Earnings Call: Q4 2019

Jan 29, 2020

Good morning, and welcome to the Silvergate Capital Corporation 4th Quarter and Full Year 2019 Earnings Conference Call. During today's presentation, all parties will be in a listen only mode. Following the presentation, the conference line will be opened for questions with instructions to follow at that time. As a reminder, this conference is being recorded. I would now like to turn the call over to Shannon Devine, Investor Relations for Silvergate. Please go ahead. Thank you, operator, and good morning, everyone. We appreciate your participation in our Q4 and full year 2019 earnings call. With me here today to talk about our Q4 and full year results are Alan Lane, our Chief Executive Officer and Tony Martino, our Chief Financial Officer. They will be joined by Ben Reynolds, EVP and Director of Corporate Development for our Q and A. As a reminder, a telephonic replay of this call will be available through 11:59 pm Eastern Time on February 12, 2020. Access to the replay is also available on the Investor Relations section of our website. Additionally, a slide deck to complement today's discussion is also available on the IR section of our website. Before we begin, let me remind everyone that this call may contain certain statements that constitute forward looking statements with the meaning of the Private Securities Litigation Reform Act of 1995. These include remarks about management's future expectations, beliefs, estimates, plans and prospects. Such statements are subject to a variety of risks, uncertainties and other factors that could cause actual results to differ materially from those indicated or implied by such statements. Such risks and other factors are set forth in our periodic and current reports filed with the Securities and Exchange Commission. We do not undertake any duty to update such forward looking statements. Additionally, during today's call, we will discuss certain non GAAP measures, which we believe are useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with U. S. GAAP. A reconciliation of these non GAAP measures to the most comparable GAAP measure can be found in our earnings release. At this point, I'll turn the call over to Alan. Thank you, Shannon, and good morning, everyone. Before I get started, I'd like to take a moment to thank the many people who helped us through our initial public offering, which culminated in our day of trading on the New York Stock Exchange on November 7, 2019. The hard work of our employees and advisors and the loyal support of our customers and partners contributed to the success of our offering. As many of you are aware, Silvergate's global payments platform known around the world as the Silvergate Exchange Network or CEN provides a significant opportunity for growth and is a real differentiator for Silvergate. The completion of our public offering has delivered not only growth capital, but also an additional public forum to market and further publicize our offerings and initiatives in the digital currency market. Turning to today's call, I would like to provide a brief overview of Silvergate and our growth strategy for those investors who were unable to hear our story during our IPO roadshow. I will then briefly review the highlights of our 4th quarter performance before handing the call over to Tony for a more detailed discussion of our results. From there, we will open the call for questions. To begin, Silvergate Capital Corporation is the leading provider of innovative financial infrastructure solutions and services to the growing digital currency industry. Silvergate was founded in 1988 as an industrial loan company. And when I joined in December of 2,008, Silvergate was a small, clean, California chartered FDIC insured financial institution. It had just under $300,000,000 in total assets consisting of commercial real estate and single family residential real estate loans funded primarily by CDs and money market deposit accounts. In 2013, we began exploring the digital currency industry as a way to gather deposits to support our lending strategies. We opened our 1st U. S. Dollar deposit account for a company in this new and unfamiliar industry in January of 2014, creating a significant first mover advantage which continues to benefit Silvergate today. What began 6 years ago as a fairly straightforward deposit account offering has evolved into a global payment platform known worldwide as the FEN. We believe that Silvergate is the 1st bank in the world to bring the legacy financial system, which historically only operates during normal business hours 5 days a week into the 20 fourseven, 365 digital currency market, which never sleeps. As the 1st mover in this still nascent industry, the Send provides us with 4 key competitive advantages. First, it creates a network effect, so that every time Silvergate onboards a new customer, we provide incremental value to customers already participating in the network. This drives long standing relationships and creates a further competitive advantage. 2nd, our network provides for a low cost customer acquisition strategy. Prior to 2019, our website didn't mention digital currency related business, but we grew rapidly by solving problems for our customers, which led to word-of-mouth referrals. The third benefit is access to an underserved customer base that is looking for products related to digital asset settlement and asset backed credit facilities. Finally, Silvergate has the ability to grow fee income, which I will discuss in more detail in a moment. Our focus is on the institutional market as we connect 80 exchanges and OTC trading desks to almost 500 institutional investors, allowing them to transact in near real time around the clock around the world. Many of our customers are using trading strategies very similar to what they might be using in the equities or commodities markets. Importantly, if you are a hedge fund and you are on the SEN, you have a competitive advantage over other hedge funds that aren't on SEN because you can move money at times that they can't and ultimately your capital is more efficient. These are no cost book transfers between Silvergate customers and because you have to be a Silvergate customer to use the SIN, the deposits don't leave Silvergate when they customers are at a distinct disadvantage. This drives significant new customer potential, which can be seen in our customer growth. We ended the year with 8 0 4 customers, a 48% increase over year end 2018. Our new customer pipeline also remains robust with more than 200 institutions in our review and approval process, which we believe bodes well for future growth. Turning to Slide 4, as our customers have grown, so too has their utilization of the sand. For the full year 2019, the FEN handled $32,700,000,000 of U. S. Dollar transfers, representing 2 96% growth year over year. We also experienced significant growth in the number of While net interest income represents a significant portion of our total revenue, we are evolving our business to a fee based model as customers rapidly adopt our global payments platform. Fee income is comprised primarily of 3 different categories, including FX transactions, cash management solutions such as wires and ACH, and lastly, send fees. For the full year 2019, digital currency customer related fee income was $4,900,000 representing an increase of 148% as compared to 2018. Our 4th quarter digital currency related fee income was $1,400,000 representing an increase of 102% as compared to the 2018 Q4. I would note that the price of bitcoin was volatile in the 4th quarter, which modestly impacted our digital currency customer related fee income and U. S. Dollar volumes as compared to the 2019 Q3. That said, the underlying growth on the center remained robust as Q4 2019 transactions grew 17% sequentially from the 2019 Q3. Looking forward, we believe that we are in the very early stages of monetizing the and expand our fee income. We continue to strike a balance between maximizing the network effect with the desire to increase fee income in the short term. Over the long term, we will continue to build out the fee income components with our new and existing customers through new product development. One example is Send Leverage, which is a new product offering that we announced earlier in January. Send Leverage will allow bank customers to obtain U. S. Dollar loans collateralized by Bitcoin held at select digital currency exchanges that are also customers of Silvergate. The product uses the Send to fund loans and process repayments in real time, 24 hours a day, 7 days per week. With this product, we plan to provide credit to existing Silvergate customers, leveraging the network effect of the SIN. We will apply the same rigorous underwriting standards that have served us well over the years to this new lending initiative. Would highlight that we are currently in a pilot with expectations of more fully rolling out the product in the second half of twenty twenty. Importantly, this further demonstrates Silvergate's innovation and focus on our customers' needs. Over time, we see San Lebri as a strong growth driver for Silvergate. Silvergate will continue to invest in new product development, a priority for future growth, as we work to enhance both the value of the Ascend and its unique competitive advantage, which will further strengthen its network effect. With that, I would now like to turn the call over to Tony for a more detailed review of our financial results. Thank you, Alan. As was already covered by Alan, Slide 4 provides the key trends around the expansion of our digital currency platform. As consistently strong customer growth continues to strengthen our network effect, resulting in significant increases in both decreased $33,400,000 or 1.8 percent to $1,800,000,000 as compared to the Q3 of 2019. At December 31, 2019, 74% of our total deposits were non interest bearing, totaling $1,300,000,000 The December 31, 2019 deposit balance includes $325,000,000 at face value of callable brokered certificates of deposit used for hedging. BCDs were initially issued between March July 2019 and were used to purchase $350,000,000 in fixed rate commercial mortgage backed securities along with $400,000,000 in notional amount of interest rate floors as part of a hedging strategy to mitigate the impact from a decrease in interest rates. The callable brokered CDs had an all in cost of 2.77% as at September 30, 2019. And during the Q4, the company called $237,500,000 of these CDs and reissued new callable brokered CDs at lower rates. The company incurred a $1,600,000 premium expense during the $325,000,000 in callable brokered CDs was 2.29% at December 31, 2019. Our weighted average cost of deposits for the quarter was 84 basis points, with a total of 78 basis points related to the callable brokered CDs. Out of the total 78 basis points, 35 basis points is related to the $1,600,000 premium expense for calling the CDs with the remaining 43 basis points resulting from the underlying all in cost of carrying the CDs throughout the quarter. This compares to a weighted cost of deposits of 50 basis points in the Q3 of 2019 and 28 basis points in the Q2 of 2019, of which 44 basis points and 22 basis points, respectively, were related to the interest and premium expense related to the callable brokered CDs. The prior year weighted average cost of deposits of 8 basis points in the Q4 of 2018 reflects the fact that we did not have any callable brokered CDs at that time. Turning to Slide 6, our net interest margin was 2.97 percent for the 4th quarter compared to 3.39% in the 3rd quarter and 3.59 percent for the Q4 of 2018. The 4th quarter decrease was driven in part the impact of the brokered CDs as reflected in our cost of deposits. In addition, you can see how the yields on loans, securities and cash were impacted by the reduction in rates in the 3rd 4th quarters of 2019. Now on to non interest income on Slide 7. Non interest income for the Q4 of 2019 was 3 point $100,000 compared to $2,600,000 in the Q3 of 2019 and a $1,100,000 increase compared to $2,000,000 in the Q4 of 2018. Non interest income for the full year was $15,800,000 compared to $7,600,000 in 2018. The full year increase was primarily due to the 102% increase in fee income from our digital currency customers and a $5,500,000 gain on the sale of our San Marcos branch that closed in the first quarter of 2019. Turning to Slide 8, non interest expense for the Q4 of 2019 was $13,700,000 which compares to $12,600,000 in the Q3 of 2019 $14,000,000 in the Q4 of 2018. The linked quarter increase of $1,000,000 was primarily due to increases in salaries and employee benefits, professional services and other general and administrative fees, largely related to our organic growth and the expansion of our operational infrastructure. On to Slide 9, total loans at December 31, 2019 were $1,040,000,000 a 3.7% increase compared to the linked quarter and a 10.3% increase compared to year end 2018, driven by an increase in our mortgage warehouse division during the year. The capital ratios on Slide 10 represent the ratios at our subsidiary, Silvergate Bank. At December 31, 2019, each of the bank's capital ratios exceeded the well capitalized levels established by federal banking regulations. Our total risk based capital ratio at 25.24 percent reflects the fact that a large proportion of our deposits are held in cash and high grade securities. Thank you again for your time today. We look forward to updating everyone on our Q1 results in April. With that, I'd like to ask the operator to open up the line for any questions. Operator? Thank you. We will now be conducting a question and answer session. Our first question comes from the line of Michael Perito with KBW. Please proceed with your question. Hey, guys. Good morning. Good morning, Mike. I had a few questions. I wanted to start, Alan, on scent leverage. I think it seems like an interesting product, but obviously there's when thinking about the underwriting and using what seems to be a pretty underlying a volatile underlying asset as collateral. I'm curious if you could maybe expand a little bit on how you plan to kind of price this product and also what the underwriting kind of process is and what makes you comfortable that the risk adjusted returns will be attractive longer term? Sure, Mike. This is Alan. So on Send Leverage, I'll start out and then I'll hand it over to Ben to provide a little additional color. So the way we're approaching the underwriting for the pilot is we are first working with what I would consider our strongest customers from a financial strength perspective, looking to make sure that they have the ability to service the debt regardless of what happens to the Bitcoin collateral. Having said that, we believe that the Bitcoin collateral provides a very, very unique and potentially, as you said, a very an opportunity for a very strong risk adjusted return because of the fact that Bitcoin is a liquid market that trades 24 hours a day, 7 days a week. And given the way we intend to underwrite the credit in terms of the type of margin requirement that we would require the collateral coverage, if you will, for the product. We certainly believe that we will have an opportunity should the underlying collateral experience volatility that would require a borrower to cover a collateral shortfall, if you will, either by selling the collateral or by adding additional U. S. Dollars, paying down the loan or adding additional dollars on the platform. The fact that the 5. We believe that we're probably one of the only banks in the world that can offer this type of functionality with the ability for our customers to be monitoring their collateral position and to be able to cover collateral shortfalls or pay down the line 24 hours a day, 7 days a week. Ben, would you like to add anything to that? Yes. So I think it's important to note that this product is targeted towards the highly sophisticated institutional investors that we have as clients. So we have close to 500 clients in that category. As Alan mentioned earlier, these are folks that are used to trading the equities and commodities markets. So they're very highly sophisticated. And that's really the target group for this. And then also, as Alan mentioned, it is a pilot. We'll walk into this and we'll demonstrate the success in the concept before we expand it. And then Mike, one other point that you had asked a question on the type of yield that we might be able to get on And again, this is a pilot and working with very strong borrowers. So the way we thought about this initially is this would likely be a high single digit type of cost to the borrower. And there will be many factors that will go into that just like any other loan that we price, given the strength of the borrower, the level of collateral coverage, etcetera. And so we intend to, as Ben mentioned, start slowly, work through all of the different features during the pilot here over the next 90 to 180 days and we'll see how it works and we'll be reporting back to you on a quarterly basis. Great. Thank you. That was helpful rundown. Appreciate it. And I had a couple of just outlook related questions I also want to hit quickly. Just one, Alan, I think there were some deposits in terms of the deposit growth in 2019, there were I think a couple of elevated balances that might have normalized and that might have impacted the ability to show kind of growth in the back half of the year. But I was curious if you had any updated thoughts on deposit growth on a net basis for 2020 that you were willing to share today? Sure. So again, I'll start and then I might ask Tony to weigh in here a little bit as well. As we look at the different deposit categories. So one of the things as I think everyone on the call is aware is the Bitcoin market itself is fairly volatile. And therefore, the deposit levels that we enjoy at different times can also experience some volatility. Having said that, we enjoy a fairly stable deposit base because of the fact that our customers in order to participate in the send, they have to have deposits on the platform in order to be able to transfer money amongst themselves across our platform 24 hours a day, 7 days a week. So we are focused on the things that we can control, which is adding new customers and encouraging adoption on the SEN and driving the number of transactions across the SEN and the deposit balances, we believe will somewhat take care of themselves over time. And so Tony, I don't know if you want to comment at all on the different categories of deposits. Sure. So Mike, it's Tony here. Just to give you a little bit more color on the breakdown. As Alan discussed, we continue to focus on building the customer distribution of that deposit base, right. So every quarter we're adding customers, more customers means less concentration among the deposits. And so that's a key element. As we move forward, we strategically want to focus on generating more fee income opportunities and become less reliant on necessarily just deposit funding. Just to give you a little bit of color or breakdown on the deposit makeup and a little bit of insight on NIM for the quarter. As we reported, we reported a NIM of 2.97. Part of that, as you know, part of our deposit makeup includes this $325,000,000 of callable brokered CDs, which obviously were used for hedging and are not part of the FinTech business. But we took advantage of the decrease in rates. We called a subset of them. We took $1,600,000 premium expense. That equated to a 30 basis point impact on NIM. So if you can normalize for that and you can see as we're moving to the Q1, we make adjustments in the non fintech area just to make sure we continue to lower our funding costs. But strategically, our approach to the broader business doesn't change. We're going to continue to add customers, continue to distribute that deposit base. As we pointed out, the digital currency deposits are at no cost. Appreciate that. And then just that kind of leads into my just my last question, just to stick with you Tony for a second. So I mean if all else equal, if we have no more action from the Fed, I mean the margin stabilize in that $3.30 range plus or minus for most of 2020? Are there any other major significant implications that we should be thinking about that could impact that figure as we move forward? No, you're exactly spot on, Mike. That's given no further moves in rates, that's where we expect the NIM to normalize. And that will happen as soon as the Q1, just to clarify? Yes. The entry point right now, that's where I see the NIM. Okay. Great, guys. Appreciate you taking my questions. Thank you. Yes. Thanks, Mike. Thank you. Our next question comes from the line of Eugene Koisman with Barclays. Please proceed with your question. Good morning. Thanks for taking my question. Good morning, Eugene. Thanks. I wanted to follow-up on the deposit discussion. It looked like both the exchange and investor count for the digital related deposits were up, but the actual deposits were down. How should we think about your ability to drive deposit growth from new client relationships going forward? And is it fair to assume that the more clients you send or the more your clients you send, the fewer deposits they need to keep with Silvergate because of the increased efficiency that Alan referenced earlier? Sure, Eugene. This is Alan again. I'll start off. So you're absolutely right. When we look at the different categories, as we reported in the press release, while the number of exchange customers and the number of institutional investors went up, the deposit levels at that point at the period end were down a bit. And candidly, they were down a bit across the quarter in the institutional investor category primarily. And what that relates to is, as the price of Bitcoin is falling and there's not a lot of volatility in the daily movement that would drive potential investor interest in trading on a daily basis. They will look they will potentially look for yield in other ways to earn yield on their funds. And as you are aware, we do not pay interest on these deposits. And so we have in fact experienced some outflows during periods of time when the opportunity to make outsized returns on trading the assets are have declined a little bit. Again, that's why we focus on just continuing to add customers, knowing that when they when the market comes back and they want to trade the assets, their best way to do that is by putting deposits at Silvergate so that they can access the different exchanges 24 hours a day, 7 days a week. And so to your point, our focus is on adding customers, which will then in turn over time drive deposits. And Ben, did you want to add to that? Yes. So if you look at the average daily price of Bitcoin in Q3 versus the average daily price of Bitcoin in Q4, In Q4, it was down about 23%. Obviously, our deposits weren't down that significantly. And so it's really, as Alan mentioned, a combination of looking at a number of factors, the number of customers that we have on the platform, what's happening to the underlying price of the asset, as well as the utilization of the Ascend. And so what we're really optimistic about is the fact that we had more Send transfers in the 4th quarter than we've ever had before at 14,400 at a time that the price was moving down. And so when you really kind of peel back the onion and you look at the institutional investor category, it's really more than the send transfers making them more efficient. It's really that they just need less cash on deposit in order to execute the same trading strategies. So as the price increases, they have more need to have more capital in order to execute the same trading strategies. And so it's a little bit while we'd love to see the deposit growth, I think we understand the drivers of that and we're very pleased with the growth of the utilization of the Ascend. And as Alan mentioned, as the asset class as a whole grows, we expect us to see the growth in deposits as well. That's fair. So help me understand if it's at all possible to try and isolate the impact from the Bitcoin volatility and the Bitcoin price on the deposit levels that we saw in the last two quarters, the drop off in deposits. So and also the impact of the this increased efficiency. So those two factors, if we can say that, let's say, X percent of deposit drop is because of 1 or the other. Yes. I'll start. So I think one of the challenging things in trying to do the correlation the way that you're looking at it, Eugene, is that there's there has been other news out there. So other banks have been have mentioned their intention to come into the space and are offering customers some yield. And so there's another element to it. It's a question that we've got when we were on the roadshow, what happens as people come in and start paying yield. That has actually been going on for an 18 month period. So it's not a new condition, but it's another variable that makes it very difficult to do the type of correlation that you were suggesting. Yes. And the other thing, this is Alan, Eugene. The other thing is the asset class and the platform, both are still in their nascent stages, if you will. So as long as we're continuing to add customers and connect folks on the sand and then oftentimes there's a little bit of a lag between when we get the account open versus when they fund the account and then when they connect to the FEN and start trading. So over time, we believe we'll be able to build stronger correlations, but at this point, it's really difficult. Got it. Got it. Thank you. And the last question is, can you give us any specifics on your efforts to date to monetize Send through fee income and FX and Send usage fees? And also on your send leverage pilot, how much demand do you anticipate for this product longer term? Sure. So, this is Alan again. I'll start. On the fee income side, we the so breaking it down, FX, we'll start there. Expanding our FX platform is a fairly new initiative for us over the last year or so. And that the activity or the opportunity in FX to a certain extent will follow the trading volumes. And so, we will likely see a little bit of volatility in the underlying FX fee income. Having said that, as we continue to expand our capabilities there, we believe that that will continue to grow up into the right. As far as other types of fees, the transactional fees, there again, the number of transactions and our ability to monetize those transactions have a little bit of volatility. But we do believe that all categories will continue to grow up into the right. But I want to say that the growth will not be linear. This is it's a new industry. It's a new space. We are offering a very unique service that clearly is well received by the market, and you can see that through the customer adoption and the adoption of the SAN. But it is going to play out over quarters. And as far as SEN leverage, did you want to comment on Send leverage, Ben? Yes. So I mean, so if you take a step back and you say, how do we maximize shareholder value as it relates to the Ascend, right? That's our objective, maximizing shareholder value and maximizing the value of the Ascend to our customers over the longer term, as Alan mentioned. So you then say, okay, well, how do you do that exactly? And so you take a product like Send Leverage. And one of the strengths of Send Leverage is really on the customer acquisition or on the business development side. So if you think about it, we have this captive group of customers and exchanges that make up the two sides of our network. And we can go out to these existing so so some of the ways that we monetize that is not is by being able to grow our loan portfolio in a and generate those what we believe are very attractive risk adjusted returns with the existing customers that we have, with the existing sales folks that we have. And so what so that's one example of what we believe that Send to be, which is ultimately a very scalable platform as we offer additional services to those customers. And we're continuing work in the R and D space, if you will, around digital asset services and really our product pipeline as we explained through the roadshow process. So I would say that's kind of how we think about it much more longer term than in terms of how can we maximize what we charge these customers this quarter. Thank you. There are no further questions at this time. I'd like to turn the call back over to Mr. Alan Lane for any closing remarks. All right. Thank you very much, operator, and thank you, Mike and Eugene, for your questions and for everybody else's participation. Just in closing to piggyback on what Ben was just saying, our entire focus here is on adding value to our customers, which we think will in turn then continue to drive value for shareholders. And so this concludes our Q4 and full year results and call and we believe that our results demonstrate the success that we have achieved growing our global payments network. The Ascend has experienced both substantial customer growth and customer adoption, which we believe bodes well for fee income growth as we look to 2020. As Ben was just alluding to, we see multiple opportunities to expand our product offerings for our digital currency customers utilizing the Send, and we're super excited with our recent launch of Send leverage. Thank you very much for your participation and we look forward to speaking to you all very soon. Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation. Have a nice day.