On Deck Capital, Inc. (NYSE:ONDK) Q4 2017 Results Earnings Conference Call February 13, 2018 8:00 AM ET
Robert Zuccaro - Deputy General Counsel
Noah Breslow - CEO
Howard Katzenberg - CFO
John Rowan - Janney Montgomery Scott
John Davis - Stifel
James Faucette - Morgan Stanley
John Hecht - Jefferies
Melissa Wedel - JPMorgan
Steven Kwok - KBW
Jed Kelly - Oppenheimer
Kyle Peterson - Needham and Company
Lloyd Walmsley - Deutsche Bank
Michael Tarkan - Compass Point
Good morning. My name is Krista, and I will be your conference operator today. At this time, I would like to welcome everyone to the OnDeck Fourth Quarter 2017 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you.
Robert Zuccaro, Deputy General Counsel, you may begin your conference.
Good morning. Welcome to OnDeck’s fourth quarter 2017 earnings conference call. I’m here with Noah Breslow, our Chief Executive Officer; and Howard Katzenberg, our Chief Financial Officer.
Today’s conference is being webcast live. Our earnings release was issued earlier today and is available on the Investor Relations section of our website.
Certain statements made during this call, including those concerning our business and financial outlook for the first quarter and full year 2018, our expected growth and originations, Unpaid Principal Balance, margins and profits, and our target provision rates, are not facts and are forward-looking statements.
These statements are subject to material risks, uncertainties and assumptions described in our SEC filings, including the Risk Factors in our most recent Forms 10-K and 10-Q. If any of the risks or uncertainties materialize or any of our assumptions prove to be inaccurate, actual results could differ materially and adversely from those anticipated. These statements are based on currently available information, we undertake no duty to update them except as required by law. Today’s discussion is also subject to limitations on forward-looking statements in today’s press release.
During this call, we will refer to non-GAAP financial measures. For information about these non-GAAP measures and reconciliation to GAAP, please refer to today’s press release and the appendix of the earnings presentation posted today on the Investor Relations section of our website.
With that, I’ll turn the call over to Noah.
Thanks, Robert, and thank you all for joining us today. 2017 was a transformative year for OnDeck. As you recall, when we reported our 2015 results, we announced our strategic decision to accelerate GAAP profitability, by taking actions, to strengthen our financial profile. Over the past year, we executed against this objective and accomplished, what we said out to do.
We achieved a record $5 million of net income for the fourth quarter, over $40 million better than the prior year. And we exited 2017 a much stronger company across all aspects of our business. Over the course of the year, we increased effective interest yield by over 200 basis points, reduced the net charge-off rate by over 100 basis points, strengthened our balance sheet, by adding nearly $100 million in funding capacity and reduced quarterly operating expense by nearly $15 million year-over-year. We believe OnDeck now has the right foundation from which to drive profitable growth and shareholder value.
Now, let me turn to the quarter’s results. During the quarter, we delivered improvements in our key originations, pricing, credit, and profitability metrics. We grew origination sequentially in the fourth quarter to $546 million, even as we incurred lower sales and marketing expense. For the full year of 2017, we originated $2.1 billion. The initiatives we have implemented to attract higher quality borrowers and grow profitably, have been working. We have improved marketing efficiency, while optimizing economics, resulting in a loan book with our highest effective interest yield or EIY, since 2015.
In addition, our OnDeck-as-a-Service program continued to exceed expectations. We set another originations record in Q4 of JPMorgan Chase and enjoyed strong quarterly sequential growth. But, we are still in the early innings of this program. To-date, loans have only been available to the select portion of existing Chase business checking account customers. In 2018, we will drive further growth, by expanding eligibility for Chase prospects and customers.
From a credit perspective, we achieved our lowest quarterly levels in 2017 for our provision rate, our 15-plus-day delinquency ratios and our net charge-off rate. Our 15-plus-day delinquency ratio decreased by 80 basis points on a sequential basis, and our net charge-offs also declined by nearly 400 basis points. Our provision rate for the fourth quarter was 6.4%, in line with our target range.
The decision we made in the first quarter of 2017 to raise underwriting standards has improved our loan performance. For fourth quarter originations, personal and OnDeck scores were at historically high levels. In fact, at year-end, over half of our portfolio had personal credit scores above 700. And we have now begun seeing the impact of our credit tightening on cohort performance. Specifically, Q1 and Q2 2017 vintages are outperforming 2016 vintages. And although it’s early, we expect this improved performance to continue for the Q3 and Q4 vintages.
Our ability to turn credit performance around so quickly this past year is a testament to our focus on risk management, product structure, and our resilient business model. In addition, our improved collections efforts had a significant impact on our recoveries. In the fourth quarter, we saw over $5 million of recoveries, while partially a function of higher charge-offs in prior quarters, also reflected improved recovery rates on charge-off balances.
Another strategic priority for us in 2017 was realigning our cost structure. During the year, we removed over $45 million of annual run rate expenses relative to Q4 2016. In the fourth quarter of 2017, operating expense was basically flat on a sequential basis at $38 million and down 28% year-over-year. As a percentage of revenue, operating expense was 43%, down from 64%, further illustrating substantial improvements we have made. We accomplished the reductions in operating expense without sacrificing our long-term opportunities and ability to grow in a responsible and profitable manner. Overall, we exited 2017 a much stronger company with all our key metrics moving in the right direction.
Looking ahead to 2018, we expect to drive double-digit loan growth due to strong customer demand, our disciplined risk management, and our focus on scaling responsibly. With improved credit performance and loan yields, our realigned cost structure and the secured funding base, our lending business is well-positioned to continue margin expansion and profit growth. We have also recently refined our long-term strategic plan for OnDeck regrounding our mission, vision and strategic focus of the Company.
Our mission is to create innovative lending experiences in financial products that help small businesses succeed. Every small business defines success differently, some in the form of growth, some in the form of protecting with they have built and others by having a peace of mind knowing that they can access capital if something unexpected happens in their business.
Our vision is to be the first choice lending partner for underserved small businesses and to be a market leader with our OnDeck-as-a-Service platform. We still see a risk segmented market in small business lending where we can serve small businesses that are creditworthy but are not well served by banks. We can also partner with banks to use our technology to serve the lowest risk portion of the small business market. As we move into 2018, you will see OnDeck execute on both our lending business and our technology business. For our lending business, we are targeting 10% to 15% loan growth with continued margin and profit growth. Behind these objectives, our priorities are to continue strengthening our credit management and loss mitigation capabilities, broaden our product reach in the field, grow our international businesses and optimize our unit economics and overall cost structure.
From a credit management standpoint, we see continued opportunities for improved decision-making, both operationally and through enhancements to our OnDeck Score and related models. In addition, our loss mitigation capabilities will substantially improve in 2018 as we roll out enhanced bureau reporting, introduce troubled debt restructuring capabilities and continue mitigating more loans where we expect markedly higher recoveries over time. Overall, we will target a 6% to 7% provision rate on a rolling quarter basis.
On the product front, we will bring to market new features to our term loan and line of credit offerings to broaden their appeal in 2018. We will be the first lender, commercial or consumer, to roll out instant funding using the debit card network, making an excellent customer experience even better. We continue to see more growth opportunities in our line of credit, and this year, we expect to roll out new amortization options and make lines of credit more available in our indirect channels. We also expect to substantially lower our funding costs for this product. Together, these activities should grow line of credit’s overall contribution to our business. And we expect to announce our next major small business lending product later this year. All of these initiatives will help the Company increase customer conversion and improve customer lifetime value.
Our international businesses are gaining momentum. And in 2018, we will continue investing in our Australian and Canadian lending businesses, which present very attractive growth and market expansion opportunities. We will also continue to our efforts to optimize our unit economics in our lending business and remain focused on additional cost efficiencies. We expect yields this year to continue increasing as the effective higher pricing works its way to the portfolio. And we will continue to be disciplined in our cost management, which includes realizing additional cost savings as we further reduce our real estate footprint.
Our improved financial performance will also allow us to reinvest in our business and capabilities. We will specifically do this in our OnDeck-as-a-Service program. As I’ve said in the past, OnDeck-as-a-Service is a key strategic differentiator and we are confident in its ability to help drive long-term growth. And over the last six months, our conviction in the opportunity to market our platform to banks has only improved. Not only are we on track to announce our second major bank partnership later this year but it has also become clear that banks are increasingly looking to digitize their origination strategies to remain competitive.
OnDeck is well-positioned to capitalize from the secular trend based on our best-in-class capabilities. To take full advantage of this opportunity, we plan to invest an incremental $5 million in technology and the OnDeck-as-a-Service business this year compared to current run-rate levels. This additional investment, which is incorporated in our 2018 guidance, will further extend our industry leading partnership capabilities.
So, in summary, 2017 was a year that we largely focused internally on strengthening our business and improving our financial profile. 2018 is going to be about benefiting from the actions we have taken and continuing to drive profitable growth, improved margins, better serve our customers, and extend our technology leadership. We also expect to benefit from the broader economic environment. The economy and employment continue to be robust, and small business confidence is at its highest level in years. And the recent tax reform will be good for OnDeck’s customers as small business owners see their tax bills reduce and their businesses benefit from consumers having additional discretionary income. Although our market remains competitive, we believe steps we have taken will position us to win.
With that, I’ll now turn it over to Howard.
Thank you, Noah. We continued benefiting from the actions we took throughout 2017 to improve our financial results. These initiatives drove solid top and bottom line performance in the fourth quarter, resulting in GAAP net income attributable to common of positive $5.1 million or $0.07 per share. Our adjusted net income was $8.1 million or $0.10 per share.
Gross revenue was approximately $88 million, up 7% year-over-year. T his growth was driven primarily by higher interest income which increased 10% over last year. The higher interest income was primarily driven by a higher effective interest yield and slightly higher average loan balance. Effective interest yield or EIY was 35.6% in the quarter, up over 200 basis points from last year’s level. This improvement reflected the impact of both higher loan pricing and improved credit performance between the periods. Please note, beginning next quarter, we will annualize the EIY metric based on calendar days instead of business days. This will reduce the metric’s quarter-to-quarter volatility, and we provided historical values for the new annualization method in our earnings supplement. Looking ahead, we expect the calendar day based EIY to exit 2018 between 35% and 36%.
Moving on, we recorded approximately $600,000 of gain on sale revenue in the period, reflecting about 4% of term loan originations sold through OnDeck Marketplace. For 2018, we expect to continue funding less than 5% of term loans through Marketplace. Other revenue increased to $3.5 million in Q4, driven by record volumes achieved in Chase program, and higher marketing fees earned from our issuing bank partner. This was offset by a $700,000 reduction in the fair value of our loan servicing asset. We expect other revenue to continue growing on a sequential basis.
Provision expense in the third quarter was $34.4 million, which translated into a provision rate of 6.4%. With respect to our other credit metrics, our 15-day delinquency rate was 6.7%. This is down from 7.5% last quarter and reflected the improved credit performance of recent originations, as well as continued strong collections execution.
Likewise, our net charge-off rate was 12.9%, down from 16.9% in the third quarter. This sequential improvement reflected nearly $10 million of lower gross charge-offs, another quarter of over $5 million of recoveries. At this point, we believe we have absorbed most of the write off associated with our previous reserve build for 2015 cohort. And net charge-off rates should be in 13% to 15% range going forward.
Driven by our substantial progress in reducing credit risk, along with our favorable economic outlook, we expect our provision rates to be between 6% and 7% on a rolling quarter basis, going forward. Given current pricing expectations, we believe targeting this rate optimizes long-term returns.
Our cost of funds rate was 6.5% in Q4, up slightly over Q3 levels. We expect our cost of funds rates to continue increasing as the Fed raises short-term rates. To counter this, we will actively seek to tighten our borrowing spreads throughout 2018, as our securitization in certain higher cost credit facilities become eligible for refinancing. Please note, to the extent we are successful executing such refinances, we will write down any outstanding debt issuance costs attributed to the respective facilities being refinanced or extinguished. At this time, we are forecasting $1.2 million of such extinguishment charges over 2018, which is reflected in our adjusted net income guidance. Altogether, our net revenue was $42 million in the fourth quarter, up more than $25 million over the prior year period and up nearly $10 million compared to the third quarter of 2017.
Operating expense was $38 million in the fourth quarter, down over 28% from the prior year period. As Noah mentioned, as a percent of gross revenue, OpEx is 43% in the fourth quarter, down significantly from 64% a year ago. These year-over-year savings and operating leverage gains were primarily driven by the successful execution of our cost rationalization program during 2017. This program achieved efficiencies across all operating expense line items and especially in sales and marketing. Specifically, as we pull back acquisition spend throughout 2017, we significantly improved our marketing efficiency. Sales and marketing cost as a percent of total originations was 2.0% in Q4, 70 basis points lower than a year ago and the lowest level we’ve achieved as a public company. Given the improvement from marketing efficiency achieved in 2017 along with our improved unit economics, we will start increasing marketing spend again in 2018.
Managing OpEx will continue to be a top focus area for the company in 2018. To this end, last week, we terminated a portion of our New York headquarters lease. Although we are booking an upfront charge in connection with this early termination, the transaction is expected to yield approximately $2 in annual savings going forward. Our work isn’t there. We will improve our operating leverage by further reducing our real estate footprint, shifting hiring to our lower cost offices, and renegotiating vendor contracts. Economies of scale should also be realized as we start growing loan balances again.
All that said, we see several opportunities to further solidify our market leadership by reinventing in our business in a targeted way. In particular, in 2018, we plan to invest in the flexibility and agility of our risk and technology systems and our OnDeck-as-a-Service capabilities. As Noah mentioned, these strategic investments will add approximately $5 million of operating expense in 2018. This will accelerate both our top and bottom-line growth in the medium to long term.
Turning to the balance sheet, our Unpaid Principal Balance or UPB was $936 million at the end of Q4. This was down $5 million from Q3’s level, primarily because we sold more loans through Marketplace in Q4. Had we retained more loans, our Unpaid Principal Balance would have increased from last quarter’s level. Going forward, we expect UPB to increase sequentially at approximately the same rate as originations growth.
Before I move on to debt, I’d like to remind everyone that from an accounting perspective, we have a full allowance against the deferred tax asset. As a result, we incurred no P&L charges in Q4 related to the reductions in corporate tax rates. As of December 31, 2017, we had $82 million in net operating loss and a deferred tax asset of $38 million for which we continue to maintain a full allowance. Of course, a major benefit of the recent tax reform is that our effective tax rate on future income will now be significantly lower.
Moving on, funding debt declined approximately 3% sequentially, reflecting the decline in UPB balances over the quarter and our decision to utilize our cash balance to fund more loans with equity. In Q4, we were pleased to welcome a unit of BlackRock to our funding platform to further diversify our stable of investors. As of year-end, we had over $1 billion of committed funding debt capacity, providing over $320 million of excess funding capacity with maturities on our credit facilities laddered through 2020. Given our strong access to funding, our capital market strategy in 2018 will be focused more on reducing our borrowing costs, enabling greater funding flexibility and extending maturities.
During the fourth quarter, we also used operating cash flow to pay down our corporate debt line by $9 million. Even with this pay down, ending cash stood at $71 million, up from $64 million at the end of Q3, driven by our improved operating cash flow. Likewise, our equity book value grew by approximately $7 million in the quarter. Overall, our liquidity and capitalization remain strong and our business operations are now generating cash. As such, we are confident in our ability to fund our expected growth.
I’d now like to highlight a few points related to our investing materials in 2018. To begin, we’ve added an earning supplement containing a consolidated set of financial and credit data. We’ve also added to our press release annualized P&L results as a percentage of average interest earning assets; this table should help investors evaluate the key drivers of our portfolio economics. In addition, we’re introducing a two metrics, pre-provision operating income, and pre-provision operating yield to evaluate the performance of our operations independent of reserve releases or builds, and the impact of loan growth on provision expense. Finally, we have retired the steady state metrics we introduced during our Analyst Day in 2015 which were historically helpful for demonstrating the financial potential of our business as we shifted away from our marketplace funding strategy in 2016.
Now, on to guidance. As it relates to our financial outlook for 2018, our priority is to maintain a substantial level of adjusted net income while profitably growing loan balances and expanding our pre-provision operating yield. Accordingly, for the full year of 2018, we expect gross revenues between $370 million and $382 million; net income attributable to OnDeck between negative $2 million and positive $10 million; and adjusted net income between $16 million and $28 million. This full year outlook assumes unpaid principal balance growth between 10% and 15%, a full year provision rate between 6% and 7%, incremental technology and analytics investment of $5 million over fourth quarter 2017 annualized run rate levels, and noteworthy real estate disposition and debt extinguishment costs during the year of $4 million and $5 million.
Please note, we expect most of our adjusted net income growth to occur in the second half of 2018. Higher loan growth related provision expense and the acceleration of growth related investments will limit adjusted net income growth in the first half.
For the first quarter of 2018, we expect gross revenue between $86 million and $90 million; net loss attributable to OnDeck between negative $5.5 million and negative $1.5 million; and adjusted net income between positive $1 million and $5 million. This quarterly forecast assumes between 5% and 10% sequential originations growth and a return to approximately $40 million of operating expense before the $3.2 million charge for the partial termination of our New York office lease.
With that, I’ll turn it back to Noah for some concluding remarks.
Thank you, Howard.
To close, in 2017, we executed on our strategic priorities to reduce our cost structure, strengthen credit performance, and establish a solid profitable foundation from which to drive our long-term growth. While we are pleased with the progress we made, we are only getting started.
In 2018, we expect originations to grow at double digit rates and we see major opportunities to grow our lending business’s top-line while driving even faster profit growth through pricing, improved capital market execution, better credit modeling and loss mitigation, and our inherent economics of scale. Our OnDeck-as-a-Service is newer, but is growing at a faster rate and delivering higher gross margins than our lending business. We will continue to invest in this area very attractive opportunity in 2018 to drive long term shareholder value. Looking out over the next 24 months, we believe these efforts will come together to create an even more profitable business.
In 2017, we improved adjusted net income over $60 million from the prior year. For 2018, we are projecting over a $20 million improvement at the midpoint of our guidance range. And we believe adjusted net income will accelerate in 2019 as we continue scaling and driving operating leverage, and the financial performance of our newer international and OnDeck-as-a-Service businesses improves.
The decisions we have made over the past year have further solidified OnDeck’s position as a clear leader in online small business lending. I am confident that our data-driven approach, innovative technology, unique product structure and now solidly profitable business will continue setting OnDeck apart from our competitors and continue enabling us to create long-term value for our shareholders, partners and small business customers.
With that, thank you for joining us today. And I’ll now turn the call back to the operator for Q&A.
[Operator Instructions] Your first question comes from the line of John Rowan with Janney. Your line is now open.
Good morning, guys. I just want to make sure I understand. So, there is -- the difference between adjusted and GAAP net income is obviously going to be stock-based comp and then the rest of it is, did you say $4 million to $5 million of onetime expenses, of which $3.2 million is the termination of the lease termination cost in 1Q, is that -- did I hear that correctly?
That’s right. And John, we actually have a table in the back of our press release that has the reconciliation to GAAP net income.
Okay. And then, as far as the tax rate going forward, I’m not sure if you guys said it or not, I heard 27% was tax reform, is that still about right?
I think -- we don’t expect to pay taxes in 2018. As I mentioned on the call, our DTA is going to roughly $28 million -- sorry, $38 million. Within the next two to three years, we can see ourselves paying taxes, and the rate on at least taxable income should be between maybe 24% and 26%.
Okay. I have another question but I’ll queue back up after others have gotten their two questions. Thanks.
Okay. Thank you.
And your next question comes from the line of John Davis with Stifel. Your line is now open.
Hey. Good morning, guys. Noah, maybe if you could talk about little bit about competition. How much of this 10% to 15% kind of expected loan growth is self driven, how much composition are you seeing? Maybe just start there and give us some commentary, will be helpful.
Yes. No, sure, happy to. So, I think in the fourth quarter, we saw really a fairly stable competitive environment. There was a bit of shake out in our industry in 2017. I think, we benefited from that overall. I think, the remaining players are operating more rationally both in terms of acquisition spend and offer quality. And I think that showed up in our sales and marketing results, as our lowest sales and marketing spend in quite some time, yet we delivered sequential originations growth. So, what we like about how our positioned for 2018 is all the levers to achieve that 10% to 15% growth number are really under our control. It’s acquisition channels we already have, it’s product features that we have a high confidence as we roll them out t hat will lead to the growth that we expect, and credit policy adjustments that are already kind of designed and in the queue. And so, if you look at our guidance for Q1, we even talked there about 5% to 10% sequential growth just for Q1. So that will give us a lot of the confidence going forward.
Okay, thanks. And then, maybe just talk a little bit about the partnership’s progress there. I know you said we’re still waiting [ph] on the one big bank I guess later this year now. But, what about the small bank effort, and just any other avenues you are going through the partnership channel? And then, anything else you can give us on JPMorgan for 2018, will be helpful? Thanks.
Sure, yes. No, happy to. So, we’re very encouraged by the progress we made in the partnership channel. Obviously, the JPMorgan Chase relationship had a record quarter in Q4, continues to scale. And we’re looking frankly doing more for them over time. And that’s partially what’s driving some of our incremental investment in this business. Our second major bank partner, just to clarify, we’re kind of already underway building out the solution for that bank. So, that is something very much that is moving ahead, which is great. And then, the third dimension here really is the inbound interest we’ve received. I think, this digital originations trend among banks is just gaining steam. And I think because of our work with JPMorgan, we have a great reputation in the market as someone who can deliver our enterprise grade solution for a major institution. So, we have a great pipeline that’s building behind those two banks. And again, we’ve seen some scope upgrade. So, I think there is an opportunity once you are working with the bank to do even more for them over time.
Okay. And just a quick follow-up on that. If we look out two to three years, how much of your business would you like to come from the partnership channel versus basically direct to you? I mean, how do you think about balancing that kind of OnDeck-as-a-Service versus direct balance sheet? Is it something that you guys would look at in a few years and think that could be 50-50 or is it 75 to 25 or sort of a high level, how do you guys think about balancing OnDeck-as-a-Service versus…
No, of course. And so, I’d say, two points there. One, we’re not giving long-term guidance on the revenue mix there. I think, it’s still too early to sort of define that. But, on the flipside, we view the opportunities as not necessarily a versus thing but more of a complementary thing. We believe in a risk segmented market. And by working with banks like JPMorgan Chase, we can reach a lot of customers at price points that we might not be able to reach on our own. So, we see great growth ahead for that business. That’s a higher gross margin business because it is a fee for service business as opposed to a balance sheet or spread lending business. And so, we view it as complementary. We’re investing commensurately with that opportunity. And it’s growing at a much faster rate than the overall OnDeck business, which is also growing well this year.
Your next question comes from the line of James Faucette with Morgan Stanley. Your line is now open.
Great, thanks. I just wanted to ask a couple of follow-up questions, and I apologize if you’ve said this. But, for whatever reason, our audio cut out when you were making some of your previous comments, particularly around OnDeck-as-a-Service. So, I guess, my first question is that you indicated that you are bringing on second partner and you’re increasing investment. How should we think about the time to return or time to pay back on that investment and what are some of the determinants or when we can start to see return in the results from net investment?
Thanks, James, and I apologies about the audio there. So, what I would say is it’s not a short-term pay back; it’s a medium to long term pay back, but there is a multiplier in that pay back as well. So, as you know working with large institutions, there is implementation timeframes. You invest upfront a fair amount of fixed cost. What we’re finding in, for example our program with JPMorgan, is very scalable once you are up and running. And so the variable costs are quite manageable. So, as with bank number two, I would think about a similar investment and then revenue ramp cycle happening in 2019-2020. And then, again, as we implement subsequent banks, we believe some of the technology investments we’re making this year will allow us to bring on new banks more quickly in a more scalable way with less fixed upfront investment. So, again, I don’t want to sort of give an impression that return instantaneous. But, I think when you think about kind of a classic enterprise software or enterprise sale, it’s quite a normal return timeframe of a couple years.
Got it. And then, back on JPMorgan and -- at what point or when do we get to a point where you feel like OnDeck is fully rolled out within JPMorgan, if you will? And I guess, you mentioned that there were some accelerations and originations in 4Q, but other revenues were flat. Can you just rearticulate kind of maybe what the offsets for there, if any? Thanks.
Yes. We did have an offset of $700,000 against other revenue in Q4. So, I think when you back that out, you will see some nice sequential growth. In terms of the overall opportunity within JPMorgan, we are still just getting started. So, we would see many years ahead of continued expansion, and that can happen through several different dimensions. One is, we’re not even close to fully penetrated on the existing customer base with the current products; two, adding additional products; and three, opening up some of these solutions, the prospects of the bank as well. So, all of those are in scope for us over the next year or two. And then, there is a ramp and a growth cycle for each of those after that.
And your next question comes from the line of John Hecht with Jefferies. Your line is now open.
Thanks, guys, very much. And I appreciate the additional color in the investment presentation as well. Just with respect to credit. You had a good quarter-to-quarter improvement in delinquencies. But overall, delinquencies flat, year-over-year, but charge-offs coming down nicely. I wonder, is there an attribution to that; is that reflective of tightening or are you guys just getting better at servicing? I seems like -- you mentioned that maybe you’re correcting a little bit more effectively from your customer base. Just wondering what you’re seeing overall in terms of credit quality was contributing to the improvement.
Yes. John, it’s really all of the above. As we’ve mentioned, the quality of recent originations has been really at historic highs. And we took pretty aggressive action this year to cut out the highest risk populations, modify offer terms to make it more profitable for us, adding manual underwriting where we thought more appropriate, and even on the back end, just the execution with collections or recoveries has improved significantly. So, I think it’s a combination of all those things really rearing its head. And you see that now in the vintage curves that we’ve also provided in the earnings supplement with the ‘17 cohorts performing very well.
And I think the good news is, we see continued opportunity to drive even more upside in the credit size. Noah talked about new iterations on the OnDeck Score to be introduced in 2018, the introduction of troubled debt restructuring, which is just something we haven’t done historically but definitely see an opportunity to benefit from really what’s considered industry best practice there, as well as continue the kind of collections enhancements we’re making.
Okay. And then, I know you gave lots of different factors with respect guidance. But, is the best way to think about the OpEx component where you take maybe the run rate of this quarter, add five into the technology investments to couple for the annualized to get through the real estate reduction, and then that will be the run rate excluding some of the one-time termination expenses?
So, we try to be very specific that in Q1 we expect our OpEx to be approximately $43 million including the $3.2 million charge. So, backing that out, we’re closer to $40 million for Q1. And what’s going on there is we’re investing again in OnDeck-as-a-Service and other areas of our business. And I think the pace throughout 2018 will be kind of modest increases each quarter on the OpEx line.
Your next question comes from the line of Melissa Wedel with JPMorgan. Your line is now open.
Thanks for taking my question, guys. I am wondering if you can dig in a little bit deeper on the improvement in recovery rate, and what’s driving that and whether we can expect that to kind of be sustainable going forward.
Yes. Thanks for the question, Melissa. I think a big driver of what’s driving the improvement in recoveries has been the fact that rather than selling the loans post charge-offs, which is what we’ve done historically, we’ve been keeping more and litigating more loans ourselves. So, that strategy has borne fruit. And part of that is that could get the snowball effect wit customers that enter into some type of payment plans where it may not be that we are receiving the full outstanding amount at one time, but they are making payments over the course of 12 over 24 months. So, as that snowball effect continues, I think, we’ll see continued increases in the recovery rate.
Okay. And then, as you think about originations growth going forward, I know that there had been an increasing share of originations to existing customers in the past that had kind of a moderating effect on EIY. What does that look like? How you are guys thinking about that for 2018 and 10% to 15% growth of originations going forward? Is that going to be similarly allocated -- to a good portion to existing customers and could that dampen EIY a little bit?
Yes. Hey, Melissa, this is Noah. So, to clarify, as we think about 2018, that 10% to 15% growth number, we really are allocating equal weights to both new and prior customers. So, the advantage obviously of new customers is you win business that then can come back you later and build out lifetime relationship; the advantage of the existing or prior customers is that they have lower loss rate structurally. So, we’re really trying to balance across those two and kind of get equal parts of our growth form each category.
Your next question comes from the line of Steven Kwok with KBW. Your line is now open.
Hi, guys. Thanks for taking my questions. I guess just touching on the guidance; can you talk about the factors that could either bring you to the high end versus the low end of the guidance, like what are the factors that we should consider there?
Yes. I think two of the biggest drivers are -- and they all relate to the same thing is, one, the rate of originations growth. Given the accounting rules, the faster we grow, we book more provisions expense upfront, and that could limit the -- or that could cause us to come in lower on the guidance ranges. The next part of the reason why we introduced the two new kind of pre-provision metrics, the operating income plus the operating yield, so we can separate really the credit performance from really how the core operations are performing regardless of that accounting rule. And the second one is provision rate, which is much more related to the underlying kind of credit quality of the new originations or a potential on the releases or builds. So, we brought down our provision rates target from 7% to now 6% to 7%; in the fourth quarter, it was 6.4%. And we think that type of number is sustainable going forward. But clearly, the higher we are, that will lower the guidance range; and the lower we are, that will create some upside.
And then, as we think about the adjusted EBITDA margin, now that you are back in growth mode, how much leveragability is there in the business? Like, as we think about on from a year-to-year basis, are you guys targeting any specific improvement in the EBITDA margin rate? And over the longer term, what you think is like a good sustainable run rate?
Yes. So, providing guidance on specific margin level, I think there is plenty of opportunity to continue driving just overall increased operating margin. So, starting with the effective interest yield, you saw that that number increased 200 basis points year-over-year. As you take down some of the recent pricing increases that have been implemented over last year, we are now finally seeing kind of the impact effect to the overall portfolio. That dynamic will continue as loans continue to roll off. So, I would expect EIY, as I said in my script, to continue increasing, which is going to enhance our unit economics.
Kind of moving down the P&L, I think provision, we guided to 6% to 7%. Certainly, I noted that there is lot of upside hopefully on some of the investments that we are making, things like DDRs that should enable strong performance with respect to the credit. And then OpEx, sales and marketing continues to present I think an attractive opportunity for continued market expansion. We were at 2.0% sales and marketing as a percentage of originations for the quarter; that was believe a low since we went public. As we continue to grow and really just focus on the highest yielding, marketing activities, that number should decline over time.
And then, with respect to the rest of the operating expense rates, as we continue to grow originations and our loans under management increases, you should see natural economies of scale. So, we are very optimistic on kind of the margin potential here for 2018 and beyond.
Your next question comes from the line of Jed Kelly with Oppenheimer. Your line is now open.
Great, thanks for taking my question. So, you had nice leverage on sales and marketing in 2017. What changes in efficiency and certain marketing channels that you are seeing is causing you to increase your sales and marketing expenses in 2018? And then, as you increase your sales and marketing, what gives you confidence that you’ll be able to bring in the same quality customer that you saw -- that you were bringing in, in 2017.
Yes. So, I think on the quality issue, we think a lot of that is under our control. If you look at a channel like direct mail for us, we have some analytical foundations behind that work that give us a lot of confidence in terms of who we’re targeting and the credit quality of those populations. That’s a channel we can very much drive the right types of credit quality. And then, we have indirect channel where we can kind of do the same thing. So, we have certain aggregators that we work with and other indirect partners where we can work with them to shape the quality of what they sent to us and then compensate them, appropriately for that. I think, as Howard noted, pricing has been ticking up reasonably well in the last quarter or two. And so that also gives us some headroom in terms of investing in customer acquisition and making that an overall sound investment decision.
So, again, we are not talking about growing 100% this year in the lending business, we’re talking about 10% to 15% growth, and balancing that between new customers and renewal customers where the renewal customers have very, very low embedded marketing costs. So, I think when you look at it on balance, we feel very confident about where the growth is going to come from and the quality that we can engineer at the right cost.
And then, secondly on the second bank partnership, how much of that is implied in your revenue guidance?
Yes, very little.
Your next question comes from the line of Mayank Tandon with Needham and Company. Your line is now open.
Hey, good morning, guys. This is Kyle Peterson on for Mayank today. I just want to ask about kind of pricing. Obviously, we’ve seen a nice uptick in EIY the last few quarters. Is this kind of at a run rate you guys are comfortable with, now that the kind of pricing adjustments have worked their way through? So, I just wanted to see how we should think about that going forward?
Yes. I think, certainly, we are comfortable at this level. You’re seeing the impact of two things, one that the higher price increase that we’ve made throughout 2017 but also improved credit performance where we have more customers paying us. And listen, as the Fed continues to raise rates, I think you could expect us to continue to raise pricing on the margins and that should result on even as we exit 2018 higher EIY than what we realized this quarter.
All right, great. And then, I noticed the gain on sale, both the volume and the margins, both were little better, still small income below peak levels. I just want to see, is there -- are you guys seeing kind of any sort of improvement in that space or is this quarter, just kind of a better than expected quarter or kind of what are your thoughts on that piece of the business?
Yes. Nothing really materially driving the increase there. It was more a function of the mix of the loan that we sold. Going forward, we are little bit less focused frankly on selling loans. I think, our strategy this year is almost completely a balance sheet driven strategy. And on that note, we do believe, as we mentioned in the prepared remarks that for example our line of credit product, we expect to bring the lower cost of capital for that product during the year; our international businesses, there is opportunity as well there, the lower cost of capital. So, we believe the balance sheet model especially with the new pricing and improved credit performance is really the dominant way we’re going to fund our loans this year.
Your next question comes from the line of Lloyd Walmsley with Deutsche Bank. Your line is now open.
Thanks. Two if I can. So, first, you are guiding to nice loan growth with EIY improvement and seeing more efficiency in marketing. I guess, can you talk about how you think you are able to get that strong growth despite higher pricing? Is it mostly a function of competitive environment or just general rates for borrowers going out across the board, allowing you to do this? And then, second one, when you look at the competitive environment for the OnDeck-as-a-Service platform business, curious when banks are evaluating you for these partnerships, what does the competitive environment looks like on that side of the business? Are they comparing you to other players, is it versus just the internal development work? And is there an opportunity potentially to extract better economics on future deals, perhaps with smaller banks? Curious to get your take there. Thanks.
So, maybe I’ll start on the loan growth component. I think a couple of things. One, as you noted, with base rates going up, lenders in the market are increasing their rates a little bit across the board commensurately. So, that backdrop I think is not unique to OnDeck. The second piece there is frankly the demand. The economy is strong right now for small business owners, the recent tax adjustments will benefit small businesses and turn I think lead to additional demand. We’re already seeing that a bit in our business. And then, finally, we have a lot of levers under our control around credit policy, around product features and functionality that we’re confident will drive growth. We’ve tested some of those features in 2017, we’ll roll them out more comprehensively in 2018. A great example of that is our line of credit product is very underpenetrated in our indirect channel. So, we’re going to increase that deployment this year.
So, I think, again, a lot of these growth drivers, we think are under our control. And I think we can do that growth while bringing pricing up modestly, to reflect base rates going up and improving economics. So, on the ODaaS side, OnDeck-as-a-Service, the competitive environment there is different. So, there are a number of direct lenders we compete within our lending business that do not attempt to sell their platform to banks. On the flip side, there are a number of software companies that are selling origination systems of differentiate shapes and sizes into the banking market. So, different competitive sets. And you are absolutely right, in many cases, what we are competing against is banks deciding build this themselves. But, we’re encouraged that actually the recent trends that banks and FinTechs are getting more and more comfortable partnering, and I think banks are understand that building it themselves could be multi-year time to market very expensive versus partnering with the FinTech and getting to market faster, at lower costs and better customer experience. So, yes, different competitive sets but certainly and -- it’s an opportunity we believe that banks are certainly warming up to and accelerating towards.
[Operator instructions] Your next question comes from the line of Michael Tarkan with Compass Point. Your line is now open.
Thanks, just a couple of quick follow-ups. On the repeat borrower number, last quarter you said it was up sequentially, but still above 50%. Is that the same case this quarter?
Yes. There is no material changes; it wasn’t up sequentially but stayed with historical quarters.
And then, on the TDR program that you expect to roll out, just how do we think about reserving for TDRs versus non-TDRs? I know sort of other financials look like of loan losses for TDRs, I am just wondering if that will have any ramifications on your provisioning moving forward? Thank you.
Yes. I think as we get closer to rolling it out, we’ll provide specific guidance on how it will impact the provision rate. But overall, I think if anything, I think it will help the provision rate, because today, we are not modeling in the effectiveness of these longer terms settlement programs of borrowers and the incremental recoveries that we expect to get. So, today, we’re sort of modeling in the recovery rates we see on the existing workout programs which are really limited in their range and scope. So, my hunch is it will be a net positive, but maybe let’s just wait until we roll it out and we can talk more explicitly about it, maybe on the next call.
We have no further questions at this time. I will turn the call over to Noah.
Everyone, thanks for joining us today and we’ll see you on the next call. Take care.
And this concludes today's conference call. You may now disconnect.