First Hawaiian, Inc. Q2 FY2023 Earnings Call

Good day, and thank you for standing by. Welcome to the First Hawaiian, Inc. Second Quarter 2023 Earnings Conference Call. At this time all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Kevin Haseyama, Investor Relations Manager. Please go ahead.

Thank you, Shannon, and thank you, everyone, for joining us as we review our Financial Results for the Second Quarter of 2023. With me today are Bob Harrison, Chairman, President and CEO; James Moses, Chief Financial Officer; and Lea Nakamura, Chief Risk Officer. 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.

Good morning, everyone. I'm pleased to welcome Lea Nakamura. Lea was recently promoted to Chief Risk Officer after holding a variety of positions in the bank, including Deputy Chief Risk Officer and Treasurer. Lea has over 30 years of banking experience, and I'm confident she'll do great in her new role. I'll start with an overview of the local economy. The Hawaii economy continues to do well. The statewide seasonally-adjusted unemployment rate in June was 3%, which is lower than the national rate of 3.6%. Total visitor arrivals were 802,000 in May, which is 5.4% higher than May 2019 arrival numbers. Japanese visitor arrivals at 34,000 were 70% below May '19 levels. Visitor spending in March was $1.7 billion, 19% higher than May 2019. The housing market has remained stable. In June, the median sales price for a single-family home on Oahu was $1.1 million or 4.5% higher than June of last year. The median sales price for condos on Oahu was $510,000, 4.5% below 2022. Turning to Slide 2. I'll give an overview of our second quarter results. Net income was $62.4 million or $0.49 per share. As loans grew, we continued to grow capital and credit quality remained excellent. Our return on average tangible assets was 1.05%, and our return on average tangible common equity was 18.57%. We continue to maintain strong capital levels with the CET1 ratio of 12.05% and total capital of 13.17%. The Board maintained the quarterly dividend at $0.26. Turning to Slide 3. Our balance sheet remains solid. In the second quarter, we brought down our excess liquidity by a little over $300 million as the recent disruptions in the banking industry calmed down. This enabled us to reduce some higher-cost short-term borrowings. We continue to have a strong liquidity position. As of June 30, our total available liquidity was $8.6 billion, which was over 100% of uninsured non-public deposits. The duration of our investment portfolio remained stable at 5.5 years, and cash flows from the portfolio were about $60 million per month, as we had expected. Turning to Slide 4, period-end loans and leases were $14.4 billion, an increase of $142 million or 1% from the end of Q1. In the second quarter, about $130 million of completed construction loans were converted to CRE. During the quarter, we also exited approximately $55 million of non-relationship shared national credits. We continue to believe that full year loan growth will be in the low to mid-single-digit range. Now I'll turn it over to Jamie.

Thanks, Bob, and good morning, everyone. Turning to Slide 5. Total deposit balances decreased by $203 million or 1% to $21.1 billion at quarter end. The retail and commercial deposits declined by $664 million or 3.4% in the second quarter. Commercial deposits declined by about $450 million and retail balances declined by about $214 million. On a year-to-date basis, retail and commercial deposits are down $964 million or 4.9%. Public deposit balances increased by $461 million in the quarter, as public time deposits grew by $555 million, which was partially offset by a decline in public operating balances. Our total cost of deposits was 111 basis points in the second quarter, an increase of 29 basis points linked quarter due to higher rates paid and the shift in mix to higher rate deposit accounts. Turning to Slide 6. Net interest income declined by $7.3 million from the prior quarter to $159.9 million. The decrease was primarily due to higher funding costs, partially offset by higher asset yields. Similarly, the net interest margin declined by 20 basis points to 2.91%. Throughout the end of the second quarter, the cumulative betas were 34.5% on interest-bearing deposits and 21% on total deposits. Looking forward, we anticipate that the net interest margin will decline by 15 to 20 basis points in the third quarter due to continued repricing and deposit migration. On Slide 7, non-interest income was $47.3 million this quarter, a $1.7 million decline from the prior quarter. The decline was primarily due to lower BOLI income along with lower credit and debit card fee income. First quarter BOLI income included a $2 million debt benefit. Expenses were $120.9 million, $2.3 million or 2% higher than the prior quarter. The increase in expenses was driven by a $1.9 million increase in salaries and benefits, which included $2.9 million of separation and severance payments. We expect our overall annual expenses to be in line with our original outlook. Now I'll turn it over to Lea.

Thank you, Jamie. Moving to Slide 8. The bank maintained its strong credit performance and healthy credit metrics in the second quarter. Year-to-date net charge-offs were $6.8 million, and our annualized quarter two charge-off rate was 10 basis points, 1 basis point higher than in quarter one. Non-performing assets and loans 90 days or more past due were 11 basis points at the end of quarter two, down 2 basis points from the prior quarter. Criticized assets increased to 93 basis points, with special mention assets at 52 basis points and classified assets at 41 basis points of total loans and leases. The bank recorded a $5 million provision for the quarter. Loans 30 to 89 days past due were $40.8 million or 28 basis points of total loans and leases at the end of quarter two, unchanged from the prior quarter. Moving to Slide 9. We have a roll forward of the allowance for the quarter by disclosure segments. The reserve increased marginally this quarter, resulting from offsetting factors, including loan growth and improved economic outlook and an increase in the qualitative overlay on construction and home equity. The allowance for credit loss increased $1.5 million to $148.6 million. This level equates to 1.03% of total loans and leases. The reserve for unfunded commitments was unchanged at $36.2 million. The allowance anticipates cyclical losses consistent with the recession and includes a qualitative overlay for potential macroeconomic impacts not captured in our base model. Turning to Slide 10, we provide a snapshot of our CRE exposure. CRE represents about 30% of our total loan portfolio outstandings. The overall credit quality of this portfolio remains very good. The increase in criticized office loans in the second quarter was primarily due to two loans. One loan consists of a handful of small office properties in Downtown Honolulu and is being actively resolved. This loan is current, and we are comfortable with the plan. The other loan is located in Downtown Los Angeles and is going through the sales process. We expect a full recovery on that loan. We continue to closely monitor this segment, given the implications of higher rates, credit tightening, and recessionary headwinds.

Thank you, Jamie and Lea. Now I am ready to take your questions.

Thank you. Our first question comes from the line of Steven Alexopoulos with JPMorgan. Your line is now open.

Hi, everyone.

Good morning, Steve.

Hey, Steve.

I want to start, so on the noninterest-bearing deposits, there was another quarter where you and the industry saw strong outflows, but I'm curious, how did this trend through the quarter? And are there any signs of the pace of outflows abating?

It's kind of hard to say for sure. I would suggest the way that we look at the data, we think that it is abating somewhat. And what I mean by that is, so far, what we've seen this quarter has been, on a relative basis, less outflow than what we saw through the three months in Q2. So if you're drawing a trend line, I think you start to see that flatten out, at least so far in the quarter that's what we've seen.

Okay. That's helpful. And on the margin then, so you've got 20 basis points this quarter, a little bit worse than what we thought coming into the quarter. Now you're saying down 15% to 20%, but I'm curious, I know you don't give longer-term guidance. But do you feel like we're getting pretty close to the bottom once we roll through? I know it's going to be contingent on what you just talked about, but if that trend line is starting to flatten on the noninterest-bearing outflows, do you think we might get some stability after the third quarter?

I do think that. And obviously, Steve, that's entirely contingent upon what happens with the Fed and rates and all that. But we do see that sort of the bottom of our guidance. We think that's probably about where it bottoms out, given sort of a stable forward outlook at this point. And that's probably like somewhere in the fourth quarter for us. So that's kind of how we're thinking about it and how we're planning going forward.

That sounds good. And then just on loan growth, so I heard you Bob, reiterating the low to mid-single digit, which I'm a little surprised because you're running about 8% higher that's year-over-year. I know the comps are tougher because you had a very strong second half. But you're not expecting to have good momentum, good conversions decree, you're not expecting more momentum to continue. I'm surprised you're not at least pointing to mid-single-digit growth. Thanks.

It's a challenging situation, Steve. We have several commercial real estate projects that are nearing completion and will be paid off soon. We're facing some headwinds with that. Regarding origination, it has been satisfactory, but we anticipate a notable number of commercial real estate payoffs in the next quarter, specifically Q3 and Q4. So, there is a balance to consider.

Got it. And I saw you called out that you saw good growth in the dealer. Where do dealer balances sit now versus historical? Just wondering how much room there might be for still an improvement there?

I have that here somewhere, but I know we're still several hundred million below the 2019 year-end. I think it was $850 million give or take, in 2019, and where we are today, Jamie?

I think it's just under $700 million. So yeah, Steve, I believe there's probably at least a couple of hundred million dollars worth of room for growth, considering historical data.

The question is, does it go back to the way it was before? And you probably saw an article in the Wall Street Journal yesterday saying probably not. I tend to agree with that. The industry has changed. But I do feel that the new number is, given that we don't have a huge difference in the amount of lines and availability to our customers, is higher than where we are today, but it's probably not where we ended 2019.

Okay. Thanks for answering my questions.

Thank you. Our next question comes from the line of David Feaster with Raymond James. Your line is now open.

Hi. Good morning, everybody.

Hey, Dave.

Maybe just following up on your commentary about the upcoming maturities and stuff. I'm just curious, could you quantify that for us? How much you have expected to roll off maybe in the next six to 12 months? Where roll-off rates are? And then where maybe repricing tends to be or as well as new loan yield add-on rates?

So Dave, just to clarify, are you talking about securities or loans?

Loans.

Got it. Okay. So I think what you're really asking is essentially a net interest margin question, right? That's what you're trying to get at. I appreciate you trying to ask it a different way. The net interest margin guidance is the net interest margin guidance. We're seeing total portfolio additions. On the commercial side, we're observing slight increases in the low 7s, while we're still adding a very limited number of residential mortgages, which are currently in the high 6s compared to where they've been previously. Those are the current roll-on rates. To be fair, in general, we are seeing a better ability to dictate pricing, structure, and credit today than we have in the past. It feels like more of a buyer's market now rather than a seller's market.

That's terrific. And ultimately, what I'm trying to figure out is kind of where does the core NIM stabilize as we look forward? So maybe on the other side of the coin, I guess on the deposit front, how is new account growth going? Where are you seeing good opportunities to take share and acquire new clients? And then just any thoughts on core deposit growth going forward, the strategy to continue to drive that? And where new money yields are on interest-bearing deposits?

We have received a number of questions, so I'll address a few of them. Firstly, regarding new deposit accounts, like many banks in your sector, we are actively pursuing new accounts and have seen success in that area. We are approaching this through various methods, not just marketing, but also by providing more value to our customers. We are upgrading our mobile offering either later this month or next month in August. Overall, these initiatives have been successful, and we aim to grow our core operating account deposits. On the lending side, we have adopted a more disciplined approach to our business. Rates and terms have returned to what appears to be more sustainable levels. The prolonged period of aggressive low rates is behind us, and liquidity is tighter, creating a better balance. For instance, we haven't engaged much in indirect lending for over four years, resulting in a decrease of almost $300 million in that area. While we value that business and have been involved for a long time, it wasn't feasible recently. However, we are beginning to see improvements, particularly in the commercial market, which is now more reasonable.

Where are you observing the new costs for interest-bearing deposits?

It's a challenging question because our customers come on at different rates. Generally, we are continuously seeking new customers, but we aren't using promotional offers, particularly for liquid accounts. This approach contributes to the decline in our balances. We focus on acquiring new customers, building relationships with them, and maintaining our existing relationships. For newer relationships, we are considering allowing some deposits to decrease while prioritizing our core customers. It varies; our top customers receive higher rates and yields, while others get lower rates, depending on account size and similar factors. Overall, it's about managing our balance sheet and relationships effectively, both with new acquisitions and our current customer base.

We talked about this starting a year ago, Dave, that for our larger balance commercial and personal customers, we really start taking care of them early, and now it's just kind of going through the rest of the balance sheet. We're getting to the earlier question from Steve; we're getting close to the end on that, I think.

That's great. Following up on your comments about the loan side, Bob, I'm curious where you see good risk-adjusted returns given the importance of liquidity and some others pulling back while you remain open for business. How is demand from your clients, and where are you identifying opportunities? Additionally, if you had to estimate, how much of your growth do you anticipate will come from the Mainland versus Hawaii?

I'll start with the end of that question. We're currently around 24% of our loans on the Mainland. As mentioned in previous calls, we expected this figure to increase slightly before the Hawaii loans, although it is keeping pace at about a percentage point. We are observing stronger dealer balances on the Mainland due to the larger portfolio. However, we noticed improvement in California a couple of weeks ago. The domestic manufacturers are ahead of the foreign ones in restoring supply, which has been beneficial. By year-end, I believe all manufacturers will be closer to their desired supply levels, leading to a new normal for floor plan outstandings. Regarding commercial real estate, we are seeing better pricing and structure both in Hawaii and on the Mainland. Since we are open for business, we will be more selective, but we are looking for well-structured transactions with higher pricing. The residential side, particularly home equity, is expected to slow down a bit, while credit cards should remain stable. Overall, consumer activity may be slower compared to the commercial sector.

That's helpful. Thank you.

Thank you. Our next question comes from the line of Kelly Motta with KBW. Your line is now open.

Hi. Thanks for the question. I apologize. Joining a little bit late, so I apologize if this has been already asked. But it seems like you're doing a pretty good job with expenses that have been really within the range you've been looking for. But just with the challenging headwinds for margin that you've been discussing at least near-term, is there any additional room on the expense side? I know you're already directing a lot of attention there. And as we look ahead, is this still a good range and still looking for the same kind of level of expenses that you have at this point? Thanks.

Hey Kelly, this is Bob. Yes, we're always focused on expenses. We have been investing more, clearly in our technology and our people. Getting good people like many other places has been a challenge. So we have made adjustments there. That, we think is really a long-term investment, much like our technology. Now that we've kind of gotten there, I think we're closer to being more of a status quo on our salary and benefits type expenses. But on a broader level, maybe I'll turn that over to Jamie.

Thank you, Kelly. As we look at the remainder of this year, we are aware that coming into 2023, we needed to invest in enhancing our digital capabilities and operational efficiencies. Regardless of whether the net interest margin will be lower in the second half of the year, we believe it is essential to proceed with these investments. Our guidance for the year remains unchanged, as we expect to stay on track. As Bob mentioned, we continuously monitor our expenses, but we've maintained a cautious approach this year regarding non-strategic spending. We feel it is important to sustain the trend we have established this year in terms of expenditures. Moving forward, we are entering the budgeting season and will certainly take a close look at our plans, but we are not providing any guidance for 2024 at this time.

Got it. And maybe a final question for me. I think in your prepared remarks, you said something about exiting some shared national credit deals. As you look ahead to where loan growth is going to be coming from, what's the appetite for continued growth on the Mainland?

I see that as two separate issues. It's clear that we ended those engagements because they were not true relationships; they were merely credit-only agreements. As we consider the limited availability and importance of liquidity and capital, our aim is to concentrate on building real relationships. This includes connections here in Hawaii, our home base, and we're committed to maximizing those opportunities. Additionally, we have partnerships on the US mainland, so our focus is mainly on areas where we can provide value beyond just credit transactions, rather than where these relationships are based.

Got it. Appreciate it. Thanks so much.

Thank you. Our next question comes from the line of Andrew Liesch with Sandler O'Neill. Your line is now open.

Hi, everyone. Just a couple of housekeeping items for me. The non-interest income is like $47 million to $48 million, still the right range we should be thinking about?

You got it.

Got it. And then the tax rate for a couple of quarters was slightly below where I was forecasting. What should we be using on that front?

I think 24% to 24.5% is a good number on the tax rate.

Got you. Thank you. You've covered everything else I wanted to ask about.

All right, Andrew. Thank you, Andrew.

Our next question comes from the line of Jared Shaw with Wells Fargo Securities. Your line is now open.

Hey, everyone. Thank you for answering my questions. To revisit the discussion about shared national credit, were the exits you mentioned this quarter due to sales or natural runoffs? If they were sales, did that result in a loss?

They were sales, but at par.

Okay. In the commentary, you mentioned the office criticized loans. I recall you said that one of them was in Downtown LA, but I thought last quarter you mentioned that your LA office was mainly in West LA and not Downtown. Can you provide an update on the current geographic exposure of your non-Hawaii office?

Connecting our previous statements to the current situation, both were accurate. We have one loan in Downtown LA, while most of the others are located in West LA. The focus right now is on resolving that one loan in Downtown LA. Regarding the broader office market, our perspective hasn't changed since last time; it mainly involves those gateway cities on the West Coast, several of which have our credit tenants. The lease functions as a loan but is specifically tied to a particular credit tenant. We feel confident about that, as well as about a couple of high-net-worth individuals who have demonstrated strong past support. Overall, we are very comfortable with the rest of our office portfolio, and we are currently addressing these two issues that have emerged.

Thank you. Looking at Slide 9 and the increase in the provision for construction and home equity, I'm curious how this aligns with your comments about positive employment trends and strong valuations. It seems that construction projects and residential developments in Hawaii should have minimal risk at this time. What is causing the need for a higher provision in these areas?

I can address that. This is Lea. Regarding construction, in both the first and second quarters, we closely examined our investor commercial real estate and construction portfolios. In the second quarter, we re-evaluated these portfolios based on current net operating incomes, interest rates, and capitalization rates. Specifically for construction, our focus was on the Mainland multifamily projects which are still underway. The metrics remain positive, but we have some uncertainty about market conditions in the next year to 18 months. Concerning home equity, we analyzed the portfolio, especially the sub-pool with high utilization, which is now moving away from teaser rates. There is some concern regarding the rising interest expenses these loans will encounter. This isn't conflicting with our previous comments about the economy; it just concerns these specific areas.

And Lea brings up an excellent point I forgot to mention earlier, Jared, that we re-underwrote the entire investor CRE portfolio for balances over $5 million during the second quarter. We assessed current interest rates and cap rates, focusing on the associated risks and stresses, and we didn't regrade anything.

Right.

We did that for two consecutive quarters just to ensure our comfort level.

Great. Thanks. Regarding the construction loans transitioning to permanent financing, were those rates set prior to the recent rate hikes? Are they coming in at lower rates, or are they based on current market rates when they shift to permanent?

Most all the construction loans. I can't think of any that are fixed rates. So they're all floating rates. Now the difference in the floating rates from when they were put on versus something that would be put on today is, as my earlier comments, is a little more spread today than there was 12 or 18 months ago. But all those are at floating rates.

Okay. And then finally for me, and I appreciate you taking the questions, when we look at sort of terminal beta on interest-bearing deposits, is 45% sort of a good ballpark to be looking at?

I think that's reasonable, Jared. The situation really hinges on what happens with deposits. The extent to which we are funding the balance sheet with either borrowings or deposits can affect that beta, depending on how it unfolds. So I believe that's a suitable number to use for now. We'll observe how that changes as we progress through the quarter and into the latter half of the year, and it will depend on how we ultimately fund the balance sheet.

Great. Thanks very much.

Thank you. And I'm currently showing no further questions at this time. I'd like to hand the call back over to Kevin Haseyama for closing remarks.

I have one last comment. This is Bob. I'd like to wish Jamie a happy birthday today, and welcome, second earnings call and all that. Kevin?

Thanks, everyone. We appreciate your interest in First Hawaiian. Please feel free to contact me if you have any additional questions. Thanks again for joining us, and enjoy the rest of your day.

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