Description

*Note: If you are familiar with Pathward, the prepaid industry or prior writeups (2022), feel free to skip the Overview section below.

Overview

Pathward Financial, Inc. (“Pathward”, “CASH”) is in the banking as a service (“BaaS”) business with prepaid card issuers. These prepaid card issuers market prepaid cards to consumers and business, the most common use cases include fintech apps (bank substitutes), payroll or retail reimbursements (check alternatives), retail general use (holiday or birthday gift cards), or other general rebates (stimulus checks). These cards are functionally equivalent to a debit card linking to a checking account, with Pathward acting as the banking sponsor and holding the cash. Prepaid card issuers require a sponsor bank, i.e. a chartered bank to house deposits, facilitate payments and provide regulatory and advisory services. This is Pathward’s bread and butter.

While Pathward does earn a spread by collecting deposits and investing the cash in higher yielding assets, it shares little else in common with other banks. Pathward earns an adjusted NIM of around 4.5%, ROTE of nearly 30%, and trades at over 3x tangible book. Pathward achieves this by earning revenue from payments (interchange fees) and advisory services (collectively non-interest income; 50% of revenue). Pathward earns a high NIM by lending to small and medium sized businesses in the US at a yield of ~6.5% while paying only ~2% on deposits (interest income; the remaining 50% of revenue).

Pathward is fundamentally misunderstood by the market. The bank does not fit well under institutional coverage; it has a high learning curve because of the nascency and niche dynamics of the prepaid card space. Many analysts disregard the prepaid market at the first mention of “fintech” (reasonable, I almost did as well), or they dismiss the thesis on asset quality and regulatory risk. Pathward often trades in lockstep to KRE, especially when volatility blows out, which doesn’t make sense given its deposits and assets have little in common with regional banks. Only three sell-side analysts cover the security. Earnings calls are often short, with many questions surrounding modeling assumptions and near-term EPS. Many of the top holders are small, unconstrained firms as a result of the odd-duckling nature of the security.

I believe that the market is incorrectly assessing deposit risk; the deposits are sticky, have low economic sensitivity, and should continue to grow. The loan book is less risky and more versatile than the market realizes, with room for higher interest income via rising yields on new loan issuance. Pathward should be able to conservatively grow net income MSD over the next few years while retiring +24% of S/O given the current valuation at around 9x normalized earnings. I think the stock could return over 20%/year through FYE 2026 without multiple expansion assuming an exit at 83/share.

Why Are People Using Prepaid Cards?

According to research from Peter Zimmerman and Paola Boel at the Cleveland Fed, consumers opt out of the banking system as a result of the high overdraft fees, the minimum balance requirements, a lack of trust, and a desire for privacy. Banks began focusing on profitability across all account sizes in the 1980s following tech improvements, which led to increased rates and overdraft fees on lower value accounts that were historically low ARPU for the banks. Lower-income consumers are not too focused on normal depositor concerns such as cash safety, service breadth or CD rates. Rather, these depositors are concerned with 1) getting cash immediately after being paid, 2) having no account minimums and no overdraft fees, 3) transparency, 4) obtaining access despite historical finance issues, and 5) ease of use with low frictions. Other examples of this atypical consumer include individuals with historical credit issues, individuals with identification issues, or truckers that need to have immediate access to cash while quickly moving between states. There is a conclusive lack of product market fit between this subset of depositors and standard banks. As Zimmerman and Boel note, it is rational for some of these consumers to close bank accounts as a byproduct of these policies. This development has been further exacerbated by the Durbin Amendment, which is covered in more detail below.

Deposits

Pathward wins business from prepaid card issuers by offering a high quality, built-out infrastructure to handle compliance, regulatory requirements and payment facilitation. Pathward processes $2.5 billion in ACH payments daily and sponsors ~280k independent ATMs in the US (there are ~400k total independent ATMs; ~530k total ATMs including independent and bank-owned).

The deposit base (prepaid cards) has transitioned over time from fintechs, reimbursement mail-ins and retail cards to larger, corporate-backed partners focused on business customers. 80-90% of Pathward’s deposits today are related to program management services, which is mostly composed of corporate payroll reimbursement for businesses (q4 2022 transcript). The remaining deposits are mostly fintech businesses that act as bank substitutes as well as other miscellaneous deposit partners.

The deposits are spread across approximately 50 partnerships (as of mid-2023), with millions of underlying end customers holding balances often less than $1,000. Management has conducted tests on the deposits and found that the weighted average life is a bit over 6 years in duration. In 2019, management noted that its top 5 deposit relationships had been partners with them for over ten years. As of mid-2023, Pathward’s largest depositor is around 13% of total deposits (likely H&R Block). I compiled a list of recent partners from announcements and public articles as follows:

The big takeaways: Most of deposits are from corporate partners relating to payrolls, the contracts are laddered out across maturities, and Pathward has continued to win new business into 2024. The payroll business (employee reimbursements) is diversified across both industries and employers. These deposits should have low cyclicality, low seasonality and should be sticky in aggregate.

The underlying end customers are typically middle-to-lower class households that value an immediate and easy-to-use payment system. Given that many of the transactions on these cards are used for necessary staples, the value on these cards shouldn’t decline much in a recession until unemployment spikes. As management has noted regarding its depositors, “…they’re always in a recession.” Further, it is possible that more consumers would enter the prepaid market in a recession as they become strapped for cash and fall out of product-market fit with standard banks.

Some prepaid depositors are likely unable to access conventional banks due to issues with ChexSystems (filtration system that banks utilize to screen customers for historical issues), travel frictions, minimum balance requirements, or other verification issues. Many of the unbanked do not even have access to a smartphone or home internet (Zimmerman and Boel). A study from 2006 (Rhine and Greene) found that immigrants were much less likely to have a bank account, with the highest unbanked rates coming from Mexican and Latin American immigrants. Immigrants are likely a key beneficiary of the prepaid card space, and I don’t expect this to change in the near term.

Pathward has continued to sign new partnerships in the latter half of 2023 and beginning of 2024. It is important to note that Pathward benefits as its deposit partners grow. For example, the EDD recently announced it will be switching to Money Network (one of Pathward’s deposit partners) following fraud issues at BoA, which should provide a tailwind for Pathward. The sales cycle for deposit partners is quite long, and management has noted current new partnerships could begin to show up in deposits in one to two years.

Assets

Pathward made a number of acquisitions in the mid-2010s, the largest of which being Michigan-based Crestmark Bank in 2018. Pathward utilized Crestmark to springboard its lending business, and its loan book today is where the bulk of yield, duration and credit risk is housed. Most of Pathward’s loan book is composed of loans to small and medium sized businesses across the nation.

Going back through FDIC bank search data, both banks have historically done well in estimating provisions for loan losses and adapted quickly in ’08 to accurately assess losses. Legacy Pathward had higher charge-offs and was modestly less accurate than Crestmark in assessing provisions for losses. Pathward had 400-500 bps net charge-offs to gross loans in CY2009 and 2010, whereas Crestmark only had 100-200 bps in CY2008-2009, with immaterial losses in 2010 and onward.

During the GFC, the asset book looked typical of a regional bank, with most assets in short-term securities, MBS, commercial loans and consumer loans. Consumer loans accounted for much of the charge-offs. Losses have been minimal since the GFC, and the balance sheet has grown and diversified across insurance premium financing, working capital financing (collateralized by AR and inventory), equipment financing (collateralized; ‘mission critical’ re-fi or third-party liquidation), structured products, ABL and other interest-earning assets.

Over the last few years, provisions have risen to between 100 and 150 bps of loans, and the cash impact from underestimating losses has increased slightly. Part of the rise is from idiosyncratic events; there was a fraudulent solar customer that caused losses in 2019 (management has since pulled back lending in this space) and there was a nonperforming loan last year that I estimate around $15 million that management worked out, realizing a recovery a few quarters thereafter. Management believes their normalized net charge off rate is closer to 50-70 bps, which is probably an overly optimistic full-cycle estimation. I am modeling out 140 bps.

Management spends a lot of time in the diligence process working out buyers prior to an issue arising, so a transfer or asset liquidation is quite efficient. In a recessionary environment, Pathward can transfer new issuances from SBA and equipment financing to insurance premium financing and working capital financing, both of which are high quality, collateralized and somewhat counter cyclical in nature. The following excerpt explaining loan yields is from the Q2 2023 earnings call:

“…our loans are highly collateralized and underwritten to a discounted basis on that collateral. So that in the event of liquidation, our recoveries limit losses we may experience. The higher yields we receive are primarily due to the human capital and due diligence performed on the collateral during the underwriting process and throughout the life of the loan and not necessarily an increased risk premium.”

The weighted average duration on the loan book and securities book is around five years and two years, respectfully, and the weighted average duration of all interest-earning assets is around four years. ~25% of assets reprice in a given a year according to management, so the asset book still has time to fully incorporate the rise in yields seen over the last two years.

Here is how I believe different rate regimes could impact EPS:

• If EFFR comes down, it’s highly likely the yield curve would normalize further even if longer-tenors come down a bit. Said differently, term premiums would somewhat extend as fed funds falls. Pathward’s liabilities would re-rate immediately as EFFR payable to depositors declines, and Pathward would have an immediate cashflow benefit from duration assets repricing. In this scenario, card processing fees would likely dip to ~$80 million from ~$140 million (3% EFFR x 70% conversion x 60% of depositors being interest-earning) and net interest income may dip to ~$380 million from ~$460 million ($7 billion interest-earning assets x 5.5% [vs. 6.6% currently]). The overall impact on operating earnings would be a drop of $20 million, excluding any one-time benefit from duration assets repricing. While this is the conservative approach, I actually believe it is fairly likely that mid-tenor yields hold current levels even as EFFR comes down, which would be net accretive to NII.
• If rates stay constant, the business should continue to generate a healthy NIM and NII. In my opinion, it is more likely that EFFR goes down from here, whereas the five year treasury around 4% is closer to a multi-cycle average. Said differently, Pathward will eventually benefit from yield curve normalization even if rates stay high. Management noted in the Q4 2023 earnings call that they expect the NIM to expand if rates stay higher for longer.
• If rates increase, the curve will also likely increase around the five-to-ten year duration as inflation and neutral rate expectations rise. New security and loan issuances on the asset side will increase in yield, and the liability side will continue to pay out EFFR to ~60% of depositors. NIM and NII should be stable, and there would be upside if EFFR were to be cut going into a recession.

I believe EPS should be stable or have incremental upside in multiple interest rate regimes. I will note two further points to consider. First, it is reasonable to assume that a recession could ensue in both the first and last scenario. This would likely include spread premiums blowing out as well as losses from the loan book. Second, one scenario that would be negative for EPS but seems less probable is a multi-year deflationary period going forward. This could result in very low EFFR and a flat, low-premium yield curve (think ZIRP) that depresses yields on new issuances.

Supply Side Analysis

Management has mentioned that they expect some pressure on the supply side as other banks have taken note of the success of the prepaid card space (q3 2023 transcript). Competition is range bound; the Durbin Amendment caps the upper end (over $10 billion in assets, covered in more detail below), whereas capital, infrastructure and network build-out costs cap the lower end by barring banks with less than a couple hundred million in assets (small banks don’t have the resources required to compete). Prepaid services, especially compliance advisory, are rolled out with a “fail and keep iterating” approach given the nascency of the space and lack of clear regulatory guidelines. Based on my understanding of the capital and personnel investment required, it takes around three years to roll out internal prepaid card services, and ROI may not show up until around year five. Some smaller banks utilize BaaS consultants that provide back-end solutions to house prepaid deposits, but this space is contracting. BaaS is low margin and there is regulatory risk for smaller banks that use these providers, reducing their appeal.

In a scenario with increasing competition (supply), Pathward and Bancorp (NYSE:TBBK; Pathward’s largest competitor, discussed in detail below) would encounter reduced card processing fee income and higher expenses while still earning mid-teens ROTE from scaled operations and NII. New entrants would share the worsening unit economics on payments but would not yet share the scale and operating leverage which allow Pathward and Bancorp to earn satisfactory ROTEs. Pathward and Bancorp would lead the charge as new supply exits the market and payment fees revert to mid-cycle equilibrium. I am not convinced that increased supply is coming online in the near term given the costs and time to build out these services, the compliance and regulatory hurdles, and the less attractive ROTEs that new entrants would encounter in the process.

Concerns & Risks – The Durbin Amendment

The Durbin Amendment, passed in 2010, caps the interchange fee that issuing banks over $10 billion in assets can charge merchants to process payment transactions. This directly reduces profits and reduces larger banks’ ability to compete with smaller banks that are not subject to the cap. The Durbin Amendment is controversial; the economic reality is likely that banks historically charged higher interchange fees to subsidize other product offerings, and limiting those fees simply moved prices up on other banking services to compensate for the lost profits. Ironically, checking accounts became more expensive (1)(2) as a result of Durbin, which likely in-turn further fueled the rise in prepaid card demand.  

As previously mentioned, the deposit pool is largely locked into multi-year contracts. Even if the Durbin Amendment were abdicated tomorrow, it would still take larger banks time and capital to compete in this space. Pathward has a strong buildout of infrastructure and compliance that would not be immediately replicable by larger banks. Lastly, I do not think that Durbin could be easily overturned in the current environment. In fact, Fed staff recently submitted a request to the Board of Governors to further lower the interchange fee cap on covered issuers (banks > $10 billion), which they note could increase costs on debit accounts, thereby providing more tailwinds for the prepaid market. Paying close attention to congressional appetite and lobbyist efforts is sufficient to monitor amendment overturn risk. I believe the near-term probability of this happening is low, but of course it could become more likely in the future.

Concerns and Risks – EIP Runoff 

One EPS hurdle Pathward will encounter this year and next year is a reduction in deposits left over from the EIP (stimulus program). These deposits were held off balance sheet and earning EFFR, flowing through card and deposit fees in non-interest income. I estimate the net impact in to processing income will be a drop off $15 million ($300 million x ~5% EFFR) in FY2024 $10 million ($200 million x ~5% EFFR) in FY2025. Overall, this is immaterial and should be offset by rising NII.

Concerns & Risks - Competition

The only scaled, fully built-out competitor to Pathward is Bancorp. Bancorp has grown rapidly in recent years and has a similar nominal value of total assets. Bancorp recently traded at a premium to Pathward at around 13x, but the stock declined nearly 30% over the last month and a half and now trades at a similar valuation to Pathward.

T0YPAJ182 published a thorough short report on Bancorp in December, calling into question its multifamily CRE risk concentrated in Texas, highlighting credit issues with one of its top borrowers, and noting the lack of ACLs or acknowledgement from management on the looming issue. Bancorp has ~40% of its loan book linked to CRE bridge loans, whereas Pathward has effectively zero.

Further, Bancorp’s deposit base is much more exposed to fintech businesses and neobanks. Neobanks were born during ZIRP and often have questionable business models and cashflows. Pathward’s deposit base, which leans toward corporate payrolls, is stickier and more durable. Pathward’s management noted that the fintech companies that they do work with have ample cash and a strong understanding of the regulatory environment (q3 2023 transcript). Pathward’s management monitors deposit partner concentration and has developed weight limitations on depositor partner industry exposure. For all of these reasons, I believe Pathward has a less risky path forward and should have an easier time selling its BaaS services to new depositor partners as compared to Bancorp.

Concerns & Risks – Peak EPS?

1. $300 million from the securities portfolio is maturing in the NTM and can be reinvested at higher rates. Additionally, there are still loans rolling over that can be reinvested at higher rates.
2. Both deposit partners as well as the underlying deposits have continued to grow organically, which should add further deposit growth in coming years.
3. Management has low risk of cash sorting in the near term compared to regional banks because most deposit partners sign long-term contracts.
4. As noted above, Pathward should have a path towards EPS accretion in a variety of rate regimes.

Concerns & Risks - Size

Pathward can continue to grow via off-balance sheet expansion without encroaching upon $10 billion in assets. I believe that incremental ROTE could still be high teens; Pathward would earn a lower NIM because it would be limited to earning EFFR on off-balance sheet deposits, rather than investing the assets into higher yielding opportunities on-balance sheet. While much of the EFFR earned would net out through processing expenses, Pathward would still earn ample noninterest income from facilitating payments and other services. The market perceives Pathward as being size constrained as evidenced by the multiple it trades at, which in turn has led to management allocating most of earnings to share repurchases. I view this market perception as an opportunity for management to continue retiring as many shares as possible at > 10% earnings yield.

Concerns & Risks - Shorts 

Short interest has gone from 2 - 4% in mid-2010s to 9% as of March 2024. I can see why shorts may be attracted to this situation: 1) they may perceive credit risk from loan book, 2) they see growth constrained as assets approach $10 billion, 3) they see headwinds from the stimulus deposit runoff 4) rates may have peaked, 5) there may be increased competition as other banks view the prepaid space opportunistically, and 6) Durbin Amendment risk. I have addressed these issues independently throughout the writeup.

The big risk in shorting this security is that the amount of shares that Pathward is buying back creates an ongoing bid; the thesis does not require animal spirits to permeate on the long side in order to work out. Shorts should also be aware that the business can still grow deposits off-balance sheet. Deposits have continued to grow, deposit partner relationships have continued to materialize into 2024, credit has remained stable, and the NIM has continued to expand.

The Pitch & Valuation

Management has shown a rational and transparent policy towards capital allocation: buy back stock when the ROE on share repurchases exceeds that which can be deployed in operations. See below from the Q1 2024 earnings transcript:

“…There will be, at some point, some use of capital. But at these prices and for a while these … this level of stock, there's not a better use of our capital than to buy the shares. And we get up into a period of twelve[x] or something then we'll have a different conversation. But right now, I can't get an ROE on capital that's better than what I'll get by buying back shares.”

Management funded acquisitions with shares when the bank was trading around 15-20x from 2015-2019, and thereafter began aggressively retiring shares when the multiple began compressing towards 10x (chart below from Koyfin). Since 2019, management has reduced S/O by ~37% and used ~82% of cumulative net income for share buybacks. Including dividends, which remain at $0.20 a share at $5.4 million per year, management has returned over 86% of cumulative net income to shareholders since 2019.

Pathward has continued to sign new deposit partners and grow existing deposits, and I expect deposits to continue growing at mid-single digits in the coming years. Proceeds from lower-yielding security and loan maturities can be reallocated to commercial financing, with new underwriting moving the yield from 8.3% today to 9.0% by 2026 (management noted new issuance is yielding ~9.0% today). Non-interest income will likely be flat as payment and card fees go ex-growth from competition and EIP depletion. Overall, with slightly increasing SG&A to total revenue and normalized tax rates increasing to 20% by 2026, I expect Pathward will conservatively do ~$185 million in net income by FY2026, which equates to a ~4.5% CAGR on net income over the 3-year period.

Assuming Pathward allocates 80% of net income to buybacks, below historical precedent, Pathward could retire over 24% of shares cumulatively through FY2026 (~11.1% EPS yield x 80% utilization rate x 3 years). Assuming no multiple expansion, an exit at FYE 2026 at 9x EPS would equate to $83/share, resulting in a total return of +70% and an IRR of ~24%.

Catalyst

Increasing earnings

Share buybacks