Earnings Call Transcript - CPF Q2 2021

Operator, Operator

Welcome to the Central Pacific Financial Corp. Second Quarter 2021 Conference Call. This call is being recorded and will be available for replay shortly after its completion on the company’s website at www.cpb.bank. I’d like to turn the call over to Mr. David Morimoto, Chief Financial Officer. Please go ahead.

David Morimoto, CFO

Thank you, Andrew, and thank you all for joining us as we review the Financial Results for the Second Quarter of 2021 for Central Pacific Financial Corp. With me this morning are Paul Yonamine, Chairman and Chief Executive Officer; Catherine Ngo, President; Arnold Martines, Executive Vice President and Chief Banking Officer; and Anna Hu, Executive Vice President and Chief Credit Officer.

Paul Yonamine, CEO

Thank you, David, and good morning, everyone. As always, we appreciate your interest in Central Pacific Financial Corp. Let me start first with some positive updates on the Hawaii economic recovery. Visitor arrivals from the U.S. Mainland to Hawaii have returned much quicker than anticipated, a good sign for economic recovery. The daily arrival count has averaged about 30,000 per day since June, which is nearly at pre-pandemic levels. In early July, the state of Hawaii began allowing arriving passengers to skip pre-testing and quarantining with proof of full vaccination against COVID in the U.S. Although we are not immune to the spike caused by the Delta variant, Hawaii’s COVID infection rates continue to be at a very low level, with our infection rates currently at the lowest in the nation. Nearly 60% of our state population is fully vaccinated as of July 21, 2021. The state of Hawaii’s unemployment rate declined to 7.7% in the month of June and is forecasted by the University of Hawaii Economic Research Organization to decline to 4.8% in 2022. The housing market in Hawaii remains hot with the median single-family home price at $979,000 in the month of June. Our financial results for the second quarter were very strong, with quarterly pretax income reaching a new record high. With increased confidence in the Hawaii economic recovery and our continued solid asset quality, liquidity, and capital, we resumed share repurchases during the second quarter and continue to pay our quarterly cash dividend. Against this backdrop, we are very optimistic about our future business profit. Digital continues to be a key strategic priority for us. Enhancements to our online and mobile banking platforms are being made on a continual basis. Additionally, in the second quarter, we issued new contactless debit cards to all of our customers and increased mobile deposit adoption among our customer base. Further, online chat is now available and online appointment scheduling is coming soon to make banking easier and more convenient for our customers. We continue to work diligently on our product and service development in the digital area.

Catherine Ngo, President

Thank you, Paul. First, I’d like to provide an update on the credit area. We are pleased that our clients have weathered the challenges of the pandemic. Nearly all of the loans we granted COVID-related payment deferrals have returned to pay status. As of June 30, we have just $3.5 million in loans remaining on deferral, the majority of which are residential mortgages. Additionally, our classified assets declined during the quarter to $42 million, and our nonperforming assets remain near historic lows at just 9 basis points of assets. I’d also like to share some recent developments in the environmental, social, and governance or ESG area. In the second quarter, we were pleased to publish our first annual 2020 ESG report. A link can be found in our slide presentation. We continue to develop our ESG reporting and look forward to providing further updates in the future. CPB’s legacy in helping the small business community is one of the pillars of our ESG program and remains a key priority for us. Last week, we were pleased to announce a new program run by our CPB foundation called We, that is W-E By Rising Tide. This program supports women entrepreneurs as we believe they are key to building a strong and resilient economy. As part of this program, we selected our first cohort of 20 women entrepreneurs from 7 different business sectors that will participate in a 10-week series of workshops on financial management, marketing, and leadership and receive free advertising and networking benefits. Support of our employees is another focus of our ESG program. We believe that investing in our employees is critical to our success. During the second quarter, we had our annual merit increases and we made a few key strategic new hires. We also continue to prioritize the health and well-being of our employees and therefore, continue to allow flexible work schedules while developing our hybrid return-to-office plan. Finally, we are pleased that the second and final phase of our Central Pacific Plaza revitalization was completed last month. We expect smaller office projects to continue as we create collaborative, refreshed, and sustainable workplaces for our employees. We also continue to refresh our branches and evaluate our branch network to meet the changing needs of our customers. I’d like to now turn the call over to Arnold Martines, our Chief Banking Officer. Arnold?

Arnold Martines, Chief Banking Officer

David Morimoto, CFO

Thank you, Arnold. Net income for the second quarter was $18.7 million or $0.66 per diluted share. Return on average assets was 1.06% and return on average equity was 13.56%. Net interest income for the second quarter was $52.1 million, which increased from the prior quarter, primarily due to greater recognition of PPP fee income due to higher forgiveness. Net interest income included $7.9 million in PPP net interest income and net loan fees compared to $5.2 million in the prior quarter. At June 30, unearned net PPP fees were $15.9 million. Net interest margin decreased to 3.16% compared to 3.19% in the prior quarter. The net interest margin normalized for PPP was 2.93% compared to 3.12% in the previous quarter. The normalized NIM decrease was due to an acceleration of MBS premium amortization, excess balance sheet liquidity, and lower investment and loan yields. Investment MBS premium amortization increased by $900,000 sequentially due to an acceleration of prepayments in the second quarter. To mitigate the prepayment risk going forward, we executed a sovereign coupon MBS bond swap totaling $175 million. We continue to deploy excess liquidity to the loan and investment portfolios to further support our net interest margin. Second quarter other operating income remained relatively flat at $10.5 million. During the quarter, there was a decrease in mortgage banking income, which was offset by higher service charges and fees and bank-owned life insurance income. Other operating expenses for the second quarter were $41.4 million compared to $37.8 million in the prior quarter, with much of the increase in the salaries and benefits line. The current quarter increase in salaries and benefits was primarily due to $1.2 million in nonrecurring reductions in the prior quarter and $2.8 million in higher incentive compensation and commission accruals, strategic hires to drive forward performance, and annual merit increases. The efficiency ratio increased to 66.2% in the second quarter due to higher other operating expenses. We expect the efficiency ratio to moderate and improve over time as we drive positive operating leverage based on our strategic investments. Net charge-offs in the second quarter totaled $0.8 million, with the majority of charge-offs coming from the consumer loan portfolio. At June 30, our allowance for credit losses was $77.8 million or 1.68% of outstanding loans, excluding the PPP loans. In the second quarter, we recorded a $3.4 million credit to the provision for credit losses due to improvements in the economic forecast and our known portfolio. The effective tax rate was 23.9% in the second quarter and going forward, we expect the effective tax rate to be in the 24% to 26% range.

Paul Yonamine, CEO

Thank you, David. In summary, Central Pacific has a solid financial credit, liquidity, and capital position, and we continue to make positive forward progress on our core business strategy. Further, we remain committed to providing support to our employees, customers, and the community as we continue to progress through the economic recovery. On behalf of our management team and employees, thank you for your continued support and confidence in our organization. At this time, we’ll be happy to address any questions you may have. Thank you. Back to you, Andrew.

Operator, Operator

The first question comes from Andrew Liesch with Piper Sandler.

Andrew Liesch, Analyst

Just want to touch on loan growth here. It’s nice to see the strength in the quarter. How large was the consumer auto purchase?

Arnold Martines, Chief Banking Officer

Yes, Andrew, this is Arnold. So in the quarter, we did have an auto loan portfolio purchase of $36 million. In addition to that, as I mentioned in my earlier comments, we resumed both our in-flow for Hawaii and our Mainland on consumer.

Andrew Liesch, Analyst

Got it. So good organic growth even beyond that purchase. Okay. That’s good to know. And then, on the residential front, it looks like you guys retained more on the balance sheet and so then had a resulting decrease on the mortgage banking income. What’s the outlook or how is the pipeline for that business right now and what’s your plans right now as far as retaining more on the balance sheet versus selling? How should we be looking at portfolio growth versus gain on sale revenue?

Paul Yonamine, CEO

Yes. So, Andrew, on residential production for Q3, we’re looking at a $250 million to $260 million range. We feel pretty confident on residential production for the second half of the year. We have several big projects that are completing in the early fourth quarter, where that’s been a super-sized residential production. And then, to your question with regard to the mix between portfolioing and selling, in the near term, we’re portfolioing more of the loans just because we are doing really well with our PPP forgiveness process, and we’re getting a lot of resolving acceleration of fee income there. So we think that near-term is opportunistic for us to just go ahead and put more in the portfolio.

Andrew Liesch, Analyst

Got it. Okay. That’s really helpful. And of the remaining $435 million of PPP, any sense on timing on how long that’s going to stick around?

Paul Yonamine, CEO

Yes. So as of June 30, the PPP net loan fees were about $15.9 million. As far as forgiveness in Q3, we’re thinking we’re going to be in the $160 million range for forgiveness. So probably a few more quarters thereafter, Andrew for us to get the PPP loans off our balance sheet.

Operator, Operator

The next question comes from Jackie Bohlen with KBW.

Jackie Bohlen, Analyst

David, thank you for the color on the premium amortization and then the bond swap. That’s helpful. I’m just wondering what impact do you expect the swap itself to have on the forward yield within the margin?

David Morimoto, CFO

Yes. Yes, Jackie, the bonds that we purchased, the yields were in the 1.60% to 1.70% area. So really the intent of the purchase was to better manage forward prepayment risk with the sovereign coupon trade. So what we’re hoping for is the first quarter portfolio yield was closer to 1.90%. It dropped down to 1.55% due to the accelerated premium amortization. We’re hoping to get the yield back to the 1.65%, 1.70% area in the third quarter and going forward. So there is an opportunity to pick up about 5 basis points on the PPP normalized NIM if we’re successful in managing the investment portfolio.

Jackie Bohlen, Analyst

Okay. So the swap is effective immediately?

David Morimoto, CFO

Yes. It was done in July.

Jackie Bohlen, Analyst

I understand that some delays can occur, which is good to know. Thank you. Additionally, I see the points made regarding mortgages and leveraging some of the PPP liquidity to expand the portfolio. I'm curious about your strategy for deploying other cash. First, are you still experiencing a continuous influx of deposits, considering the remarkable growth over the past 1.5 years? Second, what are your plans for utilizing all those funds?

David Morimoto, CFO

I’ll begin, Jackie. Our primary focus is on funding loan growth. As Arnold noted, we have a solid pipeline and anticipate stronger growth in the second half of the year compared to the first half. We felt positive about the growth in the second quarter, but we expect things to pick up in the latter half of the year. This is our main priority. However, if we find ourselves with extra liquidity, we plan to continue expanding the investment portfolio. We are currently at about 20% of our assets, so there is still room for growth in that area.

Jackie Bohlen, Analyst

Would you consider increasing the Mainland portfolio a bit, given the fluctuating percentage of the Hawaii portfolio versus the Mainland portfolio, due to excess liquidity? Are you satisfied with the current state of the Mainland portfolio, or will you focus more on securities?

David Morimoto, CFO

Yes. I think what we’ve guided to, Jackie, is roughly 10% to 15% of the total portfolio to be comprised of Mainland. So we’re still in that range and that’s still the current thought process. But obviously, to the extent that we find ourselves with excess liquidity and there are better risk/reward opportunities on the mainland, I think it would be prudent for us to take a look at those.

Jackie Bohlen, Analyst

Okay. So I would guess then, is it fair to say that that balance and everything will largely depend on organic lending opportunities in Hawaii?

David Morimoto, CFO

That’s correct. Yes.

Operator, Operator

The next question comes from Laurie Hunsicker with Compass Point.

Laurie Hunsicker, Analyst

I just wanted to go back to Andrew’s question around auto. Can you help us think about the $36 million that you purchased, what is the split between Hawaii and the U.S., what’s the FICO? And then I think that’s bringing your auto book to about $300 million, but if you have an exact number there and then what the split there is between Hawaii and Mainland and then also what the FICO is running? And just how big potentially you would grow that both?

Paul Yonamine, CEO

Laurie, this is Paul. We might have to get back to you on some of those details. Arnold, do you have any color on that?

Arnold Martines, Chief Banking Officer

I can tell you, Laurie, that the Mainland economy recovered faster than Hawaii. As we began to restart our consumer programs, such as the consumer lending program, we started in the Mainland and are now quickly moving to resume the programs in Hawaii. My expectation is that the growth in consumer lending between Hawaii and the Mainland will normalize as we continue to restart the Hawaii consumer lending in the coming quarters.

Paul Yonamine, CEO

Just to add, you’re right. The total auto portfolio is just under $300 million, it’s $290 million and $210 million of that is in Hawaii and roughly $80 million is on the Mainland. All of those numbers were as of June 30.

Anna Hu, Chief Credit Officer

Actually, Laurie, this is Anna. For the Mainland portfolio, our weighted average FICO was 757.

Laurie Hunsicker, Analyst

Okay, great. And the new purchases you’re doing, are they right around the same FICO?

Anna Hu, Chief Credit Officer

Yes. About 750.

Laurie Hunsicker, Analyst

Okay, great. And then, I guess just generally thinking about how big you would potentially grow that book, any thoughts there so that’s around number 6% of loans but how big would you like to take that?

Arnold Martines, Chief Banking Officer

So, Laurie, this is Arnold. Currently, the Mainland consumer loan portfolio is approximately $213 million, representing about 4% of our total loan portfolio. It has a good mix of consumer, unsecured, and auto loans. Regarding growth, I believe the overall percentage for the Mainland versus Hawaii will fall within the 10% to 15% range, as David mentioned. I anticipate that we will experience more growth in Hawaii, as David noted, with less growth on the Mainland. I hope that clarifies things for you.

Laurie Hunsicker, Analyst

It does, and just to put you on the spot a little bit, I want to ensure you're not planning to purchase anything subprime. Is that correct?

Arnold Martines, Chief Banking Officer

That’s correct. Absolutely.

Laurie Hunsicker, Analyst

Okay, that's helpful. I love that you were a significant PPP lender, which I believe is accurate. As we look ahead to 2022, considering the $15.9 million of unamortized fees you've mentioned, I'm trying to piece everything together. It seems your net interest income run rate will be around $45 million to $46 million per quarter. Is that the correct assessment? This suggests your margin may drop to about 2.70% to 2.75%, even with some improvement. Am I on the right track, or am I missing something? Perhaps a better question would be if you could provide some insights regarding the margin for 2022.

David Morimoto, CFO

So, yes. So if I understand the question correctly, Laurie, I think what you’re seeing is once we get past PPP fee income, what do we expect on net interest income and net interest margin, correct?

Laurie Hunsicker, Analyst

Correct.

David Morimoto, CFO

Yes, we recognized that we were a significant PPP lender, which is obviously a positive aspect, and we are aware that we are gaining from this one-time fee income in 2021. Our goal is to leverage that fee income for strategic investments that will yield positive operating leverage in future periods, starting in 2022. We aim to offset that income as well. Therefore, our expectation for 2022 is that over time, not necessarily in the first quarter, we will see net interest income rise back to the $50 million level and not drop back down to $45 million.

Paul Yonamine, CEO

Yes, Laurie, this is Paul. As Arnold mentioned earlier, we're experiencing significant success in the purchase mortgage area. We anticipate mid- to high single-digit growth for the rest of 2021. With some portfolio adjustments and leveraging the PPP fee income this year, we believe that next year, along with the growth we expect for the remainder of this year and our track record of driving further growth, we will see an increase in net interest income in 2022.

Operator, Operator

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

Paul Yonamine, CEO

Thank you very much for participating in our earnings call for the second quarter of 2021. We look forward to future opportunities to update you on our progress. Thank you.

Operator, Operator

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.