Marlin Business Services (MRLN)

Marlin Business Services Corp. (MRLN) is a provider of equipment financing to small businesses, through its principal operating subsidiary, Marlin Leasing Corporation. MRLN was founded in 1997 and went public in November 2003. The company finances over 70 categories of commercial and industrial equipment though the bulk of its portfolio is office equipment, including copiers, telephone systems, computers, and software. Marlin's average lease transaction was approximately $10,900 at June 30, 2008 leases typically stay within $250,000 for a single transaction, with lease terms ranging from 36 to 60 months. This segment is commonly referred to as the small-ticket segment. In late 2006, MRLN had introduced two new products to supplement its small-ticket leasing business, factoring (purchasing clients' accounts receivable at a discount), and business capital loans (term loans). Effective

March 12, 2008, the Company opened Marlin Business Bank, an industrial bank chartered by the State of Utah. The bank provides diversification to the company's funding source, through the issuance of FDIC-insured certificates of deposit, raised through brokered deposit relationships.

MRLN generates about two-thirds of its lease originations through an existing network of independent commercial equipment dealers and direct solicitation of its end-user customers, with the balance through lease brokers. A typical transaction involves a non-cancelable, full-payout lease. Credit underwriting is managed separately from marketing. Lease transactions originated by non-company personnel (i.e. brokers) must meet the same underwriting standards as those internally generated, ensuring uniform credit standards. Larger transactions (approximately $75,000 and up) typically generate increased levels of scrutiny. All lessees are required to carry replacement-value insurance on leased equipment. Principal competitors include smaller finance companies and regional banks, as well as a few large players such as CIT Group, American Express, and GE Commercial Finance.

Lease transactions are initially funded on a variable interest rate basis, mainly through a revolving bank facility or one of two commercial paper conduit warehouse facilities, and then refinanced as fixed-rate term debt in the asset securitization market (roughly once each year). As of June 30, 2008, MRLN's net investment in direct financing leases was of $731 million.

MRLN's stock performance remains hinged upon the company's favorable expected growth rate. Currently, the consensus expected long-term growth rate is 16%. Equipment leasing remains a highly fragmented market, and we see some opportunities for growth. In addition, MRLN remains a relatively small fish in a very big pond, with a sales force of 92 and a portfolio of $731 million. In fact, balancing growth with profitability might be more of a challenge for management than the growth itself, as the temptation to grow fast at the expense of margins and credit quality always remains.

During the quarter, MRLN added new business volume at a conservative pace. Pricing on new originations also continued to move higher and was 13.90% in 2Q08, up 61 bps from the 1Q08 pricing of 13.29%. Responding to the changes in the business environment, the company tightened its approval process. The approval rates were therefore down significantly at around 49% in 2Q08 compared to 58% in 2Q07 and 50% in 1Q08. The current environment, with liquidity crisis, is more favorable for the company to execute its price strategies. MRLN had renewed and expanded its warehouse financing facilities to an aggregate $340 million, and to supplement its core funding vehicles, MRLN launched Marlin Business Bank, which became operational from March 2008. As on June 30, 2008, the company has access to a total of $179 million of undrawn capacity under the committed funding lines along with another $20 25 million of funding available through Marlin Business Bank. We think that the company now has adequate funding capacity to support its growth.

The weakening of the economy could further put pressure on the new originations and also affect the credit quality. The result for the present quarter was primarily impacted due to the changes in the external environment, weakening of the housing related industries, such as mortgage brokers, construction related industries, real estate and financial service providers. The new business growth was also impacted by the softness in the general business activity levels, most significantly in the industries related to residential and real estate development, particularly in the states of California and Florida.

Though net interest and fee margin increased by 8 bps sequentially to 9.90% during 2Q08, it was down 73 bps on year-over-year basis. The sequential increase was mainly due to lower cost of funds which more than offset the decline in portfolio interest yield. As we have consistently stated, MRLN's net interest and fee margin could continue to experience pressure over time due to increased competition, as MRLN expands into new markets for direct business as well as into indirect business, where the company competes against larger companies with greater resources. Leverage, as measured by debt to tangible equity, decreased by 55 bps on a sequential basis and 36 bps on a year-over-year basis (to 4.06 x). Tangible equity funded 17.81% of assets at period-end, up 28 bps year-over-year.

Maintaining above-average growth over the long term is a very difficult task, and we believe MRLN's stock performance is predicated on growth. Competition tends to erode above-average returns over time, and we do not see particularly high barriers to entry in MRLN's business. Since MRLN represents only a tiny portion of the total equipment leasing business at present, the issue is likely manageable in the foreseeable future.

Credit quality weakened further during the current quarter. However, the company has tightened its credit scores and curtailed new production in industries exhibiting deteriorating fundamentals. Net charge-offs totaled $5.4 million, or 3.06% of average net investment in lease on an annualized basis. The company also increased its allowance for credit losses to $12.9 million, raising the provision as a percentage of total finance receivables to 1.79% from 1.63% in 1Q08. The delinquencies continued to rise during the recent quarter, with the 60-day delinquencies rising by 6 bps sequentially to end the quarter at 1.16%. The mortgage brokers and real estate categories and states like California and Florida primarily witnessed the increase. Though MRLN has a relatively small exposure to these categories and is also trying to bring down the exposure to these states, we expect further deterioration in credit quality in the coming quarters as the credit crisis expands to other sectors.

Finally, while roughly two-thirds of MRLN's leases amortize to a $1 residual, the profitability of the other one-third is dependent upon the residual values of leased equipment at the end of the term. Residual values (and earnings) could be compromised by obsolescence and other factors beyond MRLN's control.

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