Earnings Call Transcript - CNOB Q1 2022

Siya Vansia, Vice President of Marketing

Good morning, and welcome to today's conference call to review ConnectOne's results for the first 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. These 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 that 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 also be 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, CEO

Thank you, Siya, and good morning, everyone. We appreciate you joining us today. We are very pleased to report another strong quarter, delivering solid financial performance, significant organic balance sheet growth, and strong performance metrics here at ConnectOne. While Bill will discuss our financial highlights in some more detail, I would like to highlight that our PPNR as a percentage of assets again exceeded 2% for the seventh consecutive quarter. Return on assets was again above 1.5%, and our return on tangible equity was greater than 15%, all while our efficiency ratio remained below 40%. Our tangible book value per share was up again this quarter, increasing by 2% since the beginning of the year, and that's in an interest rate environment where others have experienced significant dilution from a reduction in the fair value of the securities portfolios. However, these impressive financial results really don't tell the whole story of what we are building here at ConnectOne. So first, we continue to invest in and strengthen our origination franchise. By leveraging our strong franchise and client-centric culture, we are gaining new clients, as well as hiring experienced bankers from revenue generators to tech talent. We are a destination of choice for some of the best business-generating talent in the industry, and a lot of that is stemming from the marketplace disruption created by M&A. We’ve also taken proactive measures to retain our top talent with attractive compensation packages. So as we sit here today, we clearly see those efforts have enhanced an already solid team and are paying dividends with yet another quarter of annualized sequential growth in loans, exceeding 10% and nearly 15% growth in deposits. Secondly, our pipeline remains near historic levels with strong demand and favorable pricing characteristics across all business lines in our markets. An important part of this success is attributable to expanding our presence and proactively following our clients into new and growing markets. As you know, we recently hired a great team to lead our Florida office. And already at this early stage, we are seeing very promising results. Traction is exceeding our initial expectations. And the factors that made it successful in the New York metropolitan area translate very well to the growing Florida market, and our culture with a client-based focus is a clear differentiator. We’ve already originated approximately $150 million in new commercial loans, some from our existing ConnectOne clients with business opportunities in Florida and some from new clients based in Florida. Deal structures and opportunities are both favorable and in line with the lending to which we have extensive experience and expertise. So, with that, let's move on to some other initiatives ConnectOne has been focused on. We are continuing to successfully adopt and expand our utilization of technology to remain competitive, create efficiencies, and provide real-time solutions. This includes improvements to internal workflows to support our hybrid work environment and support scale, along with our investments to enhance our data infrastructure, including digital initiatives that also enhance risk management tools and processes. Look over at BoeFly, even as the number of our franchisor brands on that platform increased, we are turning our efforts towards automated underwriting to improve functionality for the franchisor and franchisee and ultimately increase the profitability of the core business line. These continued investments ultimately allow BoeFly to build for scale. We are continuously improving the client experience while also achieving greater efficiency and revenue generation for that platform. We are also creating additional opportunities beyond the SBA vertical with the loyal client base that BoeFly has built. Shifting gears, as you may have seen, ConnectOne became an early member bank in the USDF Consortium, which is an association of U.S. banks with a mission to build the network to further the adoption of the USDF, which is a tokenized deposit. This is an early step in employing blockchain within the regulatory perimeter in order to offer enhanced solutions for our commercial banking clients. We are also happy to announce that we recently signed an agreement with Nymbus, a leading fintech company, to provide cloud-based banking and core services. Working in partnership with Nymbus, we will be building a niche-focused offering, providing us a new avenue to collect deposits. We are set to kick this project off in the near future, and we will share more details as we progress. Supporting our industry-leading efficiency ratio is our ability to leverage technology and streamline internal processes. A great example of this, you've heard me discuss before, is our partnership with nCino, which has been instrumental in this regard. We partnered with nCino in 2017 when our total asset size was just $4 billion to help deploy a single cloud-based platform throughout the organization and business lines. And today, we've more than doubled in size, yet we've been able to create efficiencies as we continue to build scale. So we look forward to sharing our progress in the quarters ahead. In summary, this has been an exciting time at ConnectOne. We are well-positioned. Our capital position remains strong, and we continue to internally generate capital to support growth. As you saw in our press release this morning, the Board of Directors today announced another increase to our common dividend, an increase of nearly 20%. Also, we continue to be opportunistic with share repurchases, having about $2 million in authorized capacity at the present time. So, with that, I will turn it over to Bill to give us a little more depth and some color on our results.

Bill Burns, CFO

Thank you, Frank. Good morning, everyone. There is a lot of excitement and optimism at ConnectOne. Frank mentioned our focus on accelerating organic growth while embracing technology and making investments across various areas. Despite the increased investment and related expenses, we continue to deliver strong financial metrics consistently. For the fourth consecutive quarter, our PPNR as a percent of average assets exceeded 2.15. Our return on tangible common equity was above 15%, without any reserve releases. The efficiency ratio for the quarter improved to 38.7%, down from just above 40% in the same quarter last year. Our net interest income saw a slight contraction of 4 basis points but remained above 3.70, close to historic highs for ConnectOne. Tangible book value per share rose by 2%. The increase in our tangible book value during a time when most of the industry experienced declines was due to a cautious approach to securities investments during the pandemic's low-rate environment. We chose to stay out of the market and let securities run down, while effectively hedging most of the existing portfolio. This success is also attributed to robust organic loan growth that maintained good spreads, which supported our investment discipline and hedging strategies. I want to emphasize that all our securities are classified as available-for-sale, ensuring complete transparency without any hidden fair value adjustments. Overall, ConnectOne is performing well in a rising rate environment, maintaining a high NIM and continuing to enhance our per share book value. Now, turning to the income statement, net interest income was flat compared to the previous quarter, which I anticipated, but it rose significantly by 15% from the same quarter last year. Average loans for the quarter grew by 10% year-over-year, and the margin expanded by 15 basis points over the past year. Our net interest margin has been increasing throughout the pandemic and remains at or near historic highs. We continue to originate loans at favorable rates, and I believe spreads on the asset side are improving. Loan origination for the quarter had an average weighted rate of approximately 3.8%, and based on our pipeline, origination yields could exceed 4% in the second quarter, potentially reaching as high as 4.5%. Our dynamic modeling indicates asset sensitivity, and while I expect the margin to stay relatively flat for the remaining nine months of the year, I want to be cautious with our guidance as competition for deposits is intensifying. Regarding noninterest income, this line was lower than I anticipated, primarily due to a valuation charge against the CRA fund we hold. Excluding that charge, the increase in interest rates resulted in us falling about $300,000 to $400,000 short of expectations. BoeFly had a solid quarter, generating fees exceeding $400,000, and we've seen significant growth in franchisers using this platform. I can't guarantee exact outcomes, but the trend is definitely positive. Gains on sales of loans were down, attributed partly to residential and commercial declines. As I've previously mentioned, there will be some volatility in these gains. However, I expect this figure to increase from first quarter levels throughout the remainder of 2022. Additionally, we anticipate adding about $200,000 quarterly from further BOLI in the coming quarter. Turning to expenses, they grew by 4% sequentially, primarily due to increased compensation reflecting new hires, salary increases, wage inflation, and our efforts to add and retain our team. There are two special items that essentially offset each other: an extra earn-out charge for the BoeFly acquisition, balanced by a favorable lease termination that had previously been written off at a higher level as a merger charge related to the Bank of New Jersey deal. We have some remaining small future BoeFly expenses later this year, under $1 million, and that will conclude associated costs with the BoeFly earnout. Additionally, we reorganized the OpEx section of the financials to provide one line item for technology expenses, which should enhance transparency moving forward. Our operations and tech teams have done a commendable job with strategic investments in technology while also reducing the costs associated with core and legacy systems. Looking ahead, I expect to see quarterly expense growth in the 2% range, and I’ll provide an update after the second quarter. On the topic of CECL provisioning, many banks released reserves in the quarter while others increased modest amounts. We are in the latter group, adding a small $1.5 million, reflecting loan growth and minor qualitative adjustments to our CECL model based on a potential negative economic forecast. These are broader macro forecasts and not an indication of ConnectOne's credit quality. Our nonaccrual assets have decreased for the second consecutive quarter, with delinquency and charge-off rates remaining very low. Before I hand it back to Frank, I want to express our optimism for 2022. We anticipate strong loan growth with moderate pressure. We’re building noninterest income through SBA and CRE loan sales, and while expenses are increasing to support our growth, we aim to outpace expense growth with revenue growth. To conclude, given our earnings strength and solid capital position, we have significant financial flexibility. We have the capital to support double-digit organic growth alongside potential for continued dividend increases and share repurchases. While our primary focus is organic growth, we also remain open to exploring M&A opportunities, adhering to our disciplined financial approach. Now, I will turn it back to Frank.

Frank Sorrentino, CEO

Thank you, Bill. In closing, ConnectOne delivered strong performance for this first quarter. And more importantly, we expanded our market presence and continue to invest in top talent to support our clients as they expand in capability and in reach. We also launched several initiatives to extend the technological foundation we've built while also exploring new opportunities as we participate in shaping the future of Commercial Banking. As we move through the rest of 2022, I'd like to reiterate that we are projecting strong organically driven growth, which will be supported by the investments we’ve made in our talent and our technology infrastructure, and we expect our financial performance to remain among the best in the industry. We are excited about our future, and we look forward to updating you in the quarters ahead. And with that, I'd be happy to take your questions.

Operator, Operator

Thank you. The first question comes from the line of Matt Breese with Stephens. Please go ahead.

Matthew Breese, Analyst

Hey, Bill, I want to go back to your comments on new loan yields being in the 4%, 4.5% range. Are we essentially nearing the point of it being positive to the core portfolio? And then maybe along the same lines, could you just give us some color on commercial real estate, multifamily spreads? I've been hearing that there have been some spread compression through March, but it sounds like it's starting to reverse.

Bill Burns, CFO

Yes. True to all of that. We are seeing the point where the loan yields are adding to our portfolio. So that obviously helps us as rates are rising. And yes, spreads were very tight on multifamily. We are seeing some relief there. And so even on that, and the expectation is for higher yields. As you know, multifamily typically has lower spreads for the rest of the business. And depending on the mix of originations and what specs in terms of loan growth that can affect the total yield on our portfolio.

Matthew Breese, Analyst

Okay. And the other thing is, one thing that stands out is despite on paper, the balance sheet being relatively interest rate neutral, the loan-to-deposit ratio is on the fuller side. So, could you talk to me about the incremental funding sources and the ability to protect and maintain just an overall lower cost of funds? And maybe along those lines, were expectations for betas through the first 100 or 200 hikes?

Bill Burns, CFO

Yes. No, good question, a lot to the question there. It's a little bit of a moving target. Right now, deposit rates are starting to feel pressure. However, even though higher deposit rates are lower right now than our wholesale cost of funds. So, I typically use a very conservative approach when I look and analyze spreads using our highest wholesale cost of funds to calculate spreads. That’s usually based on the home loan bank. But we're picking up spread in that we can use deposits to fund more of the growth right now. I think that will work itself out, and we will get back to a normal place. But I hope I answered your question, but it's kind of a mix right now. Deposit rates are going up, but they're actually helping to add to the spreads.

Matthew Breese, Analyst

Got it. I mean maybe going down a different path, but getting to the same outcome. If we do get a plus 200 basis point of Fed hikes by the end of the year, could you provide some longer-term core net interest income guidance by the end of this year? I’m assuming the outlook is NIM flat, but what is NII going to actually do?

Bill Burns, CFO

Yes. Our models are showing like a 2% to 3% increase with a 200 basis point rate shock.

Matthew Breese, Analyst

Got it. Okay. And then, Frank, you mentioned …

Bill Burns, CFO

There are various perspectives on this issue. We've discussed it previously. Banks assess it in different ways; some use a static approach while others use dynamic. This makes it difficult to make direct comparisons. However, I am confident that we will be able to maintain our margins regardless of the situation. Our margins have not declined over the past year, which gives me assurance that we will achieve stable margins and consistent returns moving forward.

Matthew Breese, Analyst

Understood. Frank, you had mentioned Nymbus as a third-party that you were using. Their suite of products and services is pretty robust and includes core systems. Have you taken it that far and considered using them as a core system provider? And what do they offer versus the traditional big three on that regard?

Frank Sorrentino, CEO

So, how are you doing, Matt? I believe that Nymbus presents us with an opportunity to custom design a vertical for a new line of business where we will utilize their core offerings and their expertise in identifying the specific needs of a client niche and how to effectively approach that vertical. The goal here is primarily for deposit gathering, but there will also be some lending opportunities. I don’t think any of our current capabilities can match what we expect to achieve in collaboration with Nymbus. Therefore, I am quite confident that this will enable us to focus intensely on a specific client vertical.

Matthew Breese, Analyst

Over time, I mean, I forget who you use right now as a core provider. But over time, do you anticipate fully moving to Nymbus in that regard?

Frank Sorrentino, CEO

It's difficult to provide a clear answer, Matt. You might notice that the core landscape is changing quite significantly. It was once straightforward to point fingers at the top three players. That's not the case anymore. Even companies like FIS, Fiserv, and Jack Henry are adopting progressive approaches toward the future. What I observe is that previously, you needed to identify a core system and manage everything for your bank under one primary operating system. Today, that's no longer the case. When APIs were introduced, banks could begin utilizing various products and services alongside whichever core they were using. It's now common for banks to operate multiple cores. I believe this is the trend we will continue to see in the future.

Matthew Breese, Analyst

Interesting. Okay. Excited to see where you go with this. That's all I had. Thanks for taking my questions.

Frank Sorrentino, CEO

Right, Matt.

Bill Burns, CFO

Thanks, Matt.

Operator, Operator

Thank you. The next question comes from Michael Perito with KBW. Please go ahead.

Michael Perito, Analyst

Hey, everyone. Good morning.

Bill Burns, CFO

Hi.

Michael Perito, Analyst

I wanted to start with BoeFly. Bill, you mentioned it had a strong quarter. Could you provide an update on the product roadmap for that platform? In our previous discussions, there were talks about adding new features and potential fee income opportunities like interchange, cards, deposits, and similar options. I'm curious about your current thoughts on this. Additionally, could you share your outlook on how fee income growth might trend for that business for the remainder of the year?

Frank Sorrentino, CEO

I would begin by saying that our focus with BoeFly is on enhancing the client journey within the platform and understanding their goals in order to provide the necessary support with minimal friction. We are assessing what the core platform offers, specifically enabling franchisee applicants to secure financing efficiently and profitably for us. Currently, we are developing a comprehensive loan pipeline to assist anyone using BoeFly. While this is the foundation of our business, there are many additional avenues we can explore. For instance, we are addressing repeat clients seeking further funding, which may not involve the SBA program that initially established BoeFly's reputation. We are also looking at opportunities on the franchisor side. With a loyal client base, we can consider introducing various financial products and services, starting with payment processing capabilities. Our immediate priority is to finalize our loan product offering in an automated manner, aiming to reduce client friction and effectively outpace our competition in this market.

Michael Perito, Analyst

And do you have any sense of the timing of all that being rolled out and launched? And I mean, obviously, you don’t have to be too specific, but just can you give us some general indication of where you guys feel like those things are in the varying stages of rollout or exploration?

Frank Sorrentino, CEO

All the discussions regarding our lending products are currently taking place this year, and we are presently piloting some of the complete loan products. We are collaborating with technology vendors to finalize the entire process. By the end of this year, we will be able to explain how our entire loan pipeline functions for all the products offered by BoeFly. At the same time, we are developing other products. I expect that by year-end, we will have a clearer understanding of these offerings, their appearances, and our future plans. Our main goal is to streamline the loan pipeline and effectively showcase to the market what is coming through it, including the pull-through rate, the profitability of this business line, and its overall structure. I anticipate that we will be ready to discuss these details before the year ends.

Bill Burns, CFO

But Mike, this is Bill. I wanted to add that the volumes through BoeFly are increasing. When we acquired them, they had 30 franchisors in the market. Last time we spoke a few months ago, that number was 80 or 90. We are now well over 100. This is key to BoeFly's traditional income, which comes from referral fees for placing loans with other banks. The additional initiatives we are discussing will enhance that, including working with larger franchisees, engaging more with franchisors, and potentially handling the full underwriting process at ConnectOne, which we mostly do not do right now. I hope that's helpful.

Michael Perito, Analyst

It is. And we often you guys often talk about your profitability. And obviously, it's top quartile, very strong, and I think investors sometimes wonder like what could make it improve. Is it fair to say that BoeFly could be an area of possible improvement? I mean it sounds like you guys are investing pretty heavily today. I don’t know if you guys break out or are willing to break out kind of what the return metrics of that platform look like. But is it fair to say that it's probably from a net bottom line standpoint, not contributing as much as it could in future periods as some of these initiatives take hold that you're investing in to that?

Bill Burns, CFO

I think it will be significant in the future. Right now, there are a lot of revenues, but we are also building platform. So, we are probably at breakeven, even though that's $400,000 this quarter of revenue.

Michael Perito, Analyst

Great. I have one last question. Regarding loan growth, the pipeline looks strong. I assume you’re feeling confident about the upcoming quarters. However, as we look further ahead, the economic outlook can become uncertain and hard to predict. I'm interested in your overall perspective on long-term loan growth opportunities in your markets. Additionally, any feedback from commercial customers regarding their outlook, concerns, or positive sentiments would be appreciated. Thank you.

Frank Sorrentino, CEO

I believe there are two different narratives at play. While we are observing a cautious approach from individuals considering construction projects, purchasing commercial properties, starting businesses, or acquiring businesses, partly due to recession concerns, I don't believe things are significantly slowing down. People are being more considerate in their decisions. However, I hold the view that given the amount of money circulating in the economy, the current health of consumers, and the liquidity present on both business and personal balance sheets, the likelihood of a severe recession is minimal. We are likely heading towards a reset, which will result in a decrease in the inflation rate and a higher interest rate environment that will prompt different financial decisions. Nonetheless, all the markets we are involved in are experiencing robust M&A activity, leading to substantial disruption. We are capitalizing on this by attracting exceptional talent, allowing us to generate new business organically. This moment could represent one of the best opportunities for growth in our history. We are positioned in some of the strongest markets in the country, including New York, New Jersey, the greater New York metropolitan area, and Florida. Each of these regions is influenced by the M&A trends I mentioned earlier. Therefore, I am optimistic about navigating the natural economic slowdown and capturing a larger market share.

Michael Perito, Analyst

That’s really helpful color, Frank. Thank you both for taking my questions.

Frank Sorrentino, CEO

Thanks, Michael.

Bill Burns, CFO

Thanks, Michael.

Operator, Operator

Thank you. Ladies and gentlemen, we have reached the end of the question-and-answer session, and I would like to turn the call back to the management for closing remarks.

Frank Sorrentino, CEO

Well, thank you, everyone for joining us today for our first quarter report. We certainly look forward to coming back to you in future quarters and speaking about our results as we move through 2022. So again, thank you.

Operator, Operator

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.