Bancorp Inc (TBBK) 2017 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to The Bancorp, Inc.

First Quarter 2017 Earnings Conference Call.

(Operator Instructions) As a reminder, this conference call may be recorded.

I would now like to turn the conference over to Andres Viroslav.

You may begin.

Thank you, Nicole.

Good morning, and thank you for joining us today for The Bancorp's First Quarter 2017 Financial Results Conference Call.

On the call with me today are Damian Kozlowski, Chief Executive Officer; and Paul Frenkiel, our Chief Financial Officer.

This morning's call is being webcast on our website at www.thebancorp.com.

There will be a replay of the call beginning at approximately 12:00 p.m.

Eastern Time today.

The dial-in for the replay is (855) 859-2056, with a confirmation code of 6292817.

Before I turn the call over to Damian, I would like to remind everyone that when using this conference call, the words believes, anticipates, expects and similar expressions are intended to identify forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Such statements are subject to risks and uncertainties, which could cause actual results to differ materially from those anticipated or suggested by such statements.

For further discussion of these risks and uncertainties, please see The Bancorp's filings with the SEC.

Listeners are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.

The Bancorp undertakes no obligation to publicly release the results and any revisions to forward-looking statements, which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Now I'd like to turn the call over to Bancorp's Chief Executive Officer, Damian Kozlowski.

Damian?

Thank you, Andres.

Good morning, and thank you for joining us today.

My name is Damian Kozlowski.

I am CEO of Bancorp and the President of The Bancorp Bank, I've been in these positions since June 1, 2016.

I welcome you to our first quarter 2017 earnings call.

While 2016 was a very difficult year for our company, first quarter 2017 financial results reflected our planned return to profitability.

While we did incur financial losses in 2016, it did set the stage to make progress on many key issues that faced the company.

We believe that the actions taken in 2016 have resulted in a much stronger platform, and the first quarter 2017 was the start of what we believe will be a year of improving performance.

In the quarter, The Bancorp earned $8 million in net income, or $0.14 a share, off of $49 million of total revenue net of interest expense.

Our earnings showed substantial improvement and revenue momentum continues, while expense cuts and restructuring had a noticeable impact on profitability.

Here are some of the highlights from the first quarter that underpin our progress: our integrated business plan has been completed, and we are now in full execution stage, with a copy of the plan on our website.

As part of the plan's implementation, we created a detailed 2017 budget and strategic agenda for the company.

This budget has been approved by our board and is consistent with the 3-year plan.

In the first quarter, we exceeded our internal budget and are tracking well with all our key initiatives.

We see opportunity on the upside of our financial targets, with potential recoveries upon the disposal of certain assets, such as the Florida mall, which we hold as other real estate owned.

Interest rate increases in December and March are having a positive impact on operating revenue.

Future consensus increases are also expected to have a significant positive impact.

Our expenses continue to show improvement.

Our cost reduction effort has identified approximately $20 million operating cost savings from 2017 over 2016, a portion of which we began to realize in the first quarter.

European prepaid operations have been sold.

The transaction closed April 3, and the sale will reduce our operating expenses by an estimated $400,000 per quarter.

The sale of the remainder of our HSA business was approved by the OCC and all accounts should be transferred by the end of the second quarter.

The related gain on sales anticipated significantly offset cost associated with the European prepaid operation sale and will also reduce run rate operating costs.

All other cost savings are on target, with about 60% completion of the Phase 2 cost restructuring implemented.

Projecting the realization of savings on a quarterly basis is difficult, but progress in reducing expense should continue throughout 2017.

Core revenue continued to grow both quarter-over-quarter and year-over-year.

Year-over-year business growth was led by leasing, the balances for which increased 51%.

Quarter-over-quarter business growth was also led by leasing, the balances of which increased 19% on an annualized basis.

Our other lending products also continue to show growth, and our business leaders report that continuing prospects remain very positive.

We are continuing to make headway concerning our regulatory situation.

We made significant progress in creating a new integrated compliance program that will build off our work in BSA/AML, third-party risk and consumer compliance.

This project is on track to be fully completed by the end of the second quarter and should substantially improve our compliance operating environment.

We continue to work closely with our regulators to meet their expectations and resolve the root causes of any issues.

We also continued to hire key new management in the last quarter that have already been announced, and more new key executives will be announced soon.

In summary, I believe the first quarter is the turning point.

We have a long way to go to fully implement our integrated business plan, but we are on track to deliver better results for all the constituencies that comprise The Bancorp community.

I'm now turning the call over to Paul Frenkiel, our CFO.

He will review the financial results in more detail.

Thank you, Damian.

Consistent with our business plan and budget, Bancorp returned to profitability in the first quarter of 2017.

Net income was $8 million for the quarter, reflecting both revenue growth and progress in expense reduction, in addition to a significant gain on sale of loans into a securitization.

A significant contributor to first quarter earnings was a $5 million gain on sale of loans into a variable-rate commercial loan securitization.

Through 2017, additional loans are expected to be originated, with at least one additional securitization anticipated by year-end.

While the $5 million gain on sale was a major contributor to the first quarter, the balances of the loans sold no longer earn interest for the company, therefore, related interest income was reduced during the quarter and will be lower until the loans are replaced by new originations.

Accordingly, the company earned $1.3 million less interest on such loans in Q1 2017, compared to Q1 2016.

Nonetheless, net interest income for the company as a whole grew 21% to $24.9 million between those periods.

The increase in net interest income reflected growth in leasing, SBA and SBLOC loans, and the impact of the 25 basis point rate increase in December 2016.

Since the first quarter 2017 rate increase occurred in mid-March, the full quarter positive impact will not be realized until the second quarter.

Although linked quarter net interest income was comparable, it similarly reflected a $1.6 million reduction in interest on loans held for sale into securitizations.

Excluding that factor, net interest income on a linked quarter basis also grew at an annualized rate in the 20% range.

Our largest percentage increase in loan balances was in leases, which grew organically 25% over the year, with 51% overall growth after considering a purchased portfolio.

In first quarter 2017, the leasing portfolio yielded approximately 6.3%.

Purchases of lease portfolios, while maintaining yield levels, continues -- continued to confirm the viability of this growth strategy.

Loan balances, excluding loans held for sale, grew 22% year-over-year.

The lines of business comprising these totals have historically had low charge-offs.

Our cost of funds grew minimally, reflecting only a partial adjustment of rates on our prepaid card deposits to changes in market interest rates.

Prepaid card deposits are our largest funding source and should continue to adjust to only a portion of future increases in market interest rates.

The interest margin will benefit accordingly with the impact of market interest rates on variable rate, SBLOC and SBA loans and the significant portion of the investment portfolio, which is also rate-sensitive.

Prepaid cards are the primary driver of noninterest income.

In the first quarter of the year, prepaid card fee income is traditionally higher, reflecting fees related to tax refund prepaid cards.

Accordingly, in Q1, prepaid fees were $1.5 million higher than the linked quarter.

Compared to the prior year first quarter, prepaid fees were flat, reflecting the impact of a client that exited as a result of its sale.

Reflecting that factor, and the decision of several other clients to terminate their prepaid card programs altogether, the total amount spent on prepaid cards, or gross dollar volume, was down slightly compared to Q1 2016.

Growth in other programs significantly offset the impact of those changes, resulting in that slight volume decrease.

Reductions in noninterest expenses also contributed to first quarter results.

Noninterest expense of $37.7 million for the quarter was lower than 2016 quarters and reflected progress in implementing expense reductions in several areas.

As Damian noted, additional reductions have been identified and should be realized throughout 2017.

Net interest margin for the quarter was 2.70% compared to 2.56% in Q1 2016, and 2.84% for the linked quarter.

Seasonal deposit inflows reduced net interest margins in the first quarter of the year, as the temporary excess liquidity earns a nominal rate at the Federal Reserve Bank.

The improvement in net interest margin over Q1 2016 reflected the impact of the rate increase in December 2016, which resulted in higher asset yields versus a lesser increase in deposit costs, as noted earlier.

The $1.7 million net income from discontinued operations reflected the results of the discontinued Philadelphia commercial loan division.

In addition to the interest which continues to be earned on those loans, the quarter benefited from $1.4 million of loan recoveries, primarily on the Florida mall loan.

A significant write-down to appraised value was made on that mall loan in third quarter 2016.

We took ownership of the Florida mall property during the quarter, and we are marketing it for sale.

Based on market indications, we anticipate a recovery upon its anticipated sale later this year, but the amount of such recovery and timing are difficult to predict.

While the financial results for the quarter reflected federal income tax expense at statutory rates, reversal of valuation allowances are expected later in 2017.

Leverage of capital ratios are impacted by seasonal tax refund deposit inflows in the first quarter of each year, which temporarily distort capital ratios.

Notwithstanding that first quarter distortion, the leverage ratio at the bank and holding company were, respectively, 6.7% and 7% at quarter end.

In the coming quarters, after that temporary distortion, the leverage ratio should increase and increase further with earnings accretion.

Our capital plan projects an 8% leverage ratio later in 2017.

Risk-based capital ratios are not impacted by the first quarter tax refund deposit inflows, as related funds are maintained at the Federal Reserve Bank, which has a 0 risk weighting.

Those ratios immediately benefited from the first quarter earnings and exceeded 14% at year-end -- at quarter end.

That concludes my comments, and I will turn the call back to Andres.

Thank you.

Operator, please open up the call for questions.

(Operator Instructions) Our first question comes from the line of William Wallace of Raymond James.

Paul, I'll start with your last commentary on your remarks about the distortion related to the tax refund deposits that pressure the leverage ratio.

How much bounce back do you expect from the normalization of that kind of seasonality?

I -- we went up in deposits about 5% over what we were running.

It's really difficult to predict because the -- it's hard to predict when those tax refund prepaid cards are spent, but it's all -- in all likely -- we'll get to 7% fairly quickly.

And as I said, our plan and our projection show 8% later in 2017.

Okay.

So are you anticipating that you'll get to 8% in the second half now?

I thought -- I was thinking that you guys were modeling by the end of the second quarter, but I might be wrong.

We have a significant valuation allowance, which is -- after the company has not performed well over the last 3 years, have taken losses, we -- management and also the people who provide support to us, our accountants, I think -- believe it's prudent to show profitability for longer term than 1 quarter before we were to reverse that allowance.

But that's likely to happen, and that will be a significant impact to that Tier 1 leverage ratio, probably in the $20 million range.

Yes, so what is -- what's the dollar amount of the valuation allowance as of March 31?

It's in excess of $20 million.

Do you have the actual dollar amount?

It's a difficult computation because there are multiple items.

As Damian noted, we sold the foreign operation, there are some tax implications of that, so I think for right now...

It's at least $20 million.

Yes, it's in the $20 million to $25 million range.

And so you'll have the final number by the time you file the Q?

It's still being calculated?

This is a -- I mean (inaudible)?

(inaudible) It's actually trued-up at year-end, all our taxes are trued-up at year-end.

We'll -- yes, we'll have an estimate by the Q.

Okay, so the 309,769 equity balance might not be what you end up reporting?

I'm confused.

I'm sorry, I thought that the DTA valuation allowance is in the equity (inaudible).

Okay, so yes, when we reverse the valuation allowance, it's actually going to be a credit to tax expense, which flows directly to the bottom line to -- and directly to equity.

There are some twists in terms of how that translates to capital, and it depends on timing of deductions and so forth, so -- but as I said before, we do true that up at year-end.

The actual interim period tax calculations are based on your estimates for the year.

So I can't give you an exact number because the accounting rules just don't work that way, they don't do it on a (inaudible).

And it won't impact the first quarter, it's likely a second or third quarter event when we would change that.

And then you would take into that impact into net income there, therefore, adjusting the ratios.

Okay, so assuming that you were to have reversed the allowance this quarter, do you know how much you could have used as Tier -- you would have -- could have put in the Tier 1 capital calculation without tripping over the 10% threshold?

As I said before, it's not a meaningful calculation because you do it based on what you estimate for the year.

The accounting rule says you estimate what your tax situation is for the year and then you allocate that to the quarter.

So what about for the call report rules?

Don't you have -- I mean, you have to put a number in the call report when you're calculating your Tier 1 capital, right.

You have to do an estimate, that's true.

So if you were to have -- been able to reduce it, how much room is there for the -- for DTA in your Tier 1 capital?

What I'm trying to get at is how much of a boost to the Tier 1 leverage are you going to get when you reverse the allowance?

I'm just trying to figure it out.

I can go through it with you.

It's actually not final until we do our tax return with -- we actually have 2 sets of tax advisers that work with us, so I can go through -- there are some -- it depends on the timing of deductions and the character of the deferred tax assets.

I can go through with you, I can show you, I can explain to you off-line, the difficulties in the estimation, but we can't -- the $20 million is a good estimate.

Okay, so I can assume, as I model my own calculation of capital, that $20 million will be recaptured into Tier 1 capital when you reverse the allowance?

$20 million to $25 million?

That's in our planning and it's subject to eventual...

Yes, of course.

With the tax.

But that also accounts for us showing continued profitability.

Right, of course.

You have to be able to reverse...

We believe we will, which we believe we will, to reverse it.

And do you still think you might...

That's why it wasn't reversed in the first quarter though, because it was the first quarter profitability really demonstrated in the last 3 years.

So the advisers, in collective with management and the board, believed it was prudent not to reverse it until there was a better track record of performance.

Okay.

And I believe last quarter, you guys stated that you anticipated reversing it in the second quarter.

Is that still the case?

Or could this -- is this more likely to be a third or fourth quarter event?

As Damian said, we use multiple advisers.

It's -- yes, it's possible it's second quarter that we -- like that's in our thinking, but it could be the third quarter.

Okay.

And then for the tax rate that you recorded in the first quarter, do you -- are you -- is 100% of that go -- get an allowance against it?

Or is it your...

Yes, but there are a few caveats, as I said before, because there are some foreign -- there are implications connected to the sale of our European operations that will impact that somewhat.

So I would just stick for now with the $20 million.

Okay.

And then what's the assets related to the European business that will come off the balance sheet?

Or are they off already?

They're fairly minimal, under like 1% to 2% of assets.

Some liabilities, so it's not a significant impact.

What -- the more insignificant impact to us is it's going to further reduce our overhead, we're estimating in the $400,000 a quarter range.

And this was not a business that was creating operating profitability.

So there was $400,000 more expense than revenue coming.

And when will this sale close?

They were April 30 closed.

They're already closed, it's off.

So we see that in the run rate for the second quarter then?

Absolutely.

We will see it.

There will be a restructuring charge associated with that sale, and that'll be offset by the HSA sale.

How much is it we're getting there?

It's going to be around 2 -- it's somewhere between $2 million and $3 million, but that's...

The restructuring charge?

Yes.

It hasn't been calculated yet, so I -- so we don't know what the final charge will be and what we'll be able to take, but that's -- on an economic base, it will be offset by the HSA gain.

Okay.

Okay, great.

So -- and in the HSA, you've got -- it's about $400 million of deposits that will come off the balance sheet?

No, the HSA is about $100 million, that will -- just most of which will be off by the end of this quarter.

Yes, we just received final approval from the OCC in this quarter, a letter approval, and we weren't able to act on transferring the accounts until that was finalized, which it was.

And so we have a plan in place to get that transfer completed by the end of the quarter.

Therefore, taking the gain at the same time, we would lower operating expense by having less accounts.

Okay.

Have you identified additional opportunities for deleverage outside of just the normal runoff of the tax deposits?

Yes, we're still targeting around a $4 billion balance sheet at the end of the second quarter, $4 billion to $4.1 billion.

So that's where we should be, around there, depending on the business volumes and everything, but that's where we're hoping to be.

Okay.

So in the loan sale gain, that's your commercial mortgage business.

You're not -- you didn't wrap loans out of the commercial -- out of the discontinued portfolio, did you?

No.

They -- we are only -- we -- because of the market conditions in CMBS, there is a whole bunch of changes that happened, including the retention of risk strips, but the market has significantly changed over the last couple of years.

We discontinued our CMBS program, so we're not originating for-sale fixed-rate loans anymore for the CMBS market.

These are floating rate loans that go into securitizations, CLO-like securitization we did last year that are -- and then we do also do institutional sales of those loans to third parties, so we're focused on that program.

That program does not have a hedge, obviously, because it's floating rate, and so you don't take gains and losses on the hedge either, so it's a less volatile business in addition to being a less -- it's in a less-challenged part of the market too.

Okay, and is it the same team?

Or did you change teams?

No.

The underwriting teams were doing both types of loans, so it was an integrated group.

And so that integrated group is really a marketing decision, so with our network of brokers and other -- sales force now are just focusing on one side of the house.

Really, we don't think, after talking broadly in the marketplace, it will affect our ability to originate the floating rate side.

We are targeting one more, at least one more securitization, such as we've done previously this year in the floating rate side and on a run-rate basis, we'll probably do 2 securitizations and/or our large sales of loans in the $200 million range per year, on a go-forward basis.

But we will -- they will not be in the CMBS market.

Okay.

Okay, all right, well cool.

So we've narrow focused the business, and I think we've reduced the volatility based on hedging in that business, consistent with the rest of the business plan to increase the transparency of the company and lower the volatility of our earnings.

So the $37.8 million expense, both in the first quarter, was obviously a significant improvement over the fourth and third quarters, so it's good to see a very good movement towards the expense initiative.

I assume there's probably some variable comp in there also associated with that sale or that securitization.

Is that -- so what -- if you stripped out the variable comp associated with that, how -- what would the rate have been?

What would the expense have been?

How much variable comp was in the (inaudible)?

Well, we -- it doesn't necessarily hit the same quarter, it's accrued.

The variable comp is somewhat independent of that timing, so it's difficult to match it up.

Yes, but there are -- what we can say about the expense run rate is that we're very pleased with it.

We are getting better cost reductions than we expected at this time.

Our own budget had it at significantly higher rate.

There are significant cost saves that haven't even -- we've renegotiated many of our providers to significant cost saves.

They haven't come through.

The HSA saves because of the number of accounts, there's other accounts that are exiting the business to refine the platform.

The European cost saves, there's a whole list of things we've done on T&E and other cost saves.

So there's -- while it's about 60% completed, the initiative Phase II, which remember, Phase I was reducing people, phase II is reducing operating cost and Phase III we'll kick off in October, November, which will be a reengineering of the back end of the business.

But we're very happy with where we are on the expense side, and we have still a lot of expenses that will be reduced in the second and third quarter.

So we're very optimistic that we'll continue to open the jaws of the business and reduce cost.

Would you care to update your expectations for cost saves?

It sounds as if that $20 million...

Yes, we will.

Wally, we will.

We still haven't fully bridged it out.

We're in the process of really understanding.

There's things like T&E, just to give, for example, that we were targeting to do it half, but it's even coming in better than that.

So there's some of these buckets that we're trying to understand exactly why.

When you cut 20% of the people, we were at over 700 people this time last year, I think it was almost 720 people, and we're now running at below 550 people, right.

And that's the -- and if you take Europe out of it, and you take the restructuring that we did, people tend to draw cost, and so we're trying to understand exactly what the cost structure is?

Why is it different than the saves we have in there?

And we're bridging it out, and then we'll probably give guide -- better guidance as we go into the second or the end of the second quarter and see where we are.

But right now, we're very optimistic that we'll be able to beat our own internal budgets on the cost side.

Okay.

Well, Damian, it's pleasing to see a quarter that doesn't have noise related to credit.

And I'll hop out and let somebody else ask questions.

And maybe somebody else will ask about the credit and the other portfolios.

(Operator Instructions) Our next question comes from the line of Frank Schiraldi of Sandler O'Neill.

Just follow up on capital, I just -- the 8% Tier 1 leverage by, I guess, it's by year-end, is that what you said, Damian?

Is that the feeling, thinking?

Definitely by year-end, we'll probably be -- we do have, when we write our own scenarios, we want to get back to our capital minimum that we've stated to our regulators, which is 8.5% of Tier 1 capital.

I want to also emphasize that the risk-based measures are very, very healthy for the company for various reasons.

But we do have visibility to an 8.5% by the end of the year.

We think we'll hit the 8% before then, probably sometime in the third quarter.

It depends on the valuation allowance and our continued profitability.

Once taking that in, the capital ratios will improve dramatically.

And as the cost saves are continued to be realized, net income will be generated.

So you could see an 8% happening after the second to the third quarter time frame.

Okay.

And then you get up to 8.5% by when, did you say?

You think that's possible by year-end?

No, we think we do have visibility to 8.5% by the end of the year, when we do our own projections.

I'd say it's in the most likely range.

We're not being aggressive with the way we're looking at the pro forma forecast of the business.

It does -- you got to remember we do have certain assets hanging out there.

The Florida mall is a good example.

We already were able to monetize part of it.

We sold an out parcel of the mall, which will actually help the value of the mall because it's for residential development in that marketplace, so it actually increases the value of, we believe, of the sale.

Our marketing assessment of the property will -- does forecast a gain on that property.

We don't know if that will actually happen, of course, but that's also another source of net income potential in the numbers that would be additive.

And we also budget ourselves without interest rate increases, so when we do our pro forma budget, we don't really impact the run rate based on interest rate increases.

Those interest rate increases are having an impact and as our loans reprice, will have a greater impact, because we have a lot of variable rate loans.

And so -- and securities, by the way.

So there's a lot of tailwinds that will -- that if they play out as with any reasonable modeler would expect them to play out, we should be in the comfortable range of 8-plus percent within the next 2 quarters.

Okay, I guess, just thinking about the 8.5%, is there a time period in which you have to -- you want to get or you have to get to that number?

And if you don't internally, then you look externally?

No?

No.

No.

No.

We're -- in discussions with the many parties that regulate the bank, we proposed a -- we give them very, very detailed information around our business plan and our capital plan.

At the current time, I don't want to disclose anything too much, but I think people are generally -- this could change tomorrow, of course, but people are generally pleased with the progress we've made to derisk the bank.

So how do we derisk the bank?

Well, part of it is accretion of capital through restructuring the business to create earnings, but they're also looking at the sources of risk that might have been viewed previously as sources of volatility, and we're talking about the things we did in discontinued and Walnut Street to make sure that future earnings weren't impacted.

So there's been a program here to -- within the -- this time last year, if you look at the bank, there's a lot of sources, let -- for example, discontinued's down 36% in asset levels.

We've strengthened the credit risk management practices of the banks and we have a pretty sizable initiative to have an integrated compliance plan done by the end of the second quarter, which really will change our compliance operating environment substantially.

And we're making great progress on the findings of our regulators in closing out those and validating those issues.

So it's not one area of risk, we're trying to hit every area of risk of the bank, and that really colors the view of any regulator as to whether or not you have sufficient capital and the plan to have sufficient capital.

They agree with our capital minimum, and they -- I think they believe, though I can't really speak for them, but I believe right now, we're all on the same page as to how do we grow the capital Tier 1, remember, risk-based capital isn't a problem, it's Tier 1 capital, and get it to the right level by the end of the year.

Right.

And that $20 million valuation allowance would help a lot, I guess, right, that's like -- what is that, like almost 50 basis points?

Yes, (inaudible), yes.

But I guess on that allowance, I wonder, and I don't know how to get to it, but in terms of being able to get that off in the coming quarters, or take, or reverse that, I should say, in the coming quarters, it seems to me like an issue is not only going to be the number of positive operating quarter, operating earnings quarters you're able to put up, but also the fact that if you look over the last 2, 3 years, there's still cumulative -- cume losses because of some of the marks you've taken on the discontinued ops book.

So is that going to be an issue?

Or if you could just maybe walk through a couple of the triggers?

No, it's actually a forward-looking analysis, so because the bank has strong core earnings, and that's demonstrable, and we'll have 2 quarters of validated budgeted earnings projections, the analysis is looking forward to several periods.

So if you look at our budget and our projections, we'll be able to use the accumulated deferred tax assets and NOL carryovers in a very short period of time.

So while it's prudent to wait a quarter or 2, I don't see anything standing in the way of taking those later in the year, and that's been baked into our planning.

Yes, once again, we provide a pro forma forecast of budget.

And our -- we've exceeded that, what where we thought we would be.

And it's happening on both sides of the table.

We're continuing with the revenue momentum, our balance sheet businesses are growing nicely.

You have the tailwind of the interest rate increase that really fundamentally changes.

We're an asset-sensitive bank, we're probably one of the most asset-sensitive banks in the United States.

And all those things combine to give a very positive pro forma outlook for the company, especially if -- look, you can't control revenue all the time, but you can control expense.

And we're only in -- we're only halfway done with the process, right.

So we did people, we're halfway done with the -- 60% done with the operating cost reduction, and then we're not even started on the reengineering, which will happen at the end of the -- there'll be additional saves with that process to a much more efficient company.

So there's a lot on the table for the next 18 months to 2 years around being able to maintain our -- and reduce our cost base and actually be more productive.

Okay.

it's -- okay, so it's -- and I guess the accountants, you've gotten feedback from the accountants on that, that it's really just forward-looking, and then it seems like if all goes according to plan, a couple, 1 or 2 quarters, and you'll be able to reverse it, so that's...?

There is -- for every accounting firm, there's a different way to handle the valuation of deferred tax assets.

This is a -- this is truly an art form.

And it's always a collective determination of multiple parties as to what exactly do you do and when.

And we've had a dramatic change.

There's been 3 years of pretty poor profitability of the company.

And if you -- this quarter was exceedingly positive, and so people are guarded as to, they want to see more, obviously, and we do, too.

So even if you think about the Tier 1 leverage ratio, we did -- we do have the federal tax in there, but if you back the federal tax out, and we actually realize net income of $0.22 a share instead of $0.14 a share, well, our Tier 1 leverage ratio wouldn't even deteriorate in the first quarter.

And by the way, that never has happened in the history of Bancorp since its inception.

I haven't been here the whole time, but I'm pretty sure that's true, and that's an incredibly positive sign.

It's also a positive sign that we did have some changes in programs and there was a sale of a major client where we transferred the account.

And the organic growth in the GDV was able to cover that.

So there -- it's not just the lending business that's growing, it's just not the interest rate, it's just not the cost reduction, it's all these things working together to improve the forward-looking profitability.

I mean, we weren't in any shape and form, June of this year, we had all this stuff to accomplish, all these assets that we weren't really productive, to get rid of, and the environment has changed a lot since then, the macro environment.

So all those things go into the pro forma forecast, and that's how you, at the end of the day, rate whether or not that valuation allowance will be reversed.

Okay.

And then just in terms of -- if credit of the discontinued ops book and Walnut Street.

Is there any update you can give in terms of current versus delinquencies?

Any migration within those portfolios in the quarter in 1Q?

Any negative migration?

There hasn't really been any negative migration.

The big story this quarter was that we moved -- and Frank, I'll direct you, I added some new charts, pursuant to your request from prior quarters, so I added a couple more.

So you can see the -- graphically, the nonperforming loans and you can compare it to the last quarter and so forth.

The big -- so there was no big migration, except for the mall that we took into OREO, which is a big positive, because we can't be sure of the timing, but it should sell later this year.

There should be a recovery.

It's, right now, a noninterest earning asset, so...

And it's not a drag on -- the mall has not been a drag on earnings.

We now have somebody in place running the mall.

And it won't be -- if anything, it'll be a slight positive.

Even if we retain the mall, it won't be at a big loss, say, we're not losing $3 million or $4 million a year operating it.

It's actually operating at a gain now.

So whether we sell it or not, which we believe we will, it won't hurt the company for us running that mall.

We have professional management in there running it.

Okay, so it's not a drag on earnings running it right now?

No.

Actually, if anything, it's going to be a $1 million to $2 million profit from running that mall.

Okay.

That's not a bad return, actually.

We were very aggressive -- Frank, we've been very, very aggressive and proper under the GAAP rules, of course, to -- this -- there's been volatility in the earnings of this bank.

And we've been very focused on reducing, derisking and decreasing the earnings volatility of the bank.

And the only way to do that is to make sure you put the processes in place.

For Walnut Street, we've talked about this.

There's -- we put 3 lines of credit defense.

With discontinued ops, this is a extremely tightly managed process now where we've got the full participation of all the constituents here at Bancorp, and we're going to work out of the portfolio as quickly as possible.

We're already down 36% year-over-year.

A lot of that has happened since June, including a $65 million sale that went -- that actually had a gain in it.

So I think we've got visibility.

We want to continue to do the same thing, so we want to, this time next year, hopefully we're down another 30%, 40% in that portfolio.

I believe we will be.

And as the Walnut Street security amortizes, once again, we built in discount rates.

So if we get all our cash flows back that we anticipate on that, we'll actually have gains in there.

So we -- I think we've done everything possible under the rules that are set out by GAAP to contain the risk to the banks and get out of those things that might cause future -- look at this, Europe, it's not there, right.

HSA, it's not there.

You have a lot of other activity where we're simply not -- we're not -- like CMBS in the U.S., right.

We're not there anymore.

That's probably the risky part of the securitization market.

So a lot of these things have been done purposely to lower the volatility of earnings and lower the risk profile of the bank.

Okay, okay.

Last question, just in terms of, on the credit side.

So obviously, down 36% year-over-year, you'd be hopeful or you'd expect that maybe down 30% to 40%, of course -- with runoff.

And of course, you're always looking to sell pieces of this.

But is there anything on the immediate horizon that you see kind of bulky, that you think you might be looking at selling, that might be close to just moving a large chunk or a larger-size chunk off in the coming months?

We're very active talking to people across a broad spectrum of partners from investment banks to investment firms around disposition of those assets, right.

Whenever you have a unique portfolio, even if it's marked correctly, to -- that is the mark of the value of the loan over time.

So to dispose of the entire portfolio, you might have to take a substantial loss.

And that wouldn't be prudent for our investors because that would be wasting value for them.

So if we do get an opportunity to sell 1 or 2 at, we don't have anything on the horizon for next quarter, I don't believe, but we're actively managing that portfolio in the sale category, too.

And as you know, we -- last quarter, we did have a sale.

So we don't have anything on the horizon for the next quarter, though, that we know of.

Our next question comes from the line of Matthew Breese of Piper Jaffray.

Just wanted to follow up on the mall comment, and just wanted to get a sense for, thinking about discontinued operations and Walnut Street, what is your other exposure to big-box retail malls, strip mall, some of the riskier retail asset classes?

Yes, so that really was the big one.

If you look at the charts, I -- we have a chart that gives the composition at the end of the press release, so that will give you the information.

It's a new table that gives you the type of collateral, so you can refer to that, Matthew.

Okay, so the non-owner occupied retail we should assume that's kind of mall properties?

Yes, but we've reduced our exposure, so we have many -- we don't really have anything that large.

I mean, the mall was basically it.

We do have some other large exposures, but no other malls that are comparable to the risk that we had in the Florida mall.

Got it, okay.

And then geographically, the discontinued operations, the $340 million of it, just thinking about where it is across the country, is it pretty widespread?

Or is most of it in your kind of core market?

No, the majority -- the Florida mall was an outlier.

The majority is Pennsylvania and New Jersey.

Yes, it was a community banking portfolio, really, and it was a very generalized one.

So it was a lot of different unique assets, and it was generated from the Delaware-Philadelphia area, that's where the originators were.

And then there's, as always in this area, there's always a connection to Florida.

There is -- it's like all the states between, they don't even exist.

People only fly over them, nobody drives through them, they only fly over them.

So that's why there's Florida properties and stuff in there.

And with the mall leaving, the greatest source of risk is obviously -- that was the #1 risky retail property by far.

We were aggressive making sure that was resolved.

And look, we got it -- the sponsor declared bankruptcy, and we got everything back very, very quickly.

That was in, by far, the best interest of the shareholders and of the bank's stability.

And now we get to be able to monetize that, and hopefully for a gain.

Understood.

And then Damian, in the past, you've suggested how quickly and to what level you think you can reduce the discontinued ops.

Could you update us on what your projections are there?

It's the same thing.

You want to -- we now want to reduce it by 50% over the next year or 18 months, right.

So if I -- let's be honest, if we get 36%, if we're a year from now, it's in that 30%, 40% range, that would be fantastic, with it being about 50% in the 18 months, that's kind of the minimum we want to see.

Some of these loans have natural terminations, so that we know when they're going to -- we have a few chunky loans.

I believe the top 8 loans in discontinued is what, like 1/2 or so, right.

So it's in that range.

So there's some chunky ones in there.

That -- we don't have anything right now that would be mall -- this mall-like.

There -- we have great visibility to it.

Some of these are just performing loans and they have termination dates and they will terminate over the next couple of years and they'll be gone and they'll be at other banks.

And some of these loans we've actually participated out to other banks, so there are some bona fide sponsors in here that you actually could off some of the paper to other banks who are interested in having them as clients.

So I think we -- it's very tightly managed, the risk is down substantially from where we were, just considering the marks over the last 6 months and what we've done around credit defense and then visibility to these assets through tight governance and management.

I think a 30%, minimum 30% over a year, but hopefully 50%.

Okay.

And then I wanted to get a sense for your loan growth outlook for the remainder of the year.

Will we continue to see the security portfolio come down and loan growth -- and then the loan portfolio build?

And then secondly, on the auto fleet leasing segment, can you talk about some of the protections you have in place in that portfolio?

And given some of the auto headlines, which have been negative, can you talk about lower used car prices and lower residual values?

As -- are those risk factors to you in that portfolio?

Well, the outlook for the lending businesses is very positive, right.

So we have very strong pipelines.

And it should grow -- show positive momentum because we're growing the balance sheets.

And the businesses are fairly low risk compared to -- we're not growing commercial real estate portfolios.

So I think we have good positions in these businesses.

We have a national SBA platform where we were doing a lot of franchise lending, now we're doing a very diverse business with our new leader, Jeff Nager, who came to us when I started the business -- excuse me, when I came to this business, I didn't start it, obviously.

But -- and so we're going to -- you see the momentum, we're doing things in our SBLOC business we think will continue to increase the volumes in a very, very low risk business.

As for the auto business, once again, we're not lending or leasing autos to individuals.

40% of the business is to high credit rated government agencies and municipalities.

So every -- usually AA, AAA municipalities that need very smart -- small part of their budget for vehicles.

That's 40% of the business.

It could be a big government agency, too, like a part of the military, that (inaudible).

Sometimes they don't pay on time, but they always pay.

So sometimes their delinquencies will go up a little bit.

That's usually a municipality that has decided that they'rere not going to pay us for 3 weeks because they have to pay their teachers or something, but they always pay.

So they're very low credit risk.

The -- now the other side of the business is corporate.

So we do a full underwriting as we are lending them the money, but it's fully securitized against the title of the car.

The history of the leasing business is we have a little bit of extra coverage because in many of our client situations, we're wholesaling.

We're a registered dealer in Florida, so we're wholesaling cars and then we are -- that those -- that margin is being built in, at the end of the day, in some cases, to the slight air ball you might have, as in any equipment lease, that's the difference between the value and the amount of amortization in the lease before you get to the disposal value.

And historically, we've had about a $2 million gain yearly on the residual value when we sell vehicles.

And we have a very broad process through auctioning and through connections into the used car market that makes that possible.

So I feel extremely -- if this was a business where we are doing personal leases to individuals, it's a very different business to that.

In many cases, we even tailor the cars.

So we're putting the -- for police cars, say, we're putting the sticker on it and the gun holster and all those things that, that police car needs, so it's a tailored business.

Another thing to say is because it's a lot of specialty cars, there's a couple of things that happen.

There's a broad market.

Some municipalities and people only buy used cars, and only some buy new cars, so there's a very, very broad market for these products, and then historically have had no trouble disposing of them at a slight gain.

So we feel fairly comfortable with the fleets that we have.

And remember, the -- in many cases, we're underwriting the entity, which might be a government or a corporate.

We have collateral that's a car, but that doesn't mean they're not on the hook, they're still on the hook for any loss.

So we're in a very good position, and we've had very few losses in that business.

So what is the overall percentage of municipalities and corporates?

Is it nearly (inaudible)?

40% -- I think it's a little bit higher now, but it's around 40% is municipality, government agencies, federal government.

And then 60% -- you have a quasi -- there's a lot of quasi organizations, I would say, that are almost agency government-like, for example, like an NRA or something, that would have a huge budget and -- but the pure corporate is probably 40%, 40% municipalities and government, and then the 20% are very large organizations that lease cars that aren't really corporates, but they're not really government either.

Understood.

Okay, very helpful.

And then going to the prepaid card business, can you give us an update there and the outlook for gross dollar volume on those prepaid cards?

It sounded like there is a couple of entities that might have shut down.

So I just want to get a sense for...

Yes, we had 2 programs from major providers, they've decided to, for their own business reasons, to close them down.

And then we had 1 big sale of a client, so they took that volume in-house, and there was a smaller one that sold, that wasn't as dramatic.

But when you look at our GDV of our base business, it made up for all that activity, which was very encouraging.

Internally, we were hoping that, that would happen.

Would we've been surprised if we were down a couple million in the first quarter for fees in that space?

We wouldn't have been surprised.

So our team has done a wonderful job replacing that revenue with organic growth.

I think the prospects for that business, now that we're through this little dislocation, just happened to happen now, are very good for the rest of the year for GDV growth.

Consistent with -- for the base business, consistent -- they'll be some over-and-over -- year-over-year impact because we've lost some stuff, but the GDV of the base business, new clients, et cetera, should, as we go through the year, be -- shown to be true as the numbers continue to move in the right direction.

I think in the past, you mentioned high single, maybe low double-digit GDV growth, is that still good?

Yes, I mean, that's the past, right.

That's where we've been year-over-year.

It jumps up and down depending on the quarter and everything.

We don't think there's anything -- what's happening in the market is volume is consolidating to the few top providers.

I think as we're a stronger institution, we're -- we did not have a good time over the last 3 years.

As we're a stronger institution and closed out our regulatory issues, but also appear to be a stronger player, I think that will support historical volumes.

Okay.

And maybe hop into the margin.

What is the outlook for the NIM?

I think in the past, you've noted that it could expand towards 3% by the end of the year, do you still feel like that's a reasonable goal?

Certainly, the increases in the interest rates, was the consensus, will help us get there.

We don't actually predict that.

There are some dynamics.

The highest yielding assets we have are the leasing and the SBA loans.

If you go to SBLOCs, they yield somewhat less, so it depends somewhat on the mix of those.

We're hopeful that we can continue the leasing growth and the SBA under the leadership of Jeff Nager, our new leasing -- Head of Leasing.

We are hopeful that those 2 will help push -- continue to push up the net interest margin.

Okay.

What's a good tax rate from here?

Should we keep this 38% for next quarter?

Yes, yes.

I think the way from a modeling point of view is keep that rate in place.

More likely than not, the reversal of the valuation allowance will be -- all of it or the majority of it in 1 quarter, so I think that's a fair way.

Plus, in terms of really understanding the profitability right now, that's what we're looking at.

We don't really have a big municipal portfolio as we had in the past.

Obviously, given the political climate and the -- some possibility of a lower tax rate, we're probably not going to do anything in that area until that settles out.

So I think that's the best way of looking at it.

And when you look at our website, we said the near-term goal for this year was to get at least 5% ROE and a 50 basis point ROA.

So I haven't -- we're going to update that presentation as we go through the year.

Right now, we clearly have beaten that.

And we think we do have the economics to potentially be higher than -- obviously, with onetime gains, that's off the table.

Obviously, we will exceed that.

But without onetime gains we still have the operating performance here that would exceed that substantially.

And when we did that 5%, we did a tax effective, too, we put that 38%.

For our own planning, we just assume we pay tax.

So I think that the outlook is good for the company.

Right, okay.

And then just one final one.

The sale of the European operations, sounds like a $2 million or $3 million gain there, and largely offset by the HSA.

Is that to say that the sale of the HSA...

It's the opposite.

I'm sorry, is that to say that the gain on the HSA is $2 million to $3 million as well?

Yes.

It should be a total of around $3 million, and it will be monetized, probably 2/3 or more this quarter, and then the rest of it in the next quarter.

But that will offset the -- any restructure -- we don't know exactly what that restructuring charge and how it will be taken for the European sale, but we're working on that now, but it's in the same range.

So they basically offset each other.

And so the operating performance should come through.

Once you get the gain, by the way, you get at least $400,000 of lowering of expenses, too.

I mean, that's -- that's $400,000 of a loss, so that's after the revenue adjustment, so that's at least $400,000.

That European expense will reduce by the fact there's $400,000 less expenses this quarter, and that will continue forever.

So the payback on the sale of that in getting a final deal, that was the right thing for that company to -- it survived, by the way, it's not closed down.

There's a purchaser, and it had to go through regulatory approval, we made sure it was capitalized correctly with both our own funds and the funds of the purchaser, so we're really -- there are 3 or more clients in there that we wanted to make sure that were taken care of, and we wanted to make sure we were a good partner to our friends in Europe, and we wanted to make sure the Fed, who governed that business from a regulatory point of view, were happy.

And we had everything we wanted, too.

We limited the losses, we got a great future for that company, and we also get the expense saves in the future.

So we're very happy how it turned out.

And our next question comes from the line of William Wallace of Raymond James.

Just one follow-up question on the credit side.

Just looking at the non-accruals on the continuing portfolio.

They seemed to have kind of jumped up in the first quarter.

I'm just wondering if you could talk a little bit about what drove that.

Yes, we had some increases in the non-accruals, primarily in SBAs, so we did have a little bit of an uptick there.

We're monitoring that portfolio very carefully.

We don't think that will continue the next couple of quarters.

We've started a process through all the businesses to look at portfolio review in a more tighter way.

And so Jeff, who has led that effort, who came in, in June, we did have a lot of franchise-based loans historically, and so we're diversifying that business.

And so we just wanted to make sure -- we don't think that trend will -- we don't think there's big numbers going to pop, but that was around a little bit of a cleanup of -- not that it should have been taken in previous quarters, but that's just the result of -- as we've gotten tighter, I think, around the credit risk management process, there was a little bit of a make sure that there were the right credit ratings and -- on the broad portfolio.

So it's a little bit.

If you look at our metrics generally, you have to take out discontinued, our metrics are extremely, extremely attractive.

So -- and if you take our commercial loan, or if you look at our ALLL, and you take out, obviously, it's not -- the discontinued is not in there, but if you just look at the commercial activities, our reserve is over 1%.

It's very comparable to our competitors around 120.

Obviously, the SBLOC businesses, like the SBLOC business have no losses historically, due to the fact that we have $5 billion in collateral and $600 million of outstandings, it's almost -- the market has to totally melt down to a ridiculous level.

But we feel good about where we are in the credit risk management.

And as good as we can feel about things at the discontinued portfolio.

We think we've done a lot of good work.

We don't think there's going to be big hits with the -- looks like some gains in the future for us, so we're -- it was a lot of work, I'll be honest with you, and it always is in these situations.

It's a lot of work to reduce expenses, it's a lot of work from our businesses to create revenue.

So there is a lot -- the team has done a great job, I think, to change performance for the company.

Damian, you mentioned kind of a target range of 30% to 50% reduction in the discontinued portfolio for the year.

Do you think that -- is the Walnut Street entity, is that going to be a longer-dated asset?

Or do you think that, that -- the work down of that entity will (inaudible)?

Yes, Walnut Street is...

Walnut Street is different.

It's actually -- we're not in control of Walnut Street.

It was actually a true sale.

That said, over the next few years, I -- so it's -- were not going to have, like at the end of next year, we can't really predict or set a goal.

But if you look at the maturities over the next -- of the loans over the next several years, I think it's going to pay down on its own.

And if you look at the makeup of it, only about 20% is nonperforming, it was marked independently and so forth.

The rest of it is performing.

And so as Damian said, we've taken -- we did 3 things: we made sure that the loans were marked down.

It's in nonaccrual and accounting actually requires you to discount it.

So we've got a lot of protection in there, so in the same way that we think we have done everything possible to reduce volatility in the discontinued operations, we feel the same way about Walnut Street.

Okay.

And just one last question on the tax rate.

So Paul, you suggested that after -- even after recovery of the valuation allowance, do you still think a 39% tax rate is the rate to model?

And then, if there's any kind of tax reform, you will at that point decide whether or not to invest in municipals or whatever?

Yes, it's interesting.

So what happens if there's tax reform, that changes the whole picture, because all your deferred tax assets get revalued, so there's actually an accounting implication, but it's significantly offset by the fact that instead of 35% federal rate, you go to 15%.

So long term, let's say that tax bill gets passed, banks will be significantly better off, that in essence returns, since it's bottom line, it returns, it increases returns to shareholders by 20%, doing nothing.

So that would change it, but -- so we'll have to be careful.

We'll have to watch the political environment and so forth, but historically, the bank and other banks with the highest yielding portfolios and the lowest tax rates, invested heavily in municipals.

We had a fairly big -- one of the biggest in the country, actually, portfolios.

So we're watching that, so that's a possibility for the future.

Right.

So the problem is, is that if there's tax reform, and the corporate rate goes to, I mean, 15%, then you've got a -- if you recover the DTA, you actually then have to write it back down.

Exactly.

Right.

So if I look at the $54 million balance that's reported in the press release on the balance sheet for net deferred tax asset, and I add, say, $20 million to that.

If the tax rate is reduced from 35% to 15%, I would then write down that $75 million by the corresponding percentage, is that the right way to think about it?

Yes, exactly.

That's exactly -- you divide the new percentage tax rate, it would be proportionate.

But regardless of the accounting, reducing the taxes by that amount is economically positive.

It's unbelievable.

It'll be economically positive.

Well, I agree, (inaudible).

You'll be determining how much you want to increase the earnings of the bank rather than vice versa.

And by the way, the municipality -- okay, so what's going to happen?

Nobody is going to buy municipal bonds because there's such a limited tax -- it's going to be a very difficult tax bill to pass because all the municipalities, that's what they live off of, is that -- what in essence is a subsidy.

So that's going to be a difficult constituency to overcome.

Right.

And then Damian, early in the conversation, you said there is not -- you don't have a specific time line to achieve the 8.5% leverage with the regulators?

Were we -- no, no, I misspoke.

We think we'd be at -- this is my definitive statement.

I think we can make a case, a most likely case, that 8% will happen somewhere between the second and third quarter, based on all the things we know.

I could be wrong.

But based on the profitability and the other things like the DTAs and stuff, if the world stays the way it is, without additional interest rate cuts and all -- increases and stuff, we should be able to get in that range by somewhere between the second, third quarter.

We do have visibility and we'll be close to, if not at the 8.5% level.

If that's true, the 8.5% level will come at the -- close to the year-end, or in the first quarter of next year.

But there are scenarios that are clearly would get us to 8.5% very quickly, depending on the disposition of assets and things.

So we feel -- I think everyone, like I said before, I think the constituencies involved feel comfortable with continued performance, that we can close that gap pretty quickly and get to that capital minimum.

Long term, I want to be more than 8.5%, so I want to be in the 9% plus level, so 9%, low 9% level, at least long term.

It doesn't mean we always will be there, we may have a bump in the first quarter due to the reasons we said, but that's kind of the range we're thinking longer term.

And that should happen over the year, the next year, right.

That is all the time we have for questions.

I'd like to hand the call back over to Damian Kozlowski for any closing remarks.

Yes, well, I want to thank everyone, great questions, and we're very focused on -- and continue to execute our business plan and making sure we're a good partner to all our constituencies in our community, The Bancorp community, so I thank everyone for being on the earning call today, and we'll talk soon.

Ladies and gentlemen, thank you for participating in today's conference.

This does conclude today's program.

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disconnect.

Everyone, have a great day.