Earnings Call Transcript - BMRC Q1 2024

Yahaira Garcia-Perea, Marketing and Corporate Communications Manager

Good morning and thank you for joining Bank of Marin Bancorp's Earnings Call for the First Quarter ended March 31, 2024. I'm Yahaira Garcia-Perea, Marketing and Corporate Communications Manager for Bank of Marin. Joining us on the call today are Tim Myers, President and CEO, and Tani Girton, Executive Vice President and Chief Financial Officer. Our earnings press release and supplementary presentation, which we issued this morning, can be found in the Investor Relations section of our website at bankofmarin.com, where this call is also being webcast. Closed captioning is available during the live webcast as well as on the web replay. Before we get started, I want to note that we will be discussing some non-GAAP financial measures. Please refer to the reconciliation table in our earnings press release for both GAAP and non-GAAP measures. Additionally, the discussion on this call is based on information we know as of Friday, April 26, 2024, and may contain forward-looking statements that involve risks and uncertainties. Actual results may differ materially from those set forth in such statements. For a discussion of these risks and uncertainties, please review the forward-looking statement disclosure in our earnings press release as well as our SEC filings. Following our prepared remarks, Tim, Tani, and our Chief Credit Officer, Misako Stewart, will be available to answer your questions. Now, I would like to turn the call over to Tim Myers.

Timothy Myers, President and CEO

Thank you, Yahaira. Good morning, everyone, and welcome to our first quarter earnings call. At a high level, during the first quarter, we showed deposit stability, a declining pace of deposit cost increases and continued strong liquidity. We also added to the foundation we are building for a more robust loan origination engine. Our smaller balance sheet and higher overall deposit costs resulted in slightly compressed net interest margin and core earnings reduction in the first quarter. Operating expenses, which did include some seasonal increases and downward incentive adjustments, were also higher on balance as we added key new commercial banking hires, and our talent is already helping pipeline activity in both the North Bay and Sacramento. Importantly, our concerns about overall credit quality and loss potential remain unchanged despite risk rate migration. In the quarter, we capitalized on the dislocation caused by the regional bank failures and as I noted, attracted proven relationship bankers to help drive new client acquisition. Notably, the pace of deposit cost increases slowed during February and March, reaching the lowest incremental levels since February 2023. These catalysts complement the strategic repositioning of our balance sheet late last year when we divested lower-yielding securities and scaled down short-term borrowings to improve our interest rate risk position for the year ahead. We continue our facilities optimization by consolidating two of our commercial banking offices into one, saving approximately $650,000 this year and an $800,000 annualized run rate beginning in 2025. We will continue to evaluate a range of strategic possibilities to optimize our balance sheet and expense structure to create efficiencies and increase profitability on behalf of our shareholders. We also remain firmly committed to our long-established conservative approach to credit. Overall, credit quality remained strong with nonaccrual loans at just 0.31% of total loans at quarter end, down from 0.39% the prior quarter. As we've indicated, our relationship banking model enables us to work closely with our commercial real estate borrowers most directly impacted by the current environment. We are also able to manage risk on certain CRE loans with vacancies through enhancements to collateral, either by way of cash or other income-producing properties or by having the borrower pay down the loan. During the first quarter, we made good progress in this area, and it remains a key focus. Classified loan levels did increase in the first quarter. This was due largely to three relationships of different types and geographies. Two are CRE loans that are fully secured and supportive of personal guarantees, and we believe there is minimal risk in these credits. We are not seeing the formation of material new problem loans, just previously identified problem loans continuing through the workout and resolution process. In the first quarter, we upgraded four loans totaling more than $10 million from special mention in the past. Our nonowner-occupied office portfolio overall is made up of 151 loans with an average loan size of only $2.4 million. The weighted average loan-to-value was 60%, and the weighted average debt service coverage was 1.6x based on our most recent data. There is no notable change from what we reported at year-end. Our office CRE book in San Francisco represents just 3% of our total loan portfolio and 6% of our total nonowner-occupied CRE portfolio. I also want to note that we have minimal exposure to rent control properties within our multifamily portfolio. Only 32 loans with an average balance of only $1.6 million or 2.5% of our total loan portfolio. Like the rest of our book, we are monitoring this very closely. As I noted, with our new commercial hires, we're seeing more new attractive opportunities with a dramatically improved pipeline, though the timing to close is difficult to predict. As such, our loan portfolio did decrease slightly as our originations in the quarter were offset by payoffs, scheduled repayments, and strategic exits. Much of the payoffs were related to construction loans as a result of project completion. Now turning to deposits. We maintained total deposits with quarter-end balances essentially flat from December 31. We attracted new customers during the quarter, but some clients also moved cash into alternative investments to capture higher returns, and we also saw seasonal outflows that we often see in Q1 of each year. Our noninterest-bearing deposit level remains favorable at 44% of total deposits. We continue to focus on relationship banking with high-touch service, being appropriately competitive on deposit pricing and maintaining our strong core deposit franchise. We anticipate our funding costs to further stabilize this year. We also continue to maintain high levels of capital and liquidity, and we are in a position of strength. Our total risk-based capital ratio improved to 17.05% at quarter end compared to 16.89% at the close of 2023. Total liquidity of approximately $1.9 billion consisted of cash, unencumbered securities, and total borrowing capacity. In summary, we made substantial progress by adding talent and building upon our foundation for profitability improvements and long-term growth, and these efforts are ongoing. With that, I'll turn the call over to Tani to discuss our financial results in greater detail.

Tani Girton, Executive Vice President and Chief Financial Officer

Thanks, Tim. Good morning, everyone. With interest rates higher for longer and lingering economic uncertainty, we continue to focus on further strengthening our core deposit franchise and maintaining robust liquidity and capital levels while delivering exceptional service to existing and new customers as we position Bank of Marin for continued earnings improvement in 2024. We generated net income of $2.9 million for the first quarter or $0.18 per diluted share compared to net income of $610,000 or $0.04 per share in the fourth quarter of last year. $4.2 million of the increase in net income quarter-over-quarter was due to losses on securities sales in the fourth quarter of 2023. After repositioning our balance sheet out of borrowings and some securities, lower-earning assets combined with the higher cost of deposits to make net interest income $1.6 million lower than the prior quarter. However, during the first quarter, we maintained our noninterest-bearing deposit levels while capturing higher yields on new loans. This largely offset increases in interest-bearing deposit costs. And as a result, our tax-equivalent net interest margin decreased by only 3 basis points in the first quarter, following a 5 basis point increase in the fourth quarter. Taken together, our net interest margin has stabilized over the past two quarters, and we are optimistic that we will see continued stability in the near term with a bias for improvement from new loans and existing loan repricing. At the same time, we continue to evaluate strategies that support margin expansion. Our noninterest expense base increased somewhat with the new hires Tim highlighted. Additionally, the seasonal increases related to 401(k) matches tied to bonus payments, and lower loan origination cost deferrals contributed to the $1.9 million increase over the fourth quarter. Professional service expenses related to the annual audit also tend to be higher in the first quarter. Increases were somewhat tempered by downward adjustments to incentive accruals in the first quarter, but there were much larger reductions to incentive, profit sharing, stock-based compensation, and retirement plan accruals in the fourth quarter of 2023. Moving to noninterest income. Excluding the $5.9 million loss on the sale of AFS securities associated with our fourth quarter balance sheet restructuring, noninterest income of $2.8 million was stable quarter-over-quarter. In addition to the total risk-based capital strength Tim noted, Bancorp's tangible common equity to tangible assets ratio improved to 9.76% in the first quarter from 9.73% at December 31. Our contingent liquidity is plentiful, and our deposit base is well diversified with businesses representing 59% of balances and 32% of accounts. Our largest depositor represented just 2% of total deposits while our four largest depositors comprised 5.3%. We maintained our total deposits to $3.28 billion on March 31 without tapping the brokered CD market or running CD campaigns. And noninterest-bearing deposits increased slightly to 44% of total deposits from 43.8% at December 31. The average cost of deposits increased 23 basis points to 1.38% in the first quarter compared to a 21-basis point increase from the prior quarter. Underlying these changes is a clear downward trend and monthly increases since the peak in March 2023. We believe we are appropriately competitive in regard to deposit pricing given our relationship banking model that differentiates Bank of Marin. Disciplined credit management remains a Bank of Marin core value as well. Our $350,000 provision for credit losses in the first quarter compares to a provision of $1.3 million for the previous quarter and brought the allowance for credit losses to 1.24% of total loans compared to 1.21% as of December 31. Typically, loan originations are lower in the first quarter of the year. And this year, new originations of $12.4 million were more than offset by payoffs of $21.8 million with rates on new loans averaging 266 basis points above the rates on loans paid off. Loan balances of $2.1 billion for the first quarter were down $18.8 million from the prior quarter after amortization and changes in utilization. Our Board of Directors declared a cash dividend of $0.25 per share on April 25, the 76th consecutive quarterly dividend paid by Bancorp. We didn't repurchase any stock during the quarter. Instead, we concentrated on building upon our strong capital, reinforcing credit protections, deepening relationships with our customers and developing new business. We regularly evaluate the merits of stock buyback. We also continue to assess additional possible adjustments across our balance sheet and expense structure with a focus on finding new ways to accelerate net interest income expansion and self-fund efficiency improvement. Potential actions are run through our capital plan and interest rate risk simulations, along with rigorous stress tests, to evaluate long-term benefits. In addition to meaningful profitability improvement, we screen for reasonable earn-back period, ample ongoing liquidity and capital, and sustainable balance sheet strength and profitability. With now I'll turn it back over to Tim to share some final comments.

Timothy Myers, President and CEO

Thank you, Tani. In closing, our enduring relationship-based banking model, healthy capital and liquidity levels, and favorable mix of deposits and solid funding base provide Bank of Marin a strong foundation for loan growth, margin expansion and increased profitability in coming quarters. Over the past few months, we have added a number of highly productive bankers, implemented a more active approach to developing new client relationships and increased our use of technology to enhance those efforts. All of these have positioned us to generate a higher level of loan production going forward while we maintain our disciplined underwriting. We also continue to evaluate our physical footprint and optimization opportunities as well as other ways to manage expenses while also investing in talent and technology to maximize customer satisfaction, attract new clients and further enhance our ability to generate long-term profitable returns. With that, I want to thank everyone on today's call for your interest and support. We will now open the call to your questions.

Operator, Operator

Our first question will come from Jeff Rulis with D.A. Davidson.

Jeff Rulis, Analyst

A question on the hires that you had. I know you've added folks even last year. I just wanted to try to get a sense. Were there any new in the first quarter?

Timothy Myers, President and CEO

Yes, there were some new hires. We discussed previously that we do not have a dedicated team, as they are distributed across different regions. In the first quarter, we incurred costs related to this situation, but we haven't yet balanced that out with the cost reductions and other measures we mentioned for funding. Therefore, there is a timing gap in addressing this issue.

Jeff Rulis, Analyst

Okay. Yes, this relates to the next topic. I'm trying to understand the impact on salaries, considering the seasonal fluctuations in professional services and other areas. Are there factors influencing overall expenses? Will there be moderation from this point forward, or will the recent additions continue to contribute to growth?

Tani Girton, Executive Vice President and Chief Financial Officer

Yes, I'd say puts and takes. We had some positives that offset some of the negative seasonal stuff. And so when you look at it on balance, we do have a higher base on the salaries. And this is the beginning of the year. So medical insurance costs are up, and we do have some strategies that will be kicking in the cost for which we'll be kicking in later in the year. Again, we're trying to self-fund those. But I would say we are moving into 2024 with a higher salary base.

Jeff Rulis, Analyst

Okay.

Timothy Myers, President and CEO

Just one more point, Jeff. While it's not in the salary line, I mentioned in the script that we consolidated two offices at the very end of the quarter. This will save us about $800,000 a year in lease expenses, in part to help fund the personnel acquisition. We will continue to seek out similar opportunities. I know it’s hard to quantify at this point, but we will keep finding ways to do these kinds of things.

Jeff Rulis, Analyst

Yes. No, makes sense. And Tim, the arena, the folks that were hired, their focus of lending, is it in a particular area?

Timothy Myers, President and CEO

I believe it's more focused on commercial and industrial lending than it has been in the past, but I would describe these individuals as generalists, similar to our banking history. We’re experiencing a more diversified portfolio with professional services and general C&I deals. It’s spread out, and we’re observing significant growth in areas like Sacramento, the North Bay, and Walnut Creek, where we have made new hires. Part of our strategy has been to grow and become more regionally specific in our alignment, rather than acquiring a team that focuses on multiple geographies.

Jeff Rulis, Analyst

Okay. Great. And perhaps just one last question. Regarding loan growth, you mentioned in the release that you are remaining cautious about the environment. The pipeline has increased, and you've noted some construction payoffs. I would like to get a broader perspective on loan growth moving forward. I understand, Tim, that timing is challenging, but could you share your expectations for net loan growth?

Timothy Myers, President and CEO

We are still aiming for mid-single-digit growth as we've discussed. We are really gaining traction in the market. While we can't guarantee the approval of those deals, the enthusiasm among market participants is encouraging. This gives us greater confidence that we'll experience increased yield churn and more activity, which should lead to more closures. Although it’s difficult to predict the timing of these developments, we remain optimistic about the direction things are heading.

Jeff Rulis, Analyst

So Q1's net runoff doesn't deviate from mid-single digit for the full year?

Timothy Myers, President and CEO

That is still our goal.

Operator, Operator

Our next question will come from the line of David Feaster with Raymond James.

David Feaster, Analyst

I wanted to follow up on the loan growth commentary. Originations were down in the quarter, and I'm curious about what drove that. How much of it was due to weaker demand or less appetite for credit? Additionally, where do you expect growth to come from? You mentioned more C&I, which seems like it could be a significant driver, so I would appreciate your thoughts on that.

Timothy Myers, President and CEO

Yes, no problem. On the weakness of side, I think you hit on it. I think there is weaker demand, but we are seeing a bit of a normalization as people get more used to the higher rates and higher for longer that we're seeing a lot more activity, either they can't wait it out or it's not quite as scary for them as we thought. So we are seeing a higher level of interest. There is a component of, no, we're not going to do an office property in San Francisco with 30% vacancy, even if it looks good as a smaller property or even in other parts of our footprint where there's lease rollover risk. And then you're just not going to step into a situation where it could start deteriorating relatively soon. So there is a greater degree of oversight, but we are seeing a greater degree of deals where the credit meets our criteria, more geographically dispersed and more dispersed by type of loan. So it's always hard to predict from a point in time what that means, but we are seeing all of the above right now.

David Feaster, Analyst

Okay. Touching on credit, you've established a strong reputation as an active and proactive credit manager, which is apparent this quarter. You've mentioned some credit challenges recently. I'm interested in how you plan to handle these issues, especially after evaluating the commercial real estate portfolio and the overall health of the CRE market in your area. Additionally, how do you generally approach potential modifications?

Timothy Myers, President and CEO

Yes. That's a great. That's a good question. Let me ask Misako Stewart, our CCO, who's on to jump in. She's the one that does most of that work.

Misako Stewart, Chief Credit Officer

The credit quality and management of our portfolio remain very solid. We closely monitor the credit situation, receiving updated information each quarter. We're assessing values and engaging in discussions with our borrowers. All our classified loans are backed by personal guarantees from the owners or direct borrowers. We maintain ongoing conversations to find resolutions, reach mutual agreements, and adjust loans to more appropriate levels. The balances in our graded loans do not always accurately reflect the fluctuations in our portfolio, which sees significant movement up and down. Last quarter, we saw minimal migration from past due to criticized or classified loans, and there were few downgrades from special mention to substandard. Most of these issues relate to vacancies that have not worsened but also haven't improved. As time goes on, these aspects require closer attention, prompting the downgrades. We take a proactive approach in monitoring credit and assessing risk.

David Feaster, Analyst

Okay. That's helpful. And then could you elaborate on how you are supporting the commercial real estate market across your area?

Misako Stewart, Chief Credit Officer

I'm sorry?

Timothy Myers, President and CEO

Say that again, David. Sorry.

David Feaster, Analyst

Just the help of the CRE market across your footprint?

Timothy Myers, President and CEO

Misako, you want to take that.

Misako Stewart, Chief Credit Officer

Yes. The support we observe varies by asset class. I believe industrial remains strong. The performance of office spaces varies by market, and retail is similarly varied. Multifamily continues to be a robust asset class for us. Overall, it's challenging to generalize since conditions differ across markets.

Timothy Myers, President and CEO

Yes, it is uneven. The valuation declines are most significant in our office footprint. Within office, some regions may experience a 20% decline, while areas like San Francisco face declines of 40% to 50%, heavily influenced by property size and other factors. Industrial properties are performing well in many areas, and as Misako mentioned, the multifamily sector remains strong, with few issues arising that are not unique and unrelated to broader trends. Overall, many of these categories are holding up well.

David Feaster, Analyst

Okay. That's great. I wanted to get your high-level thoughts on managing the balance in a higher-for-longer environment. You've mentioned some opportunities you're considering. You've already been active with the securities book, implementing cost savings, and still investing in the franchise with new hires. I'm curious about the types of initiatives you are contemplating. Last quarter, we discussed potential rate cuts, and now we're in a higher-for-longer scenario. Have your thoughts on managing the balance sheet changed in any way?

Timothy Myers, President and CEO

We are actively contemplating all those things, and I'll let Tani jump in here.

Tani Girton, Executive Vice President and Chief Financial Officer

Yes. We had a series of sales last year, totaling approximately $83 million in the second quarter and an additional $132 million in the fourth quarter. We still possess a substantial AFS portfolio, which provides us with considerable flexibility to selectively sell those securities and reallocate those funds into higher-yielding investment loans, depending on the opportunities available. The timing is crucial, and as Tim mentioned, we are approaching this in a focused manner and will continue to do so.

Operator, Operator

The next question will come from the line of Andrew Terrell with Stevens.

Andrew Terrell, Analyst

Maybe if I could start just on the deposit front. Looks like the interest-bearing deposit costs increased this quarter was actually maybe a little bit of an acceleration from 4Q. I've got up 33 basis points and it was 31, I believe, in the fourth quarter. I'm just trying to maybe square that with some of your commentary around the deposit cost deceleration, and maybe you mean more on kind of a month-to-month basis throughout 1Q. So maybe it would be helpful, could you share just kind of how deposit costs progressed throughout the first quarter?

Timothy Myers, President and CEO

You're 100% right, and I'm sorry if that was unclear. So yes, we saw a couple of basis point increase in the overall cost quarter-over-quarter but a big deceleration. Tani can give you specifics. But by the time you hit March there, it was the lowest level we've seen since before this crisis.

Tani Girton, Executive Vice President and Chief Financial Officer

In March 2023, we saw a 60-basis point increase in interest-bearing deposits and an overall increase of 29. I will focus on the overall cost of deposits, which has been trending down monthly. It dropped significantly to 16 and 12, then slightly increased to 14. By July 2023, it was down to 6 and then 5. There was a small uptick in September, stabilizing around 7 to 9, reaching a peak of 10 in January, then falling back to 6 and 2. Overall, there is a clear downward trend, although there have been some fluctuations along the way.

Andrew Terrell, Analyst

Got it. Okay. So we have 10, 6, and 2 for January, February, and March. It definitely looks like a significant drop in March. Also, regarding margins, I noticed the release mentioned a 260-basis point spread for new originations compared to what was paid off this quarter. I'm interested in your thoughts on this, especially since construction, which likely has a higher yield, was the most heavily paid off this quarter. As we consider you getting back to mid-single-digit loan growth later this year, do you expect that the spread between new originations and payoffs will widen from the current 260 basis points?

Timothy Myers, President and CEO

Yes. It's hard because, as you said, the cost of loans paying off were probably a little bit higher. So the loans came on again. It's a small sample, but I think it's consistent with what we're seeing is in the low 8s. 8.18%, I think, was the rate of the loans that came on in the quarter. So a material difference from a lot of our other fixed rate loans. So it just depends on the timing and the category, right, of the payoffs. But I think that is a clear trend. Just again, also whether it's going to be fixed rate or variable rate, some of the fixed rate for attractive real estate lending up is still awfully competitive. It may not seem to see the same delta rates coming on, Brazil is going up, but that's where we were for the quarter, about 8.18%.

Tani Girton, Executive Vice President and Chief Financial Officer

And I would just add that if you look at the existing portfolio, assuming a static balance sheet and no change in rates, we have 36 basis points of residual repricing in the loan book for the next 12 months.

Andrew Terrell, Analyst

Yes. Okay. And that's, I think, pretty consistent with kind of how we thought about loan repricing when we discussed it last quarter. Is that right?

Timothy Myers, President and CEO

Yes. At 17%, 18% a year is our run rate of loans repricing on the book.

Andrew Terrell, Analyst

Okay. If I could ask one more just around the dividend. I mean clearly above 100% payout ratio this quarter. And I understand you guys have a lot of capital, a very healthy capital position. Just would love to hear kind of your thoughts, Tim, on comfortability around the dividend and where it's at today and whether that's a maybe holdup as you contemplate any incremental capital-return opportunities or securities restructuring.

Timothy Myers, President and CEO

I think you just summarized what we're answering as well. You answered your own question very well. The dividend is really important to us, and we understand the importance of it to our investors. And so yes, we have a lot of capital as we work through this compressed NIM rate environment. But as you said also, we're looking at restructuring or other things we can do with our balance sheet to help provide more visibility and when expanded margin where that wouldn't be such an issue. That is all part of our ongoing discussions that we are currently involved in.

Andrew Terrell, Analyst

Okay. I appreciate it. And then actually, Tani, just one more quickly. I think if I look back at 2023, the charitable contribution line steps up in the second quarter. Should we expect something similar in 2Q of '24?

Tani Girton, Executive Vice President and Chief Financial Officer

Yes, yes. We're very committed to those contributions, and the timing is going to stay the same this year in the second quarter.

Operator, Operator

Wanted to start on noninterest-bearing deposits. I mean they saw a slight increase on the quarter, which was great to see. I mean, were there any seasonal impact to the noninterest-bearing bucket? And are you beginning to see that mix shift flow from here?

Timothy Myers, President and CEO

Yes. I'll begin, and then Tani can add. We didn't observe anything out of the ordinary. There was an outflow of approximately $27 million from noninterest-bearing and some interest-bearing accounts into higher yielding alternative investments. However, we managed to attract a total of $97 million across various types. These fluctuations are expected. I understand that we've mentioned this before, and the situation in the first quarter of last year amplified the concerns, but our noninterest-bearing commercial accounts experience significant ups and downs. I haven't observed any trend that suggests a change.

Tani Girton, Executive Vice President and Chief Financial Officer

Yes. I think we often have outflows in the first quarter, and the efforts that our team has made to make sure that we bring in inflows to compensate for that is really good.

Wood Lay, Analyst

All right. That's good to hear. And then maybe turning over to the loan growth. I think in the release, you cited some new compensation plans where we're helping the pipeline. But just any color you can give on sort of what those new compensation plans are.

Timothy Myers, President and CEO

I would say there are two components to the compensation. One is about how frequently we pay people. We've traditionally done it annually, but as generations change, so do expectations. This is an area where we can influence behavior because people tend to do what they're compensated for. The other aspect is bringing in high-quality producers, which will allow for more upside in the compensation plan. At first glance, this shouldn't increase our costs unless they achieve significantly higher production targets. This new approach was specifically designed to attract the right talent. The first component is intended to drive behavior, while the latter focuses on recruitment. Overall, at this point, I don't expect it will lead to higher costs for us, unless they exceed expectations, and in that case, we'd all be happy about it.

Wood Lay, Analyst

Yes. All right. And then last for me, just another follow-up on the classified movement. Just any additional color you can give on the types of CRE loan that moved into that bucket? Were those in the office portfolio?

Timothy Myers, President and CEO

Yes. Misako, do you want to take that, please?

Misako Stewart, Chief Credit Officer

Sure. Yes, one was office, one was retail in different locations. And both are supported by strong meaningful support by way of the guarantees with liquidity.

Operator, Operator

There are no further questions on the line. I'll now turn the call over to Tim Myers for closing remarks.

Timothy Myers, President and CEO

Yes. It appears we do not have any online questions. I want to thank everyone for your diligence and questions. And if anyone has any further, please, by all means, call Tani or I, and we're happy to further dive into some of these issues. With that, we'll see you next quarter.

Tani Girton, Executive Vice President and Chief Financial Officer

Thank you.

Operator, Operator

The meeting has now concluded. Thank you for joining. You may now disconnect.