Elevate Credit, Inc.
Q3 2018 Earnings Call Transcript

Published: 30 Oct 2018

[Operator:]

Greetings, and welcome to the Elevate Credit Third Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference your host, Al Comeaux, Chief Communications Officer.

[Al Comeaux:]

Good afternoon, and thanks for joining us on Elevate's third quarter 2018 earnings conference call. Earlier today, we issued a press release with our third quarter 2018 results. A copy of the release is available on our website at elevate.com/investors. Today's call is being webcast and is accompanied by a slide presentation, which is also available on our website. Please refer now to Slide 2 of that presentation. Our remarks and answers will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These forward-looking statements are subject to risks that could cause actual results to be materially different from those expressed or implied by such forward-looking statements. These risks include, among others, matters that we've described in our press release issued today, our most recent quarterly report on Form 10-Q and other filings we make with the SEC. Please note that all forward-looking statements speak only as of the date of this call, and we disclaim any obligation to update these forward-looking statements. During our call today, we will make reference to non-GAAP financial measures. For a complete reconciliation of historical non-GAAP to GAAP financial measures, please refer to our press release issued today and our slide presentation, both of which have been furnished to the SEC and are available on our website at elevate.com/investors. We do not provide a reconciliation of forward-looking non-GAAP financial measures, due to our inability to project special charges and certain expenses. Joining me on the call today are our Chairman and CEO, Ken Rees; as well as our CFO, Chris Lutes. I'll now turn the call over to Ken.

[Ken Rees:]

Thank you, Al, and thank you all for joining us on our call today. As indicated in our earnings release, it was a challenging quarter for Elevate. Turning to Slide 3, we experienced a number of issues that resulted in a $4.2 million loss for the quarter. The number one driver was related to charge-offs and loan loss provision, because of several important growth opportunities including the FinWise Bank partnership that we'll discuss later. We delayed underwriting-related initiative through expected to support improved performance to new customer originations. Without the benefits expected from these underwriting initiatives, new customer vintages generated higher charge-offs and loan loss provision than originally forecast and margins didn't improve in line with expectations. This will impact loan growth until we begin rolling out the new underwriting technology and analytics capabilities later this year and into 2019. Additionally, the combination of erosion in UK FX rate and increased costs for complaint management had a negative impact on the contribution from our UK product Sunny. While the FX issue was clear, I should spend a minute discuss in the UK complaint situation. In the UK, for all financial products, customers can complaint to lenders that they shouldn't have been given a loan due to a lack of affordability. If the company declines to reimburse the loan, the customer’ can also complaint to regulators to investigate the charge. This has led to the growth of claims management companies, who drive up the volume of complaints and many cases, which is false complaints. In fact, we found many batches of complaints from claims management companies in which the majority of complaints that are made about Sunny, don't even come from actual Sunny customers. Given that Sunny is an unsecured loan that follows the government recent affordability assessment requirements. This is a frustrating situation, made worse by the fact that the regulators assessed us via £550 to investigate the claim. Note that this fee is assessed on a loan that has an average size of £400, irrespective of whether they find in the customer's favor. The good news is there a complaint bonds are much lower than those of comparably sized competitors. In a recent listing of financial firms from the UK Financial Ombudsman Service Elevate Sunny ranked number 30. We believe this reflects Sunny's remarkably high levels of customer satisfaction and net promoter scores. In fact, Sunny's most recent quarterly net promoter score was 69, one of the highest recorded scores for any product in financial services. Furthermore, we believe that the UK regulators are beginning to review the actions of these so-called claims management companies, based on recent news stories about their bad practices. However, this is unlikely to fundamentally change the situation anytime soon. So we're forecasting continued high complaint volumes and cost through 2018 and into 2019. One other item that compressed earnings in Q3, where higher than legal anticipated legal expenses. These included one-time costs related to several key growth initiatives such as FinWise and the Today Card. As a result of these issues, we had a $4.2 million loss for the quarter and are lowering our full year 2018 guidance for net income to between $10 million and $14 million and are adjusting our full year 2018 guidance for revenues to between $790 million to $795 million at the lower end of our prior guidance. Despite the disappointing earnings in Q3, Elevate is making continued progress along its key financial objectives, with our long term fundamental still strong. On Slide 4, you can see, we had another good quarter for revenue growth, up 16.6% over last year to $201.5 million, as loans receivable grew by 15.5%. Demand for all three of our core products remains relatively strong and we're able to keep customer acquisition costs below our targeted range. An important takeaway is we're continuing to see annual improvements and operating margins, just not as rapidly as we had forecast. In fact, our year-to-date adjusted EBITDA margin is up 150 basis points over the last year and excluding the increased UK complaints in one-time legal charges, we would have delivered quarterly net income comparable to last year. I'd like to further stress the credit quality remains stable compared to last year has been ditched, and within our operating ranges as Chris will detail later in the presentation. That said, we're disappointed that we were not able to implement the new underwriting models and technology that we're expected to deliver improvements in originations, volumes and credit performance. This led to higher than forecast delinquencies and net charge-offs for some of the new customer vintages. To reiterate, overall portfolio credit quality remains stable, but instead of delivering improved credit performance in 2018, charge-off rates stayed flat with 2017. It's also worth noting that we continue to manage our customer acquisition costs at low levels. The $225 CAC for the quarter is below our targeted range of $250 to $300. Turning to Slide 5, I'd like to mention some of our recent product highlights. First, we're proud that Sunny, our UK installment loan product was named the best short term loan provider by the Consumer Credit Awards. This is the second year running that Sunny is been honored at the awards, which are voted on by customers. We view this award is proof that consumers recognize our mission driven approach to responsible lending and one of the reasons, we expect to be a long term winter in the UK market. Second, our Today Card Mastercard continued in its pilot phase in the third quarter. As we refined the product in advance of a larger launch. As I've noted before, we expect to begin scaling the Today Card in latter half of 2019 following tuning of the product and customer profitability. Finally, we're particularly excited to announce our agreement with FinWise Bank that will expand our RISE product to an additional 18 states. If you’ll turn to Slide 6, you'll see more on the RISE expansion. Utah-based FinWise Bank has licensed the RISE brand to originate loans in 18 states, where RISE is not currently offered. FinWise will utilize Elevate’s marketing and underwriting expertise for the RISE branded loans that originates, this is similar to our relationship today with Republic Bank, which originates the elastic line of credit. We're excited to be working with FinWise, and I have to say to a proud of the brand we built in RISE, with its customer friendly features such as lower rates, rates that can go down over time, no hidden or punitive fees in a five-day right of rescission. FinWise clearly appreciates, what we've built and wanted to take this established product and offer it to more consumers in more places. This will not only offer more Americans more and better credit options, but it will also make marketing the RISE product much more efficient, spreading out the per-loan cost of national advertising. Given the RISEs, an established product, we’re able to move very quickly on the FinWise opportunity from concept to implementation in approximately three months. Although, it did have an impact on other corporate initiatives, it has been discussed. FinWise actually began offering loans in some of these states earlier this month with a full rollout set to finish next year. We will continue offering the RISE product ourselves understate licenses or CSO relationships in the 17 states, where we've been offering it. And with that, I'll hand it over to Chris to provide additional detail on our financial performance in the quarter.

[Chris Lutes:]

Thanks, Ken, and good afternoon, everybody. I'm going to start off discussing the bridge from the Q3 analysts’ consensus to our actual results. Then I'll discuss the bridge from the fiscal year 2018 forecast, we previously provided to our updated forecasts for fiscal year 2018. And I'll close discussing our normal quarterly slides that cover growth, credit quality and margins. Turning to Slide 7, which is a bridge of the Q3 analysts’ consensus to the actual results for the quarter. The biggest variance was related to net charge-offs for the third quarter of 2018 that came in approximately $4 million higher than forecast and was primarily related to the RISE product. Our analysis of the higher charge-offs makes it clear that this wasn't a deterioration in overall RISE portfolio credit quality, rather some of the more recent vintages performed worse than forecasts to a large degree, because we didn't get as much of an improvement and underwriting as we were expecting. Our other two products, Elastic and Sunny had net charge-offs for the third quarter of 2018 that were in line with expectations. However, quarter end past due balances were higher than forecasts for the Elastic product, resulting in approximately $3.1 million in higher loan loss reserves as of September 30, 2018 than what we were originally forecasting. The reasons for this situation are similar to the RISE story, the delay in planned improvements and originations, technology and analytics. Despite the increase loss reserves, Elastic past due loan balances at quarter end were 9.3% of total Elastic loans slightly better than the 9.6% a year ago. Our portfolio analysis makes it clear that just like RISE, we don't see a deterioration in overall Elastic credit quality and this new customer loan volume will be profitable, but not until 2019. Within the direct marketing and other costs of sales line item, we realized $3 million in expense related to the UK settlement of UK complaints, as Ken previously discussed. We saw significant spike in complaints and related expense in August of 2018 and while the monthly volume of complaints is dropped off in September and October as compared to August, it is materially higher than a year ago and much higher than what we had been forecasting. We also experienced $2 million in one-time legal expenses related to documenting various initiatives such as the recent launch of FinWise and the Today Card and the debt facilities for those products. Lastly, our top line revenue was a bit short of forecast. We lost roughly $800,000 of UK revenue from a lower FX rate than forecast. Additionally, slower loan growth in late August and September resulted in a RISE revenue shortfall of $800,000 versus forecast. Elastic revenue came in slightly higher than expected for the third quarter. If we were to normalize Q3 2018 results by eliminating the UK complaints expense and the $2 million in legal expense, our third quarter 2018 results would be roughly $23.6 million in adjusted EBIDTA, and $600,000 in net income. This is comparable to Q3 of last year. Turning to Slide 8, and our bridge to the updated fiscal year 2018 forecast, charge-offs will be higher in Q4 2018, compared to what we were previously forecasting, but part of this is already been provisioned for at the end of Q3 2018 to cover the increase in Elastic past due balances. We expect continued UK complaints expense, albeit at a slightly lower level in Q4 as complaint levels have been dropping. And the legal expenses in UK FX erosion from Q3 will be a drag on full year performance as well. Lastly, our top line revenue will be lower than the prior forecast and relates to the same reasons as I discussed in the Q3 bridge. RISE revenue growth will continue to decline in Q4 versus the prior year due to slower loan growth. However, the launch of the partnership with FinWise Bank should help limit this slower growth to just Q4 of this year. This partnership from an accounting perspective is pretty similar to our partnership with Republic Bank and Elastic and was launched in October of 2018. However, the revenue growth will not be – really be apparent until Q1 2019. Slide 9, our year-to-date revenue through Q3 2018 is up 21% from the third quarter of 2017 and forecasted at 18% at the midpoint of our fiscal year 2018 guidance. Additionally, combined loans receivable principle at the end of the third quarter of 2018 grew $85 million or 15.5% from the prior year amount. Staying on Slide 9, you can see that even with reduced guidance, we are expecting very strong growth and adjusted EBIDTA, as we continue to scale the company and grow revenue. Year-to-date adjusted EBITDA totaled $84 million and almost succeeded total fiscal year 2017 adjusted EBITDA of $87 million. At the midpoint of our updated guidance, net income is expected to be up over 100% from the prior year adjusted amount of $6 million. Turning to Slide 10. Our cumulative loss rates as a percentage of loan originations for our 2018 vintage is flat with our 2017 vintage, besides the slower loan growth for RISE, this is the biggest impact on our guidance for 2018. While these critical quality results are solid, we had expected improvements in charge-off rates. Since we won't be able to drive expected improvements in margin and profitability until the new technologies and credit models are fully implemented and realize by Q2 of next year. Our current forecast will continue to assume flat loss rates with the prior year. Turning to Slide 11, our year-to-date adjusted EBITDA margin was 14.5%, up from 13% a year ago. Lastly, there were no material changes from liquidity and funding standpoint during the third quarter of 2018. Additionally, we continue to expect our cost of funds will be materially reduced in 2019. Now let me turn the call back over to Ken for a final review of our 2018 outlook and some final thoughts, before we open it up for Q&A.

[Ken Rees:]

Thanks, Chris. Before we turn the call over for questions, I'd like to review our 2018 outlook and provide some context as we look ahead to 2019. As noted on Slide 12, we've reduced our 2018 outlook ranges based on Q3 performance shortfalls. We now expect full year 2018 revenues in a range of $790 million to $795 million, which represents growth of roughly 18% midpoint versus 16% growth for 2017. For adjusted EBITDA, we now expect a range of $115 million to $120 million, a 35% increase over 2017, and we now see our full year 2018 GAAP net income between $10 million and $14 million, which at the midpoint is approximately double our full year 2017 adjusted net income of $6.9 million. In total, this now implies a full year EPS range of $0.23 to $0.32 per fully diluted share. And finally, we continue to expect stable credit trends and customer acquisition costs to remain in our targeted range of $250 to $300. Putting your own perspective, our new guidance for FY2018 represents a 1% decrease in revenue and a 1% increase in charge-off rates over our original guidance. The combination of these two factors and the RISE in UK complaints accounts for the difference between our original and revised guidance. Turning to Slide 13, looking forward to 2019 and beyond, we believe our future prospects remained unparalleled. In 2013, we generated a mere $73 million in revenue, this year, we expect to generate nearly $800 million in revenue and have just doubled the number of marketable states with our flagship product RISE. While our margin improvements have lagged behind plan, we've seen adjusted EBITDA margins increase from 4% in 2015 to 15% year-to-date this year. And we are competent that they will continue to expand in 2019. The need for better non-prime credit options remains vast and deeply underserved. We believe, we're well positioned to continue to penetrate this market with our new FinWise partnership, new originations capabilities under development, and further expansion of the partner channel. Furthermore, we believe that the combination of the underwriting initiatives, ongoing management of customer acquisition costs and an expected reduction in our cost of capital will result in improvements to both EBITDA and net income margins in 2019. And with that, let's open up the line for your questions.

[Operator:]

At this time, we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from John Hecht, Jefferies. Please proceed with your question.

[John Hecht:]

Good afternoon, guys. One quick question or clarification, the guides you talk about as flat, credit and customer acquisition costs. Is that quarter-to-quarter or year-over-year? Just so I haven’t clear on that.

[Ken Rees:]

Roughly both, John.

[John Hecht:]

Okay. And then I can understand, how the rolling out of a – or the delayed rolling out a new credit scoring module could impact credit, but you talk about it also impacting revenues. Is that because you're tightening up on the margin just to be careful with your kind of seasoning credit tools or is there some other aspect to think about there?

[Ken Rees:]

It's really that as we realize the delays, which as we discussed were largely due to the FinWise opportunity, which consumed a lot of resources that we're planning would go to the underwriting and technology improvement. We are going to be a slowing the growth of our products, while we wait for those credit improvements to come into place, which we expect to start rolling out this quarter and will be a continued to rollout over the next couple of quarters.

[John Hecht:]

And then you talked about overall core book, consistent credit quality and some of the issues are attributed to the new customers. Have you been able to kind of isolate the variables that maybe it changed or the characteristics with the new customers that might be resulting in slightly higher charge-offs?

[Ken Rees:]

Well, again, it isn't higher charge-offs, it’s higher charge-offs and we had forecasted. Our plan was that we would continue to see the improvements in underwriting that we've seen over the past few years. That's why you've seen such a dramatic improvement in charge-off rates. Since, 2014 and the delay in getting this latest generation of scores and technology out there has just kept those being flat to where they were as opposed to improving, where we wanted them to be.

[John Hecht:]

Okay. That's helpful clarification. And then final question is, I don't know 2019 – you give us some color around 2019 but no specific guidance, but how do, I guess just thinking about these new bank partnerships, where will you be in your opportunities to ramp those next year? Both the newly announced one and the Republic one and I guess particularly in the Republic one, where would you be kind of in lifecycle potential ramping? Just to give me a context of what to think about next year?

[Ken Rees:]

So Elastic ramp is about as we had anticipated it to be with Republic Bank, we don't really see in next year much change in how we think about that product. A big change for us is of course RISE. Going into this year, we didn't expect that we would have this partnership in place as fast as we did. That's why we rushed to get it out. So we think it's going to have a positive impact on next year because it – as we said it, it doubles the number of states that can be served with that product. That having been said, I think the mitigating factor on growth for the first half of 2019 is going to be getting all of these new underwriting models fully rolled out and making sure that they're performing the way we want them to perform, but that would be – I think the positive and the negative around growth prospects for 2019.

[John Hecht:]

Okay, great. Thanks guys.

[Operator:]

Our next question comes from David Scharf, JMP Securities. Please proceed with your question.

[David Scharf:]

Great. Thanks for taking my questions. Can maybe staying on the topic of credit, I appreciate that the observation that you didn't see deterioration but rather just, not the level of improvement than you were expecting. I'm wondering, if you can provide a little more, I guess granularity on the technology and the scoring models to help us understand and what precisely you expect it to benefit from when it gets rolled out. I think a lot of us hadn't necessarily been counting on a specific next generation of scoring model to factor into the margin part of the story. Maybe you can help answer that by telling us when the last kind of new scoring model is rolled out and how there are impacted your underwriting specifically. And maybe what's some of the data points are factors are that you're going to be on the lookout for in the first half of 2019?

[Ken Rees:]

Great question, David. I mean, first and foremost, we're like any fintech; we're constantly evolving the technology platform and the underwriting models that we use. The big difference here for us, it's really around some of our channels in particular, the partner channel, which is an increasingly significant part of our origination channel between people like Credit Karma and LendingTree and others. This is a massive opportunity for us to grow the business. But it does require a different approach. It's a different platform to interface with the partners. The scores are somewhat different. And we have more issues around through fraud management and other things. So these are a new generation of models that are really folks some of them at least, they’re very focused on this partner, which I would say, it’s the biggest delta in the way that we underwrite from in the past. Now there is some other aspects too. We talked about our use of a bank information in the underwriting, which is showing some very significant lift, but are just much more complicated model. So it's really the combination of those two things or the areas that we're most focused on right now and we see the biggest upside to our business from and it was built into our plan and it's disappointing that we haven't gotten that market today because, we've seen the results in both tests and in the analytics and we just need to get them rolled out, so we can start getting the benefit of the portfolio.

[David Scharf:]

Got it. That's very helpful. And maybe following up on that, I mean, what percentage, I guess two things. What percentage of maybe origination volumes in this past quarter were through, the partners like Credit Karma and secondly, the performance of newer customers that fell short of expectation. Where those heavily concentrated in borrowers that came from these channels?

[Ken Rees:]

We don't get into quite so much granularity on, which partners are bring us what, but certainly from my perspective, the biggest growth opportunity for us in customer acquisition is through these partner channels, which we have seen tremendous volume. We're actually a great fit with them because these are channels that generate a lot of traffic, but they can't really monetize non-prime customers very well. So we're a good lender to interface with them. But I would say that generally speaking, our direct mail traffic has been as anticipated, and it is more the partner traffic that has not performed as well as we wanted because we were expecting the improvements that were built into our plan. I will hope that answers.

[David Scharf:]

Yes. No, that's helpful perspective. And maybe just a couple of quick cleanup modeling questions and I’ll get back in queue. One is, I know you commented that the outlook for relatively flat, loss rates in Q4 applies to both, I guess year-over-year, quarter-over-quarter. Should we similarly be thinking about ending the year at kind of a flattish 14% allowance rate as well?

[Ken Rees:]

Yes, I would expect that.

[David Scharf:]

Okay. And then just a point of clarification on the Slide 13, the 2019 outlook that the preliminary comments, the last comment regarding the reduction cost to capital, just wanted to make sure that refers to the average borrowing costs, not an absolute reduction in interest expense or is it the latter?

[Chris Lutes:]

Well, this is Chris. I'm hopeful that the percentage reduction in the cost of funds could potentially even lead to an absolute reduction in interest expense next year. Depends upon the final negotiations and when those rate reductions are implemented. But right now, that is a possibility because, I mean, I think we're playing currently roughly a 14% to 15% blended cost of funds. And as I indicated last quarter, I'm hopeful to get that down roughly into the 11% range. And then on $500 million of debt and then there's some other potential tweaks that we're going to make to the facility that would be a little bit more advantageous. I'm hopeful that in addition to just the large decrease in the cost of funds rate, that it's possible that we'll be able to utilize more of our own free cash flow and some of those savings to not need to borrow as much and there would be an absolute reduction and interest expense. But that still needs to be finalized and we'll be able to provide more guidance on that early next year or once we finalize that reduction we may issue a separate press release as well.

[Ken Rees:]

And David, I think, you and John have really focused on the two obvious upsides for 2019 from us, which is the cost of capital reduction. We are paying above market and are working to get that down to market rates. And then the expansion in RISE by doubling the states with FinWise, I should also mention these new states, our experience is typically opening up new states is particularly good quality credit and typically comes at a particularly good customer acquisition costs, because there's not a lot of people already in these states, our competitors in these states that we're going to be going into. So we're positive about that. And then of course, we have the expected ongoing improvements in underwriting performance that we had hoped to get in place in Q3 and we'll be coming in over the next few months. Excuse me, couple of quarters.

[David Scharf:]

Got it. Thank you very much.

[Operator:]

Our next question comes from Eric Wasserstrom, UBS. Please proceed with your question.

[Eric Wasserstrom:]

Thanks. Just a couple of points to follow up on, first, just respect to the UK business, does anything that's happened change your view about the profitability or even the viability of that business?

[Ken Rees:]

Well, it certainly changes our view of the profitability of the business, but not the viability of that business. I mean, we grew that business 23% year-over-year. If we had slowed growth, we would have shown decent contribution from the business. So that's I think our current perspective on the UK. We're a leading product, from what we've mentioned the customer satisfaction scores, and we've also seen that our complaints are lower than other comparably-sized players. So while all of that shakes out, what's going to happen with these claims management companies and how the new regulators that are overseeing them, we're going to hopefully get some of their abuses under control. We will be slowing the growth and we'll see a net income coming from that business, but certainly not what we had thought that business would be going into this year.

[Chris Lutes:]

Yes. This is Chris. I mean, just in terms of kind of assessing, we are breakeven the slightly profitable right now in the UK even with this higher level of complaints. So we feel optimistic that, to the extent that the complaints expense, at least remained steady or maybe even decreases that we should be able to drive the expected profitability next year that we were kind of hoping for this year. And again, because of the large NOL that we have in the UK from prior history, a lot of that EBITDA income will fall directly to the bottom line. So it has had a material impact on our net income this year because of the increased complaints expense.

[Eric Wasserstrom:]

But I guess, I'm just wondering to the extent that net growth there reaccelerates, doesn't that also simply increased the exposure for future claims?

[Ken Rees:]

Well, I think that's what we're going to be looking into before we really hit the gas for growth again. We'd want to see the regulatory environment. A ball bent provides some protections for lenders who are following the rules. I think this is an odd sort of intermediary system, where there's still some complaints coming from loans are made before the change in rules, yet lenders are held accountable based on the new rules. That's just strange situation. So that's why I mean, we're going to be looking to increase the profitability of that business largely by just slowing things down a little bit, watching the regulatory environment. But we think, we're really well positioned as that regulatory environment stabilizes to be one of the surviving company that –surviving companies in the market that takes a big share of the market that has been exited by certainly Wonga and we expect others tags at the market over the coming month.

[Chris Lutes:]

Yes. Eric, it's Chris. One last point that I want to emphasize that Ken brought up is a majority of the complaints are pre the FCA rule implementation in January of 2015. We did not have a big book of loans prior to 2015. I think that's one of the reasons why our UK complaints expenses probably much smaller than some of the other larger players that had larger books prior to 2015, but it's also what gives us a lot of comfort that as we said, I mean we're not going to grow that that product drastically to be get some more regulatory clarity over in the UK related to this, but we also have a lot of comfort that we are currently following the new FCA rules and that the loans that we are making to new customers are generally deemed to be affordable from our perspective.

[Eric Wasserstrom:]

Great. And if I could just move to the issue of the targets is there expressed on Page 11, which looked largely unchanged from your past several quarters, but I guess, I'm curious, what has changed? Is it really just the time in which they will be achieved? Or you still, it seems like you're still fully confident that that's what the long term economics of the business look like?

[Chris Lutes:]

Yes. We've got good year-to-date margin expansion. I think the slower revenue growth will – in Q4 will compound that a little bit. If I look at those line items, I mean I'll admit even at times, I'm pleased with the loss provision at 51%, but we do expect that to get the 50% and then potentially even below 50% longer term with the continued improvements. The one that's probably hurt the most and you can see it jumps out is the direct marketing and other cost of sales. The part of the other costs of sales and why that percentage is running higher is the UK complaints, but part of it is also not necessarily the CAC. But what would Ken and I would argue is that charge-off rates was not improving, you're keeping less customers on the books for a longer period of time to really scale and drive more revenue. Because again, we allocate all of our marketing expense to first time customers to the extent that for those new first time customers were successful and we underwrite them profitably and they can come back for a second loan or a third loan or in case of Elastic. They have a long period of life from us. That's what allows us to really scale the revenue and not have incremental marketing expense. So in a lot of ways it really all boils down to what Ken talked about. We need the continued improvements in the credit quality models and opening up the new customer acquisition channels to really leverage that particular line item. Lastly, I am pleased with what the operating expense leverage that we're showing and I would expect that to continue to improve. I think there's upside or I expect that number to continue to decline and we may end up revising that target lower than the 20%. So it's just taking us. We're seeing good progress. It's just taking us longer to get there though I think what we expected.

[Ken Rees:]

That's right. From my perspective, we are 100% still are committed to the kind of targets we're showing here of getting to 20% adjusted EBITDA margins. We think it’s very doable in this space, where we're disappointed. We didn't make a little bit more headway towards that this year, but we were on track to get there.

[Eric Wasserstrom:]

Thanks very much.

[Operator:]

Our next question comes from Moshe Orenbuch, Crédit Suisse. Please proceed with your question.

[Moshe Orenbuch:]

I know it's a bit repetitive with all the other questions about the credit models, but I still trying to understand, you effectively did market through these partner channels and had subpar results because the model wasn't updated, I guess, is that the way we're supposed to just kind of understand it?

[Ken Rees:]

Maybe a different way to explain it, when we build our forecast there on vintage basis and we have the existing portfolio, do we know that's already pretty much locked, we see – we know how that's going to perform and then we have expectations about how each vintage is going to perform. We had expected in particular improvements in the partner channel that would have made these vintages perform better than I did. And we actually did think that even with the FinWise opportunity, we'd be able to get more of those underwriting improvement in place. But given the distraction, we just weren't able to get as much out as we expected. So instead of getting the expected vintage portfolio performance, it was worse than it anticipated, not worse than what we've had in the past, but worse than anticipated. The reason I pointed to the partner channel, that's where we see the biggest potential improvements coming that are going to drive that improvement vintage portfolio performance.

[Moshe Orenbuch:]

And maybe what's the – I guess, the lifecycle of one of these models and the amount of time it takes to see that improvement because when we're talking about one quarter here, right? I mean, we're talking about since Q2.

[Ken Rees:]

Right. Well, the partner channel in particular, because it's a pretty rapidly growing piece of our business, getting that into place to support their growth of business was a big deal for us. Each channel and each product have somewhat different, speeds at which they operate that the direct mail channel for instance is that’s pretty stable. But partners that the traffic can vary quite a bit even between partners. So that's where we're seeing the need to have more precisely tuned scores and more scores that are built to not just the need of the channel as a whole, but even individual partners. I hope that's helpful, but it's not so much answer of a model improvements overall for the business, but the fact that there are some pieces of business that may need faster pace of innovation in others.

[Moshe Orenbuch:]

Okay. And then I guess you mentioned the allowance rate would be stable, but you also had said that you expected some of the losses that were – that are going to happen in Q4 to be absorbed by the reserve. So I guess how does that work?

[Chris Lutes:]

Well, what we’re also going to have, as you can see on the one slide that shows the full-year bridge, I mean there is some slowing of loan growth in particular with RISE in Q4 that’s expected. So, it’s going to actually have more of a revenue impact than a credit impact. I think to Ken’s point, I mean we’ve identified where we’re not happy with some of the recent performances of the vintages. So there’s some natural – being a little bit more prudent on new customer growth as we head into Q4, so that’s where we feel that there’s some opportunity there. We’re also rolling out on the elastic products, some new collection techniques and technology that, that partnering with the bank that the banks approved that I think will allow us for some increased collection efforts as well. So, I’m comfortable at this point that the level of credit quality at the end of the – at the end of Q4 should be consistent with what we see in Q3.

[Moshe Orenbuch:]

Got it. And then lastly, I kind of looked at the balances by product and each of the products actually was down slightly from a year ago. Is that, I mean, is there something kind of driving that trend? I mean, you kind of alluded to the whole concept of repeat borrowers than I would’ve thought that that would be something that, given that if there were more of those that would have a positive impact on the average balance per loan.

[Ken Rees:]

Average, I’m sorry, just for point of clarification, while Chris is trying to think about a response, are you talking about the average balance per loan or the portfolio in total for each of the products, because we are seeing growth in each of the products from a portfolio basis.

[Moshe Orenbuch:]

All right. Well, I guess we could take that offline. That’s fine. All right, thanks.

[Operator:]

Our next question comes from Vincent Caintic, Stephens. Please proceed with your question.

[Vincent Caintic:]

Hey, thanks. Good afternoon guys. I know you can’t give 2019 guidance, but just kind of think broadly here. So, you’re making now the investments into this underwriting technology and analytics and you’re expecting that I guess by second quarter of next year that you’re going to be where you expect it to be now. So should we – should we take that to imply that the second half profitability of next year should be kind of similar to where we would have been expect in the second half profitability of this year and then we used the first half of next year. It’s kind of a bridge or are there other moving pieces we should be thinking about?

[Ken Rees:]

All right. Probably, I grew up the first part just talking about underwriting performance and charge-off performance that’s probably not inaccurate. I’d have to think a little bit harder about that. But there are a couple of things which we said that it will increase profitability as a whole or earnings as a whole. One is the reduction in cost of funds and the second being the impact of the rise expansion into double the number of states. So, those are two additional factors other than the charge-off performance.

[Vincent Caintic:]

Got It. That makes sense. And on the RISE opportunity, could you size up FinWise, maybe the potential loan volume you expect there, and any difference between that relationship versus your existing bank relationship in terms of yields, expenses, charge-offs or anything else?

[Ken Rees:]

There are pretty comparable structures between the Elastic bank partnership and the RISE bank partnership vis-à-vis that the growth, we’re not planning to disclose that, that separately, but you can look at it on just a per capita basis in a number of states. We’re actually doubling the number of states that isn’t quite double the number of customers in the addressable market, but also you have the – we believe will be likely a higher quality customer acquisition in these new states, because of lack of competition. So, it’s very sizable increase in the growth prospect for RISE.

[Vincent Caintic:]

Okay. So meaning that we can kind of look at the existing bank partnership as the growth, as a proxy for the growth trajectory of the new partnership, would that be fair?

[Ken Rees:]

I think so, yes.

[Vincent Caintic:]

Okay, perfect. And then just – yes.

[Ken Rees:]

Go ahead.

[Vincent Caintic:]

Just the last one from me. When you think about the UK, so you and one of your peers, who are also kind of talking about the UK issue and how do you see – how do you see that playing out and what do you see as the outcome? Do you just see as kind of time will work its way slowly through that or it’s just something need to happen in order to resolve the UK issues? Thanks.

[Ken Rees:]

I mean the UK market, because of this complaint; it’s already taken the largest lender Wonga. It will likely take out few others and so I think the regulators will have to address this matter as we mentioned. It’s a bit of a crazy situation right now. It’s one thing to charge a $550 investigation fee for – £550 investigation fee for a mortgage. It’s a whole different thing for a $400 short-term loan – or a £400 short-term long excuse me for mixing up the currencies. So, I do expect and people that we’ve talked to do expect it’ll get resolved in 2019 and things will stabilize and the lenders that are still in business, we’ll be able to grow and capture what’s a, I’m still a very big market, but with less competition. So we still are bullish on the market as we discussed. Earnings are going to be squeezed a bit while this is all getting dealt with. but we think we’re a long-term player in the space and we liked the UK market overall.

[Vincent Caintic:]

Okay. got it. Thank you.

[Operator:]

[Operator Instructions]. Our next question comes from Michael Tarkan, Compass Point. Please proceed with your question.

[Michael Tarkan:]

Just a big picture just back on the credit again, are you noticed anything, any changes, any material changes in your customer base, quarter-over-quarter. I know you mentioned the partner channel, but I’m just kind of wondering if there’s anything bigger picture that you’re seeing amongst your overall customer base?

[Ken Rees:]

That’s a great question and we really aren’t. I mean, whether it be – we certainly look at other financial services, providers outside of the non-prime world or starting to tighten up credit in the expectation of potential recession. We’re not seeing anything that has this nervous about this point, partly because the term of our loans is so much shorter. As you know, Mike, the average effective term is just about a year for our products. So, it makes us a – we think more competent about ability to stay on top of any changing macro issues related to our session. So net-net, generally speaking, the customer quality proved or is not fundamentally different what we’ve seen before. But as we’ve said, our opportunities to do a better job underwriting that that traffic with the plant analytics and technology initiatives just got delayed.

[Chris Lutes:]

Mike, it’s Chris. One thing I’ve noticed probably since kind of putting together my original IPO model that I was probably off, on, but when you look at where we’re at, potentially headed into talk about our recession or a credit bubble. The average elastic customer balance is probably about $200 to $300 less than what I originally assumed two to three years ago. So, if there’s a benefit there from a credit perspective is that they’re not maximizing the utilization or you’re not seeing an increase in utilization rate headed into a potential, macroeconomic credit situation. I mean where it’s hurt us is that we’re not generating quite as much revenue off of the average elastic customer as what we expected. But as I look ahead, I guess it’s probably a benefit that they’re not; we’re not seeing an uptick in the utilization, which could potentially lead to more losses down the road.

[Michael Tarkan:]

That’s helpful. And then just to follow up on that, are you seeing any material changes in the customers coming through the different channels. So that partnership channel, is it a different customer or is it just the underwriting models themselves or just have to be tweaked a little bit?

[Ken Rees:]

Yes. Not a completely different customer, but more of the concentration of the customer type, if that makes sense. So, through our direct mail in our organic, we see all of those, the broad range of the non-prime customers, but through one channel they may be really concentrated to the more and let’s say people with a limited credit experience and another one may have more defaults. So it’s tuning to that individual partner and to the partnered channel as a whole, it’s not that we’re underwriting fundamentally different customers, but that they come in and different concentrations and we need to adjust our models accordingly. I hope that makes sense.

[Michael Tarkan:]

Yes. That’s helpful. Thank you. I appreciate it.

[Operator:]

Our next question comes from Bob Napoli of William Blair. Please proceed with your question.

[Bob Napoli:]

Thank you. Good afternoon. Ken, can you give us – Chris get an update on how much of your business is coming through which marketing channel, direct mail versus maybe the marketplaces versus other and kind of the mix shift that you’ve seen?

[Ken Rees:]

Yes. We don’t get the specific split, but we’ve been pretty upfront that direct mail is our number one channel for years, but we believe that the partnered channel is the fastest-growing opportunity for us and it has been the fastest-growing channel this year. So, we are looking to that to both support the growth in top-line as well as be a key driver and improving margins for business going forward.

[Bob Napoli:]

And the partner is primarily the marketplaces and like the Lending Tree’s and Credit Karma’s.

[Ken Rees:]

Yes, absolutely. And let’s say decline traffic from other fintech lenders.

[Bob Napoli:]

Okay. And out of those partnered channels, are you seeing any change in the – I mean is that credit – is the credit, are the credit losses higher out of the partnered channel versus the direct mail channel?

[Ken Rees:]

There are generally speaking, a little bit a worst performing, the vintages that come through partner channel versus direct mail and that’s part of what we had expected would be more equalized by these new underwriting models. Yes.

[Bob Napoli:]

Okay. And then just, I mean, I hate to beat the UK to death, but – is it not crystal clear that the loans you’re underwriting today are absolutely safe from consumer coming back and saying, you underwrote, you gave me a loan, you shouldn’t have?

[Ken Rees:]

Yes. I’ve learned something in the space. The big difference between the way the U.S. regulators operate and the UK regulators operate is the U.S. regulators set very specific rules and the UK operators use more value judgment. So in the UK, you have to treat customers fairly. That’s something that can be used by regulators to say you either did or didn’t do that without a whole lot of prescriptions about how to treat customers fairly. So from a U.S. point of view, absolutely, we are adhering to all of the regulations, and in fact, we are more conservative in the way that we underwrite and manage the affordability requirements in the UK space than other people out there. So, we feel extremely good about the way that we’re underwriting customers. However, I just want to make it clear that that doesn’t prevent a customer for making a complaint. And it’s similarly, as we said it, if that customer does make a complaint and it’s evaluated by the regulators, there is a fee for investigating that. So no matter how good we are, we will have some level of complaints, but we feel that, based on what we’re doing, those complaints should be very manageable for us to go forward.

[Bob Napoli:]

And the regulator determines whether they should investigate it or is it…

[Ken Rees:]

No. The customer gets to a request that the regulator doing an investigation, so that the customers behest, and we – as we said it, that the lender pays the fee even if the customer’s complaint is rejected.

[Bob Napoli:]

Okay. Thank you. And then…

[Ken Rees:]

Yes. It is an unusual situation and I think that’s why the regulars are recognizing now that that doing that for a mortgage, they make a whole lot of sense doing that for a £400 loan such as Sunny’s, may not be sustainable for the long-term. So, we do anticipate that there’ll be a evaluating those rules and regulations, and hopefully leading to a reduction in those costs.

[Bob Napoli:]

Thanks. And the credit card that you are planning on rolling out the credit card, it sounds like more in the back half of 2019 at this point?

[Ken Rees:]

Yes. That’s actually we’ve been saying all along. We don’t – aren’t not talking about changing the rollout for the today card, because it is a new product. We’re tuning and testing all, both the customer experience and the customer profitability, but we feel like we’re still on track for a rollout in the latter half of 2019.

[Bob Napoli:]

Now that typically, I mean, I think rolling out a new credit card, you would generally expect to have losses – startup losses for some period of time and obviously a big payoff down the road, but wouldn’t you – would you not expect to have material kind of startup losses or is this going to be so gradual that it won’t be that material?

[Ken Rees:]

Our plan is to manage the growth of that portfolio. So, it doesn’t have a significant impact of the overall profitability of the company. I mean, you’re right, anytime you roll out, anytime you grow any part of the business that has a near-term impact, just because of customer acquisition costs and my last provision, but we don’t anticipate growing that faster that it impacted our overall plans going forward.

[Bob Napoli:]

Thank you very much. I appreciate it.

[Operator:]

Ladies and gentlemen, we have reached the end of the question-and-answer session. Now, I would like to turn the call back to Ken Reese for closing remarks.

[Ken Rees:]

Well, thanks to our analysts and investors on the call and of course, to our employees, who are supporting Elevate and we continue to look forward to a long perspective, growth that have opportunities, whether it be the FinWise, the margin enhancements we see in our ability to just get better and better products to serve this fast unmet need in the U.S. and the UK. Thank you all.

[Operator:]

This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation.