Earnings Call Transcript - CPF Q3 2022

Operator, Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. And welcome to the Central Pacific Financial Corp. Third Quarter 2022 Conference Call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. 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, Senior Executive Vice President, Chief Financial Officer. Please go ahead, sir.

David Morimoto, CFO

Thank you, Dante, and thank you all for joining us as we review the financial results of the third quarter of 2022 for Central Pacific Financial Corp. With me this morning are Paul Yonamine, Chairman and Chief Executive Officer; Catherine Ngo, Executive Vice Chair; Arnold Martines, President & Chief Operating Officer; and Anna Hu, Executive Vice President and Chief Credit Officer. We have prepared a supplemental slide presentation that provides additional details on our release and is available in the Investor Relations section of our website at cpb.bank. During the course of today's call, management may make forward-looking statements; while we believe these statements are based on reasonable assumptions, they involve risks that may cause actual results to differ materially from those projected. For a complete discussion of the risks related to our forward-looking statements, please refer to Slide 2 of our presentation. And now I'll turn the call over to our Chairman and CEO, Paul Yonamine.

Paul Yonamine, CEO

Thank you, David, and good morning everyone. As always, we appreciate your interest in Central Pacific Financial Corp. I'll start this morning with an update on the Hawaii market, then turn it over to the team to share our strong third-quarter financial results, as well as other key updates. The Hawaii tourism sector continues to perform well even with the summer travel season completed; we are still seeing visitor arrivals at 90% or greater compared to pre-pandemic levels from 2019. The majority of those visitors are from the U.S. Mainland. International travel to Hawaii is starting to gradually pick up now that Japan has dropped travel restrictions and is fully open. The weak Yen thus presents some headwinds; despite that, we expect a recovery of Japanese visitors going into 2023 due to significant pent-up demand. This timely recovery will support Hawaii's overall economy, which could experience a moderate slowdown in other sectors in 2023. Visitor spending is strong, reaching $1.7 billion in August, an increase of 13.8% compared to the same month in 2019. Hotel performance continues to improve with total statewide hotel occupancy at 77% and an average daily rate of $380 in August. Hawaii's employment and housing sectors are solid as well. Our statewide, seasonally adjusted unemployment rate was at 4.1% in August 2022 and is forecasted by the University of Hawaii & Economic Research Organization to remain fairly stable in 2023. Housing prices in Hawaii remain very strong, with the Oahu Median single-family home price at $1.1 million in September 2022, which is up 5% from the previous year. Like the rest of the nation, we have seen some moderation in home sales activity due to the significant rise in interest rates resulting in less home buying power. With that said, the Hawaii housing market remains healthy, but strong demand and low inventory make it less likely to experience a material downturn. Compared to most other U.S. markets, during the great financial recession, the Hawaiian market performed better than most states. With our continued strength, we believe this will once again be the case. Now I'll turn it over to Arnold Martines, our President and Chief Operating Officer, to discuss our third-quarter results. Arnold?

Arnold Martines, President & COO

Thank you, Paul. In the third quarter, we continued to focus on strong quality and diversified asset growth. Our total loan portfolio increased by $121 million or 2.3% sequentially and 9% on an annualized basis. The growth was broad-based across most loan types, except for the C&I portfolio, which included decreases in PPP loans as that portfolio has almost completely run off. We were successful in continuing to grow our residential mortgage portfolio by $32 million during the quarter, given our strength in the purchase market and our strong relationships with real estate developers and builders. During the third quarter, we continued to execute on our Mainland diversification strategy by selectively participating in Mainland commercial, real estate, and C&I loan transactions, as well as purchasing select consumer unsecured portfolios from our established lending partners. In the Mainland Commercial market, we typically partner with larger mainland banks with whom we have relationships. We participate in transactions primarily on the West Coast, ensuring that we are lending in markets that we understand and are comfortable with, while maintaining our credit underwriting and concentration standards and limits. The consumer purchases during the quarter had a weighted average FICO score of 740. Our net growth in mainland consumer purchase loans was $44 million in the third quarter. As of September 30, our total mainland consumer purchase loan balances were approximately 8% of total loans, representing a mix of auto and unsecured consumer loans. We have a healthy loan pipeline and are working closely with our lending teams to ensure we manage future loan growth, given the current operating environment and economic outlook. In particular, we intend to reduce future mainland unsecured consumer loan purchases. On the deposit front, during the third quarter, we started to see some moderation in our deposit balances, which grew significantly during the pandemic. Total deposits declined by $65 million or 1% from the prior quarter. Hawaii has traditionally had a strong and stable core deposit base, which is less likely to be impacted by interest rate swings compared to the broader nation. CPB, in particular, has a long loyal customer base, strong community ties, and the opportunity to increase our market share. We have an experienced team focused on deposit gathering in the current environment. Finally, we continue to develop our banking-as-a-service FinTech strategy while adjusting to the market environment to manage the evolving risks. The Swell fintech, which we invested in and are serving as a bank sponsor, launched an alpha pilot earlier this month. We are excited to have this Swell app off the ground and will continue to grow slowly and steadily while we learn and iterate. I'll now turn the call over to David Morimoto, our Chief Financial Officer. David.

David Morimoto, CFO

Thank you, Arnold. Turning to our earnings results, net income for the third quarter was $16.7 million or $0.61 per diluted share. Return on average assets in the third quarter was 0.91%, and return on average equity was 14.49%. The efficiency ratio was 64.6% in the third quarter. Net interest income for the third quarter was $55.4 million, which increased by $2.4 million from the prior quarter as our increases in loan balances and yields outpaced the increase in our funding costs. The net interest margin increased by 12 basis points to 3.17% in the third quarter. Our total cost of deposits was 14 basis points, increasing from the historic low of 6 basis points. We continue to manage deposit pricing to product segmentation, and thus far our interest-bearing deposit repricing beta has been less than 10%. Third quarter other operating income and operating expense normalized from the previous quarter, which included a one-time gain on the sale of our Visa Class B shares of $8.5 million and a one-time $4.9 million settlement charge on our defined benefit pension plan termination. We continue to focus on managing our expenses to drive positive operating leverage. During the third quarter, we consolidated another branch as planned, which brought our total branch costs down to 27 branches. There were one-time branch closing costs of $0.4 million this quarter. In 2022, we consolidated three branches with total estimated future annual expense savings of $0.9 million. As of September 30, our allowance for credit losses was $64.4 million or 1.19% of outstanding loans. In the third quarter, we recorded a $0.4 million provision for credit losses due to loan portfolio growth and net charge-offs. Our asset quality continues to be strong with non-performing assets to core assets at 6 basis points as of September 30. Additionally, total criticized loans were just 1.4% of total loans. Our net charge-offs were $1.6 million for the third quarter. Our loan portfolio is well-diversified, with total construction at 3% of total loans and minimal exposure to sectors that could be impacted in a downturn. Our effective tax rate was 26% in the third quarter and continues to be on the higher end of our range as a result of less tax exempt BOLI income. Going forward, we expect the effective tax rate to be in the 25% to 26% range. Our capital position remains strong, and during the third quarter, we repurchased 218,000 shares at a total cost of $4.9 million or an average cost per share of $22.33. Additionally, our Board of Directors declared a quarterly cash dividend of $0.26 per share, which will be payable on December 15 to shareholders of record on November 30. I'll now return the call to Paul.

Paul Yonamine, CEO

Thank you, David. Central Pacific had another solid quarter and continues to be well positioned to continue to deliver strong performance. We have prudent and disciplined risk management and the right leadership to drive us forward and continue to excel despite external market challenges that may come. On behalf of our management team and employees, I'd like to personally thank you for your continued support and confidence in the organization. I'd like to end with a personal note. After four great years at Central Pacific Bank, I have made the decision to retire at the end of the year. Effective January 1, 2023, I will become Chairman Emeritus of the bank and the holding company. Arnold Martines, currently President and Chief Operating Officer of CPF and CPB, will become Chief Executive Officer of both entities as well as being named to both Boards. Catherine Ngo, another valued member of the Executive Committee, is also retiring as Executive Vice Chair and will become Chair of both Boards. In fact, I'd like to ask Catherine to say a few words.

Catherine Ngo, Executive Vice Chair

Thank you, Paul. The past 12 years with this company have been both exciting and gratifying, from our recapitalization to the recovery that followed and with our recent transformation through Rise2020. It has been an honor to serve the bank with Paul, Arnold, David, and the rest of our exceptional team of leaders and employees. The bank has been transformed during this time to better support our employees, customers, and the community. I look forward to my new role as board chair and to continuing to work with Arnold in supporting the bank, particularly on our women-owned business initiative as well as President of the bank foundation.

Paul Yonamine, CEO

I thoroughly enjoyed my time at CPB and will continue to serve on the board and as an advisor to Arnold, particularly in the areas of technology and bank market development. The bank has been through a transformative stage; our Rise2020 program included the $40 million renovation of our headquarter building, our online mobile banking and ATM upgrades, and the total corporate rebrand set us on a solid path to becoming a digital-first bank that helps us excel in a rapidly changing banking paradigm. My thanks to the leadership team and board for their support, in particular, my appreciation and gratitude to Arnold, David, and Catherine for their partnership and support over the past four years. And in closing, let me say that I can think of no better banker than Arnold Martines to lead this great institution into the future. At this time, we'll be happy to address any questions you may have. Thank you very much.

Operator, Operator

Our first question comes from Andrew Leach with Piper Sandler. Mr. Leach, your line is now open.

Andrew Leach, Analyst

Thank you. Good morning, everyone, and Paul, congratulations on your retirement and Arnold and Catherine on your new roles. Certainly, well deserved for all of you. Great to see. Question on the mainland commercial real estate that was added in the quarter, it sounds like all of that was participations. Is that correct? And I'm just curious on the underwriting; do you guys go through your own underwriting after sourcing the deal and what sort of LTVs and maybe geographies are involved? Just kind of more detail on how these loans are sourced.

Arnold Martines, President & COO

Yes. Hey Andrew, this is Arnold. Thanks for the question. It's a combination of participations with banks on the Mainland, but it's also Hawaii-based customers that we've had long-time relationships with, that have diversified real estate investments in Hawaii as well as on the Mainland. And then as far as the underwriting for participations, we ensure that the transactions align with what we expect and what our standards are. I hope that answers your question. By the way, we apologize for the noise behind us; it seems like there's some construction going on outside. Hopefully, that'll pass.

Andrew Leach, Analyst

Well, I'm not hearing anything, so hopefully it's not coming through for anybody else. I guess my other question is on the Hawaii growth. Obviously, it’s stronger on the Mainland, and you had some good residential growth in the state, but on the commercial side at CRE and C&I, is there anything that's causing you to pull back? Or is this just maybe just normal trends from your customers?

Arnold Martines, President & COO

We are seeing normal trends. There's no reason at this point for us to pull back specifically when we talk about commercial real estate transactions or C&I and residential. Those are areas that we look at and expect to be stable, especially in Hawaii given the lack of inventory in residential as well as on the real estate side, just the stability here. There's only so much inventory that's available in Hawaii.

Operator, Operator

Thank you for your questions, sir. Our next question comes from David Feaster with Raymond James.

David Feaster, Analyst

Congratulations, Paul and Catherine on the retirement, and Arnold, congratulations on the promotion. I'm just curious if we could start off on the deposit side, just curious about some of the deposit trends you're seeing and then if you could touch on especially on the non-interest bearing flows? How much of that was from migration within the book towards interest bearing or cash-burning clients? Is there any seasonality to those flows? And then just curious whether you've seen any deceleration in the outflow of non-interest-bearing deposits?

Paul Yonamine, CEO

I'll have David here answer that question.

David Morimoto, CFO

Yeah. Hey, David. During the third quarter, we did see a drop in non-interest bearing deposits, and that was primarily related to some large corporate depositors that had built up a decent amount of excess liquidity. The money was just in DDA as market rates were really low for a projected period of time. Then with the Fed increasing rates as rapidly as they did, with money market rates approaching 2%, we did see some of that money leave the balance sheet. Some of it went into other interest bearing accounts, but some of it did leave the balance sheet. The good news is that we have seen the pace of those types of large corporate outflows slow down. So hopefully, we've put a lot of that behind us in the third quarter.

David Feaster, Analyst

And then maybe just touching on deposits, touching on two aspects of it. I'm curious how the Shaka digital deposits are trending and how flows are trending in that and how rates and betas are within the digital deposits? And then, Paul, I know you've spent a lot of time working on this Japanese deposit initiative; curious if there's any updates on that and whether you're starting to see some fruits from all those efforts.

David Morimoto, CFO

Hey, David. It's David again. So on the Shaka, we continue to do well with the Shaka. We continue to add new accounts, but it has been going at a slow and steady pace. So I think we're probably at about 4,000 Shaka accounts. We continue to run initiatives to drive more activity there. The rate sensitivity of that account has not changed; we still pay a modest amount of interest. I think it's three basis points of interest, unless you do the qualifying activities; 15 debit card transactions a month with direct deposit will qualify for the bonus interest rate of 1%. So, it's a decent interest-bearing checking account if you meet the qualifying activity. We haven't made any changes to that bonus rate in the current rate environment thus far. I'll turn it over to Paul.

David Feaster, Analyst

No, go ahead.

Paul Yonamine, CEO

Yeah, David. So the yen rate today is JPY151, and that presents considerable headwinds for people looking to transfer money into the United States at this moment. I would have to say that we've had a great run-up on Japanese deposits even during the pandemic. Those individuals who deposited money with us last year have been very satisfied. The scenario today is that there's tremendous pent-up demand among Japanese visitors to Hawaii; I think they have to navigate through this emotional rollercoaster because of the significant strengthening of the dollar. We think as we move into next year, that situation will ease, and when it does, I think the key takeaway for a lot of Japanese is that they shouldn't have all their assets in Japan. We hope that they will look to dollar deposits. At that time, with products like Shaka digital products for people who don't live in Hawaii, I think it's going to be a very attractive platform. So, again, in the short term, there are some headwinds, but we are confident that the Japanese will return and that there's tremendous interest in shifting assets to the U.S., and we hope to capitalize on that.

David Feaster, Analyst

How much is in the Shaka digital deposits now?

David Morimoto, CFO

David, it's about 4,000 accounts. So the average balance is about $1,000. The good news is we're seeing engagement by the Shaka customers increase over time. Initially, when people open an account, it takes time for them to move their direct deposit and start making it their primary checking account. But we're now starting to see that engagement with Shaka customers, which is good.

Paul Yonamine, CEO

This is Paul. More importantly, we're really penetrating the younger set of customers, and this was a critical component of our strategy for the Shaka offering. So, this investment is aligned with our focus on future growth.

David Feaster, Analyst

That's perfect dovetail. I wanted to touch on Swell. I know we're playing on a fourth-quarter soft launch; just curious where we are in that process, how it's going, and any updates on the evolution of that business?

David Morimoto, CFO

Yeah, David. So we moved in October from the Swell friends and family pilot to the Swell alpha pilot. So that's where we're inviting people from the Swell waitlist to open their Swell account. We’re just at the beginning of the alpha pilot. We plan to stay in the alpha pilot through mid to late November, and then we're going to start a more broad public launch. We plan to do the public launch probably in late November or early December timeframe. That’s when a much larger set of customers will be able to come in.

David Feaster, Analyst

And how's it gone so far? I mean, is there any update on how it's gone? Whether there have been any issues or just curious how it’s going in your early feedback?

David Morimoto, CFO

Yeah, no, it's as expected. You do pilots to learn, figure things out, and ensure everything is working as expected before you do the larger public launch. We went through that process with the friends and family phase, learned and iterated, and now we're doing the same thing with the alpha pilot. The process is going exactly as we expected.

Paul Yonamine, CEO

David, this is Paul. I'd like to add that with the changing climate, especially in the continental U.S., that we have become a little more rigid on our credit policies. So we're focusing more on customers and invited customers with FICO scores of 720 or higher for our initial mailings that we're planning right now.

Operator, Operator

Our next question comes from Laurie Hunsicker with Compass Point.

Laurie Hunsicker, Analyst

And Paul, Arnold, and Catherine, I just want to echo my congratulations to you. Just going back to your Japanese strategy, Paul, I'm hoping you can help us think about it. And I'm sorry, if I missed this piece. Number one, can you just remind us what Japanese deposits are at the moment? And then, Paul, as you transition into a different role, can you take us through how the Japanese strategy might change as we look to 2023? I know you've been active and traveling there. Can you just help us think about that?

Paul Yonamine, CEO

Sure. So Laurie, 16 quarters ago when I first stepped in as CEO, I think we were hovering around $650 million in terms of Japanese deposits. Today, we're just a little south of about a billion. So we've made very good progress over the last four years, but there's still tremendous potential. COVID setback and the strong dollar have presented headwinds as well. But now in my new role starting in January, where Arnold will handle all earnings calls, I will have time to spend more time in Japan, and I still have my role as a board member at CPB. Arnold requested that I focus on generating deposits from Japan, and I'm going to dedicate much of my time to this market. I know my marching orders: to go out and secure low-cost deposits. That's what I will focus on, and I hope to be successful.

Laurie Hunsicker, Analyst

Okay, I hope you are too. Great. I guess shifting over… I'm sorry, go ahead.

Paul Yonamine, CEO

No, go ahead.

Laurie Hunsicker, Analyst

I was just going to say, and then with respect to consumer, you mentioned that you are going to reduce unsecured consumer loans on the Mainland, and I'm showing that the numbers are at $310 million. Can you help us think a little bit about where that reduction is going to occur? What that book looks like, maybe by the back end of next year?

Paul Yonamine, CEO

So… Go ahead. Finish your question.

Laurie Hunsicker, Analyst

I was just going to say, and then with respect to Swell Elevate, because obviously, that's also Mainland; so that is starting to grow. Can you help us think about what the targets look like for the course of the next year? Initially, I think there was a Swell Elevate target of $8 million by the end of this year, and you backed off on that, which was great. But maybe help us think about that a little bit more. What does your target look like for the next few quarters? And then probably just one more question, sort of folded in. I mean, your credit is spectacular. The only place you've really had charge-offs has been in consumer. So maybe help us think about that a little bit, especially with the backdrop of continued chatter from CEOs and CFOs across the board saying they're very, very concerned about unsecured consumer lending. Maybe just help us think about those three pieces. In other words, what that unsecured consumer book will look like over the course of the next year? What will Elevate look like? And how you're thinking about charge-offs? Thanks.

Arnold Martines, President & COO

Thanks, Laurie. We'll try our best to respond to your questions. This is our… I'll just start by saying that obviously we recognize the headwinds. Overall, our portfolios are performing very well, including our consumer portfolios. We think the probability of a recession is higher at this point, and as a result, we're taking a look at what we plan to do in the future and to start to modify or moderate certain loan categories. So I'm going to ask Anna to start off by talking about consumer and to respond specifically to your questions about where we see that category going in the future. We'll then pass it on to David to talk a little bit about Swell and the numbers we're looking at in the future. So Anna?

Anna Hu, Executive Vice President & Chief Credit Officer

Hi, Laurie. This is Anna. So with regard to your question about our $310 million in consumer unsecured loans, we do expect to moderate that portfolio. As Arnold mentioned, we are expecting headwinds to come our way. That will occur through natural runoff on a monthly-quarterly basis. Where we may look to add is really on the auto side. We have historically performed very well in auto, and our overall expectation is to maintain somewhere in the 8% range as to where we currently are with our mainland consumer book. Shifting over to the charge-offs, we're expecting charge-offs to increase given market conditions, but we expect it to remain at an acceptable level due to our higher credit underwriting standards. Again, in this past quarter, our weighted average FICO score was 740, and we expect to maintain high credit underwriting standards going forward as well. I'll now turn it over to David to talk about our Swell Elevate side.

David Morimoto, CFO

Hey, Laurie. You're correct. The original goals for Swell were $8 million in cash deposit accounts and $8 million in lines of credit by the end of this year. We took that back to $4 million each, and that's still the target for year-end. We'll see if we get there or not. The timing of the public launch has been pushed back by a few weeks. But as we've always said, we're going to start slowly, we're going to learn, and we're going to iterate. I think what's been good about the process we've gone through this last year is that there's been a lot of turmoil with the existing neobanks out there, and it's given us an opportunity to observe and learn. We're targeting accounts and customers that we believe will be profitable customers. Our business plan now is to target fewer accounts but try to make most of them profitable. So instead of targeting a million accounts that may be unprofitable, we're looking at something like 100,000 accounts, with the aim for them to be profitable. So, that's what we're focused on. As for the targets for next year, it's very difficult to say. I think what we've always said, Laurie, is we're not going to accelerate growth unless we find a sweet spot that leads to profitable Swell customers. So growth in the next year will be stronger if we find that sweet spot; otherwise, it will be rather slow as we continue to learn and adjust.

Laurie Hunsicker, Analyst

But so just to quantify, I mean, are we looking at $10 million by the end of next year? Are we looking at $50 million or $100 million? Just rough numbers so that we can think about credit risk and how we should be assessing that?

David Morimoto, CFO

Yeah, again, I don't think it's going to be $100 million; I think it would be south of that. I think most of next year will be the team running cohort tests where we target different cohorts of the striver target market. We're trying to find the sweet spot. That's the process we'll be going through much of 2023. One final note, I would like to mention is that we do have a credit guarantee from Elevate that is cash-secured on our balance sheet.

Arnold Martines, President & COO

Laurie, this is Arnold. I'll just…

Laurie Hunsicker, Analyst

That's difficult too, right? Because Elevate is valued at a dollar a share. I mean, I'm sorry, please continue. I didn't mean to interrupt you.

Arnold Martines, President & COO

Yeah, no problem, Laurie. I know there's a slight delay. But I wanted to add that Swell is one product initiative we're working on. Obviously, we maintain very strong discipline overall concerning the bank's balance sheet. At the end of the day, we will manage consumer concentration holistically for the bank. To that extent, as we grow Swell, other sources of consumer will be reduced to maintain a strong risk management discipline and stay true to our concentration standards and limits. So, I just wanted to emphasize that we're going to manage our balance sheet effectively. We're not going to allow one product to create a huge concentration on our balance sheet.

Laurie Hunsicker, Analyst

And just one more question if I could, a different subject altogether. Your funding is fabulous; your core deposits are fabulous. Can you help us think about maybe just if you could quantify over the next several quarters how you think about margin in terms of basis points, deposit pricing? Obviously, at some point it catches up on the Fed’s flows, right? So, maybe help us think about when margin might peak and how you're thinking about that? Thanks so much.

David Morimoto, CFO

Yeah, no worries. For the third quarter, we were very pleased with the core deposit betas. The interest-bearing deposit beta in the third quarter was 9%; total deposit beta was 6%, and our average earning asset beta was 21%. That's what led to the 12 basis points of sequential NIM expansion. We are targeting to continue to see NIM expansion for the next couple quarters, and we're currently in the budget process. We're thinking that NIM may peak in mid-2023, is what we're looking at.

Paul Yonamine, CEO

Yeah, Laurie, this is Paul. Before I end the call, I wanted to address your remark about Elevate's share price currently being $1. Elevate has sufficient cash; they make deposits with us, which gives us a security interest in them. We are in a strong position, and the volume of direct mail is a significant factor in the loan origination process. We will be closely watching that. I believe I also mentioned in previous calls that through our agreements with Elevate, we have the best lending management platform. Even if there are concerns about the company's viability, I think CPB is very secure. I just wanted to emphasize that. Okay. So with that.

David Morimoto, CFO

There might be one more question.

Paul Yonamine, CEO

That was it? Okay. Dante?

Operator, Operator

Yes, sir. The question we had actually dropped back out. If you would like to continue?

David Morimoto, CFO

Okay, we'll turn it back to you.

Paul Yonamine, CEO

Okay. Well, with that, thank you very much everyone for participating in our earnings calls for the third quarter of 2022. We look forward to future opportunities to update you. Thank you.

Operator, Operator

And with that, we will end today's Central Pacific Financial Corp. conference call. Thank you for your participation. You may now disconnect your line.