Pathward Financial: A Profitable Bank Priced for a Profitability Collapse (CASH)

Pathward Financial, Inc. (NASDAQ: CASH)’s revenue grew from $486.75 million in 2019 to $746.66 million over the trailing twelve months (“TTM”). However, during that period, the firm increased its GAAP profitability and net operating profit after tax (“NOPAT”), increased its profitability invested capital (“ROIC”) and generated the equivalent of 40% of its market capitalization in free cash flow (“FCF”). With a stable portfolio of deposits and a growing non-interest-bearing business, the firm is poised for a period of volatility and lower interest rates. However, the market has priced Pathward as if its NOPAT will fall by 26%. This gives investors a huge investment opportunity.

Profitability increases with growth

GAAP net income is not a fair reflection of the profitability of a business. This is because it mixes operational and non-operational elements. In addition, there are hidden elements in MD&A, notes and footnotes of reports, for which they must be adjusted. To determine Pathward’s true profitability, we removed the impact of non-operating items such as the $3 million impairment charge reported in Pathward’s TTM income statements and the $30.14 million change in total loans and contracts of leasing. , calculated from the data on page 16 of Q3 2024 report. The result is below, which shows that as of 2019, Pathward’s NOPAT increased from $141.57 million in 2019 to $205.61 million in TTM, reaching 7.75% per year. At the same time, Pathward’s revenue rose from $486.75 million to $746.66 million.

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Source: Author’s calculations and company files

As the table shows, the firm’s NOPAT margin (NOPAT/Revenue) increased from nearly 26% in 2019 to nearly 28% in TTM, showing that the firm is converting a larger portion of its revenues into NOPAT. At the same time, its capital employed (income/average invested capital), a measure of balance sheet efficiency, rose from 0.63 to 0.75. Given that ROIC is a function of NOPAT margins and capital employed turnover, Pathward’s ROIC has grown from 16.3% in 2019 to nearly 21% in TTM. What this tells us is that management’s capital allocation has improved over this period.

With Sahm’s rule suggesting that a recession is imminent, less capitalized or financially sound banks may face liquidity problems, but with Pathward’s power, they will be able to take market share from weaker rivals and increase profitability.

Pathward’s growing profitability has helped it generate nearly $666 million in FCF since 2019, which is nearly 40% of its market cap. Pathward’s $45 million in FCF over TTM equates to an FCF yield of 2.68%.

A stable portfolio of deposits

Since the collapse of Silicon Valley Bank, investors have been interested in the quality and nature of bank deposits. Pathward operates largely as a Banking as a Service (“BaaS”) business, partnering with program managers to provide issuance, tax, credit and payment solutions to meet its goal of expanding financial inclusion. This means that most of these deposits come from millions of retail card accounts with low average balances. As of September 30, 2023, $6.38 billion of Pathward’s $6.59 billion deposit portfolio was attributable to the consumer segment, the majority of which represented funds available to be spent on prepaid debit cards and other value products stored, with $6.32 billion included.

with non-interest-bearing checking accounts and $57.8 million included in savings deposits. There are few institutional accounts in the deposit portfolio, and those institutional accounts are typically cash collateral related to loans in Pathward’s trade finance business. So the deposit franchise is very stable and has a weighted average life of six years based on Pathward’s decay model.

Profitability does not depend on high interest rates

With the Fed signaling that it will cut interest rates later this year, there could be fears that Pathward’s profitability could be affected. However, this ignores a significant part of Pathward’s business. The Company’s non-interest income includes payment card fees and deposit fees, tax advance product fees and refund transfer product fees. Under TTM, non-interest income comprised approximately 41% of Pathward’s total net income, which is defined as non-interest income plus interest income less interest expense.

Pathward deals on sale

Despite showing so much strength, Pathward trades at a significant discount to its price-to-book economic value (“PEBV”) ratio (0.74). The report means the market expects Pathward’s NOPAT to permanently decline by 26%. This expectation seems too pessimistic in the long run. Pathward’s current economic book value, or zero growth value, is $91.06/share, a 35% premium to the current price.

risks

Banks make money from the shape of the yield chart, and this usually means that upward sloping charts are good for banks. As we discussed, in what is typically a challenging time for banks, Pathward has thrived. I think the Fed’s upcoming 25 basis point rate cut may not have the beneficial impact on Pathward that people might expect. As the chart below shows, only 3.1% of the company’s liabilities are interest-bearing, so they are the only ones vulnerable to interest rate changes. The remainder of the company’s debt bears no interest, and this has been the case throughout. So while the typical bank might feel pressure on its net interest margin, Pathward’s net interest margin grew from 5.02% in 2019 to 6.56% in Q3 2024. The opposite may happen with the decline interest rates, which will affect the return on Pathward’s investments.

Conclusion

Since 2019, Pathward has demonstrated the ability to grow profitability in either low interest or rising interest rate environments. In fact, what’s remarkable is that its NOPAT has increased with revenue. In turn, the company’s NOPAT margins and invested capital turns increased, fueling an increase in ROIC. The firm’s profitability has allowed it to generate the equivalent of 40% of its market capitalization in FCF. Despite this, the business is priced for a 26% decline in NOPAT. Investors should be careful because this gives them the chance to buy a firm that is both profitable and undervalued.