Earnings Call Transcript - CNOB Q3 2024

Siya Vansia, Chief Brand and Innovation Officer

Good morning, and welcome to today's conference call to review ConnectOne's results for the third quarter of 2024 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. I'd also like to caution you that we may make forward-looking statements during today's conference call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from expectations are detailed in our SEC filings. The forward-looking statements included in this conference call are only made as of the date of this call, and the company is not obligated to publicly update or revise them. In addition, certain terms used in this call are non-GAAP financial measures, reconciliations of which are provided in the company's earnings release and accompanying tables or schedules, which have been filed today on Form 8-K with the SEC and may also be accessed through the company's website. I will now turn the call over to Frank Sorrentino. Frank, please go ahead.

Frank Sorrentino, Chairman and Chief Executive Officer

Thank you, Siya, and we appreciate everyone joining us this morning. So throughout 2024, we remain committed to our strategic priorities, including supporting our clients, extending our competitive position, driving profitable growth, and investing in our valuable franchise. Before discussing our third quarter performance, I'd like to take a moment to review our recently announced merger agreement with First of Long Island Corporation. The prudently structured transaction brings together two strong complementary financial institutions that are well-positioned in their respective markets. Expected to close during the first half of 2025, we believe it's a compelling financially disciplined transaction that creates meaningful synergies and a significantly enhanced platform for continued growth. The feedback so far has been excellent. Since the announcement, I've personally heard from many clients, employees, and shareholders from both companies, and the response has been overwhelmingly positive. With the transaction, ConnectOne will increase to more than $14 billion in assets and $11 billion in loans and deposits. In addition, we'll have an improved balance sheet mix and expanded market reach. The transaction increases our pro forma market cap to $1.3 billion, placing us in a larger higher valuation peer group while also leveraging the benefits of economic and market tailwinds already expected for our liability-sensitive positioning. Like ConnectOne, First of Long Island is commercially focused with a highly compatible client-first culture and a strong credit track record. The teams are energized and we expect to have a smooth process with integration planning already well underway. This combination significantly enhances ConnectOne's presence on Long Island, a region we've been focusing on organically over the past few years. As a result of the merger, the combined franchise in Nassau and Suffolk Counties will immediately establish us as one of the top community banks on Long Island, furthering our position as a premier New York Metro community bank. In addition, the transaction is ripe with potential revenue synergies. There's minimal client overlap, and First of Long Island's client base in operating areas is likely to be a sizable source of new business opportunities, both spread and fee-based. Some of those areas will include additional products and services, including residential mortgage origination and SBA lending, deeper commercial lending expertise which will round out their C&I relationships and offer robust treasury solutions to enhance commercial deposits. Finally, just like at ConnectOne, there are numerous opportunities to leverage geographical synergies between our Southeast Florida team and First of Long Island's clients who have a presence in Florida. Next, turning to our 2024 third quarter operating performance, we remain laser-focused and committed to our client-first culture and relationship banking model. As we previously reported, we've been actively reducing our non-relationship loans from our balance sheet during the first nine months of 2024, and these efforts have served to improve our loan-to-deposit ratio and lower our CRE concentration. As such, there was a slight reduction in our portfolio this quarter, which doesn't tell the whole story. Loan originations remain solid, and we continue to build a steady and diversified loan pipeline. Going forward, we expect loan growth may be relatively muted, slightly up or slightly down during the next two quarters, and beyond that, we see a return to mid- to high single-digit growth. Meanwhile, we continue to grow our core deposits through both existing and new client relationships. Average client deposits since the second quarter were up by approximately $130 million, or 8% on an annualized basis, partially offset by a decline in average broker deposits of $60 million and non-interest-bearing DDA continues trending upward. At the same time, third quarter net interest margin on a core basis was flat. However, we ended the quarter with a spot margin wider, upwards of 10 basis points wider as a result of the Fed's 50 basis point cut in September. Bill will provide some more detail on our current margin expansion in a few minutes. We're highly confident that ConnectOne is well positioned to drive increased profitability through the fourth quarter and into 2025 post-merger completion. Turning to credit, coming off the transition away from a zero loss environment, the industry is starting to see isolated instances of credit impairment. At ConnectOne, we fared well, reflecting solid and consistent underwriting standards while also maintaining a proactive approach to portfolio management and selective credit resolutions. This lending and credit philosophy has served us very well. With that as a strategic overview, I'm going to turn the call over to Bill. Bill, take it away.

Bill Burns, Senior Executive Vice President and Chief Financial Officer

All right. Thanks, Frank. Good morning to everyone on the call. So I'm going to start right in there with the net interest margin. I will try to give you some color, both through the third quarter and where we are today and post the Fed's first rate cut. On a reporting or GAAP basis, the margin did compress slightly during the third quarter from the sequential second quarter. However, on a core basis, the margin was actually up slightly. The GAAP to core adjustments for the sequential quarter comparison include higher average cash in the third quarter, which took the margin down by 3 basis points this quarter. In the second quarter, we had unusually high prepayment fees and non-accrual interest income which captured the margin up by about 4 basis points in that second quarter. So taking those two items into account, we calculate our core margin is up slightly from quarter two after being up 2 basis points from quarter one and 3 basis points from the fourth quarter of 2023. So the margin has been expanding at a modest clip over the past three quarters. And going forward, we are now seeing more meaningful margin widening as the Fed has begun its interest rate cuts. The spot net interest margin as of today is up approximately 10 basis points, putting our projected fourth quarter margin at about 280 basis points. Now let me dive a little deeper into our margin projections. As of today, the spot cost of our total deposits is nearly 20 basis points lower than it was during the third quarter. That resulted from a 40 basis point lowering of rates on nearly $3.7 billion of non-maturity interest-bearing deposits, which is about 50% of our total deposit base. On the asset side, we have a much lower amount that's repricing immediately, just 19% of our loan book or $1.5 billion is pure floating rate, which we priced downward immediately by 50 basis points late in the third quarter. So if you do the math on just those two items, it calculates out to about nine basis point margin improvement as of today. But that's not all. We have several other items working to our advantage, namely continued growth in core deposits with non-interest-bearing demand growing since the end of the third quarter. CDs will continue to be renewed at lower rates over time, with approximately $200 million maturing each month. The rates on CDs returning over the next 12 months averaged 4.75%. So you could expect about a 50 basis point improvement on that. Additionally, we have some $1.5 billion of adjustable-rate commercial loans, which most commonly reset at five-year intervals, and they will reprice upward over the next couple of years. Finally, the spread between newly originated loans recently being booked at rates above 7% and maybe 7.50% is about 100 basis points more of the loans coming off. The impact so far has been less significant than it could be, but that's going to grow as loan originations increase. Other than that, I'm going to refrain from specific guidance for 2025. We've got a lot of tailwinds out here which are helping, but I want to be cautious especially in light of uncertain Fed cut timing, as well as competitive pressures that could slow down our deposit betas in a decreasing rate environment. Now, I want to comment a little further on the transaction with First of Long Island. We've all seen a lot of mergers, but this one, in my opinion, is as compelling as they come. It checks all the boxes: pricing discipline, acceleration of our strategy, and it's a great cultural fit. To add to some of Frank's previous comments, the First of Long Island balance sheet is highly complementary, accelerating the positive trends ConnectOne has been realizing over the past couple of years. This transaction lowers our CRE composition by five percentage points and lowers our loan-to-deposit ratio by five percentage points. It improves our non-interest-bearing deposit composition also by five percentage points from 17% to 22%. Our allowance for credit loss percentage will be strengthened. We are at 1.02 today, and that ratio jumps to 1.33 on a pro forma basis. This higher loan loss ratio combined with First of Long Island's well-known strong asset quality creates an enviable credit reserve position. Like ConnectOne, First of Long Island is also poised to benefit from lower short-term rates, resulting in no change to our forecast of widening net interest margin. In addition, First of Long Island's 35-plus branch retail network will enhance our ability to drive additional revenue opportunities, particularly in residential and SBA lending. Lastly, I want to mention that the interest rate mark of 6.5% when we announced the deal is likely to improve to lower market rates today, with the passage of time. Right now, we estimate a one percentage point drop in that rate mark. Now turning back to ConnectOne on a stand-alone basis. I just want to comment on a few items. Core non-interest income and expenses are each expected to increase modestly in the fourth quarter and into early 2025. Our credit quality remains sound with the level of non-accrual loans and charge-offs fluctuating but remaining within our expectations. We had a modest uptick in non-accrual loans; one loan was paid off while two were placed on non-accrual, but both of those are secured and appropriately valued. Criticized and classified totals increased to 2.2% of total loans, largely a result of loan modifications related to special mention. Those loans are well secured and on a path to full restoration. Before turning it back to Frank, I want to emphasize that our capital CRE concentration and loan deposit ratios have been trending in a positive direction over the past year. These favorable trends are expected to continue pre-merger and then accelerate post-closing. So, Frank, back to you now.

Frank Sorrentino, Chairman and Chief Executive Officer

Thanks, Bill. To wrap things up, our earnings profile remains solid, our balance sheet and credit are in a good place, and we remain focused on our relationship-driven business model. We look forward to the transaction with First of Long Island, the growth opportunities related to that expansion, and ongoing market opportunities that drive organic growth. Our combined efforts all contribute to building ConnectOne Bank into a highly valuable franchise that's well-positioned to take advantage of our expanded market opportunities, driving sustainable go-forward growth. I want to thank you again for joining us today. And now we'd be happy to respond to any questions.

Operator, Operator

Thank you. The floor is now open for questions. Great. Our first question comes from Matt Breese with Stephens Inc. Your line is now open.

Matt Breese, Analyst

Hey, good morning.

Frank Sorrentino, Chairman and Chief Executive Officer

Hi Matt.

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Hey Matt.

Matt Breese, Analyst

Frank, just wanted to clarify you discussed loan growth being a bit muted here near-term before accelerating back to a mid-single-digit, high-single-digit pace. Can you just clarify around timing? Is it more muted for another two, three quarters? Or is it expected to be longer than that?

Frank Sorrentino, Chairman and Chief Executive Officer

No, I think there's a couple of things that go into that. One, I think as you've seen across the banking sector, the economy is a little bit on the slow side relative to loan growth. C&I generation is sort of slow, although it is beginning to come back to life, CRE originations are definitely down in a lot of different areas. We are seeing some increases in places like construction and some of the owner-occupied areas. And we are because of our internal efforts, in conjunction with that, being a bit disciplined about renewals for non-relationship type clients. So, while we have a pretty strong pipeline and we see it growing over time, we're also offsetting that somewhat by some of the non-relationships rather that we're trying to work out of the company. I don't think that goes beyond another quarter or maybe two. I'm not even sure if it goes out that far. I do see signs of a pickup both organically because of ConnectOne's efforts, but also because of the combined efforts with First of Long Island. So, I would expect certainly by the second quarter of 2025 that we would again regain our more normalized growth path. It could come sooner. I could be wrong. A lot of it depends on how quickly payoffs come in and how quickly loans close and what the balances are at closing date. But maybe I'm being a little bit conservative here pushing out two quarters but probably for the next quarter or so I would say could be slightly up, slightly down.

Matt Breese, Analyst

Okay. And then Bill, just turning to the NIM, I would just love to hear your thoughts and expectations around loan and deposit betas, if we follow the Fed's dot plot, and whether or not you expect those figures to be fairly similar to what they were on the up cycle?

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Yeah. Our betas were a little bit higher on the upside cycle. So it just gives us more room to keep those betas high on the way down. As I think I mentioned in the call, 80% beta for the first shift. Going forward, I forgot you get a question on that. It could range anywhere from 60 to 100 beta on the next cut, okay? So I'm sticking with the 80% of beta for now.

Matt Breese, Analyst

Okay. And then last one for me. With the deal, there was talk of I think it was a $100 million subordinated debt raise. Could you just update us on whether this remains intact, timing expectations on pricing, and whether or not this kind of remains the chosen course of capital just given how expensive update has been recently? Thank you.

Bill Burns, Senior Executive Vice President and Chief Financial Officer

The expectation is to complete that transaction a little before closing, ideally in the first quarter of next year. We have a $75 million subordinated debt repricing scheduled, likely in June or July. We will probably combine these for a $175 million offering at that time. Currently, the rates are between $850,000 and $875,000, and we hope they will decrease. Regardless, I believe we will stick to those levels as planned.

Matt Breese, Analyst

Okay. I appreciate all that. I'll leave it there. Thank you.

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Yeah. Thanks, Matt.

Operator, Operator

All right. Great. Thank you. The next question comes from Dan Tamayo with Raymond James. Your line is now open.

Dan Tamayo, Analyst

Thank you. Good morning, everybody. Yes, maybe first just a clarification. I know you guys mentioned the spot interest margin was up 10 basis points. Can you just give us a sense of what that was? I'm not sure if you were saying up from prior three months or from the third quarter average.

Bill Burns, Senior Executive Vice President and Chief Financial Officer

From the third quarter average, there's typically some fluctuation in non-core items, but I’m confident in the spot margin and the performance of other factors, which suggests we could reach $280 million for the third quarter. This figure assumes one more cut for the fourth quarter.

Dan Tamayo, Analyst

Okay. So $277 million end of the third quarter you're saying $280 million in the fourth quarter with one more cut so it seems like?

Bill Burns, Senior Executive Vice President and Chief Financial Officer

There are several factors working in our favor, especially with more CDs repricing. A variety of elements are influencing the margin. When I consider all these aspects together, we project a figure of $280 million. This might be slightly lower or potentially higher.

Dan Tamayo, Analyst

Okay. Thank you. And I guess a related question in the third quarter, it looks like loan yields were actually down a little bit. Just curious what drove that given that it...

Bill Burns, Senior Executive Vice President and Chief Financial Officer

It wasn't really based on a coupon, but rather due to a significant non-accrual interest recapture, which contributed substantially to that aspect. The reduction of 50 basis points also lowered loan yields at the end of the quarter. I believe I mentioned during the call that currently, there's a 20 basis point decrease in deposit costs and a 10 basis point decrease in loans from that cut.

Dan Tamayo, Analyst

Okay. All right. That's helpful. Thanks. And then finally just moving over to credit. So just looking at the criticized loans, doing some back-of-the-envelope math, it looks like that number was up a decent amount in the third quarter. I wonder if you could provide any color on the drivers of that number.

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Yes. We just did some loan modifications that put the loans into special mention, which is the best of the classified criticized categories. Those loans are in our view are a better position and will be restored in due course.

Dan Tamayo, Analyst

And these were I think you mentioned a CRE loan, I think relative to a year ago in the release. How much of that move was that one loan?

Bill Burns, Senior Executive Vice President and Chief Financial Officer

I don't recall, Dan. In this release or in the prior release?

Dan Tamayo, Analyst

This release. You said increases primarily due to a loan modification of one CRE relationship that was special.

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Yes, that's what I'm talking about. It was one relationship with many loans.

Dan Tamayo, Analyst

Understood. Okay. So that was really the big driver on a quarter-to-quarter basis as well?

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Yes. But I guess as I said the loans are valued appropriately on our books.

Dan Tamayo, Analyst

Got it. Okay. All right. Thank you for all the color. I’ll step back. Appreciate it.

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Thanks, Dan.

Operator, Operator

The next question comes from the line of Frank Schiraldi with Piper Sandler. Your line is now open.

Frank Schiraldi, Analyst

Good morning.

Frank Sorrentino, Chairman and Chief Executive Officer

Good morning, Frank.

Frank Schiraldi, Analyst

Just on the margin, Bill. I'm curious if that $280 million still assumes kind of similar liquidity levels to what we saw in 3Q?

Bill Burns, Senior Executive Vice President and Chief Financial Officer

We're going to pick up a couple of basis points because we've already begun to reduce some of that liquidity. So some of that is in there. I can't predict exactly what the margin is going to be but we'll probably pick up a couple of basis points from reduced liquidity. That's in my $280 million projection. As I said before, it could be a little bit higher or a tiny bit lower.

Frank Schiraldi, Analyst

Sure. The 80% beta you mentioned is based on the fact that the net interest margin has likely bottomed out, even in a stable rate environment, and with the anticipated rate cut, we still expect an immediate benefit of five basis points.

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Yes. We're still good with that. We try to be as precise as we can. It's like four or five basis points on that. But the margin when we look at it on a core basis has been trending upward by a couple of basis points each quarter. So yes, kind of flat in a way, but I'm willing to tell you that it's been with even without cuts, our margins are going up slightly.

Frank Schiraldi, Analyst

Got you. And then just on the expenses, you mentioned moderately higher in the fourth quarter. Any sort of guardrails you can put around that? Do you think you can hold it in sort of that $38 million range in the near term?

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Could be a 1% to 2% increase sequentially.

Frank Schiraldi, Analyst

Okay. Great. And lastly, regarding the First of Long Island deal, it reduces the loan-to-deposit ratio slightly, which means there is less pressure or urgency to decrease it further. It appears that you are operating within your ideal or acceptable range. Would you say there is less emphasis on lowering that in the near term?

Bill Burns, Senior Executive Vice President and Chief Financial Officer

Well, no, I was going to say that I think this transaction with all the benefits on the balance sheet gives us more flexibility to opportunistically capitalize on growth opportunities in the marketplace in the second half of next year. So, we're in a much better position than we were before the transaction from a balance sheet perspective.

Frank Schiraldi, Analyst

Okay. Yes. I mean...

Frank Sorrentino, Chairman and Chief Executive Officer

It also gives us the capability to rely more on the core deposit base, which offers a better pricing dynamic, and reduce our reliance on brokered funds or borrowings. This provides us with the ability to continue to grow our lending balance sheet, which we've never felt constrained in before. It feels better with a lower loan-to-deposit ratio.

Frank Schiraldi, Analyst

Okay. All right. Great. I appreciate it.

Operator, Operator

Our next question comes from Tim Switzer with KBW. Your line is now open.

Tim Switzer, Analyst

Good morning. Thanks. I wanted to ask, is there any opportunity with the FLIC merger and your strong capital and the subordinated debt rates to maybe do a little bit of securities restructuring, particularly with the FLIC portfolio that would be taking on at fair value, and what's the potential earnings upside you guys see there?

Bill Burns, Senior Executive Vice President and Chief Financial Officer

There certainly is some potential after their balance is marked to do restructuring. I don't think it's necessary to make our numbers, but the extent that it improves any of our ratios it provides additional capacity to grow. That's something that we consider. So we're in a good position and that portfolio is going to be marked to market both in terms of securities and loans.

Tim Switzer, Analyst

Okay. That makes sense. And I want to ask both ways. What's kind of the long-term growth outlook and revenue potential here? Any updates you can provide? Like does that improve at all with rates moving lower? Is there any opportunity to kind of leverage the FLIC merger as well in some of their customer base in the new market?

Frank Sorrentino, Chairman and Chief Executive Officer

I think the answer to that is yes on all counts. Lower rates obviously promote more business start-ups which is the business that BoeFly is really in. We've actually seen a decent uptick recently in the last quarter or so on franchisors that are utilizing the platform for BoeFly. The pull-through business that winds up in the SBA portfolio will be dramatically improved by the branch network that's available at First of Long Island and the fact that they do not do any or virtually no SBA lending. So I think there are a lot of great opportunities.

Tim Switzer, Analyst

That’s great. I appreciate it. Thanks for taking my question.

Operator, Operator

At this time, there are no further questions. I would like to turn the call back over to the management team for closing remarks.

Frank Sorrentino, Chairman and Chief Executive Officer

Well, thank you. I'd like to thank everyone for their time today. And of course thank you for all the questions. We look forward to speaking with you again during our year-end conference call in early '25. So with that, have a great day.

Operator, Operator

This concludes today's conference call. You may now disconnect.