Eagle Bancorp Inc Q2 FY2024 Earnings Call

Good day, and thank you for standing by, and welcome to Eagle Bancorp, Inc. Second Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there'll be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Eric Newell, Chief Financial Officer of Eagle Bancorp, Inc. Please go ahead.

Good morning. This is Eric Newell, Chief Financial Officer of Eagle Bancorp. Before we begin the presentation, I would like to remind everyone that some of the comments made during this call are forward-looking statements. We cannot make any promises about future performance and caution you not to place undue reliance on these forward-looking statements. Our Form 10-K for the 2023 fiscal year and current reports on Form 8-K, including the earnings presentation slides, identify risk factors that could cause the company's actual results to differ materially from those projected in any forward-looking statements made this morning, which speaks only as of today. Eagle Bancorp does not undertake to update any forward-looking statements as a result of new information or future events or developments unless required by law. This morning's commentary will include non-GAAP financial information. The earnings release, which is posted in the Investor Relations section of our website and filed with the SEC, contains reconciliations of this information to the most directly comparable GAAP information. Our periodic reports are available from the company online, at our website, or on the SEC's website. With me today is our President and CEO, Susan Riel; and our Chief Credit Officer, Jan Williams. I would now like to turn it over to Susan.

Thank you, Eric. Good morning, everyone. Before discussing our progress in continuing to execute our strategic objectives, I want to address our second-quarter results announced last night. The quarter's results were affected by a goodwill valuation, which Eric will elaborate on. It's important to note that this impairment does not impact our cash, liquidity, regulatory, or tangible capital ratios. It is a non-operating item that has been fully removed from our balance sheet, ensuring that any goodwill valuation risk will not affect our future results. That said, we are pleased to report that operating earnings in the second quarter have significantly improved from the first quarter. This improvement is largely driven by a lower provision for credit losses as we continue to prudently build reserves in response to uncertain market and economic conditions. We are rigorously focused on executing our strategic objectives of diversifying and growing our loan book and deposit franchise and capitalizing on value propositions for customer segments where we already have market presence. While achieving our loan mix goals is a multiyear endeavor, we anticipate ongoing progress in the interim, though achieving the goal may not be linear. We are already seeing encouraging results from our efforts to grow deposits and diversify our funding, although it is still early. Notably, we have onboarded a team to lead our expatriate banking services division, and we are excited about the contributions this division will bring to our deposit diversification. Additionally, our direct digital channel continues to build momentum. As this channel grows, we aim to reduce our reliance on wholesale funding, thereby lowering the costs of our interest-bearing funding. While we acknowledge the significant work ahead, we remain optimistic. Economic and interest rate uncertainties, particularly regarding office loans and other commercial real estate exposures, have presented challenges. Eagle Bank has always been committed to serving commercial real estate investors and commercial business customers in the Washington, D.C. metropolitan area, and it will continue to do so. Our strategy is designed to gradually diversify our loan portfolio while continuing to offer exceptional value to our commercial customers. We remain cautious about the office sector, understanding that a return to pre-COVID absorption rates is unlikely in our region. Nevertheless, we are dedicated to working closely with our customers to find solutions that maximize the value of their collateral. Our objective is to establish a strong foundation for sustainable growth, achieving improved and consistent profitability regardless of the interest rate environment. I am confident that we have identified the necessary actions to set us up for continued success. With that, I'll hand it over to Eric.

Thanks, Susan. We reported a GAAP net loss for the quarter totaling $84 million, or a loss of $2.78 per share, recording a $104 million impairment in the value of goodwill. Excluding the goodwill impairment, operating net income totals $20.4 million, or $0.67 per diluted share, materially improved from the $338,000 operating loss experienced in the first quarter. This impairment is a non-cash accounting charge to earnings. It has no impact on our company's core net income and operating profit, cash flows, or liquidity, nor does it impact tangible or regulatory capital ratios, which already exclude goodwill. Our capital position remains strong. Tier-1 leverage capital increased 32 basis points to 10.6% at June 30th. Common equity tier-1 capital increased 12 basis points to 13.9% at June 30th. Our March 31 common equity tier-1 capital ratio continued to exceed the CET-1 capital ratios of 75% of all other financial institutions with assets greater than $10 billion. Tangible common equity continues to exceed 10%. Tangible book value per share increased $0.48 to $38.74 per share, representing an annualized 5% growth rate from the prior quarter. On-balance sheet and contingent liquidity also remain strong. Average deposits have grown $710.3 million from a year ago at June 30th, 2023. Insured deposits totaled 73% of our total deposits, remaining stable at 71% from a year ago. During the second quarter, we increased our capacity to borrow from the Federal Reserve discount window by $1.37 billion. Available liquidity from the Federal Home Loan Bank, Federal Reserve discount window, cash, and unencumbered securities now totaled over $4 billion at June 30th. Net charge-offs declined $19.1 million from the first quarter to a more normalized $2.3 million in the second quarter. We continue to build reserves given market and economic uncertainty. The allowance for credit losses increased to $106.3 million at June 30th, representing coverage of total held for investment loans of 1.33%, increasing 8 basis points from the prior quarter. Our earnings release and investor deck disclose the allowance for credit losses attributed to our performing office loan portfolio. The allowance for credit losses coverage to performing office loans increased to 4.05% at June 30th, increasing from 3.67% at March 31st and 1.91% at December 31st. Office loans that are rated substandard have an allowance for credit losses nearing 13%, reflecting continued evaluation of new information we have received through appraisals on office properties through June 30th. Operating pre-provisioned net revenue declined to $34.4 million from $38.3 million in the linked period. The driver of the decline was average interest-bearing cash balances, which were $387 million lower in the second quarter from the first quarter. Early in January 2024, we borrowed $500 million from the Federal Reserve bank term funding program due to a favorable rate structure. These borrowings were repaid by the end of the first quarter, the principal driver impacting the decline in average cash during the second quarter. Net interest income before provision totaled $71.4 million in the second quarter, decreasing from $74.7 million in the first quarter. Net interest margin in the second quarter was 2.40%, declining 3 basis points from the first quarter. Driving the decline was replacing bank term funding program borrowings with Federal Home Loan Bank borrowings at a higher market rate. Operating non-interest expense, adjusted to exclude goodwill impairment, totaled $42.3 million, increasing from $40 million in the previous quarter. Of the $2.3 million increase, $803,000 was due to higher marketing expense related to our digital banking channel. Other expenses make up the remainder of the increase and represent an increase in other real estate taxes. During the quarter, we had relatively flat loan growth, with period-end loans growing $19 million. In our quarterly investor deck released along with our earnings, we updated our view for the remainder of 2024 performance. We provided the components of pre-provision net revenue and the effective tax rate. Our forecast for net interest margin for the full year is slightly lower from last quarter due to the first-half actuals, but we see opportunities for expansion in the second half of the year through the repricing cash flows off of the investment portfolio and opportunities to improve the funding mix. On a positive side, we expect total operating non-interest expense for the calendar year to be lower. We do not model any changes to interest rates in our forecasting. Of the $175 million of funded loan originations in the quarter, we had a weighted average rate of 7.99%. This compares to $112.5 million of funded loan originations at a weighted average rate of 7.56% in the first quarter.

Thank you, Eric. I'm pleased to announce that we have returned to a more typical charge-off level this quarter, with net charge-offs reaching $2.3 million compared to $21.4 million and $11.9 million in the first quarter of 2024 and the fourth quarter of 2023, respectively. Consequently, our provision for credit losses was reduced as well. We continue to accumulate reserves as a precaution due to uncertainties in future market conditions, appraisal valuations, and the overall economic environment. Our approach to setting the allowance for credit losses related to office loans has been structured to incorporate new information as it emerges. We remain committed to thoroughly evaluating risks each quarter as we determine the adequacy of the allowance for credit losses. The performance of our office loan portfolio has not yet been a factor in charge-offs, although valuation risk was responsible for the loss in the first quarter. We are actively assessing strategies to qualitatively evaluate risks related to valuation. This quarter, we refined our qualitative method to address perceived risks tied to historical expectations and ongoing negative net absorption of office space within our footprint. Management is also examining additional data to capture valuation risk. Based on the information available as of June 30th, we believe our allowance for credit losses is appropriate. By the end of the second quarter, total classified and criticized loans rose by $89.1 million to $716.2 million, driven in part by an increase in classified loans of $46.5 million, amounting to $408.3 million. Our disclosures note that 91% of classified and criticized loans remain performing. Three projects contributed to the rise in criticized loans, two of which are assisted living properties. We have observed a decline in the assisted living sector, attributed to enhanced in-home care coverage from federal programs, which reduces the need for assisted living facilities, alongside rising human capital costs affecting project revenues and profitability. These loans were current as of June 30th. These projects had initially anticipated stabilization and permanent financing through HUD, but the process is taking longer than expected, causing our internal ratings to reflect the increased risks associated with them. A hotel loan has also moved into special mention status, facing slower than anticipated stabilization due to COVID impacts and delays in its stabilization timeline. While operations are improving and the loan remains current and performing as expected, the project has not achieved stabilization. Non-performing loans increased to $98.2 million by June 30th from $91.5 million at the end of March, mainly due to a $5 million loan now classified as held for sale. Non-performing assets totaled $98.9 million, which is 88 basis points of total assets, marking an increase of eight basis points from the previous quarter. Loans that are 30 to 89 days past due amounted to $8.4 million as of June 30th, decreasing from $31.1 million at the end of March. As Eric mentioned, we continue to benefit from improved data on valuation through office collateral appraisals. Although there are signs of volatility in discount rates and cap rates, valuations outside the central business district have generally experienced smaller negative adjustments recently. As a reminder, there are no additional office loans in the central business district maturing for the rest of 2024 that would trigger an updated appraisal. It’s crucial to understand that we do not believe the central business district office market reflects our entire office portfolio, nor does our office portfolio reflect our income-producing commercial real estate portfolio. Our office disclosures were enhanced in the last quarter and continue to be included in our earnings reports. We are continuously reviewing all commercial real estate office loans with maturities in the upcoming 18 months and taking necessary actions to mitigate maturity risks. Such measures may include cash flow sweeps, pay-down requirements in exchange for extensions, enhanced guarantor support, payment reserves, and additional collateral. We are also developing solutions for our clients. We have established a tailored evaluation process for our office portfolio maturities, aiming for solutions that are mutually beneficial for our clients and improve the bank's credit position. To date, our solutions have allowed borrowers to maintain control of their properties. We have collaborated with our borrowers to facilitate asset sales to pay down debts, provide pay-downs and interest-only periods, bridge rent commencement on new leases, extend existing performing debt, and consider repurposing properties for residential use. Each resolution is tailored to the specific asset being evaluated. Now, I'll turn it back to Susan.

Thanks, Jan. Throughout the past year, our team has consistently demonstrated resilience, client dedication, and unwavering perseverance. With over 25 years of experience as a commercial lender in this market, we have the expertise to support clients navigating the challenges of higher interest rates. Our robust capital position provides substantial lending capacity and enables us to remain agile and continue serving our customers and communities well into the future. Our growth strategies aim to enhance pre-provisioned net revenue, thereby supporting returns on assets and equity. This approach allows us to reinvest in innovative products and services for our customers and communities while also delivering strong returns for our shareholders. In closing, I would like to extend a heartfelt thank you to our employees whose hard work every day makes Eagle a success. We also deeply value the strong partnerships we have forged with our current customers and look forward to building relationships with our future customers. With that, we will now open things up for questions.

Thank you. And our first question comes from Catherine Mealor from KBW. Your line is now open.

Thanks. Good morning.

Good morning, Catherine.

Let's begin with credit. It was encouraging to see no further movement in the office book into classifieds. I appreciate the insights on the other three loans that did move, but it’s good to observe some stability in office. I wanted to ask about the slide showing the $254 million in maturities expected in the latter half of the year. Jan, do you have an estimate of how much of that is already classified or criticized? Is some of that risk already reflected in those figures, or could we anticipate additional downgrades or changes as those loans mature?

There are some of those loans, maybe 60%, that are already criticized or classified. We have taken a hard look at all of our maturities that are coming through. A significant amount of that are short-term extensions that we made when we initially put a modification in place for that borrower. For example, the large loss that we took in the first quarter on that central business district property was extended for a year, so it will be looked at again at the end of this year. We also have a loan that we placed in non-performing status in the fourth quarter of last year. That's an office property that we took a write-down on. Those particular properties and really, all of our non-performing real estate books have current appraisals. They would be within less than a year. So we feel we've already absorbed the loss that would come from that area. It's always possible that there could be further deterioration or some kind of valuation risk associated with the appraisal on those properties. But I'm hopeful that based on the consistency I'm starting to see in appraisals, still some volatility. A lot of it is down to the individual property, but the discount rates seem to be coming a little bit closer together. And while there's still volatility in cap rates, the discount rate seems to be what's really been moving valuations in the last three or four months. So I'm cautiously optimistic that you're not going to be seeing the kind of incident that we had earlier in the year maturity-related.

Catherine, this is Eric. I want to add to what Jan mentioned. The loans we previously charged off are assessed individually in our allowance for credit losses. We review the specific reserves for these loans quarterly and have been allocating some funds for these individually evaluated loans as a precaution in case there is a potential further decline in value upon renewal.

Great. Yes, that's great. Okay, good to know. Last quarter, you mentioned that the allowance for credit losses would likely be around 135 to 140 by the end of the year, which seems to be in line with where you are now. You also indicated that charge-offs might be between $20 million and $40 million for the rest of the year. Is there any update on your guidance for those two items?

I believe we are close to the desired reserve level. However, the actual reserve is influenced by external data sources, making it difficult to predict whether we will experience further increases. Factors like unemployment, GDP, and the commercial real estate index move independently from Eagle Bank. Overall, I would say that we are nearly where we need to be.

Okay, great. And then the line of sight into charge-offs?

I am cautiously optimistic about charge-offs. The main driver we’ve observed has not been performance-related issues but rather appraisal valuation-related issues, which seem to be stabilizing a bit. There are a few more market-based transactions compared to liquidation transactions, and we are seeing significant differences in valuations. Although current market trades are below the levels seen in 2022 and 2021, I don't anticipate a substantial change. I don’t expect to see another drastic 55% drop in property values after already experiencing that reduction. Therefore, I believe we will face much less valuation risk moving forward.

Okay, great. Helpful. Thank you very much.

And thank you. And one moment for our next question. And our next question comes from Christopher Marinac from Janney Montgomery Scott LLC. Your line is now open.

Thanks. Good morning. Jan, can you continue on, I guess, on the appraisal process, what is the minimum that you have to do, I guess by regulation, and then kind of what's the process that you've had in place for a long time? And what do you do with the appraisals that you've had in this last quarter? Just kind of want to understand kind of the impact we've seen already.

Sure. Our policy is a little more stringent than what is typically required. We need to have an appraisal within one year for any of the loans that you're seeing that are non-performing. And so we would update that appraisal on an annual basis. The updates of those appraisals that have been coming in recently, particularly in suburban markets, have not been as severe with respect to discount rates and cap rates as what we had seen on central business district earlier in the year and last year. So I have some level of cautious optimism. I don't think the recent suggestion that hopefully is realizable, that interest rates are going to drop has been baked into that yet. So that could be an additional stabilizing factor. Just don't see the same level of fall-off that we were seeing. We recently had a project in the mid $30 million range in the Virginia suburbs reappraised, and its valuation held up pretty well. All things considered, there certainly was no indication of an impairment with the loan. So that was encouraging.

Great. And if you think about the differences between the suburban and the CBD, I mean, that is still kind of impacting you in a good way, right? Because you're not all central business district and you've got a fair amount of that exposure in the suburban markets. And I guess this one follow-up related to that is, it felt like maybe six months ago there was a lack of appraisal. But that's not the issue today. You really have a lot more live examples to lean on.

That's right. I think we are getting more and better live examples. We are getting better data collection. I think it's become a shared topic amongst banks as to where appraisals are coming in and what they're looking like. So through some of the groups that the bank belongs to, we're also getting the benefit of input from others. I think the rate cuts, if they happen, will also be a good force on the valuations. I couldn't help but notice REITs going up 10% in a 10-day period based on the theory that we were getting those drops in interest rates starting in September.

Great. And just last one for me, Jan, is what's the capacity of borrowers to kind of make incremental paydowns or for them to put up more collateral support? Are you seeing further evidence of that?

I think that everyone is different. And so the credit accommodation that we might ask for in return for an extension has got to be tailored to every situation being different. But in the most recent one that we're looking at, we got a pay-down in return for an extension and that is more than adequate to have the loan carry itself. So I think each situation is different. I do believe that there's some more optimism now on the part of property owners and more willingness to put in what it would take to get them through the next year to 18 months and hopefully to a new place in the market.

Great. Thanks for all the background. It's very helpful.

And thank you. And I'm showing no further questions. I would now like to turn the call back over to Susan Riel, the President and CEO, for closing remarks.

Thank you, everyone. We appreciate your questions and you taking the time to join us on the call today. We look forward to speaking with you again next quarter. Have a great day.

This concludes today's conference call. Thank you for participating. You may now disconnect.