First Foundation Inc. Q2 FY2020 Earnings Call

Greetings and welcome to First Foundation's Second Quarter 2020 Earnings Conference Call. Today's call is being recorded. Speaking today will be Scott Kavanaugh, First Foundation's Chief Executive Officer; Kevin Thompson, Chief Financial Officer; David DePillo, President of First Foundation; and John Hakopian, President of First Foundation Advisors. Before I hand the call over to Scott, please note that management will make certain predictive statements during today's call that reflect their current views and expectations about the company's performance and financial results. These forward-looking statements are made subject to the safe harbor statement included in today's earnings release. In addition, some of the discussion may include non-GAAP financial measures. For a more complete discussion of the risks and uncertainties that could cause actual results to differ materially from any forward-looking statements and reconciliations of non-GAAP financial measures, see the company's filings with the Securities and Exchange Commission. And now I would like to turn the call over to Scott Kavanaugh.

Hello, and thank you for joining us. We would like to welcome all of you to our second quarter 2020 earnings conference call. We will be providing some prepared comments regarding our activities, and then we will respond to questions. As highlighted in the press release this morning, we experienced another strong quarter across all key financial metrics of the firm. Our earnings for the second quarter were $17.9 million, a 44% increase over the second quarter of 2019 or $0.40 per share. Total revenues were $57.4 million for the quarter, an increase of 13% year-over-year. Our efficiency ratio for the second quarter was 53% at FFI and 47% at the bank, and our tangible book value per share ended the quarter at $12.16 per share. We can also report that the company's Board of Directors has declared our quarterly cash dividend of $0.07 per share. And at this time, we anticipate the continuation of the dividend in future quarters. I am extremely grateful to all of our employees who have helped us produce such strong results this quarter. It's been remarkable to see our team perform amidst all that is currently going on. As I've said in prior calls, we have been focused on the health and safety of our employees and our clients. Providing excellent client service has been a core value of ours and we remain committed to offering support to those in need. We participated in the Small Business Administration's Paycheck Protection Program, and Dave will touch on that more in detail. We have suspended any further participation in the PPP and currently, do not intend to participate in the mainstream lending program. I am also so pleased that all of our branches have been able to safely remain open to support our clients throughout all of this. And as you are aware, we rolled out our digital platforms in October of last year, which proved to be good timing with the pandemic. These digital platforms have performed well, both for our clients who need vital services, as well as our employees, who have relied on virtual technologies to conduct many of their day-to-day functions. This quarter's results are another testament to the strength of our business model. We saw strong loan and deposit growth, and despite volatile financial markets, our assets under management returned to near peak levels. I'm very grateful for all of our employees, and I want to thank all of our clients who entrust us with their financial needs. This time, let me introduce and turn the call over to our newest member of the executive team, our CFO, Kevin Thompson.

Thank you, Scott. It's great to be part of the team. In spite of a challenging economic environment, we experienced strong profitability in the quarter with a diluted EPS of $0.40 per share. As Scott mentioned, the efficiency ratio decreased to 53% at FFI and 47% at the bank, with a return on assets of 1.06% and a return on tangible common equity of 13%. Our track record during this quarter is a testament to our business model. We benefit from fairly consistent fee income from our financial advisory group, a strong loan portfolio especially focused on a conservative multifamily book, and the liability-sensitive balance sheet that is poised to benefit in this rate environment. And even as we grew deposits by 12%, we witnessed a decrease of interest expense by 30% in the quarter, which helped boost net interest income by 8% and the net interest margin to 2.96%. The ratio of allowance for credit losses to loans increased to 55 basis points this quarter. Even with strong credit metrics and trends, we used more severe economic scenario assumptions under the CECL framework to help boost our reserve levels. With strong expense management and continued operational leverage of the investments we have made in our business, pre-provision net revenue increased an impressive 17% in the quarter, despite the lower noninterest income as a result of lower transaction volumes and advisory fees in the quarter. At this time, we still believe our third-quarter multifamily loan securitization should occur as planned. All in all, it was a strong quarter, and I want to thank everyone on the First Foundation team for the warm welcome. I will now turn the call over to David DePillo, President of First Foundation.

Thank you, Kevin. First, I want to reiterate our gratitude to our team members. Thanks to their efforts, we have been able to maintain a consistent pace with our business plan projections and support our customers. During the second quarter, we originated $701 million of loans. As expected, loan demand has softened somewhat in many of our markets, but we will remain on track for a strong year, pending any additional unforeseen circumstances. The composition of our loan originations for the quarter is as follows: multifamily, 55%; commercial, including owner-occupied commercial real estate, 38%; single-family, 6%; and other, 1%. For the second quarter, the weighted average rate on our loan originations was 2.86%. Excluding PPP loans, originations were at 3.55%. I wanted to also reiterate some items about the credit quality of our loan portfolio. As Kevin mentioned, our asset quality remains strong, with NPAs remaining at 22 basis points. Approximately 85% of our portfolio is secured by real estate. Across all segments, the loan-to-value is low, averaging below 60%. Our debt service coverage ratios on our multifamily non-owner-occupied commercial real estate are strong. In our commercial business loan portfolio, we have low exposure to industries that have been hit hard by the pandemic. Specifically, hospitality and restaurants representing $51 million are less than 1% of our loan portfolio. In addition, we have no meaningful exposure to oil and gas, aviation, or cruise industries. In our owner-occupied commercial real estate portfolio, we have low exposure to hotels and retail buildings, representing $26 million and $156 million, respectively, or a combined total of 3% of our total loan portfolio. As mentioned, we participated in the PPP program and funded 604 loans, for a total balance of $171 million. The forgiveness portal, the system we used to receive, evaluate, track, and process PPP loan forgiveness requests, has not been forgone at this time as we are still awaiting further guidance from the FDA. We anticipate the majority of these loans to be forgiven in the fourth quarter of 2020 and the first quarter of 2021. We have also handled requests for forbearance, which remain low, and we have not seen any significant need for forbearance in our multifamily portfolio at this time. During the quarter, deposits grew by $617 million, which is an increase of 12% compared to the second quarter of last year. We saw growth in both retail deposits and in our specialty deposits. And our online deposit activity has contributed an additional $370 million since we launched that offering 9 months ago. Now I'd like to turn the call over to John Hakopian, President of First Foundation Advisors.

Thank you, David, and good morning. Our assets under management closed the quarter at $4.3 billion. We added $157 million of assets under management from new clients, which is at a pace that is ahead of last year. Also, client terminations are trending much lower than last quarter. This is a testament to our team who continues to perform even amidst this pandemic. Our investment philosophy, which relies on a value-based investment acumen to preserve capital and manage downside risk, has performed well for our clients. Our balanced portfolios have done well this year. Also, our trust department continues to be instrumental in our ability to build and maintain relationships with our clients. Our trust department allows us to work with clients that have financial needs beyond our traditional investment and wealth planning offerings. We have been able to eliminate some positions and do not feel the need to replace them at this time. With AUM at peak levels and with the recent reduction in staff, we anticipate margin improvement going forward. We are looking at ways to further strengthen our efficiencies by making enhancements to our core technologies and improving the client experience. This was a project that was already well underway, but has been validated by the pandemic, given the benefits we could realize in the near term. Whether we continue to operate virtually with clients for the foreseeable future or we return to the in-person model soon, we are becoming better positioned to serve our clients in either scenario, however they may prefer. We also have uncovered some new opportunities to efficiently capture assets from clients who are more inclined to leverage technology when working with a wealth manager. With these elements in place, we are seeing a strong pipeline and expect to continue to be successful in attracting new clients in the future. At this time, we are ready to take questions, and I will hand it back to the operator.

Your first question is from Matthew Clark of Piper Sandler.

Can you give us the contribution to NII this quarter from PPP?

The actual dollars? You want to go?

Yes, I don't have that with me, the actual contribution. But because of the low rates, as you know, Matthew, it did impact our net interest margin by about 4 basis points. It was a hit to our net interest margins. But I don't have the actual amount. But you could take the average loans that were out there to be about $171 million. By average, the rates were 1%. The fees are amortized over 2 years if you kind of back into that.

Okay. Yes. Okay. And then the reserve was up on a dollar basis, about $7.5 million. It doesn't look like it came through the provision. Can you just give us some color on how that was reallocated?

Sure. Yes, there are a couple of things going on there. So as part of CECL, you take your purchased credit impaired loans, and what happens is those become automatically under the fees. They automatically become purchase credit deteriorated loans under the CECL framework. And there's a process you're supposed to go through called a gross up, where you look at those loans and decide what portion of the discount you had out there is related to credits and what is non-credit. We went through the analysis, and it's all credit-related, so we appropriately dispositioned those loans into the CECL reserves. So that doesn't impact the income statement. You saw a number of our peers that have been acquisitive in the past do that same thing last quarter. So that's one item. Yes. And the other item is under CECL, there's this new thought that as you have what would have traditionally been called the other than temporary impairments on securities when cash flows have some impairment going on, historically, you would have had an evaluation allowance against that security. Under CECL guidance, actually, that runs through your credit provision now. And so what you do is you take the present value of your cash flows, compare that to your fair value or amortized cost. And you saw that last quarter, we had an IO strip adjustment, that appropriately was run through CECL this time, and there was a small increase to that this quarter as well. Does that make sense, Matthew?

Yes, that's great color. And then just shifting gears back to the margin. Do you happen to have the spot rate at the end of June on your interest-bearing deposits and maybe the interest-bearing liabilities as well, just given the dramatic drop in funding costs? Trying to get a sense for where they might be headed in 3Q?

Yes. The interest-bearing deposits fell to just under 1% by the end of the quarter. We're reporting an average of 1.18% for the quarter, indicating a noticeable decline, and we expect more changes ahead. There is still a significant amount of movement anticipated.

Yes. We still think that there's going to be an adjustment in interest expense lower in the third quarter and slightly into the fourth quarter and should be fully adjusted going into 2021. Remember, we also have described $0.5 billion of Home Loan Bank borrowings that will mature in September, I think it's mid-September, and that currently is at a rate of 1.77%. And when that wears off, I'm not sure, given our loan-to-deposit ratio and the securitization, that we'll need to replace it. But if we did, it would be in the teens in terms of what the rate adjustment would be. So I think one of the things that we're also trying to do is between Home Loan Bank advances, we want to see a decline in that. We've been very strong in the deposit-gathering mode. And then also brokered deposits, we're letting a lot of that wear off. I think we can reduce that quite a bit, maybe as much as $400 million or $500 million.

So if you look at it this way, Matthew, typically, this quarter is the one we kind of give you a margin with and without our wholesale leverage going into securitization. This year, it's particularly prominent in the fact that, as Scott mentioned, that 1-year term borrowing that we're matching against the loans available for sale is at a rate that's significantly higher than borrowing costs today, equivalent borrowing costs today are probably 20 basis points. That effect on the margin will be immediately impacted at the end of the third quarter and then full benefits going forward in the fourth quarter. If you kind of do a margin buildup, it was 2.96%, and it was 3 basis points for PPP, in that effect. So call it 3% there is kind of our rate today. And then including the effect of the wholesale leverage, about another 10 basis points.

Another 8.

Another 8 basis points. So you can kind of back into where we're at excluding those items.

Hence, in the past, we've talked about having a higher than 3 margin. I think we'll be able to attain that next quarter.

Yes. Okay. Great. And did you buy back any stock in the quarter? And if so, how much and at what price?

No, we did not. I think for the foreseeable future, Matthew, there's no real intent. When our stock was trading below tangible book value or close to tangible book value, it made more sense. I'm sure you can look at the capital levels and say it looks like it's close. So I think for the time being, we're just going to accumulate capital; we'll pay our dividends. But unless the stock dips significantly, I probably will not buy any stock back anytime in the next several quarters.

Okay. Last one for me. Regarding the multifamily portfolio, I haven't seen many deferrals at all. If the unemployment benefits are reduced, should we start to be more concerned about the underlying rents and the potential need for some forbearance?

It's kind of interesting. There's a lot of elasticity in the cash flows of our multifamily borrowers. So even if they saw, say, a 10% collection variance, maybe as high as even 20%, most of them are still cash flow positive towards debt because of the nature of our underwriting. So could there be some impact potentially if this becomes severely protracted for a long period of time and there is no safety net. But at this point, we've done some pretty severe stress analysis through our CECL modeling. And because of the richness, again, of the cash flows, it would take something beyond just a non-continuance of unemployment benefits to dramatically impact to the point of any need for forbearance or any form of default.

Our next question is from Steve Moss of B. Riley FBR.

Starting with the perhaps loan yields here. Just kind of wondering where they ended up at the quarter. I think I heard 3.55% for the quarter average. Just wondering if spreads are tighter today than they were during the quarter here?

So interesting, the loans that were funded out, obviously, the ones that are impacted the most outside of PPP, which had kind of an aberration to the net, are typically multifamily. Those came down from 3.71% in the first quarter to 3.55%, and the majority of that pipeline was built up when the Fed dropped rates, and there was kind of what we call pre-lockdown. So there was high demand and no risk-adjusted return. Our expectation is that's probably where we're going to normalize. Most people have figured out that multifamily is somewhat a safe harbor in the market; most lenders have returned. From an internal modeling standpoint, Steve, we look at that run rate as kind of consistent going forward. We had, I would say, a brief period of time of wider spreads in the market. But certainly, from what we see, all the way from the agencies through portfolio lenders, those spreads have more or less risk adjusted themselves back to where they were in the first quarter. Does that kind of answer your question on that?

Yes. And so in terms of the pipeline, just kind of curious here. I mean, you mentioned some moderation in the pipeline and slower loan growth. Any extra color kind of what you're thinking about for the back half of this year would be helpful.

We anticipated a slow July, with an uptick starting in August, and then a return to our normal production levels by the fourth quarter. Summer generally sees slower activity, compounded by COVID, and multifamily borrowers have been more cautious, taking a wait-and-see approach. However, this trend has eased, and we're beginning to see renewed momentum in our pipeline. We're currently performing better than our internal expectations for July and August, which is encouraging. We expect to reach full capacity by the end of September as we move into the fourth quarter. The market is showing signs of increased purchase and refinance activity, particularly in the robust residential mortgage sector. Multifamily lending is also picking up pace in alignment with this overall trend.

Okay. That's helpful. And then in terms of funding costs, perhaps going to customer service costs, you had pretty good growth here, I think, on an EOP basis. Just kind of curious as to how to think about that line item for the back half of this year as well?

Well, it's a confluence of two things: one, lowering costs, but higher balances. So I would say that I would probably run it flat because we are seeing huge demand by a lot of our customers to park money, so to speak. I think you've probably heard this from just about every bank. There's a demand for a home for deposits now that we haven't seen for quite some time. So I don't think the relative absolute dollars will decline. The rates have kind of bottomed out. Balances are going to be up pretty significant.

A little bit, but...

But balances are going to be up pretty significant. The way I would look at it, Steve, is even with those higher costs, the banks are already in the 40s in efficiency. That should continue to improve as our revenues continue to improve as well. I would say we wanted to be at about 50% efficiency by the end of this year. We're already ahead of schedule, even including higher balances in the customer service area.

Okay. That's helpful. And last one for me. In terms of the wealth management business, good rebound. Just with regard to the new clients coming on board, is there a further pipeline of new clients to add? And just kind of any color there would be great.

Yes. No, great question. So what we're seeing is the quality of the new clients coming on board seems to be larger relationships, relationships that also include our trust company. The volume is probably a little less, but in terms of quality and size of relationship, it's probably a better and larger client relationship.

Is that a shift in the conversation? I'm sorry, go ahead.

No. Go ahead, Steve.

In terms of whether this is due to the hiring of new relationship managers or what is driving the shift towards larger clients, can you provide some insight?

No. I think if you look back over the last several years, we've definitely been moving upstream, trying to go after larger relationships. As a result, we recently established a $25 million relationship. Through the Schwab channel, the TD channel, as well as our own channel, we've been actively bringing on larger relationships, which has been a focus for us over the last couple of years. The platform was designed for larger relationships. We've worked closely with our trust company, and our Nevada Trust offering has been particularly beneficial, along with the California Trust powers.

I think it's important to point out, we did have a reduction in staff. We really have not added relationship managers. We've actually pared back a few. I would tell you that in quarters past, margin has not been where we would like to see it. And I think on a go-forward basis, you're going to see margins start to improve and will continue to improve. We're kind of hunkered down. Most of our RMs are working off-site or remote. So to have that type of pickup in new assets is actually pretty good. But I think it's just equally as important to talk about the expense savings, which are at least a couple of million dollars so far. And as soon as we can bring our new operating system online, I think we can create more efficiencies on a go-forward basis and not feel the need to increase our staffing.

Yes. And lastly, just I think when you get more volatility in the markets, people tend not to want to manage their assets on their own, so they're out engaging a wealth manager like ourselves. And so we usually see a pickup in business when we see the volatility we've seen in the last couple of months.

Your next question is from David Feaster of Raymond James.

I want to start by discussing deposit growth. It was significant, but when I compare end-of-period to average, it appears much of the growth occurred late in the quarter. I'm interested in understanding how much of this growth you attribute to PPP or stimulus versus genuine organic growth from your digital brand, specialty deposits, or other sources. Additionally, could you share how deposits have trended early in the third quarter and your expectations regarding the sustainability of some of this deposit growth?

It's interesting. We analyzed the PPP, and about half the funds have already left, which is good news. It's probably over 60%. Of the $171 million funded through PPP, about $160 million actually went into a First Foundation account rather than another bank. As Dave mentioned, over half of that has already left the bank. When you consider the $600 million we brought in, the impact is not significant. The branch network was very successful, the digital network was also very successful, and our specialty deposits increased as well. As Dave pointed out earlier, we've had many clients reach out saying they want to deposit more, and we've certainly benefited from that, along with new relationships.

We funded $171 million in PPP, with about $160 million going into a First Foundation account instead of another bank. As Dave mentioned, over half of that has already left the bank. So, when you consider it, the impact isn’t significant compared to the $600 million we took on board. It was a broad effort; our branch network was very successful, our digital network performed exceptionally well, and our specialty deposits also increased. Additionally, as Dave pointed out earlier, many clients have reached out wanting to deposit more funds, and we have certainly benefited from that along with new relationships.

At the end of the quarter, our balance sheet shows that this is typically our highest loan-to-deposit ratio due to the wholesale leverage from those excess loans. We've reached a level not seen before, essentially 1:1 during this timeframe, and a significant portion of our balance sheet growth is currently in cash, which is unusual for us. As Scott mentioned, there's strong demand for deposits across all sectors. We expect continued growth as our digital channel expands, raising the question of how persistent this business is. When we launched that program, our rates were considerably higher than they are now, and we've been gradually lowering them, yet the growth continues without significant decline. Our retention rate remains very low as long as we're competitive in the market, which we can maintain since we aren't supporting numerous legacy branches. We're nearing a point where we can merge those with our branch rates, something we haven't done in a long time. Additionally, rent growth has been substantial, and we anticipate ongoing growth particularly in our specialty segment. The deposit pipeline remains very strong.

That's great to hear. Regarding the multifamily portfolio, I'm interested in your insights from clients. Investors seem to have some concerns about the market, and we're observing various data on rent collections. You are in a strong position in rent-controlled markets. I'm curious about the trends in rent collections for June and early July, as well as the trends in vacancy rates.

We haven't noticed any significant decline in collections from month to month or period to period. July seems to be consistent with what we saw in June and May. When speaking with our clients, they usually collect most rents during the standard collection period, with only a few tenants needing additional time at the end of the month. Aside from that, we haven't experienced any notable tenant defaults. Many municipalities are now encouraging renters to pay their rent after previously suggesting otherwise due to legal challenges they faced, as seen in cases in California. They are now being more mindful in advising tenants to prioritize rent payments. Additionally, some major cities in California, particularly Los Angeles, have introduced rental assistance programs to support renters. The trend of people working from home has increased the importance of housing, especially since many renters are in apartments and do not want to risk their job security. We observe a heightened significance of housing demand compared to the past, despite mobility remaining intact. Our daily conversations with apartment owners and the securitization process provide us with updated rent rolls, and we don't see any stress compared to July, June, or May. If lockdowns were to continue indefinitely or new challenges arose, that could change the situation, but as it stands, each day feels quite similar to the last.

I told you anecdotally, I own units myself. And in the month of April, May, June, and July, it's been 100% collections.

And you would say those are more traditional workforce housing?

Yes. Workforce housing, which is exactly the type of stuff that we do.

That's helpful. Following up on your point, Dave, regarding working from home, I have a more strategic question. I believe I know the answer as the market supports your business model. As you reflect on your position in the market and your business model, do you foresee any adjustments to your strategy in light of the increased number of remote workers, enhanced digital adoption, and evolving consumer behaviors? I'm curious about both the potential for expense savings, such as reductions in office space, and opportunities for growth or areas where you might consider investing to foster additional organic growth moving forward.

We started this journey about four years ago, deciding not to rely solely on physical locations. Our focus was on investing in technology and upgrading our systems to achieve the scale and efficiency that many institutions of our size didn't pursue at that time. Initially, we faced criticism because our efficiency ratio was higher than usual. However, we believe those investments are beginning to pay off in several ways. From the foundation of our business, when Scott established the bank, we developed it during a time when distributed technology was more effective than the approaches taken by banks 20 or 30 years ago. This setup allowed us to have a distributed workforce from the very beginning, which has been a strategic advantage. Over the past five years, we have enhanced our core systems and digital delivery. On the commercial side, we built a strong platform because we understood that our target client base needed advanced technology to accomplish their tasks. Additionally, we made a strategic choice to enhance our consumer digital delivery platform. We believe we are on the cutting edge of digital delivery for consumers, avoiding the risks of being on the bleeding edge. While larger banks invest substantial amounts to determine how to deliver these services, we opt for cost-effective, off-the-shelf solutions. Our digital branch has seen impressive growth, going from nothing to $380 million in less than nine months.

Yes.

We grew the size of a community bank in that period, literally, with a few people at no cost, effectively, on the margin to us. Our strategic partnerships with our technology providers are some of the best in the industry right now. They're using us as kind of the poster child for other banks. We've won several awards around our distributed delivery as well as our internal efficiency use of business intelligence. We feel, going into this next leg, we were just lucky to make those investments when this pandemic hit because we sit around with 15% of our staff on site and we're as efficient or more efficient than we've ever been.

I keep using the word serendipitous. I mean, it really was serendipitous. Look, looking forward, on a longer-term basis. And I think it's important to really talk about it. We have very little office exposure, if any. When you look at our CRE concentrations, it's multifamily. We're not the only bank. I mean, I've been reading all the big banks are in no hurry to bring their employees back. We were initially phasing some of our employees back, and we've halted that. I think for the foreseeable future, we're evaluating what our needs are in terms of office space. And come time for the renewal, I have a feeling we won't need near the office space that we currently have, which will be further cost savings for First Foundation. I would bet that not just banks, but a lot of different companies out there are facing the same thing that we are and realizing that you can still get good productivity from people working remotely as well.

Yes. Just the ability to reach different demographics than we've historically been able to do over half of our customer base through our digital delivery. New customer acquisition is 40 and below, which is very unique. This institution, typically, from an age and demographic perspective, was kind of 65 and above. We've kind of transformed the customer base of the bank to be a lot more broad and we want to continue to do that. That's where all our energy is really through the expansion of our product offerings, digital delivery, and that goes all the way through our high-touch customer service side. So at the end of the day, if you need a high-touch customer service and you want to do it digitally, we want to be the default option.

We have a follow-up from Matthew Clark of Piper Sandler.

On the comp line, the drop there, I guess, how much of that was driven by the deferral of origination costs tied to PPP, if any?

It's not terribly impactful. You have a little bit of a decrease during this time, with lower commissions and lower transactions happening in branches and things like that. And of course, the first quarter is when you generally have the highest benefits and salary costs. So we anticipate going forward, as things normalize, that line coming up slightly.

Matthew, we've been very firm about hiring practices throughout kind of this area. Plus or minus 1 or 2 bodies, we're at 500 employees. We feel that that's sufficient for the workload that currently we can handle. So I think for the foreseeable future, you should expect to see the headcount remain very close to 500.

On the deferral side, we've been quite conservative in terms of deferrals. While many companies tend to defer a significant amount of expenses, we prefer not to have our loan basis to be extremely high. Therefore, across all business lines, including PPP, we've maintained that number at a relatively low level.

This concludes our allotted time for today's question-and-answer session. I will turn the call back over to Mr. Scott Kavanaugh for closing remarks.

Thank you, everyone, for taking the time today. We certainly appreciate it. Overall, we are pleased with our results, and we look forward to speaking with you next quarter. This has been an extraordinary time, and our team has been up to the challenge. I am so proud of how everyone has responded. Thank you again, and have a great remainder of your day.

Thank you. This does conclude today's conference call. You may now disconnect.