Oceanfirst Financial Corp Q4 FY2020 Earnings Call

Good day and welcome to the OceanFirst Financial Corp. Earnings Conference Call. All participants will be in listen-only mode. Please note, this event is being recorded. I would now like to turn the conference over to Jill Hewitt. Please go ahead.

Thanks, Tom. Good morning and thank you all for joining us. I'm Jill Hewitt, Senior Vice President and Investor Relations Officer at OceanFirst Financial Corp. We will begin this morning's call with our forward-looking statement disclosure. Please remember that many of our remarks today contain forward-looking statements based on current expectations. Refer to our press release and other public filings, including the risk factors in our 10-K, where you will find factors that could cause actual results to differ materially from these forward-looking statements.

Thank you, Jill, and good morning to all who’ve been able to join our fourth quarter 2020 earnings conference call today. This morning, I'm joined by our President, Joe Lebel; Chief Risk Officer, Grace Vallacchi; and Chief Financial Officer, Mike Fitzpatrick. As always, we appreciate your interest in our performance and are pleased to be able to discuss our operating results with you. This morning we will cover our financial and operating performance for the quarter and provide some color regarding our priorities for 2021. Please note that our earnings release was accompanied by a set of supplemental slides that are available on the company's website. We may refer to those slides during this call. After our discussion, we look forward to taking your questions. In terms of financial results for the fourth quarter, GAAP diluted earnings per share were $0.54, a significant improvement as compared to the third quarter, and an all-time record result. GAAP earnings reflect the strong recovery as credit costs moderated. Reported earnings were impacted by a variety of items, as we positioned the balance sheet for 2021. As a result, we pegged the core results for the quarter to be $23.2 million or $0.39 per share. Regarding capital management, the Board declared a quarterly cash dividend of $0.17 per common share and approximately $0.44 per depository share of preferred stock. The common share dividend represents the company's 96th consecutive quarterly cash dividend, a 24-year uninterrupted chain of performance. The $0.17 common share dividend represents just 32% of GAAP earnings, allowing us to build tangible book value per share by 2.7% as compared to the prior quarter. There are no plans to reduce or eliminate our common dividends at the present time. Capital levels also improved with tangible stockholders' equity to tangible assets increasing 38 basis points to 8.79%. Please note that our balance sheet remains inflated, as we carried $1.3 billion of cash at year-end and averaged over $1.2 billion of cash on hand during the quarter. As a result, asset-based ratios, including capital levels, return on assets, and margins continue to be a bit distorted. As you may recall, the company suspended share repurchase activities in February of last year in recognition of the unusual risks presented by a global pandemic. Having completed our stress test process and having observed significantly improved asset quality measures this quarter, the company plans to recommend share repurchases immediately following the opening of our trading window next week.

Thanks, Chris. I'll start with the net interest margin, which was unchanged quarter-over-quarter at 2.97%. As Chris noted, we have over $1.2 billion in cash we need to deploy, which we expect to do over the next five to six quarters. We estimate excess liquidity of $1.17 billion, which has a drag on NIM of 36 basis points. The NIM also includes 24 basis points of purchase accounting accretion, up seven basis points quarter-over-quarter, while prepayment fees were minor in both quarters, leaving the core NIM down eight basis points. It should be the trough in the NIM, which primarily remains impacted by our large cash balances. Paying off the Federal Home Loan Bank advances in Q4 should benefit us to the tune of 10 basis points in 2021. And we continue to work down the brokered CDs we raised early in the pandemic. At the end of Q3, we had about $275 million in brokered CDs and ran off of $108 million in Q4. In Q1 and Q2, we will see another $156 million with a weighted average rate of 1.14% leave the balance sheet. Excluding the brokered CDs, I expect another $493 million in CDs, with a weighted average of 1.6% either renewing at a much lower average rate or also exiting the balance sheet. For the year, organic deposit growth of $1.51 billion included several wins of high-profile nine-figure corporate treasury accounts, reflecting the maturity of the treasury area we began just a few years ago. Our team and product set rival any competitor and will allow us to continue to be aggressive in reducing rates on CDs and other rate-sensitive accounts with maturing rate guarantees in 2021. While we reduced the cost of interest from 49 to 45 basis points in the quarter, we expect to continue to improve markedly in the coming year. Loan origination set an all-time high excluding PPP loans, while commercial activity was muted in the second half of the year after a strong start due largely to the pandemic. Residential lending remained a bright spot with record highs in originations.

All right. Thanks, Joe. At this point, we'll turn to the Q&A portion of the call.

We will now begin the question-and-answer session. The first question comes from Russell Gunther with D.A. Davidson. Please go ahead.

Hey, good morning guys.

Good morning, Russell.

Just a follow-up on Joe's comments regarding the LPOs and team lift outs. Understand, we'll get more of an update next quarter. But was curious on two fronts, one, I think you mentioned contiguous markets. And so, curious as to what that means from a geographic perspective? And then, two, do you have a kind of loan growth target in mind for the back half of the year?

So, I think for us, we've always described our adjacent markets as places that we can reach in a day. The approach we're taking involves adding three lenders in the fourth quarter within existing markets, including two in the Newton, North Jersey LPO, which has just secured office space and will be operational soon. We expect to keep adding in these existing markets, focusing on vibrant areas as we typically do. Our priority is acquiring talent first, as that influences our direction. We are optimistic about this. Additionally, I anticipate being able to achieve significant growth every quarter in the portfolio during the second half of the year. Early on, we want to concentrate on what we've recently accomplished, which includes properly identifying credits in the acquired banks, supporting our clients through the referral process related to PPP loans, and navigating through the pandemic effectively. We are confident about loan growth in the latter half of the year.

That's great. Thanks, Joe. And then, switching gears to the margin. Looking at the deck that you guys put out with earnings, a very helpful glide path in terms of what happened this quarter. Hoping you could extend that into 2021 and talk about how the average earning asset remix you plan to undertake will play out from a margin perspective.

I think there's kind of two keys to the margin story for us. The first, as Joe mentioned, we have a lot of deposits repricing, especially early in the year. So we have lagged many of our peers in the speed with which our deposit rates have come down. You'll see us catch up in early in the year, but that'll be helpful on margin. It's going to be more of a funding story than an asset yield story in the beginning of the year. The other thing is the FHLB advances were paid off mid-quarter. So we'll get a full quarter's worth of benefit as we go into next year. I think as the year develops, the story is going to shift more to an asset base story where you see that cash deployed. All of that cash is currently at the Federal Reserve, so you're earning somewhere in the range of 10 basis points on that. So, I can't give you a specific glide path or we don't provide guidance on future margins. But I do think to echo Joe's comments, we believe that Q4 was the trough and that margin expands from here.

Thank you, Chris. And then last question for me is on the expense side of things. So, I've got the expectation around the incremental branch reductions. I think the system conversion for Country Bank is in the first quarter. Could you talk about your expectations for core expenses over the next few quarters and the ability to target and achieve positive operating leverage for 2021?

As we head into 2021, we noted that there were some unusual items in Q4, such as our elevated FDIC assessment. This was due to the significant portfolio of loans we moved to held-for-sale and downgraded to non-performing in Q3, which affected our non-performing assets ratio and increased our FDIC assessments. We estimate that about $1.03 million of our Q4 expenses were unusual, making it appear higher than normal. For this year, we are currently seeing about $1.25 million in COVID-related expenses, which we expect to decrease. Additionally, we will be closing four branches in early April due to regulatory requirements related to our national bank charter. Overall, we anticipate our expenses to remain relatively flat. While there has been some NIM compression that masked our operating leverage, we've shown improvement in our core revenue and expenses over the past four quarters. We will continue to evaluate our branch network in light of the talent Joe is bringing on board, and by April, we should have a clearer picture of the full-year expense outlook. For the first quarter, expenses should remain flat, with a potential positive impact.

Great. Thanks, Chris. That's it for me guys. I appreciate it.

Thanks, Russell.

The next question comes from Matthew Breese with Stephens. Please go ahead.

Good morning.

Hi, Matt.

Hey, I got to go back to the NIM. I understand there's a 36 basis point drag from liquidity, and you're attempting to put that to work over the next five or six quarters. What is on the low end? How much of that can you recapture over the next, call it five, six quarters? If you had to give yourself an A grade, a B grade, a C grade, how much of that do you think you could recapture through deployment?

I think when we finish deployment, we would likely be in our historical range of the low 320s to 340s. So, once completed, that's about where we would end up. I believe the transition will be relatively smooth over the next four quarters, depending on certain events. You might see some improvement in Q1 due to the funding issues I've mentioned. Also, remember that some brokered CDs rolled off in the fourth quarter, which will provide a full quarter’s benefit in Q1. The CDs that roll off in Q1 will offer a full quarter benefit in Q2. So it's primarily a funding issue. We believe that over the next four to six quarters, we should stabilize margins back to where we used to be in the low 320s to 340 range.

Okay. Great. And then, more so than your peers with the proactive actions on deferrals. To me it feels like you probably have a better outlook for the overall profitability of the Bank. If we assume that we're in this interest rate environment for a while, let's just say through 2022, maybe into 2023, in terms of ROA and return on tangible goals, could you just share with us your outlook and what you hope to achieve there?

We need to clarify our view on what we call the iceberg issue. Due to the CARES Act, it has been valid to restructure loans without labeling them as troubled debt restructurings, which complicates our understanding of the remaining credit risk on our books. That's why we've reported that 97.1% of loans are paying according to their pre-COVID terms without any concessions or special deals. We believe we have a solid assessment of our credit risk. In the last quarter, most charge-offs were linked to the sale of high-risk residential loans as forbearance periods ended. When excluding those, our net charge-offs were quite low. As we move into 2021, I should mention that the forecasts we developed in the fourth quarter did not factor in the new Senate makeup or the possibility of significant fiscal stimulus, which could have a positive impact. Under CECL, these economic changes are important, and they could benefit us going forward. Additionally, a large portion of our reserve is based on qualitative factors rather than quantitative ones. Regarding your question about profitability metrics, while the pandemic is not over and we still need to manage our special mention substandard loans, we feel well-positioned, with 84% of that segment being current on payments. This situation will likely impact profitability concerning provision requirements. We believe this won't hinder us significantly. The second factor to consider is the yield curve as we utilize our cash. Initially, even though the long end of the yield curve began to rise, loan rates remained unchanged, reflecting competitive market conditions. We believe we can achieve our margin goals within the current interest rate climate. Should there be notable changes in the yield curve, it could enhance our situation. We anticipate being able to increase our earnings above a one return on assets, and with our leverage, we expect to see a favorable return on equity.

Okay. Great. My last question is about mergers and acquisitions. I'm interested in how your discussions have progressed this year or over the past few months, particularly if industry deferrals have decreased. What are your expectations? Do you believe that, given the increased discussions, you might engage in M&A again this year?

I mentioned earlier last year that we had essentially removed ourselves from the market while we took stock of our situation. The first step in this process is understanding our own balance sheet. It's crucial to have everything in order at home before engaging in discussions. This was one of the reasons we acted decisively to maintain our desired balance sheet position. We are now confident that we have a clear understanding of our credit risk and balance sheet status, which satisfies the first condition for considering mergers and acquisitions. The second condition involves being able to assess other companies. Observing the earnings season, it is evident that many in the industry are performing well, and indicators such as forbearances are trending positively. This gives us visibility into balance sheets and credit quality, thus meeting the second condition. The next step is identifying smart and actionable opportunities, which can be unpredictable and depend on various factors. We anticipate that many will explore strategic alternatives, likely in the first half of this year, and we plan to do the same. If we find an opportunity that adds value for our shareholders, we are ready to act immediately. We currently have $1 billion in cash available and can leverage our earnings without needing an acquisition to improve efficiencies or earnings. Therefore, we do not feel pressured to pursue acquisitions, but the industry is now in a position to consider them.

Great. I appreciate it. And that's all I had. Thank you very much.

Thanks, Matt.

Our next question comes from Christopher Marinac with FIG Partners. Please go ahead.

Hey, thanks. Good morning, Chris and team. I know it's been almost a year since the pandemic started and you were one of the first banks to recognize the risk. So just kind of want to circle back on what has to happen to reverse some of the criticized and classified loans. Do you think some of that might start happening this quarter, or will it take longer for that to unwind and therefore influence reserves as you were talking about earlier?

Yeah. So, I mean, the first is, we don't feel that there's going to be a lot of pressure on reserves there based on our assessment of things like LTVs and the payment currency and all that. I think it's going to be a methodical process where you'll see it come down a little bit in each quarter. And then, if you fast forward a few quarters, it'll become much less significant. These are really pandemic-driven decisions where people are okay. We can see that they have a source of payment for us, but they were weakened, right? I mean, if you don't think that people would be weakened after a pandemic, you're probably in the wrong business. But Grace, I know you've got some very good kind of granular data around LTVs and segments. So maybe you could just share that with Chris.

Sure. So, in the special mention and substandard book, the special mention portfolio has LTVs less than 60%, and in substandard, it's around 50%. And as Chris mentioned earlier, 84% of those loans are performing as agreed with pre-COVID terms. Said differently, only 16% are past due or on non-accrual, or our PCD loans. So, I think the point there being that demonstrates that, we're pretty rigorous in evaluating the risk in our credits. It doesn't necessarily mean that they can't pay us. It's just that there's an indication of some sort of weakness, some impact from COVID.

I believe when considering the losses in those segments, the loan-to-value ratios and our performance, even on loan sales, reflect the liquidity discounts faced this year while trying to sell loans during a pandemic. We don't think there is significant content there, and the reserve already factors in this migration.

Got it. That's helpful background. Thank you, both. And Chris, just big picture follow-up. As you've built a digital bank for OceanFirst the last several years, what have you not done just in terms of functionality? Is there anything that you haven't yet accomplished on that, or do you feel like you are where you want to be with the digital processes?

There are several aspects to consider. We believe we offer a competitive and effective range of digital products that allow our customers to perform as they would at any major bank. Moving forward, our investments will focus on two key areas that may not be immediately obvious. The first is business process automation, which enhances the efficiency of the bank. Our goal is to enable our employees to work more effectively and efficiently, which is significant for how customers perceive us. The second area involves attracting new customers in the digital era. Our branch network continues to bring in new customers daily. We are improving our digital distribution efforts, which go beyond just online account opening. While our online account opening service allows customers to set up accounts in six minutes and we have seen substantial growth in usage, many people still prefer to visit a branch first. This presents a challenge we need to address. We believe our features and functionality for customers are strong, but we also need to enhance what we provide to our employees for faster, more effective service. Ultimately, the challenge lies more in marketing strategies rather than just digital solutions—specifically, how we can encourage customers to open accounts with OceanFirst using mobile devices.

That's great. Thanks for sharing your thoughts on that. I appreciate all the information today.

All right. Thanks, Chris.

The next question comes from Frank Schiraldi with Piper Sandler. Please go ahead.

Good morning.

Hi, Frank.

I need to follow up on mergers and acquisitions. What does the wishlist look like in terms of what makes the most sense and what is most attractive? Are we considering potential market opportunities in New Jersey? Is it an add-on deal? If so, what geographic area are we focusing on?

Good morning, Frank. After each acquisition, we conduct a post-acquisition review about a year later where we discuss with the Board what worked well, what met our expectations, and what didn't. Now that we have completed seven acquisitions, we can share a few insights that may be evident. First, establishing your own market share is crucial. Secondly, working with a company that has strong pre-deal competitive performance metrics, including good margins and returns on assets, will yield better results after the acquisition. It’s not overly complicated. We have a structured strategy in place for combining commercial banks in shared markets with like-minded companies that target similar customers, yielding good margins and earnings. When you minimize combined operating expenses, the results are promising. Whether it's through an acquisition, merger, or merger of equals, this approach remains optimal. Additionally, the larger the scale of the opportunity, the greater the potential for increases in earnings per share for our shareholders. As we explore these options, we find that contiguous markets are acceptable, although they offer fewer cost savings. If the business model differs significantly from ours, we may need to address funding or lending complications. Therefore, we evaluate potential deals based on key performance indicators of the combined companies, such as return on assets, margins, and return on equity. We also assess the raw earnings per share increase and the price-to-earnings ratio after accounting for cost savings, as these factors are pivotal to our analysis. While the concept of earn-back has been a frequent topic in the industry recently, it serves merely as a guideline for us. Our primary goal is to identify businesses that align with ours, whether in overlapping or adjacent markets, as this strategy seems to offer the most benefit. We've always been open to considering a range of options, so we're continually scanning the market for opportunities. If something viable arises, we would be ready to act.

Okay. Well, thanks for all that. And then, I guess, same sort of question on the organic side is to think about loan growth coming back, particularly in the back half of 2021. Where's the most interest? I mean, is it just primarily in C&I? Is there areas of CRE, that are particularly interesting, given maybe rates are going to be low for a while and you can lock in some spread. What's of most interest here in this environment?

I believe we are open to various types of growth. While that may sound vague, let me clarify. Many banks have concerns regarding commercial real estate concentration, but we are not facing those issues. There are specific areas within commercial real estate, like industrial and last-mile logistics, that are valuable to many. The competition in those segments is high, and we are interested in refrigerated storage and similar opportunities without any restrictions in pursuing them. Overall, we are not limited in our commercial real estate activities. Additionally, our swap product has been competitive over the past two years, allowing us to manage long-term fixed-rate duration risk on our balance sheet. This may result in slightly lower loan origination spreads, but we benefit from early swap income, which is advantageous. We aim to recruit as many commercial and industrial lenders as possible and engage in as much C&I business as we can. However, we are aware that many lenders are targeting the same opportunities due to their CRE restrictions, giving us the flexibility to pursue where the opportunities lie. I believe as we bring in new talent and strengthen our existing teams, we will see benefits in both areas. I am not constrained by the duration, rates, or terms, as long as we adhere to our credit criteria. It's worth noting that our commercial pipelines were slightly over $200 million at the end of Q4, showing significant growth since then.

Thanks for the information. I have one last question. I found the gains in the equity portfolio to be quite interesting. I'm curious, given the current interest rates and the need for yield, if this is just a one-time opportunity or if you plan to use this approach for deploying cash in the future. Also, while it's not exactly the same, how do you compare this with investing in your own company through buybacks?

I view this as a unique opportunity that is likely a one-time event. To provide some context, after our capital raise at the start of 2020, we found ourselves with a substantial excess cash reserve in our holding company. We began investing in companies, initially focusing on subordinated debt and other instruments that we were quite familiar with. We felt we had a better understanding than the market regarding credit discipline and underwriting, which resulted in favorable outcomes. We realized significant gains from these debt instruments. While searching for yield, we revisited a strategy from our past. In 2008, we identified several companies with high dividend yields and modest payout ratios, where we believed we understood the balance sheet strength. Our intention was to acquire yield, and that portfolio ended up yielding over 5%, a figure we anticipate maintaining for an extended period. Subsequently, as the markets surged, the value of our chosen instruments appreciated quickly and significantly, leading to a decrease in their effective yield compared to our original strategy. Once yields dropped sufficiently, we reassessed our position; we initially bought these for yield, but with the yield now low and gains realized, we decided to convert these into tangible book value and reduce risk on our balance sheet. We will explore a wider array of strategies for deploying our cash than we did a few years ago. Our treasury team has matured significantly, and we aim to be methodical, thoughtful, and conservative in our approach. We are considering alternative ways to utilize that cash, as we believe it will be available for the long term, not just through the loan portfolio. While we have concentrated on our loan book recently, we're also evaluating the investment portfolio. However, we think fixed-income securities may not be the most favorable option currently, so we are proceeding with caution.

Okay. Got it. Makes sense. Thanks.

The next question comes from Erik Zwick with Boenning & Scattergood. Please go ahead.

Good morning.

Good morning, Erik.

I wanted to start by asking about the new recruiting efforts. Joe, you mentioned some details earlier. In your opening remarks, you said you're actively recruiting. I’m curious if you have specific criteria in mind or if you're targeting individuals you know from the past, or perhaps lenders who specialize in certain asset classes. Additionally, are you noticing any common traits among the organizations from which you're successfully recruiting these individuals?

Thanks for that, Erik. We have a group of candidates that we've been considering for a while and we always keep in touch with them. Sometimes the timing is right for people and sometimes it’s not. Recently, we’ve been fortunate to bring in new talent, and I've noticed a significant interest from individuals—even those we don’t know well—who are open to discussions, which is very valuable. This is part of what we've established here. There are no limitations for us; I’m open to recruiting C&I or CRE lenders, with no areas being off-limits. I respect that people have their specialty niches, and it's particularly fascinating in the current rate environment to find ways to differentiate ourselves without taking unnecessary risks. I'm all for that. Historically, we tend to recruit from larger organizations because they usually provide seasoned lenders who not only have strong sales experience but also a solid credit background and training, which is essential for our company's underwriting process. We typically find ourselves recruiting from larger companies, and there is certainly no lack of qualified talent, which is a positive situation to be in.

I agree. Thank you for the insightful information. My final question today is about your strategy for the new round of PPP, especially considering that you've sold significant balances from the previous rounds. Can we assume that any interest you're getting from current customers might involve a third-party? I'm just interested in how you're approaching this at the moment.

We are actively lending to our customers who have a need. The clients from our last sale will still be supported for additional requests. We've separated our process; the loans we sold are managed by a third party, while the requests from the loans we didn't sell, which is just under half of our portfolio, come directly to us. Feedback from our peers indicates a positive trend. The SBA has introduced a new rule requiring a 25% reduction in revenue to qualify for the new funding round, but only a small number of businesses are actually qualifying. This is encouraging as it reflects fewer businesses in dire straits. We are processing loans smoothly, with an automated system connected to the SBA. However, I don’t expect large numbers for us or even across the industry in comparison to previous rounds. We’re addressing the demand, but it won’t be significant.

Great. Thanks for taking my questions.

Thanks, Erik.

The next question comes from William Wallace with Raymond James. Please go ahead.

Hi. Thanks, guys. Good morning.

Hey, Wally.

Just two quick kind of housekeeping questions, but as a quick follow-up on that PPP question. What are the balances left at the end of the year? And then also what was the NII and net interest margin impact from the PPP loans during the fourth quarter?

The balances at the end of the year below $100 million. And so the impact going forward would be relatively nominal. We fell in the deck that when we sold off the PPP loan, those were relatively low rate. So they created the NIM during the quarter by about nine basis points.

Okay. Yeah. Okay. Thank you. And then, do you guys have any determination as to whether you will be able to push off the impacts of the Durbin Amendment since you crossed $10 billion in 2020?

We are still waiting for final guidance on this matter. The interim guidance suggests there may be a way for us to avoid the Durbin Amendment, but the Federal Reserve could also choose to apply it on a case-by-case basis for banks. We are in touch with our regulators to clarify what the final decision will be for us. We surpassed the $10 billion mark on January 1st, which puts us in a unique situation. The interpretation indicates that if a bank exceeded $10 billion due to the pandemic, it might not be impacted the same way, and while that wasn't our exact situation, there's an argument that due to the absence of PPP loans during the pandemic, we may have opted to keep our assets under $10 billion by year-end, but the pandemic changed that opportunity. This is an ongoing discussion, and I can't provide any further guidance at this time.

I don’t know if you’re aware, but there was a bank in Tennessee that exceeded $10 billion due to an acquisition, and they announced on their earnings call yesterday. I think it was yesterday, but everything blends together this week, that the regulators mentioned they would provide relief. If you’re following that, does that give you hope that you might qualify as well?

I think hope is an appropriate term. One of the great aspects of our Federal Reserve system is its regional nature. The central bank is not centralized; instead, it consists of 12 different banks. There are moments when obtaining a consistent answer across all 12 banks is straightforward, and other times, it requires navigating through the process. Nevertheless, that did provide us with hope.

Okay. All right. That is fair answer. Thank you. Thank you, guys. That's all I had. I appreciate.

Wally, the PPP loans in the 1231 with $95 million on our balance sheet and that's been running down as they’re forgiven.

Thanks, Wally.

As we have no further questions, this concludes our question-and-answer session. I would now like to turn the conference back over to Christopher Maher for any closing remarks.

Thank you. With that, I'd like to thank everyone for their participation on the call this morning. We remain focused on building the business, deploying that cash and improving earnings. We look forward to discussing our first quarter results with you in April. Thank you.

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