both the SBA and ST portfolios this quarter. I was hoping you could just speak a bit about both within the ST book of business, how does the current level of losses, compared to what you were anticipating? Do you think we see a continued progression higher from here? And then similar question for SBA, within the SBA book specifically, are you more extensively reviewing any of this credit right now just given the rate moves upward that we’ve seen? And are there any areas or pockets of stress that you’re seeing develop within the book?
Kent Landvatter
Sure. So the net charge-offs for the quarter were comprised of about $2.8 million from the SP HFI book. And then about 250,000 from our SBA portfolio. On the SBA side, Andrew, about 241 of the 250 was related to SBA assets that we’ve carried as classified since 2019. These accounts started moving through the resolution process again once the courts reopened from COVID earlier this year.
And so during Q3, we received sizable paydowns on those two classified accounts commensurate with the partial release of collateral, so while the accounts continue to be well reserved — I’m sorry well secured from an LTV standpoint. On the remaining collateral, we felt it was prudent for our policies to charge off the remaining exposure during the quarter.
And then moving to your question about the SP HFI portfolio. As we mentioned in the last few quarters, we began to see what we expected as far as normalization net charge-offs during the first quarter of the year. And we’ve been communicating our expectations on that normalization of credit since our capital raise last year. So the net charge also generally in line with our expectations and what we’ve been communicating since the capital raise. There’s not — as far as specific weakness, there’s nothing, I would point to, there’s nothing that would concern me. within the different portfolios that we manage generally in line with expectations.
Andrew Terrell
Okay, understood. I appreciate the time.
Kent Landvatter
Thank you.
Operator
Thank you. [Operator Instructions] Ladies and gentlemen, there are no further questions at this time. And this will conclude today’s conference. Thank you very much for your participation. You may now disconnect.
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