First Hawaiian, Inc. Q3 FY2022 Earnings Call

Good day, and thank you for standing by. Welcome to the First Hawaiian, Inc. Q3 2022 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Kevin Haseyama, Investor Relations Manager. Please go ahead.

Thank you, everyone, for joining us as we review our financial results for the third quarter of 2022. With me today are Bob Harrison, Chairman, President and CEO; Ralph Mesick, Chief Risk Officer and Interim CFO, and other members from the management team. We have prepared a slide presentation that we will refer to in our remarks today. The presentation is available for downloading and viewing on our website at fhb.com in the Investor Relations section. During today's call, we will be making forward-looking statements. So please refer to Slide 1 for our safe harbor statement. We may also discuss certain non-GAAP financial measures. The appendix to this presentation contains reconciliations of these non-GAAP financial measurements to the most directly comparable GAAP measurements. And now I'll turn the call over to Bob.

Thank you, Kevin. Good morning, everyone. I'll start with a brief update on the local economy. Hawaii's economy continues to be resilient. In September, the statewide unemployment rate fell to 3.5%, which is in line with the national unemployment rate. Total visitor arrivals were 703,000 in September of this year, which is 4.5% lower than September 2019 arrivals. This is a strong result considering the Japanese visitor arrivals were 3.4% of the total this year compared to 19.6% of the total in September 2019. Japanese visitor arrivals represent a significant upside when they return to more normalized levels. Despite the lower number of arrivals, visitor spending in September was $1.48 billion, which was 18.5% higher than September 2019. While higher interest rates have caused a slowdown in the housing market, continued demand and lack of supply have kept prices stable. In September, single-family home sales on Oahu were down 34.4% from last year, but the median sales price was $1.1 million, 4.8% higher. Turning to Slide 2 to review our third-quarter results. We had a very strong quarter as net income grew to $69 million or $0.54 per share. We continue to benefit from our asset-sensitive loan portfolio and low-cost core deposit base. Our return on average tangible assets was 1.14%, and return on average tangible common equity was 21.53%. The Board maintained the quarterly dividend at $0.26. During the quarter, we repurchased approximately 107,000 shares for $2.5 million, and we continue to maintain strong capital levels after dividend payments and share repurchases. The common equity Tier 1 ratio was 11.79% at quarter-end and total capital was 12.92%. Turning to Slide 3. The balance sheet continues to be well positioned for the current environment. It remains asset-sensitive, with about $5.4 billion or 39% of the loan portfolio repricing within 90 days, and we saw the responsiveness of our loan yield to higher interest rates in the third quarter. We also improved the balance sheet mix in the third quarter as we deployed excess cash and investment securities runoff into higher-yielding loans. The investment portfolio continues to perform well as rates have increased. The duration of the portfolio remains stable at 5.5 years in the third quarter, virtually unchanged from year-end. And cash flows from the portfolio ran about $90 million per month for the third quarter. During the quarter, we reclassified an additional $420 million of securities to held to maturity to reduce the accounting volatility associated with AOCI adjustments. Our liquidity position remains very strong, with a 62% loan deposit ratio, a strong core deposit base and steady cash flows from the investment portfolio. Turning to Slide 4. Period-end loans and leases were $13.7 billion, an increase of $438 million or 3.3% from the end of Q2. We experienced growth in all portfolios, with the largest increases in commercial real estate and commercial & industrial loans. On a year-to-date basis, total loans and leases are up $738 million or 5.7%. Excluding PPP loans, total loans and leases are up $928 million or 7.3%, in line with our full-year outlook of mid- to high single-digit growth, which remains unchanged. As expected, a large portion of the increase in the commercial book was on the mainland, where the rebound in loan demand started earlier. Looking forward, the fourth-quarter loan pipeline remains robust, driven primarily by commercial loans in Hawaii and Guam. This should put us at the high end of our original full-year loan growth guidance. Turning to Slide 5. Deposits fell by $510 million or 2.3% to $22.1 billion at quarter-end. Approximately $347 million, or two-thirds, of the decline was attributable to 10 large commercial accounts. Our total deposit costs were 24 basis points in the third quarter, an increase of 16 basis points from the prior quarter. This is primarily due to rate increases on corporate accounts, money market accounts, and other high-balance accounts. Rate adjustment on savings and checking accounts in our market have remained stable so far this cycle. Our favorable deposit mix, with 42% of deposits in noninterest-bearing accounts, continues to help provide stability to our total deposit cost. We expect continued volatility in deposit balances given the unprecedented growth in deposits we saw during the pandemic as well as rising rates. However, our liquidity levels remain strong, and we have a variety of options to fund loan growth. Now I'll turn it over to Ralph.

Thank you, Bob. Turning to Slide 6. Net interest income increased by $17.6 million, or 12.1% over the prior quarter, to $162.7 million. Excluding the impact of PPP fees and interest, net interest income increased $18.5 million. The increase was primarily due to higher yields on balances of loans, partially offset by higher deposit costs. The net interest margin increased 33 basis points to 2.93%, driven by higher yields on loans, cash, and investment securities, partially offset by higher rates on deposits. While we anticipate that deposit cost increases will begin to accelerate in the fourth quarter, the balance sheet remains well positioned to continue to benefit from rising rates, and we expect the margin to increase by 10 to 15 basis points in the fourth quarter. Turning to Slide 7. Noninterest income was $45.9 million this quarter, a $1.7 million increase over the prior quarter. We continue to see improvement in activity-based revenue, including trust and investment services income despite the continued market volatility. BOLI income continued to be negatively impacted by higher bond yields and the continued decline in the equity markets. We expect BOLI income to return to historical levels of $3 million to $3.5 million per quarter when the market volatility subsides. Expenses were $113.3 million, an increase of $4.2 million from the prior quarter, in line with expectation. The increase was primarily due to higher compensation expenses, a full quarter of expenses associated with the new core system, and additional post-core conversion costs. As we stated last quarter, we believe that expenses will be between $113 million and $114 million in the fourth quarter. Turning to Slide 8. I'll make a few comments on credit. Asset quality continues to be strong. In Q3, the net charge-offs were $2.8 million. Our year-to-date annualized net charge-off rate is flat at 8 basis points lower than the last three years. Non-performing assets and 90-day past due loans were at 10 basis points, also flat from the prior quarter. Criticized assets continued to decline, dropping from 0.91% of total loans in Q2 to 0.81% in Q3. The bank recorded a $3.2 million provision for the quarter, which included $1.2 million set aside for unfunded exposures. Loans 30 to 89 days past due were $46.1 million or 34 basis points of total loans and leases at the end of Q3, about 7 basis points below Q2. Moving to Slide 9. You see a roll forward of the allowance for the quarter by disclosure segments. The allowance for credit loss decreased by $0.8 million to $148.2 million. The level equates to 1.08% of all loans. The reserve for unfunded commitments increased by $1.2 million to $30.1 million. Reserve needs for loan growth were offset by improvements in the portfolio risk profile this quarter. The allowance anticipates higher credit losses consistent with a potential recession and includes a qualitative overlay for potential macroeconomic impacts not captured in our model. Let me now turn the call back to Bob for any closing remarks.

Thanks, Ralph. To summarize, we expect to finish 2022 with another strong quarter, and our balance sheet is well positioned to perform well in a range of economic outcomes. And finally, you have probably seen the announcement earlier this month of the addition of Mike Fujimoto to the Board of Directors of First Hawaiian, Inc. Mike has served on the bank Board, and we are pleased to extend his expertise to the holding company Board of Directors. And now we're happy to take your questions.

Our first question comes from Steven Alexopoulos of JPMorgan.

I wanted to start and dive a little bit into the reduction in the noninterest-bearing deposits. Can you give more color on what you saw in the quarter? I know you called out the 10 accounts where customers just moved a portion of balances to higher-yielding alternatives and how much additional runoff should we expect?

Yes, the segment involving large corporate customers can be quite unpredictable. Over $100 million of that came from title companies, and it's difficult to forecast their end-of-quarter balances. We didn’t lose any accounts, though some balances shifted for reasons that remain unclear. It didn’t appear to be connected to a move towards higher-yielding accounts. For instance, this week our noninterest-bearing account balances increased by a couple of hundred million compared to the quarter-end. Overall, it's a volatile period for our deposits. Now, I'll let Ralph share any additional insights he may have on this.

Sure. Steve, what we saw this quarter, I think, was not unexpected. Some larger accounts with temporary balances moving out. If you back out those balances, the net differential was probably about a 2% to 2.5% annualized decrease. In Q4, we're projecting deposits to be flat to slightly down. And I think the outlook for the NIM expansion would incorporate a range of outcomes that we might expect. The midpoint probably approximates a decline that would approximate that net differential that we saw where the higher side would probably represent something with a more stable balance sheet and the low end of the range would probably be indicative of the deposit flows we saw in Q3.

Got you. Okay. That's helpful. I want to stay along those lines. So if we look at your cycle to date deposit beta is relatively low, and I know historically, Hawaii has been viewed as a market where you could pay lower rates on deposits just given the competitive dynamics of the market. We think about the digital age, right, businesses, consumers could move money basically pretty easily on their phone. Is that historical view still accurate?

Yes. So I think if you were to take a look at what we're projecting for through Q4, I think the total deposit beta is around 10%, and then interest-bearing about 18%. You compare that to the last cycle. I think what we saw in terms of cumulative beta was about 18% total deposits and about 29% in interest-bearing. We think the slope of the deposit repricing is about what we expected based on past cycles. I think, at this point, we're, as I said, expecting about a cumulative beta around 10% to 11% through year-end. And then I think what we're looking at going forward is we're trying to be thoughtful, align our pricing to the value proposition we have across the product sets. And I think if we're successful in doing that, we're going to minimize our funding costs through the cycle and maximize retention of those deposit customers.

And to add to that, Steve, your question specifically on mobile, that's something we pay a lot of attention to. In fact, Chris is with us today to answer any of the technology questions. But as far as this specifically relates to the ability to move money, that's something we watch very closely. We haven't seen that yet, but that's one of the reasons we continue to invest in technology and really the data and the analytics around our customers so that we can stay in front of that when it comes.

Right. Right. Okay. That's helpful. And then one final one for me. Just looking at the C&I loan growth was really strong this quarter, even beyond the pickup in dealer. Can you give a little more color on why such strong growth this quarter there?

Yes. Maybe I'll start and ask Ralph to add comments. I mean, first, as you mentioned, dealer, in Q1, floor plan balances grew $9 million, Q2, $43 million this quarter, $57 million. So we are really starting to see slower than maybe we would have anticipated a year ago. We are starting to see that build back on those balances. And we think that will continue. It's hard to predict exactly what it is. So that's just staying there in the background, and my assumption is that we'll continue to see steady growth in that as 2023 unfolds, Q4 in 2023. As far as the rest of the portfolio, we've just seen a lot of commercial real estate transactions, both here for the fourth quarter and this past quarter on the mainland. So it's been a good market. We see that continuing through Q4. It's a little harder to see what Q1 and 2023 looks like. But Ralph, comments you would add?

Yes. I mean the only thing I would say to add to that is we're starting to see spread widening, which is good, I think, and we're able to look at opportunities that I think are going to be pretty attractive in terms of putting it on the balance sheet, even with the rate environment that we're facing today.

And our next question will come from David Feaster of Raymond James.

Maybe just touching on the margin expansion. I appreciate the guidance, 10 to 15 basis points in this upcoming quarter. Just curious what rate hike assumptions are embedded in that? Is that assuming a 75 in the next two meetings? And then just, at a high level, how do you think about managing rate sensitivity? You're obviously very rate-sensitive naturally just given the nature and complexion of your loan and deposit portfolios. But I'm curious whether you're interested in maybe trying to lock some of that in at this point? And how would you do that, whether it's longer-duration securities, more fixed-rate lending, or just curious how you think about that more broadly?

Yes. A couple of questions there. I'm going to pass to Ralph first and then do any cleanup afterwards. Ralph?

Okay. The assumption for Fed funds is, at the end of Q4, would be to kind of give you an idea of what we're modeling today. I guess the question you had on hedging, last quarter, we said that we were going to look at trying to become less asset sensitive, but we're going to do that over time. We weren't going to try to time the market. So we have started slowly a program to sort of address that. I think you see this quarter that we did about a $200 million swap. It actually was a collar that we put in place. So we'll do that in a very measured and programmatic way. So I think what we want to do is be in a position when rates do, at some point, trend back down, being less asset sensitive than we were last cycle.

Okay. That makes sense. And then maybe just following up on the pipeline, I'm glad to hear that it's holding up well, primarily comprised of commercial loans in Hawaii and Guam. Just curious, how is demand trending and maybe the pulse and sentiment of your clients in Hawaii? And then I guess if we had to think about your growth, if we were going to sustain this mid- to high single-digit kind of pace, would you expect it to be more of a function of continued stronger originations or maybe slower payoffs and pay downs, I guess, maybe probably a combination thereof. But I'm just curious how you think about those two dynamics as you think about your loan growth rate.

Let me begin. Looking ahead, we believe that payoffs in the residential portfolio will occur only when someone moves, as refinancing is not anticipated in the near future. We are experiencing a significant slowdown in origination, similar to trends across the nation. The growth we're witnessing is primarily on the commercial side. Regarding customer sentiment, it remains quite positive. Even with a decline in arrivals, we continue to observe robust spending by visitors, which has not diminished. We are aware of the demand dynamics, and while the return of travelers from Japan may be slow due to the yen-dollar exchange rate, we expect that to improve over time, contributing to the strong influx of Westbound Travelers we have observed throughout the pandemic as we reopened. Ralph, do you have any additional comments on this?

Yes. Currently, there are concerns, but not significant changes. A large condo project is being introduced to the market today, so we'll observe how buyer demand in the residential sector evolves. Given the situation with rates, we are monitoring this closely and trying to balance potential opportunities with associated risks.

I want to touch on asset quality. Last quarter, you mentioned maintaining a degree of caution due to the environment, and you have a good understanding of the market. As you evaluate the Hawaiian economy, are there any areas within your portfolio or the competitive landscape that raise concerns? Are you noticing higher rates? Your portfolio is in great shape, but are higher rates beginning to influence cap rates in any way? Are there any other trends from the industry or competitive landscape that you think are worth mentioning?

Sure. Let me start on the consumer, and I'll pass over to Ralph on more rates affecting commercial real estate. But on the consumer, we're still seeing very strong performance across all those portfolios. A little bit of normalization I would say on the card side and a little bit indirect. But that's where we always see that. It was better than normal during COVID, and I think we're returning more to a normalized environment. Where that will go with inflation being what it is as the months unfold? We'll have to wait and see. But right now, it's still excellent. And we really haven't seen any signs of weakness in that. We do have some concerns about interest rates impacting real estate projects. And maybe I'll turn it over to Ralph for a comment on that.

Yes. I'll probably add to you, David, kind of first talking to what do we anticipate for cap rates. We're not really sure what to anticipate other than I think if you look back historically, there's usually a pretty strong correlation between rates and cap rates. I think, this time, with the amount of inflation in the market, I think that's probably something that we'll have to see. But then speaking more to our underwriting, I would say that we're a cash flow lender. So cash flow has been pretty much the constraint that we've had in terms of lending in the real estate market, not so much loan-to-value ratios. You'll see, I think, across like most banks' portfolios today that the loan-to-value ratios are pretty low, primarily because of the fact that people are really lending against cash flow. From our perspective, we do stress our underwriting. So we stress interest rates, we stress occupancies. I think that kind of an exercise helps us kind of understand where we might be today. And I think what we're feeling good about is really sort of the fact that we're in great locations that tend to hold up pretty well in terms of values. Sponsorship in our portfolio has been pretty strong. And I think, during COVID, there was really strong indication, especially with some of the hotel owners how they sort of managed through a period of complete disruption. So I think it's just something that we're going to pay attention to, but I think location, sponsorship, and I think the way that we underwrite in terms of being a cash flow lender, that gives us a lot of confidence in the portfolio as we move into 2023.

How do you view the reserve moving forward? I'm curious if you expect changes due to the potential for weaker CECL inputs and how that impacts your perspective on the reserve in relation to those comments.

I would say that the reserve currently anticipates a recession in 2023. It was initially built up due to COVID, which has since subsided, but other macroeconomic factors have started to emerge. If we analyze the situation, we estimate a one-year loss rate against the portfolio, planning for losses similar to what we experienced at the peak of our losses in the last cycle. Overall, it's a healthy reserve, and I believe it is suitable for the current market conditions and our projections for the next 12 months.

Yes. And then to add to that would be depending on loan growth is what we would look at for the appropriate level for the reserve, to add to it.

Yes. And as I had mentioned in the comments, we saw loan growth. Typically, that would have probably caused us to have a higher provision this quarter. But we had a lot of improvement in terms of the overall risk profile of the portfolio.

And our next question will come from Andrew Liesch of Piper Sandler.

So a question on the expense outlook from here. I think in the past, you mentioned a more normalized expense growth rate would be 4% to 5%. Is that how we should be looking at it from here if we just sort of annualize this $113 million to $114 million and then build off that? Is that the best way to look at it?

Andrew, this is Bob. I'll start and then pass it to Ralph. We're focusing on revenue, which is why we provided guidance of $113 million to $114 million for the quarter, a figure we remain confident about for Q4. We approached that target closely in Q3. We're currently in the budgeting phase, so we don't have clear insights for 2023 yet due to some variables in play. We are nearing the end of the core conversion process, and while most consultants have concluded their services, there is still a bit of work happening in Q4, which adds some complexities. However, we are comfortable with the $113 million to $114 million range for this quarter. Ralph, do you have anything to add?

No. I think, to Bob's point, we're going to have a little bit of expense this quarter that related to kind of the cure period and the conversion that will go away. And then going into the next year, we'll probably have some inflation-related increases. But I think at this point, we're still working through the budget, and we haven't really projected out for a 2023 expense growth rate.

Got you. All right. That's helpful. And then on the fee side, if I just ignore the BOLI issue, the nice increase in fee income. How do you think that's going to trend here in the fourth quarter with maybe some holiday travel and increasing transactions? Do you think it's going to have another nice step up here in the fourth quarter?

Generally, the activity-related things for cards and merchant processing, we do see a nice uptick in Q4. Historically, that's what we've seen. And if we have good visitor numbers, which still really are driven by the Thanksgiving through year-end Christmas period. So a little hard to see right now. But, historically, we've always seen a pick up in those kinds of activity revenue lines in the fourth quarter.

Yes. And I think on the wealth side, we've seen some challenges with equity accounts, but we've seen a lot of good performance in terms of money market accounts now we're getting fee income off of. So that's where we're sort of seeing the kind of net increase in that area.

Our next question will come from Kelly Motta of KBW.

Thanks so much for the question, for all the color today. I was just wondering, I don't think it's been mentioned on the call yet today. If there is any update on the CFO search that's been ongoing this year and perhaps timing of that?

Thank you, Kelly. This is Bob. We were close to a candidate, but it didn't work out for them and their families. We're still working on that and hope to reach a conclusion very soon.

Got it. Well, I can't imagine Hawaii is too hard of a sell.

It works for all of us.

Looking at capital and capital return, your CET1 ratios remain very strong. I noticed you've transferred another portion to HTM. I'm curious about your thoughts on buybacks. Are there any changes in how you plan to allocate funds for buybacks? And does ongoing interest rate volatility influence your perspective on repurchases?

Thank you, Kelly. I'll start off. Regarding our common equity Tier 1, our target remains at 12%. Currently, we are below that primarily because of strong loan growth. As you may have noticed, we did not buy back many shares in the third quarter, and I anticipate that this will remain relatively low as we focus on rebuilding our common equity Tier 1 to meet our 12% target. We expect to achieve this over the current quarter and possibly into the next. We still have the ability to repurchase shares and may be able to act on that opportunistically. We will continue to evaluate this option next year as well, but for now, we are still striving towards our 12% guideline.

Got it. That's helpful. I noticed that your residential mortgage yields decreased. I understand there wasn't much growth in that area, but it was surprising to see the yields decline slightly. Were there any special promotions or unusual prepayment trends that could explain this?

We did have a project that closed out, along with a couple of others this quarter that we had made some commitments on. I think the yield on production this quarter was a bit lower.

Our next question comes from Timur Braziler of Wells Fargo.

Maybe starting on the loan growth that you're seeing on the mainland. I'm just wondering, is that primarily shared national credits? And then for the commercial real estate portfolio, which industries are really driving that strong loan growth?

Yes. Part of that is the dealer floor plan because we have that both here and in the mainland. So some of that growth you're seeing is dealer floor plan. And in our dealer book, most of that is non-shared national credit, but there are a couple that are larger and more syndicated deals. So I don't know the breakdown of that specifically. We're also doing commercial real estate loans, and many of those are shared national credits, but not all. And that tends to be more in the multifamily. But, Ralph, do you have more of a breakdown on that?

No. With regard to this, in the CRE book, it was a combination of some dealer-related assets owner-occupied and pretty much multifamily and some industrial.

Got it. And as you're thinking about funding future loan growth, I understand your commentary about the deposit base, and there's still being a little bit of uncertainty there. Should we expect that, at least in the near term, majority of the loan growth is going to be funded through the bond book still? And I'm just wondering what's your appetite for maybe layering in some more time deposits? I know is those things ease this quarter and just maybe talk about the market for time deposits in Hawaii.

Yes. As we look at the investment portfolio, that's going to be our primary funding source for loan growth. There might be some timing differences in there depending on loan funding versus maturity or cash flows coming off the investment portfolio. So there might be some of the public time deposits or other methods we might use to kind of bridge that, but that's what we'd primarily be looking at.

Okay. And then for those public time deposits, what type of sensitivity do they have to interest rates? Is that pretty much 1 for 1 with what's going on at the Fed? Or is there some sort of discount to that?

It's a pretty strong correlation.

Okay. I understand. Lastly, regarding asset quality and the allowance level, I want to confirm my understanding. It seems we are nearing the bottom of the allowance to loan ratio, and any additional loan growth will be managed with this in mind. Is there still a chance that overall credit trends in the portfolio could improve, leading to a continued decline in the allowance for loan ratio, regardless of any immediate loan growth?

We still have some qualitative factors in the loan loss reserve. We need to monitor the market and the economy closely and adjust accordingly. Other than that, I believe there is some correlation between loan growth and provision.

Yes. I would think it'd be a pretty strong correlation at this point just given where we're at and what we sort of see out into the future.

Our next question will come from Christopher Larmoyeux.

So with core conversion done, I think some resources might have been freed up. Can you talk about what the roadmap and focus is regarding investment spend into the business going forward?

I'm sorry, Christian, we weren't able to hear the question. Would you mind repeating it?

With the core conversion, we took a careful approach to modern open banking architecture and API design, which has enhanced our ability to offer distinct new products and services. Recently, we introduced a new credit card, Priority Unlimited, developed through custom integration by our software team that merges various platforms for a more cohesive acquisition and fulfillment process. Over the past few months since the launch, we have also been working on creating a comprehensive 360-degree view of our customers using a blend of traditional dealer architecture and machine learning. This approach allows us to capture dealer interactions in real-time and perform real-time analytics, enabling our bankers to provide more actionable and personalized insights to our customers. Moving forward, we are in the process of upgrading our online banking platform for all consumer and small business clients. Once the upgrade is complete, we will have a unified platform for commercial, small business, and consumer customers, each tailored to their specific needs but operating on the same system. This change will lead to greater efficiencies in our back office and enhance the overall customer experience. Additionally, we will continue to utilize AI and machine learning in various business areas, such as underwriting, to facilitate quicker and more effective decision-making.

And then just to add to that, Christian. As we look at that pretty robust roadmap, and from a cost perspective and bringing back down to that, we're going to be doing that in really a thoughtful way to not overspend in any one period, but there's a lot on our plate, and that's what the customers want. They want that functionality, and we need to evolve. So there will be that continued investment in the business to make that happen. And we're going through that budgeting process now for 2023. So we don't really have a view on it today, but that will be part of our budgeting process for next year.

Now I'm showing no further questions. I would now like to turn the conference back to Kevin Haseyama for closing remarks.

We appreciate your interest in First Hawaiian, and please feel free to contact me if you have any additional questions. Thanks again for joining us and have a good day. Bye.

And this concludes today's conference. Thank you for participating. You may now disconnect.