Earnings Call Transcript - CNOB Q2 2020

Operator, Operator

Good day and welcome to the ConnectOne Bancorp Inc. Second Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask a question. Please note this event is being recorded. I would now like to turn the conference over to Ms. Siya Vansia, with ConnectOne. Please go ahead.

Siya Vansia, Director of Investor Relations

Good morning, and welcome to today's conference call to review ConnectOne's results for the second 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 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 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 those 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, everyone, and thank you for joining us on our conference call today. I hope you and your families have all been safe and healthy. We at ConnectOne had a good second quarter. And I'm proud of how ConnectOne has responded to the current challenges the industry is facing in this uncertain economy. Looking at some of the key quarterly metrics for ConnectOne. We continue to generate very strong earnings, delivering earnings of $0.30 per share, which included $15 million of reserves predominantly due to the uncertainty regarding the pandemic. The strength of our organization continues to be demonstrated by our strong pre-tax net operating revenue, which was in excess of 1.95% of total average assets, placing us among the strongest in the industry. We also delivered on an improved net interest margin this quarter, resulting in sequential net interest income growth of 10% and over 30% on a year-over-year basis. While many other banks are experiencing margin contraction and in some cases significant compression, we continue to demonstrate the ability to drive exceptionally strong organic earnings power. In regard to provisioning, we're essentially matching our reserves from the first quarter. We now have close to $28 million in reserves for issues related to the pandemic should they arise, bringing our total reserves for loans to approximately 1.08%. Bill will have a little bit more to say about the provision in the reserves a little later on in this presentation. Despite the large reserve build, we still managed to grow our tangible book value per share to $16.28. Overall, we continue to navigate through the pandemic in a solid forward-looking fashion, which is a testament to the resilience of our team and our relationship banking model. Operationally, we've adopted a comprehensive return-to-work strategy with a heavy focus on leveraging our technology, including reopening our offices with enhanced contactless solutions. While we're taking gradual steps to return to normalcy, we've also learned through this pandemic how to best serve our clients, whether that's in person or through our digital channels. And in turn, our clients have shown less reliance on our physical locations. The investments we've made in financial technology and in our infrastructure over the past few years has played a critical role in competitively positioning ConnectOne's virtual hybrid bank model, while the environment that COVID created has accelerated the transition to our digital banking products for many of our clients. Additionally, as we move into the future state of banking in the digital world, we're excited to further leverage our strong technological foundation to take advantage of new opportunities. Most recently, we partnered with nCino to launch a virtual portal to digitize the Paycheck Protection Program forgiveness process, which is now available to our borrowers under the program. As you know, we were an active participant in the SBA's Paycheck Protection Program, funding over $470 million of loans. I'm very proud of our team for quickly responding to our clients' needs, especially in this time of crisis. And while some banks consider these loans as giving up economics, our Paycheck Protection Program loans are generally done with existing clients. And we believe it's a service necessary to provide in order to ensure the continuity of our clients' businesses. Bill will touch a little bit on the economic impacts of that program momentarily. On another front, FinTech subsidiary BoeFly also performed very well, providing a new channel for lending in the Paycheck Protection Program. Separately, from ConnectOne, they processed over $400 million in loans to over 15 banks, and we believe their growing momentum will extend beyond the Paycheck Protection Program as skills learned will be applied to pursuing additional opportunities in the future. Also, BoeFly generally has done best in times of higher-than-normal unemployment when folks who are laid off decide to start a business. We expect to see a pickup in business there once stabilization begins with the COVID pandemic. We also worked with some of our borrowers by helping them through challenges that have resulted from the pandemic. As of June 30, we had approximately $930 million in deferments. However, since the end of the second quarter, there have been virtually no first-time deferment requests from borrowers. We expect that more than 50% of the deferments will return to original terms in the third quarter. Many segments and geographic regions of the U.S. economy are experiencing stress. And I'd be remiss by not stating that as the pandemic crisis persists, there still remains the potential for increased levels of impaired loans across all segments of the portfolio. However, ConnectOne has very low exposure to the hot-button industries, such as transportation, energy, and hospitality. Our portfolio is underwritten with low loan-to-value ratios and reasonable capitalization rates. Additionally, overall COVID-19 trends have vastly improved in the Northeast since the onset of the pandemic earlier this year. Multifamily rent collections in the New Jersey market are tracking at approximately 95%. Restaurants in our market have been doing pretty well in this transition. Home sales in our suburban markets in some cases are at near all-time highs. And our construction portfolio is performing very well with projects moving to completion. Since our inception, ConnectOne has developed its expertise in commercial real estate and is committed to having a well-diversified loan portfolio. While overall loans are down slightly this quarter as a result of our conservative stance given the current environment, we're constantly looking at where we can get the best rate of return relative to the risks that we take in our company. We take great pride in our team's focus on expanding client relationships. I'm pleased to note that total average deposits for the second quarter increased by $240 million, which is nearly 20% on an annualized basis. We've always been committed to being good stewards of our shareholders' capital resources, conservative in our financial commitments, and continue to return capital to shareholders through quarterly dividends. This approach has served us well. And in that regard, the Board just declared our $0.09 per share common dividend along with today's earnings release. While we expect a relatively flat balance sheet for the remainder of 2020, depending on the duration of this pandemic, we believe our balance sheet remains well positioned. We have sound growing capital levels, and our position was further strengthened with the recent completion of a $75 million subordinated debt offering. A significant portion of that offering, upwards of $50 million, is intended to pay off existing subordinated debt. So switching gears and taking a look at our acquisition of Bancorp of New Jersey. The final phase of our integration conversion was completed virtually on May 4 with no delays. The transition has been seamless. As we previously mentioned, we closed eight branches during the quarter. We also continue to evaluate all of our brick-and-mortar strategy and plan to close an additional four locations later this year. As we rationalize our physical footprint, we believe that ConnectOne's performance, especially our operating efficiency will reflect the benefits of this initiative. In conclusion, we are diligently executing on our priorities and continue to use our full range of banking expertise to support our clients. I'm pleased with our second quarter results and the underlying fundamentals of the company. And with that, as a strategic update, I'd like to now turn the call over to Bill to provide some more details on this quarter's performance. Bill?

Bill Burns, CFO

Okay. Thank you, Frank. And good morning, everyone. So we had another great quarter on an operating basis. Our pre-provision net operating revenue was up significantly on a sequential basis. We reached $37.5 million this quarter versus $32.6 million in the first quarter. That's an increase of $5 million. As a percentage of assets, that amounts to 1.95% for the quarter, as that metric continues to be in the upper end of our peer group ranging from 1.75% to 2% consistently over the past five quarters. The primary reason for the exceptionally strong performance this quarter was a $5 million increase in net interest income. Most of that, about $4 million of the $5 million, was driven by PPP loans on our balance sheet; and the remaining $1 million in positive variance being due to higher net interest margin. The PPP fees are running through interest income over a nine-month period on average. That creates a current yield on that portfolio in the low 5% range. Our core margin is performing stronger than most. So I'll review with you again color on that. You may remember, we did anticipate a widening margin in our last earnings call three months ago. First off, we have a relatively small percentage of loans that re-price immediately, about $1 billion of $6 billion loan portfolio. Of that $1 billion, virtually all have built-in floors. So although the average loan yields did decline, the decline was less than it was for most other banks, resulting in far less NIM pressure on the asset side of the balance sheet. Next, even before the pandemic, we were anticipating a stable lower interest rate environment, and we had shifted our wholesale funding towards shorter-term structures. With the Fed's actions in the first quarter, those positions re-priced immediately and significantly. Finally, we've been aggressive in reducing deposit rates, probably leading the pack while still retaining and growing our core deposit base. It is true that in the quarter the NIM benefitted from the PPP, by upwards of 10 basis points. But the NIM also contracted by 10 basis points due to excess liquidity. So our margin was strong on a core basis. Frankly, any way you want to look at the NIM, we were strong. Looking forward for the net interest margin, we have some moving parts. As is usually the case, let me tell you what I can. First, the PPP will continue to help for a couple of quarters then will trail off concurrent with the loan forgiveness timeline. Our excess liquidity, we've already been working that down. Removing that drag will improve margin immediately. We still have some room for lower deposit rates, especially as CDs continue to run off. Over the next six months, 40% of the CD portfolio will mature, carrying a weighted average rate right now of 2.20%. We'll have a choice when those mature, whether we want to be competitive or let some of those CDs run off. Now, offsetting those positive margin items is the recent subordinated debt offering. That’s going to compress NIM by about five basis points in the third quarter, although that will come down to just two basis point compression once we pay off $50 million of subordinated debt that's outstanding. We'll do that either later this year or early next year. Finally, I want to add, there may be a bias towards lower loan origination rates versus the average yield on the portfolio which would compress the margin. All in all, I predict a relatively stable, if not slightly improving margin for the rest of 2020. I want to make a couple of comments about BoeFly because there were a couple of items that impacted noninterest income and expense. First, we recorded $2.3 million in PPP referral fees. These were for loans referred by BoeFly to and originated by other banks. Next, offsetting that income in the quarter, we are accruing an advertisement to the valuation of the BoeFly acquisition due to all the PPP volume ConnectOne had, and that resulted in recognizing a similar $2.3 million expense offsetting the fees. Let's turn now to credit and reserves. Our provision for loan losses was elevated due to qualitative factors, namely an increase in the projected duration of the pandemic. We believe the $15 million total provision for the quarter is conservative, especially when we consider the positive trends in deferred loans. When it comes to reserves, we'd much rather be ahead of the curve versus playing catch-up. I want to expand a bit on what Frank said about deferments, that more than 50% are coming off deferral. That's based on loans that have been reviewed so far. That number is likely to get even better as all the deferment terms run their course. Our reserves as a percentage of loans have increased to 1.08% on a GAAP basis. If you were to exclude the PPP loans, which have a 0% risk weighting, and add back the purchase accounting discount, that ratio increases to approximately 1.25%. The reserve ratio was only 0.75% at year-end 2019. So we've had growth in both reserves and capital during the quarter, improving our fortress even further to go along with ongoing strong net operating revenue to successfully withstand any prolonged crisis. Our bank leverage ratio stands at a healthy 10.1%. Just a couple of comments on expense growth and efficiency. Expense growth, I expect, will continue to be moderate, as we have more Bank of New Jersey expense savings coming. We are closing four more branches later this year. Having said that, there will likely be more back office expense associated with managing the deferments and processing PPP forgiveness, as well as, as always, continued investment in technology and infrastructure. As far as the efficiency ratio goes, look, without our typical revenue growth, it will be challenging to improve where we are at the 41% or 42% level. I feel confident that we can at the worst stay at that level. I'll turn it back over to Frank for closing comments, and then we'll have some questions.

Frank Sorrentino, CEO

Great. Thank you, Bill. So while we've all seen the improvement in reports on businesses reopening, the nation and the banking industry still face considerable uncertainty about how long this pandemic will persist. The longer it persists, the more pressure there is on borrowers, and the higher the expectations may become for loans to become impaired. Nonetheless, we remain disciplined and steadfast in our belief that our experienced management team, strong balance sheet and risk controls will help us successfully navigate this operating environment. We're confident that together, we'll all get through this. When we come out on the other side, ConnectOne will get back to executing on prudent growth trends and producing strong metrics as we've always focused on in the past. Now with that, we're happy to take your questions. Operator?

Operator, Operator

Thank you. We will now begin the question-and-answer session. The first question today comes from Matthew Breese of Piper Jaffray. Please go ahead.

Matthew Breese, Analyst

Good morning.

Frank Sorrentino, CEO

Good morning, Matt.

Bill Burns, CFO

Good morning.

Matthew Breese, Analyst

Hey, Bill, there's a lot of pluses and minuses to the NIM outlook. If we were to just say longer-term, a year out or 18 months out, once we put behind us the deployment of liquidity, PPP, the sub-debt raise, lower deposit costs, where do you think the settling point in this environment for the core NIM is?

Bill Burns, CFO

Well, like I said before, it's flat to up through this year. And then going into next year, it's going to depend on whether the economy is back, what the shape of the yield curve is, and how steep it is; where spreads are. So it's really hard for me to predict. But I think we'll be starting off at a good place.

Matthew Breese, Analyst

Okay. And then, you had some very encouraging data points and deferrals coming due in the cure rate. In the case of those loans that aren't curing and therefore need another 90 days or whatever you're providing, could you just talk about that book, what is it comprised of most typically and some of the underwriting characteristics in terms of LTVs or debt service coverage? Just want to get a sense for the stuff that needs additional help, what your protection against loss content looks like.

Bill Burns, CFO

Yes. Well, the majority of it is collateralized loans that were underwritten with good loan-to-value ratios. We feel we have a lot of cushion in those. Look, if there is a loss in those, I don't think it can be much. There's a small portion in commercial and industrial. We've stayed away from high-risk industries. There are strong borrower guarantees. At the end of the day, there's probably just a small portion in that bucket.

Matthew Breese, Analyst

My last question is about the strong fees from BoeFly that came with an expense. Will the acquisition adjustment continue for a while, or will it eventually decrease? If BoeFly keeps performing well, can more of that impact the bottom line? How does that work?

Bill Burns, CFO

Yes, yes, yes. They drop more to the bottom line. There could be a little bit more adjustment, but it's very small. The success will not be hurt materially by any adjustments to the acquisition price.

Matthew Breese, Analyst

Okay. And just following the fee income discussion, so this quarter I view as more it was one time because of PPP. Should we expect fee income to trend back to that $2.5 million, $2.7 million kind of core run rate in the coming quarters?

Bill Burns, CFO

It may be somewhat lower from BoeFly due to economic cuts and reduced activity. However, we remain confident that BoeFly, through the PPP program, has enhanced distribution channels. Overall, this is a positive development. The fees generated from the PPP and the optimistic future outlook are slightly tempered by lower fees from their regular business during the crisis.

Matthew Breese, Analyst

Okay. Just last one really quick. The tax rate is coming in at about 14.5% the first two quarters of the year. Where do you expect that to be for the back half of the year and then in 2021?

Bill Burns, CFO

Well, it depends on the level of pre-tax income. So it gets impacted by what the level of provisioning is. Should the level of provisioning go lower, we're going to get back up to the 20% range. If it stays at this level, it'll sort of be consistent with what it was this quarter.

Matthew Breese, Analyst

Understood, okay. Thanks. That's all I had.

Bill Burns, CFO

Okay. Thanks, Matthew.

Operator, Operator

The next question comes from Chris O'Connell of KBW. Please go ahead.

Chris O'Connell, Analyst

Hi. Good morning. This is Chris, filling in for Collyn.

Bill Burns, CFO

Hi, Chris.

Chris O'Connell, Analyst

I would like to begin by discussing the expenses. I appreciate the guidance and efficiency. Are the four additional branches beyond the original cost-saving plans for the acquisition?

Bill Burns, CFO

Yes. That is separate from the acquisition. So it's additional savings.

Chris O'Connell, Analyst

Do you have an idea of the timing of that or the plans for the timing in the back half of the year?

Bill Burns, CFO

By the end of the year.

Chris O'Connell, Analyst

Any idea if it's going to be more weighted for the savings coming in the third quarter or the fourth quarter?

Bill Burns, CFO

No. The accounting has changed over the years. But you're right, there'll be more in the third quarter that will accrue to the bottom line.

Chris O'Connell, Analyst

Got it. Okay, great. And then, as for your mention of starting to reduce the excess liquidity levels?

Bill Burns, CFO

Right.

Chris O'Connell, Analyst

To our understanding is that the non-interest-bearing deposits are coming down as well as customers utilize the PPP funds?

Bill Burns, CFO

No. It's not the non-interest-bearing balances. Those have remained pretty constant. That's really good news, because they went up with the PPP program. Even as the PPP funds are being used, our non-interest-bearing demand balances are staying higher. That's good news for profitability and the margin. In terms of liquidity coming off, we have the PPP borrowings. We'll save 35 to 40 basis points on the liability side. If you're trying to calculate this, we're getting nine basis points and we're paying 35 basis points on it. So there's a negative spread. Okay. That helps.

Chris O'Connell, Analyst

Do you see the cash over the next two to three quarters coming back down to kind of that $135 million?

Bill Burns, CFO

I was going to say $150 million, but $135 million is fine too.

Chris O'Connell, Analyst

Okay, great. And how are you guys assuming the trajectory for the PPP loan forgiveness?

Bill Burns, CFO

We are estimating on average a nine-month timeframe. We reassess on October 1 for the fourth quarter. Right now, we're amortizing it over a nine-month life which results in a yield on the portfolio in the low fives.

Chris O'Connell, Analyst

Great, and just last question. I know it hasn't been an issue in a while, but as for the remaining taxi portfolio?

Bill Burns, CFO

Right.

Chris O'Connell, Analyst

Has anything changed with the pandemic? And how you guys are looking at that portfolio?

Bill Burns, CFO

Quantitatively, we have it valued at $150,000 a medallion. We understand there's some pressure on it now. We just don't know for sure. The valuation is based on the long-term outlook, and not necessarily the short-term of the pandemic. That's where we are right now, and not much else to say there. Any qualitative thoughts Frank, on the prospect of the industry?

Frank Sorrentino, CEO

Yeah. I mean, it's just hard to determine what's ultimately going to happen there. The city is really operating at 20% or 30% of its ultimate capacity, in all forms of business there. All forms of transportation in the city are negatively impacted right now. The transportation network companies are down 70% or so. Guys are afraid to drive. The unemployment benefits are impacting, people not going to drive. They'd rather stay home and collect their $600. Until this pandemic sort of makes its way through, it's going to be hard to determine what's happening. One of the encouraging things that we have seen in the last two weeks though is the number of taxicabs that are getting onto the road are beginning to increase at a fairly steady pace. We're certainly going to keep our eyes on that and keep well positioned to follow the trends there. But I think it's a little too early to make any determinations.

Chris O'Connell, Analyst

Got it. Understood. I appreciate the color. Thanks.

Frank Sorrentino, CEO

Okay. Thank you. Chris.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to management for any closing remarks.

Frank Sorrentino, CEO

Yes. Thank you. Thanks for the questions. We really appreciate everyone taking the time in joining us on our second quarter conference call. We certainly look forward to speaking with you again at our next call. Thank you everyone, and enjoy the rest of the summer.

Operator, Operator

Conference is now concluded. Thank you for attending today's presentation. You may now disconnect.