Is TCF jumping from 'frying pan into the fire’ by holding, not selling, car loans?

Just over a year after taking the helm at TCF Financial, Craig Dahl is facing his most daunting business challenge to date: reinventing the company’s struggling auto business.

It is a significant shift for the Wayzata, Minn., company. TCF entered the auto lending business in 2011 and aggressively built it into a fee machine, selling off low-quality loans and keeping better credits on its books. Gains on the sales quickly became an important — and mostly reliable — source of revenue.

TCF got into the auto business when it was booming, fueled by record car sales and a healthy appetite among investors in the secondary market. But after an industrywide rise in problem loans began to stir credit fears, TCF’s gains on its sale of auto loans unexpectedly plunged 90% during the fourth quarter compared to the third, creating a troubling hole in the company’s earnings.

Dahl said in April that TCF will stop selling its auto originations to shield its profits from further swings. But analysts describe the move as just the beginning of a tough road ahead. To make up for the lost revenue, TCF has begun slashing costs, laying off staff and exiting dealer relationships. Perhaps the biggest question facing Dahl, though, is whether he can quickly find a way to make up the lost revenue.

“Most investors are taking a wait-and-see approach on this transformation,” said Nathan Race, an analyst with Piper Jaffray. “I don’t really have concerns about them being able to execute on the expense saves. In terms of replacing revenue, it’s going to be a challenge.”

Under Dahl’s plan, TCF will keep nearly all of the auto loans it originates on its books. As of March 31, auto loans accounted for about 15% of the company’s loan portfolio, a concentration that is expected to remain steady in the months ahead.

To boost profitability, TCF expects to move down the credit spectrum, focusing on borrowers with slightly blemished but not quite subprime credit. In the months ahead, there will be a “slight change in mix” in the quality of the auto loans in its portfolio, executives said during the company’s first-quarter earnings call. The average FICO score in the portfolio was 732 as of March 31.

That has analysts concerned about the potential for higher credit costs — and further earnings woes — down the road.

“In many ways we see this is as jumping out of the frying pan and into the fire given the concentration of near-prime auto loans will start increasing at a time when the economic cycle is already reaching the later innings,” said Steven Alexopoulos, an analyst with JPMorgan Chase, in a note to clients.

The situation marks Dahl’s first big test as CEO of the $22 billion-asset company. He took the reins in January 2016, succeeding longtime CEO William Cooper, who remained as chairman until his death in February of this year. Dahl was named chairman in April.

Under Cooper’s leadership, TCF remade itself several times in response to adversity. In the late 1990s, TCF switched charters and ultimately transformed itself from a struggling thrift into a profitable commercial bank.

Two decades later, after post-crisis rules imposed caps on swipe fees — a key source of revenue for TCF — Cooper acquired the auto finance company Gateway One, which generated a new source of noninterest income from loan sales.

As other regional banks scaled back their auto units in recent years, amid fears of excessive risk-taking, TCF stayed the course and continued to aggressively originate loans.

“This is a company that’s had to reinvent their business model multiple times,” said Chris McGratty, an analyst with Keefe, Bruyette & Woods. TCF has “had to adapt before, and they will adapt again.”

Dahl faces an uphill battle to get TCF’s earnings back on track, but analysts say they are confident in his ability to do so.

First-quarter profits slid 4% year over year, to $46.3 million, due to lower gains on the sale of auto loans as well as higher costs associated with the restructuring.

By the end of this year, TCF plans to lay off 200 employees in the struggling auto unit and scale back its relationship with dealers. Dahl said he expects returns in the auto business to bounce back by 2018.

Meanwhile, auto originations — which amounted to $863 million in the first quarter — are expected to fall by as much as 40% in the year ahead, according to the company.

“The gain-on-sale model that we were using really is no longer meeting our expectations,” Dahl said during a conference presentation Wednesday. “We believe the shift in strategy is prudent at this time to reduce the volatility of earnings, optimize profitability and increase our operating leverage.”

TCF’s auto woes come at a particularly inopportune time.

The company is currently in the midst of a legal battle with the Consumer Financial Protection Bureau over its overdraft op-in policy. If the company falls short in its legal fight, it could be forced to make costly changes in its retail business, analysts said.

The combination of factors has weighed on TCF’s stock as shares are down over 20% from the beginning of the year. The KBW Bank Index is down about 1% over the same span.

“There’s still a cloud over their earnings,” McGratty said. “And the market isn’t forgiving for earnings misses after the run after the election — the market is pretty punishing.”

As Dahl looks for new sources of revenue, he could build up commercial real estate lending. TCF's CRE portfolio has room to grow, unlike many of its peers, McGratty said. CRE loans make up about 8% of TCF’s total portfolio, according to the Federal Deposit Insurance Corp.

Dahl could also simply focus on the company’s established niches in inventory and equipment finance as he weathers the storm in the auto market, Race said.

“They are going to have to get back to blocking and tackling,” Race said.

Perhaps the most damaging effect of TCF’s recent auto problems is that it shined a light on the company's worst-case scenario.

Analysts held open the possibility that TCF could continue to report lackluster earnings, particularly if the restructuring takes longer than expected. Additionally, the company could be forced to overhaul its approach to earning overdraft fees if it comes up short in its case with the CFPB.

The CFPB alleges that TCF has tricked customers into signing up for costly overdraft services, by withholding information about how to opt out.

It’s unclear how the next several months will unfold for Dahl, who is in the midst of an undeniably challenging second year as CEO.

But unless he catches a break, and succeeds in quickly putting TCF on a more profitable path, he could have to start the process of exploring a sale, Race said.

“In the event [an earnings turnaround] doesn’t unfold … there could be some increased pressure to find a partner,” he said.