Bank of N.T. Butterfield & Son Ltd Q2 FY2022 Earnings Call

Good morning. My name is Andrew, and I will be your conference operator today. At this time, I would like to welcome everyone to the second quarter 2022 earnings call for the Bank of N.T. Butterfield and Sun Limited. Please note, this event is being recorded. I would now like to turn the conference over to Noah Fields, Butterfield's Head of Investor Relations.

Thank you. Good morning, everyone, and thank you for joining us. Today, we will be reviewing Butterfield's second quarter 2020 financial results. On the call, I'm joined by Michael Collins, Butterfield's Chairman and Chief Executive Officer; Craig Bridgewater, Group Chief Financial Officer; and Michael Schrum, President and Group Chief Risk Officer. Following their prepared remarks, we will open the call up for a question-and-answer session. Yesterday afternoon, we issued a press release announcing our second quarter results. The press release and financial statements, along with a slide presentation that we will refer to during our remarks on this call, are available on the Investor Relations section of our website at www.butterfieldgroup.com. Before I turn the call over to Michael Collins, I would like to remind everyone that today's discussions will refer to certain non-GAAP measures, which we believe are important in evaluating the company's performance. For a reconciliation of these measures to U.S. GAAP, please refer to the earnings press release and slide presentation. Today's call and associated materials may also contain certain forward-looking statements, which are subject to risks, uncertainties, and other factors that may cause actual results to differ materially from those contemplated by these statements. Additional information regarding these risks can be found in our SEC filings. I will now turn the call over to Michael Collins.

Thank you, Noah, and thanks to everyone joining the call today. I am very pleased with the bank's financial and operational achievements during the second quarter of 2022. We have continued to benefit from rising interest rates, disciplined expense management, and increased noninterest earnings. This resulted in strong net income and earnings per share growth as well as a very strong quarterly return on tangible common equity. Butterfield continues to be a leading provider of offshore banking and private trust products and services, with operations in highly regarded jurisdictions. Our banking business benefits from franchise-level market shares of between 30% and 40% in Bermuda and the Cayman Islands, with a growing presence in the Channel Islands. In the Bahamas, Switzerland, and Singapore, we provide specialized financial services offerings in addition to our prime Central London mortgage products available to high net-worth borrowers. I will turn now to Slide 4, where we provide a summary of second quarter highlights. Butterfield reported net income for the second quarter of $49.1 million or $0.99 per diluted common share and core net income of $50.2 million or $1.01 per diluted share. Our core return on average tangible common equity was a record 27.8% in the quarter compared to 21.9% in the prior quarter. Our net interest margin improved 23 basis points to 2.26%, with the cost of deposits rising 4 basis points to 16 basis points. The Board of Directors again declared a quarterly cash dividend of $0.44 per share. Share repurchases were paused in the quarter due to increasing OCI marks, which has continued to keep the TCE to TA ratio around 5%. We view share repurchases as an important part of capital management and will recommence share buybacks when appropriate. I will now turn the call over to Craig Bridgewater to provide more details on the second quarter results.

Thank you, Michael. I will begin on Slide 6, which provides a summary of net interest income and net interest margin. In the second quarter, we reported net interest income of $82 million, an increase of 8% versus the prior quarter. The increase was due mainly to improved yields on all interest-earning assets. Average investment balances decreased by $82.5 million due to unrealized losses in the AFS portfolio as market interest rates climbed. New money yields on investments increased to 3.85%, up from 2.67% in the previous quarter. We made aggregate reinvestments of $120 million in the second quarter of 2022 versus $257 million in the previous quarter. The majority of our securities consisted of Freddies, Fannies, and some U.S. treasuries. Paydowns continued to decelerate with $172 million of portfolio paydowns in the second quarter of 2022 versus $209 million in the previous quarter. The average loan balance was down $77.4 million due primarily to a weaker pound sterling, which impacted the translated value of loans denominated in pounds. Approximately 39% of our loans are originated in our Channel Islands and U.K. segment, whose operating currency is pounds. If we remove the impact of the change in the U.S. dollar-pound sterling FX rates, loan balances increased by 4% in our Channel Islands and U.K. segment and 4.4% in total. Overall loan yields were up 22 basis points versus the second quarter, primarily due to the impact of rate increases in floating-rate loans, particularly in Cayman. During the quarter, we had loan originations of $387 million versus $176 million of originations in the first quarter of 2022. This quarter's increase included a significant loan to the Cayman Islands government. Turning to Slide 7, noninterest income was up 3.8% quarter-over-quarter, benefiting from increased trust fees due to the continued onboarding of new business and activity-based fees. Additionally, noninterest revenues increased from the scheduled recognition of unclaimed customer drafts and checks as well as higher banking fees as a result of increased consumer spending. As we have noted previously, noninterest income remains a stable and capital-efficient source of revenues with a fee income ratio of 38.9% during the second quarter. Slide 8 provides a summary of core noninterest expenses. Total core noninterest expenses were $81.9 million, up marginally from $81.6 million in the prior quarter and within our current targeted range. We are seeing some signs of wage inflation and have executed some salary adjustments, particularly in our more competitive labor markets of Canada, Singapore, and the Channel Islands for targeted specialist skills. We are continuing to evaluate the need to make other inflation-related adjustments elsewhere. The core efficiency ratio continued to improve to 60.2%, returning to our through-cycle target of 60%. As an organization, we have been disciplined in the management of expenses, and we will continue to manage core while investing in the infrastructure necessary to conduct our business. I will now turn the call over to Michael Schrum to review the balance sheet.

Thank you, Craig. Slide 9 summarizes regulatory and leverage capital levels. Butterfield's capital levels continue to be strong and above regulatory requirements. Our TCE to TA ratio of 5.1% has increased slightly as deposit levels have moderated, but the ratio remains below our internal target range of 6% to 6.5% due to lower marks in our available-for-sale portfolio, resulting from higher long-term U.S. dollar interest rates. As a reminder, TCE to TA is not a regulatory ratio for Butterfield, and the ex-cash TCE to TA ratio was 5.6%. We moved a further $332 million at fair value from AFS to HTM during this quarter to significantly mitigate any further OCI impact on the TCE to TA ratio. We continue to anticipate that the rate-driven OCI marks will keep this ratio below the target range for a few quarters as U.S. dollar interest rates rise, and this is also expected to benefit net interest income. Our current dividend payout ratio was 46.6% in the second quarter of 2022, having declined from a pandemic high of 60.5% in 2020, and now is more in line with our through-cycle target of approximately 50%. Turning now to Slide 10. Butterfield's balance sheet remains strong and conservatively managed with a high degree of liquidity. Period-end deposit balances dropped by approximately $800 million to $13.1 billion versus the prior quarter. We have been anticipating these outflows of pandemic-related deposits, which also include a $251 million foreign exchange impact from the strength of the U.S. dollar. Average deposit balances are down approximately $500 million to $13.6 billion for the second quarter. Butterfield's low-risk density of 33.8% continues to reflect the regulatory efficiency and conservative nature of our balance sheet. On Slide 11, we show that Butterfield's asset quality remains exceptionally high with low credit risk in the investment portfolio, which is comprised of 96% AAA-rated U.S. government-guaranteed agency securities. Credit quality continues to remain strong with nonaccrual loans holding at 1.2% of gross loans and a net charge-off ratio of 7 basis points. Economic activity in our lending jurisdictions continues to improve. However, given the threat of an economic slowdown following the U.S. Fed's actions to curtail inflation, we are keeping a close contact with borrowers to address any concerns that may be emerging. If we see cash flow challenges for borrowers due to rising rates, we will remain patient lenders, and we have a long track record of working with customers to assist them. On Slide 12, we present the average cash and securities balance sheet, with a summary net interest rate sensitivity analysis. Duration in the FS portfolio fell by 0.2 years following the transfer of approximately $332 million of longer duration securities from AFS to HTM at fair value. During the past few quarters, we have modeled an increase in NII in a down 100-basis-point parallel shift in the yield curve based on the assumption that we would be able to pass along a portion of the negative rates to the positives. With interest rates now well above 0, the down 100-basis-point scenario has reverted to show a more traditional picture. We continue to expect a sensitivity to result in improving NII as market rates increase. I will now turn the call back to Michael Collins.

Thank you, Michael. With tourism and economic activity returning to our core markets, we are well-positioned to benefit from a post-pandemic recovery. This was an important quarter for Butterfield as we saw NIM expansion continue to demonstrate our asset sensitivity. M&A also remains an important aspect of Butterfield's growth story. We continue to evaluate and pursue acquisitions with in-market deals under review or consideration and more activity on the trust side of the business. Our typical deal takes anywhere from 12 to 18 months from initial discussions to conclusion, with total consideration typically under $50 million and below 8x EBITDA. We recognize the need to carefully evaluate trust acquisitions and are particularly cautious around all aspects of AML and KYC. We have terminated discussions on a few deals recently due to our low-risk tolerance and will continue to be disciplined in our diligence and acquisition strategy. We will inform the market with an update as soon as it is appropriate. Butterfield remains well positioned for profitability and growth by leveraging our strong balance sheet, capital-efficient noninterest earnings, demonstrated expense control, proven capital management, and low credit risk. We continue to create shareholder value with leading positions in operating jurisdictions with high barriers to entry, robust infrastructure, efficient operations, and a customer-centric culture. Thank you. And with that, we'd be happy to take your questions.

The first question comes from Timur Braziler with Wells Fargo.

Can we start on balance sheet size? Just looking at the deposit outflows this quarter, I think, in prior conversations, it was identified that there was roughly $1.2 billion of kind of surplus deposits, saw a decline of a little bit over $800 million this quarter, $250 million of that was FX related. So is that implying there's another, call it, $600 million that you would classify as surplus deposits? Any color on just deposit expectations in the back end of the year would be helpful.

Thanks, Timur. It's Michael Schrum. I'll start with a brief history. Looking back to Q4 2020, we experienced a significant increase in deposits, largely driven by government pandemic-related stimulus, which contributed to our balance sheet. In previous quarters, we indicated that about $600 million of these deposits came from corporate sources, while another $600 million was likely retail-related, including onetime pension withdrawals. This quarter included some foreign exchange volatility, but we also noticed corporate clients returning to risk assets, particularly in the Channel Islands segment, where a large real estate fund took on risk with a particular purchase. Moving forward, we believe deposit balances remain elevated. Traditionally, before the pandemic, deposit levels aligned closely with GDP growth, as we hold a 40% market share in our core markets of Cayman and Bermuda. If we are considering a return to a more typical balance sheet, we estimate there could be an additional $500 million or so in primarily retail pandemic-related deposits that would eventually migrate into pension assets. However, the timing of this transition is currently uncertain, but that's my estimate.

Okay. That's good color. And then maybe just talking through asset sensitivity. Can you just remind us what you have currently priced in through the loan book, primarily on the Bermuda mortgages? What's kind of been passed along to the customer? And then as a corollary to that, just how you think about the pace of higher mortgage rates versus sensitivity on the credit front?

Yes. Tim, it's Craig. Yes. I guess just to focus particularly on the Bermuda book. As you know, any increases in rates have a 90-day notice period. So we would expect, obviously, those rate increases to take place 90 days after we actually announced that we're going to do that. So that's kind of historically based on the Fed rate rises this year, 150 basis points. We've passed on 100 basis points to the Bermuda base rate. So we did nothing in March. We increased by 50 basis points in May. So essentially, that will become effective in a few weeks' time in August. We had an increase of 50 basis points in June when the Fed went 75 basis points. So that will come more in line in September. So that's kind of how we're seeing those rate adjustments becoming ineffective. So we would expect in Q3 that we will have, I guess, a higher velocity of net interest income, particularly when it comes to the Bermuda residential book.

And have you noticed the changes in net interest income?

I'd just add to that. Obviously, we are seeing more demand for fixed rates. I think customers are wanting to protect our cash flows. And as we sit here today, probably 20%, 22% of the resi loan book is fixed rate 3 to 5 years, which is a good outcome. We need more fixed-rate assets anyway. And obviously, customers are reacting appropriately, I think, to also the velocity of rate increases in the market.

Okay. And have you made a decision on potentially this week's 75 basis point hike as to what you're going to do with that?

We are still discussing it. Overall, as you know from our history, we kind of have a 50% loan beta on the Bermuda residential book and a little bit higher than that on the commercial side. So we'll react to what our competitors are doing in the market and take that into consideration when the Fed actually announces something. However, you would expect over the full cycle to see about a 50% pass-through.

Okay. And then just last one for me. Looking at the Channel Island deposits, maybe just talk through early performance. I know you called out in the release that the beta and the deposit book was a little bit higher. Overall, they still have an excellent funding base. Just maybe talk through the Channel Island deposits? And if you can, an updated expectation on overall betas of U.S. cycle?

Yes. So for Channel Islands, that is, I guess, our most competitive market when it comes to deposits and when it comes to cost banking. And we've actually seen the, I guess, the price pressures in that market over the last few months as well. We obviously have a watch and brief on that. We are working with various customers to make sure that we remain competitive, and we do pricing that makes sense in those markets. But to your point, we would expect a higher beta in Channel Islands, but we've been managing that quite closely so far and just trying to increase prices where necessary and just make sure that we're still engaged with our customer.

And I'll just add to that, Craig. Sorry, it's Michael Schrum. So from a modeling perspective, what goes into the disclosures here is obviously below 50% beta for the Bermuda and Cayman depositors, and 50% on demand for Channel Islands, 80% on fixed, just so you can put the disclosures into context there.

The next question comes from David Feaster with Raymond James.

I wanted to follow up on the deposit discussion and talk about your plans for using liquidity. We currently have over $1.3 billion in cash. If we set aside $500 million for potential deposit outflows, that leaves around $800 million available. How do you approach deploying excess liquidity? What do you consider a normal cash balance? Additionally, what are your thoughts on securities, expected cash flows each quarter, and your plans for securities purchases?

Yes. Thank you, David. This is Michael Schrum. You may have noticed that we've experienced slightly slower prepayment speeds. Our MBS book is quite fully extended, so duration does not change much from here. When we consider deposits and cash balances, we manage multicurrency cash balances, including sterling savings accounts in Bermuda, and operate four different banks to ensure they all have adequate funding and liquidity. While we maintain some reserves in Bermuda, we typically keep 15% to 20% of deposits in cash or near cash assets, which fall into the cash and equivalents and short-term investment categories. This usually represents a three-month ladder since we don’t have access to a Fed window. We do maintain a significant amount of excess cash and have opportunities to ladder from both reinvestment and new cash. In this quarter, we adopted a more conservative approach due to observed deposit outflows and aimed to stabilize before resuming purchases. However, we will reinvest what matures from the investment portfolio, which will help improve net interest income as well.

That makes sense. And then maybe just touching on asset quality and credit. Obviously, the macro economy is increasingly uncertain, and you alluded to that in your prepared remarks, in the press release, but at the same time, tourism in Bermuda and everything is doing pretty well. Just curious, any high-level thoughts on the health of your local economies, the pulse of your clients and update us on some of the housing trends and mortgage trends across your footprint? Just any commentary would be helpful.

Each of our economies is slightly different. In Bermuda, I would say the GDP is stable or slightly increasing. Anecdotally, the tourism season is going very well, with places like Hamilton Princess fully booked and a lot of visitors around. However, air capacity is down by 40% compared to pre-pandemic levels, making it a bit more challenging to reach the area. Overall, the economy is maintaining its status. In the Cayman Islands, we're seeing strong GDP growth. Specifically regarding housing costs, rents in Bermuda have risen by about 20% to 30%, and housing prices are also up, probably in the upper single digits. In the Cayman Islands, the economy is thriving, with population growth driving housing costs up by 30% to 40%, indicating a high-growth market. Even though summer is typically the off-peak season for tourism, the economy there continues to perform well. The Channel Islands are also well-managed, similar to Cayman, and they operate with no national debt. Their economies lean more towards international business rather than tourism. Both Guernsey and Jersey are experiencing GDP growth. Housing costs didn’t see dramatic increases, although there was some rise during the pandemic. Overall, Bermuda seems to be growing the slowest, while Cayman is thriving, and the Channel Islands are doing quite well. From a mortgage perspective, we are preparing for potential stress. We have an effective outreach program and are assessing mortgages that might encounter difficulties, proactively engaging with clients to help them plan their repayments. While we’re not currently observing any significant stress from the data, we are preparing for possible challenges and reaching out to our clients as necessary.

Okay. That's very helpful. Could you quantify the increase in other revenues from the recognition of unclaimed customer assets? Also, could you discuss the various factors affecting the fee income line, considering the investments you’re making and the current market volatility and economic uncertainty? I understand that some of your business lines are less affected by market fluctuations, but any insights on the factors influencing the fee income lines would be appreciated.

Yes, it's Craig. We're pleased to discuss each of those lines, which are performing differently but showing some strength overall. The other income related to unclaimed assets is around $1.8 million. To provide some context, we review unclaimed assets quarterly, looking back after seven years to see what's unclaimed and recognize what we can. This is a regular process for us, and this quarter's figure is relatively large compared to our expectations, so we don't anticipate this level recurring. We do regularly recognize these unclaimed assets each quarter. In terms of other points of interest regarding income, trust income, and trust fees, our strategy is currently yielding positive results. A few quarters back, we mainly received a fixed fee from clients and were not fully capturing activity-based fees or accounting for things like tax reporting. Now, we are much better at capturing those fees, which continue to show through each quarter, while trust fees remain stable, reflecting the value of services we provide to our plans. Foreign exchange revenue is another area of focus. We've discussed our strategy for strengthening relationships with our plans, especially on the corporate side, such as with reinsurance and captive companies, to help them manage their foreign exchange exposure. We still see strength in this area, having generated $12 million this quarter compared to $12.4 million in Q1. Although it's a slight decrease, it still compares well to last year's fourth quarter, which was about $10.9 million. This strategy continues to benefit us. Lastly, banking fees are worth mentioning. As Michael noted regarding our economies, as they continue to open up and activity rises, particularly with increased tourism, we expect to see higher levels of banking fees, especially from credit card transactions.

The next question comes from Michael Perito with KBW.

I wanted to revisit Timur's line of questioning and ensure I was accurately thinking about the size of the balance sheet. If we look back to the end of 2020, the core balance sheet was around $13 billion, maybe approximately $13.25 billion for rough calculations. Assuming a low single-digit growth rate over the past 1.5 years, this would suggest that by the end of this year, the balance sheet should be around $13.7 billion, give or take. This indicates there would be about $600 million in excess assets, which aligns with the access deposit you provided. Do you generally agree with this assessment? Additionally, does the comment in the investor deck suggest that from this core number, whether by the end of this year or early next year, you expect low single-digit growth moving forward?

Mike, it's Michael Schrum. I believe the calculations are accurate, but the timing might be off by a quarter. In Q3 2020, we had a deposit level of $12 billion. There was a significant increase in Q4 2020, and deposit levels continued to rise in the first half of 2021. Therefore, if we start from that $12 billion and project forward a few years, that is likely where we would anticipate the balance sheet to be.

Yes. Apologies. I was talking about assets. Assets of like, core $13.25 billion. So like it sounds like we're on the same page, just I was talking assets you're talking deposits. Okay. And then so low single-digit growth off of that kind of normalized implied number is in the range of what you guys are expecting moving forward?

Yes. I mean, as you know, there is some uncertainty around deposit flows. I think we know how to characterize the deposits. I think for a couple of quarters now, we've been sort of saying that as government shrinks their balance sheet, and we go into a tightening cycle, we would expect some outflows here. And I think that's what we're seeing now. We do know that we have some retail deposits on here as well. So I think we can kind of characterize those buckets. And certainly, what we've seen so far isn't what we would call the core retail deposit outflows at all. So they're related to specifically funds and people parking money on our balance sheet, really that was stimulus-related and risk-off related corporate deposits.

Got it. Helpful. And then switching to the efficiency ratio. I think there was a comment in the deck that the 60% level is kind of like your over-cycle efficiency ratio expectation. But it's fair to think that, that's going to move into the high 50s here as NIM continues to presumably move higher, right? I mean, is that generally a fair assumption? And it sounds like you guys are still pretty focused on trying to limit as much OpEx growth as you can. And in the third quarter, there should be another nice positive benefit to margin.

Yes, we expect that as we move into significantly higher rates, we will likely drop below the 60% efficiency ratio. It's encouraging to see that our fee lines are helping to stabilize earnings. We do not anticipate any substantial growth in operating expenses. Internally, we have discussed whether to expedite some projects, such as the branch refurbishment in Bermuda and digitization initiatives for our customers. We're aiming to build on the trend we observed during the pandemic, where retail customers shifted to online services out of necessity, and we adapted to that. We believe this trend will persist, and we want to respond accordingly.

Yes. Mike, as you know from the past, we have indicated a target efficiency rate of around 60% because trust is fundamentally a people-centric business. Therefore, we're looking at a 70% efficiency ratio. For banking, considering our market share, it’s likely around 50%. When rates are low, we’re typically in the mid-60s, and as rates rise, we could easily find ourselves in the upper 50s. However, over the long term, we anticipate it to be about 60%.

Got it. Lastly, I noticed that the dividend payout has been slightly higher in the past couple of years, but it appears to be set for a decrease now. I appreciate your insights, Michael Collins, on mergers and acquisitions, and they were quite helpful. I am just wondering if you could share your updated thoughts on the dividend payout, total payout, and buyback interests? Any additional details would be appreciated.

Our capital strategy has remained largely consistent since the IPO, demonstrating its effectiveness throughout the entire cycle, including periods of low interest rates which have influenced net interest income due to asset sensitivity in our balance sheet. We aim for a payout ratio of around 50% throughout the cycle; however, it won't be precisely that. We also assess the stability of our income, especially from fees, to determine if there’s room for further increases. Additionally, we want to ensure we maintain adequate regulatory capital levels to support both organic growth opportunities in our primary markets and to have strategies in place to manage risk-weighted asset growth, particularly if some customers face challenges and shift down the risk weight spectrum. Furthermore, we will consider share repurchases, depending on market conditions and ongoing M&A conversations. Currently, our tangible common equity is below our target range, which has led us to pause share repurchases for the next couple of quarters. Any excess capital that we don’t require for organic growth or M&A will be distributed as a combined payout ratio of 50% cash dividend and share repurchases. The Board is very supportive of our share repurchase program, but it has been temporarily on hold.

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

Thank you, Andrew, and thanks to everyone for dialing in today. We look forward to speaking with you again next quarter. Have a great day.

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