Eastern Bankshares, Inc. Q3 FY2022 Earnings Call

Hello, and welcome to the Eastern Bankshares, Inc. Third Quarter 2022 Earnings Conference Call. Today's call will include forward-looking statements regarding Eastern's future financial and operational results, outlook, business strategies, and potential risks. These statements are based on management's current beliefs and are subject to various risks and uncertainties that could cause actual outcomes to differ significantly. For more information on these risks, please refer to the disclosures in the earnings press release and the company's recent filings with the Securities and Exchange Commission. Any forward-looking statements made during this call reflect management's views as of today and the company does not have an obligation to update them in the future. Additionally, the call will address certain non-GAAP financial measures; for reconciliations to GAAP figures, please consult the earnings press release available at investor.easternbank.com. Please note this event is being recorded and all lines are muted to avoid background noise. After the speakers' remarks, there will be a question-and-answer session. I will now hand the call over to Bob Rivers, Chair and CEO.

Thank you, Michelle. Good morning, everyone and thank you for joining our third quarter earnings call. Joining me today is Jim Fitzgerald, our Chief Administrative Officer and Chief Financial Officer. Our performance continued to be strong, demonstrated continued improvement in a number of key measures. Operating net income in the third quarter was 49% higher than the comparable prior year quarter, a new record, driven by our highest ever quarterly revenue, which increased 34% year-over-year. As a result, Eastern's return on assets continue to improve, as did the efficiency ratio, which declined eight percentage points from a year ago. Underlying this progress, our deposit costs continue to be well managed, rising only four basis points from the prior quarter, despite another 150 basis point increase in the Fed funds rate over the past three months and an increase of three percentage points since the beginning of the year. Growth in loan outstandings continued to accelerate during the quarter, rising 16% overall on an annualized basis, driven by record commercial and home equity loan production with net charge-offs of just one basis point. As a result, the net interest margin increased 24 basis points during the quarter. In addition, Eastern Insurance Group acquired its second agency of the year in August, and its 36th since 2002, and Eastern Bank was recognized by the Boston Business Journal as one of the most charitable companies in our region, our 10th time in the top 10. We think it is increasingly clear that the investments we have been making in the growth of our company are paying off. In addition to significant financial leverage, the acquisition of Century Bank, which closed last November, helped increase our deposit market share to the fourth largest in the Greater Boston market. Our record commercial loan originations reflect just the beginning of the benefits we expect to achieve through the expansion of our commercial lending teams. Our continued significant investments in technology have elevated our digital capabilities, better serving our customers and improving process workflows that we believe will ultimately reduce expenses. As always, these results reflect the hard work and tremendous commitment of my 2,100 Eastern colleagues with whom I am privileged to work and whom I thank for all that they do every day to serve our customers, communities, and each other. Once again, thank you for joining us today and for your interest in Eastern. And now I'll turn things over to Jim for an in-depth review of our third quarter financial performance and outlook for the remainder of 2022 and for 2023.

Thank you, Bob, and good morning, everyone. We are very pleased with our third quarter results, which indicate ongoing momentum from the first and second quarters of this year. The growth in our net interest income and margin was driven by higher rates and strong loan growth. Net income for the quarter was $54.8 million, or $0.33 per diluted share, while operating net income was $55.7 million, or $0.34 per diluted share. This marks a 49% increase in operating net income compared to the same quarter of 2021. Net interest income increased by 10% from the previous quarter, with net interest margin rising by 24 basis points. Our asset yields went up by 29 basis points, and our cost of funds increased by eight basis points. We also saw robust loan growth across all major portfolios, with commercial loans rising by 16% quarter-over-quarter, organic residential mortgage growth at 10%, and consumer loans increasing by 6%, all on an annualized basis. The board has approved a dividend of $0.10 per share, payable on December 15 to shareholders of record as of December 2, 2022. In the third quarter, we repurchased 1.5 million shares at an average price of $19.52. Regarding our balance sheet, assets declined by $300 million from Q2, finishing the quarter at $22 billion. Deposits fell by $430 million, balanced by a $380 million increase in borrowings. Loans increased by $505 million, while cash decreased by $210 million. The securities portfolio dropped by $700 million mainly due to market value reductions. All major loan categories showed growth during the quarter. Commercial loans grew by $357 million, or 16% annualized, organic residential loans increased by $52 million, or 10% annualized, and consumer loans, particularly home equity loans, rose by $19 million, or 6% annualized. As mentioned, while deposits were down $430 million, average deposits showed little change from Q2. We have noted the tightening market for deposits and anticipated price increases and a challenging environment, which has indeed occurred. We are now adjusting our deposit pricing to stay competitive and have utilized some borrowing capacity to support loan growth this quarter. Shareholder equity fell by $303 million due to lower AOCI and share repurchases, offset slightly by an increase in retained earnings. GAAP net income was $54.8 million, or $0.33 per diluted share, while operating earnings reached $55.7 million, or $0.34 per diluted share. Our results indicate strong progress in key areas. Net interest income of $152.2 million was $14.4 million, or 10%, higher than Q2, thanks to elevated rates and solid loan growth. Asset yields rose 29 basis points quarter-over-quarter, with funding costs up by eight basis points, leading to a net interest margin expansion of 24 basis points from 2.63% to 2.87% during the quarter. The provision for loan losses stood at $6.5 million, compared to a $1.1 million provision in Q2, driven primarily by the increase in loans. Out of the $6.5 million provision, $4.7 million was attributed to loan growth, while $1.8 million was due to a slight rise in our ACL factors. Non-interest income on an operating basis reached $45.3 million in Q3, with insurance revenues at $23.8 million, reflecting an 8% increase from the same quarter last year but a decrease of $900,000 from Q2. We have observed a reduction in deposit service charges attributable to changes in our overdraft practices. Other operating expenses were generally consistent with the previous quarter and the prior year. The value of rabbi trust assets declined by $2.2 million due to stock market drops, and we encountered minor losses on security sales, both of which are excluded from operating earnings calculations. Non-interest expense for the third quarter was $116.8 million, compared to $111 million in Q2. When viewed on an operating basis, non-interest expense came to $117.4 million, up from $114.4 million in Q2, primarily due to increased salaries and benefits driven by higher incentive compensation. There was also a $2.4 million increase in benefit expense due to lower rabbi trust losses, though overall expenses were consistent with Q2 and prior years. The tax rate for the quarter was 24%, and we have provided guidance for the full year tax rate in the outlook slides. Our marginal tax rate is higher than the average, and as projected earnings rise, the average tax rate will also increase. Asset quality remains strong, with net charge-offs close to zero, non-performing loans at low levels, and reserve coverage exceeding 380% for non-performing loans. The loan that was classified as non-performing in Q2 was fully paid off in Q3, leading to a corresponding reduction in non-performing loans. We are actively monitoring our portfolios and have not identified any significant negative trends in commercial portfolios or early delinquencies in consumer portfolios at this time. We will continue to keep a close watch on credit quality trends. As I mentioned, the provision in the quarter was $6.5 million due primarily to loan growth and was sufficient to maintain allowance of about 1% of total loans. I wanted to review our outlook pages and make some additional comments. Although the environment is challenging, we expect the continuing increases in rates to improve our net interest income for Q4 and into 2023. We expect to see net interest income for 2022 in the range of $570 million to $580 million, and we expect to see our net interest margin move into the low 3% range in early 2023, if not late 2022. We would expect full year 2023 net interest income to have a percentage growth rate over full year 2022 in the low teens. We expect commercial loan growth to produce another strong quarter in Q4. Q3 was a record for commercial loan originations and generated 16% growth on an annualized basis. We would expect those levels to come down, but we expect Q4 to be above our long term target growth rate of the mid to high single digits. Higher rates in a slowing economy are expected to have an impact as we transition into 2023, and we would expect slower loan growth than in 2022. We will update our views on that next quarter. Given the change in the liquidity outlook generally, we have decided to discontinue our flow arrangement for residential mortgages with embraced home loans that we described on the last call. Although the program was working well, the challenging outlook for deposits and liquidity has reduced our appetite. We will close out the existing pipeline over the next 90 days. We would expect our organic mortgage loan growth to decline due to the general slowdown in the mortgage market. We completed the hedging program we described on the last call in Q3 and feel very good about the long term benefits of reducing our asset sensitivity. There's no change in our guidance on non-interest income from last quarter as we still expect $180 million to $190 million for 2022. We do not expect growth in non-interest income in 2023 due to the reduction in deposit service charges mentioned previously related to overdraft revenue and pressures on wealth, mortgage and interest rate swap fees due to market conditions. We are adjusting our operating non-interest expense guidance for 2022. We expect expenses to be between $455 million and $465 million for 2022, up slightly from the prior guidance. We continue to invest in our commercial teams and technology and are confident these investments are critical to our success and will be a long-term competitive advantage. In addition to the outside hires for our commercial team, we mentioned earlier in the year, we've added the support and infrastructure needed to grow at the faster pace we've experienced in 2022. The 10% and 16% annualized commercial loan growth rates we experienced in Q2 and Q3 were an early dividend on that investment. We also have some investments in digital account opening and workload technology that will be coming on stream in late 2022 and early '23 that we are excited about for both our customers and also our colleagues. The combination of these investments along with salary adjustments we have made for colleagues at the lower end of the wage scale to help offset some of the inflation challenges as well as general wage pressures will drive our salary and benefit costs higher in 2023 than the increases in prior years. We would expect growth in salaries and benefits of 6% to 7.5% in 2023. This is well above our long-term experience and we would expect that to return to more normal levels as inflation declines. Included in this increase is our healthcare costs, which are expected to be up 7% in 2023. We expect the other major expense line items; occupancy, professional services, marketing and other expenses to have increases in the low single digits for the year. We commenced our second share repurchase authorization in Q3 and for the quarter purchased a total of 1.5 million shares. As we mentioned on the outlook slide, future purchases will be determined by market conditions as well as capital and liquidity considerations. As we point out in the outlook, we will recognize a non-cash charge in Q4 related to the required use of defined benefit pension settlement accounting for 2022 for our pension plan that I will explain in a moment. Our preliminary estimate, which is based on data at the end of August and is very preliminary, is that the incremental pension expense will likely be in the range of $10 million to $15 million. As background, GAAP requires Eastern to use settlement accounting if during a calendar year the total amount of lump-sum distributions from our pension plan taken by retirees and other former employees exceeds the settlement accounting threshold, which is the total amount of service and interest cost of the pension plan for that year. Our pension plan administrators test for the settlement accounting threshold throughout the year. We learned this quarter that the total amount of lump-sum payouts for 2022 will exceed the accounting threshold for the year, and therefore we will be required to apply pension settlement accounting retrospectively for all of 2022. The actuarial work to calculate the incremental pension expense resulting from the required use of settlement accounting is complex, and therefore our estimated incremental expense of $10 million to $15 million is preliminary. We intend to publicly disclose the actual settlement accounting charge for Q4 promptly after it's finalized, which we anticipate will be in early December. In closing, we continue to see a great opportunity to further penetrate our market in Eastern Massachusetts and Southern New Hampshire. We experienced an improvement in our deposit market share through the Century acquisition last year, and our growth rate for commercial loans in 2022 stands out in our market. Although we expect the environment to be challenging in 2023, we're confident that we are well positioned in an excellent market for long-term growth. Thank you very much, and we are ready for questions. Michelle?

Our first question comes from Mark Fitzgibbon, Piper Sandler. Please go ahead.

Hey guys. Good morning. I'm wondering if you could start by sharing with us and I apologize if you said this at the very beginning, I missed a couple of minutes, but the loan pipeline, the mix, and maybe the average rate.

Sure. So Mark, we don't disclose the loan pipeline. It's calculated a little bit differently for different products, but on the commercial side, which is where we focus most of our strategic attention, the pipeline is about the same size as it was at the end coming into Q3. We do expect a good quarter for closings in Q4 and expect that to come down, and as I articulated, we would expect slower growth as 2023 looks like it'll be a more difficult year than 2022, but the pipeline going into the fourth quarter is at about the same level as it was the prior quarter. In terms of yields, new business on the commercial side is sort of in the high load up mid to high fives percent range, those would be for fixed rates.

Okay, great. And then secondly, Jim, on Page 11, you detail the total securities portfolio yield and it came down a bit from the second quarter to the third quarter. I was just curious why that was.

Sure. Premium amortization, we had one or two selected situations where we had to accelerate premiumization primarily due to payoffs of the securities.

Okay. And as you kind of think about the size of the securities portfolio and I know you're using cash flow to fund loan growth, how quickly can you shrink down that securities portfolio? Do you have a target in mind for it?

Sure. That's a very good question. In many ways, the answer is going to be quite similar to what we mentioned last quarter. The cash flow from this portfolio currently stands at around $70 million a month, which amounts to approximately $800 million a year, or between $800 million and $850 million yearly. At this stage in the rate cycle, these are the changes we anticipate. We expect to see it decline within those parameters. Naturally, if interest rates fluctuate and new opportunities arise, we would address those situations then, but for now, that's our outlook.

Okay, And lastly, what would you say your spot deposit rate is today?

That's a difficult question because there are many different deposit products across various sectors. Therefore, it's challenging for me to provide a clear answer. However, we do anticipate an increase in our deposit costs in the fourth quarter.

Thank you. The next question comes from Damon DelMonte, KBW. Please go ahead.

Hey, good morning everyone. Hope everybody's doing well today. Jim, I was just wondering if you could revisit the commentary on the decision to terminate the relationship with Encore. I didn't quite get everything that you had said there.

I'm amused by the situation with Encore, the local casino leader, which has become somewhat of a local joke. As we discussed last quarter, when the liquidity environment was very different earlier this year, we aimed to shift cash flows from the securities market. We had a strong pre-existing relationship with Embrace, which allowed us to buy loans they originated according to our underwriting criteria and incorporate them into our portfolio on a flow basis. In our last call at the end of Q2, we mentioned a target of $400 million for this initiative, which was a bit of an experiment to gauge its effectiveness. However, due to the changing liquidity outlook, our appetite for this has decreased. We have informed Embrace that we are discontinuing this program. There are still loans in the pipeline that will complete in the usual manner. As I mentioned, we were pleased with how the program performed, but the shift in liquidity is what prompted our change in strategy.

Got it. And then you had said to the last question that the securities portfolio is putting off about $800 million a year in cash flows.

Yes.

And so do you expect all that to be used to fund loan growth or do you think you're going to have to reinvest some of that back in the securities portfolio?

No, we would anticipate as those cash flows are received to bring the securities portfolio down and fund loan growth with those, yes.

Got it. Okay, great. And then I guess, with respect to the margin, commentary points to a higher margin going through year-end, excuse me, and into 2023 do you think that you're going to end up peaking somewhere halfway through the year, or do you think that there's still enough flexibility on the balance sheet particularly on the funding side to keep that margin moving higher?

It's a challenging question, Damon, due to the uncertainty surrounding rates. What we can articulate is that the rate increases that have occurred and are anticipated in the coming months will certainly enhance the margin, and we can observe that. However, looking further out, the volatility and concerns regarding liquidity make it difficult to project beyond that.

Yeah, fair enough. I know that wasn't an easy question. So I appreciate the response. Again, I guess just lastly credit trends remain strong and you kind of look at the reserve level here. Do you try to kind of hold it in this 101, 102, 103 type range as you look out over the next few quarters?

You're asking some very good and complex questions, Damon. What we observed this quarter was that based on our forecast, which does not predict a severe recession but does indicate a slowdown in growth followed by a modest recession, we didn't see a significant change in our ACL factors. Most of the provision was related to loan growth, which is what we experienced this quarter. That's all we know for now.

Okay, Sounds good. That's all that I have for now. Thanks a lot. Appreciate it.

The next question comes from Laurie Hunsicker, Compass Point. Please go ahead.

Yeah, hi Bob, Jim, and Jill. Good morning. Hoping Jim, that you can go back to the expense guide slides or commentary, just wanted to think about that. If I'm doing the math off the operating guide that you have provided, just simply going from right in the middle, the $460 million to $500 million operating expense for full year '23 compared to '22, that's almost 9% growth and completely get your comments around the compensation growth expense of 6% to 7.5%. Just can you help us think a little bit about where that delta is going higher?

Certainly. The main increase is in salaries and benefits. There is some growth in other categories, but it is at a more modest level.

I see that the salaries and benefits are at the higher end of your guidance, which makes sense with the current inflation. However, while you mentioned single-digit growth elsewhere, your full-year expense growth guidance is nearly 9%. Maybe I need to speak to you privately about this, as I feel I'm not fully grasping the situation.

Sure, No, happy to do that.

Yes. I'll follow up with you offline. Can you talk very high level, the buyback obviously great to see you buying back this quarter, but it's slowed pretty significantly from last quarter. Can you help us think about how you look at that going forward?

Sure. I just one reminder from the historical side, we did conclude the first repurchase and needed to get regulatory approval for the second. So there was a time period in there where we were pending regulatory approval. So there was just as a reminder there, there was a gap in time where we were waiting for that approval. I think going forward, it's similar to what we would've said previously, but just added the liquidity constraints. Obviously, market conditions are very important as we evaluate it, but also our capital liquidity position, and as those change that becomes a factor in the overall decision and we'll make those decisions as we go forward.

Okay. Okay. And any comments around the price, how you think about it up here?

Yes, I would consider our typical earn back calculations. In the past, we have been very pleased with that timeframe, which is why we have been quite aggressive in buying back our shares. That approach continues to be in effect; however, current market conditions along with liquidity and capital are also influencing our decisions.

Okay. Great. And then, regarding margin net interest income, was there any non-accruing loans in income recovery booked this quarter related to your decrease in non-performers?

There was a modest amount, very small amount. Laurie.

Okay. And then the increase in borrowings in the quarter, can you talk a little bit about that just because your core deposits are so nice and low and cost, and obviously the borrowings aren't. Just how you're thinking about that or how we should think about that going forward?

Your points are well understood. I want to clarify that one of our proudest achievements has been maintaining a deposit-funded structure. Our primary goal remains to ensure that deposits constitute the majority of our funding. Liquidity shifted rapidly in the latter part of the second quarter and particularly in the third quarter. While we did not alter our pricing strategies, we initiated a more aggressive approach in the fourth quarter to retain deposits. We experienced minor outflows, which is what led to the need for additional borrowings.

Okay. And so – okay, I guess more importantly, how do you think about using borrowings then going forward?

It's challenging to provide a concise answer to that, Laurie, because we have various pricing strategies for deposits. The aim of these strategies is to retain and ultimately grow deposits, especially in the current environment. There are many factors involved in this approach. We have significant borrowing capacity, and at $380 million, our balance sheet treats that as a modest amount at the end of the quarter. The key challenge is to set deposit prices that not only keep our existing deposits but also help us grow them, while also considering our borrowing capabilities. Ideally, we hope to remain as deposit-funded as possible over time, but it's a tough market to navigate.

Okay, Great. Thanks for taking my question.

Thank you. There are no further questions at this time. I will turn the call back over to Bob Rivers for closing remarks.

Great. Well thanks again, Michelle, and thanks to all of you for joining the call. Thanks very much for your questions and we look forward to talking with you again on our next quarterly earnings call. Thanks again everyone.

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