Earnings Call Transcript - BOH Q2 2023

Operator, Operator

Good day and thank you for standing by. Welcome to the Bank of Hawaii Corporation Second Quarter 2023 Earnings Conference Call. At this time all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Cindy Wyrick, Director of Investor Relations. Please go ahead.

Cindy Wyrick, Director of Investor Relations

Thank you. I'd like to welcome everyone and thank you for joining us today as we discuss the financial results for the second quarter of 2023. Joining me today is our CEO, Peter Ho; our CFO, Dean Shigemura; our Chief Risk Officer, Mary Sellers and the newest member of our IR team. Before we get started let me remind you that today's conference call will contain some forward-looking statements. And while we believe our assumptions are reasonable, there are a variety of reasons that the actual results may differ materially from those projected. During the call today, we will be referencing a slide presentation as well as the earnings release, both of which are available on our website boh.com under the Investor Relations tab. And now I'd like to turn the call over to Peter Ho.

Peter Ho, CEO

Thanks, Cindy. Good morning or good afternoon everyone. Thank you for your interest in Bank Hawaii Corporation. I'll begin today's call with some general commentary on our results. I'll then hand the call over to Mary to cover credit, which is a great story. And then, Dean will delve deeper into the financials. We'll then be happy to entertain your questions. Bank Hawaii delivered solid results for the second quarter of 2023. Total deposits grew in the quarter and we enhanced our liquidity position substantially with cash and immediately available credit lines. Credit remains a strength with NPAs and net charge-offs of 8 basis points and 4 basis points, respectively. We recorded earnings per share of $1.12 for the quarter. Net interest income was negatively impacted by higher interest rates and attendant higher borrowing costs. Fee income performed well during the quarter and expenses were controlled, both on a reported and normalized basis. Given the environment, expense management will continue to be a particular focus of ours going forward. Deposit quality is obviously a critical factor in today's environment, but I thought I'd spend a little time reviewing Bank of Hawaii's exceptional deposit position. Our deposit story really begins with our deposit marketplace, which is different from nearly all other deposit markets in the country. 97% of the State of Hawaii’s deposit base as measured by the FDIC is held by five local banks all headquartered within the State of Hawaii and all having served the local community for many, many years. Therefore, it's not surprising that the events of early March with SVB and Signature Bank had a rather muted impact on the Hawaii marketplace as compared to the broader national small bank marketplace. We've built our deposit franchise over a 125-year history, one relationship at a time. Our deposit base is well-diversified and well-tenured. 49% of our deposits are with consumer clients, 39% with commercial customers, and 12% with municipalities. Even within these categories, we have further diversification by industry, income demographic, and government agency or jurisdiction. More than half of our deposits are from clients with whom we've been doing business with for 20 years or longer. Another 24% are from clients with whom we've been doing business with for between 10 and 20 years. Given this backdrop, it's not surprising that our deposit performance through both the first and second quarters has been quite stable. Additionally, we have been able to maintain deposit stability while also keeping funding costs reasonably controlled. Our deposit beta for Q2 was 21%. In terms of additional liquidity, we improved our cash and immediately available lines of credit positions substantially to $8.5 billion by quarter end. Broker deposits are yet another form of liquidity available to us, although we do not currently have broker deposits within our deposit mix as of quarter end. Given the stability of our deposit base and abundant liquidity in place. Brokered deposits, however, are solid liquidity options for us. I'll finish off with a little color on the Hawaiian economy. Our visitor industry continues to perform well. Total visitor expenditures in May were up 19% from 2019 pre-pandemic levels. This level includes a still recovering Japan segment, which remains down 66% from pre-pandemic levels by spend. Oahu single-family home prices were down 4.5% in June from a year ago at $1,050,000. Inventory, however, remains tight at 17 average days on market and total inventory of 2.6 months. Hawaii’s unemployment rate was down to 3% in June compared to 3.7% at year-end.

Mary Sellers, Chief Risk Officer

Thank you, Peter. Bank of Hawaii's lending philosophy is grounded in two fundamental tenants. Lending and markets we know and to longstanding relationships we understand. While growing the loan portfolio in a safe and measured way over time, our focus is on ongoing disciplined portfolio management. We consistently, actively exit those products or segments that prove to have higher risk profiles, creating outsized credit losses and volatility. In the consumer portfolio, these non-core segments included land and interest-only loans in our residential portfolios, purchased home equity pools, indirect auto loans originated in Oregon, our revolving personal flex line product, and our credit card portfolio. Similarly, in our commercial portfolio, we spent a number of years working out of a scored small business portfolio, a pool of non-relationship shared national credits, and a large ticket leasing portfolio. Concurrently, we're continually focused on optimizing the risk profile within our core portfolio by biasing the mix within it to those products and segments that have proven to carry lower risk. This disciplined management coupled with consistent conservative underwriting has proven itself through lower net charge-off rates over the years and positions our portfolio to continue to realize lower credit losses through different economic cycles. All of this is reflected in our portfolio construct today, which is built on long-tenured relationships, diversified by asset categories with 60% consumer and 40% commercial, appropriately sized exposures, and 79% secured with real estate with a combined weighted average loan to value of 55%. Our commercial real estate portfolio, which represents 27% of the total loan portfolio, is diversified across various asset types. The portfolio built on relationships with demonstrated experience and financial capacity is conservatively leveraged with a weighted average loan to value of 50%. Maturities across the commercial real estate portfolio remain very manageable with 10% maturing prior to 2025. Our office portfolio is 2.7% of total loans and granular and has a weighted average loan-to-value of 56%. 26% of the portfolio is in the downtown Honolulu central business district. This segment has a 63% weighted average loan-to-value and 47% of the exposure is further supported by repayment guarantees. 3% of the loans in the office segment are maturing through 2024. Tail risk in the commercial real estate portfolio remains modest with just 0.8% having an LTV greater than 80%. Our construction portfolio represents 2% of total loans, with the majority of this in low-income or affordable housing, which continues to be chronically undersupplied in our markets. Credit quality remained strong in the first quarter with debt charge-offs up $1.4 million or 4 basis points annualized of total average loans and leases outstanding down 4 basis points for the linked quarter and up 2 basis points year-over-year. Non-performing assets were $11.5 million or 8 basis points, down 1 basis point from the first quarter and down 4 basis points year-over-year. All non-performing assets are secured with real estate with a weighted average loan-to-value of 57%. Loans delinquent 30 days or more remained stable at 22 basis points at the end of the quarter. Criticized loans as a percentage of total loans were 1.47%, up modestly for the linked quarter and year-over-year, but comparable to 4Q 2019. At the end of the quarter, the allowance for credit losses was $145.4 million, up $1.8 million for the linked quarter and the ratio of the allowance to total loans and leases outstanding was flat at 1.04%. Given there were no significant changes in the economic forecast from the University of Hawaii Economic Research Organization, stable asset quality and modest growth. The allowance does continue to consider downside risk, including higher unemployment, inflation, and interest rates, as well as the general uncertainty in our environment. The reserve for unfunded commitments was $6.3 million, down $700,000 for the linked period.

Dean Shigemura, CFO

Thank you, Mary. Net interest income was $124.3 million in the second quarter, a decrease of $11.6 million linked quarter. Net interest margin was 2.22%, a decrease of 25 basis points linked quarter. Linked quarter decreases in both net interest income and margin were primarily due to higher funding costs, partially offset by loan growth and higher asset yields as the inverted yield curve and higher short-term rates continue to pressure our income and margin. We continue to exercise deposit pricing discipline as evidenced by our deposit beta continuing to outperform that of peer banks. Nevertheless, deposit rates are expected to continue to rise, and we also expect a continued moderate mix shift from non-interest bearing into interest-bearing savings and time deposits. As a result, we expect our cumulative deposit beta in this cycle will peak at approximately 30% in the fourth quarter, which, while higher than our historic beta of 20%, is still well below levels of peers. During the quarter we continued remixing our loans by shifting to a greater floating and variable rate exposure which now comprise approximately 60% of new loan originations, while allowing our investment portfolio to run off. In addition, we proactively added on-balance sheet liquidity as a mitigant against higher for longer short-term rates, although the higher liquidity negatively impacted our margin by approximately 4 basis points. On the liability side, we added $1.25 billion of fixed-rate term funding at an average maturity of 2.5 years and an average rate of 4.3%. We also increased our time deposit balances by $380 million at an average rate of 4.04%. In addition to our on-balance sheet actions, we added $200 million notional of pay fixed received float swaps in the quarter to hedge a portion of our fixed rate loan exposure. From an earning asset perspective, net interest income and margin are being supported by strong cash flow and overall asset repricing at higher rates. With $2.8 billion of annual cash flows from maturities and pay downs of loans and investments, we have ample opportunity to redeploy funds into higher-yielding assets. In addition to strong cash flow, loans and securities repricing, the added liquidity and interest rate swaps resulted in a further approximately $4.8 billion in assets that are repricing annually, which provides additional rate sensitivity. The yield on fixed rate maturities and pay downs of loans and investments in the second quarter was 3.8% and 2.1%, respectively. These cash flows continue to be reinvested predominantly into new loans, which are yielding approximately 7%, were held in cash at the Fed, which preserves liquidity, and is currently yielding 5.25%. Non-interest income totaled $43.3 million in the second quarter. Included in the results was a $1.5 million gain from the sale of a low-income housing tax credit investment. The first quarter results included a $600,000 charge related to a change in the Visa Class B conversion ratio, which is reported as a contra revenue item in investments securities gains losses. Adjusting for these items, non-interest income was $41.7 million in the second quarter, an increase of $400,000 linked quarter and lower by $400,000 from the second quarter of 2022. Trends and transaction activity and asset management fees have improved off of lower levels and we are starting to see modest growth. Core non-interest income is expected to be $41 million to $42 million per quarter for the remainder of the year, which is higher than our prior guidance. However, there will be a non-core charge of $800,000 in the third quarter from a further adjustment to the Visa Class B conversion ratio. This $800,000 charge is not included in the core non-interest income guidance. During the second quarter as is our practice, we managed our expenses in a disciplined manner as inflationary conditions continued. Expenses in the second quarter were $104 million. Included in the first quarter were severance expenses of $3.1 million and seasonal payroll taxes and benefit expenses from incentive payouts, which totaled $4 million. Adjusting for the severance and seasonal payroll benefits and expenses in the first quarter, expenses in the second quarter decreased by $800,000 linked quarter and were up $1.1 million from the second quarter of 2022. The year-over-year increase of 1.1% is well under the annual rate of inflation and included a considerable increase to the FDIC insurance rate, as well as annual employee merit increases. Expenses in the third quarter are expected to be approximately the same as the second quarter, but are expected to trend lower in the fourth quarter. While inflation continues to pressure expenses, reduced hiring, delay in non-core projects and other actions are being taken that moderate expense growth. To summarize the remainder of our financial performance, in the second quarter of 2023 net income was $46.1 million and earnings per common share was $1.12. Our return on common equity was 14.95% and our efficiency ratio was 62.07%. We recorded a provision for credit loss of $2.5 million this quarter. The effective tax rate in the second quarter was 24.57% and the rate for the full year of 2023 is expected to be approximately 24.5%. Our capital remains well within regulatory well-capitalized levels with all regulatory capital ratios increasing from the prior quarter. We continue to maintain healthy excesses above the regulatory minimum well-capitalized requirements. During the second quarter, we paid out $28 million to common shareholders in dividends and $2 million in preferred stock dividends. We did not repurchase shares of common stock during the quarter under our share repurchase program. And finally, our Board declared a dividend of $0.70 per common share for the third quarter of 2023. Now we'll be happy to take your questions.

Operator, Operator

Thank you. At this time, we’ll conduct the question-and-answer session. Our first question comes from the line of Jeff Rulis with D.A. Davidson. Your line is open.

Jeff Rulis, Analyst

Thanks. Good morning.

Peter Ho, CEO

Hi, Jeff.

Jeff Rulis, Analyst

Maybe a question for Dean. Just on the funding costs, I guess, the cost of funds for the quarter at 1.08%. How does that compare at the end of the quarter? What was that number? And then if you have it as well though, the monthly June margin overall?

Dean Shigemura, CFO

Yes, are you inquiring about the funding costs specifically on the liability side or something else?

Jeff Rulis, Analyst

For the first quarter, what was that at the quarter end, just spot rate?

Peter Ho, CEO

The funding costs for the quarter were 1.08%. Can you tell me how that compared to the end of the quarter? Also, do you have the overall monthly margin for June?

Dean Shigemura, CFO

Yes. The margin for the quarter or the month was 2.14%. However, if we adjust for the liquidity we brought on during the quarter, that number is actually closer to 2.20%. The liquidity had an impact on our margin during the month.

Jeff Rulis, Analyst

Got you. Okay.

Peter Ho, CEO

Later in the quarter.

Dean Shigemura, CFO

Later in the quarter, yes.

Jeff Rulis, Analyst

Yes. Okay. I wanted to circle back on the expenses. A pretty specific guide in the third quarter or the fourth quarter. And Peter, in kind of the prepared remarks, it seem to suggest a little more possibly could lean on that or manage that somewhat lower. I don't know if that changes. I think you've said for the full year guidance was expenses up 3% off of 2022 core base. Has that changed at all? Or is that more of a further out into 2024? Or am I just reading into commentary about cost management?

Peter Ho, CEO

Yes, Jeff, we are closely examining our expenses. We view this as a controllable area, especially in a challenging environment for margins and rates. Given the expected fee income, this is a reasonable focus for us. I anticipate seeing some effects from expense reductions later this year, certainly by the fourth quarter and into next year. However, I'm not prepared to provide specific guidance on the exact levels, but they will be lower.

Jeff Rulis, Analyst

I just wanted to check in on that. I appreciate it. Peter, you've mentioned the potential for a capital build as the securities portfolio matures. I recall it was an expectation for total capital equivalent to grow over one to two years organically. Could you provide an update on your current progress or direction regarding that?

Peter Ho, CEO

Not quite clear on the TCE piece. I mean, generally, Jeff, that we're looking to build capital through, obviously, earnings retention, as well as taking a good hard look at the asset base of the company. And candidly, the liquidity that we've built is running a little counter to capital build, if you will. And I think that was obviously for good reason, coming out of SVB, Signature situation in March. The reality though is, our deposit base has been incredibly stable, and we have a pretty good-sized war chest of immediately available backup line of credit. And so, the lever that may be available at this point is to bring down some of that $1.7 billion in cash that we're holding, which would improve capital slowly over time. And so, really our capital plan is, I would characterize it as an organic one at this point, with an emphasis on retaining earnings as well as managing the overall size of the balance sheet.

Jeff Rulis, Analyst

Great. Okay. I’ll step back. Thanks.

Peter Ho, CEO

Thanks, Jeff.

Operator, Operator

Thank you. One moment for our next question. Our next question comes from the line of Andrew Liesch with Piper Sandler. Your line is open.

Andrew Liesch, Analyst

Hey, good morning everyone.

Peter Ho, CEO

Good morning, Andrew.

Andrew Liesch, Analyst

Just a quick question on this liquidity build that came on later in the quarter. Has all that been deployed into earning assets? Or is there still some investments to be made on that front?

Dean Shigemura, CFO

It's primarily sitting in Fed funds sold right now, so we have readily available liquidity on the balance sheet. The yield we're earning is at the Fed, so we're earning the effective fed funds rate. We're also considering where to place the funds in terms of investments.

Andrew Liesch, Analyst

Got it. It seems that the overall impact on the margin will be lower, but there might be a slight increase in net interest income. Is that correct?

Dean Shigemura, CFO

Right. Yes.

Peter Ho, CEO

Yes. So that's exactly right. It's dilutive to margin, accretive to NII and dilutive to capital.

Andrew Liesch, Analyst

Got you. All right. And then on loan growth going forward. It seems like you had some pretty good gains on the commercial side. I'm just curious what drove that. And then looking out, I mean, how do you expect the total portfolio trend just modest, like low to mid-single-digit growth?

Peter Ho, CEO

Yes. I think we had a good C&I quarter. I'm not sure that's necessarily replicable in the coming quarters. So we had growth in both commercial as well as consumer. And what I would anticipate is, likely loan growth to be flat at this point moving forward. It just seems like the consumers slowed down a bit based on rate, seems like commercial clients are sitting on their hands a bit on transactions. Hopefully, we'll see that change as more positive signals come out of the economy, hopefully. But for now, feels reasonably muted, I think.

Andrew Liesch, Analyst

Got you. Thanks for taking the question. I will step back.

Operator, Operator

One moment for our next question. Our next question comes from the line of Kelly Motta with KBW. Your line is open.

Kelly Motta, Analyst

Hi, good morning. Thank you for the questions. I really appreciate the insights regarding deposits and the updated outlook for deposit betas. In your commentary, you mentioned ongoing pressure on noninterest-bearing deposits. I'm curious about your outlook on the runoff of noninterest-bearing deposits into higher rate accounts and where you think the percentages might stabilize, along with the timing. Is this really going to be the last quarter for this trend, or could it continue if there are additional rate hikes?

Dean Shigemura, CFO

Yes, the guidance regarding the beta takes into account the shift in the mix, which means some transfer from noninterest-bearing to interest-bearing deposits. This peaked at 30% in the fourth quarter. Currently, we're seeing 29% in noninterest-bearing deposits, and it may decrease to around 26% or 27%.

Peter Ho, CEO

Yes, Kelly, that would place us at approximately the midpoint between pre-pandemic levels, which were around 30%, and the levels from 2007 when rates were higher, in the mid-20s. We are uncertain about which base we'll reach, but we think this is a reasonable approach. We anticipate some ongoing shift in mix this quarter, continuing potentially into the fourth quarter. However, we have noticed some leveling off in that decline. It seems that June was down just over 1%, compared to an average decrease of about 2% per month over the past year, indicating an improvement. July appears to be fairly flat at this point, and with a few days left in the month, if that trend holds, it would likely represent our best monthly performance in about a year.

Kelly Motta, Analyst

Got it. That's very helpful. In terms of the margin, you mentioned that it was about 2.14% for June, which includes some of the liquidity build you had. Could you remind us when you took on those fixed-rate borrowings and added the cash, and whether that is fully reflected in the June margin? As we look ahead, given your expectations for declines and the comments on deposit beta, how should we think about the margin moving forward, especially with the possibility of another rate hike or two?

Dean Shigemura, CFO

The term funding was established in mid-May, which was around the midpoint of the quarter. Therefore, the June margin of 2.14% reflects the complete impact of that liquidity. Looking ahead to the end of the year, we anticipate that the margin will reach its lowest point in the fourth quarter, showing a gradual decrease from what we experienced in the second quarter.

Kelly Motta, Analyst

Got it. I appreciate that. And you said you put on some swaps during the quarter. Can you just provide us a bit more color just trying to get some sense on how to model around that? I may have missed the amount of that, so that would just be helpful in terms of modeling.

Dean Shigemura, CFO

Sure. Towards the end of the quarter, we initiated a $200 million notional pay fixed receive float swap to hedge some of our fixed rate loans. The term is approximately two to 2.5 years.

Kelly Motta, Analyst

Okay. Got it. Maybe the last one for me, if I could sneak it in. With capital, I know you said you're in the rebuild mode. Just in terms of the dividend, I think you reiterated the $0.70 dividend around earnings. But just wondering how you guys feel about this level? Obviously, the earnings have come down a bit with the margin. I'm wondering how you're feeling in terms of the comfort level of the payout at this stage.

Peter Ho, CEO

Yes, the dividends are important to us and we aim to maintain our dividend levels. This is, of course, dependent on earnings, interest rates, inflation, credit, and other factors. Our process involves reviewing this with our Board at the end of each quarter, and for now, we intend to keep that level.

Kelly Motta, Analyst

Thank you so much. I’ll step back.

Peter Ho, CEO

Yes. Take care.

Cindy Wyrick, Director of Investor Relations

Thank you, everyone, again, for joining us today and for your continued interest in Bank of Hawaii. As always, please feel free to reach out to either Chang or me if you have any additional questions or if you need further clarification on any of the topics discussed today. Thanks, everyone. Have a good day.

Operator, Operator

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.