OneMain Holdings, Inc. (OMF) Q2 2018 Earnings Report, Transcript and Summary

Welcome to the OneMain Financial Second Quarter 2018 Earnings Conference Call and Webcast. Hosting the call today from OneMain is Kathryn Miller, Vice President of Investor Relations. Today's call is being recorded. [Operator Instructions]. It is now my pleasure to turn the floor over to Kathryn Miller. You may begin.

Thank you, Brandi. Good morning, and thanks for joining us. Let me begin by directing you to Pages 2 and 3 of the second quarter 2018 investor presentation, which contain important disclosures concerning forward-looking statements and the use of non-GAAP measures. The presentation can be found in the Investor Relations section of our website. Our discussion today will contain certain forward-looking statements reflecting management's current beliefs about the company's future financial performance and business prospects. And these forward-looking statements are subject to inherent risks and uncertainties and speak only as of today. Factors that could cause actual results to differ materially from these forward-looking statements are set forth in our earnings press release. We caution you not to place undue reliance on forward-looking statements. If you may be listening to this via replay at some point after today, we remind you that the remarks made herein are as of today, July 31, and have not been updated subsequent to this call. Our call this morning will include formal remarks from Jay Levine, our President and CEO; and Scott Parker, our Chief Financial Officer. After the conclusion of our formal remarks, we will conduct a Q&A period. So now let me turn the call over to Jay.

Thanks, Kathryn, and good morning. We had a strong second quarter as we continue to execute on all of our key strategic priorities. Our ongoing commitment to consistent underwriting and appropriate risk-adjusted returns coupled with the growth of our portfolio's secured mix drove our second quarter results. The growth of our portfolio's secured mix has been a key focus. Secured lending contributes stronger credit performance to our portfolio, enhances the operating leverage of our model and provides our customers with options for their financing needs. Ending net receivables were up 11% versus last year, primarily driven by the growth of secured lending, which reached 44% of the total portfolio versus 40% last year. In addition, credit performance continued to strengthen, both net charge-offs and our 90-day delinquency ratio improved in the second quarter versus last year. We also achieved solid operating leverage, while reinvesting in our business. As a result, our Consumer & Insurance segment reported a $1.18 of adjusted diluted earnings per share. In addition, we further strengthened our balance sheet during the second quarter. We continue to increase the proportion of longer duration unsecured borrowing, we increased the capacity of our conduit facilities and most important, we further reduced our tangible leverage ratio. So all in, the continued execution across our key strategic priorities is yielding strong financial results. Accordingly, with the benefit of our first half performance and the continued stability of the U.S. consumer and the overall economy, we are updating the outlook for a few of our 2018 strategic priorities. We now expect ending net receivables growth between 8% and 10%, net charge-offs between 6.5% and 6.7% and our secured funding mix to be between 50% and 55%. Meanwhile, we remain well on our way to achieving our tangible leverage target of 7x by year-end. And while I'd said it before, it's worth repeating, Apollo and Värde support the prioritization of these key objectives with the same passion and conviction as our management team and our 10,000 team members. By maintaining our focus on these strategic priorities, we are enhancing the fundamental trends that drive resiliency in our portfolio, profitability in our business and long-term value creation for all shareholders. With that, I'll turn the call over to Scott.

Thanks, Jay. Our second quarter results reflected our continued progress along all of our key initiatives. We earned $7 million of GAAP net income or $0.05 per diluted share. GAAP net income included $106 million charge related to the Fortress sale of its OneMain stake. The impact was noncash, non-tax deductible and equity neutral. Our Consumer & Insurance segment earned $160 million this quarter on an adjusted net income basis or $1.18 per diluted share compared to $110 million or $0.81 in the second quarter of 2017. Excluding the impact of the Fortress's transaction, the growth trajectory of our recurring GAAP earnings remained strong, driven by our core operations and the declining impact of acquisition-related charges. We expect further improvement in our GAAP income as these trends continue. Let's discuss the key drivers of our C&I financial performance for the quarter. Originations grew 9% to $3.2 billion and were 47% secured, consistent with last year's level. We saw continued momentum throughout the quarter with June originations at almost 50% secured. Ending net receivables grew $1.6 billion versus last year, about 80% of that growth was secured. As Jay mentioned earlier, we are updating our ending net receivables growth outlook for the full year reflecting our expectations, but we can continue to prioritize the growth of secured lending, while maintaining consistent credit standards and appropriate risk-adjusted returns. Interest income was $911 million in the second quarter, up about 14% from last year's levels, largely reflecting higher-average assets. Yield was 24.1% in the second quarter compared with 23.9% last year as the benefit of our ongoing pricing initiatives was partially offset by our continued focus on secured lending. Yield was up sequentially due to seasonal improvement in 90-plus delinquencies. We continue to expect yield to remain around the first quarter 2018 levels as our secured mix continues to grow and late stage delinquencies seasonally increase in the second half of the year. Credit performance was solid in the second quarter. 30- to 89-day delinquencies were stable at 2.1%, 90-plus delinquencies declined to 1.9%, and net charge-offs were 6.6%, an improvement of 30 basis points versus last year. With regard to our full year outlook, we expect net charge-offs between 6.5% and 6.7%, reflecting the benefits of disciplined underwriting and the lower losses associated with secured lending. Total reserves increased by $11 million to $729 million in the second quarter. This represented 4.7% of receivables compared to 4.8% in the prior quarter. We continue to expect stable trends in our reserve ratio this year. Second quarter operating expenses were $317 million, up about 6% versus last year. The increase largely reflected the investment initiatives, we previously highlighted. Even with these investments, our OpEx ratio improved by 50 basis points versus last year. Moving on to funding and liquidity. We issued $900 million of a 8-year unsecured debt at 7.125% and redeemed the remaining $800 million of the 7.25% notes due in 2021. This redemption of legacy OneMain bonds enabled us to consolidate our major operating entities under Springleaf's Finance Corp. our unsecured debt issuing entity. This was an important milestone for us as we continue to simplify both our legal structure and our financial reporting for the benefits of our investors, lenders and rating agencies. At quarter end, 53% of our total debt was secured, surpassing our goal of 55% for the year. As a result, we now expect our secured debt to be between 50% and 55% by year-end. I'd also like to highlight that in May, Moody's upgraded our corporate debt rating to B1 from B2. And in July, S&P upgraded our rating to B+ from B and maintained their positive outlook. Kroll also recently initiated coverage with a BB+ rating. From a liquidity standpoint, we continue to be in a very strong position. We had $6.2 billion of unencumbered receivables and more than $550 million of cash and cash equivalents. In addition, we expanded our conduit capacity by about $0.5 billion in the second quarter, bringing our total undrawn capacity to $5.4 billion. We currently have about two years of forward liquidity assuming no new fundings. And lastly, our tangible leverage ratio was 8.1x at the end of the quarter, down more than a turn from the first quarter of 2018. We remain on track to achieve 7x, driven primarily by the accelerated growth in GAAP earnings that I mentioned earlier. So overall, we are pleased with the second quarter operating performance. We look forward to building on these results throughout the remainder of this year. And with that, I'll turn it over to Jay for closing remarks.

Thanks, Scott. In summary, our second quarter results demonstrate momentum in our business, and we are well positioned to continue to drive it forward. As you are all likely aware, we announced that I'd be stepping down as CEO and handing over the rein to Doug Shulman, a very capable and gifted leader. I'm thrilled to be partnering with Doug through the transition and beyond. Doug has built the track record of helping financial service companies grow and evolve, while always putting customers and team members first. This, of course, resonates very deeply with the heart of who we are at OneMain. I will remain Chairman of the Board and look forward to staying actively involved with the long-term strategy of the business, external affairs and furthering our commitment to the importance of overall consumer financial wellbeing. I'd like to express my appreciation for all the support and great experiences I've enjoyed during my years as OneMain's CEO. I'm humbled by the millions of families we've been able to serve and help to get to a better place financially and I'm beyond thankful for our 10,000 team members, who make that happen each and every day. And with that, I'll turn the call over to the operator to begin the Q&A.

[Operator Instructions]. And our first question is coming from the line of Michael Kaye from Wells Fargo.

I had a quick question on the management change. Can you just talk about what made him the right fit for CEO? He does have an impressive background, but he doesn't seem to have any consumer lending experience? And secondarily, what kind of changes do you think we could expect from him under his new leadership? And what was his vision of OneMain that made him stand out for you?

It's a great set of questions. So let me take it. First of all, what I would say about Doug is, most importantly, for any company he is a strong leader. And I think that's exactly what Doug is and that's what really stood out. He has got, I think, tremendous EQ, has a great way around people. And is very thoughtful about businesses, what's needed to drive and grow, and that's really been his entire career. So I think that's really what stood out in terms of for myself, the board, and the rest of the management team that's met him. He is just very aware and a very good leader. The great thing about the company is there are 10,000 people across this company that are very good and have a lot of experience around consumer finance and have been doing it for decades. So what's really I think needed around any great company is great leadership and vision, and I think those are the things that Doug will bring once he gets here. I think it's early to say exactly what his vision is. We've gone through a recruiting process, and he recently agreed to join. He is currently on garden leave, will start sometime in September. But I suspect shortly after he gets here, we get to see legs. He will get his arms around what a great market position we have and just had to further that, as time goes on. And that sort of hopefully answers the vast majority of your questions. Future changes, I think, it's way too early to comment, but what I would say is both myself, Doug has met the management team and the entire board has total confidence in the management team.

Okay. That's helpful. I appreciate that. Second question, I noticed the tangible leverage came down nicely quarter-on-quarter. Just wanted to get your update on your current thinking on potential capital recurrence for next year? And may be some early conversations you had on that topic with Apollo?

Yes. I think we mentioned, Michael, that in the first quarter because of some of the debt we issued we had some excess cash, and so that kind of came through in the second quarter. We're very focused, as you know on achieving the 7x leverage that something we've committed to the marketplace as well as the rating agencies. But clearly, as we've talked about in the past, we expect to generate excess capital as we go forward, past that leverage. And I think the board continues to talk about that, and we will give you kind of updates as we get further on through the year.

Your next question comes from the line of Michael Tarkan of Compass Point.

Question on the competitive landscape. Growth is picking up a little bit, we're seeing the online channel, the online players grow pretty significantly over the past couple quarters. I'm wondering what you're seeing there? Whether you think you have the ability to take some more pricing? And just any kind of update on the online efforts?

I'll take a crack at it, and Scott, will have a couple of things to say. I would say, the competitive landscape has stayed pretty similar for us, remember -- I think the online guys are largely upmarket, and we've seen -- we've talked about it as a decent market for us, sort of below what would be considered prime sort of, in general, 700 and down by way of FICO. So not the overwhelming competition like you're seeing at the higher end. So I think we're in a good place to support where we want to be.

Yes, I think from a pricing point of view, we feel that we're at a better spot, where we're providing very good value for our customers as well as kind of good risk-adjusted returns for our portfolio. As we mentioned, we're continuing to see positive momentum in our secured lending part of the business. But I think from a pricing point of view, we've been pretty kind of stable we continue to test, but we haven't seen anything that's changed in the last couple of quarters, as Jay mentioned.

Okay. And then just as a follow-up on the credit side, the 6.5% to 6.7%. I know it's early in terms of thinking about 2019, but given that, I guess, June originations 50% secured, if the macro environment kind of hold as is, should we expect that number to continue to drift a little bit lower moving forward?

I just think, yes. Assuming all the things you just mentioned in regards to the macro trends, just because of the portfolio mix with our hard-secured and direct auto, the loss rates on those half of the unsecured we'll kind of remix and impact -- improve the charge-offs.

Your next question comes from the line of Kevin Barker of Piper Jaffray.

You've left out the operating expense at 5% even though the growth is picking up and net charge-offs are coming down. Can you just give us an idea of like how you expect the expense growth to play out into the end of the year and then into 2019, given some of the emerging ad campaign you mentioned last quarter and some of the places where you're trying to grow your markets?

Sure. So I think we still think that 5% growth for this year is reasonable. You saw in the second quarter, one, first quarter as we mentioned was seasonally low quarter for us around marketing, because of the -- there is not a lot of growth in the first quarter in the portfolio. So there is an uptick in our marketing cost in the second quarter and going into year-end. We did launch the branding campaign that was started in April. We still -- it's still early in regards to that process. And then as we've talked about there are other areas that we're looking at the business of investing in both technology and capabilities to improve our customer engagement. In regards to thinking about next year, I think I'll leave you, we'll continue to drive operating leverage, because of the kind of growth of revenue relative to the growth of expenses. But we do think it's a good time to invest and continue to enhance our business proposition, especially as some other people mentioned on the call, it is a competitive landscape and we want to make sure that we're kind of top of mind for our borrowers.

Do you have a target on the amount of operating leverage you want to generate this year and then into 2019?

Well, this year, I think you're seeing the kind of -- our revenue growth clearly is growing faster than our expenses. As we think about '19, I think it is still a little bit early as we've talked about, Doug will be coming on board, and I think will layout kind of 2019 framework later in the year versus trying to do it mid-year in '18.

Your next question comes from the line of Sanjay Sakhrani of KBW.

I guess, I wanted to follow-up a little bit more on the revised receivables growth. Just trying to think through where the incremental opportunities are on that front? And maybe just related to sort of the health of the consumer right now. Are they taking on more leverage now? Or is it that they can afford to take on more debt because their incomes are growing?

Look, I would say a couple of things, and just to put our loans in context, remember a big chunk of the dollars we put out are going to consolidate other debt. So north of 50% of our dollars that we write to customers are being used to pay off other loans. So whether it's an existing auto loan, whether it happens to be a loan to us, whether it's credit card. So even for last year, I think, it was over $10 billion, over $5 billion about was used to pay off other debt. So the customer is not necessarily, if we lend 10, he is not going to take on 10 of additional debt. And I think what we are also finding increasingly as across the board we are getting more comfortable offering the range of products. What customers are finding with the auto loans is they're using a lower rate on the direct auto to pay off higher cost debt so they get into a better place. So in all cases when we make a loan, we're trying to see a customer in a better place cash flow wise and like otherwise would have been, that's always where our underwriting comes out and we're going through various imaginations on the credit bureau, a lot of if then's, if you pay this off, what do you look like because we're always trying to get to a customer with better free cash flow, to better place for the customer to be in, and it's a better place for us to be with respect to the customers. So I think we're seeing very steady leverage numbers. We're seeing as I talked about marginally more credit card debt over the last few years. But quarter-to-quarter the last few quarters has been very stable. So in general, we've seen a healthy consumer with income up modestly. We look a lot like America. So if American income is up 2% to 3%, generally, our customer base will up very similar to that. And I would say, we feel good about both the loans we're writing and the health of the customer that we're writing it to.

Okay. Great. And then just a follow-up, looking at the guidance and the yield being stable, but the loss rate guidance coming down. I guess, it's probably appropriate to assume that the core portfolio credits improving as a result of that versus mix may be. Could you just talk about sort of what's driving that loss rate down? Is it just again similar things that you mentioned? Or is it something else?

The loss is really just the continuation of big driver, is the mix of the shift in secured lending over the last couple of years. So it takes some time for that to grow through the portfolio. And I think also focused on disciplined underwriting, both those two are the drivers of our charge-offs.

Okay. One last question, just a follow-up on the capital return. How much does sort of CECL play into whether or not you contemplate capital return? Is that part of the planning process? And then where are the debt rating agencies with thinking through CECL and how they're going to utilize it or apply it?

Good questions. I think I'll defer. We've had conversations with the rating agencies. I think there is still a lot of discussion around how -- what the impact of CECL would be around capital in capital levels and I don't think there is any conclusive decision on that. So clearly, it will be an input into the overall kind of capital planning for us and others, but the clarity around that even though the accounting pronouncement is -- the take effect in early 2020 is still, I think, work in process.

[Operator Instructions]. Your next question comes from the line of Mark DeVries of Barclays.

Could you give us a sense of how much more you think the secured mix can grow into 2019? Should we still think of something potentially around 50% north of that? And also could you give us a sense of how the mix of the direct auto versus hard-secured is trending?

Sure. I think clearly, we've mentioned that, kind of the target is to get to 50%. It's a large portfolio. So even with 80% of our growth year-over-year being secured, we're able to move the portfolio from 40% to 44%. So as I mentioned in my prepared remarks, having originations at the end of June kind of getting to that 50%, we would have to held that study for several quarters in order to get the overall portfolio to that kind of 50-50 level. But that's I think, Mark, think about that as our kind of near term that will take us probably through '19. And then we'll kind of go from there. From a perspective of kind of direct auto, the portfolio we showed in the deck is about 22% of the portfolio this quarter versus around 18% a year ago. So I think we're getting both growth in our direct auto as well as our hard-secured. Back to Jay's point, clearly the customer that we have in regards to the products that they're looking at have to have the ability that we can refinance and pay off that other loan as well as advance them the money they're looking for and then have the free cash flow to actually for the combination of kind of the new loan. So it's something that we continue to improve the effectiveness of our selling and explanation and customer awareness. But it's very hard for us since people don't walk in looking for a direct auto, it's a product that we sell. It's really a matter of our execution and effectiveness that kind of taking customers with that profile and explaining the benefits of the product.

Okay. Great. And then just had a follow-up question from one of your comments, Jay, about how some of these online lenders are generally a little bit more upmarket. Just hoping to get some color on why you think that is? Is it not comfort with more subprime credit? Is it I think a point you guys have made that having the physical stores and having the customers come in has a big underwriting advantage from a credit management perspective? Or is it also just that your customers generally kind of need that physical store to go into close loans?

Look, I would say, it is always hard to say is the loan well originated or well serviced. And the answer is, yes. It's a combination of all the above. I think it's important for us -- let me take a step back for a second, 85% plus of our applications start online. So a good chunk of our customers are digitally savvy, we're interacting a fair amount before they come into the branch, but that coming into the branch allows us to enhance the relationship, which is important when it comes to servicing, renewals, maintaining that relationship for a longer period of time than just a transaction. So the fact that we are community-based, the fact that we can leverage being there sort of plays very well into the model. And I think as you said, it leads to both, I think, stronger loans upfront and then better servicing overtime. So it's -- and I think it's also, if I go back to why us, and why not the others, you go back overtime and for those that did try to go down, it was challenging. I think loss rates were significantly higher than anyone anticipated, while they lend at high rates they thought it would be the returns. It's a customer that needs high touch servicing. They don't just wake up every month and say let's ACH everything else because I have plenty of liquidity in my account. Most of the customers like a good chunk of America are paycheck to paycheck, and they're going to prioritize if something happens and we want to make sure via that relationship that we are top of the list when it comes to front of mind, who they are going to pay in any given month, and it really comes from being in the community, building that relationship and being there when it matters.

Your next question comes from the line of Rick Shane of JPMorgan.

I just want to follow-up on the topic that Sanjay addressed, which is, in terms of originations and that mix. Obviously, some of this has been driven, the growth has been driven by the mix to secured. But I'm curious are you guys changing the LTVs at all on the loans that you're making given sort of the volatility we've seen in used car prices? And are loan sizes going up? Or is it more customers, more accounts?

Well, several questions. So I think in regards to our LTV policy, it's really based on different -- the risk grading that we have on each of the customers, kind of leads to the LTV. And so the better credits we have, we'll have a little bit higher LTV than other credits. You're second question, and so when we think about that, the secured loans, as we've talked about many times are larger than our unsecured loans, but in regards to unit count and average balances, unit count is growing as well as kind of the loan sizes are growing kind of modestly also at the same time. So you got the combination of both account growth and modest loan growth.

Great. Okay. And so we can level set versus the other auto lenders that we follow, what is your expectation on these car prices over the next year? What's the underlying assumption?

I think, we've mentioned before, Rick. I mean, clearly, we kind of look at that, but the number of cars that we actually repossess that we have to kind of sell at auction is pretty small relative to our portfolio. So we kind of monitor, but it's not a significant impact on our losses. From a perspective of what used car prices move up and down by certain kind of percentages that clearly are published out there. So we're mindful of that, but it's not the key driver. Key driver for our losses on our secured portfolio is frequency, which kind of goes back to kind of employment. So what we focus more on...

Definitely tied to waiver, I would agree with that.

Correct.

Look, I would just add. With almost 5 years of history of writing refinance loans against newer cars, we're still running at sub 2% losses. We've been through multiple vintages, and I'd say, we continue to be very impressed. And I fully appreciate your questions, but it's hard to benchmark against us -- against any of the in-directs, because it's just so different in terms of the underwriting, the customer proposition, knowing the customer has been in the car, and look we -- as you said, we think about all those things. But it is just a very different thing and we frequently wind up in the challenge of why it is so different than indirect auto, which is why we call it direct, but that's probably just not enough.

No, fair enough. The credit metrics really do diverge, there is no question about that. And by the way that brings me to really what should be my last point. Jay, congratulations. I really appreciated the back and forth over the years and look forward to continuing the conversations.

Awesome. Thank you so much.

Your next question comes from the line of Moshe Orenbuch of Crédit Suisse.

Maybe just if you could kind of talk a little bit about your thoughts having kind of done this ad campaign and thinking kind of more intermediate or longer term debt growth? Is there an expansion in either products set or geography that you would be thinking about kind of over the next couple of years?

I would say, on ad campaign, the purpose is to be front of mind, right. You never totally know when someone is going to have a borrowing need. So -- and while asking our other results, it is still too early to sort of tell exactly, but I can tell you for those that are in the markets especially those directly related to us have all said phenomenal response, but too early to tell. I think it's -- we want to keep doing what we're doing. I think we feel good about the places we are, the markets we're in, the geographies we have, the product suite we have. I think it's early, Doug will certainly do an assessment when he gets here, but from the standpoint of management team, and the board, I think across-the-board, we feel good about where our branches are, the customers we're serving, the products we're offering and our ability to execute against it.

And just kind of a follow-up on the financial side. I mean, you've had pretty good success given both for year spreads have been and what intermediate term rates have done issuing debt. Can you talk a little bit about the plans for the funding? Because I mean, you've had some very good success on the securitization side, and so how should we think about that mix and the relative costs of each?

So, Moshe, this is Scott. Clearly, we have 2 different funding sources that we have. I think we have been pretty explicit this year in regards to where we want to get that mix too for many reasons. So we're balancing the cost of our secured ABS program relative to the unsecured markets. As we've talked about before the unsecured markets, we can get longer duration. We've been able to achieve that in the last 2 issuances that we've had. So we have been able to do a 7- and a 8-year transaction on the first half of the year, which enhances both our liquidity profile as well as it provides kind of a buffer in regards to interest rate sensitivity for the portfolio. So we think the place to be is kind of in that 50, 55 range that we provided kind of an update to on our priorities this year. And so I think I have to think about more than just the cost of the coupon, it's really the other tertiary benefits of enhancing our liquidity, interest-rate management and also building a longer duration kind of liability stack for our business.

Your next question comes from the line of Arren Cyganovich of Citi.

Following up on those running questions, the ABS markets had pretty tight credit spreads recently. How you're thinking about the overall cost of funds as you get the benefit of that? And -- or do you assume a bit of a credit spread widening when you think about that going out into next year?

If you look at it, we just -- we did an auto ABS transaction recently. So we continue to look at those markets. We have been able, as we've talked about before, our spreads have come in significantly over the last couple of years that have kind of partially offset the kind of the increase in short-term rates. And so if you look at going forward, we will continue to access both the ABS secured market as well as the unsecured market on a routine basis to kind of fund the overall business model.

And then on potential for capital return, I'm just trying to think of you will end the year at around 7x leverage, it will be within your kind of target range for 2019, but obviously CECL is going to be a fairly large impact on the allowance. Do you think that will preclude you from doing capital return in 2019?

Arren, I think someone asked earlier on the call. I think they're still kind of in process discussion around how rating agencies and others will kind of adjust potential calculations based on the CECL adoption. So I think it's a little bit too early to kind of -- to advise you on that piece. But I think, if you think about what reserves and capital are buffer for losses, in a CECL world, they're thinking about those abstractly, I don't think it's the appropriate way. Now it's just a matter to what degree -- what percentage of those potential reserves are kind of able to be commit as "Capital." So I don't have an answer for you today, but we're in constant conversations around that.

You're not saying it's an impossibility for 2019 it's just you have to wait to see how they...

Yes, I think there is still -- I think there is more work to go on understanding how different parties will address and kind of think about the implementation of CECL relative to capital levels.

Thank you. I'd now like to turn the call over to Jay for any closing or additional comments.

Sure. Thanks, everyone. And look I just want to again express my thanks to everybody on this call, everybody that's been on the call the last 5-plus years as we've been on the journey to build the leading finance company in this country. And I'll again say, it's been nothing but a thrill and honor to have led this company. And like all of you, I'm continuing to play a big part and will be watching its success, as it continues to grow and serve the millions of Americans that need the help for what we do. So thank you all again, and have a great day.

Thank you. This does conclude today's conference. You may now disconnect your lines, and have a wonderful day.