Marlin Business Services Corp.
Q2 2018 Earnings Call Transcript

Published: 3 Aug 2018

[Operator:]

Greetings, and welcome to Marlin Business Services Corp Second Quarter 2018 Earnings 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, Lasse Glassen.

[Lasse Glassen:]

Good morning and thank you for joining us today for Marlin Business Services Corp's 2018 second quarter results conference call. On the call today is Jeff Hilzinger, President and Chief Executive Officer; Lou Maslowe, Senior Vice President and Chief Risk Officer; and 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 more detailed discussion of 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 2018 second quarter results. I will begin with an overview of the highlights from the second quarter along with our recent progress on the Marlin 2.0 strategy aimed at transforming our company from a micro-ticket equipment lessor into a broader provider of credit products and services to small businesses. Lou Maslowe, our Chief Risk Officer will comment on credit quality and Taylor Kamp, our Chief Financial Officer will follow with additional details on our financial results and business outlook. Once again, Marlin delivered a strong performance this past quarter highlighted by solid origination volume, stable credit quality and excellent earnings growth. Excluding referral volume, total origination volume was $172.2 million for the quarter compared with $155.5 million last year resulting in a year-over-year increase of 11%. Growth in the quarter was driven by continued traction in our direct origination channel which focuses on providing financing to our existing customers. During the quarter, direct origination volume increased to $36.3 million compared with $23.6 million last year resulting in a year-over-year increase of 54%. In terms of originations by product type, we also enjoyed double-digit growth in both our equipment and working capital loan products. Also in the quarter as part of Marlin's capital markets activities, we referred or sold $22.5 million of leases and loans. Due to these origination and capital markets activities, our net investments in leases and loans expanded to $963.1 million up 12% from a year ago and our total managed assets grew to approximately $1.1 billion an increase of 18% from a year ago. Importantly, we remain keenly focused on maintaining our disciplined underwriting standards as evidenced by our portfolio performance, which remains stable and within expectations during the quarter. Looking at our second quarter profitability, we recorded GAAP earnings of $0.52 per diluted share, compared with $0.36 per diluted share for the second quarter last year. On a non-GAAP basis, we also reported earnings of $6.5 million or $0.52 per diluted share compared with non-GAAP earnings of $4.2 million or $0.38 per diluted share a year ago. A reconciliation of non-GAAP to GAAP net income is available in the press release we published yesterday afternoon. I'd now like to move to an update on our Marlin 2.0 business transformation initiatives. As you may recall, through Marlin 2.0, we expect to drive growth and improve returns on equity by first strategically expanding our target market, second, better leveraging the company's capital base and fixed costs through origination and portfolio growth. Third, improving our operating efficiency by better leveraging fixed cost through scale and through operational improvements to reduce unit processing costs. And fourth, proactively managing the company's risk profile to be consistent with our risk appetite. I'd like to share with you the progress we've made on each of these areas since our last call. First, with respect to our strategic market expansion, under the Marlin 2.0 strategy, rather than thinking of ourselves as solely an equipment lessor, we are focused on providing multiple products and developing financing solutions to help small businesses grow. Along with this, we have also broadened our go-to market strategy by not only continuing to originate through our equipment vendor partners but also directly with our end-user customers. Beyond our traditional equipment finance business, we continue to be very pleased with the performance of our working capital loan product, which was introduced in 2015. During the second quarter, working capital loan origination volume increased by nearly 14% year-over-year to $16.8 million. Further, the performance of the working capital loan portfolio which rates $30 million at quarter end continues to exceed our expectations, delivering strong risk adjusted returns and contributing in a meaningful way to our overall profitability. We also remain pleased with our efforts to provide financing solutions directly to our end-user customers. A key aspect of Marlin 2.0 is leveraging our relationships with our end-user customers including our approximately 80,000 active small business customers and the 2,500 plus new customer relationships we originate each month. The objective under our direct strategy is to identify additional financing opportunities with these existing customers by offering multiple products and to create ongoing relationships with these customers by meeting a broader set of their financing needs. As I mentioned earlier in my remarks, this initiative is working well and momentum continues to build. We also made good progress during the quarter on our second key priority, which focuses on leveraging Marlin's capital and fixed costs through growth. Our continued solid origination volume and portfolio growth during the quarter allowed us to further reduce our equity to assets ratio to 17% from 17.2% in the prior quarter. Moreover, we continue to manage the size and composition of our balance sheet through our capital markets activities. During the second quarter, we sold 17 million in assets and investor demand for Marlin's product remained strong. Along with providing Marlin with another source of funding, we view these transactions as a way to optimize our portfolio by better managing its overall size and composition in terms of returns, credit risk and exposure levels to particular industries, geographies, and asset classes. As an update to comments we made on our last earnings call and as we announced earlier this week subsequent to the end of the quarter, we successfully completed an asset-backed securitization transaction issuing approximately $202 million in term notes to various institutional investors. This was Marlin's first foray into the ABS market since 2010. And as Taylor will discuss further in his comments, the transaction was very successful and exceeded our expectations in terms of the advanced rate achieved, cost of funds, and overall demand for the notes. The two primary strategic objectives of this financing were to diversify our funding sources and to release capital for growth by achieving a higher advanced rate against the securitized assets than what was being achieved in Marlin Business Bank, our wholly depository. While our cost of funds in the securitization was higher than our depository cost of funds, the transaction substantially improved our capital efficiency by releasing approximately $25 million of capital through a deeper advanced rate against the securitized assets. This will ultimately lead to higher returns on equity by allowing us to continue to grow and scale within our existing capital base. While we expect Marlin Business Bank to remain an important part of our future funding strategy, we also expect to be problematic issuer of asset-backed securities in the future as we use a mix of depository funding, wholesale funding, and capital markets activities to optimize our capital structure over time and across credit cycles. Moving on to our third area of focus, we are also making progress in better leveraging the company's fix cost through growth and by improving operational efficiencies through our process renewal initiatives. After adjusting for temporary acquisition related sales commissions, our adjusted operating efficiency ratio for the quarter improved to 54.3% from 55.2% last year. And our adjusted non-interest expense as a percentage of average managed finance receivables for the quarter improved to 6.1% from 6.8% last year. Our process renewal teams also continued to make good progress in modernizing and automating our business processes and in identifying and implementing restructuring initiatives to better position the company for future growth. Our fourth and final key area of focus is proactively managing the company's risk profile to be in line with our risk appetite. We continue to fine tune our enterprise wide risk management program that defines the aggregate level and types of risk Marlin is willing to assume to achieve our strategic objectives. While this will be an ongoing effort, our work is yielding good results. Over the last several quarters, delinquency and charge-off trends have stabilized. And our portfolio is performing within an acceptable range. Lou will provide additional details on the portfolio's performance in his remarks. In summary, we enjoyed a strong second quarter and are pleased with our performance through the first-half of 2018. Our focus remains on executing against our plan while continuing to make progress on our key Marlin 2.0 strategic objectives through initiatives like the securitization transaction this past quarter. With that, I would like to now turn the call over to Lou Maslowe, our Chief Risk Officer, to discuss the performance of our portfolio in more detail. Lou?

[Lou Maslowe:]

Thank you, Jeff, and good morning, everyone. We are pleased with Marlin's second quarter portfolio performance which remained in line with our expectations and demonstrated improved delinquencies with a modest uptick in charge-offs. Equipment finance receivables over 30-days delinquent were 97 basis points, down 10 basis points from the first quarter and up 3 basis points year-over-year. The sequential improvement observed in many of Marlin's origination platforms. Equipment finance receivables over 60-days delinquent were 56 basis points, down 10 basis points from the first quarter and up 2 basis points from the second of last year. As we noted on the last call, the higher delinquency we experienced at the end of the first quarter was a minor blip. And it returned to our historical range in the second quarter. Aggregate net charge-offs increased in the second quarter to 184 basis points of average finance receivables on an annualized basis as compared with 168 basis points in the prior quarter and 165 basis points in the second quarter of 2017. Increased quarterly and year-over-year charge-offs were evident in both our equipment finance and working capital loan products which I will address separately. Equipment finance charge-offs increased by 6 basis points quarter-over-quarter and 19 basis points year-over-year. Equipment finance second quarter charge-offs were in line with expectations and within the quarterly average and standard deviation since the first quarter of 2013 of 151 and 19 basis points respectively. The increase year-over-year is consistent with the trend we have seen since the first quarter of 2017, representing a return to more normal portfolio performance and a good economic environment. Overall, we remain comfortable with the level of equipment finance credit losses. And we anticipate that the losses will remain within the range that we have seen over the past year. Charge-offs for our working capital loan product increased in the second quarter to 600 basis of points of average finance receivables on an annualized basis from 310 basis points in the first quarter of 2018. The result in the second quarter of 2018 is the highest level of second quarter of 2017 which had charge-offs of 619 basis points. As you may recall, however, we have targeted an annual charge-off rate of 600 basis points for this product. So we remain very satisfied with the portfolio's performance especially considering that the average quarterly charge-offs over the past five quarters has been 433 basis points. Given that the average contract size and the working capital loan portfolio is $39,000 as compared to $17,000 in equipment finance, there tends to be greater volatility in the working capital loan portfolio as evidenced by quarterly standard deviation and charge-offs of 177 basis points since the second quarter of 2016. Looking at performance from a quarterly vantage perspective, 8 of the 11 cohorts since the product's inception have performed better than target with 4 of the cohorts having been fully paid out and with only 1 exceeding target. We are satisfied with quality of the portfolio and expect performance to remain consistent with our target. The allowance for credit losses was 1.62% of average finance receivables, which was down from 1.68% in the first quarter. On an absolute basis, the second quarter allowance for credit losses of $15.6 million was flat with the prior quarter. The allowance percentage improvement was driven primarily by improved equipment finance delinquency migration results which were largely offset by growth in the portfolio. Contributing to the reduction in equipment finance allowance from Q1 to Q2 was a reduction in a hurricane loss allowance for $486,000 to $359,000 due to hurricane related charge-offs. We remain confident that the hurricane loss allowance will be sufficient to address remaining losses in the restructured portfolio, of which there is remaining net investment of $2.3 million. Marlin's risk management team has numerous projects underway to further enhance the effectiveness and efficiency of our credit underwriting. An example of one these key projects is a modification to our credit criteria for existing customers. Marlin's risk committee recently approved a proposal to increase exposure appetite with existing customers based on several key factors including the customer's Marlin credit score, repayment history and transaction pricing. This strategy optimizes Marlin's underwriting for existing customers which as expected have performed better than new customers. This is an example of several initiatives in the company designed to support our direct strategy. In closing, our portfolio continues to perform well. And we remain focused on identifying changes to our underwriting at optimized risk and reward. With that, I'll turn the call over to our CFO, Taylor Kamp for a more detailed discussion of our second quarter performance. Taylor?

[Taylor Kamp:]

Thank you, Lou and Jeff, and good morning. Marlin continued its string of strong results in the second quarter. This was driven by attractive growth in originations and record portfolio size resulting in excellent earnings growth and ROE expansion, all while maintaining stable portfolio performance. Second quarter net income was $6.5 million or $0.52 per diluted share compared with $4.6 million or $0.36 per diluted share for the second quarter last year. Second quarter net income on an adjusted basis a year ago was $4.8 million or $0.38 per diluted share. One of the main drivers of the increase in earnings from last year was due to a lower effective tax rate. When adjusting for the new tax rate, second quarter 2017 adjusted net income would have been approximately $0.46 per diluted share. For the quarter, yield on total originations of 12.24% was down 20 basis points from the prior quarter and up 3 basis points from the second quarter of 2017. Having successfully passed through price increase of 25 basis points, and 100 basis points during the second quarter in the equipment and working capital loan products respectively, the decline in yield from last quarter was due primarily to change in product mix. During the second quarter, we continued implement a series of initiatives designed to further improve yields and increase origination volume. These initiatives included stepped up efforts to fill open sales positions, made enhancements to our working capital loan product to simplify the customer experience, accelerated and increased focus on our national account vendor activity and vocational vehicle program, initiated an early phase-in of a risk-based pricing model in the direct and indirect channels, and finally we accelerated work on several new growth projects, including a targeted credit score card for better quality lead generation. Referral volume of $5.6 million was up $1.4 million from the prior quarter, and down $6.7 million from the second quarter of 2017. This year-over-year decline was due to a decrease in the amount of Horizon Keystone referrals as we now have transitioned the majority of leases originated by Horizon to Marlin's balance sheet. During the quarter, we syndicated a total of $16.9 million in loans and leases. This was a little less than normal as we were focused on completing the ABS deal. We will likely resume selling at our normal pace over the next couple of quarters. This capital markets activity generated an immediate net pre-tax gain on sale in the quarter of approximately $900,000 that was recorded in Other Income. We continue to service the assets sold and will recognize servicing fees over their life. We are currently servicing almost $100 million in assets for our funding partners, which allows us to maintain an ongoing relationship with these customers in support of our direct strategy. Our investment in leases and loans grew approximately 3% from last quarter, and 12% year-over-year to $963.1 million, all-time record. Total managed assets increased 18% from a year ago to approximately $1.1 billion. As our syndication and forward flow programs continue to expand, the total managed portfolio which captures both on and off balance sheet assets serviced by Marlin will continue to grow faster than our held portfolio. For the quarter, net interest margin, or NIM, was 10.31%, down 12 basis points from the prior quarter and 56 basis points from the second quarter of 2017. The decrease in margin percentage was primarily due to the lag we are experiencing in passing through increases in base interest rates and a product mix with lower yields. We are increasing our pricing as aggressively as the market will allow, and we expect to continue passing through price increases as long as base rates are rising. Interest expense increased to 159 basis points compared with 149 basis points for the previous quarter, and 125 basis points for the second quarter of 2017. I previously indicated price increases will lag the increase in base rates, but we expect NIM to ultimately normalize to historical levels as base rate increases subside. Second quarter non-interest expenses were $16 million, compared with $16.6 million in the prior quarter, and $15.2 million in the second quarter last year. The decrease from the prior quarter was primarily due to the annual capping of payroll tax and decreases in long-term incentives from seasonal highs last quarter, both of which totaled almost $600,000. The year-over-year increase in non-interest expense is primarily due to increases in long-term incentives and sales commissions, as well as acquisition-related costs, all totaling almost $500,000. As we have previously communicated, we expect quarterly non-interest expense for the rest of the year to remain around $16 million per quarter. The company's efficiency ratio for the second quarter was 55.6%. After adjusting for temporary acquisition-related sales commissions, the efficiency ratio was 54.3%, which better reflects the company's continuing level of core operating expenses. We expect this core efficiency ratio to continue to improve in the future as we continue to leverage fixed cost through portfolio growth and operate more efficiently through our various process renewal initiatives. As noted by Jeff, we're introducing a new productivity metric as another way to measure our improving operating efficiency, which is the ratio of non-interest expenses to average total managed assets. For the second quarter, this improved to 6.1% from 6.8% in the prior year period. We believe this metric complements the operating efficiency metric by better capturing the impact of the faster growth in our managed portfolio. Our capital position remained strong in the quarter, with an equity-to-assets ratio of 17%, 36 basis points above last year. After adjusting the prior year equity balance for the new tax rate on a pro forma basis, second quarter 2018 equity-to-assets ratio would have decreased by approximately 65 basis points. As Jeff mentioned, on July 27th, Marlin Leasing Corp. had successfully issued $201.7 million of fixed rate asset-backed notes to a diverse mix of institutional investors in a private securitization transaction. This was Marlin's first ABS transaction in eight years. The notes, which were issued in seven classes, of which the top three were AAA rated, have fixed interest rates ranging from 2.55% to 5.02%, with a weighted average interest rate of 3.41%. As with all prior term securitizations, this financing will be recorded on our balance sheet as a financing transaction. I am pleased to report that investor demand was excellent. Overall, we were very happy with the terms we were able to achieve, including an initial 98% advance rate against the net book value of the collateral. Considering that our bank funding provides an effective advance rate of a little less than 85%, this ABS funding which released almost $25 million of capital, will allow us to significantly improve our consolidated leverage and drive future expansion of ROE. And finally, our Board of Directors declared a regular quarterly dividend of $0.14 per share payable on August 23rd of 2018 to shareholders of record as of August 13th, 2018. Now, turning to our business outlook for 2018, total origination volume, including referral volume, is expected to finish approximately 15% to 20% above 2017 levels. Portfolio performance is expected to remain in line with the results observed over the last 12 months. Net interest margin as a percentage of AFR is expected to be between 9.75% and 10%. ROE is expected to continue to improve in 2018 as the company continues to improve operating scale. And lastly, EPS is expected to be between $2.00 and $2.10 per share. Given our origination volume through the first-half of 2018, we've updated our original guidance of 20% growth to a range of 15% to 20% growth. The primary driver underlying this change is the near-term impact of open sales positions resulting from several restructuring initiatives that we've implemented within our sales force to better position it for future growth. In addition, we've adjusted our net interest margin guidance, of 10% to 10.25%, to a range of 9.75% to 10%. This is due primarily to, one, the lag we are experiencing in passing through increases in base interest rates. Two, our decision to upsize the recent securitization based on better-than-expected execution, and three, updated assumptions regarding product mix. And finally, as a result of our strong EPS performance during the first-half of the year we have increased the bottom of our guidance range by $0.05, and we now expect full-year earnings in a range of $2.00 to $2.10 per share. In conclusion, we had a strong second quarter and equally impressive first-half of 2018. Our momentum continues to build as we look ahead to the rest of the year, and beyond. That concludes our prepared remarks. And with that, let's open the call to questions. Operator?

[Operator:]

At this time, we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Chris York from JMP Securities. Please proceed with your question.

[Chris York:]

Morning, guys. And thanks for taking my questions.

[Jeff Hilzinger:]

Morning, Chris.

[Chris York:]

So, I'll begin on originations. Could you elaborate on the driver in the reduction in origination guidance? I'm a bit confused on the description. Does the description mean that you have let go some equipment finance sales employees, and are trying to fill the positions today?

[Jeff Hilzinger:]

No, Chris. We've used the term restructuring, and probably shouldn't have. It's more of a set of repositioning actions. So those are positions that were - we came open over the course of the year as a result of natural turnover. And lag and filling those positions was a conscious choice on our part, mostly because one of things that one of the teams is working on in terms of the repositioning actions within the sales force is identifying or clarifying exactly what the profile is that we want for candidates that we're recruiting. And it's part of an effort to create a more systematic approach to the way that we recruit and the way that we sell. And so while the teams were working on creating that new profile, it didn't make sense for us to recruit people before that was done because we might find ourselves having recruited people that didn't fit as well as if we had waited. So it was a conscious choice for us to just slow the recruitment until we had clarity around exactly what the profile was that we were trying to attract.

[Chris York:]

Okay, that makes a little bit more sense. How much - I noticed acquisition-related sales commission, how much of this was in the quarter on the non-interest expense, and is this reoccurring?

[Jeff Hilzinger:]

Chris, can you say that again or ask that again?

[Chris York:]

Yes. You call out acquisition-related sales commissions in regards to adjusting for your core efficiency ratio.

[Jeff Hilzinger:]

Right. Yes, so those are expenses related to our Horizon purchase and they're special commissions paid to Horizon based on volume. And when certain volume targets are hit those will cease. And so we're adjusting for those because we view those as somewhat temporary.

[Chris York:]

Okay. Getting back to the originations, so could you maybe provide us with the monthly volume, and then any update on July in regards to equipment leasing production.

[Jeff Hilzinger:]

In terms of average monthly origination volume?

[Chris York:]

I'm just trying to understand the trends in Q2 for origination down in the equipment leasing. So, like April, May, June, and then has it rebounded in July? Just trying to understand the trends a little bit better?

[Jeff Hilzinger:]

Yes, I mean, July's origination volume was better than the trends in the second quarter. But they were still below our plan. And we kind of expect that we'll come through in the third quarter and the whole fourth quarter and get back to more to our normal sort of guidance level as we build these open sales positions as the benefits from the repositioning actions begin to take effect. And of course, there's seasonality as well. So we're naturally biased towards having a greater than 50% portion of our total annual volume occur in the last-half of the year.

[Chris York:]

Okay. And then does the reduction in guidance here for originations impact your longer-term view either on origination volume or the size of the loans in the lease portfolio by 2020?

[Jeff Hilzinger:]

No, we still feel good about the original guidance for the three reasons that I mentioned before, in terms of continuing to regain traction through the second-half of this year. But we've also continued to aggressively pursue inorganic opportunities as well. And we have a number of interesting things that we've been looking at. And that we believe over time, as with HKF, that there will be other opportunities that'll present themselves to sort of augment or supplement the improving organic growth in the business.

[Chris York:]

Great, okay. Turning to the securitization, obviously nice to see and help begin the financial leverage story of Marlin 2.0. So you upsized the deal, is it conceivable that you will have some excess funding for some quarters?

[Jeff Hilzinger:]

Yes, it's a good question, Chris. And you saw that our NIM has been compressed a bit, in part, because of the ABS facility. Some of it has to do with our yield. But we are carrying some additional deposits, if that's the question, additional deposits that we'll be paying off over the course of the next 60 days or so. We had to ramp up a little bit. We had a maturity in deposits in June, and so had to issue some very short-term deposits to cover that. And those will be paid off over the next 60 days. So will get back some of our NIM for that purpose because they're sort of - here I call it double debt. And then just, I'll anticipate your next question on the NIM. The initiatives that we discussed around increasing yields will help that. And then elsewhere on the balance sheet, and this is how we got to our targeted guidance on EPS or we didn't reduce our guidance on EPS, is that we have some benefits elsewhere on the P&L associated with some assets sales. We'll go back to normal levels in that. We'll have sort of continued lateral expenses, non-interest expenses. Obviously we have stable credit performance. And we also have been picking up a little bit to our original plan on the tax line. And so that's really - that's how we're making up the NIM difference.

[Chris York:]

Okay. And clearly you knocked out some - and I have a follow-up, so I appreciate that. A couple more, so yes, you touched on the tax rate. Your guidance was 24 to 27, so - and you didn't -

[Jeff Hilzinger:]

Yes, we'll be at the low end of that, Chris.

[Chris York:]

Okay. And then the advance rate on the securitization, cleared up some capital, any thoughts on potentially using that for buyback?

[Jeff Hilzinger:]

Yes, that's a good question as well, Chris. So obviously between - we released about $10 million of capital when we revalued the DTL as a result of the tax law change in December. And we released $25 million of capital in the securitization, so quite a bit of capital release over the last six months. So it's been an active topic of conversation with the board about exactly how to best use that. So we believe that organic growth is probably the best use. Inorganic growth, depending on the opportunity is probably the next best use. And then, to the extent that we feel like we have excess capital beyond that, a share buyback would be a logical place to go except it's not as attractive at $31 a share as it was at $21 a share. So we're still working with the Board on trying to understand given our pipeline of opportunities, and given our sense of organic growth opportunity how much excess capital is there, and what is the best way to return that to shareholders. And we're going to continue to release capital as we remain a programmatic ABS issuer, and as we get to a more normalized mix given the credit environment that we're in between wholesale and depository funding. So it's not just thinking about the $35 million that's been released the last six months, it's also thinking about subsequent capital releases that will occur as we change the mix away from being completely in the depository.

[Chris York:]

Makes a lot of sense, Jeff, very thoughtful and comprehensive answer. And then last one, I don't want to hog all your time. You talked a little bit about the inorganic opportunities, number two in your answer there. Could you update us on what you're seeing in regards to opportunities?

[Jeff Hilzinger:]

Yes, we think about, as we've talked about in the past, we think about M&A or corporate development more broadly at sort of two levels. One would be at the product level. So we have equipment finance and working capital. And there are other products that are sufficiently different than the two that we already have that it probably would require us to acquire a platform, at least if not an entire company in order to acquire the ability to be able to originate and deliver that product. And then the other level is really kind of product extension, either within working capital or equipment finance. HKF was an example of that. And we're seeing opportunities at both levels, but we're seeing more down at the product extension level, and opportunities to - a lot more like the [indiscernible] acquisition and would have the same kind of basic rationale. So, the criteria that we use for that is we want it to be accretive from an EPS standpoint from day one, we want it to be accretive to our ROE targets within three years. And it's likely that it would be as a result of extending into products that we can leverage our infrastructure across, but give us access to markets that we would like to have access to but have had trouble accessing because these markets are filled with these current incumbents. So that's kind of the way we think about it at least at the product extension level.

[Chris York:]

Perfect. Thanks for that. That's it from me. I'll hop back in the queue, thanks guys.

[Jeff Hilzinger:]

Thanks, Chris.

[Taylor Kamp:]

Thank you.

[Operator:]

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

[Brian Hogan:]

Good morning.

[Jeff Hilzinger:]

Good morning, Brian.

[Brian Hogan:]

A question on the beta on your pricing increases, have you been able to pass on more than the increases in base rates?

[Taylor Kamp:]

Yes, we're basically using the increase in base rates, Brian, as an excuse to pass through as much price increase as we can. And so you know, we - the last quarter, our view on that was a 25 basis point increase in equipment finance would allow us to basically recapture some of the increases that have already occurred and then a 100 basis points in working capital. But you know, the price increases definitely lag as we said they would. They are probably lagging a little bit more than what we had originally thought and I think the reason for that is because we didn't see many price increases coming through at the end of last year. And that's probably because our bank competitors had excess deposits that were at a low cost. And so they were able to sort of sustain their previous - their pre-pricing - their pre-base rate increase pricing for a period of time. But now we're seeing basically everybody, banks and specialty finance companies are all raising their pricing and we're going to be on a quarterly cadence to do the same thing so long as base interest rates continue to rise.

[Brian Hogan:]

All right. That's a nice segue. My question is actually on the competitive environment. What are you seeing? Are you seeing the banks being more competitive because of the deposit pricing? Obviously, you just said they're starting to increase pricing too but what's the competitive environment like?

[Taylor Kamp:]

Yes, I would stratify it by transaction size. So we really don't see much change below 50. It's kind of the same folks competing in the same way and there are fewer banks there than there are above 50. Above 50, we definitely see as you start to get up into the 50 to 250 range, you're starting to move into the low end of the banks' appetite. And there, we're not seeing credit quality decline yet, but we definitely are seeing tightening pricing for the same credit quality. So for us - again, that's one of the reasons why I don't think it makes sense for Marlin to try to become a larger ticket player in the equipment finance base, because we just don't have the financial raw material to compete effectively. But with an average transaction size of 17 in equipment and sort of seeing the strata on the pricing break occur at around 50, there's still room for us to increase the average transaction size while staying within the competitive band that we want to be in.

[Brian Hogan:]

Sure. How much of your business is above 50?

[Taylor Kamp:]

I don't have the number off the top of my head, but it's not much.

[Brian Hogan:]

All right. Your loan originations - down quarter-over-quarter, you've been having some nice sequential increases every quarter or just - are you seeing it like a step back in demand, is it competitive, what's -

[Taylor Kamp:]

No, I think that the experience that we've had in our origination trends, it really doesn't have anything to do with the market. I mean, we continue to see lots of opportunity, market is big, it continues to be fragmented, you know, it definitely has become more competitive above 50 and I'm not saying it hasn't - it's not more competitive below 50 either, it's just less more competitive below 50 than it is above 50. I think the impact is more caused by ourselves as we are going through a process of trying to reposition the front end of our business like we did with the backend of our business last year so that we can grow and we can leverage the infrastructure that we have from an origination standpoint. So it's a conscious choice on our part to go through a set of actions that position us to be able to get back to our more normalized guidance on origination going forward.

[Brian Hogan:]

Do you expect loans to be 6%-7% of origination volume or…

[Taylor Kamp:]

Yes, well, we kind of have a guideline on working capital around 10% of origination volume, but we would like to originate more working capital loans. In our direct business, direct is growing very nicely, but the equipment finance product is growing faster than the working capital loan product. And that's not necessarily a bad thing, because we really like the risk-reward characteristics of the equipment finance business in direct, but we would like to do more working capital as well. And it's a new effort for us and we're evaluating constantly, you know, our lead generation and lead selection process. One of the reasons I think that equipment finance is growing faster than working capital is because we selected higher credit quality customers during the quarter that we marketed to and I think the working capital loan product resonated less with them than the equipment finance product did and so we had a higher take-up rate in equipment finances than working capital. So that's a learning and we're evolving and iterating our lead generation process. Taylor talked about that in one of the bullet points of the initiatives that we're working on. So we're definitely on a learning curve in terms of trying to figure out how do we dial in our marketing and how do we dial in our lead generation approach so that we can get to a mix - a product mix between equipment finance and working capital that works best for us.

[Brian Hogan:]

All right. On the syndication volume, what are your expectations for the year? There's obviously a decrease in the second quarter, was that tied to the securitization, a little lower volume because of that and do you expect it to kind of rebound going forward. And then with that what are you seeing on gain and sale yields, I mean, I calculated about a 5.4% yield this quarter, but is that like a run rate?

[Taylor Kamp:]

Yes, Brian, thanks, good question. So as we were leading up to the ABS deal, clearly the pool of assets that we were collateralizing there was overlapping a little bit with those assets we were selecting through - for syndication. And so rather than complicate that, we decreased the amount of syndication for the quarter so that we didn't muck up our selection. Our targets for the year are about $30 million a quarter. It's been a little higher, a little lower, depending on the quarter. We'll go back to that - something like that for the rest of the year by a quarter maybe a little more in the third quarter and 4% to 5% isn't a bad net gain.

[Brian Hogan:]

All right. What do you see from an economic perspective, I mean, all indications are that it's still pretty strong and are you seeing good demand across your equipment types and geographies?

[Jeff Hilzinger:]

Yes. I think that when you look at the demand from our dealers and you look at the demand from our end-user customers, I think it continues to be strong and I think when you look at our portfolio, I think it's - the performance of the portfolio, indicates, I think, the general health of small business, but I think also the psychology of small business in terms of their interest in investing in their business and investing in growth, you know, is something that we hear a lot as well. And there's some external validation as well, which I'm going to let Lou speak to a little bit here.

[Lou Maslowe:]

Yes, thanks, Jeff. One of the indexes we look at is small business lending index with Reuters PayNet Index and it's at a record high. It's available publicly, and some other indexes that we monitor as well like the national federation of independent businesses. They do a small business - index, also at a record high or a near-record high. So, all indications are that the environment remains very positive.

[Brian Hogan:]

Right. And last one from me, your efficiency ratio, obviously it's a modest improvement, you have been going back - past couple of years has been pretty flat and maybe modest improvement this quarter. Where do you see it going and how long does it take to get there? Is it sub-50 in a couple of years, can you remind us for the year? And how did you get there?

[Jeff Hilzinger:]

The bulk of the way we get there is by scaling, by leveraging our fixed cost and scale. So, I think a lot of the processes for new initiatives that we put in place have release capacity that has get the flow to the financial, because we are only partially on the path towards our scale objective. So, our modeling shows that there is a lot of scale benefit that gets released as the company's portfolio increases from what was 600 million or 700 million a couple of years ago to about a 1.5 billion or 1.6 billion. That would imply our annual origination volume is sort of the 1 billion-1.1 billion range, so we are probably a couple years - on a couple year path to get to originations to that level. And then with the 2.1 weighted average life in our portfolio on 1 billion of origination volume, we are sort of in the 1.5 billion-1.6 billion level. And we always believe scale benefits as we get bigger, but as we get above a 1.5 billion to 1.6 billion, earnings growth becomes more linear to asset growth, because we really have at that point, you know, we leverage the bulk of the fixed cost that we had. So I think efficiency ratio then is somewhere in the mid to high 40s when we get to where we are fully scaled, so…

[Taylor Kamp:]

And we should exit the year in the fourth quarter just a hair above 50.

[Brian Hogan:]

Yes.

[Taylor Kamp:]

And just back on your point about the transaction size, Brian, over 50,000 is less than 5% of our origination volume. So we really are…

[Jeff Hilzinger:]

Of the portfolio.

[Taylor Kamp:]

Excuse me; of the portfolio. Yes.

[Brian Hogan:]

Okay, thanks. I appreciate it.

[Jeff Hilzinger:]

Thank you.

[Operator:]

[Operator Instructions] There are no further questions at this time. I would like to turn the call back to Jeff Hilzinger for closing remarks.

[Jeff Hilzinger:]

Thank you for your support and for joining us on today's call. With the first-half of 2018 now behind now, we are working hard to ensure a strong second-half of the year. Overall, we couldn't be more excited about our future and the opportunity in front of us to drive shareholder value. Thanks again. We look forward to speaking with you when we report our 2018 third quarter results in early November. Thanks again.

[Operator:]

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