The Bancorp, Inc. (TBBK) Q3 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to The Bancorp Inc. Third Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I'd now like to introduce your host for today’s conference Mr. Andres Viroslav. Sir, you may begin..

Thank you, Kaily. Good morning and thank you for joining us today for The Bancorp's third quarter 2016 financial results conference call. On the call with me today are Damian Kozlowski, Chief Executive Officer; and Paul Frenkiel, our Chief Financial Officer. This morning's call is being webcast on our Web site at www.thebancorp.com. There will be a replay of the call beginning at approximately 12.00 PM Eastern Time today. The dial-in for the replay is 855-859-2056 with a confirmation code of 96088598. Before I turn the call over to Damian, I would like to remind everyone that when used in this conference call, the words believes, anticipates, expects and similar impressions are intended to identify forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to risks and uncertainties which could cause actual results to differ materially from those anticipated or suggested by such statements. For further discussion of these risks and uncertainties, please see The Bancorp's filings with the SEC. Listeners are cautioned not to place undue reliance on these forward-looking statements which speak only as of the date hereof. The Bancorp undertakes no obligation to publicly release the results of any revisions to forward-looking statements, which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Now, I'd like to turn the call over to The Bancorp's Chief Executive Officer, Damian Kozlowski. Damian?

Thank you, Andres. Good morning and thank you for joining us today. My name is Damian Kozlowski, I'm the CEO of Bancorp and the President of The Bancorp Bank. I've been in these positions since June 1. I welcome you to my second quarterly earnings call. We are extremely disappointed that an issue arose with a large lending relationship and discontinued operations, which resulted in a third quarter loss. The results of the third quarter reflected a fair value mark in connection with the secured commercial real estate loan held and discontinued operations. The loan in a principal amount of $41.9 million became nonperforming after quarter end due to the failure to make required principal payments. Based on a preliminary estimate of the collateral value by an independent certified appraiser, the fair value was reduced by $23.9 million and the amount was recorded as a charge to earnings. The appraiser estimate is preliminary, possibly subject to change based upon a full appraisal which is in process. The appraiser is considering recent market changes and pending lease renewals. Despite the third quarter accounting charge on this lending relationship, we have made substantial improvements that we believe will yield positive financial results in the coming quarters. Here is what we accomplished. Number one, we’ve completed our integrated and comprehensive business plan for the Company. The plan was completed and approved by the Board in September and we are on track to implement many of the provisions by the end of the year. The key focus of the plan is reducing our cost of maintaining business momentum within our core business lines, while significantly increasing our platforms productivity. The plan also includes an enterprise view of both strategic priorities and risk management. The plan will now be implemented as our guide to realize earnings potential and will also be the template for a strategic budgeting process. An Investor Presentation with additional details will be provided and posted on our Web site in the coming weeks. Number two, our expenses are now being meaningfully reduced. Lookback expenses were only $1.4 million versus an estimate over $3 million for the third quarter and were significantly less than the $13 million expense in the second quarter. We reduced staffing by approximately 20% or approximately 140 staff positions, which we estimate will result in run rate saves in and various expense categories of approximately 3 million per quarter. We are now implementing Phase 2 of our cost reduction plan and target 20% to 25% of our run rate operating cost base, not including employee costs. These savings will begin to be realized over the next several quarters. We will do our utmost to accelerate the process as these specified plans vary in complexity and timing. We completed the sale of our remaining HSA business, which will reduce our operating expense and significantly reduce the number of accounts the bank manages. Number three, core revenue continued to grow both quarter-over-quarter and year-over-year. Year-over-year business growth was led by a 49% increase in leases outstanding to $333 million reflecting a $60 million acquisition and 20% organic growth. Quarter-over-quarter business was also led by leases outstanding, which increased 5% or 20% annualized. Discontinued operation continues to be worked down and during the quarter we sold approximately 64 million of loans with an approximate 500 -- $500,000 gain. We are highly focused on addressing all regulatory issues quickly. We’ve developed a new regulatory plan that will better focus the bank on resolving all the issues we need to resolve. And we believe we have a passport to significantly improve our regulatory status over the next year and we will dedicate all the resources necessary to accomplish this objective. In summary, in this quarter we made substantial progress where we’ve much more to do and we are wasting no time in executing our new business plan. Now I’m turning the call over to Paul Frenkiel, our CFO, to review the financial results in more detail.

Thank you, Damian. The third quarter loss resulted from a fair value mark in connection with the secured commercial real estate loan held in discontinued operations. That loan in the principal amount of $41.9 million became nonperforming after the end of the quarter due to the failure to make required principal payments. Based on a preliminary estimate of the collateral value by an independent certified appraiser, the fair value was reduced by $23.9 million and that amount was recorded as the charge to earnings. The appraiser estimate is preliminary possibly subject to change based upon a full appraisal which is in process. The appraiser is considering recent market changes and pending lease renewals. The full benefit, the full amount of the $23.9 million charge dropped to the bottom line with no tax benefit. However, the resulting deferred tax valuation allowance of approximately $10 million increases the previously available $8 million of those allowances. Based on our earnings projections for 2017, we expect that the total of $18 million of valuation allowances will reverse next year and increase after-tax income in that amount. While BSA lookback expense during the second quarter amounted to $13.4 million the related outside consulting engagement was concluded during the third quarter with $1.3 million of expense and will no longer impact earnings. While severance costs related to quarter and staffing reductions amounted to $1.2 million during the quarter related quarterly expense reductions are estimated at $3 million. The goal of reducing our run rate operating cost base not including employee costs by 20% to 25% is being closely managed to accelerate the cost reductions. Sales of discontinued loans continue to be pursued, June 30, 2016 unpaid discount -- discontinued loan principal of $494 million included $70 million of residential mortgages which may be either sold or retained. That left approximately $424 million of commercial loan principal. During the quarter, the $424 million of commercial loan principal was reduced to $340 million as a result of $64 million of loan sales, principal repayments, and an $8 million transferred to other real estate owned, which was include -- concluded to be well secured. The mark of $23 million at June 30, 2016 was increased to $45 million at September 30 as a result of the single lending relationship discussed earlier. Thus, the $340 million of loan principal at September 30 left the quarter end mark of $45 million, resulted in approximately $295 million of net commercial loan balances at quarter end compared to approximately $401 million of net discontinued commercial loan balances at June 30, 2016. At September 30, 2016, the largest 16 discontinued loan relationships amounted to approximately $248 million and had a mark of approximately $38 million out of the total 9/30/16 mark of $45 million. Of the $248 million, approximately $92 million were nonperforming. Of the $45 million 9/30/16 mark approximately $37 million was against that $92 million, resulting in approximately $55 million in net nonperforming loans. The $248 million principal for the 16 largest relationships compared to $300 million at June 30, 2016. Cumulative marks against the original outstanding principal of the remaining $248 million for those large relationships amounted to $73 million or approximately 26% of that original principal. Year-over-year increases in our primary lending lines of business were reflected in the 32% increase in net interest income. Our largest increase in loans was in leases, which grew organically 20% over the year and with 49% overall growth after considering acquisitions. Continuing acquisitions confirmed the viability of that growth strategy. Total loan balances including continuing line of business loans held for sale, which contribute interest income prior to sale, grew 31% year-over-year. Linked quarter change in those totals was comparable. The lines of business comprising those totals have historically had low charge-offs. Prepaid deposits are the largest funding source for the bank and should adjust only a portion of future increases in market interest rates. The interest margin will accordingly benefit with related rate increases on variable rate SBLOC, SBA loans and the large proportion of the investment portfolio, which is rate sensitive. The net interest margin for the quarter was 2.69% compared to 2.34% in Q3 2015. The increase reflected a reduction in balances at the Federal Reserve Bank, earning a nominal rate and the 25 basis point Fed increase in December 2015. The reduction in Federal Reserve Bank balances and improvement in net interest margin reflected the impact of the exit of nonstrategic deposits in the first quarter 2016. Average year-over-year quarterly prepaid card deposits, which are the primary driver of deposit growth, increased by approximately 8% and exceeded GDV growth of approximately 11% between those two periods. Bancorp supports many of the industry's leading players in payments. Continuing initiatives are projected to contribute to double-digit GDV growth and continuing the fee growth. Looking forward, we have game changing positives, which should contribute to profitability. First, the BSA lookback was finally concluded in the third quarter. Second, while in the third quarter the bank expensed approximately $1.2 million in severance for staffing reductions. Future decreases in related expense are estimated at $3 million per quarter. Third, our goal of reducing overall noninterest expense by 20% to 25% not including employee costs, has advanced to the delineation of the specific steps required to achieve that goal. We are using all available resources to accelerate these reductions. Fourth, quarter over -- prior year quarter net interest income grew 32% continuing a strong history of growth, which may be further bolstered by an increasingly probable 25 basis point December fed hike. The business model, Damien, discussed earlier match the compounded impact of these increasing revenues coupled with the decreasing expense base on return on equity, which the Company plans to utilize as a measure of progress. We're looking forward to executing on these plans and reporting back to you on financial progress next quarter. Damien this concludes the financial report.

Thank you, Paul. Operator, please open the call for questions.

[Operator Instructions] Our first question comes from the line of Frank Schiraldi with Sandler O'Neill. Your line is open.

Good morning. I just want to start with this -- with the discontinued ops book and I wonder if you could share with us when is the last time this property, the collateral behind this loan went through a full appraisal?

Well, we just did it. The most recent one was in -- is in process. We're not really going to address the specifics of this loan. This issue really arose at the end of the quarter. Actually, past the end of the quarter when the loan became nonperforming, so …

Right. I'm just trying to get a sense, I guess, of why -- and you’ve noted it’s a preliminary appraisal, but I would think especially in the 16 large loans that the last full appraisal has been pretty recent. So I’m just trying to figure out why there would be such a big delta between presumably that appraisal and this one?

We're looking into that ourselves, Frank. It was unexpected. And so we have appraisal where we're analyzing all aspects of that loan, which was not an issue or a concern prior to the borrowers -- prior to the end of the -- to the first part actually of this, of October when it became nonperforming. We are analyzing all that.

This was a loan that was performing and reviewed recently when we looked at all the marks. There was a recent changes in the property, around lease renewals and that affected the third parties assessment. Whenever you have a situation like this you have to look at a very conservative view of an as is ability to dispose of the property and that is affecting the value in the preliminary estimate. So any recent changes and renewals or the thought that some of the tenants of this particular property may renewal have to go into the estimate. And this is not a market view of what you may dispose the property at, but simply a cash flow view of the property. And once again this is preliminary and may change. The assessment is ongoing. We are reporting this as this became an issue on October 1 after the quarter end and we're trying to be as transparent and forthright is possible getting the most accurate information we have at the time to the market.

Right. Okay. I guess the appraisals are generally, on investor -- are generally based on the cash flows, right. So just wondering if you could talk about -- I mean, you’ve gone through some third-party reviews in the past certainly, so on these 16 large loans I would imagine that you've had full appraisals on them rather recently. I mean, I don’t know if you can give a sort of a timeframe of when the full appraisals would have been done just more generally on the discontinued ops book, especially these larger size loans?

We can't get into the actual, because once again this is a preliminary estimate of recent changes in the cash flows. When the loan was reviewed by multiple third parties as recently as the second quarter, there wasn’t thought to be a problem by any of those parties or the management of the bank. There was recent changes in the cash flows of the property and that is affecting the preliminary estimate. Once again, that’s preliminary estimate of the as is value of the cash flows of the property and not of any other type of measure, such as market value of the property.

Okay. I guess, just on as you’ve gone through these third-party reviews, and you noted the last one you did was pretty recent, at that point you do an appraisal on all these large properties, right. And then you would markdown some of these even, I guess, performing loans if the LTV was too high on these -- on the updated appraisal, is that fair or …?

Appraisals are done when one of two things. One is that there's been a substantial change in the property status, which only happened recently on this property leading to this view that the collateral was substantially different. But that process is ongoing and I can't really comment it, because it's not complete. We are trying to give the market the best information we have at the time. And once again this is an as is appraisal of the property and not any other view of the property. We have to use that view in order. Obviously, this property is delinquent. Foreclosure may be imminent and therefore the value on the property has to be really based on what the performance of the property is at this moment. But there are no third-party including management, believed that this was going to be either delinquent, this loan was going to delinquent. It had been current. The loan had been in force since 2013. There hadn’t been any problems and this is a surprise and we're deeply disappointed that this occurred. We believe this also is in systemic. We believe this is a one-time item. We’ve worked down the discontinued book, looked at the mark multiple times on the portfolio. This was one of the largest loans in the portfolio by far. And obviously there is -- its disappointing to us, but once again this is going to be a very, what we believe is a accurate and very conservative mark and it's also preliminary. So it may change. It is subject to a change over the next few weeks.

Okay. So what is the other time you would do that -- I mean, you mentioned you do an appraisal something has changed like it has in this property. When is the other time an appraisal would have been triggered, so on -- these just only 16 again?

Yes, its -- we’ve a -- we’ve policies in place at the bank and whenever -- obviously, at the time of underwriting appraisals are updated depending on the judgment of the credit risk management organization. In this particular case those changes occurred recently and some of those changes may have resulted in the sponsor deciding to become delinquent, therefore resulting in the view of the appraiser. So I can't really -- once again this is an ongoing. The appraisal may change and I can't add any more color to this particular credit at the time.

Okay. Now just more broadly into this continued ops book, I’m just wondering if you can -- when you do the third-party review and again you did a full one, pretty recently. I thought that you get new appraisals on all these larger size properties. That’s not the case …

No. not every quarter. The appraisal.

No, not every quarter, but when you do the big third-party review I thought, you know?

We are doing the third-party review every quarter for material changes in information and that's reviewed by our auditor etcetera. So if there's material changes or an event, only the bank can really trigger a change in our view of the underlying collateral. There was no event on this loan until recently.

Okay. So even like last quarter when you go through the loan book and you take significant march it's not based on -- necessarily you’re not doing a bunch of updated appraisals to get to those marks?

In some cases there may have been updated appraisals or appraisals that happened in the quarter. I can't speak to all the specifics. But its reviewed by third parties and every -- it’s a consensus view of and then reviewed by our auditors.

One thing that might be -- I don’t know if you have it available or if you can disclose it at some point, would be loan-to-value updated for marks and obviously updated for the latest appraisal of the especially those larger size loans in the discontinued ops book?

Well, they’re going to vary on each specific loan. So clearly …

Right. Just on average.

… [multiple speakers] information clearly it's been reviewed by the party and doubly reviewed now by our own internal review staff. So it varies on each loan, so …

Okay. Yes, I mean, I would just be looking for an average, but I don’t know if you would be willing to something to think about. I think that might be something investors would like to see, but -- okay, just moving on from that, I just wanted to ask on capital. So, Paul, you mentioned the -- I think the $18 million valuation allowance that should come back in based on your earnings projections, should come back in to book, to capital levels in 2017, right. So that would not be, for example, in -- for instance in your Tier 1 leverage ratio, which was at the bank I think about 740 in the quarter. I believe you guys target like an 8% ratio there longer term, if I’m not mistaken. I’m just wondering is it -- I guess, you don't have to necessarily be there tomorrow, so is that $18 million valuation allowances that comes back in that sort of cures or get you back close to that target of 8%, is that the right way to think about?

It's that and it’s the early earnings, which will allow us to reverse those valuation allowances. We don't predict specific earnings, but if you run your model and you look at the revenue growth and you look at the expense reductions, you'll see very in the next coming quarters will be back to 8%.

And we -- and I think I’ve talked about this before, we're really looking for this bank to operate a minimum of 8.5% Tier 1 leverage ratio and also have a cushion over that. But as we look at our own financials even with this unfortunate circumstance, which once again we do not believe it’s systemic. There really was an event in this case. We think we can manage that 50 basis points over our 8.5% minimum towards the end of next year. The valuation allowance of course will be part of that equation.

I’m sorry, I miss, what was the 8.5% for which ratio?

For Tier 1 leverage ratio. Ultimately that's where we want our minimum to be and we want a little cushion over that at the -- by the end of the next year.

Okay. So you think you'll be, so 8.50%, I’m sorry, so is it target of 8.50% rather than 8% and you feel that you can get there through the valuation allowance and earnings by the end of next year.

Yes, but we wanted the recent capital raised to get as much closer to the 8% before this -- unfortunately before this occurrence, we were at 8% and therefore at the total Company level. So it's unfortunate. It's not -- obviously if we had any inclination, if we knew anything we would've reported this last quarter. There was no event. This was a paying client of ours and the belief was that the collateral was sound under the information that we had that was reviewed. Therefore it was a surprise. So that impinges obviously a little bit on our Tier 1 leverage ratio, but there's enough room in our profitability as we plan it out to get us back to where our 8%, within our 8.5% and that ultimately to 9% over the next year.

I guess, just one follow-up question on the discontinued ops book. I mean you’ve said you feel like this is just isolated, it's not systemic. I guess any color you can give on why it would've, it seems like there were maybe a couple of leases or so several large leases that were not renewed, I mean, why the change in this specific credit? Is it geography, is it the location of the building?

Once again, let’s wait for the -- the appraiser is doing a complete analysis and we're doing a complete evaluation too, so we are comfortable to understand every aspect of that loan. And, frank, we may I don’t know that we’re required to put in the 10-Q, but we are looking at it and we will look at that.

Okay. All right. Yes, because anything you can say, I mean, about the other 15 large loans there in terms of loan-to-value or on updated appraisals, it would be helpful to be able to say this is ring fenced and this is just sort of an isolated incident this quarter. So, anyway, one last question I had was on the staff reductions. I just wonder if could talk a little bit about where the reductions are coming and if you're able to reduce on the compliance risk side of things or is that just one area that kind of remains off-limits until the BSA orders is taken off?

No that was companywide. We took less -- I can't give you the exact percentage, but we took more -- less client, the back end of the business, to less of a client facing or more of the -- yes, less of the client facing personal. We took more managers than regular employees where we reduced 25% -- 20% overall. 25% of those were managers. There was some reduction in the BSA element, but that was redundancy. That we had in two of our locations and we're dedicated to the lookback. So as the look back ended, those resources were no longer necessary, but it was companywide. We took a hard look across the Company. We do believe there's more opportunity out there over the coming months. We are not willing to announce that yet, but we're still a very focused on the Phase 2 of it, which is reducing the overall cost base. We are looking at every contract. We're looking at the way we operate in each of our locations and believe that target is achievable.

Okay. And I guess on the BSA element, that stuff, I would have imagine you’ve to be careful where you cut there and your point is any cuts there were just really redundancies related to lookback, which was completed in the quarter anyway?

If you can imagine the lookback, it was a Herculean effort by this organization, considering the amount of data and the length of the lookback, which was 18 months. So there were a lot of resources dedicated to that. We are closing in at the full implementation of our new AML system. We're reviewing what was the right support levels for that system, but the cuts that we did make in that area, we believe were prudent and still supports our ability to move forward on removing the consent orders.

Okay. So in terms of BSA AML, would you say in terms of meeting the issues in the consent orders you already completed all of it now, so it is sort of a waiting game or there is still little bit of work to be done even though the lookback is completed here?

There is -- we were going to set up a new process. We redoubled our efforts looking at the entire scope of activities. There are three very important activities that the bank must fully comply with all the regulations. Its BSA, its third-party risk management and consumer compliance. So what we've done is we're focusing ourselves on making sure that all requirements are being met. We're looking back at -- we are taking a little bit of a step back looking at everything that we've done in the past to make sure it's integrated and comprehensive. My team is putting those three topics under new directed plans to make sure they can be completed as soon as possible.

All right. I appreciate it. Thank you.

Thank you very much, Frank.

Thank you. Our next question comes from the line of William Wallace with Raymond James. Your line is open.

Thank you. Good morning.

Good morning.

Back to the discontinued portfolio, I just -- if you’re saying this is a one-off event, it's not systemic, there is nothing -- nothing ongoing that's causing you concern about any the other 15 loans, I don’t understand why you won't tell us a little bit more about what happened with this specific loan?

I don't think we're going to have a problem with that once. I personally want to see the appraisers complete the report and understand how -- they basically gave us the number without the support and they are working on the report now. So I don’t want to speculate and we want to look at the …

I’m not asking for speculation on why the appraiser is coming up with their $20 million or their $18 million valuation on the property. I’m more curious as to why the borrower defaulted on the loan, what happened, what was the underlying event that caused this loan to stop paying?

Unfortunately there was potentially an event that occurred. But we, at this present time cannot discuss it. Its under review with the appraiser. We can't speak …

But why can't you discuss it? I guess, that’s what I’m trying to figure out. Is there a legal reason?

Well, obviously this is a delinquent loan and will result in potentially in litigation. Once again, this value is preliminary. It's based on cash flows of the property. It is not necessarily a market value on the property, but because of the situation we have to look at that in order to put the as is value on it, and that's what we did. But we -- at this time we really can't disclose any more than we already have. It would be unfair. It's in preliminary review and there may be ongoing litigation due to the borrower.

Okay. Why -- I guess, I mean, you could -- I hope you can understand as outsiders looking in, the frustration of $32 million mark one quarter and then $24 million mark the next quarter and then you're saying it's a one-off event, but we can't -- I mean, we’re getting nothing. We have no way of understanding what happened that to come up to -- agree or disagree as to whether or not this is a one-off and so it's -- I don’t know, it's a little bit -- its creating kind of cloudiness around the picture, which is frustrating as an outsider looking. So whatever information to Frank's point that you guys can provide us to help us have some level of transparency into the 16 loans, which continue to be a pressure to the story, the better we can sleep at night knowing that perhaps this really is a one-off event and we’re one step closer to putting this all behind us. So I would really encourage you guys to provide whatever detail and color you can in the Q or whenever you get more clarity around whatever -- why every appraiser -- why you disagree with the appraisal is what I assume might be the case, it would help -- it would be helpful to us.

Once again, I will state its preliminary, number one. Number two, it's based on the as is cash flows of the property. Number three, this is just recently become delinquent and may result in litigation for the Company, and number four, this is not necessarily the value that the market may place on the property.

Okay. Do you anticipate, like has the appraiser given you a timeframe as to when they expect to complete their full review?

We're pressuring him to get it done as soon as possible. He didn't give us a day.

Okay. When will you file the Q, around the 15th or so?

November 9, is the due date.

9th, okay.

So we will hold off until then to try and get as much clarity as possible.

Yes, we really are, when we say we're disappointed with the situation, we are. As you know, we have to go through a process that’s reviewed pretty extensively. We did look at the entire book when I first -- management looked at it all again. Obviously, we took a substantial mark in the last quarter. We did not believe at that time. Obviously we reviewed this loan and did not believe at the time that the collateral package, but also the borrower presented an ability to not only want to repay the loan, but there wouldn’t be an issue and it is a surprise to us.

Yes, I believe you there for sure. No question. So I guess what’s …

[Multiple speakers] there would have been no incentive by management not to discloses this in the last mark. It would have made no sense.

Right.

It would have made no sense at all. So we're very disappointed and we hope we can resolve the situation ultimately realize the value of the property, do what we have to do and then put it behind us.

Okay. I think I can speak for everybody in insane that we look forward to whatever clarity you can provide us whether it's on the Q or in an 8-K, once the appraisal is complete and you guys have a little bit more visibility into what the exit event might be for this credit.

Yes, we will do that, Will.

Thanks. Okay. Moving on to the efficiency initiative in place, Paul, you mentioned in your prepared remarks and I apologize, if I missed it, but you did -- it sounded like you gave a number for severance that we will see in the fourth quarter?

The severance, we actually took in the third quarter. It approximated $1.2 million. So if you -- for your model, that’s obviously the number isn't going to recur, that $1.2 million won't recur. It happened, the position eliminations happened at the very end of the quarter, so there wasn’t very much impact in the third quarter, but we also stated that throughout all the different expense categories we're estimating a $3 million quarterly reduction.

And then that $1.2 million is on top of the $1.34 million that you disclose as the lookback costs?

Yes. So, if you're trying to do a normalization those would come out, those expenses would come out.

Right. So you start at 42.2 and then we will see $3 million less in the fourth quarter plus -- are there -- is there going to be a plus related to the efficiency initiatives or will we not start to see additional savings until next year?

You will start to see -- yes, we’ve already taken some actions. So you should see it start. I can't tell you exactly what the impact will be, because there's a lot of time. It also depends on when we purge accounts. We're renegotiating contracts etcetera, etcetera. So, over the next few quarters you will see things start to decrease and by the next -- by this time next year obviously or at the end of next year, the longer-term initiatives will be able to, things that may include things like real estate will be completed. But the early step which is including reduction of counts with things like HSA, the employee costs, the renegotiation of short of contracts, the hard look at the way we're using both consulting and legal services, you will start to see that in the fourth quarter. Just I don't have a prediction right now of exactly what that will be, but you should …

So, if we look at the target of 20% to 25% improvement, how much do you think, maybe, let's just say, you’re -- we're fast forwarding a year and you’re reporting your third quarter of 2017, how much of that 20% to 25% do you think -- do you target we might be able to have seen within the first year. Are you going to be 70%, 80% done or is there a lot …

Yes, it’s a -- well, I think it's at least 75% done.

Okay.

But once again this is a little bit predicated on our revenue.

Right.

So we need to see depending on what our -- if revenue was flat, then you will see the full 20% -- 75% [indiscernible] revenue grow is a lot. We may have expense base. We still believe that we can have mid-single-digit ROE next year and that will be able to power the earnings forward.

Okay. So that's you -- basically you answered it, but to clarify, that was -- it was a segue to my next question, which is of the 20% to 25% improvements, could you basically just say 75% of that is going to be cost and 25% of that’s going to be revenue?

No, that’s all cost.

Okay.

Everything we're taking out, this is a cost initiative. The revenue is separated on our business plans, so we're very focused on rightsizing or level setting the cost of the bank. What we're doing now is reengineering the bank. So what we're going to be doing is looking at every unit that has expense in it, operations unit, everything from wire transfer to processing with our third parties. And we're methodically going through everyone of that. Some of these requires organizational redesign and so these are longer-term. Others are outsourcing. So, I can't mention those things on this call, but some of the things that we do today are inefficient and could be better outsourced at a higher quality. So we’re at that stage where we’re going unit by unit and assessing the value of each process that we have and how it should best be done. That old buy, build or hire decision. So that process is ongoing. It started prior to the restructuring, but that process should be concluded in the next 60 days. However, some of those actions have already been -- the lower hanging fruit is already been taken.

Okay, great. Thanks. And then, you mentioned, Damian, in your prepared remarks that you are going to put some sort of presentation on your Web site that will provide some more specifics around the initiative. I guess, it sounds like maybe some sort of checklist?

Yes, we’re going to -- we’re updating the investor, there is an investor presentation on the site. We’re going to update it substantially with all new information, as well as the overall strategy of the bank in more details, which will also include a checklist.

Okay. Okay. Thanks, guys. I will hop out. I appreciate it.

Thank you, Will.

Thank you. Our next question comes from the line of Matthew Breese with Piper Jaffray. Your line is open.

Good morning, everybody. As you go through additional looks at the discontinued operations portfolio, do you think there might be additional marks as you continue to review there and does this quarter's events change your confidence level on the existing marks?

No. it doesn't change. Across the portfolio, no. It is very unfortunate what happened. It was absolutely unanticipated by management, but also by our third parties. Once again, it's still in the -- we don't know the outcome of it. This is part of the issue here. As soon as we know the outcome of it, we will tell you. We really are in a preliminary stage. We are obviously announcing earnings and wasn't sure whether or not that process would be ended by November 9. So we made a determination to go to the market with the best information we had at the time, the most complete and be transparent about it, instead of delaying earnings and then hoping that as the process was concluded by then. So we’re trying to give the most relevant information that we have at this point to the market, so they can assess the opportunity to invest or not invest in our Company and that’s it. We think that the earnings have tremendous value in the positives. There's a lot that’s going on here. We have revenue momentum and we're taking care of the issues we’ve with regulators, as well as radically changing our cost structure. It is absolutely unfortunate this happened. This was not a loan. Obviously this was a loan that was made several years ago that had been performing for three years. The collateral package was thought to be of market relevant, that the loan was not impaired in any way, that it's a valuable piece of real estate. That does have a real market value to it. However, once again it became impaired recently, because of changes in the status of what may be perceived as an as is valuation and because it may have foreclosure that is our responsibility to report that to the market.

Understood. Okay. And then looking ahead, I know you’ve talked about the valuation allowance recovery. Does that assume you can regain profitability over what timeframe? Like next quarter or the next …

Yes, that’s required. But based on our projections, we believe we will get the full amount of the reversal next year in 2017.

Yes, you have to be able to show, obviously a projection, but also a performance for that. We believe we will do that. I think we will start seeing those changes occur in the fourth quarter of this year. We will have a meaningfully different profitability than we had in the previous quarters over the last couple of years. And we are just trying to put the Company on the right track. It's unfortunate we got so distracted. This is a loan that could have happened six months ago, it could happened three months ago, it could happen six months from now. And it is very unfortunate at this time in place that this has happened. But that we have no choice, but to follow the GAAP rules that we live under and follow the guidance of our third-party assessment of the collateral.

Understood. So the guidance is that you'll be profitable next quarter?

We don’t actually give guidance. We are suggesting. If you look at the specific items in the press release and into the discussion where you take out the severance and you add in the savings and you look at the beginning of the expense cuts, your model should, I would think show that.

Of course, we can't also predict revenue. So we don't we are -- we don’t know exactly what the quarter will look like in the fourth quarter. We do have revenue met. I mean, we are cutting expenses. So the result should be improved profitability over time and we believe that improved profitability will be present in our fourth quarter results.

Right. And then as you recover the DTA valuation allowance, does that change your outlook on tax rate?

No, the corporate tax rate is currently, its either 34% or 35%. So that’s basically fixed. There is a small impact from state, several percent in addition to that for state taxes, but it doesn't really meaningfully change that.

Okay. And then when thinking about your capital ratios and where you want to bring those to, does that imply that the balance sheet needs to come down quite a bit, needs to shrink and if you could talk about that a little bit and where you would like to see the balance sheet over the next year or two?

We don't want to grow the balance sheet substantially. However, there is -- that’s because we want to run a very efficient bank. So even if -- we conceive of this bank remaining under $5 billion over the next three years. Having said that, there is still a significant, as we resolve some of our issues, there is a significant opportunity out there and in the payment space and obviously that’s a deposit generator. So we want to run an efficient bank kind of where we are, maybe a little couple hundred million dollars lower, depending on where we are with capital. But we don't want it -- we don't want to substantially grow the size of our balance sheet over the next few years. We would rather focus more on having the appropriate capital structure and making sure that our balance sheet is more effectively used.

Right. And then, when thinking about the mix of the balance sheet and making sure its effectively used, what does that imply for the margin, the net interest margin and the trajectory of that over the next 12 months?

Well, obviously the margin will -- we may delever the bank slightly after a few hundred million dollars more, it becomes increasingly difficult to do that. That maybe one of those strategies. We haven't decided, we may employ. However, the margin should continue to rise and it rises, because of our increases in the loan book obviously, right. So it can increase because of that, but it could also as a loan to deposit ratio increases and the amount of investments we hold decreases, but also it will be substantially impacted by any movements by the Fed. This bank is obviously would benefit tremendously, considering our stable deposit base and we have a sizable portion of our assets variably based. So any changes in interest rates either in the curve or in the Fed's movement has a very positive impact in this bank. We don't have a lot of market sensitivity, it's on the upside. That’s very different than other banks, because of the structure we have. We don't have deposits that really reprice. So that’s a huge benefit of our business model.

Right. So then in terms of a Feb hike, if they were to hike in December, what kind of impact might that have on interest income?

Okay, to give this, -- to give you an example, just in the security portfolio, it would add $1.6 million to the year. It would add, if you look at the SBLOC total, the SBA loan total, those are all directly tied to those rates. And as Damian said that there is a much more modest impact on our cost of fund. So, the majority of that 25% of the 25 bps would flow through to the variable rate aspect of the portfolio.

Yes, that’s a $100 billion of assets too. So if you look at the SBLOC about 600, you have just under three so -- by $900 billion worth of assets, that would reprice to the upside.

Got it. Okay. And then could you talk about the prepaid business a little bit? What are the underlying growth trajectory of the prepaid deposits, both close loop and open loop?

We're not really -- we don’t project and differentiate between close loop and open loop in terms of the average deposits. It really varies by program, but in total we're still expecting double-digit GDV growth gross dollar volume, and that implies double-digit deposit growth, the growth this quarter over the prior -- last year's third quarter was especially strong 18%, some of that was timing, depending on, for instance, when Social Security credits go on the cards. So we're still looking for double digits -- double-digit growth in that.

And what you will probably see is the industry continues to be on the path of maturing and consolidating so, and as I’ve about said before that it's likely that the larger providers will get most of the volume as you have in a maturing industry and fees will slightly trail down over time, so the double-digit GDV growth will result and if it's low enough, it will result as it's in this quarter year-over-year and single-digit revenue growth. But once again that this quarter is not indicative necessarily of that trend. It's fairly -- it bounces around depending on which programs, incentive fees and everything else. So this quarter may not actually be representative of it, but generally over time you'll see the fee growth probably lag slightly GDV growth in the marketplace.

Got it. That’s all I had. Thank you.

Thank you. At this time, I’d like to turn the call back to Mr. Kozlowski, for closing remarks.

Okay. Thank you very much everyone. We really do appreciate you joining us today. This concludes The Bancorp earnings call.