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Marlin Business Services Corp (NASDAQ: MRLN)
Q3 2020 Earnings Call
Oct 30, 2020, 9:00 a.m. ET
- Prepared Remarks
- Questions and Answers
- Call Participants
Greetings and welcome to the Marlin Capital Solutions Third Quarter 2020 Earnings Conference Call. [Operator Instructions] It is now my pleasure to introduce your host, Lasse Glassen from ADDO Investor Relations. Thank you sir, you may begin.
Lasse Glassen -- Managing Director, ADDO Investor Relations
Good morning, and thank you for joining us today for Marlin Business Services Corp.'s 2020 third quarter results conference call. On the call today is Jeff Hilzinger, President and Chief Executive Officer; Lou Maslowe Senior Vice President and Chief Risk Officer; and Mike Bogansky, Senior Vice President and Chief Financial Officer.
Before beginning today's call, let me remind you that some of the statements made today will be forward-looking and are made under the Private Securities Litigation Reform Act of 1995, as further described in Slide 2 of the Company's quarterly earnings supplemental presentation, which is posted under the Events & Presentations in the Investors section of the Company's website at www.marlincapitalsolutions.com. Such forward-looking statements represent only the Company's current beliefs regarding future events and are not guarantees of performance or results. Actual performance or results may differ materially from those projected or implied in such forward-looking statements due to a variety of factors including, but not limited to, the factors described under the headings Forward-Looking Statements and Risk Factors in Marlin's periodic reports filed with the United States Securities and Exchange Commission, including the most recent annual report on Form 10-K and quarterly reports on Form 10-Q, which are also available in the Investors section of the Company's website. Investors are cautioned not to place undue reliance on such forward-looking statements.
During this call, Marlin may discuss various non-GAAP financial measures, including adjusted earnings per share and adjusted operating efficiency ratio. Please refer to our earnings release for a description of these and other non-GAAP financial measures, as well as a reconciliation of such measures to the most direct comparable GAAP financial measures.
With that, it's now my pleasure to turn the call over to Marlin's President and CEO, Jeff Hilzinger. Jeff?
Jeff Hilzinger -- President and Chief Executive Officer
Thank you, Lasse. Good morning, and thank you, everyone, for joining us to discuss our 2020 third quarter results. My comments today will focus on an overview of the key highlights from this past quarter and Marlin's continuing efforts to mitigate the impact of the COVID-19 pandemic on our business. Lou Maslowe, our Chief Risk Officer, will provide an update on the performance of our portfolio, and Mike Bogansky, our Chief Financial Officer, will follow with additional details on our third quarter financial results.
Given the significant challenges we faced in the first half of 2020 arising from the pandemic, I am very pleased with the resiliency of our business and our return to profitability in the third quarter. Due to significantly improving portfolio performance and outlook, coupled with the benefits from the cost reductions we implemented earlier in the year, we generated net income of $2.7 million or $0.23 per diluted share compared with net income of $7.4 million or $0.60 per diluted share a year ago and net loss of $5.9 million or $0.50 per diluted share last quarter.
Portfolio performance improved throughout the third quarter and has continued to improve into the fourth quarter as well. Assumptions underlying our loss reserves have become more informed by our recent experience, and our capital position remains strong with a reserve coverage ratio of 6.75%, a total risk-based capital ratio of 22.49% and book value per share of $15.23. As we look ahead, we believe that our strong balance sheet and the investments we're making in our digital origination platform have put us in a great position to better serve our partners and customers in the future and to take full advantage of the increased demand for small business financing as the economy recovers.
As has been the case since the beginning of the COVID-19 health crisis, a top priority for the Company has been working with our existing customers to help them whether this crisis and to protect the value of our portfolio, while limiting the erosion of shareholder capital. We have provided substantial assistance to our customers over the past six months, completing over 5,600 loan and lease modification requests. As of the end of the third quarter, the modified contracts totaled $130 million or 14.3% of total receivables, consisting of $118 million of equipment finance contracts and $12 million of working capital loans.
As Lou will discuss in more detail in his remarks, we've been very pleased with the performance of both the modified and non-modified portfolios with each significantly exceeding our performance expectations during the quarter. In fact, as of the end of the third quarter, 30-plus day delinquencies began approaching the high end of our pre-COVID range, and we expect delinquencies will continue to improve during the fourth quarter. Net charge-offs during the quarter, while elevated, were also much better than our expectations. This is particularly true in our working capital loan portfolio, which experienced net charge-offs during the quarter that were consistent with our pre-COVID plan. As with delinquencies, total net charge-off levels have also continued to improve during the fourth quarter.
With improving visibility related to the impact of COVID-19 on the value of our portfolio, I want to emphasize that the assumptions underlying our current loss reserves have incorporated our actual experience to date, and our capital position remains very strong. As you will recall, we are required to include our estimated lifetime credit losses in our allowance for credit losses under CECL, and our current estimate of $61.3 million is reflected in our book value per share of $15.23 as of September 30. Additionally, as of the end of the quarter, our consolidated total risk-based capital ratio of 22.49% remained at more than double the requirement for a well-capitalized bank holding company.
Turning now to origination activity, as anticipated, third quarter total sourced origination volume of $68.5 million was well below our year-ago results, which was due to several factors. First, much of the lower volume was directly attributable to actions we took in the second and third quarters to both reduce costs and to restructure the front end of our business to better facilitate the implementation of our digital initiative. While we knew these actions would negatively impact origination volume in the near term, we also believe that these actions have put us in a much stronger competitive position for the longer term. Next, we observed continuing soft demand for financing by small business borrowers in our markets during the third quarter due to the challenges facing many industries. And finally, although we've made good progress recently in opening up our initial underwriting response to the pandemic, origination volume during the quarter was impacted by lower approval rates stemming from our tighter underwriting criteria during the quarter. That said, approval and booking rates are currently approaching pre-COVID levels, and our improving portfolio performance allowed us to shift our priorities late in the quarter from protecting and restructuring the business to growing again.
Looking at the bottom line, I am very pleased with the quarter-over-quarter improvement in net income that we were able to achieve in the third quarter. As I noted earlier, this return to profitability was driven primarily by our improved outlook regarding portfolio performance that led to a sharp reduction in the provision for credit losses compared with the second quarter. We also began to realize the initial benefits from the cost reductions that were implemented during the second and third quarters, resulting in a 22% reduction in operating expenses during the quarter as compared to the prior year period. Lou will provide additional details about the portfolio in his remarks and Mike will discuss our leaner cost structure in his remarks.
Before turning the call over to Lou, I would like to provide a quick update on actions we are taking to accelerate the automation and digitization of our origination platform. While becoming more digital has always been part of our longer-term strategic road map, the pandemic has accelerated the use of digital tools generally and has provided us with the opportunity to accelerate our own digital pivot. Our digital platform is being designed to offer an easier and more convenient customer and partner experience, while also allowing us to rescale more efficiently as the economy recovers. Our digital pivot is a key corporate initiative for Marlin during the second half of 2020, and the implementation process remains on schedule. We currently expect to roll out the initial phase of the platform, which we are calling Express, during the first quarter of 2021. The Express platform will offer customers and partners a completely digital experience, from application through funding, which will allow us to take advantage of the accelerating adoption of digital financing by our partners and customers. We look forward to providing updates on our progress on future calls.
In summary, our results this past quarter provide welcome evidence that we are beginning to emerge from this crisis. Without question, many challenges remain. However, we have returned to profitability, and I believe we have positioned the Company for sustained profitability in the future. Looking ahead to the fourth quarter and beyond, I believe Marlin is now in a position to take full advantage of opportunities to serve our partners and customers and to restore growth in our origination volume as the small business economy shows its resilience and continues to adapt and recover from the effects of the pandemic.
With that, I'd like to now turn the call over to Lou Maslowe, our Chief Risk Officer, to discuss the performance of our portfolio in more detail. Lou?
Lou Maslowe -- Senior Vice President, Chief Risk Officer
Thank you, Jeff, and good morning, everyone. As Jeff mentioned, we are very pleased with the portfolio performance in the third quarter, as we begin to emerge from the crisis. Before I get into the details of the portfolio performance, I would like to explain why we are gaining confidence regarding the resiliency of our portfolio and what is motivating our willingness to adjust our underwriting standards to drive approval rates to near pre-COVID levels.
I would first note that the delinquency and charge-off performance we have experienced for the total portfolio was much better than our expectations early in the pandemic. This better-than-expected performance applies to both the modified and non-modified portfolios. Marlin's vintage delinquency rates are improving and are trending toward normal. Post-pandemic originations are performing on par or better than the early stage vintage delinquency historically. And we attribute this to stronger credit quality due to more restrictive underwriting that was implemented shortly after the beginning of the pandemic.
Although we have experienced positive trends, there remains prominent risk factors that could cause increasing stress on the portfolio. The pandemic's resurgence could lead to a return of mandated shutdowns on industries where Marlin has strong concentrations such as restaurants and retail. Labor market health and federal stimulus will be critical factors to watch, as will the pandemic's trajectory on the macro-economy. We will continue to closely monitor these developments and act proactively, just as we've done since the onset of the pandemic.
Now, looking at the key asset quality metrics, equipment finance on-book receivables over 30 days delinquent were 2.13%, down 177 basis points from the prior quarter and up 86 basis points from the third quarter of 2019. Equipment finance receivables over 60 days delinquent were 1.42%, down 110 basis points from the prior quarter and up 55 basis points from the third quarter of 2019. The decrease in delinquency was driven by improvement in the non-modified portfolio, better-than-expected modified portfolio performance and elevated charge-offs. The September 30 non-modified portfolio 31-plus day delinquency was 1.7% as compared to 4.4% at June 30, while the modified portfolio delinquency was 4.95% as of September 30 as compared to 0.5% at June 30.
From a sector perspective, the highest concentration of 31-plus delinquency dollars was in Miscellaneous Services, which was 3.4%. And this sector comprised approximately 20% of total 31-plus delinquent dollars. Miscellaneous Services is an amalgamation of service-related SIC codes, the largest of which are business services, repair services, and equipment rental and leasing. The rest of Marlin's industry sectors, exceeding 5% of total portfolio, including restaurants and retail, had delinquency at or below 2% at quarter-end.
Aggregate total finance receivables net charge-offs increased in the third quarter to 4.54% of average finance receivables on an annualized basis as compared with 3.47% in the prior quarter and 1.99% in the second quarter of 2019. Equipment finance net charge-offs were 4.49%, an increase of 110 basis points quarter-over-quarter and 247 basis points year-over-year. As discussed on the Q2 earnings call, we anticipated that Q3 charge-offs would be elevated as delinquent customers that either didn't request or failed to consummate an approved modification proved to be unable or unwilling to make scheduled payments. Less than $100,000 of the Q3 charge-offs came from the modified portfolio. Marlin's top industry sectors, each representing greater than 5% of portfolio, had elevated charge-offs in the quarter. Annualized charge-offs in Q3 for these sectors was 5.1% for Miscellaneous Services, 7.2& percent for restaurants, 4.3% for medical, and finally, 5.9% for retail.
Transitioning now to discuss working capital loans, third quarter 15-plus day delinquency decreased 45 basis points from the prior quarter to 3.93%, while 30-plus day delinquency increased by 26 basis points to 2.94%. Working capital loan net charge-offs in the third quarter increased to 6.32% of average working capital loans on an annualized basis from 4.87% in the second quarter and from 1.42% in the third quarter of 2019, the latter of which benefited from an extraordinary recovery during the quarter. As of quarter-end, approximately 46% of the working capital portfolio has been modified, of which 22% remains in the deferral period. It is important to note that almost all of the working capital modifications require partial payments. Overall, we continue to be extremely pleased with the performance of the working capital portfolio, which has performed better during this downturn, and we anticipate that it continues to be a highly profitable product.
Modification activity diminished significantly as we received approximately 700 equipment finance and 65 working capital requests for first time or extended modifications in the third quarter as compared to approximately 7,800 and 500 through the second quarter, respectively. We have largely discontinued offering pandemic-related modifications to our customers but are still evaluating individual requests based on the facts and circumstances surrounding the customer. As of September 30, 85% of equipment finance modifications were completely out of the deferral period, and most of the customers have resumed paying according to their original payment schedule. The 31-plus delinquency for this cohort is only 4.74%. Of the remaining 15% of equipment finance modifications totaling $18 million still in the deferral period, approximately 53% are required to make partial payments. Substantially all the remaining equipment finance and working capital modified contracts are scheduled to resume their normal payments before December 31 of this year.
Lastly, I'd like to provide an update on our underwriting strategy. As discussed during the Q2 earnings call, we developed a model to assign each industry to a low, moderate or highly impacted risk segment for each of the eight [Phonetic] geographic clusters we defined. This model differentiates our underwriting based on the industry and geographic risks inherent to each specific borrower, as well as Marlin portfolio performance data for those industries. Utilizing this model and the improved outlook for portfolio performance, we've made adjustments for the fourth quarter that should result in a highest approval rate for both equipment finance and working capital since the pandemic began.
In closing, while we anticipate that equipment finance charge-offs in the fourth quarter will decline from the levels experienced in the third quarter, they will remain elevated in the fourth quarter as compared to pre-COVID levels. As discussed earlier, pandemic-related economic risk remain. But our portfolio has proven to be resilient, given our significant borrower diversification and prudent underwriting.
With that, I'll turn the call over to our CFO, Mike Bogansky, for a more detailed discussion of our third quarter financial performance. Mike?
Michael Bogansky -- Chief Financial Officer
Thank you, Lou, and good morning, everyone. Our third quarter net income was $2.7 million or $0.23 per diluted share compared with net income of $7.4 million or $0.60 per diluted share for the third quarter last year. Net income on an adjusted basis was $3.2 million or $0.27 per diluted share compared with net income on an adjusted basis of $7.4 million or $0.60 per diluted share a year ago. As expected, our third quarter performance reflects the ongoing impact from COVID-19, but I am pleased with our return to profitability. We have benefited from the operational measures we implemented earlier this year to proactively reduce costs, protect our portfolio and ensure business continuity and financial stability.
As Jeff mentioned, our origination activity in the quarter was adversely impacted by several factors, including the purposeful actions we took to reduce our workforce and reposition the front end of the business, as well as the ongoing effects of the pandemic and our [Phonetic] balancing the weakness in origination activity with our improved portfolio performance. We experienced a notable decrease in delinquency from the prior quarter, and the portfolio continued to stabilize as the modified portfolio resumed repayment status. Given these encouraging trends, we recognized substantially lower loss provisions as compared to the first and second quarters of 2020.
Consistent with the first half of this year, our provision for credit losses remains a significant driver of our financial results. As the challenging economic conditions persisted through the third quarter, we continued to revise our macroeconomic assumptions and credit outlook to reflect the ongoing impact from the COVID-19 crisis. As we previously noted, unemployment rates and business bankruptcy forecasts are two key economic factors that we input into our loss reserve model. Business bankruptcies have continued to increase in the third quarter. And while the unemployment rate has declined from its peak in the second quarter of 2020, it is expected to remain significantly above recent historical levels.
Under the CECL standard, forward-looking economic forecasting is a key factor in determining the allowance for credit losses. We recorded a $7.2 million provision for credit losses in the third quarter compared to $18.8 million in the prior quarter and $7.7 million in the third quarter of 2019. Our provision expense for the third quarter of 2020 included approximately $4 million from new origination activity and approximately $3 million from updated economic forecast, loss rates and qualitative factors. The component of the provision relating to changing economic conditions was much less than the first and second quarters as the forecast for business bankruptcies and unemployment were only slightly revised. Furthermore, the impacts from COVID-19 were previously reflected in our allowance for credit losses at the end of the second quarter. We will continue to closely monitor and evaluate the evolving economic environment and refine our outlook and update our loss reserves accordingly.
Turning to third quarter yields, the yield on total originations was 9.34%, up 18 basis points from the prior quarter and down 404 basis points from the third quarter of 2019. The sequential quarter increase was relatively modest. However, the year-over-year decline is almost entirely attributable to the significant reduction in working capital loan volume as we tightened underwriting standards in the wake of the COVID-19 crisis. Equipment finance yields during the third quarter were 8.77%, down 3 basis points from the second quarter.
For the quarter, net interest margin, or NIM, was 8.87%, up 19 basis points from the prior quarter and down 68 basis points from the second quarter of 2019. The sequential quarter increase was driven primarily by an increase in fee income, coupled with a decline in our marginal cost of funds resulting from lower deposit rates. The year-over-year decrease in margin percentage was primarily related to the decrease in new origination loan and lease yields and a change in the presentation of residual income, driven by the adoption of CECL, that were partially offset by a decrease in interest expense from lower deposit rates.
The Company's interest expense as a percent of average total finance receivables was 203 basis points in the third quarter of 2020 compared with 222 basis points for the prior quarter and 250 basis points for the third quarter of 2019. This decrease was the result of lower rates and a shift in mix, as higher-rate long-term debt paid down. We expect liquidity levels to continue to decline and normalize back to pre-pandemic levels by the end of the year.
Non-interest income was $4.2 million for the third quarter of 2020 compared with $3.8 million in the prior quarter and $10.4 million in the prior year period. The sequential increase in non-interest income is primarily due to uncollectible property tax expense from the prior quarter. And the year-over-year decrease is primarily due to a $6.4 million decrease in gain from the sale of assets.
Moving to expenses, third quarter non-interest expenses were $14.2 million compared with $13.5 million in the prior quarter and $17 million in the third quarter of 2019. Included in our third quarter non-interest expense was a $1 million intangible asset impairment charge from our acquisition of Fleet Financing Resources and $1 million of expenses associated with our reorganization, that were partially offset by a $1.4 million benefit associated with an adjustment to our acquisition earn-out liability. Expenses in the third quarter also reflect higher salaries and benefits expenses as employees returned from furlough. The year-over-year decrease was primarily due to a reduction in salaries and benefits expenses due to lower headcount of 104 employees and lower commission and incentive compensation expenses.
As we discussed last quarter, we proactively reduced operating expenses. Following our actions to reorganize our front office, reduced headcount and lower general and administrative expenses, we have begun to realize meaningful cost savings. As a result, we expect to achieve an annualized run rate cost savings of approximately $7 million to $9 million based on normalized pre-crisis origination levels.
Moving on to income taxes, our effective tax rate was unusually low at 16.1% for the third quarter. As you may recall from last quarter, this was due to GAAP interim tax reporting requirements that limit our prior quarterly tax benefit due to our quarterly pre-tax loss relative to full year expectations. This relates only to the timing of income tax recognition between quarters, as our effective tax rate for the nine months ended September 30, 2020 was 35.6%.
Our Board of Directors declared a regular quarterly dividend of $0.14 per share, payable on November 19, 2020 to shareholders of record as of November 9, 2020. We remain very confident in the strength of our balance sheet and capital position, as well as our ability to withstand any future potential losses, should they occur. We will continue to closely monitor and evaluate our capital position and potential liquidity requirements.
We are pleased with the impact that the operational measures taken earlier this year have had on our financial results as we returned to profitability in the third quarter. The economic impacts of the COVID-19 pandemic continue to be felt by small business sector across the US. However, we have seen positive developments throughout the third quarter and into the fourth quarter. Assuming that the economic impact from COVID-19 in the US does not further deteriorate from current levels, we expect fourth quarter financial results to be marked by the following: a decline in charge-offs with a further improvement in portfolio delinquencies; modest growth in origination volume on a sequential quarter basis; and continued benefit from our cost reduction initiatives.
As we look ahead, we remain committed to supporting our customers and partners, prioritizing the health and safety of our employees and ultimately emerging from this crisis well positioned to drive profitable sustainable growth and maximize value for our shareholders.
That concludes our prepared remarks. And with that, let's open up the call for questions. Operator?
Questions and Answers:
[Operator Instructions] There are no questions this morning. I will now turn the call back to management for closing remarks.
Jeff Hilzinger -- President and Chief Executive Officer
Thank you for your support and for joining us on today's call. We look forward to speaking with you again when we report our 2020 fourth quarter results in late January. Thank you again for your time and attention this morning, and please stay safe and healthy.
[Operator Closing Remarks]
Duration: 30 minutes
Lasse Glassen -- Managing Director, ADDO Investor Relations
Jeff Hilzinger -- President and Chief Executive Officer
Lou Maslowe -- Senior Vice President, Chief Risk Officer
Michael Bogansky -- Chief Financial Officer
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