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TFS Financial Corp (NASDAQ:TFSL)

Q4 2012 Earnings Call

October 31, 2012 10:00 am ET

Executives

Marc A. Stefanski - Chairman, Chief Executive Officer, President and Chairman of Executive Committee

Paul J. Huml - Chief Operating Officer and Chief Accounting Officer

David S. Huffman - Chief Financial Officer, Secretary and Member of Investment Committee

Meredith S. Weil - Chief Operating Officer of Third Federal Savings and Loan

Analysts

Matthew Breese - Sterne Agee & Leach Inc., Research Division

Joseph Albert Stieven - Stieven Capital Advisors, L.P.

Frank Rango

Operator

Welcome to TFS Financial Corporation's Fourth Fiscal Quarter Earnings Conference Call and Webcast. Hosting the call today from TFS Financial is Mr. Marc Stefanski, Chief Executive Officer. He is joined by Mr. Dave Huffman, Chief Financial Officer; and Ms. Meredith Weil, Chief Operating Officer of Third Federal Savings; and Mr. Paul Huml, Chief Accounting Officer.

Today's call is being recorded and will be available for replay beginning at 2 p.m. Eastern Standard Time. The dial number for your replay is (800)283-4783. [Operator Instructions]

Some of the information provided during the conference call may contain statements of future expectations and other forward-looking statements. These expectations are based on the management's current views and assumptions and involve known and unknown risks and uncertainties. It is possible that the company's actual results and the financial condition may differ, possibly materially, from the anticipated results and the financial condition indicated in these forward-looking statements. For a discussion of some of the risks and important factors that could affect the firm's future results, see Risk Factors in the company's latest annual report on www.thirdfederal.com. TFS Financial Corporation assumes no obligation to update any forward-looking information provided during the conference call.

It is now my pleasure to turn the floor over to Mr. Marc Stefanski. Sir, you may begin.

Marc A. Stefanski

Good morning, everyone. Welcome. And for all of our friends in the Northeast, you've been in our thoughts and prayers. Hope everything is well with you and your families. And we'd like to start off by having Paul Huml go over the deck that was published yesterday. And so Paul, if you don't mind.

Paul J. Huml

Okay. Thanks, Marc, and welcome to everyone. As Marc mentioned, we filed the earnings release yesterday and also the slide deck that we'll briefly go over today. So just going through the slide deck and Page 3 is just sort of the summary where we're at, at September 30, 2012 versus 2011. You'll see our assets have gone up by about $600 million and our deposits have gone up as well. Shareholders' equities are very consistent.

From our strategic overview, not a whole lot has changed. I think our focus has been on the ARM production that we've tried to generate and you'd see some of the numbers on there just from the percentage of our production being the adjustable rate is 56% this year, it was 55% last year. That's a significant change from where we've been in prior years, you can see 19% in fiscal 2010. So that's been a big strategic move on our part is to generate more first mortgage adjustable products. And the -- you can see of the some of the FICO scores and the average LTVs are very, very strong for the production that we've been doing. So that's really where we are from a strategic standpoint. Markets of operation, not a whole lot of change there, really just the same Florida and Ohio markets.

Going on the next slide. Really, the financial highlights, obviously, the strong capital numbers come out as being a good issue for us. I would say from a net interest income, as you can see, from year-to-year, we have increased our net interest income. Obviously, the bad side is the elevated provision for loan losses over the last few years. I think one of the other things that comes out in the non-interest income which has dropped a little bit over the years, is really our decision of not selling loans into Fannie Mae. So you'd see a lot of those noninterest income numbers, particularly in 2010, generated from sales.

Down below, you'll see the, again, the net interest margin has increased over the last couple of years. Some of the asset quality numbers have a tough comparison as you look across, just because of the number of regulatory changes that have occurred over the last year or so that's caused some additional charge-offs, different classifications from charging off SVAs. So it's difficult as you go through some of those things to see some across-the-board comparisons, but maybe there's some charts a little later as we look at delinquencies that might shed a little better light on comparison.

Next slide, capital position. Again, very strong numbers. These are the last 3 ratios on the table are our, the thrift only, does not take into account the holding company and the capital that is at that level.

Next slide is really the deposit overview, which tells has told the story as we've maintained our deposit levels have increased as we slowly lowered the average costs of those deposits. And a lot of that is from the CDs that have matured, higher-rated CDs, longer-term that are maturing and continue to roll off. So we hope to continue that.

Next page is, really, again, the focus on adjustable rate production and where we've done. We had a strong year as far as production, over $2.6 billion of loans that have come through, 56% of them were adjustable. And again, the total credit parameters, the credit scores and the loan-to-value ratios are very strong. And you can see where we have sort of changed our approach from fiscal '09 through to 2012, generating a lot more adjustable rate in this low interest rate environment as we're trying to provide some protection -- interest rate protection going forward.

In another slide, a little bit more on that adjustable rate growth and where it's come. We're -- the chart at the bottom sort of tells the story of really turning that ship around, which has been a traditionally fixed rate lender, into getting more of an adjustable rate, the first mortgage portfolio. So you can see we're about 35% of the total first mortgage portfolio is now in adjustable rate. You can see the new state expansion. We had started that in May 2011, we've recently added California to that mix, and we have about $335 million of closed loans on our books at September 30 from those new states.

The next page, some of the loan delinquencies and charge-offs. And again, you get into the same of the -- some of the same comparison issues, particularly in the charge off number, you see the fiscal year-end 2012 of $159 million of charge-offs, and it's really driven by a couple of different things impacted by the specific valuation charge-off in the December quarter. And then in this quarter, we had additional regulatory guidance dealing with Chapter 7 loans and Chapter 7 bankruptcy where the individuals have their debts discharged by the bankruptcy court, but they continue to pay their loans. So the regulators have come out, the OCC has come out, and stated that those loans should be considered troubled debt restructurings, and where the loans have been completely discharged, be shown as a troubled debt restructuring and non-accrual. And this is regardless of what the loan performance on these loans were. So that had an impact in our charge-off as the number of these loans have been performing and continue to perform. Our previous history was if these loans and bankruptcy got to 30 days delinquent, then they were reviewed and gone through the process. The OCC regulation has now accelerated that, that say anything that's in the Chapter 7 bankruptcy where the loan has been discharged, we have to take a look at it and decide on a collateral view, what the loan is worth. So that's impacted a number of those things. I think that the number that we can try to focus on, from a comparison standpoint, is really the delinquency numbers going forward because that's really going to tell us what loans are performing, what loans are not. So I think we've continued to see those numbers improve. And in total, at September 30, it's about 1.6 total delinquencies. So that has helped and that's sort of a number that, going forward, we can try to focus on from a comparison standpoint.

The next page is, so it's a graph of some of those loan portfolio trends. And again, you'll see in this quarter that OCC regulatory guidance impacted a couple of those, particularly the troubled debt restructuring and the nonperforming assets where we have seen some declining and leveling off. This quarter, those went up by adding some of those mainly performing loans into those categories. The delinquencies truly say what -- where the total loans are performing, so we continue to see a good trend on that chart. Getting to the regulatory status, which I know generates a lot of interest among our investors, our shareholders and us as well as we try to work through this, unfortunately, we don't have a whole lot new to add at this point. We're still in the same boat. We're -- still, the MOUs are in place. We're still waiting for any substantial news from either our regulators.

From our standpoint, I think there are 2 -- essentially, 2 MOUs. One that deals with the thrift, the operating company which is controlled by the OCC, and the other is really controlled by the Federal Reserve and affects the holding company. I think our focus right now is to try to get the OCC to work on that MOU, get those issues corrected and then, focus on the Fed after that as it's been -- obviously, we've been working on both, but our focus at this point is to get the operational, since that's 99% of the company, to focus on the thrift and get that cleared up. Obviously, the other issues having the earnings that are not tremendous, doesn't help in our overall strategies, discuss some dividends. But if we continue to try to work through those issues and we'll focus on getting those MOUs lifted.

And so, that in a nutshell, is really where we've been in this quarter, this fiscal year. And at this point, I would like to open it up for questions from the callers.

Question-and-Answer Session

Operator

[Operator Instructions] We'll go first to the side of Matthew Breese with Sterne Agee.

Matthew Breese - Sterne Agee & Leach Inc., Research Division

Maybe start big picture around the MOU. I guess, after 21 months of being under it, is it -- and no buybacks, is it time to test the non-objection and try and buy back some stock at this point?

Marc A. Stefanski

Well, until the MOU's are lifted, that's a futile attempt. It's a nice attempt, but I think to try to force the hand of federal government is a big, big mistake. And I think that we have to prove ourselves in terms of profitability, we have to prove ourselves in terms of finishing off the interest rate risk modeling, enterprise risk management process, whatever is required. But I think we'd be foolish to try to muscle the Federal Reserve or anyone else to say, "Hey, we think that we're in the queue now and we should -- we're entitled to our day in court." I just think that the regulatory environment as you know is just -- it's a very tough one in all of the banking industry. And so, we -- the only thing that's going to help us is to continue to improve our performance and to prove ourselves. And that's the best I can throw at you at this time.

Matthew Breese - Sterne Agee & Leach Inc., Research Division

Okay. And with that being said, in terms of the MOU, it sounds like the language around it hasn't changed. It's still related to interest rate risk management and overall, enterprise risk management. How far along in that process do you think we are? What inning do you think we're in here?

Marc A. Stefanski

Well, it's kind of early as far as the interest rate risk modeling. We bought a system at the beginning of last year and we just began to scratch the surface on its capability and the hiring process of getting people on board to -- who completely understand and can work with this system. And so, from our review this year, I mean, it's too early to give a significant, let's say, improved significant -- being -- improving significantly from where we were in terms of modeling. Now, some folks will say, "Well, it was adequate, what we had." And that's fine. But with the new model, we, again, have to prove that we know what we're doing with it and that we collect enough data, that we have the people in place and the processes in place to continue to monitor that and to make it an effective tool for predicting what -- well, trying to predict where interest rates are going to go and how our modeling capability will ensure the safety of the organization.

Matthew Breese - Sterne Agee & Leach Inc., Research Division

And on the enterprise risk management systems, where do those stand?

Marc A. Stefanski

Well, I think we're in pretty good shape as far as that's concerned. A couple of years ago, and I don't want to look back too much. But a couple of years ago when the MOU came into place, we were well on our way to completing the enterprise risk management process before we got the MOU. So the MOU was thrown at us after we already started that process, and we continue to have made strides in that area.

David S. Huffman

Yes, I think -- this is Dave, Matt. I think we have made significant strides there in, so far, structure of governance, policies, procedures, risk indicators. There's a separate committee formed at the Board. There's a management committee that supports the Board. So I think we've made a lot of progress in that arena.

Matthew Breese - Sterne Agee & Leach Inc., Research Division

And when is -- when is your next regulatory exam, both OCC and at the Fed level?

Paul J. Huml

Well unfortunately, our regulators have made it clear to us that it's -- that we should not be commenting on regulatory schedules, when they come in and when their exams are.

Marc A. Stefanski

But we welcome them everyday of the week. Our arms and our doors are wide open for them to come anytime they want.

Matthew Breese - Sterne Agee & Leach Inc., Research Division

Are they typically regularly scheduled? What I mean by that is, the MOU is in place on February 7, 2011, is it fair to assume then 3 to 6 months before that is when the regular scheduled exam occurs?

Paul J. Huml

I think it's been very difficult to put a schedule on it, particularly because the MOU is put in place by the Office of Thrift Supervision, which is no longer in place. You had 2 regulators that took over in July of 2011 that was brand-new, put their own policies, procedures in place. So there is no, at least from what we've been able to determine, a set pattern of regulatory scrutiny.

Matthew Breese - Sterne Agee & Leach Inc., Research Division

And I guess my last question. Is there any change in thinking around a potential second step conversion? And what would be some of the triggers that would push you towards something like that?

Marc A. Stefanski

The answer to the first part of the question is no. And some of the triggers would it would have to be a compelling business reason to do that. And I've always said publicly that, that's hopefully something the next generation the Stefanski family will have to take a look at and decide.

Operator

We'll go next to the side of Joe Stieven with Stieven Capital.

Joseph Albert Stieven - Stieven Capital Advisors, L.P.

You talked about improving profitability. Can you put some more meat on the bone regarding that, because, obviously, the last couple of quarters, perhaps it's always just been barely achieved. And when I look at your cost of funds, compared to a lot of people, it looks like you have a ton of room on your cost of funds. So that's question #1, I'll probably jump back in the queue after you answer that.

Marc A. Stefanski

All right, Dave, help us.

David S. Huffman

Thanks, Marc. And thanks, Joe. We are looking at different ways to fund or to price our funding sources. We traditionally have been almost entirely retail-oriented or retail-dependent, and we are kind of working now to be a little less aggressive in our retail pricing and to take advantage of some of the wholesale pricing opportunities that are out there. So you might see, as we move forward, a kind of a rebalancing of our funding sources between retail and wholesale, with a little more allocated to wholesale than the retail. And that should drive that cost down. Joe, are you still on?

Joseph Albert Stieven - Stieven Capital Advisors, L.P.

I think I am. I guess, my next question is, but just even looking at your retail pricing, it looks like your retail pricing is -- you have room just to move down retail pricing and probably not have much degradation in your deposit base from there. Or can you comment on that, when you look at your pricing compared to competition?

David S. Huffman

Right. I think that we constantly monitor the competition in the specific markets where we operate. And I think that we have adjusted our positioning there where previously, we were, let's say, top of the market on any term CDs because we try to provide some interest rate risk management with the attraction of longer-term CDs. We've narrowed that and in most cases, we're not at the top anymore on those. So we do try to watch that, Joe, where I think we're very sensitive to the need to improve our earnings and that the pricing of the funding sources is a good opportunity for us to make an impact.

Joseph Albert Stieven - Stieven Capital Advisors, L.P.

And just the final thing, and I'm just going to express a point. I mean, we, as investors, have tried to be patient. But with you guys sitting at 20-plus percent total capital, at some point in time, it gets very frustrating that when you have a taxless [ph] ratio like you have, capital like you have, and you have excess cash to date at the holding company, that there -- we only wish that you can at least be polite, but aggressively polite, to get these regulators to come back and look at this because it's just -- remember in that CAMEL rating, the C is capital, and we are the ones who provide capital. We do the returns in this process, and it's very frustrating. So I'm not complaining at you, I'm complaining with you. And I just think at some point in time, we want you to be polite, respectful with your regulators, but be a little bit more aggressive.

Marc A. Stefanski

Thank you for your comments. We feel the pain and we're right there with you, and no one is more frustrated with the process than our management team and the Board. But thanks again.

Operator

We'll go next to the side of Frank Rango with Purchase Capital Management.

Frank Rango

You highlighted that profitability is one of the important considerations that the regulators will have in lifting the MOU. And I was -- I'm trying to understand a little bit better your longer-term plan to improve profitability. I see you've made some good progress with the net interest margin, but it seems to have been offset by non-interest income going away, so they're kind of like neutralizing each other. Expenses have been steadily -- slowly, but steadily marching higher. The only place I can really see where it's obvious that earnings could really be improved is by provisioning less, which you seem to be -- there seem to be one-time hits over the more recent provisioning, but I can see that possibly improving profitability. But just given the capital structure of the company, et cetera, I'm hoping you could give us a little bit better understanding of how you're going to get this company's ROE a little bit more in line with where it should be.

Marc A. Stefanski

That's a tough one because we have so much capital. But we're taking a look at various different things. One of the things that Dave just touched on in terms of wholesale versus retail funding, we've always held back our wholesale funding because we weren't sure of the economic environment that we were in, how that would play out, or the regulatory perspective on how they would view our liquidity position. And I think one of the good things that's occurred over the last year with the OCC and the Feds taking a look at what we're doing, is we have some clarity as far as our liquidity position is concerned. That seems to be a little bit less emotional and more calculated and more sensible. So we have some room to improve that by borrowing some more, which will help profitability. Along with that, Meredith, we were talking about potential loan sales and that kind of thing.

Meredith S. Weil

We've been evaluating the possibility of loan sales, and that will continue and potentially, take advantage of the current spread in the market. I think also for consideration is as we -- as the market improves and the economy improves, some of the expenses that we've had to take on to manage the foreclosure process and the delinquencies and really, the collection effort, hopefully, will minimize. Part of it is just the general economy and it's been in a slow improvement process. But we do expect that as the economy improves, our expense base will shrink.

David S. Huffman

And as, I think Frank observed, we would expect at some point, the improvement in our delinquencies to translate into lower credit provisioning. And those are big numbers that are going through our -- there are still big numbers going through our income statement currently.

Frank Rango

Right. So as you increase the -- as you've increased the number of ARMs going through your -- or putting up those in your portfolio, what's happening to the fixed rate production that you're doing?

Meredith S. Weil

We continue to experience fixed rate production, but our fixed rate portfolio is shrinking. Obviously, our fixed rate portfolio is large to begin with. And so the volume that we're doing, and we're actually really very uncompetitive in the fixed rate market, but because of our brand and who we are, customers continue to go -- to come to us. So while we continue to have fixed rate production, our fixed rate portfolio is shrinking, and we're looking for opportunities to sell.

Frank Rango

Right. Well, I remember, going back a couple of years, you decided not to originate for sale to Fannie Mae. I'm wondering if you're rethinking that strategy at all? I mean, if you've got -- you got people come to you who want to -- who want fixed rate product, why not act as a mortgage banker, sell it and then turn on the sell to Fannie or Freddie, or one of the agencies?

David S. Huffman

Sure. Everything's on the table, we're looking at everything that would help improve the profitability of the organization without risking anything like our culture and things that might be very precious to us and especially, in our footprint.

Frank Rango

But can you explain why you haven't done that yet? I mean, it seems if you've got the demand for it. I saw some reference to -- something to do with putbacks in your latest earnings statement, maybe I misread it, but it has to do with past production. I mean, maybe you can elaborate a little bit on that?

Marc A. Stefanski

Yes. I mean, that really relates to past production and more from Fannie Mae going back and looking at loans where they've incurred a loss. And going back and looking at original underwriting issues, file issues, or maybe there is some issues with some of the things that were done. There's no massive list that they're looking at, they're just going back. And so, these are more of a one-off. I think we had about $2.4 million of actual cost incurred during the year. And as a precaution, we put another $2.4 million of accrual on the books, so that certainly generated $4.8 million of expense that really, we've not had in the past. So hopefully, that -- we can get a handle on that, and that number is not going to increase, but that's what that relates to.

Meredith S. Weil

And with respect to the Fannie sales, we have recently started doing the HARP program. So putting Fannie refis that we currently hold as Fannie service loans and refinancing them and selling them back to Fannie Mae. So we have started to implement some of the process that they require. It isn't as efficient to actually produce a Fannie Mae loan, and that's been part of our hesitation, is really the efficiencies. There's also, with respect to the loan sales, I'm looking at potential private investors selling a big portion of our portfolio while we might make some money, it would affect our margin. And so, we've been very careful about evaluating, really, when is the appropriate time to sell loans. And then, obviously, with the HARP loans, we are getting some Fannie experience with some of the more rigorous requirements that they've implemented in the last couple of years and are evaluating whether or not we want to expand that.

Operator

And we'll take a follow-up question from Matthew Breese with Sterne Agee.

Matthew Breese - Sterne Agee & Leach Inc., Research Division

How much in the way of CDs are repricing over the next 6 months, and at what costs?

Meredith S. Weil

I think we talked about this a little bit last time around. We do have several hundred million that are coming due in the next several months. They're currently priced over 3%, so we do -- and I think, the chart we have in the presentation really gets to the fact that the CDs that are repricing were long-term CDs, they were purchased 4 plus years ago, and so the rates are higher. And as they reprice, either we will borrow wholesale to continue to fund our loans or they'll reprice at much lower rates.

David S. Huffman

Yes. I think you'll see more detail when the 10-K comes out as to what's in the deposits and what is maturing.

Matthew Breese - Sterne Agee & Leach Inc., Research Division

And then as it relates to the pop in non-accrual loans, how much of that, on a sequential basis, was related to the OCC guidance?

David S. Huffman

I think we really added about $34 million of non-accrual loans from the guidance.

Matthew Breese - Sterne Agee & Leach Inc., Research Division

And then my last question, what should we be looking at for a good run rate on salaries and comp and benefit on a quarterly basis?

David S. Huffman

Say [ph] what you're seeing there for the September quarter, would be -- would cover you pretty well.

Matthew Breese - Sterne Agee & Leach Inc., Research Division

Okay. So around $13.8 million is a good quarterly run rate?

David S. Huffman

Yes, I don't know if that...

Marc A. Stefanski

Where is $13.8 million? Where are you getting that?

Matthew Breese - Sterne Agee & Leach Inc., Research Division

Oh, I'm sorry, I looked at -- I'm sorry, it's $20.3 million.

David S. Huffman

Yes, $20 million. Yes, that would probably give you -- there is some variability to that, but for purposes of running some models out, I don't think you will be far off the mark with that.

Operator

[Operator Instructions] We'll go next to the side of Wathel Wischanski [ph] with McKesson Canada.

Unknown Analyst

Yes. My question is regarding loan loss provision and what you forecast is going to be happening over the course of the next year. And do you see opportunity in giving your excess capital, to actually grow the loan book within your existing markets and expanding into other markets?

Marc A. Stefanski

Well, I think from a provisions standpoint, it's tough to predict. I think we've certainly felt that -- I think if you went back a year ago, I don't think we felt that we would have $102 million in our provision for this year, and we felt we'd be a lot lower. If you go back in history, our provision 2006 prior was generally under $10 million for the year. So we've tried to focus high credit quality when we originate loans, so having any loan loss is not something that we've grown accustomed to. So we certainly hope and expect that number to be lower next year, but trying to put a number on it at this point, I think we've -- a lot of it is so dependent on the economy and where it goes. I mean, certainly our delinquencies are trending in the right direction, but there's still a lot of unknown as to what's happening with the economy and where that's going to go.

David S. Huffman

And I think your second question with respect to capital leverage, we certainly have the opportunity to grow our book of business both in our footprint and in our expansion state. So we would expect to see that occur over the next couple of years.

Operator

And there are no more questions at this time.

Marc A. Stefanski

Okay. Well, on behalf of all Third Federal, the Board of Directors and the management team, I'd like to thank you for calling in this morning and continuing to have faith and confidence in Third Federal, the management team. And of course, Paul Huml will be available for additional questions and he's at your disposal. So again, thank you. And again, to our friends and investors in the Northeast, we wish you well and our thoughts and prayers. Thank you.

Operator

This does conclude today's teleconference. As a reminder, the dial-in number for the replay is (800)283-4783. Please disconnect your lines at this time, and have a wonderful day.

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