Good morning, and welcome to the ConnectOne Bancorp, Inc. Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note, today's event is being recorded. I'd now like to turn the conference over to Siya Vansia. Please go ahead, ma'am.

Good morning, and welcome to today's conference call to review ConnectOne's results for the second quarter 2023 and to update you on recent developments. On today's call will be Frank Sorrentino, Chairman and Chief Executive Officer; Bill Burns, Senior Executive Vice President and Chief Financial Officer. Also with us is Elizabeth Magennis, President of ConnectOne Bank and Steve Primiano, EVP and Treasurer. I'd also like to caution you that we may make forward-looking statements during today's conference call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from expectations are detailed in our SEC filings. The forward-looking statements included in this conference call are only made as of the date of this call and the company is not obligated to publicly update or revise them. In addition, certain terms used in this call are non-GAAP financial measures, reconciliations of which are provided in the company's earnings release and accompanying tables or schedules, which have been filed today on Form 8-K with the SEC and may also be accessed through the company's website. I will now turn the call over to Frank Sorrentino. Frank, please go ahead.

Thank you, Siya, and good morning, everyone. We appreciate you joining us for this call. As you saw in this morning's earnings release, ConnectOne's performance, despite being impacted by Fed policy, continues to show strong and stable qualities in a challenging environment. Since the beginning of the year and through the turmoil in March, we have maintained and even increased client deposits as we have diligently supported and deepened our client relationships while adding new ones. Additionally, we continue to bolster our sources of liquidity while maximizing our insured deposits, achieving a top-tier uninsured deposit coverage ratio of about 250%. I would like to summarize some of the key operating highlights from our quarter, and then Bill will provide more detail later. As expected, our loan portfolio was mostly flat for the quarter, although the loan mix improved, reflecting a healthy 17% annualized growth rate in commercial and industrial lending. Our investments in this area are beginning to positively impact both sides of our balance sheet. Our capital levels remain strong, and our prudent philosophies and hedging strategies have resulted in minimal negative impact from accumulated other comprehensive income. Tangible common equity increased to 9.19% as of June 30, which is well above peer averages, and our tangible book value per share rose for the 13th consecutive quarter to $22.34, a 40% increase over that period. Our net interest margin did compress sequentially by about 19 basis points, primarily due to the shift from non-interest bearing demand and interest-bearing accounts. However, both our net interest margin and earnings deposit account trends stabilized at their current levels during the quarter, at least for now. Bill will discuss this in more detail later. Our credit quality remains excellent, with delinquencies as a percentage of total loans near zero at just 0.04%. This reflects our high credit standards, a well-diversified portfolio, and our relationship-based client philosophy. Regarding our commercial real estate portfolio, we have very minimal exposure to office space, with New York City office accounting for less than 1% of total loans. Our overall office exposure is mainly in Northern New Jersey, consisting of high tenancy specialty services and multi-use buildings, totaling around 5% of our total portfolio. That portfolio is performing well and is rated pass. Now, looking at our multifamily portfolio, our loans were historically underwritten with prudent standards, including high internally determined debt service coverage ratios at low loan-to-value ratios. Loan underwriting also includes stress testing for interest rate increases, cap rate increases, and potential stresses on net operating income. Regarding rollover risk, we have thoroughly reviewed our portfolio. Currently, only about $60 million of the multifamily loans will face significant re-pricing during the rest of 2023, with $190 million in the following 12 months. Most of those clients are longstanding, financially strong customers of the bank, posing very limited risk. In some cases, we are proactively seeking credit enhancements, such as additional collateral and/or personal guarantees, and have largely succeeded in doing so. We also have the ability to offer rate or amortization concessions in very limited cases to maintain sound loan performance. Overall, while our loan pipeline remains robust, we expect a relatively flat outlook regarding overall loan growth. Looking ahead, we are well-positioned with growth opportunities in key markets such as Long Island, South Florida, and within deposit-rich sectors in commercial and industrial lending, as well as healthcare and others. Simultaneously, we foresee a decrease in multifamily lending due to lower purchase demand and ongoing rate competition. In terms of our operating strategy, we’ve focused on integrating key technology and infrastructure investments. This optimization will continue to position ConnectOne for the future while enhancing our franchise value. We are executing several innovative initiatives aimed at improving client experience, digitizing workflows, and expanding opportunities to support our deposit franchise and drive organic growth. For instance, we recently launched a partnership with MANTL and successfully integrated the first phase of this omnichannel deposit origination platform. We are also creating opportunities across new verticals. Our franchise referral and lending platform, developed in collaboration with BoeFly, has seen enhancements in its infrastructure and user base during the quarter, improving our clients’ workflow efficiency and driving revenue. Additionally, I'm pleased to share that our SBA lending platform continues to gain momentum, boosting our non-interest income growth with recorded gains of $500,000 in the second quarter, and we aim to improve on that in future quarters. While we are investing in ways for our clients to access our products and services and enhancing our systems and communication tools, we are also capitalizing on market disruption opportunities to attract high-performing, revenue-generating talent to support future growth. Over the past few months, we have onboarded about a dozen client-facing team members in both new and existing markets. As ConnectOne continues to leverage opportunities for smart growth, we are committed to managing expenses. This includes our ongoing focus on optimizing operations, staff count, and branch footprint while leveraging technology to enhance human capital efficiency. While we acknowledge this may differ from what you’re hearing from other banks, many of which are cutting costs or implementing expense reductions, we believe the current environment presents unique opportunities to invest in support of ConnectOne's distinct growth strategies, potentially yielding attractive returns. This approach is consistent with our history of superior growth and profitability over the long term. Regarding our outlook for the remainder of 2023, despite the industry facing challenges, we firmly believe that ConnectOne's conservative client-focused model, diversified balance sheet, strong liquidity, and track record of prudent underwriting and profitability position us well for the challenges ahead and the flexibility to continue investing in our valued franchise. Now, I will turn it over to Bill. Bill?

Okay. Thanks Frank, and good morning. Thank you all for joining us today. We'll get to your questions shortly, but first, I'd like to start off with some comments regarding deposits and liquidity. First off, we are in very good shape regarding client deposit flows. Here, defining client deposits as all deposits other than broker. And in this economic environment where, first, the money supply and aggregate deposits are contracting; and second, where regional community bank deposits have been migrating to the largest banks, we have maintained and even have grown our client deposit base. That's true whether you analyze the trends on a point-to-point or on an average balance basis. Now we did increase broker by more than $300 million during the latter part of the first quarter, and that was to increase on-balance sheet cash liquidity, but we have largely wound that down during the second quarter. So that contributed to a decline in aggregate deposits sequentially but not client deposits, which are up. In terms of overall liquidity, we are now covering our uninsured and uncollateralized deposits by more than 2.4 times, and that is a very, very strong metric. The next area I'd like to cover is the net interest margin. We did experience another 19 basis points of sequential compression, but there's good news here, as the low point of the margin actually occurred in April, while May and June saw some margin expansion. Several moving parts here. First, non-interest bearing demand, which declined heading into the month of April, remained relatively constant for the remainder of the quarter. Since we had been proactive and aggressive with rate increases early on during the cycle, we were generally able to hold off rate increases for much of the current quarter. Looking at deposit rate trends, we appear to be approaching our terminal beta, which is about 50 to 55, depending on how you measure it. As far as the NIM for the remainder of '23, there are factors working in our favor and some against. On the positive side, our projected new loan funding rates are approximately 8.2% and are expected to replace loans going off the books at rates below 7%. There’s about $300 million in turnover per quarter that we project, and that excludes any resets. Yesterday's Fed rate increase will likely help the margin, albeit slightly. Finally, the non-interest bearing demand appears to be flattening out. As I've spoken to before, the value of DDA is even greater in a higher rate environment. Working against the margin is the continuing pricing of CDs; we have about $400 million per quarter over the course of the next year and an estimated 100 basis point increase in cost. I just mentioned that we have been able to hold firm on deposit pricing recently. We, of course, are keenly aware that competition could intensify, which will accelerate our deposit costs once again. When you add it all up, I’m going to give some conservative guidance here and say that, although we expect some further compression, it is not likely to be anywhere near what we've experienced over the past year. I would hope compression, if any, would be no higher than the single digits. Long term, we are in a liability-sensitive position and would expect material margin expansion when that inverted yield curve returns to its traditional shape. We've run some preliminary modeling and see a rough cut that for every 100 basis point drop in short-term rates, we see a 20 basis point improvement in the net interest margin, which over the course of a complete cycle would bring us back to our 340, maybe a little higher long-term margin. Along with that, all the other metrics reflect a high-performing banking organization. On expenses, we will, in some respects, as Frank was talking about, follow our longer-term strategic view. We will capitalize on opportunities for talent, and we'll continue to invest in technological improvements. This is not to say we want to also focus, as we always do, on efficiency in terms of continued rationalization, always, of vendors and consultants and reallocation of resources depending on the changing landscape. For example, we have planned to close another New Jersey branch late in the year. We recognize some of our peers have reported cost-cutting programs. However, as a top-tier efficient bank with non-interest expenses as a percent of assets consistently less than 1.5%, we are in a constant optimization mode. Given all I just stated, I'm going to forecast expense growth of approximately 5% on an annualized basis. On the non-interest income front, we remain optimistic about our growth prospects, especially given the momentum from SBA. We reported $500,000 of gains this quarter and expect that number to increase in the coming quarters, and BoeFly is expected to contribute to non-interest income growth as well. Now moving on to the ACL and credit. Frank mentioned this as well. Credit quality remains sound with delinquencies at just 4 basis points of total loans at quarter-end and net charge-offs for the quarter were just 5 basis points annualized. The non-performing asset ratio was basically flat, increasing slightly to 0.53 from 0.48 a quarter ago, but it is down from 0.69 a year ago. The provision for the quarter was $3 million, and as you know, it's difficult to project CECL modeling. But right now, my outlook is for similar provisioning for the remainder of 2023. A little bit about capital. Capital remains at very strong levels and continues to grow. Stock repurchases were modest at 270,000 shares during the current quarter, completed at about $15 per share, a good 20% below the current stock price. With our stock still trading today below tangible book value and what we believe is a significant discount for long-term value, we plan to continue that program at a similar pace for the duration of 2023. Our dividend, which was increased last quarter, still represents just a 33% payout, even based on this quarter's EPS. We have a good cushion for stock repurchases. Before we get to questions, I'll turn it over to Frank again.

Thanks, Bill. In summary, despite the ever-changing environment and the headwinds faced by the industry, we remain committed to our long-term strategic priorities. As we have in many prior cycles, ConnectOne's deep, experienced team continues to remain focused on serving our clients, building a best-in-class team and creating long-term value for our shareholders. We're confident that our commitment to improving and building upon our distinctive operating platform and maintaining our people-focused mission will allow us to not only remain resilient but to take advantage of the unique opportunities ahead. We look forward to sharing our continued progress in the quarters ahead. And with that, we're happy to take your questions. Operator?

Hey, good morning, guys. Thanks for taking my questions.

Good morning, Mike.

Bill, could you please clarify the period for the 5% expense growth? Is that an annual figure for 2023, or does it pertain to the second half of this year or next year? I apologize if I missed that information.

Well, I would say it's for the next couple of quarters, and we'll see how things are going on the revenue side before we give further guidance for 2024.

Okay. So, 5% growth off?

Annualized. So, divide that by four for a sequential number.

Thank you for that. I'm curious about the opportunities arising from the local market dislocation that Frank mentioned in his remarks and in the release. Frank, could you elaborate on this? I feel there are typically two phases of disruption: the initial wave and then a follow-up. Where do you think we currently stand in this process? What kind of talent are you focusing on? I assume there are certain areas you're not considering as well. Could you share some insights on that?

I wouldn't focus on what we aren't interested in, but I believe we're caught between the first and second phases. Many individuals are still reeling from the changes and upheaval that occurred in mid to late March. Some are still determining their next steps and how they want to proceed. I see a second wave forming, which includes those who have been displaced or have moved to other organizations and are discovering that their new situations are not ideal. They are looking for environments that feel more like home. We are capitalizing on both of these trends. Additionally, there are numerous opportunities in the market related to the recent mergers and acquisitions that have influenced many individuals to leave larger regional banks for places where they can conduct business more effectively, engage in meaningful conversations, and be recognized as decision-makers. In terms of opportunities, we are starting to see a transformation in our Commercial and Industrial (C&I) operations, which has taken a long time to develop, but we continue to bring in exceptional talent. This growth is allowing us to extend our reach into nearby markets. We are very enthusiastic about the opportunities we have been able to pursue that we couldn't have tackled before. That’s why we’re discussing our expenses differently than others who are focusing on layoffs and cutting costs. We see this as the time to invest, bring in top talent, and believe this will yield positive results over the long term.

That's helpful. Maybe a follow-up on that for Liz, just on the SBA side. Can you remind us the size of that team today and maybe just some near-term expectations around origination growth? I mean, that was a nice line item this quarter for you guys. Just curious where that could trend over the next few quarters here.

Yeah. We have a very good pipeline ahead of us. The team is about 10 people. There are probably four business development/originators on that team and the raw production support, but we're remaining optimistic for that line of business. So, we're getting in front of some nice deals there. And, of course, we're also looking at deals that we're saying no to. But primarily, the loans that we have in that pipeline are pretty strong.

Okay. Is this a decent run rate, Liz, based on the pipeline? I mean, I'm sure it can move around a little bit.

Yeah. Mike, this is Bill. I'd say a minimum of $500,000 and possibly $750,000. And that's just for this year, and then we'll see next year, okay?

Okay. Yeah. Perfect. Thanks. And then just one last one for me, and then I'll step back. Just Frank, I apologize if I missed this. But I just wondered if you could expand a little bit more just on the dynamics of when kind of a resumption of balance sheet growth makes sense for you guys? And what are the key kind of contributors to that decision? Is it macro? Is it pipeline levels? Is it incremental spread, all of the above? Just curious how you guys think about that, if you can give us some expanded thoughts that would be great.

Mike, I see that interest rates and Federal Reserve policy have certainly reduced demand. We're observing significantly less purchase activity and fewer business combinations, which impacts our preferred types of business. I would attribute about half of the slowdown in our ability to add new assets for balance sheet growth to macroeconomic factors. Additionally, when we analyze credit metrics and determine where to focus, there’s also decreased demand or initiative from our side to pursue certain business types. Our pipeline is surprisingly strong, but largely it is just replacing the existing business that is naturally cycling off. I believe that as the Fed begins to relax its stance and as people gain more confidence in the current interest rate environment, coupled with the economy moving into its next phase—though I hesitate to call it a rebound—there will likely be a natural uptick in demand. We should begin seeing an increase in asset generation alongside deposit growth. I think both will happen simultaneously because if the Fed eases its approach to interest rate hikes and the tightening measures, we’ll likely see deposits returning and a rise in demand for business loans.

Of course, we always keep an eye on spreads and profitability. So, just like in the past, we're not going to chase deals based on pricing. So, how aggressive the competition also factors into how larger growth rate we have.

Yeah. Yeah. That all makes sense. Thank you guys for taking my questions this morning. I appreciate the color.

Great, Mike.

Thanks Mike.

Thank you. And the next question comes from Daniel Tamayo with Raymond James.

Thank you. Good morning, guys.

Hello, Danny.

In regard to the securities portfolio, it's a similar question to the loan growth. You've been allowing it to decrease a bit over the past few quarters. How much further are you willing to let it decline before you consider adding more securities?

We try to keep it at a certain level of total interest-earning assets. I think in the max, it was probably around 10%, and it's gone down to where it is today at 8%. So, it's not that big a number either way for us, but for now probably flat. I wouldn't want to see it going down too much, okay, just from an on-balance sheet liquidity perspective.

Thank you, Bill. To focus on your comments about margins, you mentioned that you expect no more than single-digit pressure going forward. Assuming the yield curve remains stable and there are no cuts, how do you view the third quarter and the stability beyond that?

I can't give you exact projections on net interest margin, but it's hard to say right now that there could be any more compression because there continues to be competition on the deposit side. The structure of the way assets and liabilities are re-pricing right now, I'm looking at a margin that's maybe just a little bit lower than where it is today, or flattened out.

Okay. All right, I appreciate that. Thanks for taking my questions.

Thank you. And the next question comes from Frank Schiraldi with Piper Sandler.

Good morning.

Hey, Frank.

I just want to confirm what I heard regarding the new loan funding. Did you mention that the pipeline is at 8%?

Yeah. That is right. And then we've been working on it.

What is the makeup of that? Is that in terms of C&Is, stabilized CRE construction; what's mostly in that number?

A big portion of C&Is. As Frank had mentioned that we've had some good growth in C&I. Even though the loan portfolio was flat, we had some good growth in C&I. So that's what's driving some of the rate, which is a good rate to put loans on and also our deposits.

Okay. I just wondered if you could just maybe talk a little bit more about the area of the market you guys are in in terms of C&I. Like what the average size of loans, the geography that drove that growth in the quarter, or the mix shift in the quarter. Is there generally real estate collateral as well in there? Just kind of curious if you can give a little more color on the C&I growth in the quarter.

I think it includes a bit of everything you've mentioned. Mostly, it's concentrated in our market area, particularly in the New York metro region. Loan sizes typically range from $3 million to $15 million, primarily for businesses. There is some real estate involved, especially with occupied buildings related to various sectors, including manufacturing in Northern New Jersey and Long Island. However, the focus is mainly on commercial and industrial lending for diverse purposes. This segment is quite varied, but the common thread is that these are largely family-owned businesses that have been around for a long time. Another shared aspect is that most of these clients are ones we likely wouldn't have encountered otherwise, largely due to recent disruptions. Many are either lacking banking support or are unhappy with changes at their current banks due to mergers or instability from mid-March.

Okay. That's helpful. Bill, regarding your guidance on margins going forward, does that include some ongoing shift from commercial real estate to commercial and industrial? I'm curious if you can share any insights on how much we might see in terms of C&I growth or that shift through the end of the year, especially in relation to your forecast of low single-digit margin contraction from here.

I'll try to give you an exact answer, but it's not that great in terms of mix in the entire portfolio and probably add just a couple of basis points in terms of margin. It's not the real driver. The real drivers are that the non-interest-bearing demand is leveling off, and that we're seeing less pressure on the deposit pricing side because we raised prices earlier and had more compression than others early on in the cycle.

Okay. So, yeah, it's not a big driver. But just curious what do you think in mix shift back half of the year, sorry if I missed it, in terms of potential growth in the C&I.

It's a couple of percent on the pie chart.

Okay. Lastly, regarding efficiencies, you have consistently been a very efficient bank. Given the Federal Reserve's actions and the margin contraction, your efficiency ratios are currently above 50%. Do you believe that returning to more normalized margins is necessary to drop back below that 50% threshold, especially as you consider further investments? Is that the correct way to approach this, or how should we view it?

The banks that were at 50% are now at 60%. We were at 40% and are now at 50%. The non-interest expense as a percentage of assets remains constant. If you analyze our peers based on that, you'll find that we rank among the best, and that performance is holding steady. If we can raise the margin to around 340, I believe we could return to an efficiency level of about 40%.

Gotcha. Okay, great. Thanks for all the color.

Sure.

Thanks, Frank.

Thank you. And the next question comes from Matthew Breese with Stephens Inc.

Hey, good morning.

Good morning, Matt.

Hey, Matt.

Hey, Bill, I sense some cautious optimism on the demand deposit front and stability in the mix of deposits. Has that held up so far in July? Are you seeing continued stability?

It has leveled off completely in the second quarter, and then I noticed a slight increase very early in July. It's difficult to determine right now if demand for deposits is still declining. Typically, what is occurring with ConnectOne is also happening with other banks. I am curious about the experiences of others. I believe there is certainly a stabilization compared to the rapid decline we saw earlier in the year.

Okay. And then, I appreciate all the NIM commentary. Maybe just give us some update on the NII outlook. It's been coming down for a couple of quarters for obvious reasons, deposits and rates. Is this a floor in your view or are we near a floor?

In terms of net interest income?

Net interest income?

Yes, net interest income is likely to decline if we maintain flat loans and experience market compression. That’s just how it works mathematically. However, I believe we are approaching a point where margins will stabilize. Even with minimal loan growth anticipated throughout the year, next year may tell a different story. We might not see large growth rates, but I expect any growth will be in the single digits, and we should start to see margins widening again. I hope this information assists you with your modeling.

It does. Regarding fee income, the gain on sale items appears to be included in other income and has been quite volatile. What is the breakdown between BoeFly, SBA, and other items? Can we expect to build on this quarter's $3.4 million rate?

Yeah. My best guess would be yes. That's something we can grow off of in terms of the SBA increasing a little bit in BoeFly as well. BoeFly generates about $1 million a year in revenue. Right now, we're on a $500,000 a quarter pace on SBA. We did have some CRE sales causing the volatility that I was aware of. It's been a tough market for that right now, but something that we probably will pick up again. There are a bunch of banks in this area we have relationships with that look to us for product. So, I feel clear about this being the bottom, and now we can see growth from here.

Okay. Appreciate that. Last one, Frank. I was hoping for some color on the late June interagency guidance around CRE accommodations and workouts that basically the regulators are saying. We acknowledge commercial real estate headwinds; please work with your customers. What does that mean in practice? What do you think the tools are that are at your disposal? And how does this pan out from a disclosure standpoint in your view?

Yeah. I think that just from a high-level perspective, anything that we've seen has really been the delta between what the contractual change in the obligation of a loan is relative to its interest rate and what is a market rate today is where the change has occurred. I don't want to give anyone the idea that we've done anything for anybody to go below what the market rate should be at this moment in time. If you have a contractual obligation at 250 or 300 basis points of some index, and that's way outside of market, then obviously, we're going to try to make an accommodation. I would tell you though that it's been pretty far and between. Most folks are just happy that we're doing loans at whatever the contracted rate was. Those that really aren't and want to seek out a better alternative somewhere else, there is an option to do that. In very few cases, that we had to actually sit down with the borrower and say, hey, we know your rates supposed the contraction change to X, but we're willing to take it to Y and get you through the next cycle. My comments were that if we need to do that and it makes good economic sense, we're going to do that. We're a client-focused bank. That's the non-technical answer.

Matt, I’m uncertain about the impact of the regulators' statement. The accounting for modifications has changed, which is positive because if we modify a loan to support the borrower and it continues to perform, everyone benefits: the borrower, the bank, and our shareholders. Such modifications shouldn't be categorized as non-performing assets. We do still disclose loans that we modified during the period that are struggling, but that status doesn’t remain as long as the loan is performing well. I'm not entirely sure how useful that statement was; it’s not a significant issue. Of course, we don’t want to give away anything, but in cases where it’s genuinely necessary, that’s a tool we’ve always had and will continue to use.

Okay. Understood. I appreciate that. Maybe just as a follow-up. In the case where you do have maybe a bad set of circumstances, a nasty rate reset combined with a nasty cap rate reset, are you finding that your clients, your borrowers are willing to put additional cash and equity into the deals, so-called cash and refi to keep the property in their pocket, so to speak?

Yes, Matt, I would agree that this is indeed the case. In situations where we've engaged with borrowers who have encountered challenges, particularly with transitional properties that haven’t gone as planned, we’ve found that they are often willing to provide personal guarantees, additional collateral, or even cash to help adjust the loan terms. Our credit metrics indicate that we haven't faced significant issues with problem loans in these scenarios. At ConnectOne Bank, we are committed to collaborating with our clients, and because of the strong quality of our client base, they have been cooperative in addressing these matters.

Great. Well, I appreciate all the color. Thank you for taking my questions.

Thanks, Matt.

Thank you. And this concludes the question-and-answer session. I would like to return the floor to management for any closing comments.

I want to thank everyone again for their time today and certainly look forward to speaking with you all again during our third-quarter conference call. So, have a nice day. Enjoy the rest of your summer. Thank you again.

Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.