Debra Wordwell [ph] – IR
Harold Gilkey – Chairman and CEO
Dan Byrne – EVP and CFO
Jim Bradshaw – D.A. Davidson
Sterling Financial Corporation (STSA) Q1 2008 Earnings Call Transcript April 22, 2008 11:00 AM ET
Good day everyone and welcome to the first quarter 2008 earnings conference call. Each of you will be on listen-only mode until the question and answer session following today's presentation. Today's conference is being recorded for replay. Additionally, the replay will be available at Sterling's website www.sterlingfinancialcorporation-spokane.com immediately following the call.
I would now like to turn the call over to Ms. Debra Wordwell [ph] of Sterling Financial Corporation.
Thank you, Abby. Good morning and welcome to Sterling Financial Corporation's first quarter 2008 earnings conference call. With us today I have Mr. Harold Gilkey, Chairman and Chief Executive Officer, and Mr. Dan Byrne, Executive Vice President and Chief Financial Officer.
Before I turn the call over to Harold, I must remind you that during today's conference call Sterling's management will be referencing forward-looking statements that are not historical facts (inaudible) to our future operating results. These forward-looking statements include but are not limited to statements about our plans, objectives, expectations and other statements (inaudible) that are not historical facts. These forward-looking statements are inherently subject to (inaudible) business, economic and competitive (inaudible) many of which are beyond our control.
In addition, these forward-looking statements are subject to assumptions, (inaudible) future business strategies and (inaudible). Sterling's actual results may differ materially from the results discussed in these forward-looking statements (inaudible). These risks include but are not limited to the possibility of adverse economic development that may among other things increase delinquency risks (inaudible) dips in demand for Sterling's loan and other products, increased costs and lower-than-expected revenues or cost savings, acquisitions, changes in accounting policy, changes in the monetary and fiscal policy (inaudible) federal government, changes in laws, regulations.
I would also note that Harold and Dan are presenting at the following upcoming conference on May 6th, 2008 at the Washington Asset Management Annual Client Event in Seattle, May 7th through the 8th at D.A. Davidson & Company's 10th Annual Financial Services Conference in Seattle. On August 11th through 12th, Sterling will host Analyst Day at Hayden Lake, Idaho near its corporate headquarters.
With that said, I would like to turn the call over to Mr. Harold Gilkey, Chairman and Chief Executive Officer of Sterling Financial Corporation.
Thank you (inaudible).
Excuse me, this is the conference coordinator. Are the speakers still online?
Yes, we are.
Thank you. Your line had cut out. I apologize.
Let me begin again. Yesterday, we announced our earnings of $0.06 per share for the first quarter of 2008. During the quarter, Sterling recognized a credit provision of $0.37 -- I'm sorry, $37 million or roughly $30 million higher than planned equating to a reduction in reported earnings of $0.36 a share. Let me put that another way. Without this charge, Sterling would have come in at the higher end of management's guidance. Hello?
Yes, sir. You can still be heard.
Thank you. It would have come in at the high-end of management's guidance of $0.38 to $0.42 per share. In other words, Sterling's core banking business is performing generally very well. Earnings were impacted by the unfolding credit crunch created by the larger global financial institutions in the subprime market. Sterling did not participate in these lending practices that led up to the mortgage crisis. Still, Sterling needs to play the hand that was dealt. We are doing that.
The level of provisioning this quarter adequately addresses the illiquidity of many of our borrowers that are facing due to the higher inventory carrying issues. Many of these borrowers have residential product that is in finished or near completion stage. Ultimately, the market will need to work through the current inventory levels until they return to normal and meet the normal supply and demand.
We are encouraged by the preliminary signs that the residential housing market is beginning to pick up and we think it could be the initial bottoming phase of this cycle. I recognize that we are currently operating in a very uncertain environment. But I believe it is prudent to redo assessments on a regular basis.
In the quarter, Sterling's core business remained strong thanks to the focus and dedication of our employees on our customer base. Sterling Financial Corporation achieved total assets totaling $12.7 billion, representing 11% year-over-year increase and a 4% sequential growth. Loan receivables increased by 9% to $9.1 billion from a year ago level and were up 2% sequentially representing an annual growth rate of 8%.
Deposits rose 4% to $7.8 billion year-over-year and were up 2% on a linked quarter basis. New loan originations were $1.1 billion, $195 million lower than levels of a year ago. That is a direct result of Sterling de-emphasizing its construction lending. Construction originations were down $271 million in the quarter from the first quarter of 2007.
Sterling's capital adequacy and liquidity remained strong. Total capital advanced 7% to $1.2 billion from year-ago levels. Our total risk based capital was 10.9%. Sterling has cash, cash equivalents and high-grade investment securities of $2.5 billion. Sterling's investment securities provide substantial liquidity and collateral for borrowings. Sterling has additional borrowing capacity of over $700 million through the Federal Home Loan Bank of Seattle, plus over $2.5 billion in additional liquidity through commercial banks and the Federal Reserve Bank.
Our credit quality issues are contained within a segment of Sterling's portfolio, Residential Construction. Our commercial real estate portfolio is behaving normally. We have made nice strides in building our corporate business banking business. And our consumer portfolio is stable, even though it has been in a slight rise in the automobile delinquencies related to borrowers working in the construction industry.
As I have often said, time, money and management will resolve credit quality issues. Sterling is devoting significant management resources to work out distressed residential construction loans and reposition our loan portfolio. We have activated a residential construction special projects team to support the internal efforts of our real estate and credit administration divisions to work out and resolve distressed loans.
Ultimately, the market will work through its current inventory levels until they return to normal to meet both supply and demand. We believe progress is being made. First, all lenders in our market area cut back on funding of new residential construction. That means no new inventory. Secondly, residential sales activity is picking up month by month. That means inventory absorption. Third, we are entering the important spring and summer selling season for residential housing. That means sales velocity is likely to pick up.
Our subsidiary, Golf Savings Bank, which originates permanent single-family residential mortgages, is experiencing a significant increase in application volume. Medium home prices in our core markets seem to be stable. Yes, they have softened a bit, but they are not anywhere near as weak as other parts of the country.
Lastly, Sterling operates in an area of the United States, the Pacific Northwest, where the economy remains solid, and the growth drivers such as population migration and new job creation continue to be favorable.
With respect to the goodwill litigation expenses, late Friday afternoon, Sterling received notice that the United States government filed an appeal, the ruling rendering -- rendered by the United States Federal Court of Claims in January of this year, which awarded Sterling just over $1 million in damages for breach of contract related to past acquisitions of failed institutions. Over the next two weeks, Sterling will evaluate its course of action.
Regardless of the outside influences that impacted our business, I still believe banking is simple business. Take a deposit, make a loan, charge a fee and control your operating expenses. We are in fact building a franchise that is the leading financial holding company for the benefit of our shareholders, our customers, our community and our employees. I'm confident in our people and our basic cultural icon, Hometown Helpful.
At this point, I would like to turn the call over to Dan Byrne for more detail on the numbers. Dan?
Thanks, Harold. I will just (inaudible) provided in the press release. I'm going to focus on a few key highlights for the quarter and provide the opportunity to ask specific questions during the Q&A.
At the end of the first quarter, Sterling's total assets were a record near $12.7 billion and total loans receivable had increased to a record $9.1 billion. Sterling's total loan originations were $1.1 billion for the first quarter and I would add that our residential construction had a sharp decline in originations down to 18% from the last quarter.
Yesterday, we announced earnings of $2.9 million or $0.06 per diluted share for the quarter. During the quarter, we had a credit provision of $37 million, which as Harold mentioned is much higher than we were expecting when we gave our guidance in January. If the provision had held to our prior expectations of $6 million to $7 million, we would have been reporting earnings at the high side of our previous guidance, which had been $0.38 to $0.42. Also yesterday, Sterling's Board of Directors declared a regular dividend of $0.10 per share payable to shareholders on July 11, 2008 to shareholders of record of June 30, 2008.
With respect to net interest income, it increased to $92.1 million for the first quarter of 2008, a slight increase from the $92.0 million on a linked-quarter basis and up 14% over the same period a year ago. The net interest margin on a tax equivalent basis was 3.24% for the first quarter of 2008. That compares to 3.34% on a linked-quarter basis and 3.41% for the same quarter a year ago. Being asset-sensitive in the near-term, our loans have been more responsive to the Fed rate cuts and have been re-pricing quicker than our deposits and borrowings.
We took several steps to stabilize net interest income. During the quarter, our treasury management team worked very hard to reposition our borrowings and re-price our deposits, and I think we were quite successful at minimizing the impact of the rate cuts to our net interest margin.
Second, we aggressively added to our mortgage-backed security levels with high-quality agency securities to reduce our asset sensitivity. These actions muted the decrease in the margin. I would add that the increase in non-performing assets adversely affected net interest margin by approximately 8 basis points during the quarter. The remaining margin compression was due primarily to the reduction in short-term interest rates during the quarter.
Total non-interest income was up approximately 1% for the first quarter compared to the linked quarter, although the quarter included a $2.1 million charge for early extinguishment of trust preferred securities. Mortgage banking operating income for the first quarter of 2008 was $6.2 million compared to $6.7 million in the linked quarter and $8.9 million in the same quarter a year ago. The declines are mostly reflective of the disappearance of the conduit market, coupled with a retreat of life insurance companies, which have slowed down their funding of new loans.
Brokered income for the quarter was $1.1 million, which is less than half of what it had been a year ago. Because of the declines in prices for portfolio loan sales, we also backed away from selling some of our products such as SBA and commercial loans. We do expect that pricing will improve later in 2008 and we may be back in the market at the appropriate time.
Gain on sale of loans was a little more interesting because of the volatility in resale market and the inconsistent pricing that we saw in the market. In the first quarter, residential loan originations were $411.1 million and loan sales were $335.5 million, which is up on a linked-quarter basis but down from the year-ago quarter. And the margin on loan sales have bounced around a little bit, so the margins were down on a linked-quarter basis, but the increase in volume made up for most of the margin difference.
Gains on the sale generated approximately two-thirds of mortgage banking income. Other mortgage banking income primarily reflects modification fees and that is held fairly steady at roughly $1 million across the periods that we are comparing.
Regarding our Golf Savings Bank franchise, since the disruption of the mortgage markets began last August, the level of loan production and profitability has been steadily rising. Although the loan origination pie is smaller, so is the competition. We have seen the level of applications for the residential and loans rise by nearly 36% to over $500 million since year-end.
Our efficiency ratio also improved slightly during the quarter as operating expenses decreased, while the income components of the ratio held steady. We had been working to reduce operating expenses and continually improve our operations. The ratio of non-interest expenses to average assets dropped a little bit more dramatically down to 2.33% for the first quarter of 2008. That is down from 2.52% on a linked-quarter basis and 2.60% in the same period a year ago.
Full-time equivalent employees decreased slightly to 2557 from 2571 at the end of the year. During the first quarter, total operating expenses decreased $3.8 million from the fourth quarter of 2007, although fourth quarter of 2007 did have some non-recurring adjustments which accounted for about $1.8 million of this difference. Sterling nevertheless decreased operating expenses by approximately $2 million, which came primarily in occupancy and marketing-related expenses. At March 31, 2007, non-performing assets were $204.0 million, which is up from $126.5 million last quarter and $18.9 million from a year-ago period.
As we have identified in the press release and in prior conference calls, the largest component of non-performers are in the residential construction portfolio, which accounts for 75% of all non-performing assets and about 73% of the increase from last quarter. The balance of the non-performing assets is in other loan types that tend to be more typical of a growing company and are pretty well diversified across our loan portfolio.
Now, regarding the residential construction, Boise is still the market that has our closest attention with 31 million in non-performing assets or 20% of the total residential construction non-performers. There we have 31 borrowers that are in the non-performing status. This is up from $27 million last quarter.
In southern California, we have four borrowers with projects that have a combined $25 million in non-performing loans and that accounted for 60% of total non-performing residential construction loans. In Bend, we have six borrowers with a combined $20 million of non-performing loans or 13% of our residential construction non-performing assets.
The Portland, Vancouver market experienced some change this quarter with non-performers related to the residential construction portfolio increasing by approximately $25 million. This is concentrated mostly in the Vancouver area with six new non-performing borrowers totaling $18 million. One particular borrower is a developer with three projects and has outstanding balances of $11 million.
We also had an increase in residential non-performing loans in Utah where non-performers increased by $11 million across five new non-performing borrowers. The significant new non-performing loan in Utah is a developer outside of Salt Lake City where we had lending offices and a total of $7 million outstanding balances. Total commitments in Utah amount to only $63 million in total.
In the Puget Sound area, residential construction non-performing loans increased $9 million to just under $21 million at quarter-end. The new non-performing assets come from one developer in Snohomish County north of Seattle. The older non-performing asset is also a developer in Snohomish County, totaling about $8 million. We also own some real estate in South of Seattle near Tacoma amounting to about $1 million related to one single project.
Regarding the Puget Sound, I would like to point out that we have about $1 billion in residential construction commitments in this market or about 40% of our portfolio. So comparatively, I would say the Puget Sound is still holding up fairly well.
Regarding non-performing loans that are outside of residential construction, I will tell you that we have experienced an increase related to Commercial Banking, which increased to $29 million at quarter end, about $6 million from the prior quarter. And most of the new non-performers in this category are associated with or impacted by the slowdown in residential construction.
There was also a new income property construction non-performing asset totaling $8 million in Southern California for which we have reasonably high confidence it will be resolved positively. The balance of the non-performers or 6% of a $204 million total are pretty well distributed across other product lines, including multi-family permanent loans, commercial real estate, residential and consumer loans.
With respect to classified assets, we did see an increase to $402.8 million, which is up from $234.3 million last quarter. This increase is due in part to our taking a very aggressive stance to scrutinize our problem assets and included both outstanding balances as well as total commitments to ensure that we are presenting a conservative and comprehensive look at the level of these assets. The majority of the classified assets also fall into the residential construction category. We remain cautious about the outlook for 2008.
And with respect to income taxes, the accrual rate was down a bit in the first quarter to 28% compared to 33% in the first quarter of 2007. We continue to capitalize on the availability of tax credits throughout our operational footprint.
Looking ahead in 2008, our guidance for earnings per share for 2008 will be impacted by a couple of significant factors. The first will be the level of classified and non-performing assets over the next couple of quarters, the severity of charge-offs that we anticipate in these categories, and obviously there is some uncertainty as to what will happen with the national and regional economic growth, as well as actions by the Federal Reserve Board over the next couple of quarters.
With respect to interest rates, we expect the Federal Reserve to continue reducing the Fed funds rate. We believe the recent yield curve steepening will continue in 2008 and the relationship of the spread between LIBOR and treasury REITs will be maintained. With these variables, we may see our net interest margin under pressure in the second and third quarters and may compress by another 10 to 15 basis points over the next two quarters before it stabilizes.
We expect to end 2008 with total assets of approximately $13 billion. We do expect to see increases in our loan portfolio driven by our commercial, commercial real estate, and consumer loan portfolios, which will be offset by a decrease in the construction loan portfolio. We expect to remain well capitalized from a capital perspective through 2008 with our core capital ratios improving through year-end from expected growth in retained earnings. Also, in regards to liquidity at the holding company, we have a $10 million line of credit from a commercial bank that remains untapped. And at the bank level, we have excellent collateral to support additional lending from the Federal Home Loan Bank and other sources if necessary.
We have assumed that the economy in the Pacific Northwest will begin to slow but will remain stronger than the national economy and certainly stronger than some of the hard-hit regional sectors around the country. It is our belief that Boise, Idaho and Portland, Oregon markets will slow, but they will avoid recession and that the California economy will stabilize, but it may take until 2009.
Regarding the housing market, while we think that we are in a bottoming phase, there are a lot of moving parts and it is difficult to gauge how long this will last. When it comes to projecting non-performing assets and provisioning for the next few quarters, we realize that we have a very fluid situation and we are making a number of assumptions on how quickly loans will get paid off, the ability of our borrowers to carry the inventory until sold and their overall liquidity positions.
That being said, we do not expect the provision to be as high in the second quarter as it was in the first quarter. Based on the level of classified assets and the level of assets on the watchlist, we do expect a migration within our risk rating system and that we have experienced over the last four to six weeks, we think the provision in dollar terms will be in the range of the high-teens to the mid to high 20s.
We expect some turnover in non-performing assets and we think it will peak in the next quarter or two. We expect non-performing and classified assets to rise in the second quarter, to flatten out modestly in the third quarter, and to be flat to down in the fourth quarter as inventory of residential construction loans starts to get worked off. We expect the composition of our non-performing assets to remain weighted toward the residential construction portfolio.
We confirm our earlier guidance for non-interest income to be on track for 2008 and is expected to be in the increasing range for the year of between 8% and 12%. We confirm our earlier guidance for the volume of residential loans to be sold into the secondary market during 2008 from a range from approximately $1.3 billion to $1.4 billion with loan sales margin averaging between 125 to 140 basis points.
With that said, we may need to readjust that in the future if the pace we saw in the first quarter continues at those levels. We have not changed our earlier guidance with respect to total operating expenses, which are expected to increase for the year between 4% and 8%. We also expect Sterling's effective tax rate to be below our prior guidance in the range of 29% to 30% as the effects of tax credits will be a little more pronounced. So, with all of these assumptions and considerations, we are updating our 2008 earnings guidance to be within a range of $0.90 to $1.00 per share.
With that, I will turn it back to Harold.
Thank you, Dan. Sterling did not anticipate the size of the provision for potential credit losses. The risk assessment of many of our borrowers rapidly and unexpectedly heightened during the course of this last quarter as the subprime mortgage crisis rippled through the economy. We have activated a highly focused team of Sterling professionals to help resolve and work out the level of non-performing assets. We are working in partnership with our borrowers to help them through this difficult period. We are making every attempt to contain the effects of the credit crunch so that it doesn't spread to assets that are now performing well.
We are reassessing again our assumptions as related to residential construction non-performing assets to determine unforeseen exposures. Some may call me an optimist, but I believe that I have a balanced outlook. And as I have said many times before, time, money and management will get the industry and Sterling through the current credit disruption. I also know that everyday people need a place to live, families expand, they merge, they move, they vacation and they get new jobs. America will remain a highly mobile and dynamic society.
Already in the Pacific Northwest, we see these dynamics returning. Residential sales data is beginning to improve month by month. And yes, I recognize the trends are weak on a year-over-year basis. Still sequentially, the number of closed sales are up, inventories are receding and pricing is generally stabilizing albeit at a slightly lower level.
Most of all, I have confidence in the strength and preservation of the Sterling franchise. Our capital and liquidity positions remain solid. The operations of our core banking businesses are solid and performing well. We live in an area of the country where the primary economic drivers are constructive employment levels, job creation and net in migration channeling well. We believe we have a strong management team that has the experience to address the current market disruption and the asset quality challenges.
Our credit team is capable and seasoned and has significant experience in loan resolution and workout. We have a diversified loan portfolio. We are continuing to build our commercial banking franchises in Sterling Savings Bank and our residential home loan business in Golf Savings Bank.
At this time, I will turn the call back over to Abby to begin the Q&A answering session. Thank you.
(Operator instructions) The first question comes from Jim Bradshaw of D.A. Davidson. Sir, your line is open.
Good morning. Harold or Dan, how much of the reserve, the $145 million in reserves, is general versus -- or specific versus general reserves, I should say?
The majority of it is in the general category. We have got approximately $19 million in specific reserves.
And Dan, should I read from that it is just too early for you to identify loss exposure, or is the loss exposure on the non-performing asset bucket generally not all that severe?
Well, before Dan answers that question, Jim, I think that basically what we have experienced as a liquidity crisis are borrowers, not on a money security, the inventory. And therefore, the largest effect on us will be primarily a non-accrual activity. And then, the next impact will be how many of those homes do we actually end up with, which is followed by how well the market pricing holds up. And we believe that our advances under our normal credit rate were appropriate for the time, but ultimately it depends on the inventory. Dan, do you want to expand on that?
Sure. I would just add that we have not seen a lot in the way of actual charge-offs, Jim. Actually, charge-offs were down a little bit in the first quarter compared to the fourth quarter. So it's a little hard for us to gauge. We're really looking at what our historical losses are and trying to be conservative in projecting those. But, to be honest, it is a little hard to gauge at this point.
Sure. Maybe, Dan, you could touch on inflows and outflows into the non-performing asset bucket, how about $80 million increase I think, how much paid off or cured in the quarter? How much and then (inaudible) back into how much the net addition was?
Sure. I would say that we are probably more coming into the bucket than going out of the bucket. And interestingly enough, we did see a progressively improving outflow of items that were getting paid off for the quarter. My recollection is that we had somewhere in the neighborhood of about $20 million of loans that were paid off during the quarter, which was about doubling of what we saw in the fourth quarter.
And those loans were in the non-performing bucket.
Those were in the non-performing bucket.
And Dan, how much of the classified balance -- of the $400 million classified is undispersed?
I would say it is about 30%, 30% to 25%.
Okay. And then, the last question for me is, there is some speculation that you guys might raise capital. I just wonder if you could sort of talk through the capital process, the dividend, how safe is it, what conditions would lead you to raise capital from where you sit today? And what capital ratio is the tangible ratio that we ought to be concentrating on as we think about your needs?
Well, I think, first of all, as I indicated, our capital is in a solid position. So I feel that at the present time, we can't foresee any real need for an injection of capital. As you know, a couple of years ago, we issued a shelf offering, and we have not used that. It expires, I think Dan, within the next 90 days. And if capital were needed, I think that one of the things we would be very conscious of is not to dilute our existing shareholders in the form of some preferred offering, maybe rights offering specifically to our shareholders.
And lastly, our discussion in our Board meeting yesterday was to maintain our dividend at $0.10 a share. We feel comfortable that that fits into our cash flow. We have done a good deal of analysis on our capital ratios and our cash flow to meet our needs and recognize that we have also set up some liquidity positions to meet those needs. So, I feel that we have done the necessary steps and have a reasonably good policy towards our dividend functioning. And at this time, we don't see any need for capital to be injected in the company. But, if we were to do it, we would do it on a non-dilutive basis.
I would just add to Harold's comments that we have been monitoring the capital markets and the trust preferred markets. While the pooled securities aren't as available as they had been in the past, there are abilities to issue trust preferreds on an individual issuer basis. And so, we have been monitoring and exploring those as probably the first line of any capital that we would look to. But I think Harold answered the other items.
The one thing I would address, Jim, in terms of what we are targeting, we are looking more at the regulatory risk-based capital as being kind of our indicator. And so, we want to maintain well capitalized status and well capitalized with some comfortable margin, and we feel like we have that pretty well established.
Thank you very much. Appreciate it.
Jim, we will see you at the conference in early May.
A couple of weeks, yes, thanks a lot, guys.
(Operator instructions) At this time, sir, there are no further questions.
Well, obviously, the press release and the expanded nature of Dan's presentation today has covered that. If any analyst has a desire, both Dan and I will be available later in the day. We do have our Annual Shareholders Meeting, which will take place in approximately an hour and 15 minutes, and so we look forward to having our conversations. Thank you very much for your participation in this conference. We look forward to talking to you again, and the second-quarter conference earnings release will be scheduled for Monday, July 21, followed by an earnings call the next morning at 8:00 am Pacific Daylight time. Thank you and that concludes our call.
Thank you everybody.
A replay for the call will be available in one hour. You may access the replay by dialing 402-998-1330. This concludes today's conference call.
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