East West Bancorp Inc Q2 FY2022 Earnings Call

Good day, and welcome to the East West Bancorp Second Quarter 2022 Earnings Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Julianna Balicka. Please go ahead.

Thank you, Sarah. Good morning, and thank you, everyone, for joining us to review the financial results of East West Bancorp for the second quarter of 2022. With me on this conference call today are Dominic Ng, our Chairman and Chief Executive Officer; and Irene Oh, our Chief Financial Officer. We would like to caution you that during the course of the call, management may make projections or other forward-looking statements regarding events or future financial performance of the Company within the meaning of the safe harbor provision of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may differ materially from the actual results due to a number of risks and uncertainties. For a more detailed description of risk factors that could affect the Company's operating results, please refer to our filings with the Securities and Exchange Commission, including our annual report on Form 10-K for the year ended December 31, 2021. In addition, some of the numbers referenced on this call pertain to adjusted numbers. Please refer to the bank's regulatory filings, including our Form 8-K filed today for the reconciliation of GAAP to non-GAAP financial measures. During the course of the call, we will be referencing a slide deck that is available as part of the webcast and on the Investor Relations site. As a reminder, today's call is being recorded and will also be available in replay format on our Investor Relations website. I will now turn the call over to Dominic.

Thank you, Julianna. Good morning, and thank you everyone for joining us for our earnings call. I will begin the review of our financial results on Slide 3 of our presentation. This morning, we reported net income of $258 million and earnings per share of $1.81 for the second quarter of 2022. Our earnings per share grew 38% annualized for the first quarter of 2022. Total revenue of $551 million grew 45% linked quarter annualized, including record net interest income of $473 million. Our strong revenue growth, combined with controlled expense management, drove second quarter 2022 adjusted pre-tax, pre-provision income growth of 62% linked quarter annualized. Our bottom line returns are industry-leading. We returned 1.7% on average assets, 18% on average equity and 20% on average tangible equity. All our profitability ratios expanded. The second quarter results demonstrate the strength of East West's business model, which is geared for outperformance. Our balance sheet is well positioned for rising interest rates and revenue growth this quarter reflected not only loan growth but also net interest margin expansion of 36 basis points quarter-over-quarter. Our loan portfolio is well diversified and second quarter growth was broad-based across our major loan portfolios of commercial real estate, commercial and industrial, and residential mortgage. Our deposit base spans consumer, small business, and corporate commercial accounts. Quarter-over-quarter, average non-interest-bearing demand deposits increased 8% linked quarter annualized and totaled 44% of average deposits for the second quarter. We have a resilient balance sheet with strong capital and high liquidity. The diversification of our loans and deposits is important, not just because it helps support growth across different economic cycles, but also because it supports prudent risk management and our conservative credit culture. The economic environment is changing, but we are well positioned to navigate it with confidence and importantly, help our customers navigate well too. Slide 4 presents a summary of our balance sheet. As of June 30, 2022, total loans reached a record high of $46.5 billion. Second quarter average loans were $44.6 billion and grew 24% linked quarter annualized. Based on our year-to-date results, we are updating our loan growth outlook for the full year to a range of 16% to 18%, up from 13% to 15% previously. All else equal, our outlook does imply a slower rate of loan growth in the second half of the year compared with the pace of the first half. Our current pipelines are healthy, our borrowers' financial positions and liquidity are strong, and we are very optimistic about the future of East West Bank. However, in an environment of rising interest rates, real estate transaction volume may slow, impacting commercial and residential mortgage growth. Also, the high pace of C&I loan growth in the first half of 2022 may moderate due to inflationary, supply chain, and other macroeconomic pressures. Given the current economic uncertainty, we wanted to be conservative in our expectations and prudent in our growth. Total deposits were $54.3 billion as of June 30, 2022, and second quarter average deposits were $54.1 billion. Average total deposits grew 1% linked quarter annualized in the second quarter. Turning to Slide 5. Earlier in the quarter, we repurchased $100 million of common stock or 1.4 million shares. As you can see in the exhibit on this slide, our capital ratios are healthy and strong. As of June 30, 2022, we had a common equity Tier 1 ratio of 12%, a total capital ratio of 13.2%, and a tangible common equity ratio of 8.3%, which provides us with meaningful capacity for future growth. East West's Board of Directors has declared a third quarter 2022 dividend for the Company's common stock. The quarterly common dividend of $0.40 is payable on August 15, 2022, to stockholders of record on August 1, 2022. Moving onto a discussion of our loan portfolio beginning with Slide 6. C&I loans outstanding were $15.4 billion as of June 30, 2022, an increase of 15% annualized from March 31, 2022. Total C&I commitments were $22 billion as of June 30, sequentially up by 20% annualized. Our C&I loan utilization rate was stable quarter-over-quarter at 70%. Overall, similar to recent quarters, second quarter C&I growth was well diversified across our lending teams, geographies, and specialized verticals, including robust growth in our private equity and entertainment portfolios in terms of loans outstanding and commitments. Slides 7 and 8 show the details of our commercial real estate focus, which is well diversified by geography and property type and consists of loan-to-value loans. Total commercial real estate loans were $18.5 billion as of June 30, 2022, up by 37% annualized from March 31. Both were broad-based and well diversified geographically. Our property type segments grew in the second quarter, with the strongest net growth in multifamily and industrial commercial real estate loans. In Slide 9, we provide details regarding our residential mortgage portfolio, which consists of single-family mortgages and home equity lines of credit. I would highlight that 84% of our home equity line of credit commitments are in a first lien position. Residential mortgage loans totaled $12.5 billion as of June 30, 2022, growing by 33% annualized from March 31. I will now turn the call over to Irene for a more detailed discussion of our asset quality and income statement.

Thank you, Dominic. I'll start with our asset quality metrics and components of our allowance for loan losses on Slides 10 and 11. The asset quality of our portfolio continues to be strong. Quarter-over-quarter, non-performing assets decreased by 5%, down to $90 million, and the non-performing assets ratio improved by 1 basis point down to 14 basis points of total assets as of June 30. Other REO and foreclosed assets were down to zero as of June 30. Total criticized loans increased modestly to 2.2% of loans from 1.9% as of March 31, largely from CRE and C&I loans. Early-stage delinquency loans decreased quarter-over-quarter to $39 million. During the second quarter, we booked net recoveries of $7 million or 6 basis points of average loans annualized compared to net charge-offs of 8 basis points of average loans annualized for the first quarter. The second quarter recoveries were primarily in C&I loans. Our allowance totaled $563 million as of June 30 or 1.21% of loans compared to 1.25% as of March 31. The quarter-over-quarter change in the allowance largely reflects the mix of the loan portfolio as of June 30 as well as second quarter loan growth. During the second quarter, we recorded a provision for credit losses of $13.5 million compared to $8 million for the first quarter. Now moving to a discussion of our income statement on Page 12. This slide summarizes the key line items of the income statement, which I'll discuss in more details on the following slide. Of note, amortization of tax credit and other investments in the second quarter was $15 million compared with $14 million in the first quarter. This is lower than what we had previously anticipated because of timing. We expect the amortization of tax credit and other investment expenses to be approximately $40 million in the third quarter and $25 million in the fourth quarter now. Second quarter 2022 income tax expense was $83 million compared with income tax expense of $6 million for the first quarter of 2020. Year-to-date, the effective tax rate for the first six months of 2022 was 22%. We currently expect that the full year effective tax rate will be approximately 21%, including the impact of tax credit investments expected in the second half of the year. Now, we view the key drivers of our net interest income and net interest margin on Slides 13 through 16, starting with the average balance sheet. Second quarter average loans of $44.6 billion grew by $2.5 billion or 24% annualized. The strong growth across all loan categories drove a favorable mix shift in average earning assets quarter-over-quarter. In the second quarter, average loans made up 76% of average earning assets compared with 72% in the prior quarter. Second quarter average deposits of $54.1 billion grew by $104.5 million or 1% linked quarter annualized. Growth in average non-interest-bearing demand deposits, CDs, savings, and interest-bearing checking accounts was partially offset by a decrease in average money market accounts. This quarter, we observed customers utilizing their excess funds for acquisitions and investments. Importantly, we saw quarter-over-quarter growth in average demand deposits, which made up 44% of our average deposits in the second quarter compared with 43% in the first quarter and 39% in the year-ago quarter. Turning to Slide 14. Second quarter 2022 net interest income of $473 million was the highest quarterly net interest income in the history of East West, growing by 55% linked quarter annualized. The net interest margin of 3.23% expanded by 36 basis points quarter-over-quarter. As you can see from the waterfall chart on this slide, the net interest margin expansion in the second quarter reflects the impact of higher loan and earning asset yields, which increased the NIM by 31 basis points, plus the favorable earning asset mix shift which expanded the NIM by 12 basis points. This was partially offset by 7 basis points of compression from higher costs of interest-bearing funds. Turning to Slide 15. The second quarter average loan yield was 3.95%, an increase of 32 basis points quarter-over-quarter. The average loan yield comprised an average coupon yield of 3.83 plus yield adjustments, which contributed 12 basis points to the overall loan yield in the second quarter. As of June 30, the spot coupon rate on our loans was 4.19. In this slide, we also present the coupon spot yields for each major loan portfolio for the last three quarter-end periods. You can see the positive impact of rising interest rates on each loan portfolio as loans re-price. In total, 63% of our loan portfolio is variable rate, including 32% linked to the prime rate and 26% linked to LIBOR or SOFR rates. Note these loans re-price at least monthly. Turning to Slide 16. Our average cost of deposits for the second quarter was 17 basis points, up 7 basis points from the first quarter. Our spot rate on total deposits was 32 basis points as of June 30, with a year-to-date increase of 21 basis points. This translates to a 15% cumulative beta relative to the 150 basis point increase in the target Fed funds rate over the same period. In comparison, the cumulative beta on our loans has been 50% as our loan coupon spot rates increased by 75 basis points year-to-date. We started the rising interest rate cycle from a position of strength with historically high levels of demand deposits for East West Bank, strong liquidity, and an average loan-to-deposit ratio of 82% in the second quarter. These balance sheet characteristics bolster the asset sensitivity benefits of our variable rate loan portfolio, supporting strong revenue growth through the cycle. Moving on to fee income on Slide 17. Total non-interest income in the second quarter was $78 million, down from $80 million in the first quarter. Customer-driven fee income and net gains on sales of loans were $65 million, essentially unchanged from the first quarter and up 3% year-over-year. Moving on to Slide 19. Second quarter non-interest expense was $197 million, excluding amortization of tax credits and other investments and core deposit intangible amortization, adjusted non-interest expense was $181 million in the second quarter, up $6 million or 4% sequentially from a seasonally lower first quarter. The second quarter adjusted efficiency ratio was 33% compared with 35% in the first quarter. This reflects strong revenue growth and our ongoing disciplined expense management. With that, I'll now review our updated outlook for the full year of 2022 on Slide 19. For the full year 2022 compared to our full year 2021 results, we currently expect year-over-year loan growth, excluding PPP, of approximately 16% to 18%, reflecting year-to-date performance. Our updated outlook is an increase from our previous outlook of 13% to 15% loan growth. Year-over-year, net interest income growth, excluding PPP, is expected to be in the range of 30% to 35%, an increase from our previous outlook of net interest income growth ranging from 22% to 24%. Our updated outlook reflects loan growth as well as the impact of anticipated Fed funds rate increases on our asset-sensitive balance sheet, underpinning our interest income assumptions as the forward interest rate curve as of June 30, with Fed funds expected to reach 3.50 by year-end. Adjusted non-interest expense growth, excluding tax credit investment amortization, is expected to be approximately 9% to 10% year-over-year, an increase from our previous outlook for expense growth of approximately 8%. For 2022, we currently expect that provisions for credit losses will be in the range of $60 million to $70 million for the full year. This is up from our previous outlook for provisions for credit losses in the range of $50 million to $60 million. Finally, we now expect that the full year 2022 effective tax rate will be 21%. This is compared with our previous outlook, which was for an effective tax rate of 18% to 19%. The change in our outlook reflects higher pretax income and a lower amount of tax credit investment compared with our previous forecast. There will be quarterly variability in the tax rate due to the timing of tax credit investments placed into service. We currently expect that the third quarter tax credit investment amortization expense will be approximately $40 million. With that, I'll now turn the call back to Dominic for closing remarks.

Thank you, Irene. In closing, we have had a great first half of the year and look forward to delivering strong financial results to our shareholders in the second half of 2022. We're well positioned to navigate the current environment. Our balance sheet is asset sensitive. We have ample liquidity and strong capital. Our credit quality is likewise strong. Our associates are focused on providing superior banking services to our customers, and I wish to thank them for their efforts and excellent results. I will now open up the call to questions.

Thank you. We will now begin the question-and-answer session. Our first question comes from Ebrahim Poonawala with Bank of America Merrill Lynch. Please go ahead.

I guess first question is just around loan growth outlook. Dominic, you mentioned about maybe your guidance obviously assumes some slowdown in the back half. Is that just out of being wanting to be conservative given all the things you laid out or over the last two to four weeks, have you actually seen customer appetite to borrow and activity begin to slow down?

From our perspective, no one can accurately predict what the economy will look like in the next 6 to 12 months, despite various forecasts. With rising interest rates, we anticipate a decrease in refinancing activities for single-family mortgages and commercial real estate. Additionally, we are uncertain about consumer behavior during the upcoming holiday season—whether people will continue to buy gifts for their loved ones or not. At this point, it's unclear. While our customers are performing well, we feel it is wise to prepare for a potential slowdown. Logically, as interest rates continue to rise, refinancing activity is likely to decline, and significant investments might be postponed. Overall, even though our customers are doing fine, we believe it's prudent to lower our projections in case the economy takes a downturn.

Got it. And I guess one question for you, Irene. Give us your assumption on the deposit beta as we think about relative to your NII guidance? And just to put a fine point on your NII outlook, assuming 35% year-over-year growth implies exit fourth quarter NII closer to $575 million to $600 million. Just want to make sure we're thinking about that correctly.

Yes. I think Ebrahim, your number is pretty close to where I think we'll end up. On the deposit betas, I think for East West and really, the entire industry, we've been able to lag the deposit costs. So realistically, I think we're very proud of what we've done year-to-date. I want to give a shout-out to all of our team members. Frontline, this variable rate pricing is very challenging. But realistically, we do expect that deposit beta to increase for the rest of the year. With that said, with the strong amount of operating accounts that we have, the strong amount of DDA that we have, the percentage of our total deposits overall, at this point, I'm very comfortable that our kind of lifetime or cycle through deposit beta will be much better than what we had in the last cycle.

Next question comes from Brandon King with Truist. Please go ahead.

I wanted to first note loan growth. I thought it was pretty slow growth in China in the past quarter. I was wondering what you're seeing on the ground there and what are your expectations into the second half of the year and if that's also assuming slow growth there?

Brandon, I have some difficulty hearing your question. Is that — what is it?

The loan growth second half of the year.

About China, our operations in both China and Hong Kong performed exceptionally well in the first half of the year, despite the media coverage regarding lockdowns in Shanghai and quarantine measures in Hong Kong. Our team in that region faced significant personal challenges, including being confined to their homes while working, and some even being stuck in the office for over two months. Despite these difficulties, they managed to keep the business running and maintain strong relationships with our clients, actually achieving growth in loans and deposits. However, it's important to note that China represents only 5% of our balance sheet, so it won’t significantly affect our overall financial performance. I'm genuinely pleased with their accomplishments as they continue to develop a diverse commercial and industrial (C&I) business that includes various sectors such as manufacturing, consumer goods, entertainment, private equity, technology, clean energy, digital media, and healthcare. They have successfully diversified their focus and attracted high-quality customers. Furthermore, our clients have been thriving. Over the past few years, especially after tariffs were enacted in the U.S., our loan portfolio in China has maintained excellent asset quality without any credit issues. This success can be attributed to our bridge banking strategy, our in-depth understanding of China, and our expertise in cross-border business, which provide us with a unique competitive advantage. At East West, we leverage our skills in cross-border operations between the U.S. and China to offer specialized services that cater to businesses operating in both markets, a service that most U.S. banks do not provide. This gives us a significant edge with less competition, allowing us to select quality clients. Overall, I'm very pleased with the current state of our operations. As of today, our teams in Hong Kong and China have returned to the office and are operating as usual, and we expect them to continue delivering strong results in the second half of the year.

Okay. And then more of a big picture question as far as the business plan as the adjusted efficiency ratio reached 30% and potentially below, I mean what is now what you kind of picture in the efficiency ratio? I know you've seen a lot of positive operating messages. Is there a decision for you to accelerate some investments, particularly next year because of where the efficiency ratio was there?

Yes. I think on the efficiency ratio, Brandon, we don't have a ratio that we're trying to target. This is the time where Dominic goes through the calculation of the numerator and denominator. Obviously, for East West, we remain disciplined on spending. With that said, we have continued to make the investments we think necessary to support our business. Our cash management products, you see that with the outstanding growth we have cross-border as Dominic talked about, also particularly on the consumer side, on the digital side as well. In this kind of environment, we're an asset-sensitive bank. So with the revenue increasing, obviously, that efficiency ratio adjusted to that. But just to recap, we don't just try to guide to our efficiency ratio, but we make investments we need to support the business.

Yes. The efficiency ratio is a report card kind of metric, and metrics like return on equity, return on assets, efficiency ratio—these are report card numbers. We looked at it and are proud to be in that position. However, we are much more focused on measuring inputs such as deposit growth, loan growth, interest margin expansion, asset quality, and making sure the expenses grow according to what the balance sheet calls for. That's what we're trying to focus on.

I'll just add that maybe the report card numbers of ROA and ROE matter more for us.

Our next question comes from Chris McGratty with KBW. Please go ahead.

Dominic, positive, just surprised to see the buyback in the quarter. How do we think about prospective use of the rest of the buyback, given the markets, the stock valuation, but also uncertainty in the macro?

Okay. On the buyback, well, I've said it before that the bank is always shareholder-friendly, but we are relatively, I think, more prudent and conservative than other banks. We are opportunistic. When we do see the right time and place, we do strike. That's what we did in the second quarter. Here's what I see based on the economic landscape today and looking forward and seeing that we'll continue to increase interest rates with many economists not predicting a good economy going forward. We feel that it’s probably best to pause and wait. That’s consistent with East West Bank's philosophy. When we feel that it’s the right moment and we have plenty of capital and earnings, we will step in and do the right thing for shareholders. In the meantime, we feel that preserving capital is a better approach right now. Reflecting back several years ago, most banks were actively doing buybacks, while East West was one of the isolated few that didn't. But if you look at what we've done in the last four to five years, we have almost doubled our balance sheet organically, not through acquisitions. We knew we had the engine that could grow, and we did not want to spend capital on buybacks when we knew that we had plenty of growth opportunities. It did not hurt to have plenty of capital at the beginning of COVID. Our position is that we will always consider shareholders' returns, but we want to look at it from a long-term perspective when it comes to buybacks.

That's great perspective. If I could ask one more. A common thread throughout the quarter for all the banks has just been deposits and levels. I think the concern in the market is that with the Fed executing Q2, there's going to be a narrow pocket on deposits. I'm sure you've looked over your portfolio and kind of separated what may be at risk. But could you share with us any observations about what pieces of the book might be at more risk and how much you think could flow out if the Fed does what it says it's going to do? Thank you.

I think the key part of East West Bank's deposit franchise is our retail banking deposits. We, unlike many regional banks, actually have a very strong retail banking deposit franchise that is stable with plenty of customers who have banked with East West for many years. They are the ones we do not expect much volatility from. Obviously, when rates rise substantially, we do need to ensure we take care of them and pay them a higher rate. However, I don't expect a lot of volatility from the retail banking side. We expect that we will have opportunities for growth. One good example is that we started a business checking deposit product about a year ago. In the last six months, we brought in about close to $500 million of DDA deposits. We will continue to find opportunities to grow DDA balances with small business customers. Additionally, we continue to see activities from overseas investors still putting money in the United States. Most of them view East West as their first choice. From that standpoint, we feel pretty good. Of course, we do have commercial accounts that have more volatility due to operational needs. These are the ones we keep a close eye on. Still, we feel that our current deposit rates give us more room to work with our customers if we need to pay a higher rate to retain more deposits.

Our next question comes from Jared Shaw with Wells Fargo. Please go ahead.

Hi. Good morning. Thanks. Maybe just following up a little bit on the deposit side. When you look at your guidance for NII, what's the expectation for overall deposit growth? I guess maybe sort of loan-to-deposit ratio in this environment? And it sounds like, Dominic, you think that in that scenario, you can still see DDA balance growth from some of these new initiatives. Is that the right way to look at it?

We do expect that deposits will grow for the entire year. I think quarter-over-quarter, especially on an average basis, you will see variability, for example, this quarter as well. Historically, we've had clients, one client in particular related to tax property tax payments made in the second quarter, the balances go down. We saw that this quarter as well. With that said, I would like to comment on just the granularity of the deposits that we have, as Dominic mentioned. Not only do we have a broad base on the retail side, small business on the retail side. Overall, on the commercial side as well, the deposits are very granular in nature. So that's something that we believe will continue to help us as we go through the cycle.

But with that backdrop, should we assume that you'd be comfortable getting that loan-to-deposit ratio back north of 90% if loan growth is there?

Yes, if loan growth is there. We've commented on this before. High 80s, low 90s is something we're very comfortable with, again, particularly with the granularity of the deposits that we have.

We don't have a problem of growing loan balances due to pressure from deposits because at this 80-plus percent loan-to-deposit ratio we have plenty of room. So we just — the reason that we do not have a very high expectation of high loan growth for the second half despite the fact that we have good pipelines and good momentum is because the overall economic outlook does not look very good. But if it turns out that we continue to find high-quality loans that we can book, then we will simply do so because we've got plenty of deposits to support it.

Great. And then just as a follow-up to my second question. Looking at the expense guide and the increase there, is that primarily just performance based on better revenue drives, better performance incentive comp? Or are there some new initiatives in there for the franchise?

We always make incremental investments every single year. East West's philosophy is to never do a major big project and load it in one year, causing volatility in our earnings. So we'll continue to invest. Of course, there are certain inflationary factors in here simply because wages and other types of miscellaneous expenses have increased due to the 9.1% consumer price index number that came out recently. Our position is that while we're managing our expenses very prudently, we expect them to go up slightly. That’s why we're guiding it up from an 8% increase to a 9% to 10% increase.

Our next question comes from Clark Wright with D.A. Davidson. Please go ahead.

This is Clark Wright on for Gary Tenner this morning. My question pertains to loan growth in the guidance. Assuming a lower pace of growth in the second half, it wouldn't be surprising given the first half growth. Could you maybe provide insights into the pipeline building into the third quarter? And whether or not your projections assume a drop off in the fourth quarter or if the drop-off is balanced between the third and fourth?

Well, we are just being prudent because sometimes a pipeline does not result in funding. Our projection right now is that there may be a lot of deals in the making, but I expect prudent investors—who are our great customers—may look at it two to three months from now and conclude that maybe they shouldn't move forward. We are anticipating that some people will think about doing deals and then end up not going through with them. A very simple example is in the residential mortgage area; we expect some people who anticipated refinancing may decide not to because rates are too high. This transitional period may lead to uncertainty where investors will hold off on transactions that may not look as attractive due to higher rates while asset prices remain high.

This concludes our question-and-answer session. I would like to turn the conference back over to Dominic Ng for any closing remarks.

Well, thank you all for joining the call, and we are looking forward to talking with you again in October. Thank you.

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