Earnings Call Transcript - CNOB Q2 2022

Siya Vansia, Chief Brand and Innovation Officer

Good morning, and welcome to today's conference call to review ConnectOne's results for the second quarter of 2022 and to update you on recent developments. On today's conference call will be Frank Sorrentino Chairman and Chief Executive Officer; and Bill Burns, Senior Executive Vice President and Chief Financial Officer. The results as well as notice of this conference call on a listen-only basis over the Internet were distributed this morning in a press release that has been covered by the financial media. At this time, let me remind you that certain statements and assumptions in this conference call contain or are based upon forward-looking information and are being made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to numerous assumptions, uncertainties and known or unknown risks, which could cause actual results to differ materially from those anticipated. These risk factors are more fully discussed in the Company's filings with the Securities and Exchange Commission. 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 be also accessed through the Company's website at ir.connectonebank.com. Each listener is encouraged to review those reconciliations provided in the earnings release, together with all other information. I will now turn the call over to Frank Sorrentino. Frank, please go ahead.

Frank Sorrentino, Chairman and Chief Executive Officer

Thank you, Siya, and good morning, everyone. We appreciate you joining us here today. I thought before we get started, I would like to take a moment to review our longer-term track record, which, of course, we are very proud of. ConnectOne's performance metrics are consistently top tier in the industry. Our net interest margin has expanded since the early stages of the pandemic as opposed to contraction for most of the industry. Our tangible book value per share continues to increase now for the ninth straight quarter, reflecting our core profitability and sound balance sheet management. Our organic growth has consistently been above 10%, and we've expanded both geographically and through new verticals. We've remained disciplined to our commercial banking business model and focused on lines of business where ConnectOne has expertise and competitive advantages. We augmented our organic growth with opportunistic value-enhancing M&A, and our FinTech acquisition, BoeFly, is gaining momentum and is poised to create significant value. Our client-first tech-forward culture has led to strong performance and increased market share through various business cycles. And finally, in our view, with our track record of success, we are and remain a very compelling investment opportunity. With that, we're exceedingly pleased with ConnectOne's all-around performance in the second quarter, highlighted by significant organic balance sheet growth and continued record performance metrics. Annualized loan growth was 17%, while noninterest-bearing demand grew by an annualized 20%. Our PPNR as a percent of assets was 2.28%, exceeding 2% for the eighth consecutive quarter. Return on assets exceeded 1.5%, and return on tangible common equity exceeded 15%. Our net interest margin has continued to expand, and our efficiency ratio remains below 40%. Finally, our tangible book value increased again this quarter to almost $21 a share. These results are a testament to the success of our client-centric culture and relationship-focused origination franchise. The investments we continue to make in our team, infrastructure, and digitization are paying dividends as we again saw record loan fundings this quarter. Our continued double-digit growth illustrates both the strength and the diversification in the markets we serve, bolstered by recent acceleration of hires, the lifting of teams, and expansion of our geographic reach. Origination metrics were favorable. Weighted average origination yields were in excess of 4.75%, and that number is now well in excess of 5% heading into the third quarter. Credit metrics were sound, with strong LTVs and conservative debt service coverage ratios, reflecting very conservative underwriting. This quarter's growth was higher than we initially guided, but it does not come as a surprise to us. We had a robust pipeline entering the quarter, loan growth across the industry is up. Our originations were diverse, spread amongst all segments and markets, with C&I growth gaining momentum this quarter with additional synergies driven through BoeFly. Looking ahead, the loan pipeline remains strong with increasing spreads and rates. Our Florida team success exemplified that ConnectOne's relationship-focused model can be a clear differentiator in these other markets. We are seeing continued strong loan demand and core deposit growth there with the aggregate loan and deposit origination projected to be upwards of $200 million by year-end. With the hiring of additional staff and the opening of our permanent office in West Palm, we expect even further momentum. Turning to deposits, we expect competition to continue to increase. However, ConnectOne is well positioned to adapt to changing market dynamics. Our client-focused model has a proven record of generating core deposits to keep pace with loan growth. We also have a number of tech initiatives that are geared toward augmenting that deposit growth. To that end, we're excited to announce a partnership with MANTL to enhance the bank's deposit origination platform. This partnership allows us to leverage technology to expand our reach in supporting consumer, small business, and commercial clients while optimizing our workflows. Each of these improvements allows ConnectOne to build frictionless client experiences and processes that support continued scale and efficiency. As a reminder, last quarter, we announced a partnership with Nymbus to launch a new B2B vertical on the Nymbus platform. This partnership provides ConnectOne the opportunity to expand into new business verticals while leveraging lean and Nymbus cloud-based tools and ultimately create a new avenue to drive deposits. Implementation has begun on both these fronts, and you can expect to hear more about this at the end of the year. On to BoeFly, our fintech subsidiary, which continues to shine. The platform continues to generate noninterest income and fees, and revenues are growing as franchisor adoption is running strong. The franchisee market is ripe with opportunities, and we continue to explore avenues to expand that platform. Under the leadership of Mike Rozman, BoeFly has not only expanded its core business, it has also helped spawn new verticals within ConnectOne. Our SBA unit is now generating respectable volume, and our franchise lending group is seeing great deal flow. The franchisor lending opportunities are providing high-quality clients to the bank. Expect to hear more about this as the year progresses. Shifting to the macro environment, we are certainly conscious of the possibility of a potential recession, which may lead to some loan stress across the industry. Just want to remind everyone, we operate in some of the strongest markets in the country. So far, our clients appear to be in sound financial condition. Overall, nonperforming assets and delinquencies at ConnectOne remain low, and we have very limited exposure to consumer business lines, which may be more susceptible to the recent market dynamics. Before I turn it over to Bill, let me just mention that we continue to attract top talent to bolster bench strength across all lines at ConnectOne. Capitalizing on M&A disruption, we've been successful in adding staff in all areas of the Company. ConnectOne continues to be a top choice for displaced experienced bankers, and we're building for the future across all of our markets. With that, let me now turn it over to Bill.

Bill Burns, Senior Executive Vice President and Chief Financial Officer

All right. Thank you, Frank. Good morning, everyone. I also would like to say a few words before getting started, and I wanted to address head-on what are probably the two most important factors currently depressing bank stocks, including our own. First and foremost is the possibility of a recession and the resulting potential impact on credit losses. Second, to a lesser degree, is the uncertain impact continued Fed tightening will have on net interest margins. So first, with regard to potential recession, its impact on ConnectOne. The credit story of ConnectOne is excellent. We have a long track record of solid credit performance. We've been able to produce strong organic growth, while avoiding hot-headed industries such as New York City office, hospitality, big-box retail, and New York City luxury multifamily. Our construction portfolio is about 10% of the total portfolio. We have particular expertise here. It provides nice returns, and losses have been virtually zero. We have immaterial amounts of consumer debt and virtually no second position retail and no credit card exposure. Even our taxing portfolio is now expected to generate recoveries. We are well-reserved on the CECL with a healthy level of total coverage. Our deep commercial origination franchise allows us to generate meaningful growth without reaching on credit pricing or terms. All in all, we believe we're in a solid position to withstand an economic downturn. This takes me to the net interest margin for ConnectOne. The second quarter reflected a record high net interest margin that eclipsed 3.9%. Included in that 3.90% metric was some extra PPP accretion and some back interest recoveries. On a core basis, I estimate we were still slightly above 3.70%, still very high by historical and industry standards, and moderately higher from the first quarter on that same. Our margin has continued to widen since the early stages of the pandemic, which is remarkable. I'm even more proud of the fact that it remains relatively stable, and we attribute that to two things. First, we've been proactive and reactive to anticipated and actual market and competitive rate moves, anticipating rate declines a couple of years ago, then locking in longer-term funding. Along with that, hedges to our AFS portfolio when rates were low. We tend to move quickly when market deposit rates start to change, whether it's to improve profitability or maintain our market share. And second, just as important, our strong business development team continues to build the book of business that generally is more valuable on the risk-reward spectrum than most. Our clients are typically willing to pay just a little bit more based on our service and response time, while our noninterest deposit growth remains strong, reflecting a relationship-based approach. So that combination of organic growth and margin stability has led to a very strong performance track record, including PPNR, return on assets and equity, tangible book value per share growth, and, along with those metrics, a very low efficiency ratio. Now in terms of the margin going forward, again, our goal is for stability, and we believe our margin will continue to be relatively stable. Speaking structurally, there are asset-sensitive characteristics on our balance sheet, namely 20% of the loan book is pure floating, another 40% is adjustable, resetting at various times over the next three years, and noninterest-bearing deposits have grown and are presently a healthy 26% of total deposits. Notwithstanding those positive attributes, there is some deposit beta catch-up going on impacting the entire industry, which is going to quicken the pace of increased funding costs. We have an inverted yield curve, and for however long that lasts, it will be a challenge for all of us. The performance of ConnectOne's securities portfolio has been among the best out there. We refrained from buying securities when rates were at the bottom. We hedged what we had, and the result has been a very, very slight impact on our OCI and intangible book value per share. More recently, we've been buyers of securities yields in excess of 4% to 4.75%, and those are now being marked up, not down. Tangible book value per share increased once again in the second quarter. It's the ninth consecutive quarter of upward movement, and it's up 10% from a year ago. As a result of that, we are now trading at a very low price of tangible book just 1.2 times. We continue to believe we are undervalued. We have the capital strength and retained earnings to continue stock repurchases. Switching gears, I just want to emphasize some of Frank's remarks on BoeFly. BoeFly's bread and butter, which is referral fees on SBA loans to franchisees, gained modestly as we continue to build our franchisor network. An additional avenue for growth is in the non-SBA franchisee lending space as well as the franchisor lending space, where we're making headway, and that has already contributed to ConnectOne's increased C&I originations. We are also researching avenues to sell those loans in the secondary market, but either way, they bring value to us. Now let me move on to operating expenses. Adjusting for the final BoeFly earnout payment, which was $833,000 for the quarter, expenses accelerated a little faster than I previously guided you. You should view this as a good thing, as it's all related to planned additions to staff that came on board earlier than expected. ConnectOne continues to be a top choice for experienced bankers displaced or dissolved by M&A. We're building for the future in our traditional operating markets as well as in extended geographies. For next quarter, as I said, the BoeFly earnout payments are done, but we do expect to see some more core expense increases, followed by probably a flattening out in the fourth quarter. We're going to be okay with a slight increase in our efficiency ratio, but I expect that to continue trending downwards towards the end of the year and into 2023. In terms of loan growth, the pipeline remains strong, and another 5% sequential quarterly growth rate is possible. However, with rates rising, we expect a slowdown in the fourth quarter, and that trend is likely to continue for us and the industry into 2023. With that, I will turn it back over to Frank.

Frank Sorrentino, Chairman and Chief Executive Officer

Thanks, Bill. I have to say, I'm extremely proud of all that we have accomplished here in the second quarter. We, as a team, continue to leverage the momentum that we've built. We delivered really strong performance, which is truly a testament to the ConnectOne team, and I mean the entire team. We've built momentum in the technology space, launching several initiatives to create more opportunities for us to enhance our shareholder value and our franchise value. I feel really good about where we are and what we have the potential to do. A lot of the work we've done is beginning now to pay dividends, and we've got a lot more runway ahead of us. Our best days certainly lie ahead, and I'm confident we'll navigate any challenges that we encounter along the way. I look forward to updating all of you on continued developments in the third quarter. And with that, we're happy to take your questions.

Operator, Operator

Our first question comes from Frank Schiraldi with Piper Sandler.

Justin Crowley, Analyst

It's actually Justin Crowley on for Frank this morning. I just wanted to start. So with the strong loan growth in the quarter, the loan-to-deposit ratio is sort of running at the higher end of where you guys have been recently. Could you maybe just provide some commentary on if the strong loan growth continues, particularly as you alluded to, maybe in the third quarter, seeing somewhat of a similar result, sort of the strategies behind managing that at this level or below this level as you think about margin going forward?

Frank Sorrentino, Chairman and Chief Executive Officer

Sure. Why don't I just start with the business part of it, and then maybe Bill could talk a little bit about what's behind that. We, at ConnectOne, have always operated in the geography above 100% loan-to-deposit ratio, and it's sort of bounced around between 105% and 115% or so. It really depends on which quarter we have stronger loan growth as opposed to others. Generally, with loan growth, there's corresponding deposit growth. Sometimes there are timing mismatches, and so that loan-to-deposit ratio may bounce around a bit. In general, just about every single relationship that we're onboarding comes with the depository relationship, and we're seeing that in the growth of our non-interest-bearing demand, which is the place that we care about the most. On top of that, this quarter was interesting to dive into the loan growth because a lot of it came from non-CRE components. C&I was a pretty big percentage this time. We are seeing more opportunities for onboarding deposit-rich clients along with their loans as we've seen in the past. That will take some time. The balance sheet is big, so it does take time to move any of those metrics. We monitor this closely and watch for what we're doing. We price accordingly relative to who brings us deposits and who doesn't. Overall, we're comfortable with where we are. We'd like to see the loan-to-deposit ratio a little lower, and we'll be working towards that as we move forward. Bill, maybe...

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Yes. Justin, I think you were suggesting that a higher loan-to-deposit ratio means a lower margin. I don't necessarily agree with that. The most important thing in terms of funding is building noninterest-bearing demand deposits. We've been doing a good job at that. In terms of other sources of deposits, there are more market-based sources of deposits that we can utilize if we want to, or the Federal Home Loan Bank. It probably doesn't matter which one. The other aspect of the margin is the rate we're earning on our loans. It continues to go up. I think we averaged 4.75% in the quarter. Right now, our average loan rate for this month has been over 5%. All in all, I talked about looking for stability in the margin, where we've been operating at some of our highest levels. If it goes down a little, it's not going to be too much, and I still think we can drive the returns we've driven before, which includes return on assets of over 1.5% and return on equity over 15%.

Justin Crowley, Analyst

Okay. Great. That's helpful. Yes, no, I guess I was just trying to get a sense for as you look at that loan-to-deposit ratio, it changes your thinking on having to pass off these costs to your depositors as far as rates you are paying. I guess sort of in that vein, could you provide just maybe a little more detail on this new partnership with MANTL and then sort of square that with the Nymbus partnership, what that does on the deposit gathering side, sort of outside from the core banking functionality that I believe Nymbus will also bring?

Frank Sorrentino, Chairman and Chief Executive Officer

Right. Let's start with Nymbus first and work backwards. Nymbus is a new core that we're bringing on for a specific purpose, to stand up a particular vertical, to service a certain market segment. That will work completely independently, and we're pretty excited about the opportunity there to create a bespoke solution for a particular segment of the marketplace. That really doesn't interact with the rest of the ConnectOne set of relationships that we have or other market segments. MANTL, on the other hand, for the vast majority of the business we do here at ConnectOne, will replace a variety of systems that we have today in order to onboard new clients and manage the deposit origination, product set, and services, the way we reach out to clients, the way clients can access various products here at ConnectOne. It will transform not only the front end, making the ability to open an account seamless and within minutes, but it will also dramatically transform the back end and reduce friction, duplication of services, and better clean data for us to use going forward. We are pretty excited about the idea of taking the various things we've built up over the years in how we open new accounts and really streamlining that process, making it easier. Amidst the fact that we are now in multiple markets, market expansion is important for us, both geographically and otherwise. Having a high-end platform to digitize this entire process is crucial to our efficiency.

Justin Crowley, Analyst

Okay. Great. I appreciate it. And then just quickly on the buyback, it sounds like you guys still view the stock as pretty attractive. Were you fairly active in the quarter following the activity in the March quarter? Is there anything either on the growth side or just as far as macroeconomic uncertainty that could cause you to take a step back as we head into the end of the year as far as repurchases go? Or do the level buybacks this quarter make sense here?

Bill Burns, Senior Executive Vice President and Chief Financial Officer

We think we're very undervalued, and it's a good buy at these levels. In terms of capacity, a lot of people were hurt by the AOCI hit. We didn't have that. We've got a tremendous amount of return on equity. Our dividend rate, although we've increased it, is still pretty low, and the dividend payout ratio is manageable. We have the capacity to continue to buy back.

Operator, Operator

Our next question comes from Michael Perito with KBW.

Michael Perito, Analyst

Obviously good results here, and Frank, I have been following your public commentary over the last 90 days. The environment, though, is challenging just from a credit clarity standpoint. I was curious, it sounds like all your borrowers are healthy, and there's this perception versus reality gap where borrowers seem healthy, but you're seeing retailers starting to report some concerning data. Are there any areas where maybe you are more or less concerned or thinking about deprioritizing growth, whether that be commercial real estate with exposure to consumer discretionary or anything of that nature? Just curious how you guys are thinking about it?

Frank Sorrentino, Chairman and Chief Executive Officer

Michael, over the last 90 days, I've made a lot of commentary about what I think is happening. Whether we are going into a recession is going to wind up being semantics. The business climate is still pretty good. I believe consumers still have strong balance sheets; businesses have good, strong balance sheets. The psychology has changed. Everyone is talking about interest rates, a slowdown, and whether we will return to the office or work from home. There's clearly a shift in sentiment regarding the future. I stand firm that we will have a bit of a slowdown, and I don't know if it will technically be a recession or not. However, I believe this will be short-lived. There is more liquidity in the system now than has ever been before. I've never seen stronger balance sheets than I have leading into what is supposed to be a recession. Therefore, we remain bullish about taking advantage of opportunities presented in this market. That being said, we will be disciplined and cautious, not just throw darts at anything, but do what we've always done here. If you recall, over the last 17 years of our existence, we've always excelled in turbulent times, and this appears to be one of those periods. The sectors that concern me, as you know, we have a very small consumer business. I really have very little concern there. The only sector I would monitor closely is our office sector, which is small on our balance sheet, mostly concentrated in New Jersey, and is over 80% personally guaranteed with good credit-type tenants occupying the space. That is the segment that we are watching closely. We feel confident in our construction portfolio moving forward. We're also seeing opportunities as many players pull away from that market. I believe there are good sponsors out there that warrant financing their projects.

Michael Perito, Analyst

Helpful perspective, Frank. In terms of BoeFly and how that's positioned for this environment, I don't necessarily mean from a credit perspective, but instead competitively. The SBA secondary market for fixed loans seems to have been frozen since the Fed's moved at this pace. Are you seeing players pull back? Has there been market share opportunities? Or do you expect that to happen, even if it hasn't happened yet? Or do you think there could be potential challenges if we enter a more challenging environment for the consumer that some SBA type products could slow down from an origination standpoint?

Frank Sorrentino, Chairman and Chief Executive Officer

Yes, I think we've seen a little bit of a slowdown within the SBA vertical itself, but we're also seeing lots of opportunities outside of the SBA vertical. BoeFly has been successful at expanding into other verticals and concentrations. While the core business of BoeFly may slow a little, we keep adding franchisors to the platform, which is encouraging. So I believe we're going to continue to grow that core business. All of these verticals, led by Mike Rozman, have generated exciting opportunities for us. We are still in the early innings, but as the year progresses, I think we will be able to report more detail on the developing segments.

Michael Perito, Analyst

Great. Lastly, Frank, you've provided a lot of color already on margin, and I appreciate that. I've been curious about the deposit side: have you seen anything structurally different, as it seems you're outperforming expectations? Has there been less competition? Is it related more to M&A disruption or the liquidity your peers have versus previous times? Just curious if you could break that down a little more and see if there's anything that might help you sustain this outperformance?

Bill Burns, Senior Executive Vice President and Chief Financial Officer

A bunch of the things you mentioned are happening right now. We haven't seen a dramatic rise in our cost of funds in our non-interest-bearing accounts. The average rate for the last quarter was 38 basis points, ending the quarter at 45 basis points. That hasn't moved much, but I anticipate that with all the Fed increases, the beta will need to catch up at some point. I'm just being cautious about it; we aren't seeing too much pressure on the core deposit side currently, but I imagine it will come.

Frank Sorrentino, Chairman and Chief Executive Officer

To answer the other part of your question, Michael, I still see a lot of competition in the market today. It hasn't disappeared; however, it has changed. There are different competitors now, and the types of businesses have changed somewhat. In some areas, we have better competitive advantages, in others, it's becoming tougher. One area where we believe we are gaining competitive advantages is in our C&I platform. We've been building that for the last eight years, and it has gained momentum recently. We've hired great talent in that space, and it's starting to pay off. Our DDA percentage is at a record high for ConnectOne, although we believe it could be higher. We aim to make progress on that over time; the transitions we're making are reflected in the numbers. Notably, this is the first quarter our multifamily exposure declined slightly, while C&I has surged ahead. These transitions are showing up in the numbers, which demonstrate our progress.

Operator, Operator

Our next question comes from Matthew Breese with Stephens.

Matthew Breese, Analyst

You talked a bit about recession fears. I'm focused on higher interest rates and cap rates, part of the same issue. Are you seeing any sort of valuation deterioration across commercial real estate multifamily due to higher cap rates? Secondly, regarding the recession fears, have you changed how you're underwriting to reflect the weakened environment, whether it’s more cash upfront or personal guarantees?

Frank Sorrentino, Chairman and Chief Executive Officer

We continually monitor our portfolio and what's happening across various segments related to our multifamily portfolio. Remember, we are very debt service constrained when underwriting these transactions, so typically, from an LTV basis, they are quite low. The current portfolio is in the high 50s or just under 60% from an LTV perspective. If you were to stress-test the assets we currently hold with higher interest rates, you would find they would pass the test considering we did that during underwriting. Even with the recent 75-basis point move, the 10-year bond yield fell. Many banks including insurance companies, Fannie, and Freddie are providing loans for multifamily with a favorable rate. Overall, our portfolio seems robust. New projects coming in now may face different challenges, but we are maintaining disciplined underwriting. We emphasize stress testing, especially in our construction segment since projects starting today likely won't complete for 18 to 24 months. We've observed developers shelving projects after discussions with us to assess the situation. If that's your definition of changing our lending standards, then yes, we are making adjustments. However, our loan policy remains consistent; we maintain a disciplined and conservative approach in underwriting, particularly in construction, and it's serving us well. We are witnessing strength on developers' balance sheets, which gives us confidence in financing successful projects.

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Frank, to clarify your previous comment about nominal stability, when we're measuring it off the core NIM around 3.70 as opposed to the all-in numbers.

Frank Sorrentino, Chairman and Chief Executive Officer

Correct.

Matthew Breese, Analyst

Got it. I appreciate that. Lastly, Frank, could you elaborate on the ultimate vision for BoeFly, a more robust SBA platform, and other tech capabilities? What are the fee income or loan growth opportunities? Should we expect more material benefits, and if so, when?

Frank Sorrentino, Chairman and Chief Executive Officer

Yes. As I mentioned in the past quarters, by year-end, I think we will be in a position to develop a model detailing BoeFly's contribution to ConnectOne from both its core business and the new verticals it is building. We are on track. By the fourth quarter or the first quarter of next year, we should outline BoeFly’s impact as an entity. Currently, overlaps exist, and we are in the testing phase for many products. I believe we will see clearer contributions from BoeFly as we progress through the year, and I remain optimistic about Mike Rozman and his team's efforts in developing a comprehensive financial services platform that rivals any bank.

Operator, Operator

At this time, we have reached the end of the question-and-answer session. I would now like to turn the floor back over to management for any closing remarks.

Frank Sorrentino, Chairman and Chief Executive Officer

Thank you for all those great questions. I appreciate everyone joining our second quarter conference call, and we look forward to speaking to you again. I hope everybody has a great summer, and thank you. We'll see you in the third quarter.

Operator, Operator

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation, and have a great day.