Start Time: 17:00 January 1, 0000 5:33 PM ET
Pathward Financial, Inc. (NASDAQ:CASH)
Q3 2022 Earnings Conference Call
July 27, 2022, 17:00 PM ET
Company Participants
Brett Pharr – CEO
Anthony Sharett – President
Glen Herrick – CFO
Justin Schempp – VP, IR
Conference Call Participants
Frank Schiraldi – Piper Sandler
Steve Moss – B. Riley Securities
Andrew Stimpson – Keefe, Bruyette & Woods
Operator
Ladies and gentlemen, thank you for standing by, and welcome to the Pathward Financial Investor Conference Call for the Third Fiscal Quarter of 2022. 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 Justin Schempp, Vice President of Investor Relations and Financial Reporting. Please go ahead.
Justin Schempp
Thank you. And welcome Pathward Financial’s third fiscal quarter of 2022 conference call and webcast. On July 13, the company legally changed its name to Pathward Financial, and we will refer to ourselves as such throughout today’s call.
Our CEO, Brett Pharr; President, Anthony Sharett; and CFO, Glen Herrick will discuss our operating and financial results, after which we will take your questions. Additional information, including the earnings release and investor presentation, may be found on our Web site 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 may 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 within the appendix of the investor presentation.
Now, let me turn the call over to Brett Pharr, our CEO.
Brett Pharr
Thank you, everyone, for joining Pathward Financial’s third fiscal quarter 2022 earnings call. I am pleased to host this call today, our first, using our company’s new corporate name, which reflects our continued commitment by providing a path forward to people and businesses so they can reach the next stage of their financial journey.
As Justin mentioned, our company legally changed its name to Pathward earlier this month. Our corporate name has changed the full transition to our new brand, including the launch of our new brand, identity and Web site is still underway, and we will complete it by calendar year end.
Turning to our financial results. Net income was $22.4 million, down $16.3 million compared to $38.7 million in the same prior year period. Earnings per share for the quarter were $0.76. That’s compared to $1.21 in the prior year.
As previously disclosed, our earnings this year have been impacted by a slowdown in the renewable energy tax credit lending market, lower tax advanced demand than we assumed and certain one-time branding and separation agreement expenses.
We continue to benefit from our business model of using low-cost deposits from our banking-as-a-service business, lending them to a variety of commercial finance asset classes, allowing substantial return of capital to our shareholders. This model will generate higher returns once the market lending rates begin to reflect the higher rate environment.
We anticipate that our net interest margin will continue to expand as the result of our ongoing mix shift into higher interest earning assets, coupled with higher overall rates on new business originations and increases to the variable loan portion of our existing portfolio. Our confidence in steadily growing earnings per share has never been higher.
Like others in our industry, we are facing a challenging macroeconomic and geopolitical landscape. Third quarter expenses were higher compared to the previous year as we incurred higher employee compensation costs as well as higher technology-related spending to enhance our capabilities to get ahead of market expectations and respond to industry-wide inflationary pressures.
In response to these headwinds, we will concentrate our efforts to drive productivity and enhance efficiency. Our income tax rate was up compared to the second quarter due to delays in the development of renewable energy projects in our pipeline. As we’ve noted in the past, our income tax fluctuates primarily due to these projects.
The solar construction market has been largely impacted by supply chain constraints, leading the volumes level to lower expectations and as a result, we anticipate our tax rate to be higher than previously expected in the short term.
To address credit in the current environment, we are pleased that our growing Commercial Finance portfolio remains healthy as reflected in our reduced allowance reserve rates. We continue to be confident in the ability of this well diversified portfolio to perform, even during a difficult economic environment as it has done historically.
Our team has deep experience and hands-on collateral management, which has helped mitigate losses during previous cyclical downturns. Because of this hands-on collateral management, our ability to manage losses in the downturn far exceed traditional C&I lending.
Given the dynamic economic environment, we believe it will be helpful to provide guidance for the current and next fiscal year. We expect fiscal year 2023 GAAP earnings per share to be in the range of $5.25 to $5.75.
When adjusting for certain nonrecurring items net of tax, we expect an adjusted earnings per share to be in the range of $5.10 to $5.60. At this point, we will only be providing guidance for EPS and will not be addressing specifics on various income statement items. Glen will discuss our broad assumptions in more detail later.
Now, let me turn the call over to our President, Anthony Sharett, to provide updates on our lines of business.
Anthony Sharett
Thank you, Brett. Let me first update you on our banking-as-a-service business, which includes our payments, tech services, and consumer lending capabilities. We are prioritizing relationships that have more favorable, sustainable economics, which often means longer-term agreements with partners that use a broader suite of capabilities and multi-product solutions that we provide.
A great example of this is our relationship with H&R Block, with whom we have an agreement in place through June of 2025. Consistent with these priorities, we are not renewing agreements with Liberty Tax and Jackson Hewitt. As a result, we expect taxpayer advanced volumes to decline roughly 30% next year, which will impact fiscal year ’23 revenue, but also will help reduce the magnitude of the seasonal volatility in our business.
We did not expect any material impact to our refund transfer volumes, which we view as our core tax services payment solution. By exiting these two limited partnerships, we expect to gain extensive efficiencies over time, and it will allow us to focus our resources on our growing H&R Block and other banking-as-a-service partnerships.
Changes in capital markets are also impacting our banking-as-a-service business. Recent pullbacks and investment funding of Neobanks and fintech firms are slowing opportunities at our pipeline. But new solutions and programs with legacy partners, which represent the majority of our banking-as-a-service business, remain strong and ongoing.
Moving to credit quality. Our total nonperforming loans and leases as a percentage of total loans and leases improved 24 basis points from the prior quarter to 0.71%. The allowance as a percentage of loans and leases decreased from 2.38% in the prior quarter to 2.04% in the current quarter, due in large part to the decrease in seasonal reserves for the tax services loan portfolio.
Excluding the reserves for the tax loans, reserves dropped from 1.59% to 1.44%. As Brett mentioned, we are pleased with our team’s ability to continue to grow the Commercial Finance portfolio. The loans and leases in the Commercial Finance portfolio were 2.9 billion at June 30, an increase of 14% from the third fiscal quarter last year.
As we potentially enter a period of stagflation, characterized by low or negative growth coupled with higher interest rates and inflation, we continue to believe our Commercial Financial portfolio is well positioned. First, rising rates will result in higher yields on our new business and existing variable loan portfolios.
Further, our customer base tends to expand as companies lose their traditional funding sources during the credit cycle, which favorably impacts our working capital lines such as asset-based lending and factoring. For these reasons, we expect continued strong loan growth and higher yields on the commercial portfolio going forward.
Now, let me turn the call over to Glen Herrick, our CFO, to provide an overview of our financials.
Glen Herrick
Thank you, Anthony, and good afternoon, everyone. Net income for the quarter ended June 30 totaled $22.4 million, or $0.76 per share, a decrease of $16.3 million from the third quarter of fiscal year 2021. Excluding 3.4 million of rebrand-related expenses and 3.1 million of separation expenses, net of tax impact, our adjusted net income was 27.3 million for the quarter.
The quarter’s net interest income of $72.2 million represents a 5% increase from the prior year. Higher yields on the securities portfolio and greater Commercial Finance interest income more than offset the sale of the remaining community bank portfolio year-over-year. While we are seeing some growth in Commercial Finance yields, the yield beta to rate increases has been slower than we have expected thus far, likely due to excess liquidity in the market.
In total, quarterly average loans and leases grew by $129 million, or 4%, driven by strong growth in the asset-based lending and factoring portfolios. Concurrently, interest expense was elevated this quarter beyond its traditional run rate, as the company accelerated $900,000 of interest expense associated with the retirement of the subordinated debt.
Our balance sheet optimization, combined with higher yields and a reduction in excess cash from stimulus payments, helped drive the third quarter net interest margin to 4.76% compared to 3.75% in the prior year. Noninterest income of $54 million was down $8.5 million from the prior year.
As Brett mentioned, the prior year’s quarter benefited from greater card fee income associated with stimulus activity as well as timing of last year’s tax season. Furthermore, the company recorded fewer gains on loan sales in the current fiscal year, as the solar construction market has been impacted by supply chain constraints, leading to extended construction terms.
For the nine months ended June 30, total tax product income net of losses and direct product expenses was $43.5 million, up from $40 million recorded in the prior year period. While taxpayer advances came in below our expectations, overall refund transfer volume grew 9% year-over-year. Looking ahead to next year, we expect strong refund transfer volumes and greater efficiency in our tax line of business as we exit the two aforementioned partnerships.
Total noninterest expenses for the quarter increased 19% year-over-year. Excluding the 3.4 million of rebrand-related expenses, 3.1 million in separation costs and 1.2 million in expenses related to the nonrenewal of the two tax partner agreements, core expenses increased 9% year-over-year. The increase in expenses generally stemmed from higher compensation caused by industry-wide inflationary pressures and greater technology spend to support current and future Commercial Finance growth.
Additionally, the company started to incur higher card expenses under the rising rate environment. As interest rates rise, we will experience elevated card expenses with some partners associated with certain contractual agreements. However, we do expect the higher variable card expenses to be less than the corresponding revenue gains as interest income benefits from the higher rate environment and through additional fee income from off balance sheet deposits.
Income tax expense in the third quarter increased to $7 million compared to $4.9 million in the prior year. These expenses correspond to effective tax rates of 22.6% and 11%, respectively. As mentioned previously, the increase is driven by reductions in renewable energy investment tax credits compared to the prior year.
To expand further on the guidance Brett provided earlier in the call, we estimate fiscal year 2022 GAAP earnings per share to be in the range of $5.04 to $5.24 and fiscal year 2023 GAAP EPS to be in the range of $5.25 to $5.75.
When adjusting for gain on sale of trademarks, rebrand-related expenses and separation expenses, the company expects fiscal year 2022 adjusted earnings per share to be in the range of $4.28 to $4.48 and fiscal year 2023 adjusted EPS to be in the range of $5.10 to $5.60.
These estimates assume a Fed funds rate of 3.5% by September of 2023. Any increases above this level could positively impact our earnings, while our earnings may be negatively impacted if rates do not reach that expected level.
As we mentioned in last quarter’s call, the company retired the outstanding $75 million subordinated debt on May 15, 2022. The debt had recently moved out of its fixed rate phase to a variable rate. As a result of the retirement, the company will save approximately $6 million of interest expense over the next year.
Finally, the company remains well capitalized with a regulatory leverage ratio for the bank of 8.2% and we remain committed to returning capital to shareholders. In July, we repurchased 306,000 shares at an average price of $40.74 through July 22.
That concludes our prepared remarks. Operator, please open up the line for questions.
Question-and-Answer Session
Operator
Thank you. [Operator Instructions]. Our first question is with Frank Schiraldi from Piper Sandler. Frank, your line is open.
Brett Pharr
Hi, Frank.
Frank Schiraldi
I wonder if in terms of the EPS guide, you could just give a little detail on — does that reflect sort of a steady state environment in terms of the macro? Does it assume some macro deterioration in line with the economic outlook, or how do you think about that when you’re giving the 2023 guide?
Brett Pharr
Well, I think the first big picture piece of this is it’s the yield question. And as we are helping everybody understand, our portfolio will not reprice as quickly as some might have thought. And the other thing what’s going on, and Glen mentioned it in his comments, there’s extreme liquidity in the market. And so even though rates have moved up in theory, they’ve not moved up in practice. And I’m talking about intermediate duration kind ones. So we do believe we’re going to get obviously higher net interest margin and we’re going to get the benefit of the yield, perhaps not as aggressive as some might have thought. And then as we go through this period from a yield perspective, we’ll sustain that benefit for a longer period of time that might have been thought even as we come down a lower rate environment. So not really about the macroeconomic environment as much as it’s about the speed at which yield will pick up.
Frank Schiraldi
Okay. So it doesn’t necessarily reflect an economic slowdown at all. It’s just more subtle on the NIM side I guess of things?
Brett Pharr
That’s right.
Frank Schiraldi
And then, I guess maybe you could — if you could just talk a little bit to the — Brett, you noted that maybe yields have moved higher as much as some may have thought. Is it the liquidity? What is the main reason why the market lending rates haven’t really reflected the increase in rates to date?
Brett Pharr
Yes. Again, that’s kind of what we were talking about is banks are flushed with deposits and they continue to be flushed with deposits. And so rates are reflective of why I can put it out for versus having it sit in Fed funds, because I’m not having a problem gathering deposits. Now, I believe that’s going to flip. And this is going to quickly turn. And then we’ll have some pricing that’s going on in the marketplace that’s a little bit more like normal you have when there’s a rate increase. We’ve never had a situation where you’ve got this kind of a rate increase with this much liquidity in the market. It’s going to take a while through the system.
Frank Schiraldi
Okay. And then just on the announced exiting of those two relationships on the tax side, any sort of color you can give? I know you talked about the reduction in the refund advance product expected year-over-year, but you also talked about maybe picking up some efficiencies over time. So if we think about what the impact is to the bottom line on 2023 earnings, if you guys have that math for us?
Brett Pharr
Well, Anthony, why don’t you talk a little bit about what you’re doing there and why? Then maybe, Glen, you can address any kind of a math question?
Anthony Sharett
Sure. As we noted in our remarks, we really want to focus on partners base that have broad banking-as-a-service utilities for us. While we don’t necessarily disclose partner economics, we do expect our taxpayer advanced volumes to be reduced by about 30%, but the impact of these exits included in the Q3 guidance, but we believe we’ll be able to improve our efficiency over time by redeploying these resources to optimize our core, what we call our enterprise part. And number two, do you think it will have the result of impact of reducing [indiscernible]?
Glen Herrick
Yes. And I think Anthony covered it there, Frank. We provided a fair amount of detail around the reduction in tax advances. We list out the components of the revenue and other items for our tax advances. And that’s all — all that is factored into our overall guidance for fiscal year ’23 that we will not have Jackson Hewitt and Liberty going forward. And then as you might assume, there are resources internally that we can either save or we can redeploy it to higher growth, higher margin type of businesses.
Frank Schiraldi
I guess that’s what I’m kind of getting at. I guess that’s more down the road as opposed to baked into the idea that there’s some offset here, because there’s some ability to do some other things that’s more sort of down the road baked into 2023.
Glen Herrick
That’s correct.
Frank Schiraldi
Okay. And then I think, Anthony, you mentioned this, the slowing pipeline as far as new partners, but the strength of existing partnerships on the banking-as-a-service side, and just wondered if you guys maybe could give any color into growth from here on the card fee side?
Brett Pharr
Let me take the start of that and then I pass it to you, Anthony. So, Frank, what we’re seeing with our partners is a lot of new programs, a lot of new ideas coming out. Because of the sort of macroeconomic environment and what’s going on, that’s pretty well understood in fintechs and some of the venture capital firms, the Neobanks, were seeing a little bit of a slowdown there. And that’s kind of play its way out. I actually think there’ll be some of them that survive and come back strong. But we’re still seeing interest in from our existing partners, large programs, new products, new capabilities, and bringing those in. So Anthony, what would you add to that?
Anthony Sharett
I think that’s well put. Again, as we look to optimize our core enterprise partners, even back to the last question, we’re going to be either saving or redeploying resources to really grow and go wider and deeper with those partners. We have seen a pullback of Neobank and fintechs because of the investments in those companies is declining. But we still do have a robust pipeline of opportunities. And those are the ones that we’re really going to be focused on in our banking-as-a-service pipeline.
Frank Schiraldi
Okay. Thanks for all the color.
Brett Pharr
Thanks, Frank.
Operator
Next question is with Steve Moss from B. Riley Securities. Steve, your line is open.
Steve Moss
Good afternoon.
Brett Pharr
Hi, Steve.
Steve Moss
Maybe just starting here on — hi, Brett — starting on the tax side here, maybe just — were there any pricing demands from the tax partners that made the business less attractive and caused the change in business plans here?
Brett Pharr
Well, I would say it really wasn’t a pure pricing conversation. We’re really wanting to go to this portion of the industry where you’re offering a breadth of products, not a single threaded product through a partner. Having a partner is an administrative proposition. And if you can have two, three or four products or capabilities going to the same partner that gives you economies of scale that makes sense, both of those arrangements were single product arrangements. And that’s what we’re trying to get away from.
Glen Herrick
Steve, this is Glen. I think you’re going to assume though that these contracts came up for renewal and Brett addressed the strategic thinking there. But you could also assume that as a single threaded product and a new contract or renewal that perhaps the economics didn’t — what the new economics might be would not clear our return hurdles.
Steve Moss
Right. And kind of on that point, I was going to go to next, is just is there a fundamental shift in the business outlook or maybe the business plans here after this year’s unusual tax season?
Brett Pharr
I don’t think — I would say there’s a fundamental shift except this that we’re thinking about the tax business as banking-as-a-service. We expect our interactions with the tax business to be broader and to begin to address other kinds of consumer things. And as Anthony mentioned in his remarks, our relationship with H&R Block is exactly that nature where it’s broader than just a tax play.
Steve Moss
Okay. And then on the tax credit side of the business, Glen, I think it was you who mentioned that the short-term — going to get short-term impact for the tax credits. Just kind of curious, does it go into fiscal ’23? And, if so, kind of what are you guys assuming for a marginal tax rate in your guidance?
Brett Pharr
Go ahead, Glen.
Glen Herrick
Sure. So it’s hard to predict, Steve, how long does this go? Now market color says there’s still demand for projects out there. But either between projects getting delayed, primarily supply chain, and other perhaps permitting issues, the whole market has seen a slowdown. So we’re projecting roughly low double digit type tax rate for next year.
Steve Moss
Okay. And then in terms of — I guess the other thing just kind of want to ask on the efficiency initiative here, just kind of curious. What are the type of cost savings you guys are seeking? And just how to think about expenses here for the upcoming quarter?
Brett Pharr
Glen, go ahead.
Glen Herrick
Yes. Well, as we’ve talked about, we’re continuing to look for expense efficiencies, being able to scale. I’m also tied with some of these — moving on from two of our tax partners. And so we expect to improve our efficiency ratio over time. Some of the lumpiness in our business could have some short-term ups and downs. But we are working hard to improve that over time.
Steve Moss
Okay. All right. Thank you very much for all the color.
Brett Pharr
Thank you.
Operator
Our next question is from Michael Perito from KBW. Michael, your line is open.
Andrew Stimpson
Hi. This is Mike’s associate Andrew filling in for him. Thank you for taking my questions. First off, I just wanted to move to the credit side again. Are you making any changes to the underwriting process in the Commercial Finance or consumer loan portfolios yet? Or are you seeing any trends, whether it be inventory or cash flow or anything, starting to give you some concern given the macro uncertainty?
Brett Pharr
Well, if you remember, the majority of our exposure is in Commercial Finance, not traditional C&I, which is heavy collateral managed. And that is precisely what you want to have when you’re entering into any kind of a downturn environment. So to answer your first question, are we changing anything? No. This is what you want it to happen in this particular period of time. We are not seeing any real deterioration in our borrowers. We are starting to see some borrowers trying to leave traditional commercial banks because they’ve had covenant issues, et cetera, some of which may go all the way back to COVID. And so we’re picking up. And some of our ABL growth has been precisely due to that. On the consumer lending side, I’ll remind you that the majority of our consumer lending portfolio is in some way credit enhanced, meaning that there’s a — it’s a waterfall approach or some other kind of arrangement. And again, with maybe one slight exception, we’re not seeing much deterioration in that space either.
Andrew Stimpson
Great. Thank you. I appreciate the color there. And then just lastly for me, what kind of a balance sheet size do you expect kind of in the near term here and the next quarter? So do you think assets might shrink a bit more or just any sort of color there?
Brett Pharr
Glen, why don’t you handle that?
Glen Herrick
Yes. We’ve talked about this in the past too. We expect to kind of move around between $6.5 billion to $7 billion for the foreseeable future.
Andrew Stimpson
Great. Thank you. I appreciate the time and thanks for taking my questions.
Brett Pharr
Thank you.
Operator
At this time, there are no further questions. So I’d like to turn the conference back to the management team for any closing remarks.
Brett Pharr
We appreciate everybody attending today. Appreciate the questions.
Operator
That concludes the Pathward Financial’s third quarter fiscal year 2022 investor call. Thank you for your participation. You may now disconnect your lines.
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