Santander Consumer USA Holdings Inc.
Q4 2017 Earnings Call Transcript

Published: 31 Jan 2018

[Operator:]

Good morning, and welcome to the Santander Consumer USA Holdings Fourth Quarter 2017 Earnings Conference Call. At this time, all parties have been placed into a listen-only mode. Following today’s presentation, the floor will be open for your question. [Operator Instructions] It is now my pleasure to introduce your host, Evan Black, Vice President of Investor Relations. Evan, the floor is yours.

[Evan Black:]

Thank you, Melanie. Good morning, and thank you for joining the call. On the call today, we have Scott Powell, President and CEO; and Juan Carlos Alvarez, CFO. Before we begin, as you are aware, certain statements made today such as projections for SC's future performance are forward-looking statements. Actual results could be materially different from those projected. SC has no obligation to update the information presented on this call. For further information concerning factors that could cause these results to differ, please refer to our public SEC filings. On today's call, our speakers will reference certain non-GAAP financial measures that we believe will provide useful information for investors. A reconciliation of these measures to U.S. GAAP is included in the earnings release issued today, January 31, 2018. Please reference Tables 8 and Table 9 of today’s press release or the appendix of today's presentation for further details. For those of you listening to the webcast, there are few user-controlled slides to review as well as a full investor presentation on the Investor Relations website. Now, I'll turn the call over to Scott Powell. Scott?

[Scott Powell:]

Great. Thanks, Evan. Good morning, everybody. Thanks for joining the call. So I'd like to start with a review of our 2017 highlights and some of the notable events, before I turn the call over to Juan Carlos for a detailed walk-through of the fourth quarter. So if you go to Page 3 in the presentation. I will hit some of these high points. So 2017 was a pivotal year for us, and we're really proud of the progress we've made across a broad range of regulatory and business issues, and I'll talk about some of those in a minute. So our full-year net income was $1.3 billion, which was impacted by a number of items that we will discuss and reconcile for you. The biggest item was the impact of the tax law change which added $652 million to our 2017 net income. You should know that going forward, our tax rate is going to decline pretty significantly from 36% to just over 21%, and we believe that the tax law change will be a very positive thing for our economy, our customers, and for our shareholders. So our adjusted net income was $627 million, that's excluding the tax law impact in the settlement with our former CEO and fourth quarter legal reserves. Some other notable items for 2017 include the fact that we launched a prime flow loan program with Santander Group and we executed $2.6 billion of sales and we retained the servicing on those loans. We remain a leading ABS issuer with $7.9 billion in sales, including our first ever lease securitization for $1 billion. And we're very happy to report that credit has stabilized, kind of evidenced by loss delinquency and recovery trends, and then notably our TDR balances are basically flat. So from third quarter to fourth quarter we are flat at $6.3 billion. Our 61 plus delinquency rate from the third quarter to fourth quarter of this year only increased from 5.1% to 5.4%. Our year-over-year net losses were up 60 basis points, but if you can compare that to the change from 2015 to 2016 that change was up 140 basis points. And our recovery rates, if you look at the fourth quarter of 2016 to the fourth quarter of 2017 they are down a little bit from 48% to 46%, but we feel pretty good about that. So that's pretty solid. We've continued to strengthen our management team here at Santander Consumer and we're very focused on deepening our relationship with Chrysler and improving our overall service dealers. On Chrysler, we originated $12.7 billion in 2017 and if you look at our fourth quarter originations this year versus the fourth quarter originations last year, you'll see that we are up about 12% in terms of our originations in the Chrysler program. We launched the VIP program for dealers. We increased our floorplan business that was done through SBNA by 14% and we had a very strong year for lease originations. We will continue to be very focused on increasing volume and penetration for our partner Chrysler. As I mentioned, we did complete the purchase of the stock of the former CEO or Santander Consumer, which takes SHUSA’s ownership to 68%. Of course the biggest news in 2017 was that Santander U.S. passed the Federal Reserve's capital stress test and the Federal Reserve also closed our 2014 written agreement related to dividend payments. So we're able to resume our dividend payments for the first time since 2014. And then you'll know that we are declaring a dividend of $0.05 per share that will be paying in February. That said, on the regulatory front, we do have a lot more work to do. There are two written agreements outstanding with the Federal Reserve, one from 2015 and one from 2017. And we continue to work on those issues and we are making progress. And Santander Consumer has the biggest business for Santander U.S. is absolutely critical to our future progress on regulatory issues and it’s critical to success in that category. Just a couple more comments about our immediate priorities. We are very focused on optimizing our credit and pricing models to increase our originations for Chrysler and in our core non-prime business, and as always we maintain our discipline around expenses. I guess the last comment before I turn it over to Juan Carlos is we feel really good about the strength of the U.S. economy and the [car] market. You all know that unemployment is very, very low and the economy is growing. And then on the car market, new car sales are expected to be down a bit from 2017. I guess its $17.6 million to $17.3 million. That's still very robust and then used car prices are expected to be down a bit as well. I’m not exactly sure what the number will be, but somewhere less than 5%, I would say. So we feel really good about the macro environment for business. And then just as a reminder, there is a headwind as rates rise for us. So with that, I will turn it over to Juan Carlos.

[Juan Carlos Alvarez:]

Thanks Scott. I’d like to start with a few highlights for the quarter. Q4 2017 was a good quarter for us. We generated net income of $580 million or $160 per dilutive common share. Adjusted net income in Q4 totaled $98 million or $0.27 per diluted common share. I will elaborate on these and other financial metrics in more details. Let's turn to a Slide 4, for some key economic indicators that influence or originations and credit performance. Building on what as Scott said, the overall microeconomic environment remains stable and supportive of our business. Consumer confidence remains high. GDP growth is strong and unemployment levels continue to be very low. These metrics are strong indicators of the health of the economy. U.S. auto sales remain robust with industry experts expecting a moderate decrease in 2018 from 2017. But instead of level of as Scott said that is indicative of stable and healthy market for new vehicles. We're also optimistic about tax reform and the help that it will provide to consumers. At the same time, tax reform for us will lead to more competitive pricing environment and potentially higher interest rates which can be headwinds for SC. On a Slide 5, there are a few key factors that can influence our loss severity in credit performance. We are pleased to see their auction only recovery rate to represents our auto-related recoveries from the auction links increases slightly to 43.4% from 43% in Q4 last year. Our auction plus recovery rate, which includes insurance proceeds, bankruptcy and deficiency sales was 46.4% in the quarter, compared to 47.9% the same quarter last year. Additionally, non-prime industry securitization data including net loss and delinquency trend continue to be relatively stable to moderately higher. Let’s turn to Slide 6 to cover originations. Our total core loan originations decreased in the quarter compared to 27% in the quarter compared to the prior year quarter. Total FCA quarterly originations were higher year-on-year, as Scott mentioned. Total Chrysler loan originations were flat in the quarter compared to the prior year quarter, while Chrysler lease originations continue to be a strong increasing 34% compared to Q4 last year. As we clearly communicated last quarter, our goal is to increase non-prime volume that’s our bread and butter as well as increased prime volume by continuing to leverage our flow agreement with Santander volume pricing for the appropriate risk return profile on all originations. During the second half of 2017, we set fourth new initiatives to improve our pricing as well as dealer and customer experience, which we believe will increase our competitive position in the market. We are confident in our ability to effectively execute our origination strategy in 2018 and look forward to updating you on our progress in the quarters to come. Moving to Slide 7. The Chrysler Capital quarterly penetration rate for Q4 of 2017 has been relatively stable since September at 18%, down from 21% last quarter. A reminder, in the past we provided the point in time penetration rate at the end of the quarter, but the quarterly penetration rate is more representative of our performance with FCA. Chrysler Capital volume and penetration rates are influenced by strategies implemented by FCA including product mix or higher margin vehicles and incentive. With rate increasing, we anticipate that cemented rate offerings in the market will become more competitive, which should internally to higher originations with Chrysler dealers are supposed to cash incentives offer directly to customers to more prevalent in a low rate environment. Turning to Slide 8, service for other balances have decreased versus the prior year to lower prime originations and the timing of asset sales. Looking ahead, we expect to drive the service for other platform via our flow agreement with Santander. In 2017, we executed $2.6 billion in prime or loan sales through this agreement. While we do not execute our sale in the fourth quarter, we expect to have a sale completed during Q1. Additionally, during the first quarter of 2018, we expect to complete a prime auto loan portfolio of conversion with a new third-party, which would increase our service for other balance by more than $1 billion. We intend to pursue similar opportunities in the future. Let's move to the Slide 10 and review our financial performance for the quarter. Interest on finance receivables and loans decreased 8% year-over-year primarily driven by lower average rate balances partially offset by the timing of prime asset sales. The interest expense increased 9% versus the prior year quarter primarily driven by the increase in benchmark rates over the period. Provision for credit losses decreased to $562 million in Q4 2017 from $686 million in Q4 of 2016. This decrease in provision is driven by a combination of lower balances, stabilizing credit performance and recovery rates. This quarter the other income line had a loss of $38 million driven by $140 million in personal lending customer charge-offs and $23 million determent to the market discount. These are consistent with difficulties on patterns in the held-for-sale portfolio. Turning to Slide 11, we will review vintage performance. This slide displays gross and net losses for 2014, 2015 and 2016 vintages. Consistent with our update from last quarter, our 2016 vintage continues to outperform the 2015 vintage on a gross as well as net loss basis. While it is bit premature to accurately measure the performances of the 2017 vintage, we believe 2017 will likely fall somewhere between the 2015 and 2016 vintages in terms of gross and net losses. We move to Slide 12. The 31 to 60 and 61 delinquency rate buckets of 10.3% and 5.4% in the quarter are both up 30 basis points compared to Q4 last year. Our rate gross and net loss ratios increased 20 and 40 basis points respectively in the quarter compared to Q4 last year. The year-over-year increase in both of these ratios were driven by the aging of the more non-prime 2015 vintage and a lower portfolio balance. Regarding hurricanes, on the Q3 call, we mentioned that we provided relief to our costumers via loan modifications primarily in the form of extensions and mostly in the earliest stage delinquency buckets. As a result of those modifications, we experienced a slight benefit for reported delinquency and loss figures during Q3. Now towards the end of Q4, as we expected we started to experience some normalization in delinquency and loss. In 2018, we expect the hurricane benefits to reverse mostly in the first quarter and believe that we remain adequately reserved. As a reminder, last quarter we had an incremental $53 million reserve for hurricanes. Let’s move to Slide 13 to review the loss figures in dollars. Net charge-offs for RIC remained relatively flat compared to Q4 last year. Let me briefly address the main components of the net charge-off walk. The $31 million decrease is driven by lower balances versus the prior year quarter. Our average RIC held for investment decreased approximately $1.1 billion, or 4% and also by low mix. The $18 million increase in the other category is primarily driven by loans and bankruptcy which were written down in Q4. This bankruptcy related charge-offs are primarily timing-related and would have likely otherwise occur in future quarters. Turning our attention to provisions and reserves on Slide 14. At the end of Q4 2017, the allowance for credit loss totaled $3.3 billion which is a decrease from $3.4 billion last quarter. The allowance increased $103 million due to new originations and $80 million due to TDR migration. As Scott highlighted earlier, the outstanding TDR balance in Q4 is relatively flat compared to last quarter and the increase in TDR migration have stabilized versus the prior quarter increase of $130 million. These increases were more than offset by a $90 million decrease in the allowance due to favorable performance adjustments and $204 million due to liquidations and others. Those include payoffs and charge-offs. The allowance to loans ratio was 12.6% as of the end of this quarter, down 20 basis points from the end of the prior period. Turning to Slide 15. The operating expenses this quarter totaled $426 million. Adjusted operating expenses excluding the settlement with the former CEO and legal reserves were $269 million, down 9% from the $296 million in the prior year period. This year-over-year improvement in adjusted operating expenses is driven by disciplined expense management, but also lower compensation expense and favorable marks on a portion of our derivative portfolio. The expense ratio for the quarter was 3.5%, adjusted expense ratio was 2.2%. Turning to Slide 16. Our finding and liquidity position remains strong with total committed funding of more than $40 billion. During the quarter, we offer and sold $2 billion in asset-backed securities, including our inaugural lease ABS securitization, ticker SRT. As Scott highlighted, the successful launch of the ABS platform totaled more than – the lease ABS platform totaled more than $1 billion in securities offered and sold and was a significant milestone for SC as it creates additional funding at a lower cost for our lease business. While there were no asset sales during this quarter, as I mentioned earlier, we expect to close another flow transaction with Santander during Q1. And finally, turning to Slide 17. Our CET1 ratio at quarter end was 16.3% or 14.8% excluding the significant items mentioned at the beginning of the call. Please reference Tables 8 and 9 of today's press release or the appendix for further details on those significant items and reconciliation to that. Our capital levels remain above our internal capital targets and we look forward to further optimizing our balance sheet in the future. As Scott mentioned, we’re also declaring a cash dividend of $0.05 per share for the first quarter of 2018. Now looking ahead to Q1, I’ll make some comments that will be relative to Q4 of 2017. We expect net finance and other interest income to be flat to up 2%, depending on origination volumes, including leases and the timing of Santander sales. Provision expense is expected to be down $20 million depending on new originations and credit performance. Total other income, we expect to be up $55 million to $75 million in line with seasonal patterns and lower Bluestem balances. Operating expenses are expected to be up $20 million to $40 million compared to the adjusted operating expenses in Q4, which were $269 million. And turning to taxes, over the last several quarters we talked about the benefit of SCI or Puerto Rico operation on our effective tax rate. As stated in our disclosure we have changed the classification of earnings and we no longer intend to permanently reinvest SCI related earnings. This efficient will have no impact on our servicing operation in Puerto Rico, which provides geographic diversification and enhance [indiscernible]. Looking ahead, we expect our effective tax rate to be slightly above 21%. And as mentioned earlier, we expect most of the tax benefits to support SC’s growth, increase shareholder returns and further increase professional development initiatives for our employees. And before we begin Q&A, I'd like to turn it back to Scott.

[Scott Powell:]

Thanks, Juan Carlos. Just a couple more comments, couple more topics, I’d like to share. One is the impact of Hurricane Maria on the Island of Puerto Rico. We mentioned this on the last earnings call, but I'm very proud of the fact that the Company and with our employees, we donated over $2 million for relief efforts in Puerto Rico as well as direct assistance to our employees in Puerto Rico. And so it's very important and we also assist the $81,000 Santander Consumer customers on the Island. And as Juan Carlos said, even though our tax position related to Puerto Rico has changed. We are still committed to the service center that we operate in Puerto Rico. And then the other exciting news this morning was the announcement about AutoFi. InnoVentures, which is that Santander Group’s venture fund is making an investment in AutoFi and at the same time Santander Consumer will be come part of their platform as one of their lenders, and so we're very excited about that because that really enhances our digital product offering along with our own of RoadLoans offering. It's one of those things that is positioning us well for the future. So we're very excited to be working with AutoFi. And I think with that, we will go to Q&A.

[Operator:]

Thank you. We will now open the call up for questions. As a remainder, please limit yourself to one question and one follow-up. Thank you. Our first question comes from John Hecht with Jefferies. Please go ahead.

[John Hecht:]

Thanks very much guys. First question is generally speaking the credit and the allowance and the provision pursued some of the guidance we gave us, but the provision was a bit higher on a dollar basis than you guided. And just wondering given that dollar net charge-offs were down in the TDR migration is stabilizing. I’m wondering what drove that elevated provision relative to the guidance you gave us last quarter?

[Juan Carlos Alvarez:]

Yes, thanks John. If you feel things, we were expecting a somewhat higher ALLL release. As we've discussed before in our calls, there are many variables and models that impact our allowance including gross performance, recovery and number of other things and outlook. So it was driven by ALLL expectation as well. The outlook on our credit, as we've highlighted this, we see the stabilizing and credit performance and that doesn't change versus the number in ALLL doesn’t change that view of the underlying trend.

[John Hecht:]

Pivoting and TDR migration and you're giving us some information about the 2016 vintage versus the 2015 vintage performance. How should we think about just generally speaking the ALLL trend as the step through 2018?

[Juan Carlos Alvarez:]

Our ALLL is going to continue to be driven by the same methodology as we’ve had. As Scott mentioned, our TDR balances and that’s in line with our expectations are trying to level off, okay. That's something that we've been discussing for most of 2017. We still expect that to be confirmed in the early part of 2018 and that will have a – everything else the same and leveling impact on our ALLL which will also be affected by our portfolio growth expectations in originations.

[John Hecht:]

Great. Thanks very much guys.

[Operator:]

We will go next to Chris Donat with Sandler O'Neill. Please go ahead.

[Christopher Donat:]

Good morning. Thanks for taking my questions. I wanted to ask about with the comment on stabilization in credit and then also the likely benefits from tax reform for consumers. Is it reasonable to assume the credit quality will be stable here without some sort of shock or can it even be aggressive and assume that we might see year-on-year decreases in charge-offs and delinquencies because of the benefits to tax reform or am I again ahead of myself there?

[Scott Powell:]

Yes. Chris, I think you might be getting ahead of yourself a little bit there. I wish it were true. And then I think there is a marginal positive impact on our target customers’ disposable income. There's a kind of a wide range of estimates out there. It's going to be positive. I think it will help certainly on the credit side. I wouldn’t expect a dramatic impact, but I do think it helps with the stabilization of credit and for all the other reasons that we've touched on, yes, I think we've shown really good about the environment. Our target customer is really – the delinquency rates there when you look at the macroeconomic drivers is really tied unemployment. So given where unemployment is, given the growing economy, giving consumer confidence, and then the tax law change, putting some extra money in people's pockets, I think it's going to have a positive impact. It's a little hard to know how fast and how much, but it's got to be good at the end of the day.

[Christopher Donat:]

Got it. Thanks on that. And then just one small one on the service for others portfolio, would you expect an addition of $1 billion, can you comment on the timing of that is something – that something is going to be late in the first quarter or do you see a partial impact in the first quarter and just trying to get and understand how it might affect second quarter too?

[Juan Carlos Alvarez:]

We expect it to close during the first quarter, okay. So I’ll call it – or in the middle of the first quarter, but still the impact for Q1 will be relative this month.

[Christopher Donat:]

Okay. Thank you.

[Operator:]

We will go next to Steven Kwok with KBW.

[Steven Kwok:]

Hi. Thanks for taking my questions. I guess just can you talk about the competitive environment and when we look at originations in the fourth quarter, what’s your baseline expectations on that?

[Scott Powell:]

Yes. On the competitive environment, I think it's been pretty stable. There is nothing too much to highlight there. There are some people who are bigger players, who have noted pull back in the non-prime space, but there are still a lot of competitors out there to fill in. And so we don't see anything crazy happening on pricing or anything really new to know in the competitive frame.

[Steven Kwok:]

I mean will it be a good occasion to highlight the initiatives that we put in place?

[Scott Powell:]

Yes. To your question about our originations – based on originations in the fourth quarter. We expect to improve our originations going forward. And so, we've been working really hard even on optimizing our pricing models and optimizing our credit models, so we can capture more in the segments where we do business. And we've seen some good early results from that, and so we fully expect as we move forward to be growing up the numbers you see in the fourth quarter.

[Steven Kwok:]

Got it. Scott, and just around [CCEL], I know it's kind of too early, but can you talk about what the expected impacts are that you're seeing, and are you guys try to get ahead of that by elevating your capital just so ahead of this CCEL happening in 2020?

[Scott Powell:]

Not as specifically, as you know we have excess capital compared to our internal targets. Both the ratios have been boosted by the [indiscernible], so we are not building capital specifically to CCEL. We're not getting guidance either, but it should be incorporated into our 2018 CCAR submission, but it’s something that we do, we are analyzing so you can imaging in detail. But it’s not something that is going to drive more capital expectations or planning in 2018.

[Steven Kwok:]

Got it. But how should we think about the impacts on CCEL from a reserve perspective. Is there a way you could walk us through that?

[Scott Powell:]

Was still haven't finalized the numbers and we still haven't talked about them.

[Steven Kwok:]

Got it. Just last question is if I plug in all your guidance for the first quarter I get to about a $0.40 EPS, is that in the right ballpark?

[Scott Powell:]

So we will limit ourselves for the guidance that we’ve given you. As we’ve talked about the key trends that we expect quarter-on-quarter compared to – as it relates to net finance and other interest income, provision and total other income as well as total. Our operating expenses we’re referring to see the impact of disciplined management, and then taking to account the impact of the lower effective tax rate that we highlighted.

[Steven Kwok:]

Got it. Thanks for taking the questions.

[Operator:]

We’ll go next to Mark DeVries with Barclays.

[Mark DeVries:]

Thank you. Could you discuss what plans you have for using the substantial excess capital it's been building. Is there anything you can do to distribute that to shareholders outside of the dividend that you have declared so far?

[Scott Powell:]

Well, the answer to the last question is no. I mean we have to go through the normal capital cycle with the Federal Reserve like everyone else. So there is nothing special we can do outside of that. So it all flows through the Feds capital planning success. But in terms of what we're going to do at that time, we will be investing more on employees. We've done a number of things around, for example, around improving tuition reimbursement if you do and taking the opportunity there, and do more training work on career development, you saw a lot of folks announce raising their minimum wage to $15 an hour. The entry wage here at Santander Consumer was already higher than $15 an hour even in our call centers, and so you don't feel like we need to do that. Certainly we will be thinking about ways to invest in our business and also – again, we expect competitors to be more – somewhat more aggressive probably in the marketplace. So we've got to thoughtful about that, but the majority of it we expect to hit the bottom line.

[Juan Carlos Alvarez:]

And maybe to add to that regarding the capital actions. We know what we're going to do in Q1. We just announced the increased dividend. Coming out of CCAR, we also highlighted what the expected capital actions were for Q2 and the CCAR information that we have to go through is coming up very quickly in April. And the difference as we all know now is that this time around we're in a normal capital planning cycle. So all the options are available to us in that regard, but we still have to go through there through the process.

[Mark DeVries:]

Got it, thanks. And can you just discuss first the implications on returns. As you kind of shift towards at least given your current origination the recent focus than the focus on your installment contracts. I know you're making an effort to grow that part of the business again, but can you just talk about the relative returns on leasing versus your loans?

[Juan Carlos Alvarez:]

Leasing provides healthy I think we've talked about target ROAs in the past for lease per se a good return. It’s a business that we feel comfortable with. We also talked about the improved funding platform that we have heard. That’s also going to help or has helped. And certainly we've been successful in terms of year-on-year originations with respect to continue to make good progress in there. That's supported by – let’s not forget by receivable resharing agreement with FCA. But so no more progress there, but it's not people are turning away or turning just to lease and turning away from or core non-prime and originations, right? When you look that origination stable that's where you see the significant dropped and that's what the initiatives that as Scott talked about that's what Chrysler to correct.

[Scott Powell:]

Yes, and the real focus there is on core non-prime because that’s were the biggest decline happened in originations. But Juan Carlos’ point, we will be looking to increase loan originations for Chrysler and core non-prime and then as Juan Carlos said, we're very comfortable with the leasing. So we’d expect that to grow future as well.

[Mark DeVries:]

Got it. Thank you.

[Operator:]

And we will go next to David Scharf with JMP Securities.

[David Scharf:]

Hi, good morning. Thanks for taking my questions. First off and I think you sort of partially responded to this for the prior question relating to competition. But I'm wondering during the fourth quarter and I realize that the seasonally kind of low volume for quarter maybe it doesn't give you the best reads. But were there any noticeable changes in your capture rates, particularly for your lowest sub-prime bands that give you a sense for how we ought to be thinking about first half volumes and mix?

[Juan Carlos Alvarez:]

What I would tell you is nothing and early part of the quarter, but as we got closer to the end of the quarter, some of the initiatives that Scott talked about started having an impact and improved capture rates in the channels for those were deployed. We also talked about how those trends have continued in the first few weeks of the year and that’s what encouraging about coming months. So I think those initiatives are trying to have an impact, and we expect we have more to do and expect more of it.

[David Scharf:]

Got it. That’s healthful. And as a follow-up, zeroing in on perhaps some of the inputs into your provision expense guidance for Q1 about $20 million sequentially down, is it safe to assume that based on the expectation that TDR balances may have or imminently about to peak and your other commentary about how the 2016 vintage is performing and aging that ALLL inherent in that provision expense that year is flattish from Q4 levels?

[Juan Carlos Alvarez:]

So just to be clear, we expect provision expense to be either down – from down 20 to up 20, both sides are flat. The factors that you mentioned do go into it. The TDR – our expectations about TDR will level off and we will go into that expectation, absolutely.

[David Scharf:]

Got it. Thank you.

[Operator:]

We will go next to Arren Cyganovich with Citi. Please go ahead.

[Arren Cyganovich:]

Thanks. I was wondered if you touch about the penetration rate was down quarter-over-quarter. Is that seasonal or is there is something in the mix that drove that difference between the third quarters?

[Juan Carlos Alvarez:]

Well, there's seasonality certainly on the interaction or the originations in that sense. But it pertains through the penetration rate. During Q3, we talked about how he had been let’s say relatively volatile at high to low 20s with some of the summer initiatives, and then came back down to end the quarter at 18% in September. For the fourth quarter, that penetration rate has remained very stable around 18%. Again as we make further progress on the initiatives that we disclosed, we do expect to make good progress on that penetration rate.

[Scott Powell:]

Yes. And Arren, I would add two things to you. So if you look at the origination volume for Chrysler from the third quarter – from the fourth quarter of last year, the fourth quarter of this year, there is growth there. And certainly the number of initiatives that we have around dealers, especially and making it easier for Chrysler dealers to with us is also if it's a less it's also reasonable or optimistic about the penetration rate improvement in the future.

[Arren Cyganovich:]

Great. Thank you.

[Operator:]

And we will go next to Jack Micenko with SIG. Please go ahead.

[Jack Micenko:]

Hi. Good morning. I wanted to talk first about your go forward asset yields. You've been coming down, you’ve been I think increasing cycle a bit. You said competition is stable, curves here is maybe beginning to steeped and then you talked about some new initiatives to drive more volume. So how do we in a big picture basis sort of things kind of stay the way they are comparatively? How do we think about new money yields in 2018 for the portfolio?

[Juan Carlos Alvarez:]

Yes. So the picture that you're looking at in 2017 is impacted by having originated on a relative basis less, core non-prime and having held on balance sheet prime loans, more prime loans that are later going to be sold to Santander through the flow agreement. So that in itself puts pressure on the yield number. As we look ahead with the success that we expect in terms of our originations, we expect in terms of our core non-prime originations that should help us increase the top number, the yield. And then obviously the amount of prime loans that we originate for the flow agreement are also going to have an impact, but the mix should go back more to what it had been in the past and help that line.

[Jack Micenko:]

Okay. And than I guess, Scott…

[Juan Carlos Alvarez:]

Jack if I may – so that’s the topline. The one thing to keep in mind, right and it’s very evident from the result is that the cost of funding rate has going up significantly over 2017 even though funding and spreads have tightened. That headwind in base rate is significant for us and if we expect rates to go higher as we do that’s something that we are also going to have to continue to manage through because it will remain a headwind for NIM.

[Jack Micenko:]

Okay, got it. So the topline yields maybe not translate into NIM?

[Juan Carlos Alvarez:]

Correct.

[Jack Micenko:]

And than Scott, company has build about 300 basis points of capital last year 2017, and on some reasonable asset number, maybe even goes higher or all else equal, when you talk about a target you're above that. What is the rate you need to work through some of the regulatory things? What's the right level of capital you think to run the Company and how long does it take to get to that right level with the things you're thinking about in terms of growth and dividend and other things?

[Scott Powell:]

Yes. I mean, I think we said before is that CET1 of 12.5% is the right level to run the Company. And then in terms of I guess that you're really asking about – take to get there and that's a more complicated question. That it's hard to really say. The good news is we're in a much better position as we enter the CCAR cycle with the Federal Reserve and we are in the process of thinking about what we might propose. And we haven't reached the conclusion. It has to be really thoughtful proposal in terms of how we do this, so I don't think I can give you much more guidance on that except to say as Juan Carlos said which is all the options are on the table now, just have to be thoughtful about how we progress through the process.

[Jack Micenko:]

Yes. It’s fair enough. I know that's kind of a multifaceted question. Thanks for taking the question guys.

[Operator:]

And we’ll go next to Betsy Graseck with Morgan Stanley.

[Scott Powell:]

Hey, Betsy.

[Betsy Graseck:]

Hi, good morning. A couple of follow-ups. On the growth question, obviously, number one use of the capital generated here. The question is how are you going to be thinking about getting that growth? Is that just a function? Have you got more sheet, same pricing, same risk metrics, just waiting more in, or do you expect that it would be going a little bit more down market? Are you going to be more competitive on spreads? I mean just wanted to understand where? What you're going to flex in order to generate that growth.

[Scott Powell:]

One of the things I really love about this business is the power of analytics and how this business works, and so, I mentioned that we are very focused on optimizing our risk and pricing models. So we want to make sure that we are getting paid for the expected credit losses primarily that we will experience in these different segments, and so getting the analytics right in pricing in each segment the right way can create opportunities for it. It can also create problems if you do it wrong. So we have been sending a lot of time with analytics and optimizing our pricing in the market for the expected losses. And so, yes, there's no shift to deeper credit happening here. We expect to increase our penetration rate in our traditional bread and butter markets, which is really non-prime, which is near-prime and sub-prime. And those opportunities exist with Chrysler dealers as well. And then the other thing we think that will help us with creating more originations is that whole focus on dealer service that I mentioned which is – like it or not, there's a perception, JD Power results are public. So if you look at JD Power results, you'll see that towards the bottom of the list, how the dealers feel about us. So we need to make it easier to deal with us. We need to be much more dealer friendly, we need to be much more responsive, and we are working on that. And so as dealers feel that we believe that will help with our capture rate across the board.

[Betsy Graseck:]

Okay. So on the first point, I get a non-dealer – I get the dealer point that's very clear on a first point. To analytics or not – you're leveraging the analytics to drive more business at the current rate than you did in the past that's really boiled down to, you're going to waive more business and like basically what you're saying is you could have waived more business in the past, but you didn't?

[Scott Powell:]

Yes. It's really – yes, it's not quite that black and white. It's really about optimizing the tradeoff between risk and pricing and finding the places where we feel like we've got an opportunity to capture more volume. Typically to do that, you have to go in with a lower price or more attractive structure to get that. But we think there are places where we can do that. And our early returns from those from network. That's why we believe that DRIVE increase originations.

[Betsy Graseck:]

Got it. I'm just wondering why now, is it because the tax rate has changed and so that gives you more opportunity to wave more business in? Is that – if you're not taking more risk and you’re not changing spreads than is it the tax rate that enables you to do that?

[Scott Powell:]

No, not the tax rate change. I would say it’s – we’ve made a lot of management changes going back to when I arrived here and I feel like we've got a different approach when it comes to thinking about pricing for this risk and we've also brought in other folks in the organization that know how to do it and they’ve done it before, so having best part of it.

[Betsy Graseck:]

Okay, and then just lastly on the analytics piece, I know you had a conversation earlier about tax rate change, could change how you're borrowers behave? How quickly do you think you'll be able to see that in the analytics and then how long do you have to see it in the analytics before you take action on it?

[Scott Powell:]

Well, that's a hard one. I think, yes – I don't think we'll see it quickly. I think we'll see it over time. It’s too soon. People have to see the less upholding in their paychecks and I think what I think we'll see it. It's going to take time to emerge and there are things that people do to react to that. So and that’s a big answer, but...

[Betsy Graseck:]

Yes.

[Juan Carlos Alvarez:]

Yes, it will show up. It’s just targeted dollar quickly.

[Betsy Graseck:]

Yes, I'm just wondering like once you start seeing and after see it for six months before you take action or you've been quicker than that?

[Scott Powell:]

No, I mean if we see the significant improvement and risk, we would respond to that very quickly, provided we're convinced we understand it and what causing it. And then we can publish more effectively, okay.

[Betsy Graseck:]

Okay. All right, thanks a lot.

[Scott Powell:]

Thanks. Thanks for this hard questions.

[Operator:]

And we’ll go next to Rick Shane with JPMorgan.

[Richard Shane:]

Hey, guys, couple of questions here. First of all, the debate on the quarter is really going to be the performance adjustment of $90 million. Why should we not see that as a one-time item, and can you give us a lot more specifics on what DRIVE that $90 million change?

[Juan Carlos Alvarez:]

On the $90 million – you’re talking about the $90 million adjustment in the legal reserves.

[Richard Shane:]

No, I'm looking at the…?

[Juan Carlos Alvarez:]

$90 million…

[Richard Shane:]

Yes, the performance adjustment?

[Juan Carlos Alvarez:]

Yes, ALLL. Yes, that's just a reflection of credit performance during the quarter. And you if you go back and look at earlier quarters, you'll see that is [indiscernible] positive number that that we've presented for quite a long time and the thing is speaks to the trends that we’ve discussed earlier in the call.

[Richard Shane:]

Okay, and again given that should be not a recurring, why should we not break that out from a one-time adjustments?

[Scott Powell:]

I wouldn’t say it should be – it could be reoccurring, right?

[Juan Carlos Alvarez:]

Yes.

[Scott Powell:]

Because that’s just the part of the allowance, which reflects the improved performance segments of the portfolio. So if our outlook continues to improve, we would continue to see that reduction.

[Richard Shane:]

Yes. I’m missing why we talk about it that’s a significant non-recurring. Is that…

[Juan Carlos Alvarez:]

The reason we would talk about is non-recurring is that – if credit outlook is to your credit performance is remain consistent with your expectations we wouldn't see that again that's why I'm trying to understand whether or not we should include it or not include it.

[Scott Powell:]

I think our coverage ratio has come down a little bit over the quarter. A lot of things factors as we've discussed earlier going to ALLL, but it's not a non-recurring item. Last quarter it was already positive, a smaller number. Earlier quarters had a negative, so the number will continue to grow. If credit and credit outlook continues to improve that number should continue to be there.

[Richard Shane:]

Next question. I want to talk a little bit about Bluestem. Frankly it's been for sale for so long that no one even talks about it anymore. You guys break it out in terms of your numbers and show a pretty substantial drag. If there is no resolution in terms of selling it, does it make sense to try to either buy out the contract or is there something within the existing framework that you guys can do to mitigate the impact on your earnings?

[Juan Carlos Alvarez:]

No, we are still – our intense is to sell it and thus we continue to account for it the way we do. It’s a held-for-sale portfolio and we will continue to work at it. That’s really the answer. That’s the option that we're looking at. The profitability you're talking about, Q4 was a drag, but it’s in line with the expectation that we had for the quarter. Okay, the seasonality on customer activity is very much in line with what we anticipated in that regard.

[Richard Shane:]

Understood. And again, we understand the seasonality there, but if you look at it that you guys present the numbers on an annual basis to and it’s still – it's a substantial drag, at least the way that you guys are presenting and so that really drives the question.

[Juan Carlos Alvarez:]

We are going to continue to work on finding the right solution for that portfolio and our intent is to sell.

[Scott Powell:]

We are still working on it is the short answer and we're exploring all options.

[Richard Shane:]

Thank you.

[Scott Powell:]

You bet.

[Operator:]

And we will go next to Moshe Orenbuch with Credit Suisse.

[Scott Powell:]

Good morning.

[Moshe Orenbuch:]

So most the questions I had actually have been asked and answered, but I wanted to ask quickly about the lease securitization, I mean is that open up the balance sheet capacity for other things either so as you're alliance with your parent or elsewhere and should we think about that as one way to kind of help grow the non-prime – the more prime assets and your penetration with Chrysler?

[Juan Carlos Alvarez:]

That is correct. It's incremental funding and incremental lower cost funding. So you're right in that regard, we were using funding from other facilities that are now creed by buy the amount of sale we do in SRT.

[Moshe Orenbuch:]

Got it. And I'm also kind of struck by the amount of time that the Bluestem marketing process has taken. I mean I don't know if there's anything you can kind of add to what the sticking point are and can you find someone to stand in your shoes there is because – maybe if you could just talk about that a little bit?

[Juan Carlos Alvarez:]

Yes. I mean the ballpark here is that we're not selling a portfolio, right, we're selling partnership, it's a business. And you have to find the right partner that is not just looking to put on equivalent of a securitized position in their books. They need to be to partner up for a true business and it has to work for both parts. So that’s what makes this particularly tricky and that’s why it’s taking so long. But as Scott said, we continue to work at it and explore many options here.

[Moshe Orenbuch:]

Okay. Thank you.

[Operator:]

And we will take our last question from Geoffrey Elliott with Autonomous Research. Please go ahead.

[Geoffrey Elliott:]

Hi. Thanks for taking the question. On the hurricane impacts, you mentioned that kind of flips to a negative for 1Q. Could you help quantify that a little bit and then where do we see that do we see that in the provision expense line and how big is the impact going to be that?

[Scott Powell:]

Yes, so you should see it in the provisions – you should neutral to provisions. The way we talked about it last quarter, I think it was from a follow-up question and there was little bit in the net charge-off ratio. There was a small benefit to Q3. The bulk of that benefit remains there during Q4. Okay, the benefit to the ratio. And then that should be reversed in their early part of 2018. I think we quantified it last quarter if we did the way we talked about it and saying that they wouldn’t have been flat. It was in the range of call it 20 basis points to 30 basis points on the charge-off.

[Geoffrey Elliott:]

Great, and then just following up on credit, the TDR portfolio stable pretty much this quarter, if you talk about kind of thinking and starting to decline into 2018? Can you give us a sense of how much you think that could come off and what you think I could free up in terms of reserves?

[Scott Powell:]

Yes, so to clarify we are not expecting it to pick. We're expecting it to level of, okay. We're always going to have and we certainly don't expect to come down. We're always going to have TDR flow at after they very rapid growth we’ve had when we changed our methodology and we're seen starting to see the leveling off that we anticipated and as we go forward this should just be moving in line with our portfolio growth and the mix of our portfolio. There is not a big going to come down is a leveling off.

[Geoffrey Elliott:]

Great, thanks very much. End of Q&A

[Scott Powell:]

Okay. Well thank you everyone for joining the call. Thanks for your interest in our company and certainly can reach out to Evan and our investor team if you have any questions and I look forward to chatting with you the next quarter end. Thanks.

[Juan Carlos Alvarez:]

Thank you.

[Operator:]

And that does conclude today’s call. We thank you for your participation. You may now disconnect.