Marlin Business Services Corp.
Q2 2017 Earnings Call Transcript

Published: 28 Jul 2017

[Operator:]

Greetings, and welcome to the Marlin Business Services Corporation Second Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host Mr. Lasse Glassen, Addo Investor Relations. Please go ahead.

[Lasse Glassen:]

Good morning, and thank you for joining us today for Marlin Business Services Corp's 2017 second quarter results conference call. On the call today is Jeff Hilzinger, President and Chief Executive Officer; Ed Siciliano, Executive Vice President and Chief Operating Officer; Lou Maslowe, Senior Vice President and Chief Risk Officer; and Taylor Kamp, Senior Vice President and Chief Financial Officer. Before beginning today’s call, let me remind you that some of the statements made today will be forward-looking and are made under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those projected or implied due to a variety of factors. We refer you to Marlin's recent filings with the SEC for a more detailed discussions on the risks that could impact the company's future operating results and financial condition. With that, it's now my pleasure to turn the call over to Marlin's President and CEO, Jeff Hilzinger. Jeff?

[Jeff Hilzinger:]

Thank you, Lasse. Good morning and thank you everyone for joining us to discuss our 2017 second quarter results. I'll begin my comments this morning with an overview of the key highlights from this past quarter, including an update on our Marlin 2.0 initiative that is designed to transform our company from primarily a micro-ticket equipment lessor into a broader provider of credit products and services to small business. Ed Siciliano, our Chief Operating Officer will provide additional remarks on our second quarter operational performance. Lou Maslowe, our Chief Credit Officer will discuss portfolio performance, and Taylor Kamp, our Chief Financial Officer will then wrap up our prepared remarks with details on our financial results and business outlook. Marlin delivered another strong performance in the second quarter. In addition to benefiting from robust customer demand, our results reflects solid execution of our Marlin 2.0 strategy that is leading to improvements in scale enhanced operational efficiencies, sustained profitable growth and a more attractive return on equity. Total second quarter source origination volume of $167.8 million, was up more than 34% from a year ago. This growth was broad based and driven by the strength of our equipment finance business, including Horizon Keystone Financial, which we acquired earlier in the year and which continues to exceed our expectations. In addition, origination volume for Funding Stream, our working capital owned business, increased to $14.8 million or 9% of total sourced originations in the quarter, up from $7.8 million or 6% of total originations a year ago. Thanks to the strong origination activity, investment in leases and loans increased to $858.7 million, up over 4% compared to the previous quarter and up 18% from a year ago. This origination activity also allowed us to sell or refer $24.8 million of volume during the quarter to third parties as part of the continued growth and development of our capital markets activities. Furthermore, we achieved this strong growth while adhering to our strict underwriting standards, with portfolio performance remaining within an acceptable range during the quarter. Over my last 14 months as Marlin’s CEO, I'm very happy with the success we've had in assembling a world class leadership team to take the company into the future. And I am pleased to report that our efforts over the past year to round out the team are nearly complete. During the quarter, we announced Dan Castellini’s promotion to Senior Vice President with responsibility for leading the development of new products to support the 2.0 strategy. We also announced the appointment of Laura Anger is Senior Vice President And Chief Human Resources Officer. In addition to guiding Marlin's overall human resources activities, Laura will be responsible for developing Marlin’s HR function to a more strategic level so that we can continue to recruit and retain the most talented people in our industry. With Laura's appointment, the only remaining open position on the Marlin senior leadership team is the position of Chief Marketing Officer. I am pleased to report that we have identified two strong finalists, each of whom are exceptionally qualified. So we expect to reach a decision on the new CMO soon. This position is particularly important as we expand our direct strategy and develop customer response and credit targeting models. Without a doubt, we continue to assemble an extremely talented leadership team with tremendous industry experience, and I believe this group is ideally suited to continue executing our plan to take Marlin to the next level of growth and profitability. Next, I'd like to provide an update on our Marlin 2.0 business transformation initiative. As you may recall, through Marlin 2.0, we expect to drive sustainable growth and improve returns on equity by first strategically expanding our target market. Second, better leveraging the company's capital base in fixed cost through origination and portfolio growth. And third, improving our operating efficiency by better leveraging fixed cost through scale and through operational improvements to reduce unit processing costs. I'd like to share with you the progress we've made in each of these areas since our last call. First, the primary objective of the Marlin 2.0 strategy is to transform the company from primarily a micro ticket lessor into a broader provider of credit products and services to small businesses. As a result, we are now focusing on providing multiple products to a wider array of small businesses. In support of this, we are quite pleased with the ongoing success of Funding Stream, our working capital loan product. While origination volumes have increased each sequential quarter since we began offering this product just over two years ago, we continue to carefully manage its growth as we fine tune our underwriting and credit models. Within equipment finance, our franchise and transportation businesses also continued to gain traction, as we continue to evaluate and evolve these new channels to maximize their profitability and relevance to the 2.0 strategy. In addition, to organically develop products, we are also actively looking at other corporate development opportunities and initiatives to enter new markets. A good example of this was our first quarter acquisition of Horizon Keystone Financial, which extended our existing equipment finance business into the office furniture, HVAC and automotive aftermarket verticals. Along with these current Marlin offerings, Dan Castellini and his team are busy evaluating potential additional new products to further meet the financing needs of our small business customers. We expect to have more to report on our ongoing new product and corporate development efforts on future calls. In addition to expanding our product offerings, we are also making progress in broadening our go to market strategy. Historically, Marlin has viewed its equipment dealers, distributors and manufacturers as its primary customers. However, an important component of Marlin 2.0 is acknowledging that our addressable customer base also includes our end user customers. As I noted on our call last quarter, earlier this year we realigned most of our origination resources into two teams, with one team focused on our traditional indirect or intermediary customers, and a new team focused on serving our direct or end user customers. The end user team’s objectives are to identify additional financing opportunities with existing end user customers, and to create ongoing relationships with these customers. With more than 350,000 lifetime end user customers, including over 70,000 active contracts and approaching 2,000 new end user customers originated per month, this is a large and in many ways, untapped market opportunity for the company. In addition to creating a proprietary flow of follow-on financing opportunities, it is important to highlight that we do not incur customer acquisition costs beyond the initial transaction. So this follow-on business significantly lowers our weighted average customer acquisition cost. During the quarter, we continued to fine tune the reorganization of our origination sources into indirect and direct teams and focused on how the two teams can work best together to maximize our end user penetration. In addition, we also continued to expand the size of the direct team. Although the end user initiative is still in its early days, we are seeing positive trends in cross selling multiple products, including equipment finance, franchise finance and Funding Stream. I expect that our efforts to reach these customers more effectively will be further enhanced once the Chief Marketing Officer is on board. We also made good progress during the quarter on our second key priority, which focuses on using capital more productively. Our strong origination volume and portfolio growth during the quarter, allowed us to further reduce our equity to assets ratio to 16.7% this quarter, from 17.2% in the prior quarter and 18.5% in the second quarter last year. To further leverage our capital, we continue our efforts to establish a wholesale credit facility at the holding company level and continue to expect to have this facility in place in the near future. Additionally, we continue to improve our ability to manage the size and composition of our balance sheet through our evolving capital markets activities. During the quarter, we sold two portfolios totaling $12.4 million and referred $12.3 million of volume to various third parties. Investor demand and pricing for Marlin's product was strong and execution on the two transactions in the second quarter was the best since we started our capital markets program last year. The majority of the referral volume was originated by Horizon Keystone Financial and we do expect that this volume will shift from being funded on a referral basis, to being predominantly booked on balance sheet by the end of the year. And finally, we also continued to make progress during the quarter in better leveraging the company's fixed cost through growth and by improving operational efficiencies through our process renewal initiative. As evidence of process renewal’s growing success, during the first half of 2017, the company was able to process an additional $20.6 million of volume as compared to the second half of 2016 without adding any net new origination credit or operations headcount. On a per headcount basis, application volume increase 13% and book volume increased 9% in the first half of 2017 as compared to the second half of 2016. Our ability to further improve efficiencies and ultimately achieve our efficiency ratio goal of 45% by 2020, centers on the success of this initiative. Internal Marlin teams continue to work toward additional significant improvements in cycle times, quality and overall productivity in our origination, production and servicing processes. Another key element of process renewal are the investments we are making to upgrade our information technology resources across the company. We recently completed a three year IT strategic plan that focuses on automating processes that have been optimized by the process renewal initiative, improve the effectiveness of our IT infrastructure and support our direct origination strategy. At the center of the IT strategic plan is adding additional functionality to our SalesForce.com platform, including sophisticated data warehouse and backend analytics capabilities. We are also adding tools from (Mercado) to enhance our use of digital marketing to support our direct origination strategy. I look forward to updating you on our continued progress on future calls. In summary, we've had a very productive first half of 2017, and I want to thank everybody at Marlin for their strong execution, which is delivering excellent results. Our origination volume and portfolio growth are at record levels. Portfolio performance remains within our targeted range. We’re making excellent progress on our key Marlin 2.0 business initiatives, and we're enjoying strong momentum as we look ahead to continued strong execution during the second half of the year. With that, I'd like to now turn the call over to Ed Siciliano, our Chief Operating Officer to discuss our second quarter operational performance in more detail. Ed.

[Ed Siciliano:]

Thank you, Jeff. Good morning everyone. My comments today will focus on our second quarter originations and capital markets activities. New originations funded in the second quarter of $155.5 million was up 28% compared to the second quarter last year, while total source origination volume of $167.8 million, increased 34% from the prior year period. Looking at new originations funded during the quarter in more detail, equipment finance origination volume of $140.7 million, increased 6% from the prior quarter and 24% from the second quarter of 2016. These increases were a large part the result of a more productive salesforce driving increased activity levels and dealer contribution. In addition, we are seeing a return on investment spend made in the past two years. Funding Stream, our working capital loan product, produced another strong quarter, with origination volume of $14.8 million. This was up 7% from the prior quarter and nearly two times higher than a year ago. This past quarter, Funding Stream represented 8.8% of total sourced originations, up from 8.2% of total sourced origination funded in the first quarter and 6.3% in the prior year period. Due to the short Funding Stream tenures, the portfolio increased by only $6.1 million from the fourth quarter, and now represents approximately 3% of the total portfolio. Similar to previous quarters, the continued growth in Funding Stream again helped increase overall total yield our new originations funded. However, we successfully passed on rate increases within our equipment finance business, driving a 29 basis point increase over last quarter. For the quarter, total yield on new originations funded of 12.21%, was up 35 basis points from the prior quarter and 43 basis points from the second quarter of 2016. Over 70% of Funding Stream loans were originated with existing Marlin customers, as we remain focused on marketing to our known customers, primarily to maintain strong credit quality associated with this product. Referral volume of $12.3 million was down $10 million from the prior quarter, but increased 3.5 times from the second quarter of 2016. First quarter referral volume was elevated due to a particularly large transaction that took place in the first quarter. Contributing to the strong year of the year growth was our acquisition of Horizon Keystone, as well as some larger transactions best suited for our partner's portfolio. The integration of Horizon Keystone has been seamless. And during the quarter, we began moving more of its originations volume onto our balance sheet. This migration of assets to Marlin’s balance sheet, will likely continue through the balance of the year. Entering 2018, we're likely to place the majority of Horizon’s originations on balance sheet. Marlin's process renewal initiative continues to produce promising results that have exceeded our expectations. During the quarter, the company processed over 7,700 finance transactions, an increase of 15% over the same period a year ago, without adding additional headcount. This improvement in efficiency already demonstrates the positive impact of process renewal. Perhaps more powerful, we expect the whole process in headcount slack in 2018, further driving our overall efficiency. During the quarter, we completed portfolio sales totaling $12.4 million. These transactions in the second quarter generated an immediate gain on sale of $477,000 that was recorded in other income. Once again, we continue to service the leases that were sold and we’ll recognize servicing fees over the life of leases. We are currently servicing over $36 million in assets for our value funding partners, while allowing us to maintain an ongoing relationship with these customers. In closing, we are pleased with the second quarter and we firmly believe that we are executing on a plan that will deliver meaningful shareholder value over time. With that, I'll turn the call over to our Chief Risk Officer, Louis Maslowe. Lou?

[Louis Maslowe:]

Thank you, Ed and good morning everyone. Today I will provide you with an update on Marlin's portfolio performance, as well as steps we've taken over the past quarter to further strengthen Marlin's risk management governance. Equipment finance receivables over 30 days delinquent or 94 basis points, up four basis points from the first quarter and 22 basis points above June 30, 2016. Equipment finance receivables over 60 days delinquent, were 54 basis points, up only two basis points from the first quarter and 10 basis points above Q2 of last year. These slight delinquency increases quarter over quarter, were primarily due to the quarter's higher syndication volume and some adjustments made to past collection practices. Whereas year over year increases are primarily attributed to movement of portfolio performance toward more historical norms. Funding Stream delinquency also increased in both the 15 day and 30 day buckets to 89 and 35 basis points respectively. While the increases in basis points from the prior quarter appears material, in terms of dollars and number of contracts, it is small. In this case 15 plus and 30 plus day delinquency is only 230,000 and 91,000 consisting of eight and four past due accounts respectively. Aggregate net charge offs in the second quarter increased to 1.65% of average finance receivables on an annualized basis, as compared to 1.57% in the first quarter and 1.38% in Q2 of last year. As mentioned last quarter, we anticipate net charge offs will continue to increase modestly over time as our high yielding Funding Stream product grows as a percentage of the total portfolio. Net charge offs in the leasing portfolio increased by five basis points and 17 basis points compared to Q1 of 2017 and Q2 of 2016 respectively. Leasing net charge offs of 1.51% is very close to the quarterly average of 1.47% since Q1 of 2013. It is worth noting that if the year to date 2017 portfolio sales of $21 million were still in the portfolio, net leasing charge offs would have been approximately 1.43% or about eight basis points lower than reported for Q2. Syndications are utilized strategically to manage concentration risk in the portfolio and to optimize our return on equity. Funding Stream charge offs of $380,000 represented 6.19% on an annualized basis, which is in line with the 600 basis points target for this product in the current economic environment, and what we view as an acceptable and profitable level for the product. Keep in mind that given the nature of the Funding Stream product and size of the portfolio, results are subject to volatility from one quarter to the next, as evidenced by the range of charge offs over the past five quarters, from a low of 1.11% to a high of 6.19%. Although results remain satisfactory, we analyze all transactions that default and make adjustments to our underwriting as deemed appropriate. For example, we recently made some adjustments to our underwriting approach on loan renewals to ensure that the approval requirements are as stringent as the original advance. Notwithstanding the clear upward trend in both delinquency and net charge offs over the past year, our portfolio analysis of key risk indicators, including delinquency and charge offs by channel, transaction, size, vintage and credit scores, affirm the fact that our portfolio quality remained solid. We also benchmark our credit metrics to the equipment finance industry, which is also experiencing a return to more historical performance levels following an extended period of low delinquency and credit losses. For example, the Thomson Reuters PayNet Small Business Delinquency Index has increased 13 basis points from 1.56% at June 30, 2016 to 1.69% as of May 30, 2017, which is the latest information available. Over the same period, the Thomson Reuters PayNet Default Index has increased by 17 basis points from 1.7% to 1.87%. During Q2, we performed an extensive analysis of our historical through the cycle credit losses. This was done to ensure that our credit underwriting and expected losses are aligned with the pricing and profitability of each of our sales channels and Marlin as a whole. We analyzed our portfolio performance dating back to 2007 and divided the past 10 years into recession and non-recession periods. We determined that our target average portfolio performance during non-recession periods, based on our current portfolio mix, is 1.76%. Our rolling four quarter average of 1.5% remains well below the targeted threshold. In addition to our ongoing close attention to credit risk, we are strengthening our overall enterprise risk management as we prepare to exceed one billion in assets in the near future. This entails increasing attention and focus on Marlin's ability to identify, assess, aggregate, control, monitor and report on a range of risk types, including most importantly, operational risk, as well as regulatory and compliance risk. As part of this effort, we have separated the internal audit and regulatory compliance functions and dedicated a full time resource to the ERM function. In conclusion, we will continue to monitor the driving forces behind our enterprise risk profile and portfolio performance. But based on a market and historical perspective, as well as our through the cycle analysis, we are comfortable with our portfolio quality and performance at this time. With that, I’ll turn the call over to our CFO, Taylor Kamp for a more detailed discussion of our second quarter financial performance. Taylor.

[Taylor Kamp:]

Thank you, Lou and good morning. Marlin generated strong second quarter results, led by robust growth in originations and record portfolio size, while maintaining credit performance consistent with our expectations. Excluding the expenses related to the previously announced regulatory matter, second quarter net income on an adjusted basis, was $4.8 million or $0.38 per diluted share compared with $4.5 million or $0.36 per diluted share for the second quarter last year. Our investment in leases and loans grew approximately 4% from last quarter and 18% year over year to $859 million, an all-time record. Through June 2017, Marlin has originated close to $5.3 billion in loans and leases since its inception. Excluding the charge, return on equity on an adjusted basis was 11.80%, up 14 basis points from a year ago. The increase in adjusted basis ROE was primarily due to higher net income as a result of the record portfolio size, efficiency improvements from the growth in scale, the added contribution of Horizon Keystone, and higher syndication fees. We expect ROE to continue to increase throughout 2017 as the business grows and we better leverage fixed costs through increasing scale and benefits from process renewal. For the quarter, net interest margin was 10.87%, relatively flat from the prior quarter but 63 basis points lower than a year ago. The decrease in margin percentage from a year ago was primarily driven by a decline in late fees and end of lease revenue resulting from changes in certain servicing practices, growth in lower yielding equipment finance and franchise channels, and an increase in the company's cost of funds. This was partially offset by an increase of 43 basis points in new origination loan and lease yield over the second quarter last year. The portfolio continued to perform within acceptable range in the second quarter. The allowance for credit loss reserves was 1.46% of total finance receivables. And coverage of total 60 day delinquencies was 245.9%. As we've mentioned in previous calls, it is important to note that our reserve methodology is very sensitive to small, short term changes in delinquency and loss emergence. Second quarter operating expenses were $15.1 million, compared to $12.5 million in the second quarter last year. In addition to the second quarter $300,000 charge related to the previously announced regulatory matter, the increase in other expenses from the second quarter last year was primarily due to timing differences in executive salaries and benefits, the addition of Horizon Keystone, increases to the direct team, and the timing of new equity plans. The company’s efficiency ratio for the second quarter was 56.69%, compared to 55.63% in the second quarter last year. Excluding the impact of the previously announced regulatory matter, the efficiency ratio in the second quarter of 2017 was 55.17% or 46 basis point improvement from a year ago. Our capital position remained strong in the quarter, with an equity to assets ratio of 16.67%, 182 basis points below last year. The ongoing decrease in the capital ratio quarter to quarter was by design and resulted from continued strong asset growth and share repurchases. During the second quarter, the company's board of directors authorized a stock repurchase program of up to $10 million of its outstanding shares of common stock, replacing the stock repurchase program announced in July of 2014. In the quarter, under the new and old authorizations, the company repurchase approximately 82,000 shares at an average price of $25.22 per share. Note that the impact of the repurchase will not be fully reflected in the average share count until the third quarter. $9.4 million remains available to repurchase shares under the new authorization. The manner, timing and amount of any purchase will be governed by Marlin's capital plan, which is based on an evaluation of market conditions, stock price and the availability of other attractive investment opportunities. In addition, I am pleased to report that our Board of Directors declared a regular quarterly dividend of $0.14 per share payable on August 17, 2017 to shareholders of record as of August 7, 2017. We remain focused on the precise execution of our growth strategy and maintaining our commitment to deliver strong returns, increasing net income and value to our shareholders. Now turning to our business outlook. Full year 2017 total new originations funded is expected to finish at least 20% above 2016 levels. Portfolio performance is anticipated to continue to remain within our targeted and historical range. Net interest margin as a percentage is expect to remain relatively constant for the remainder of 2017, with the continued growth in lower yielding equipment finance channels and franchise finance and updates to our historical servicing practices, offset by expected growth in the company's higher yielding Funding Stream loan business and increasing new business yields in certain equipment finance channels. And finally, we expect ROE to grow to the low teens on an adjusted basis by the end of the fourth quarter of 2017, as strategic initiatives gain traction and the company continues to improve operating scale. In conclusion, Marlin’s second quarter results reflect continued robust progress toward our strategic objectives, led by strong origination volume and new business yields, a growing portfolio, improving EPS and a higher ROE. We expect to continue this operating momentum into the second half of the year and beyond. And with that, I will turn the call over to the Operator for Q&A.

[Operator:]

[Operator Instructions] Our first question comes from Chris York of JMP Securities. Please proceed with your question.

[Chris York:]

Thanks for taking my questions. Good morning guys. So I wanted to begin a little bit by drilling down on your origination guidance, which appears conservative. So it's like calculated correctly, I have on balance sheet originations up 31%, year over year in the first half of the year. And then if I look out, 3Q appears to be a relatively easy comp. so I'm trying to reconcile these two items with the guidance, which appears low. Otherwise it may imply some meaningful consideration. So how should we be if thinking about origination growth in the second half of this year?

[Jeff Hilzinger:]

Hey Chris, it's Jeff. Thanks for the question. I think the reason for our cautiousness on origination guidance relative to the first half performance is because as Lou mentioned in his comments, we not only went through - the through the cycle analysis we did was part of a broader sort of channel profitability, return on equity process in anticipation of this year's business planning process. And from that, I think there's going to be some shifts in emphasis between the different channels that we have. And it may mean - obviously all designed to improve the weighted average return on equity for the company and to make sure that we're allocating capital and resources to the places that are the most promising. But it may mean that we have to pull back a little bit on some of the underperforming channels while we're continuing to invest in moving those resources to the well performing channels. So we don't know yet because we haven’t been through the business planning process to know exactly what that's going to look like, but we just - we thought through the guidance it might be good if we signaled that we're going to be going through that process. So we’ll be in a position I think to talk about that process we went through, the ROE process in a little more detail on next quarter's call.

[Chris York:]

Got it.

[Jeff Hilzinger:]

I don’t know Ed if you had some things that you want to add as well.

[Ed Siciliano:]

Yes. Chris, the only thing I would add is it's a good problem to have. It isn't - it’s possible that we exceed the guidance that we offered up in the beginning of last year. However, saying that, it looks like Q3 with the summer seasonality is probably going to be flat to Q2. And the other thing, and I'm sure you've noticed that we've implemented a series of price increases, so far we have not had an impact on volume as a result of doing that, but as we turn that screw a little more and look for profitability and enhance ROE, we may see some friction on volume growth as a result of getting more price out of the business. So I would expect to see that in Q3 and Q4 as we continue to look for a little more pricing, test that edge of elasticity on pricing.

[Chris York:]

Helpful. And then just to clarify on the guidance. So now you have a couple of metrics. So are we thinking about source originations or on balance sheet originations?

[Ed Siciliano:]

I was looking on balance sheet for the guidance that we gave. Source is going to be a bigger number because we're just originating more now in a wider box to sell.

[Chris York:]

Got it. So then just to clarify a little bit further, so the Q2 155, Ed, if you're thinking it’s maybe flattish in Q3 so then we should be thinking about on balance sheet of 155-ish if you will in Q3?

[Ed Siciliano:]

Yes, early in the quarter but yes, that's correct.

[Chris York:]

Okay, very helpful. And then switching to pricing which you brought up when you talked about in your prepared remarks, I'm curious to learn how much of the move in base rates have you been able to pass on to customers?

[Ed Siciliano:]

Yes. So our target for the quarter was 25 basis points as our cost of funds is increasing, Fed’s moving slowly. So we achieved that. We actually got 29 basis points on our equipment finance business. We're going to look to do that again in the third quarter, because even though the Fed did not move over the past couple of days here, our cost of funds continues to rise. So we're going to try to implement another price increase surgically again. Not all channels. Some of our major account channels, we don't have that latitude because the banks haven't moved yet. But in our micro ticket business, we do have latitude and we’re taking advantage of that.

[Jeff Hilzinger:]

I think too, Chris, as - I mean, one of the benefits we've talked about with process renewals is not just improving operating efficiency, but it improves the customer experience because value and - or speed and convenience is the value proposition and small balance lending, and it always has been and I think it always will be. So to the extent that we can deliver a customer experience that is better on those dimensions, then it allows us then I think to test the price elasticity of a convenience priced model. And so I think we need to continue to try to really press the boundaries. I think edge term of - sort of trying to discover where the edge is. I think that edge is going to move as process renewal continues to have its impact on the business and customers feel a better experience. So yes. So I think that the - I think the Fed price increase sort of gives us an opportunity, because people kind of - the market kind of expects that prices are going to go up. But even in the absence of that, I think because of the things that are unique to Marlin that are going on, there is also an opportunity for us to raise pricing.

[Chris York:]

Interesting. That’s a helpful way to think about it. So yes. And then maybe switching to the other side, right, just think about the change in deposits. And should we - how should we think about the lessons there given the changes in base rates, which was less than the increase that you just said of 29 basis points on your assets, your yields and your loans.

[Jeff Hilzinger:]

Yes. So quite frankly, you need to compare the increases on our new business yields to the cost of our incremental deposits. And the increase in yields, as Ed said, actually increased a little bit more than the deposits we bought last quarter and the quarter before from quarter one to quarter two. So we've more than covered the increase in the deposits. But one thing to note is that the deposits repriced a little faster than our yields of new business. They also tend to bake in anticipated rates a little bit more so. So it's not just that the Fed raised rates in March. That was already partially baked into the CD deposit rate. So right now we're doing a good job, not only passing it on but exceeding the increase in cost of funds.

[Ed Siciliano:]

It’s an unusual dynamic, Chris that we're able to grow origination volume and also increase price. That’s a very - in my experience, that's an unusual dynamic. And I think it's primarily because the most - most of Marlin's origination volume is coming from segments where the competition is very fragmented. So if in the more traditional vendor channels that we have like national accounts and office equipment, we find that the price - passing through price increases is a lot more difficult, then in those segments that are more retail like can have more fragmented competition. So I don't think that dynamic is probably being felt by all vendor finance companies. I would expect that that's probably not the case. But again that's - I continue to say that I think Marlin really is a unique vendor finance model. I don't even really - I talked about it with a capital V for vendor versus a small V for vendor and this is definitely a small V business and you see it - this is another manifestation of the fact that we've got - at least in the historical part of the business, it's very - the competition is very fragmented.

[Chris York:]

Great. And then maybe pulling it all together, so for guidance, your NIM guidance is essentially - well, help me clarify it. So you expect your margin maybe of 10.87 for second quarter. You said it’s expected to be flat for the remainder of the year. So that 10.87, where we should be pinning down that flat comment.

[Jeff Hilzinger:]

Yes. I would say, barring some other additional increase in market rates, we would expect our NIM to be relatively flat in Q3 and Q4. As you know, there is - there are lots of ins and outs as I commented on in my script, but I do believe that's the right guidance.

[Chris York:]

Got it. Okay. last one here and then - help us about the expectation for the use of your buyback, which you noted that you did use some repurchases here in the second quarter, because it does seem like you have a lot of uses for your capital, especially with the prospective high marginal ROEs and then potential new products that Jeff, you mentioned and like the businesses of Horizon Keystone that you purchased in Q1. And then the other thing to think about is the relatively tight amount of authority to comply with the capital agreement with the FDIC. So could you help us kind of pull that all together?

[Jeff Hilzinger:]

Yes. I can speak to the purpose of it and Taylor can talk to the impact of it. So really the purpose of that, of the shares that were bought back in the quarter, Chris, was to try to maintain flat share count from the beginning of the quarter to the end of the quarter. And that's just an ongoing objective that we have. So it's - obviously we wouldn't have done that if we didn't think that there was value at $25 a share, which we do. But so I think that perspective, coupled with the fact that we targeted a particular number of shares and you'll see as it rolls through the next quarter, you'll see that the impact is going to be that on an average basis, we're trying to keep share count flat.

[Taylor Kamp:]

Yes. I would say we take a long view of this and we do believe our strategy and believe our stock is a bargain. And so we took advantage of the fact that we had a little bit of capital. And so. It just made sense to us at the time.

[Chris York:]

Great. That’s it for me. Thanks guys.

[Operator:]

Our next question comes from Brian Hogan of William Blair. Please proceed with your question.

[Brian Hogan:]

Good morning. So going back to the originations and the outlook and the changes there, would you say it's totally credit driven over the competitive environment as well or a combination of the two? And then talk about the competitive environment as well please.

[Ed Siciliano:]

Yes. Hey Brian, it’s Ed. Hey, completely not credit driven. Approval rate, as you've seen, it’s gone down consistently over the past three quarters. Really what's driving this is a number of factors. Volume is up broad based along the lines of our core channels, certainly our investment channel, transportation franchise, product, Funding Stream. On the competitive front, I think we are enjoying a period where our primary competitors over the years, the independents, have been acquired. There’s been some disruption as a result of that. I think they're gaining a little bit of business there. Small business confidence being up, maybe predicated on some of the things that they're hoping for in Washington around healthcare and tax. But demand is strong and capital investments are being made and working capital products, our Funding Stream product is being taken for expansion. So it's really - it's not - it has nothing really to do with credit. It has everything to do with the investment we've made in new channels and some other tailwinds we have relative to competition and small business confidence.

[Brian Hogan:]

Sure. And it’s obviously driving the strong growth. And I guess maybe my question was a little bit more around the slowdown going back to the previous questions about like going from 30% growth in the first half, down to - closer to 20% and you're talking about like changing the credit boxes in this and whatever else. I guess that was more of the question, is that?

[Jeff Hilzinger:]

Yes. I think it's not just a credit box, Brian. It’s - we said since the first call I was on that yield is not a proxy for ROE. And so we've built a model that allows us to isolate the seven or eight drivers or levers that go into determining channel profitability. And we've been working through a process of optimizing, resetting those levers so that we optimize the profitability within each channel. And then we'll use the business planning process to revisit the allocation of capital to those channels that have the chance of being the most optimized. And so certainly credit boxes is one of those levers and it's an important one as is yield, but there are others as well. So we're not necessarily adjusting our credit box to try to reduce risk in an absolute sense. We're trying to adjust the credit box so that it contributes to the optimization of ROE within each channel and then changing the channel mix so that it optimizes the enterprise ROE. That's the general approach.

[Brian Hogan:]

All right. And going to the credit quality, you said through a non-recession period average over - during the past 10 years was like 1.76%. And you're below that today, but you have a different mix of business. I mean did that 1.76% adjust for business mix and because obviously you have lower yielding stuff, which is hopefully lower risk. I just kind of - because over the last year we've seen the NIM come down, yields come down. It’s starting to reverse a little bit here, but I’m just trying to reconcile some of the changes in the NIM and the write in charge offs.

[Louis Maslowe:]

Sure. Hi Brian. This is Lou. Thanks for the question. The 1.76% is a prospective through the cycle number based on our current and expected mix. So through the analysis we made adjustments for each channel based on where we see each channel going. So if you would actually do a calculation - and the 1.76 by the way is post-recession. So the total through the cycle would include the recessionary period. 1.76 is just what we’ve seen since really beginning in January of 2011 which is what we viewed as the beginning of the post-recession period. So this is the number that we're using based on our current approach and strategy to the business.

[Brian Hogan:]

All right. Moving to operating efficiency, you made a number of hires so one more to go and operating efficiency is essentially flat year over year. It sounds like it's going to start to show, but we haven't seen it yet. What gives you the confidence that it’s going to start to come through?

[Ed Siciliano:]

Yes. I mean Brian, if you look at overall headcount in the business from the end of last year, we're up 12, what is it, 11 people. And keeping in mind that 12 additions came from Horizon Keystone. So we're actually down some operational heads. We're down a couple of sales heads and we've added to the senior management team as Jeff has highlighted. And that number has basically going to be flat for the foreseeable future, certainly for the next four quarters. So holding that flat, which is being driven by process renewal and higher productivity out of the salesforce, we think that the outcome is inevitable, that you're going to see efficiency gains. It really revolves around that. Some of the cost, the expense increases year over year were driven by Horizon Keystone and additional senior staff and that's basically done. So with that finished, from here on in, it should just be slow gains on the efficiency ratio.

[Jeff Hilzinger:]

Yes. I think there’ll may be additional heads, Brian that we add to the direct lending initiative, but they may be supplied by movement away from some of the other platforms that aren't as attractive strategically or financially as direct. Like I said before, we need to kind of go through our business planning process to see exactly what the specifics of that look like, but generally speaking there's - given where a process renewal is going, there's no reason for us to have to add additional production headcount through next year. We’ve got to be able to handle the increased origination volume that's in our guidance without adding headcount. So I think the combination of continuing to use - to leverage our capital and then being able to reduce processing costs is going to have a big impact on operating efficiency.

[Ed Siciliano:]

From our perspective Brian, this quarter is the pivot point. Appreciate the skepticism, but the second quarter is the pivot point where things start to turn and we start to see the improvements because the investments have now been made.

[Jeff Hilzinger:]

I mean there's been a fair amount of investment in 2.0, Brian over the last year, really over the last three quarters, and most of that's done at this point and we're pretty much - this quarter we were, but for the second half of this year and 2018, it’s heads down focus on execution.

[Ed Siciliano:]

Yes. And Brian, before you ask the question, I would say we still stand behind our guidance that the efficiency ratio will exit the year in the low 50s.

[Brian Hogan:]

All right. That was going to be my next question, a target to still stand by and how fast do you expect to go from there? So I mean looking in 2018 then, you won’t expect further improvement from the low 50s? Is that…

[Jeff Hilzinger:]

Yes. Definitely. So I think we've given some guidance that we’ll be in the mid-40s within the next two years. So that's still the guidance.

[Brian Hogan:]

All right, and then the last one. You said low teens ROE exiting the year. So just using a 13% ROE calculates out to be about $0.54 in 4Q. Is that a reasonable number?

[Jeff Hilzinger:]

That’s a little high. Q4? Yes, that’s a little high.

[Taylor Kamp:]

I don't think that - that operating efficiency ratio isn’t the average for the full quarter, Brian. That’s coming out of fourth quarter.

[Jeff Hilzinger:]

It’s coming out of the fourth quarter.

[Taylor Kamp:]

The average you're probably getting a little higher on the EPS estimate for the full quarter.

[Brian Hogan:]

All right. Thank you for your time today.

[Operator:]

[Operator instructions]. Our next question comes from Bill Dezellem of Tieton Capital Management. Please proceed with your question.

[Bill Dezellem:]

Thank you. I have a couple of questions. First of all, Jeff you had alluded to this in response to one of the questions, but I’d like to dive into it further and that's the improvements that you’ve made in the approval, denial speed, speed of approval or denials really since you joined. Would you talk through that please?

[Jeff Hilzinger:]

Well, that’s a subset of the process renewal effort. So the operational side of credit adjudication is in scope for that team. The primary form of improving operating efficiency and credit is going to be increasing penetration of credit scoring. So that’s - we've got - and that's obviously something that Lou and our data folks are really focused on. So getting the no touch scoring up, both in terms of the average transaction size and then in terms of industries that have been previously excluded that we’ll begin including in that, we expect to see significant improvements in that. And then they’ll - having said that, there'll always be a section - there’ll always be a segment of the flow that needs some sort of manual intervention. But there's a lot that you can do even if - even in a manually accredited adjudicated flow. Improving access to internet data, presenting the data to the credit person in a way that’s already - that’s sort of already it’s attracted by the machine. It’s presented in a way that a decision could be made very quickly. I mean it's very tactical stuff, but when you compound all these things together, they can have a really significant impact on reducing credit adjudication cycle times. And I don't know, Lou if you - Lou may have something - may have a perspective as well.

[Louis Maslowe:]

Just to - just as an example, so this year we've put into enhancements to our credit scoring model that have moved up from the low 40s and auto decisions, now up to around 50%. So I mean 7% on a lot of application gains a lot of efficiency. And we’ll continue to and we’ll have at least one or two further iterations this year, and it's not about taking more risk or less risk with the credit models. It’s about just becoming more efficient by letting the decision engine make the decisions rather than having to go to individuals.

[Ed Siciliano:]

The only thing I would add is more of our business these days is being entered through a portal MarlinNet, being auto scored as Jeff and Lou were covered, being documented using EDOCS. So signatures are done electronically and the first call the customer gets is a welcome call, very, very fast and efficient.

[Bill Dezellem:]

And the things you have described, are those ones that have already been implemented or those are things still to come?

[Jeff Hilzinger:]

many of those have already been implemented, but we don't - I mean none of this stuff is really done on a big bang basis, because you really want to be - we have a tendency to approach these things through a pilot and then as - and then we iterate through what we learn in pilot and then we eventually roll those learnings out into other flows or into other channels. So all of these things, salesforce, EDOCS, CMS, the implementation of credit scoring, it's all in the process of being rolled through the company. And they’re at different points of penetration depending on which one we're talking about.

[Bill Dezellem:]

That's helpful, and I do have one additional question. Your sources of equipment finance increased I think a little over 1,200. That's the highest for some time. Would you talk about the implications of that increase in number of sources?

[Ed Siciliano:]

Yes. So those are basically vendor manufacturer relationships, and it really just has to do with the traction of the expanded sales channels. We have more relationships to draw from for daily flow of small business applications. So it's a very healthy sign overall for the business.

[Bill Dezellem:]

And do you anticipate that number continues to grow?

[Ed Siciliano:]

Over time yes, but there's also a real emphasis on penetration of those sources and maximizing wallet share within those sources. So it will grow slowly, but I think our penetration will increase at the same time.

[Jeff Hilzinger:]

Yes. I wouldn't - generally speaking, more sources is better. But the quality of the source is equally important because you can have a subset of your sources that are submitting low approval, low conversion flows and the operating burden on the system or on the economics implicit in those flows may result in a very low ROE. On the other hand, you can - you have some dealers that are completely in tune with what Marlin's about. They submit stuff that they know that Marlin is going to prove and that we know will convert, and those are very high quality dealer program. So we surveil - we're always trying to add dealers because there's natural attrition, but we have our own surveillance process that we use, both in terms of trying to figure out whether we're getting the credit quality that we want and the flows from these dealers, but increasingly looking at how attractive those flows are with respect to their overall economics, not just credit.

[Bill Dezellem:]

That’s helpful. Thank you all.

[Operator:]

Ladies and gentlemen, we have reached the end of our question and answer session. I would like to turn the call back over to Mr. Jeff Hilzinger, President and CEO for closing comments.

[Jeff Hilzinger:]

I'd like to thank everybody for your support, for joining us on the call today. We look forward to speaking with you again when we report our 2017 third quarter results at the end of October. Thank you.

[Operator:]

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.