VersaBank (TSX: VB) Q3 2022 earnings call dated Aug. 31, 2022
Corporate Participants:
David Taylor — President and Chief Executive Officer
Shawn Clarke — Chief Financial Officer
Analysts:
Greg Macdonald — LodeRock Research — Analyst
Bradley Ness — Choral Capital — Analyst
Presentation:
Operator
Good morning, ladies and gentlemen. Welcome to VersaBank’s Third Quarter 2022 Financial Results Conference Call. This morning VersaBank issued a news release reporting its financial results for the third quarter and year-to-date ending July 31st, 2022. That news release along with the Bank’s financial statements and supplemental financial information are available on the Bank’s website in the Investor Relations section, as well as on SEDAR and EDGAR. [Operator Instructions] I would like to remind our listeners that the statements about future events made on this call are forward-looking in nature and are based on certain assumptions and analysis made by VersaBank management. Actual results could differ materially from our expectations due to various material risks and uncertainties associated with VersaBank’s business. Please refer to VersaBank’s forward-looking statement advisory in today’s presentation.
I would now like to turn the call over to Mr. David Taylor, President and Chief Executive Officer of VersaBank. Please go ahead, Mr. Taylor.
David Taylor — President and Chief Executive Officer
Good morning everyone and thank you for joining us for this call. With me today are Shawn Clarke, our Chief Financial Officer. Before I begin, just a quick reminder regarding the adjustments we made last quarter to the way we are describing our business and our quarterly results. These include breaking out non-interest expense into its component Digital Banking and DRTC parts, who provides a clear picture of the individual performance of each of the operations and enabling better comparison to our peers in each sector.
In addition, within our Digital Banking operation, we now present net interest margin based on both total assets as this convention with publicly traded Bank of Canada, as well as excluding cash securities and other assets from total assets as is the practice of US banks. Finally, we began report our efficiency ratio for only our Digital Banking operations, which excludes the impact of DRTC.
Now onto the results for the quarter, which are reported and will be discussed on this call in our reporting currency of Canadian dollar. I will note that we provide US dollar translations for most of our financial numbers in our standard investor presentation, which will be updated and available on our website shortly. The third quarter saw outstanding loan growth in our core Digital Banking operations, as a 75% year-over-year and 24% sequential increase in our Canadian Point-of-Sale Financing business drove our loan portfolio to another new high of more than CAD2.8 billion and I will note that 75% year-over-year growth batters very healthy 51% year-over-year growth in the Canadian Point-of-Sale portfolio last quarter.
It is worth mentioning here that we see this growth with essentially no impact on our interest margin and without relaxing our stringent credit. Continued growth in our loan portfolio drove record quarterly revenue for the third quarter, both for Digital Banking operations and on a consolidated basis. We achieved near record profitability as we returned to both year-over-year and sequential growth in net income, even with net income be dampened by transitory non-interest expenses related to future growth initiatives that we believe will accelerate our growth in both the near and long-term.
Specifically, we continue to incur short-term costs related to our acquisition of a national US bank, which I will discuss more in a moment, development of the equivalent of our highly successful point-of-sale financing solution for the US market, continued preparation for launch of our Canadian dollar version of our revolutionary Digital Deposit Receipts, as well as incremental costs associated with listing on NASDAQ last September.
Combined, these transitory costs [Technical Issues] approximately CAD3 million to our Q3 non-interest expenses. We expect these costs to dissipate over the fourth quarter and return to normalized levels for 2023 and these transitory costs third quarter 2022 net income would have been by far our best quarterly profitability in our history.
John will discuss the financials in more detail in a moment. In addition to our strong financial performance, the major highlight for the third quarter was the announcement of our signing of a definitive agreement to acquire a fully operational OCC chartered national US bank, Minnesota based Stearns Bank Holdingford. This is a transformational next step VersaBank’s long-term growth strategy something has been a priority for us for several years and one of the key reasons for our NASDAQ listing.
We are steadily progressing towards closing the transaction which we expect by the end of the calendar year. We renamed VersaBank USA upon closing, Stearns Bank Holdingford forward will provide VersaBank with a platform from which to rollout our immensely successful Canadian Point-of-Sale financing model to underserved US market, while substantially the same as our Canadian Point-of-Sale offering going forward, you will hear us refer to the US version of this program as our US receivable purchase program, which is the language that is more consistent with US market environment.
We are currently enjoying working with the teams holding for current company’s turns financial and look forward to exploring future opportunities for collaboration to our mutual benefit. Our Q2 earnings — on our Q2 earnings call, I discussed having signed up our first customer, the limited early rollout of our receivable purchase program in the US, that customer is a large North American commercial transportation financing business, focused on independent owner-operators. They are great example of the inherent value of our offering, addressing an unmet need the market by providing highly flexible and economically superior technology based outcome. They have already significantly expanded their business with us.
The US customer and small business point-of-sale financing market is massive, CAD1.8 trillion and growing rapidly. Our unique and attractive solution arrives at a time when one of the two primary sources of funding for point-of-sale business in the US, the public market is all but trade up. We are continuing — we continue to be very encouraged by the discussions we’re having with potential partners in the US and very much look forward to closing on our US bank acquisition to be able to fully capitalize on this opportunity.
I’d now like to turn the call over to Shawn to review our financial results in detail. Shawn?
Shawn Clarke — Chief Financial Officer
Thank you, David. Before I jump in folks, just a quick reminder that our full financial statements MD&A for the third quarter and year-to-date 2022 are available on our website under the Investor Relations section, as well as on SEDAR and on EDGAR. And as David mentioned, all of the following numbers are reported in Canadian dollars as per our financial statements unless otherwise noted. Starting with an overview of the balance sheet, total assets at the end of the third quarter surpassed CAD3 billion mark first time CAD3.1 billion, up 35% from CAD2.3 billion at the end of Q3 last year and up 14% from CAD2.7 billion at the end of the second quarter of this year.
Cash and securities at the end of Q3 was CAD218 million or 7% of total assets, down from CAD297 million or 13% total assets with the end of Q3 last year and up CAD198 million or 7% total assets at the end of Q2 of this year. These trends are the result of the Bank deploying cash into higher-yielding lending assets and lower securities over the course of the quarter. Our total loan portfolio at the end of the third quarter proves another record balance of CAD2.81 billion, an increase of 44% year-over-year at 15% sequentially. I’ll come back to this in a moment.
Book value per share increased 8% year-over-year and 2% sequentially to CAD12.14, which is also a record for the bank. These trends are both a function of higher retained earnings resulting from net income growth, partially offset by dividends paid with a year-over-year increase also being impacted by our common share offering in the US last September.
Our CET1 ratio was 12.51% up from 11.94% end of Q3 of last year and down from 13.6% at the end of Q2 of this year, while our leverage ratio at the end of Q3 was 10.38%, up from 9.99% last year and down from 11.63% at the end of Q2 of this year, with our CET1 and leverage ratio remained well above our internal targets.
Turning to the income statement, total consolidated revenue increased 35% year-over-year to 14% sequentially to a record CAD21.2 million with the increase driven primarily by higher net interest income from our Digital Banking operations, resulting from strong growth in our loan portfolio as I mentioned earlier. As David noted previously, we returned to both year-over-year and sequential growth consolidated net income in Q3 increases of 5% to 16% over the respective periods. Net income for Q3 was CAD5.7 million and as with the case in Q2 was dampened by a number of transitory costs related critical investments in several strategic growth initiatives, including the US bank acquisition, the launch of the US version of our Point-of-Sale offering and preparation for the launch of our Digital Deposit Receipts all incurred in advance of these initiatives generating incremental profitability for the bank.
Transitory costs also include certain elevated costs resulting from our listing on NASDAQ, which we’ve been able to reduce substantially commencing in early August. As David noted previously, these transitory cost totaled approximately CAD3 million for the current quarter. Earnings per share for Q3 was CAD0.20 which is down 20% year-over-year due to the higher number of shares outstanding result — sorry, higher number of shares outstanding resulting from the issuance of 6.3 million common shares under our US IPO in September of last year.
Earnings per share was up however sequentially by 18% I want to reiterate David’s comments earlier that we expect the costs associated with the strategic business development initiatives to mitigate somewhat in the fourth quarter and return to normalized levels for 2023.
The strong growth in our overall loan portfolio is driven by our Point-of-Sale Financing business which increased 75% year-over-year and 24% sequentially, reaching the CAD2 billion mark. This growth continue to be driven mainly by strong demand for home finance, home improvement, HVAC and other receivable financing. Our Point-of-Sale portfolio continues to expand a portion of the overall portfolio as well as per our strategy now representing 71% of our total loan portfolio as at July 31st, up from 66% last quarter.
Our Commercial Real Estate portfolio increased 1% year-over-year and decreased 3% sequentially to CAD804 million at the end of Q3. As we noted last quarter, management has taken a more cautionary stance perspective in commercial portfolio due to expected volatility and valuations within this asset class in a rising interest rate environment and the potential impact of same in the borrower’s ability to service debt, as well as due to concerns related to higher commodity prices attributable to current global supply chain disruptions and a very tight labor market, both of which have the potential to drive higher construction costs. Notwithstanding our cautious approach, we remain very comfortable with the risk profile of our Commercial Real Estate portfolio, which as well established well capitalized development partners and further which post modest loan-to-value ratios on individual transactions.
Turning to the income statement for our Digital Banking operations, net interest income for this segment for the third quarter increased 38% year-over-year and 16% sequentially to a record CAD20.1 million. These increasing trends were both primarily a function of loan growth in the respective periods. Net interest margin on all interest generating assets for Q3 was 2.76%, essentially unchanged from the second quarter of 2022 — second quarter of 2022 and up from 2.61% from Q3 of last year. Year-over-year increase was primarily the result of higher yields earned on loans and liquid securities. Net interest margin excluding the impact of cash, securities and other assets for Q3 was 3.07% compared with 3.43% in the same period last year and 3.11% for Q2 of this year. These modest increases are primarily the result of changes in the Bank’s funding mix.
Non-interest expenses for the quarter of CAD13.2 million compared to CAD8.2 million for Q3 of last year and CAD11.8 million for Q2 of this year, both increases were due primarily to higher costs, approximately CAD3 million of which were in transitory nature related to strategic growth initiatives and our NASDAQ listing which we discussed earlier this morning. The year-over-year increase was also a function of higher salary and benefit expense attributable to higher staffing levels to support expanded business activity across the Bank, higher costs associated with employee retention and higher office and facility related costs attributable to the implementation of the bank’s return to work strategy.
Cost of funds for Q3 was 1.94%, which represents an increase of 53 basis points year-over-year and 56 basis points sequentially, primarily the result of a higher interest rate environment and change in the bank’s funding mix. Notably we increased for significantly less than the Bank of Canada’s benchmark increase it was up 50 basis points during the quarter, as well as a result of our continued focus on ultra-low funding low cost funding sources primarily derived from insolvency professional deposits.
Insolvency professional deposit balances contracted slightly in Q3, despite adding more partners as we experienced a lag effect of the Government of Canada’s COVID 19/support and historically low bankruptcy activity, by recent increases, bankruptcy activity is still well below pre-pandemic levels. As a result, our insolvency professional deposit comprise a smaller portion of our overall deposit base this quarter. We do however expect return to growth in our insolvency professionals deposits in early fiscal 2023, driven by an anticipated increase in the volume of consumer bankruptcies, which historically accompany the rising interest rate environment and as we continue to add new insolvency professional partners.
Our provisions for credit losses in Q3 once again recited a prudent risk mitigation strategy inherent to our lending models and outstanding credit quality of our loan portfolio. For Q3, we recognized provision for credit losses or PCL in the amount of CAD166,000 compared to pre-sales mean out of $96,000 in the same period a year ago and $78,000 in Q2 of this year. These sales are percent PCL as a percentage of average loans was 0.03% this quarter compared with the 12-quarter average of negative 0.01%, which continues to be amongst the lowest of the publicly traded Canadian federally licensed banks.
Gross impaired loans at the end of Q3 were CAD1.4 million was CAD1 million about amount having being repaid two days at the quarter end and the remaining CAD400,000 scheduled to be repaid early September of this year. Turning now to DRTC, our Cybersecurity Services and Banking and Financial Technology Development operations. Revenue and gross profit which are generated entirely by the cybersecurity services component of the business increased 7% and decreased 2% year-over-year to CAD2.1 million and CAD1.2 million respectively. Revenue and gross profit were down 12% and 17% sequentially. The sequential decrease were a function of lower engagements over the course of Q3. However, on a year-to-date basis both revenue and gross profit were up 27% and 26% respectively.
Importantly DRTC services business continues to be profitable despite incurring higher salary and benefits and business development costs. DRTC on a consolidated basis reported a net loss of CAD0.7 million compared to net income of CAD0.2 million in Q3 of last year and a loss of CAD0.5 million in Q2 of this year, with the loss being driven by cost outside of cybersecurity services business related to work on strategic growth initiatives including DRTC’s work on the Bank’s Digital Deposit Receipts, as well as our technology development initiatives that are not yet contributing to revenue.
I’d now like to turn the call back to David for some closing remarks. David?
David Taylor — President and Chief Executive Officer
Thanks, Shawn. Finally, before I open the call up for questions, a quick update on our Canadian Digital Deposit Receipts which I know is of great interest to many of you and which represents a significant opportunity within our low cost deposit funding strategy. But before I do that, I want to be clear with respect to VersaBank’s exposure to the so called cryptocurrencies, quite simply, we have not. We hold no such assets, we never have, accordingly our balance sheet has in no way have been impacted by the meltdown in the cryptocurrency market.
If anything, we expect to benefit from this meltdown, our Digital Deposit Receipts represents an attractive alternative to the unregulated stablecoin market, with the goal of providing individuals and businesses with a highly encrypted interest earning Digital Deposit with a Federal regulated bank that can also be used for transactional purposes.
Recently the Canadian Office of the Superintendent of Financial Institutions published an advisory entitled interim arrangements for regulatory capital and liquidity treatment of crypto asset exposures. We at VersaBank applied OSFI’s leadership in this regard as we fundamentally believe that a regulated industry is the best interest of the users of the digital currency. We are confident that our Digital Deposit Receipt model is consistent with the content of OSFI’s advisory as we continue to evolve our model amidst the changing macro environment.
We look forward to providing updates on our progress towards commercial launch, as we continue our constructive discourse with OSFI to ensure their prudential comfort. Our cybersecurity business and DRTC continues accretive to the Bank’s overall earnings, although still relatively small part of our P&L, DRTC overall plays a critical role in our competitive advantage as a digital bank combining technology development for our own internal benefit, with a significant growth opportunity and rapidly expanding market is the best of both roads.
The third quarter of 2022 a strong evidence of the ability of our Digital Banking operations to generate outsized growth as we continue to grow our loan portfolio, led by continued success and expansion of Canadian point-of-Sale financing business. We expect continued momentum throughout the remainder of the year and into 2023, as consumer spending is expected to remain robust, although likely somewhat moderate from 2022 levels due to the Bank of Canada’s actions and our unique solution continues to be very attractive source of financing to our partners.
We expect this to support increased volumes contributing to continued strong growth in the Point-of-Sale portfolio. Our success and growth of our Point-of-Sale solution in Canada gives us great confidence around our opportunity in the significantly larger US market. On closing our US acquisition, which will provide access to ample US dollar deposit funding, we expect to significantly ramp up our US Receivables Purchase Program, signing up new partners and expanding business with existing partners.
With each passing month, we’re seeing for more potential opportunity for our unique solution in the US as an attractive option for consumer and small business point-of-sale finance firms. At the end of the day, our businesses are very simple one, the larger our loan portfolio, the greater our profitability and with the anticipated continued strong growth in the Canadian Point-of-Sale portfolio and the significant opportunity with our US Receivable Purchase program, the opportunity for outsized net income growth has never been better.
With that I would now like to open the call to questions. Operator?
Questions and Answers:
Operator
Thank you, Mr. Taylor. [Operator Instructions] Your first question comes from Greg Macdonald, LodeRock Research. Please go ahead.
Greg Macdonald — LodeRock Research — Analyst
Thank you. Good morning, David. Good morning, Shawn. How are you guys?
David Taylor — President and Chief Executive Officer
Very good. Thanks, Greg.
Greg Macdonald — LodeRock Research — Analyst
Good. Hey, I just have two questions and then I’ll pass it on to the others. First is on DRTC, you talk about a sequential decline in revenue and then the press release itself talks more also about growth continue to be expected in that business, specifically benefiting from investments made in 2022. Can you just talk overall about the business outlook there and is that specifically the issue? It’s getting a number of products in the suite that kind of sets that business up for growth. Is that still a business that we should expect double-digit growth on a sustainable basis? And then I have a second.
David Taylor — President and Chief Executive Officer
Well, there is some seasonality in DRTC’s business particularly with DBG, our Digital penetration tester. So I — we expect towards the end of the year, it will come back if it does normally. Some of the new products that we’ve been working on have now been launched and have been quite well received and we’ve got one contract signed and maybe two more to go. So we’re pretty excited about that — in that some of these products took a little while to develop. There is another aspect to type testing we do that we’ve been engaged by a very large Canadian corporate and there’s a lot of revenue associated with that.
So generally speaking, what we’ve been working on so to speak in the skunk-works is now coming to market ready products and in fact, has been — has and contracted by some parties already. So it looks very good for DRTC.
Greg Macdonald — LodeRock Research — Analyst
And is pen testing still the major demand in that business?
David Taylor — President and Chief Executive Officer
It is now, but there is another aspect to pen testing, app testing is an area that we are growing in quite rapidly. And then this compliance with anti-spam legislation software that we developed is very popular too. So, that’s something we developed internally and seems to be very well repeated by the marketplace.
Greg Macdonald — LodeRock Research — Analyst
Okay, thanks for that. And the second is on the insolvency deposit strategy, this is something that’s interesting to me. I would have expected more small business still yours to drive — to drive more insolvency growth and we haven’t really seen that increased interest rates certainly almost certainly going to drive consumer insolvency. Can you talk — you state specifically that you expect growth in early 2023 which suggest to me that you’re getting some signals from the market, I know you’re adding partners, but can you talk generally about what you’re seeing there and the level of growth you expect in that part of the deposit structure?
David Taylor — President and Chief Executive Officer
Well, we are still the first like Statistics Canada is reporting. We’re still about 10% less than normal in a Solvency Canada, but on top of 35 year low. So the 10% less tends to dampen the deposits that we raise in that area and also there is quite a lag effect. So we’re still seeing a little contraction in our deposits even though we’ve signed up some new partners, the 35-year low is still sort of impacting our deposits.
Now I expect that things as most people do and can do, Greg, it is increasing interest rates kind of create fair amount of [Technical Issues] for people and small them, that’s living on the edge and that’s 10% below normal insolvencies and proposals will probably get up to 10%, 15% above normal and with about a six month lag, put the 2023 with significantly increasing deposits.
Greg Macdonald — LodeRock Research — Analyst
Okay, that’s helpful. Thanks, David. I’ll pass it on.
Operator
[Operator Instructions] Your next question will come from Bradley Ness of Choral Capital. Please go ahead.
Bradley Ness — Choral Capital — Analyst
Hello gentlemen. Can you hear me?
David Taylor — President and Chief Executive Officer
Sure, can, Brad.
Bradley Ness — Choral Capital — Analyst
Great. I just wanted to delve a little bit into the CAD3 million of the transitory costs. Can you break that down for me a little bit?
David Taylor — President and Chief Executive Officer
Yeah, certainly, Brad. About 60% of it would be legal consulting primarily to do with the Stearns acquisition and the refinement of the US receivable program, it’s about 40% or so that’s associated with savings, we’ve got renewal of our directors and officers liability insurance. But when we listed on the NASDAQ, we agreed to a premium of about CAD3.6 million per year for that insurance and we subsequently renewed it with about a CAD2.1 million savings in August just now. So those are real, they’re really transitory costs and certainly we can look forward about CAD500,000 per month reduction in D&O expenses to do with the NASDAQ.
There was also some NASDAQ cost that we had used outside parties to do the reporting and now we’re doing that internally.
Bradley Ness — Choral Capital — Analyst
Okay, great. Thank you. And I’m just trying to look at my math here, you said the CAD500 reduction per month, so that CAD3 million right there and that just related to the D&O expense.
David Taylor — President and Chief Executive Officer
No, sorry, that’s 500 — it was CAD2.1 million per quarter.
Bradley Ness — Choral Capital — Analyst
Okay, per quarter. Got it. So that should fall off in August and with the other 60% of that CAD3 million basically fall off once you complete the acquisition you think?
David Taylor — President and Chief Executive Officer
Absolutely, will tail-off a little bit in the quarter we’re now and that we’re very close to submitting the application OCC in the Fed for the acquisition, but I can’t say for sure with legal expenses will occur a little bit, but we believe we’re sort of at the tail end now of the creation of the application and the consulting fees and the legal should tail off and diminish in first part of 2023.
Bradley Ness — Choral Capital — Analyst
Okay, great, thanks. And regarding the DRTC, it seems like revenue has been flat, but expenses have grown CAD1 million versus the year ago quarter. It does seem like you’re incurring some VCAD expenses in there, is that correct?
David Taylor — President and Chief Executive Officer
VCAD expenses and expenses with respect to the sort of skunk-works type projects that we’ve got going on in DRTC, so yeah, we’ve got some — we think some exciting projects that we’re not ready yet to reveal it.
Bradley Ness — Choral Capital — Analyst
Okay. And when I think about how you divided up the bank with the digital bank and DRTC and financial reporting, if you’re incurring a fair amount of costs from VCAD in DRTC, is that where the VCAD is going to show up entirely in DRTC, is it just going to be partially in DRTC?
David Taylor — President and Chief Executive Officer
It would show up in the bank, it’s a bank product that DRTC is providing the service, so little bit service agreement with between DRTC and the bank, basically the DRTC owns we call VersaVault and VersaVault is a key technology for the issuance of these digital [Technical Issues].
Bradley Ness — Choral Capital — Analyst
Okay, maybe as a recommendation, if you could break out kind of the VCAD related expenses from DRTC, it would clean it up for me would definitely be appreciated. But let’s see two more and then I’ll open up to someone else. So what is the balance of the US Point-of-Sale loans now?
David Taylor — President and Chief Executive Officer
I think it’s CAD39 million right now US.
Bradley Ness — Choral Capital — Analyst
CAD39 million. Okay, thank you. And lastly, here on the VCAD commercial launch now that you are totally within the OSFI guidance, what’s the timeframe then as you’re thinking about that launch?
David Taylor — President and Chief Executive Officer
Well, I’m thinking about it before the end of our fiscal year, which is October 31st. And yes, as I said in the presentation, I was very pleased of OSFI came out with definitive guideline because it’s now early for us to tick the boxes with our Digital Deposit Receipt. They’ve given a nice list of a Group one crypto asset they call it from our perspective, it’s crypto liability. So we’re very pleased to see OSFI come out with that that clear direction. So presently, we are just going over our product and ensuring that it meets OSFI guidelines completely.
Bradley Ness — Choral Capital — Analyst
Okay. You think that’s a two-month process, I know you guys are ready to go six months ago or so maybe the longer?
David Taylor — President and Chief Executive Officer
It might be less, see we are working with OSFI FINTRAC and TDIC to ensure they’re comfortable with it and some — so to say with the wind know before it’s time they move we should say. I’d like to go of course a lot faster, I live in a fast fact world, but we think it’s wonderful product, it’s a product that the market wants, it’s absolutely one since the stablecoin industry meltdown and we think it also provides a huge increase in the security of a bank’s deposit utilizing distributed ledger and highly encrypted, so it’s a quantum leap I think in the banking industry over what is presently renewed. So I mean I’d love to go faster but [Technical Issues] be a little bit by the end of the year.
Bradley Ness — Choral Capital — Analyst
Okay, thank you gentlemen.
David Taylor — President and Chief Executive Officer
Thank you, Brad. Look forward to seeing some time.
Bradley Ness — Choral Capital — Analyst
Got it.
David Taylor — President and Chief Executive Officer
Okay.
Operator
Mr. Taylor, there are no other questions from the phone line sir. I will turn the call back to you for closing remarks.
David Taylor — President and Chief Executive Officer
Oh, really. Well, I’d just like to thank everybody for dialing in and those asking questions and look forward to talking to you again at the end of our fiscal year. Thank you.
Operator
[Operator Closing Comments]