Description

Summary

Pathward Financial (“CASH” or “the Company”) is a differentiated SMIDcap bank trading at ~7.5x P/E, a material discount from historical multiples, despite earnings inflecting positively. CASH has a pristine balance sheet and all FCF is utilized for share repurchases. Insiders are reiterating their confidence with recent open market purchases. We expect the equity to rerate substantially over the next 12 months, as the market begins to capitalize sustainable NIM expansion, and the ongoing buybacks exhaust any remaining sellers. We target ~$60/share as conservative fair value in 12 months for ~50% upside.      

Business Overview

Pathward Financial is a top 3 operator in prepaid debit card banking in the US. To explain with a simple example, a retailer develops an in-house prepaid card program (gift cards or rewards) and partners with CASH, which takes the deposits and provides access to the payment networks. As the consumer makes a purchase with the card, the merchant will pay a small fee (interchange fees) on the transacted amount, typically 50-150bps. The economics are then split between the program manager (i.e. retailer), the bank (e.g. CASH) and the payment processor (e.g. Marqeta). 

The rest of the business is a straightforward banking model – the liabilities are the deposits from the prepaid cards, and the assets are a diversified book of securities and loans. The largest category is higher yielding commercial finance loans (49% of interest-bearing assets), then MBS (26%), warehouse finance (6%), cash and Fed Funds (5%) and various other categories. The income statement is simple – comprising of net interest margin, provision for credit losses, fee income, and operating expenses. 

There are 3 reasons why the business model for CASH is structurally advantaged vs. the average bank:

• Zero cost deposits 

• Regulatory benefits (Durbin Amendment) 

• Oligopolistic industry 

First, CASH does not pay interest on prepaid card balances, which accounted for 96% of the Company’s liabilities as of the most recent quarter. This is the key differentiator for CASH versus the average bank, which pays interest on deposits (savings accounts for instance). Therefore, CASH typically earns outsized NIMs relative to the broader banking industry – NIM stood at 5.23% for fiscal 4Q’22. 

The second aspect is a regulatory one. The Durbin Amendment, which was passed as part of the Dod-Frank Act, caps interchange fees paid by the merchant to banks. However, banks with less than $10bn of assets are exempt from this rule (including CASH), which means that smaller banks enjoy higher fee earnings than larger competitors. This dovetails nicely to the final point, that prepaid debit card banking is a consolidated industry, dominated by the top 3 players (TBBK, CASH and GDOT) who collectively have ~40% market share. Barriers to entry are high in terms of upfront investment (cost of capital, compliance and underwriting infrastructure, and relationships with card program managers). At the same time, larger banks are less incentivized to compete aggressively due to the cap imposed by the Durbin Amendment. 

Investment Merit (1): Macro Tailwinds 

To ascertain the potential for NIM expansion in the current rising rate environment, we need to consider two key variables: duration and fixed/floating mix of both assets and liabilities. In this regard, CASH is very well positioned to capture the benefit of rising rates, because the liabilities side won’t be repriced at all (cost of deposits remains zero) while 50% of assets reprice within 12 months. Latest presentation illustrates this clearly:

Doing some math: Fed Funds rate is forecasted be around 4.25% by end of 2022, with potential for more in 2023. Variable rate loans reprice automatically, while the fixed rate portfolio benefits too as loans mature and reinvest at higher rates. In addition, CASH enjoys a mix shift tailwind, as higher yielding commercial finance loans are emphasized over lower yielding asset classes. Incorporating all these factors, we estimate that 2023 NIM will approach ~6.00% (recall Sept quarter NIM was already 5.23%). 

Investment Merit (2): Low Valuation 

Before we get to discuss how cheap CASH is, we need to model out 2023 earnings. We have modelled the following case analysis, with assumptions that we believe are reasonable/conservative:

We would argue that ~7.5x P/E is exceptionally cheap for a business of this quality, given sustainably high ROEs (~22% expected for 2023 based on above numbers). With that said, relative valuation is important too, so let’s review the comp set, including direct comps TBBK/GDOT, and the broader SMIDcap banking industry: 

Source: Bloomberg & Street Estimates

CASH is certainly one of the cheaper names on the list, but the true rel-val attractiveness only becomes apparent if you analyze each component of the following checklist, which CASH passes with flying colors (while comps fall short): 

• Earnings profile (CASH has a huge fee component vs. NIM; comps do not)

• Cost of deposits (stable at 0% for cash, rising for comps)

• Pace of NIM expansion (slower for comps)

• Asset/loan quality (comps have a lot of CRE, resi and consumer exposure)

• Capital allocation (CASH is directing 100% of FCF for buybacks; comps are not)

• Liabilities/leverage (CASH effectively has no corporate debt; many comps do)

Finally, it’s instructive to look at TBBK, which is the best comp for CASH and a bank that likewise had strong earnings for the Sept’22 quarter. We believe that CASH can soon catch up to TBBK’s valuation, and indeed we would argue that both names are primed for strong multiple expansion in the upcoming quarters. However, CASH is truly a unique animal in that it marries the zero-cost funding of the prepaid debit cards (liabilities side of the B/S) with a differentiated, higher yielding commercial finance lending franchise (assets side of the B/S). Even TBBK does not quite measure up, with NIM of only 3.69% in the latest quarter, versus 5.23% for CASH.

Investment Merit (3): Mix Shift to Higher Margins 

One of the main criticisms of CASH in previous years was an underperforming asset base, overindexed to low yielding securities. This was rectified in 2019 when the Company acquired Crestmark, a bank that specialized in higher yielding commercial finance loans. This was a highly complementary acquisition, as CASH brought zero-cost deposits from the payments business, while Crestmark brought the commercial lending franchise and the underwriting capabilities to the table. There is a clear value-creation playbook in place, as the asset mix is an ongoing shift to the higher yielding Crestmark loans, providing a tailwind to NIM irrespective of the rates environment. 

The commercial finance business is primarily asset-based lending, leases and receivables factoring. Crestmark has a demonstrated history of excellent credit performance, even through the GFC, where charge-off rates peaked at ~300bps of assets in 2009 (from ~150bps pre-crisis). Management describes the low-LTV underwriting philosophy as being ambivalent to whether the borrower defaults or not, as the bank is able to recover the principal through its battle tested enforcement and liquidation protocols. 

This is a key reason why we are comfortable with the CASH investment through a potential economic downturn. Majority of the lending is done on a secured basis, with hard collateral, on conservative LTVs that would allow the bank to recoup the basis on a downside liquidation scenario. In the case of factoring, CASH focuses on more complex transactions where the transaction is underwritten and analyzed invoice by invoice – rather than a volume-based programmatic approach. Further, management notes that credit performance should be much stronger in any future recessions versus the GFC, as the bank no longer has any commercial real estate exposure. 

Investment Merit (4): Attractive Capital Allocation 

The Company has returned most of the earnings to shareholders for the past 3 years. For context, of the $343mm of cumulative Net Income from FY’19-21, CASH paid $21mm in dividends, and bought back $269mm of stock. The buyback pace continued in full pace in FY’22 also, for $167mm of stock.

The Company needs little reinvestment into the business, has a debt-free balance sheet and is unable to pursue large acquisitions due to the Durbin Amendment. Furthermore, management is acutely aware of how accretive it is to buy back stock while the price lingers in the low $40s – as evidenced by public commentary regarding buybacks and insider open market purchases earlier this year.

Quantifying the Upside 

As discussed, we believe that $158mm is a reasonable proxy for a mid-cycle Net Income. We are comfortable underwriting a 10.0x P/E multiple, in line with CASH’s historical average, and a modest premium to the comp median (justified by the business quality). This is not to say CASH cannot achieve a premium valuation, and indeed we would not be surprised to see CASH trade at low teens multiples during the frothier parts of the business cycle. We believe the modelling is conservative, as we don’t include the impacts from share repurchases, discount the possibility of more aggressive Fed actions, and do not give credit for additional growth in fee income.

Risks and Considerations

1. Execution Risk: the stock sold off significantly on F3Q earnings, as CASH disclosed a couple of customer losses for the tax services business and gave FY’23 guidance that disappointed the market. The Company was not able to immediately capture NIM expansion implied by the Fed rate hikes, because there was still too much excess liquidity in the banking system for fixed-rate commercial loans. At the same time, some variable rate loans also did not reprice in time due to rate floors. For the stock to re-rate, the Company must show a cleaner trajectory of NIM expansion in the upcoming quarters. We believe these are temporary headwinds that will be worked out in the near term, and the stock has fully derated to price in the disappointment

2. Credit Risk: the other cause of the derating from the peak of $64/share in the past year was fears about credit losses in a recession. However, losses peaked at ~440bps and ~300bps for CASH and Crestmark respectively during GFC, and we expect NIM net of losses to remain positive during a sharp recession. The Company would then be in an excellent position to retire shares at trough valuations (recall CASH bought back $119mm of stock during the COVID panic of 2020) and create further value for long-term oriented shareholders. 

3. Regulatory Risk: It is our understanding that the risk of a material legislative development regarding the Durbin Amendment is low, though admittedly these aspects are hard to predict over the long term. CASH and direct peers have all had regulatory hiccups in prior years, but the Company is currently in good standing with all regulatory agencies. 

4. Competitive Risk: Given high ROEs, we may expect excess returns to be eroded over the long term, but competitive threats should not be meaningful in the next handful of years. It is difficult to replicate the program manager relationships, compliance and underwriting capabilities for a new entrant in short order, while big banks are unlikely to make a major push for market share given that the Durbin Amendment limits ROICs for this line of business. 

5. Dead Money Risk: for a $1.2bn market cap, $8-10mm ADV stock that is mostly owned by passive holders, “will anybody care?” is a fair question. Management is not particularly promotional, and analyst coverage is sparse, with only 3 smaller shops covering the stock. With all that said, the Company is taking full advantage of this with share buybacks, before the market wakes up to the upcoming earnings inflection.  

Miscellaneous Observations

• The Company is currently undergoing a rebranding process. CASH sold the “Meta” trademark to Facebook for a tidy sum of $60mm, which was basically found money. While this is truly a non-recurring gain, we like the management savvy of negotiating a windfall for the Company. Meta Financial was recently renamed “Pathward” – the rebranding process guided to be complete by the end of 2022. 

• The Company issued $20mm in sub debt in Sept 2022, with the intention of repurchasing more shares at prevailing prices. It is our understanding that management is comfortable with modest leverage at attractive interest rates, and are encouraged to see such blocking and tackling 

• The following table summarizes recent open market purchases by insiders. Management has reasonable skin in the game through their equity ownership, bolstered by recent adds. 

Catalyst

• NIM expansion / Earnings Growth 
• Continued buybacks 
• Multiple Rerating