Mechanics Bancorp (MCHB) Q3 2021 Earnings Call Transcript

Good day, and welcome to the HomeStreet Third Quarter 2021 Earnings Call. All participants will be in a listen-only mode. On today's presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. Now I would like to turn the call over to Mr. Mark Mason, Chairman and CEO. Please go ahead.

Hello and thank you for joining us for our third quarter 2021 earnings call. Before we begin, I'd like to remind you that our detailed earnings release and an accompanying investor presentation were filed with the SEC on Form 8-K yesterday and are available on our website at ir.homestreet.com under the news and events link. In addition, a recording and a transcript of this call will be available at the same address following our call. Please note that during our call today, we may make certain predictive statements that reflect our current views and expectations about the company's performance and financial results. These are forward-looking statements that are made subject to the Safe Harbor statements included in yesterday's earnings release, our investor deck and the risk factors disclosed in our other public filings. Additionally, reconciliations to non-GAAP measures referred to in our call today can be found on our earnings release and investor deck available on our website. Joining me today is our Chief Financial Officer, John Michel. John will briefly discuss our financial results and then I'd like to give an update on our results of operations and our outlook going forward. John?

Thank you, Mark. Good morning, everyone, and thank you for joining us. In the third quarter of 2021, our net income was $27 million, or $1.31 per share, as compared to net income of $29 million, or $1.37 per share, in the second quarter of 2021. Our annualized return on tangible common equity for the third quarter was 15.6%. Our annualized return on average assets was 1.48% and our efficiency ratio was 62.8%. Our net interest income in the third quarter was slightly lower than the second quarter due to a $1.7 million decrease in interest income derived from PPP loans, which was partially offset by higher levels of non-PPP loans. PPP loans caused our net interest margin to be higher by 11 basis points. Excluding the impact of PPP loans, our net interest margin in the third quarter of 2021 was consistent with our net interest margin in the second quarter of 2021. As of September 30, 2021, outstanding PPP loans were $77 million with deferred fees of $2.4 million. As a result of the continued favorable performance of our loan portfolio and the improving outlook of the impact of COVID-19 on our loan portfolio, we recorded a $5 million recovery of our allowance for credit losses in the third quarter of 2021. As we continue to have more clarity on the minimal impact COVID-19 is having on our loan portfolio and with projected improvements in our economies, we expect to recover additional amounts of our allowance for credit losses in future periods. Our ratio of non-performing assets to total assets improved to 26 basis points. Our ratio of ACL to total loans was 1.06%. The $3.8 million decrease in net gain on loan origination and sales activities in the third quarter of 2021 as compared to the second quarter of 2021 was due primarily to a lower volume of single-family mortgage rate locks and lower levels of CRE loans sold in the third quarter. The $0.9 million decrease in non-interest expense in the third quarter as compared to the second quarter was primarily due to lower compensation costs, which were partially offset by higher general administrative and other expenses. The $3.2 million decrease in compensation costs was primarily due to reduced commissions resulting from lower levels of loans closed in our single-family mortgage operations and lower benefit costs due to third-quarter seasonality. General administrative and other costs increased due to a $1.9 million reimbursement of legal costs received from our insurance carrier in the second quarter of 2021 and higher marketing costs. During the third quarter of 2021, we repurchased 2% of our outstanding common stock at an average price of $40.26 per share and declared and paid a dividend of $0.25 per share. Since the beginning of 2021, we have repurchased 7% of our outstanding common stock. This is in addition to the 12% and 9% repurchases in 2019 and 2020, respectively. I will now turn the call over to Mark.

Thank you, John. HomeStreet's results for the third quarter continued our outstanding results for the year. Our results reflect our diversified business model, the benefits of our conservative credit culture and continuing focus on operating efficiency. Our loan origination levels remained strong with $804 million of originations, excluding the impact of PPP loans and despite continuing high levels of prepayments. Our total loans grew at an annualized rate of 19% during the quarter, and 9% year-to-date. As expected, our single-family mortgage loan volume and profit margins decreased from second-quarter levels and our revenue has now declined to near normal levels. The credit quality of our loan portfolio continued its strong performance. As John mentioned, greater clarity on the impact of COVID on our portfolio allowed us to recover $5 million of our ACL. For the second consecutive quarter, our mortgage banking revenue comprised only 17% of total revenue and less than 8% of our net income. We continue to anticipate a slight decrease in our origination and gain on sales activities over the next few quarters. Due to increasing revenues from other operations, we expect the revenue contributions from our single-family mortgage banking business to represent an even smaller share of total company revenue going forward. We expect our overall net interest margin to continue to benefit in the fourth quarter of 2021 from the forgiveness of PPP loans. Looking forward, with the Federal Reserve indicating that short-term interest rates will remain low for the foreseeable future, we expect our net interest margin excluding the impact of PPP loans to remain level as the benefit of our deposits continuing to reprice downward is expected to offset any decline in the yields on our portfolio loans. As I’ve mentioned previously, we continue to increase our commercial real estate loan originations, primarily multifamily, both for sale and for our portfolio. The strong fundamentals and demand in our markets and our successful platform has supported this initiative. These continuing high levels of loan production are expected to result in 10% to 15% growth in our loan portfolio next year and beyond with a commensurate increase in net interest income. Our efficiency ratio in the third quarter was consistent with the prior quarter at 62.8%. While the expected decline in mortgage banking profitability is likely to result in upward pressure on our efficiency ratio through mid-next year, we anticipate that as a result of loan portfolio growth and related increases in net interest income and our ability to leverage our existing operating infrastructure, we have the opportunity to improve our efficiency ratio to approximately 60% in the second half of next year and ultimately to the mid- to high-50% range beyond that. Based upon our continuing strong financial results and positive outlook, we repurchased $15 million of our common stock during the quarter and paid a $0.25 per share dividend, which today equates to a yield of approximately 2.3% on the market value of our common stock. We anticipate continuing to efficiently retain capital for growth while returning excess capital to shareholders. In that regard and subject to our Board of Directors' review and approval and the non-objection of our regulators, we plan on repurchasing $20 million of our outstanding shares in the fourth quarter. Additionally, given our consistently strong performance, the Board of Directors anticipates discussing an increase in our dividend in the first quarter of next year. Of course, future declarations of the current or higher levels of dividends are subject to our financial condition and future outlook at that time as well as corporate governance, legal and regulatory requirements. Last quarter, we disclosed that we were evaluating the use of securitizations as a tool to enable us to originate multifamily permanent loans to our full potential, to uncap individual borrower lending limits and to improve our capital efficiency and retain the servicing on these loans, and that we planned on completing our first securitization this year. While we continue to evaluate the use of securitizations, we have instead agreed to execute a whole loan sale in the fourth quarter due to extremely favorable prices available in the secondary market today. Looking forward through 2022, we expect lower levels of portfolio loan sales either through whole loan sales or securitization, as we plan to retain loans in our portfolio to generate increasing levels of net interest income. Since going public in 2012, HomeStreet has been executing the strategy to convert from a legacy thrift to a full-service commercial and consumer bank. This conversion focused on the development of commercial lending and deposit product lines and more recently reducing the size of our single-family mortgage banking business. S&P has recently recognized our successful conversion, and HomeStreet’s global industry classification standard code will be changed from thrifts and mortgage finance institution to a regional bank effective as of November 1 of this year. This change may qualify HomeStreet for inclusion in certain regional bank indexes that currently exclude us. To reiterate my comments from last quarter, the investments that we have made and the improvements in our efficiency and profitability have provided us with the operating leverage that will enable us the opportunity to grow revenue and, in turn, earnings without commensurate additions to personnel or other operating expenses. And while quarter-to-quarter earnings may show some degree of volatility, excluding recoveries of our allowance for credit losses and excluding non-recurring items, such as PPP loans and expense recoveries, and of course subject to any unforeseen changes in the economy or our business, we believe we have the opportunity to continue to grow year-over-year earnings per share over the next few years. Specifically, we believe that current estimates understate our possible earnings per share over the next few years. Given our performance in relation to peers, and my forward-looking comments today, I believe our stock is significantly undervalued. Today, we trade at a meaningful discount to our peers on a price-to-earnings or tangible book value basis. Specifically, based upon multiples of 2022 consensus earnings estimates, the median of our peers trade at over 30% higher than HomeStreet. Historically, this discount was largely attributed to high levels of mortgage banking revenues and earnings and its associated volatility. Historically, this was accurate with mortgage banking revenues exceeding 50% of total revenues. However, even at the height of last year's mortgage refinancing, our mortgage banking revenues never exceeded 32% of total revenues, and the last two quarters of mortgage banking revenue represented only 17% of revenues and less than 8% of the bottom line. Today, a meaningful discount associated with mortgage banking and volatility is unwarranted, and I believe our shares represent a tremendous opportunity for investors. The best way for me to describe the current state of affairs at HomeStreet is that while we are pleased to have achieved strong operating results and total shareholder returns over the prior decade, this is not the same HomeStreet of ten years ago. Nor is it the same HomeStreet of even three years ago. What we have been able to accomplish with our effective reorganization is to have brought the company to a place where we can expect to achieve lower earnings volatility, higher operational profitability and stronger earnings growth, all of which we believe should compare very favorably to our regional banking peers going forward. With that, this concludes our prepared comments today. We appreciate your attention and John, I would be happy to answer any questions you have at this time.

I'll begin the question-and-answer session. First question comes from Jeff Rulis from D.A. Davidson. Please go ahead.

Good morning. Question on the gain on sale projections in 2022. You've got sort of flattish fee income expectations; just trying to see what that line item year-over-year looks like. Maybe you could detail a little bit more of what you see with the gain on sale item?

Obviously, we expect gain on sales of single-family mortgage loans to decline from this year. Earlier this year we still had much more meaningful levels of refinancing activity, so absent a meaningful decline in mortgage rates we are expecting the revenues next year in the single-family mortgage banking area to look a lot more like the second half of this year. So you can see there would be a noticeable decline in those revenues. Additionally, given my earlier statements that we are planning to sell less multifamily loans next year either by whole loan sale or securitization, those revenues are expected to decline also.

For this year, yes. So just to add: the third-quarter revenue numbers are probably pretty consistent from a single-family perspective going forward and not expected to be substantially different either up or down from there. The other thing I want to point out is as prepayment speeds decline, we would expect some uptick in our loan servicing revenue on the single-family mortgage side. All said, some of that may offset declines.

Right. It's countercyclical. Jeff, you've looked at our results for a long time and seen that. Our servicing results have been pretty poor during falling rates because high repayment speeds create high levels of decay or amortization of servicing rights. Also, when looking at these third-quarter results, we didn't have a multifamily loan sale. So you really need to look at both third and fourth quarters to get a realistic run rate going forward. As we mentioned, we've agreed to a whole loan sale of multifamily loans in the fourth quarter at premiums that were sufficient to keep us from securitizing, so we're expecting that to be a strong loan sale.

Got you. And as a housekeeping item, John, what were the PPP balances at quarter end?

They were at $77 million and the deferred fees were about $2.5 million. Our expectations are that through the fourth quarter we will continue some forgiveness activity and then we don't expect anything material to be affecting next year's results on the PPP side — it will be a small benefit.

Go ahead.

Also, to be on the revenue question, we believe that revenue loss will be made up by other revenue increases, primarily greater net interest income. All of these things together, along with continuing repurchases, make us believe we are not going to see a diminution in earnings per share next year despite the broad estimates in hand.

Yeah. If you look at our numbers, because of the declining balances this year due to PPP loans, we expect our year-over-year loan balances to increase by 10% to 15% next year, and we expect our average balance of loans to increase by a similar level.

And does that 10% to 15% include loans held for sale?

The 10% to 15% is loans held for investment. Loans held for sale tend to be more fluctuating; historically we've had a loan sale on a quarterly basis, but in the future that will be more variable. So the 10% to 15% excludes loans held for sale.

Okay. Got it. And the 19% annualized loan growth in the quarter — would you include the held-for-sale loans in that figure?

Yes, we did include held-for-sale loans in that calculation because between the second quarter and the third quarter there was a big jump due to reclassification. To get that annualized number we included all loans. That's why our year-to-date run rate was 9%. We have strong growth when you pull back PPP loans in terms of our overall portfolio.

Got you. Thanks for clarifying. I'll step back.

Next question is from Steve Moss from B. Riley Securities. Please go ahead.

Hi, good morning. Maybe just following up on the loan pipeline being strong. I hear you on multifamily originations. You saw some growth here in the quarter and construction and other spots. How are you thinking about the mix in terms of growth going forward?

We have a very strong pipeline, particularly in commercial real estate and multifamily. In single-family mortgage we are entering the seasonally lower volume period and the fourth quarter tends to be a time when you draw down the pipeline, so we will likely exit the fourth quarter with a smaller single-family pipeline than we entered. That may not be true in the commercial area. Loan rates remain attractive and in areas like the Fannie Mae DUS business, recent changes in lending caps for the agencies have spurred greater originations. The change in administration increased the multifamily caps by about 10% from the 2021 cap and the agencies have become more competitive since those announcements. So we're expecting much stronger agency lending through the end of the year and at least next year.

One other thing: our single-family loans originated for portfolio have been strong this year and we continue to have pretty strong results. Prepayments have been so high these last two and a half years that it's been hard to keep pace. We expect with prepayments going down next year that our single-family portfolio will start growing next year, right?

Yes. It's been reduced since we downsized the business.

Right, right. Exactly. Okay. That's helpful. And then in terms of loan pricing, curious where rates are on what you're putting on the books these days versus what is rolling off?

That condition hasn't changed — loans are prepaying for reasons. In the aggregate in the third quarter, we ran off loans at about a 3.38% rate and replaced them with loans at about 3.39%, but that's not true by category. For example, single-family loans that prepaid averaged 3.93% and the single-family loans we added averaged 3.36%. That gives perspective on what happens with runoff. The PPP loans also affect the aggregate because those loan rates were low at about 1%. In our ongoing portfolios — the multifamily permanent portfolio plus non-residential CRE permanent portfolio — we ran off at 4.21% and added at 3.22%. These trends continue and our peers are having the same experience. Fortunately, our funding costs continue to fall and overall we believe we are able to maintain our core net interest margin.

That's helpful. And in terms of capital deployment, you talked about increasing buybacks by $20 million. That seems like signaling sustained profitability closer to this quarter's current level. How are you thinking about that, especially for 2022?

We have been fairly aggressive with our buyback program but careful during the pandemic to structure repurchases so that buybacks during a quarter generally have not exceeded what we've earned in that quarter together with dividends. We were sensitive to that relationship as the pandemic extended, and we maintained a somewhat higher level of capital than we would have targeted in normal times. Going forward, should the pandemic subside and conditions normalize, you may see us extend buyback activity beyond current earnings in conjunction with dividends. That would reduce our capital ratios somewhat, not significantly, but modestly below current levels. Relative to capital and earnings, our buyback program may be slightly elevated compared with a normal course.

Okay. Great. That's helpful. Thank you very much.

Thank you, Steve.

Thanks, Steve.

This concludes our question-and-answer session. I'd like to turn the call back over to Mr. Mark Mason for final remarks. Please go ahead, sir.

We appreciate... Before we leave, we're looking at the queue. Does Jeff Rulis have another question? Operator, can you check?

One moment. Our next question is a follow-up from Jeff Rulis from D.A. Davidson. Please go ahead.

Sorry to hold everyone up, but a quick question on the EPS being understated. A big piece of expectations might be year-over-year 2021 versus 2022 on the provision. Year-to-date you had a $9 million recovery. Are you excluding that in your conversation? And if you're including it, any expectations you have on the provision line for 2022 are relevant?

Great, and thanks for asking that question. We are anticipating, absent changes in COVID-related risk or other credit risk, further drawdowns in our ACL next year. If we realize what I would consider a full normalization of that credit risk related to COVID next year, we would likely normalize our ACL coverage levels. That would anticipate us recovering the remainder of provisions we established against pandemic-related risk, offset by growth in the portfolio and whatever other adjustments we might feel are needed to adequately state our ACL under the new standards. Considering we have a growing composition of multifamily loans in our held-for-investment portfolio, and that potential impact on the ACL, our ACL could end up at or slightly lower relative to where we were pre-pandemic. We have not had losses in multifamily loans as an institution, simply stated. Given our high composition of real-estate-related lending and conservatively underwritten hard collateral, we have a lot of safety in our ACL coverage. So our next year's comments do contain the assumption that we will recover all or substantially all of the pandemic-related provisions from 2020, offset by portfolio growth.

Got it. So if you are growing loans 10% to 15% in 2022, we could still see a continued drawdown of reserves in 2022, meaning the provision line could be a benefit versus an expense?

Yes. That's correct.

Okay. Thank you, guys.

That will conclude our question-and-answer session. We'll go to Mr. Mark Mason now for closing remarks.

Thank you, operator. And thank you to everyone who joined us today for your attendance and patience in our prepared comments and the great Q&A. We look forward to talking to you next quarter.

Conference is now concluded. Thank you for attending today's presentation. You may now disconnect.