Silvergate Capital Corporation (NYSE:SI) Q4 2022 Earnings Call Transcript

Silvergate Capital Corporation (NYSE:SI) Q4 2022 Earnings Call Transcript January 17, 2023

Operator: Hello and welcome to today’s Silvergate Capital Corporation Fourth Quarter 2022 Earnings Conference Call. My name is Bailey and I will be the operator for today’s call. I would now like to pass the conference to our host, Hunter Stenback, Silvergate Capital Investor Relations. Please go ahead.

Hunter Stenback: Thank you, operator, and good morning, everyone. We appreciate your participation in the Silvergate Capital Corporation fourth quarter 2022 earnings call. With me here today are Alan Lane, our Chief Executive Officer; Tony Martino, our Chief Financial Officer; and Ben Reynolds, our President. As a reminder, a telephonic replay of this call will be available through 11:59 p.m. Eastern Time on January31, 2023. 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 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 within 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, including the COVID-19 pandemic 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. Now, I would like to turn the call over to Alan.

Alan Lane: Thank you, Hunter, and good morning, everyone. As many of you know, we provided select preliminary and unaudited fourth quarter financial metrics on January 5th. Before I dive into our I want to provide a recap of what happened in the digital asset industry in recent months and its impact on Silvergate. Significant over leverage in the industry has led to several high-profile bankruptcies and sparked a crisis of confidence and lack of trust across the entire digital asset ecosystem. As a result, many industry participants have shifted to a €œrisk off€ position across digital asset trading platforms. To that end, we saw a modest decline in Silvergate’s digital asset customers in the fourth quarter, a trend that we expect to continue in 2023 as the digital asset industry undergoes further transformation.

In turn, total deposits from digital asset customers declined to $3.8 billion at December 31, 2022, compared to $11.9 billion at September 30, 2022. Average deposits were $7.3 billion with a high of $11.9 billion and a low of billion during the fourth quarter. As of December 31, 2022, approximately $150 million of Silvergate deposits were from customers that had filed for bankruptcy. In order to satisfy these deposit outflows, we took commensurate steps to ensure that we were maintaining cash liquidity in excess of digital asset related deposits. We initially utilized wholesale funding to satisfy outflows, and subsequently, we sold debt securities to accommodate sustained lower deposit levels and maintain our highly liquid balance sheet. Importantly, we currently maintain a cash position in excess of our digital asset related deposits, and customers know they can access 100% of their deposits.

Tony will provide more color on the security sales and balance sheet management strategy in a few minutes. Turning to our core offerings, the Silvergate Exchange Network, or SEN, despite the significant decline in deposits, transfer volume on the SEN was $117 billion, an increase of 4% on a sequential basis, demonstrating that our platform continues to serve as critical market infrastructure for the digital asset industry. The SEN has operated uninterrupted 24 hours a day, seven days a week. Turning to SEN Leverage. Total approved commitments declined 23% to $1.1 billion compared to $1.5 billion at the end of the third quarter. In addition, we experienced a range of outstanding SEN Leverage balances during the quarter between $282 million and $377 million with an average outstanding balance of $328 million.

All of our SEN Leverage loans continued to perform as expected with no losses or forced liquidations. Looking ahead, we expect to maintain existing utilization for SEN Leverage in 2023 and expect commitments to shrink to approximately $400 million by the end of the second quarter of 2023. As we discussed on our Business Update Call, we are taking several decisive actions to ensure our business remains resilient during a sustained period of lower deposit levels. To that end, we are in the process of evaluating our product portfolio and customer relationships with a focus on profitability. As it relates to our customer base, after a thorough analysis, we have made the difficult but deliberate decision to offboard certain non-core customers in the coming weeks.

Importantly, we are prioritizing and remain committed to our core customers who routinely transact on the SEN. While our valuation is still being conducted, we believe the impact of these customer exits will not exceed 10% of our digital asset related deposits. We will also be eliminating certain products that have become too costly or complex. We have concluded that product such as digital asset custody and certain cash management services, which are used by a minority of our customers and require significant resources to operate, can no longer be offered profitably. While we remain focused on providing innovative solutions, reducing our product portfolio will allow us to better serve our core institutional digital asset customers. Moving forward, our product offering consists of our most value-added solutions and reflect what we do best, with solutions like the SEN, wires via our proprietary API and deposit accounts.

In addition, we made the difficult decision to reduce our workforce by approximately 200 people or 40%. We estimate aggregate costs associated with the reduction in force of approximately $8 million, primarily consisting of severance payments, employee benefits, and related costs. We expect to incur the majority of these charges in the first quarter of 2023. Taken together, we believe that focusing on providing a streamlined offering to our core customers and managing expenses will help Silvergate return to profitability in the second half of 2023. While we are narrowing our focus, I want to emphasize that Silvergate’s mission has not changed. I recognize that we’ve made some difficult decisions recently, but we are confident that these changes will enable us to serve our core customers in a responsible and profitable manner.

We are committed to maintaining a highly liquid balance sheet with minimal credit exposure and a strong capital position, ensuring maximum flexibility for our customers. We continue to believe in the digital asset industry and stand ready to support our customers. I’ll now turn the call over to Tony to review our financial results in more detail before we take your questions. Tony?

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Tony Martino: Thank you, Alan, and good morning, everyone. Starting on slide 3 with our key financial results. Silvergate reported a net loss attributable to common shareholders of $1 billion or loss of $33.16 per common share. Excluding and derivatives, impairment charges and restructuring charges, adjusted net income available to common shareholders was $15.1 million or $0.48 per adjusted diluted share. Tier 1 leverage ratio was 5.36%, based on average assets of approximately $15 billion and continues to exceed the well capitalized standards as defined by federal banking regulations. We expect our Tier 1 leverage ratio to improve over time as we reduce wholesale funding and the resultant size of our balance sheet. In addition, book value per common share was $12.93.

Moving on to slide 5. As we disclosed earlier this month, total deposits from digital asset customers declined to $3.8 billion during the quarter, compared to $11.9 billion in the third quarter and $14.1 billion in the fourth quarter of 2021. Average digital asset customer deposits were $7.3 billion in the quarter, down 40% compared to last quarter. As a result of the crisis of confidence the industry experienced, we saw higher volatility in our deposit base as the range of deposits during the quarter widened within a high of $11.9 billion to a low of $3.5 billion. Our weighted average cost of deposits for the quarter increased to 77 basis points compared to 16 basis points during the third quarter. As Alan mentioned, we initially utilized wholesale funding to satisfy outflows.

The annualized cost of digital asset deposits remained at zero, reflecting our low cost digital asset deposit strategy. As we have said before, deposits with Silvergate have been and continue to be safely held. At the end of the fourth quarter, we held total cash and cash equivalents of $4.6 billion, which is in excess of deposits from digital asset customers. Our business is designed to accommodate deposit inflows and outflows under a range of market conditions. Turning to slide 6, net interest income was $53.7 million in the fourth quarter, a decrease of $27.2 million compared to the third quarter, and an increase of $15.5 million compared to the fourth quarter of 2021. Net interest margin was 1.54% for the fourth quarter compared to 2.21% in the third quarter and 1.11% in the fourth quarter of last year.

As we outlined in our business update earlier this month, we sold debt securities for cash proceeds in order to accommodate sustained lower deposit levels and maintain our highly liquid balance sheet. We sold $5.2 billion of debt securities during the quarter, resulting in a loss on the sale of securities of $751.4 million. This sale included available for sale securities as well as certain securities that were previously identified as held to maturity. Our securities portfolio had an average outstanding balance of $9.8 billion with a corresponding yield of 2.61% for the fourth quarter down from an average balance of $11.8 billion at the end of the third quarter with its corresponding yield of 2.09%. As of quarter end, our securities portfolio had a balance of $5.7 billion.

As part of our risk management strategy, we hedged approximately 35% of our interest earning assets to protect against downside interest rate risk. Looking ahead, we expect to sell a portion of these securities estimated to be $1.7 billion in early 2023 to reduce wholesale borrowings, which resulted in the recognition of impairment charge of $134.5 million in the fourth quarter related to the unrealized loss on those securities expected to be sold. Subsequent to the end of the year, we sold approximately $1.5 billion of securities, and as always, we will continue to evaluate our balance sheet and liquidity management needs, which will depend on deposit flows and customer behavior. Turning to slide 7, non-interest loss for the fourth quarter of 2022 was $887.3 million compared to non-interest income of $8.5 million in the prior quarter and $11.1 million in the fourth quarter of 2021.

Losses on securities were $885.8 million and losses on derivative were $8.7 million, resulting from the sale of debt securities and related derivatives and impairment charge during the quarter. Excluding these losses on securities derivatives, adjusted non-interest income for the quarter was $7.2 million. As a result of the strategic actions Alan outlined earlier, we expect quarterly net interest income and fee income in 2023 to trend lower than adjusted fourth quarter 2022 levels. Slide 8 shows non-interest expense for the quarter of $238.5 million compared to $33.2 million in the prior quarter, and $25.7 million in the same quarter of last year. The increase sequentially and year-over-year primarily resulted from $196.2 million impairment charge on developed technology assets we acquired earlier in the year, as well as increases in salaries and employee benefits attributable to a $3.7 million restructuring charge related to exiting the mortgage lending product during the fourth quarter of 2022.

Excluding the impairment on intangible assets and restructuring charges, adjusted non-interest expense for the quarter was $38.6 million. As Alan discussed, earlier this month, we announced the reduction in force of approximately 200 employees or 40% in order to account for the economic realities facing the business and industry today. We estimate the aggregate cost associated with the reduction in force of approximately $8.1 million, primarily consisting of severance payments, employee benefits and related costs, and expect to incur the majority of these charges in the first quarter. Cost savings associated with the reduction in force are expected to be $7 million to $8 million per quarter. Our expense base in the first half of the year will continue to be assessed as we evaluate individual vendor contracts and other costs as a result of the strategic actions that Alan mentioned.

We expect expenses in the second half of the year to be lower compared to the first half of the year. We recognized the tax benefit of $24.3 million for the fourth quarter of 2022, reflecting an effective tax recovery rate of 2.3% compared to an expense of $13.5 million for the third quarter of 2022 with a corresponding effective tax rate of 23.7%. The income tax benefit recorded in the fourth quarter of 2022 was driven by the loss recognized during the quarter and the resulting reversal of prior period income tax expense incurred during the first three quarters of the year, partially offset by a charge from the transition to a 100% valuation allowance on deferred tax assets. As a result of losses incurred during the quarter, we’ve established a deferred tax asset balance of $342 million and applied a 100% valuation allowance against this asset.

The deferred tax asset balance associated with net operating losses will carry forward indefinitely and can be utilized against 80% of future taxable income. While this was a tough quarter in light of significant challenges in the broader digital asset industry and difficult decisions we had to make as a company, we remain committed to serving our core customers. We look forward to providing further updates on our business throughout 2023. With that, I would like to ask the operator to open up the line for any questions. Operator?

Q&A Session

Operator: Our first question today comes from the line of Michael Perito from KBW.

Michael Perito: I have a few things I want to get to, but I’ll let some of my colleagues ask on the others. The one I want to start on was kind of your comment about deposit flows in customer behavior driving decisions around selling securities. And I’m just — I guess I’m curious, what the recent update is on both. I mean, it seems like you sold some but not all of the securities that you earmarked for sale when you pre-released earlier this month. And I’m just curious if there’s any update to deposit flows and customer behavior that you’re willing to provide at this point?

Alan Lane: Yes. I’ll touch on the deposit question and turn it over to Tony for the securities question. So, on the deposit question, Mike, we are not — we’re going to stick with our standard approach here, which is to not provide any guidance whatsoever. As I think, abundantly clear in the fourth quarter, any guidance in this initiative is speculation. And in similar fashion reporting on deposit movement in a two-week period is not indicative of what we might expect for the entire quarter. And so, we don’t want to provide any update at this point that would cause people to think that deposits are going to be surging higher or that they’re going to be lower. The SEN continues to 24/7. We continue to maintain cash on balance sheet in excess of all of our deposits in this initiative.

So, our customers know that they can access their deposits 24 hours a day, seven days a week. If they bring additional deposits on as some customers have, we’re going to continue to hold those in cash on our balance sheet. And if customers choose to withdraw, as some have, they know that they can have 24/7 — well, they can have access to move those 24/7 over the SEN or they can withdraw them via wire transfer during normal banking hours, and we stand ready, willing and able to assist our customers with their liquidity needs, which is the primary function that Silvergate has provided to this ecosystem since we got into this business nine years ago. And so, with that, Tony, would you like to touch on the security sales?

Tony Martino: Yes, sure. Thanks, Alan. So, Mike, as we disclosed, we anticipated selling approximately $1.7 billion of securities and had recorded an impairment charge for that sale, which is part of the loss. And as Alan said, we’re only two weeks into the year, but we did execute on that plan. We’ve sold $1.5 billion of the billion $1.7 billion that we have earmarked. And so, that’s transpired in the first two weeks of the year. And beyond that, as Alan said, it’s early — it’s too early in the quarter to guide further. But, as we said, we have earmarked those securities for sale. The purpose was primarily to reduce borrowings. And that’s what we’ve done as of point in time. Thanks.

Michael Perito: Got it. Helpful. And then just for my second question. I appreciate all the commentary, Alan, around how you’re kind of refocusing the business and trying to right size the OpEx side for the new kind of lower deposit level. I’m just curious though, the kind of focusing and removing some functionality that’s more expensive and non-core is element. But then the other element, right, is making sure you’re getting paid for what you’re providing appropriately. And I’m just curious, when you think about the SEN, when you think about SEN Leverage, when you think about everything that you still are conducting, how are you thinking about the ROI on those products? As I think, maybe some of the risk factors around just taking deposits seem a little bit more amplified in this business than a typical commercial deposit. Just curious what your updated thought processes are there.

Alan Lane: Yes. Mike, I appreciate that question. And I’ll ask Ben to address it. Thanks.

Ben Reynolds: Yes. So, as Alan mentioned in his prepared comments, some of the products that we offer today have just become too costly or complex to continue offering. So, as with any business, you make assumptions about customer adoption of new products and when they don’t scale the way that you anticipated, sometimes it’s — you need to make course corrections. So, digital asset custody is an example of that for us. It’s a very competitive space and difficult to differentiate yourself. Kind of switching gears to the cash management solutions that we mentioned. We don’t want to provide more details at this time related to that because we want to make sure that we notify some of our strategic partners and customers first. But, what I can tell you is fee income’s going to be lower in 2023.

But, when you peel back the onion, you’d note that the margins on some of the products that we’re not — that we would need to continue to invest in, we just won’t continue to do that. And so, we do expect a boost of profitability by discontinuing those products despite an overall decline in fee income next several quarters. The other thing, Mike, that’s worth mentioning on this topic is that as we do offer the SEN and wires and other products that are critical to our core customer base, we do expect those products to generate significant fee income. But that is difficult to predict as, it’s often dependent on market conditions. So, sort of everything’s on the table in terms of how to monetize the platform. But I’d say more work is probably needed in order to say exactly how we’re going to do that beyond the way we do today, which is through deposits.

Thanks for the question.