Earnings Call Transcript - CNOB Q3 2020

Operator, Operator

Greetings and welcome to the ConnectOne Bancorp Incorporated Third Quarter 2020 Earnings call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Siya Vansia. Thank you, Siya. You may begin.

Siya Vansia, Host

Good morning, and welcome to today's conference call to review ConnectOne's results for the third quarter of 2020 and to update you on recent developments. On today's conference call will be Frank Sorrentino, Chairman and Chief Executive Officer; and Bill Burns, Executive Vice President and Chief Financial Officer. The results, as well as the notice of this conference call being available 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 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 the 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 the 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 at ir.connectonebank.com. Each listener is encouraged to review these reconciliations provided in the earnings release, together with all other information provided in the release. I will now turn the call over to Frank Sorrentino. Frank, please go ahead.

Frank Sorrentino, CEO

Thank you, Siya, and good morning, everybody. I'd like to start this morning with a summary of our recent financial results and also update you on some of our key initiatives. We delivered another strong quarter highlighted by a wider net interest margin and a lower provision for loan losses. Pre-tax pre-provision earnings were $37.6 million for the quarter, up slightly from the second quarter and up 24% from last year. As a percentage of assets, pre-provision net revenue reached 2% this quarter. Our net interest margin widened by five basis points sequentially to 3.49%, reflecting our well-positioned balance sheet and we continue to add to our reserves for the pandemic at a much lower level than the previous two quarters. We added $5 million to reserves this quarter versus $31 million in total for the past two quarters. Our reserves increased to 1.19% of loans, but on an adjusted basis, that number is over 1.3%. And Bill will give you some further details regarding our reserves in a few minutes. As you know, we have historically delivered superior growth in tangible book value. In the past quarter alone, we increased tangible book value per share by another 3.6% to $16.87. Overall, I'm very proud of our third quarter performance and the continued outstanding execution on our operating objectives. We feel strongly about the strength and direction of our company as we continue to navigate through this changing and challenging environment. Along with our proven response to the pandemic, we remain well-positioned and prepared to get back to our organic growth model. On the lending side, similar to industry trends, we experienced slight contraction in loan balances during the third quarter as payoffs surpassed loan originations. A good portion of the decline in our loan portfolio occurred in the construction segment, reflecting the natural and healthy life cycle for that business line, as well as delays related to COVID. We're seeing that trend improve as our current loan pipeline is robust. We therefore expect to return to net loan growth over the next few quarters. I want to make it clear we are well-positioned to grow as the overall economic landscape becomes more favorable. Our teams are actively engaged with our clients. We're seeing demand across our markets at spreads that are currently very attractive. And we, of course, remain diligent and prudent in assessing and underwriting any new loans. Our strong operating earnings have boosted our capital ratios, giving us the flexibility and strength to both withstand the crisis and be positioned to grow our balance sheet. We also continue to focus on creating operational efficiencies while reducing our brick-and-mortar footprint. During the quarter, we closed two branches in New Jersey, in addition to the seven retail locations closed in connection with the BKJ acquisition earlier this year. Earlier this week, we announced an agreement to sell two additional leased branch offices in Orange County, New York. So we remain one of the most efficient banks in the industry and even in a challenging operating environment, we've demonstrated the ability to continue to improve our efficiency, which is a testament to our operating model. We continue to utilize technology to optimize our operations, digitize our experiences, and position ourselves for the future state of banking. This is not a new trend for ConnectOne as we already have a great team in place that is successfully executing our operating model. We're continuously making investments in infrastructure, communication tools, and digital channels. Most recently, we furthered our digital investment in nCino by actively participating in its integration with the construction software company, Built. Built's product enhances and digitizes the management of the construction loan portfolio. We are proud to be the first bank to roll out this integration and believe partnerships like these represent the future of banking technology. We're also nearing the end of our infrastructure rebuild of our BoeFly subsidiary, an online business marketplace that connects small businesses, largely franchisees with a wide network of financial lenders across the U.S. to deliver fee income to us with no credit risk to the bank. This initiative will further enhance the foundation BoeFly has successfully executed on while simultaneously providing enhanced capabilities to increase new users and drive revenues. Turning to credit, we have continued to see a consistent downward trajectory in the level of loan deferrals, which started out as approximately $1 billion representing more than 15% of our total loans and is now projected to decline to 3% to 4% of total loans by the end of the year. As we have reported previously, we have very little exposure to those hot-button industries such as airlines, transportation, energy, and hospitality. And of the remaining loans on deferral, more than 90% are well-secured. Before I turn the call over to Bill, I want to mention that our board of directors just declared our $0.09 per share common dividend along with today's earnings release. And as you know, we have suspended our share repurchases. With our growing capital base, we're positioned to resume that program, hopefully in the not too distant future. And with that, I'll turn it over to Bill for some more details on the quarter's performance.

Bill Burns, CFO

Okay. Thank you, Frank, and good morning, everyone. So we're very pleased with the operating results this quarter. And I'm going to expand upon some of the metrics Frank spoke to. We had another great quarter with pre-provision net revenue as a percent of assets reaching 2%. That places us near the top of the industry and amongst a handful of banks. Our provision for loan losses was down from the previous two quarters; it was still slightly elevated from a historical perspective at $5 million; we usually run in the $1 million to $2 million range for provision. But even with that higher provision, our quarterly GAAP return on assets was in excess of 1.3%. Return on tangible common equity was about 15%. Those are great metrics, even in the normal operating environment. So these best-in-class metrics are typical for us. And going forward, we believe our branch-light technology-focused, super-efficient operating model combined with our strong asset origination platform and our well-positioned balance sheet will deliver superior returns and strong tangible book growth even during the pandemic. And from a credit perspective, we are very comfortable with where we stand. Our reserves have doubled from one year ago to $74 million. Our non-performing assets (NPAs) are essentially flat; we had a decent-sized recovery in the quarter, and delinquency trends are stable. In addition, our capital ratios have reached near all-time highs, even in the face of that part cash bank New Jersey acquisition that closed in the first quarter and the recent significant reserve build. Our tangible common equity ratio at the holding company is now above 9%, leverage of the bank is above 10%, and total risk-based capital is above 13%. And with our strong operating earnings, we have the flexibility in future quarters to increase reserves without tipping into capital or diluting book value. So we are in a great position from a capital perspective, and we're prepared to remain opportunistic on the M&A front, both traditional and FinTech, grow organically when it's prudent to do so. And when we see the light at the end of the tunnel, we'll be positioned to resume stock purchases and potentially increase our cash dividend. Let me just go back to our operating performance to give you some more color. Our net interest margin widened once again by five basis points on a GAAP basis and by eight basis points when you exclude purchase accounting adjustments. The reasons for this increase: first off, we reduced some of our excess cash liquidity by paying off maturing borrowings; and second, our interest-bearing deposit cost improved by 17 basis points sequentially, reflecting even lower rates on non-money market non-maturity deposits, as well as the benefit of CDs rolling over. Now partially offsetting those positives were our loan yields declined in the quarter, but only by eight basis points. That included a slowdown in the accretion of the PPP fees as the expected forgiveness timetable has been extended. We still have about $8 million to go on income-earning provision there, and we are accreting at a pace that takes us to the middle of next year. And then also, we issued $75 million in sub debt at the end of the second quarter, and that contracted the margin by a few basis points in this third quarter. Likely to keep in mind, we do have an additional $50 million of variable-rate sub debt that's still outstanding. We expect to call that early next year, and that will serve to widen the margin when it is called. So going forward, I still anticipate favorable near-term trends with regards to the margin and relative stability even in the longer term. But we are not completely immune to the challenging low-rate environment that can negatively impact our industry. It was also a strong quarter for non-interest income. We executed on some commercial loan sales, resulting in a total gain on sales loans of $600,000. I have been mentioning that in prior calls for everyone to expect this. And going forward, we may have more from time to time, but it's not necessarily every quarter. Our Bank-Owned Life Insurance (BOLI) was a little elevated for the quarter. On the expense side, those were slightly higher as well. The salary and benefits line increased mostly due to compensation accruals, some of which were related to the PPP program. And for our PPP program expenses, we did not capitalize any expenses there. In occupancy, there were a couple of one-time items. So going forward, especially in light of the recently announced branch closures, we expect that line to decline. Still, even with the higher expenses, our efficiency ratio improved to an impressive 40% for the quarter. As for the two branch sales we announced earlier this week, we didn't disclose a lot about it because it's only small, but these branches were already part of our consolidation plan. And in this particular case, it made sense from a financial perspective to get a slight premium and to get out of those leases. Strategically, as Frank mentioned earlier, it fits right in with our operating philosophy. Let me talk a little bit now about deferrals and reserve levels. Our reserves as a percentage of loans have increased to 1.19, that's up 11 basis points sequentially. Excluding the PPP loans, adds another 10 basis points to that ratio and purchase accounting non-accretable discount, which will be added on to CECL another eight. So on a comparable basis, I'd say the reserve was more like 1.37% versus 0.75% when we reported year-end 2019 so that's a large reserve build. We talked about deferrals; that initial level of total deferrals has come down industry-wide, and the same is true here at ConnectOne. We're estimating that by year-end, we'll have $200 million to $250 million in total deferrals. That equates to about 3% to 4% of total loans, and that range could vary, but not by too much. And of that total, 90-plus-percent is well-collateralized. So we feel very comfortable when you compare those numbers to the 30-plus million in extra reserves we've already recorded. Keep in mind that so far reserve levels are based on models and assumptions, and the industry works its way out of all of the deferrals; the reserves will be based at some point, I'm not going through the charge-offs, but we are not there yet. So far, things are looking good, but there remain uncertainties related to the length and depth of the pandemic, government-imposed controls, and overall economic conditions. So before we go back to Frank and get into Q&A, I wanted to comment on our effective tax rate, which was higher; that's typical for us. So with the strong pre-tax operating earnings, our percentage of tax-free income and lead effectiveness has declined a little. As always, we work with our tax advisors to minimize our tax rates; the trend is going to be a little higher, probably in the 22% to 23% range for core earnings and about 20% for this full year 2020, which includes the elevated provisioning. And with that, I'm going to turn it back over to Frank.

Frank Sorrentino, CEO

Well, thank you, Bill. As you can see, we're very pleased with our third quarter performance. Our balance sheet remains strong and I'm exceptionally proud of our team and their continued resiliency. In closing, while many insights on this, there are tremendous opportunities for banks like ConnectOne in the current environment. ConnectOne has had a long-standing track record of success from making smart moves, hiring and attracting good people, gaining new clients, investing in technology, successfully executing on a variety of M&A; and you may recall that some of our best growth was on the heels of the 2008 financial crisis. Because of our agility and the way we're put together, ConnectOne has not only weathered this recent storm, but we're poised to take advantage of attractive growth opportunities, and we're already beginning to see signs of that. We're excited about our future and remain confident in our ability to drive value for our shareholders, our team, and our clients. With that, I'd be happy to take any questions. Operator?

Operator, Operator

Thank you. We will now begin a question-and-answer session. Our first question comes from Collyn Gilbert with KBW. Please go ahead with your question.

Collyn Gilbert, Analyst

Maybe if we could start with asset yields. You guys have been able to hold those much higher than your peers and higher than I certainly would have anticipated. Can you just talk about that? I mean, it's great. But I think the fear in the back of my mind or others, perhaps is like what the downward pressure is on that. So maybe just talk about the dynamic and what you're seeing in terms of new loan origination yields and how you see that trending?

Bill Burns, CFO

Right. It's a combination of things—how we're structured and also new origination yield. So the structure of our assets is a little bit longer duration and we have less pure floating than most other banks. And then in our adjustable-rate loans, we have a lot of floors in place that we've already hit. So we're just structured to do better in a floating-rate environment. And then I have to tell you, in terms of loans going back on the books, they're going on pretty close to the yields in the portfolio. So the downward pressure of new loans that are going on is very, very small. So things are looking good. Going forward, it's possible, yes, in the next year or two that as adjustable-rate loans hit their term, there could be some pressure there, but I also think that we're getting good spreads on new loans. So it could be potentially some pressure on the margin, but I don't see it being drastic, and I see a good outlook for the next few quarters, and then fairly stable margin is my projection.

Collyn Gilbert, Analyst

So even though that’s a longer duration, you’re not seeing refinance risk in the books? Or is it that the way they’re structured makes the penalties too significant for some borrowers to refinance into a lower structure?

Bill Burns, CFO

Yes. If they do pay up, there are prepayment penalties for some of those. So while this doesn't directly answer your question, the overall structure does not suggest a sharp decline in rates. It has been falling, with an eight basis point decrease this quarter, but that’s not significant, especially considering our ability to reduce deposit costs. We have many CDs maturing in the next few quarters, which provides us with that ability. I would say there is still upward pressure and momentum on the margin, but there are various factors like liquidity and PPP that could have the opposite effect. Overall, I am optimistic for the upcoming quarters and believe the margin will remain stable after that.

Collyn Gilbert, Analyst

Okay. Okay. And then shifting to loan growth. Frank, you had indicated the pipeline is strong, maybe looking to see net loan growth over the next few quarters. Can you just tighten that up a bit? I mean, I know it's hard to gauge what pay downs are going to be, but kind of as you see growth rates in 2021 normalizing to kind of what level do you think?

Frank Sorrentino, CEO

Collyn, that's a hard question to answer. Certainly, we're starting at a deficit. We definitely saw in the last two quarters shrinkage in the balance sheet because of payoffs, not so much because of originations. Our originations were actually pretty strong, but we did see a higher rate of payoffs. Now some of those payoffs, as I described, were just naturally occurring payoffs in our construction portfolio and other types of loans. Some of them were refinances, people who did take advantage of lower rates, and we've chosen not to match those rates. So it's really going to be hard to tell if the payoffs are going to continue with the same pace, which would mute the loan growth going into next year or are we going to be able to pick up the pace of that growth to overcome that, or did the payoffs slow down a bit and so we get even more or additional growth. So a lot of it's going to depend on what happens in the competitive environment, the rate environment. And I don't think it's going to be a function of our ability to keep our pipeline full and generate new loan requests, I think it's really going to be all focused on what happens on the pay downs and payoffs.

Collyn Gilbert, Analyst

Okay. Okay. That's helpful. And then just on the deferrals. Can you just talk about some of the dynamics there and what you're seeing within that book that's giving you the confidence to think that you could drop it to $200 million to $250 million by the end of the year?

Bill Burns, CFO

Well, that's based on the schedule for the deferrals coming off, and so that's basically what it is. I know people have a number at a point in time, but it's hard to say if the deferral runs out next week, and it's going back on invoicing a week from now, should that be part of the deferral number or not. So I think it's better — we did give out information as of the 15th of September. I think it's better to look forward a couple of months and give an estimate, and that's why we did it that way. But that's based on the contractual aspects of the initial deferrals. That's what those numbers are based on.

Collyn Gilbert, Analyst

Okay. In terms of the behavior you've observed so far and regarding those who have already completed their initial process and then requested second attempts or modifications, what trends are you noticing in the changes that have had to be made regarding the payment structure?

Frank Sorrentino, CEO

Yes. Oh, Collyn, I think we've seen a pretty healthy percentage of deferrals in the second round than potentially a third round, if there is one, not total deferral. So maybe it's just deferral of principal or partial deferral. So, I think the trends are good. I think we're moving in the right direction relative to the entire deferral portfolio. There are competitive pressures out there. I know that sounds ridiculous, but a lot of our colleagues in the banking industry are giving deferrals a little bit easier than we would normally choose to do so. We are being a little bit tougher with some of our clients, demanding a lot of financial information in order to make that decision, especially about a second-round deferral. But a lot of this is going to depend on what really happens with the state of the economy and other government action. Everyone's sort of caught up in this first and second round deferral, but I mean, look around the globe, if we're going to be facing any sort of additional shutdown, which I don't predict, but if that were to happen, we could see that number actually begin to increase. We don't see that trend occurring today, but I just want to put that on the table that some of this is outside of our control.

Bill Burns, CFO

And I also just want to emphasize that what we're seeing in the deferral portfolio and what was coming off, we're not really seeing stress coming from that. It's more that there is uncertainty about what's going to happen in the future that's leading us to the excess reserve levels we're taking. There's nothing within that deferred portfolio, very little, where we say, oh, look, here's a problem right here. That's really not going on. So I said in my comments so far everything looks good; the reserves are based on probabilities and assumptions, and we're just going to have — the whole industry is going to have to see what happens. I think that's a fair statement.

Operator, Operator

Thank you. Our next question comes from Matt Breese with Stephens Inc. Please go ahead with your question.

Matt Breese, Analyst

Just going back to the margin. Bill, could you frame for us—you still have quite a bit of higher cost CDs and higher cost borrowings, what the maturity schedule on those two items looks like over the next quarter, over the next year? And then maybe provide a little bit of more specific core NIM guidance where do you think it could peak out in the near term, in the next year?

Bill Burns, CFO

We've got about — on the CDs, specifically we've got about $300 million that's coming due over the next year. And those rates are 2% plus — oh, $300 million per—sorry, $300 million per quarter. So there's a lot of benefit coming from that.

Matt Breese, Analyst

Right. Do you have the same stats on the borrowing's book?

Bill Burns, CFO

It's smaller. But we still have—as those borrowings come due, obviously, we're going to get a benefit from that as well.

Matt Breese, Analyst

Okay. And you mentioned you expect near-term NIM expansion and then stabilization. Could you just give us an idea of where that plateau mark could be?

Bill Burns, CFO

Yes. I — it would be hard for us to give you exact numbers. Look, I think we could still, if we have a floor in the 335 to 340 range in the margin, that's still going to, going forward with growth, that's going to drive very high return on tangible common equities. And I'm giving you just the bottom of that. It all depends on the shape of the yield curve and our ability to grow assets and what spreads are going to be. Okay. It's really hard to give you a projection like that. I just want to add on—Collyn had asked about the asset yields holding in, and that was a benefit for the margin. We talked about the ability to lower deposit rates, which we were aggressive in doing, and that helped. But also, there were a lot of other banks that did that. It might have been prudent for them to extend liabilities and extend the durations, and they locked in 2% funding or 3% funding for three to seven years at the time, it seemed really good. We didn't do any of that. We felt the rates were staying low, and we didn't need to go out long. And we felt if rates ever rose, we would be able to offset that with higher asset yields as we're a fairly—where we grow faster than most other banks. So what was right for us turned out to work out better in this environment.

Matt Breese, Analyst

Understood. Okay. And then turning to expenses, just want to understand the components a little bit better there. It sounds like a lot of the increase in occupancy was one time.

Bill Burns, CFO

Right.

Matt Breese, Analyst

Increase in salaries and benefits, though; how much of that is subject to change due to the PPP stuff? And what do you have in mind for quarterly expenses in the next couple of quarters?

Bill Burns, CFO

Yes. I think about — on the salary and benefit line about flat going to next quarter; it's possible it could be down a little bit. And the occupancy line, you can see just sort of jumped up, again, one-time items. And we have some more expenses coming from the branch closures.

Matt Breese, Analyst

Okay. My last question, Frank or Bill, either one of you, just wanted to get a sense for how you feel about the overall Metro New York City economy; there's a ton of bad press out there. And it seems like it's mostly tied to Midtown. But I want to get your sense for activity in the overall geography? And then as you talk to your customers, what does the health of the borrower look like, and how is there a P&L across all the various asset classes that you deal with?

Frank Sorrentino, CEO

I mean, Matt; I think New York is an interesting place right now. Certainly, if you would have been there the last week or two of August, you would have called it a ghost town. That's just not what it is today; life is returning. The ability for restaurants now to monopolize the sidewalks in the streets has really turned most of New York into a big bazaar. People are out, people are shopping, stores are reopening, and there's more and more people coming back to the city to work in their offices; we're seeing evidence of that every single day. So the direction is a good one. With all that being said, I don't think we're going back to where we came from necessarily; it will be different. But I do believe there will be some reset relative to some of the valuations clearly. A lot of the net lease arrangements for restaurants and small stores and in the retail segment are not going back to where they came from. But that was a trend that was occurring before COVID; this just accelerated that entire trend. But you'd be surprised I was talking to a pretty large restaurant group last week, and they're pretty excited about the opportunities that are now being presented to them to have superior locations at leases that they can actually not only afford but they think they can make money even in this environment. So I think there's big fish starting to become a more upbeat mood about what the possibilities and opportunities are in New York City. And I think I said a few things about that in my own comments about that I think we're well poised to take advantage of some of those opportunities as they move forward. So just like the old adage, don't believe anything you hear and only believe half of what you read. It's going to be important for you to pick which half.

Operator, Operator

Thank you. There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

Frank Sorrentino, CEO

Well, thank you. Thank you for the questions. And thank you all that joined us today on our third quarter conference call. We certainly look forward to speaking to you again at our next quarterly call. So thank you and enjoy.

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.