Preferred Bank Q1 FY2020 Earnings Call

Good day and welcome to the Preferred Bank First Quarter 2020 Conference Call and Webcast. All participants will be in listen-only mode. Please note, this event is being recorded. I would now like to turn the conference call over to Mr. Tony Rossi of Financial Profiles. Mr. Rossi, the floor is yours, sir.

Thanks, Mike. Hello, everyone, and thank you for joining us to discuss Preferred Bank's financial results for the first quarter ended March 31, 2020. With me today from management are Chairman and CEO, Li Yu; President and Chief Operating Officer, Wellington Chen; Chief Financial Officer, Edward Czajka; and Chief Credit Officer, Nick Pi. Management will provide a brief summary of the results and then we will open up the call to your questions. During the course of this conference call, statements made by management may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based upon specific assumptions that may or may not prove correct. Forward-looking statements are also subject to known and unknown risks, uncertainties, and other factors relating to Preferred Bank's operations and business environment, all of which are difficult to predict and many of which are beyond the control of Preferred Bank. For a detailed description of these risks and uncertainties, please refer to the SEC required documents the Bank files with the Federal Deposit Insurance Corporation or FDIC. If any of these uncertainties materialize or any of these assumptions prove incorrect, Preferred Bank's results could differ materially from its expectations as set forth in these statements. Preferred Bank assumes no obligation to update such forward-looking statements. At this time, I would like to turn the call over to Mr. Li Yu. Please go ahead.

Thank you very much. Good morning, ladies and gentlemen. The events in the first quarter of 2020 are truly astonishing, but I am very pleased to report that for the quarter, Preferred Bank's net income was $16.2 million or $1.08 per share. Although this seems to be a little less than the previous quarter, that is really because we decided to build up our liquidity reserve and make a significant provision in the quarter. On a net interest income basis, our net interest income for the quarter is better than the previous quarter and the same quarter last year. For the quarter, deposits grew by $103 million. Loan growth was $168 million. A large portion of the loan growth is coming from customers' increased drawdown of their unused credit lines, which we estimated to be between $100 million and $120 million. Part of it is drawn down credit lines to funds that stayed with the bank, which also helped the deposit growth. At quarter-end, we estimated the available credit line for customer drawdown is a little bit over $400 million, but many of those credit lines are under a borrowing-based formula. So, the actual amount is probably between $300 million to $350 million. As of March 31, we have on-balance-sheet liquidity of $720 million, and we have off-balance-sheet liquidity of another $650 million. So, we can satisfy should the need arise. For the quarter, our net interest margin actually improved a little bit from the previous quarter. This is welcome news as we all know that the first quarter had rather large federal rate cuts. These rate cuts drastically changed the interest sensitivity of the Bank. As of March 31, 14.9% of loans are fixed-rate loans. 19.4% of the loans are floating rates without a floor, and 65.7% of the loans are floating rates with a floor. Of those floating rates with a floor, all but $28 million, or 1%, are operating at the floor right now. With the continued high repricing of our TCD portfolio downwards, we feel that our net interest margin has hit the bottom in March at about 18%, and we anticipate gradual improvement from that point on. Our first-quarter efficiency ratio was 34.9%. Recently, S&P Global issued a study ranking banks between $3 billion to $10 billion and ranked Preferred Bank number one in the nation for efficiency ratio. With our cost control and gradually improving net interest margin, we see our operating metrics as favorable. Moreover, S&P also rated us as number one overall in the nation. There are no signs of credit deterioration at this point in time, but we know the nation is currently entering into a recession stage, and our lifestyle has changed for at least an extended period of time. The recovery may be slow. With this in mind, we decided to build up our credit reserve. The first step is to adopt CECL, which increased our reserve by $8 million. The next step was providing a $5.3 million loan loss provision for the first quarter. At this point in time, all 13 branches of our bank are operating for business. Observing the stay-at-home order, 45% of our staff is working from home. We're able to handle customer needs through increased usage of digital banking. Our loan activity was able to handle many deferment requests by our customers and manage the first phase of the PPP program requests. We are gearing up for the second phase of PPP and the upcoming Main Street Lending Program. We're pleased that the banking industry and we have become part of the solution this time. The dark days for our nation will be over soon, I hope. And we are committed to being a factor, a contributor to our recovery. Thank you very much. I'm ready for your questions.

Thank you, sir. Our first question will come from David Feaster of Raymond James. Please go ahead.

Hey, good afternoon, guys. I just wanted to start on the provision. Could you maybe just talk a bit about some of the factors in the model that drove the $5.3 million provision for the pandemic? And then maybe as the economic outlook has seemingly deteriorated further in the second quarter, maybe how you think about additional reserve build going forward?

Well, we would obviously ask Nick to answer your first question. For your second question, you and I can join to answer that, right?

Sure, yes. David, this is Nick speaking, and our CECL model covers mainly three portions. The first portion is the quantitative side, we use the PDLG model to figure out the quantitative side and also we use a flex factor to provide reasonable and supportive forecast for the future 12 months, along with a 6-month revision period. The second part is the qualitative side, where we have nine different factors. Definitely a few factors reflect the current macro and microeconomic situation, along with third-party individual evaluation on those problem loans. As of March 31, we adjusted our qualitative side as well as the flex factor on the quantitative side to reflect the current pandemic situation. So, for the $5.3 million reserve in Q1, I would like to say that around 71% is really related to the pandemic situation.

David, to answer your second question, we will probably review the situation every quarter, look at the economic condition, and obviously, analyze our loan portfolio. Most probably, we will continue to increase our reserve. With all those deferments, all the affected loans so far are deferred for six months, generally expiring in early October. As of now, on that portfolio, any weakness will probably show up in late fourth quarter or early first quarter next year. You wouldn’t have a real reading on the situation. You can only judge by the general situation of the economy and activities by taking prudent steps. But we decided to continuously beef up our reserve.

Okay. That's very helpful. Thank you. And then just on the margin, I mean you guys have done a phenomenal job managing the margin. And I appreciate the color on the proportion of fixed rate and variable-rate loans at floors. But just taking a look at that, reading kind of in between the lines in your commentary and the press release, it sounds like there could be some pressure here in the second quarter and then maybe improve after that over the remainder of the year?

You see, there are three other factors. Ed will add more detail to it. There are three factors other than the pure interest rate and margin. The first factor is pay-offs, loan payoffs or loan payments; all loans get paid off usually don’t carry a higher rate. The second factor is the new loan rate or the coupon rate or floor rate. The third factor is the competition situation for deposits. There is only the second factor we can control, which is to manage our margin for the new loans. I can say that it’s an expansion situation compared to previously. The first and third factors, however, we cannot control. Pay-offs in the first quarter appear to be slowing down, so we are generally more optimistic compared to previously. But the exact calculation of that is difficult. Ed, do you want to add on to that?

Yes. No, I think you’ve said it all. With the slowdown in pay-offs, that will help maintain the margin, in addition to what you already talked about regarding the CDs repricing. When this all started in mid-March, we saw considerable spikes in CD rates across the board, competition and everywhere. Since then, it’s come down about 40 to 50 basis points in the last month or so. So, that certainly bodes well for us going forward with the CD portfolio continuing to reprice. If we don’t get pressure on the asset side, I think it’s safe to say we’ll probably see some expansion later in Q2 and Q3.

Okay. That's extremely helpful. Last one from me. Loan growth is really strong, even exclusive of the drawdowns in C&I. I guess, what are you hearing from your clients or what's the pulse of your clients? And how do you think about, or I guess how have C&I drawdowns been early in the second quarter in that $350 million that you mentioned that were remaining and just general thoughts on loan growth in your pipeline going forward?

Okay. I will turn it over to Wellington to answer the question.

Hi, Dave. This is Wellington. Obviously, looking at our loan pipeline has slowed down. Customers are being more careful about what they are acquiring and what type of projects they want to take on. At the same time, due to COVID-19, we are exercising extra caution and being even more selective of what type of customers and loans we want to pursue right now. The last thing we want to do is book a new loan and then have to do the payment deferment.

To answer part of your question about the drawdown, as I stated in the press release, the drawdowns since the beginning of April are indeed slowing down.

And next, we have Steve Moss with B. Riley, FBR.

Good morning. I would like to follow up on the CECL assumptions. Could you provide some insight on the unemployment and GDP inputs you are considering? Additionally, how should we view the loan loss provision for the second quarter compared to the first?

Hi, Steve. This is Nick again. Our Q side, qualitative side, links with the macroeconomic situation, but we do not directly reflect that in our reserve because we don’t really have that many consumer loans. We are indirectly impacted, rather than directly. We do have a flex factor as well as qualitative factors reflecting the external economic situation. We base our reserve refinements on those and use different scales: low, moderate, severe, and extremely high.

Okay. And then just as we think about the provision here for the second quarter, I mean likely to see obviously more reserve build, just kind of like. Do you think it's reasonable just to assume the first quarter level, just any color around that would be helpful?

Actually, it’s very hard to tell at this point in time. But you can believe that we are determined to be on the more prudent side going forward. Equally as significant changes in the economic assumption, next quarter, whether economic conditions will drastically change or not, we have to see how the situation evolves. But we are leaning towards being prudent.

Okay. And then in terms of the funding side, I think you said 40 basis points lower for CD rates. Just wondering what exactly that rate is; can you refresh my memory here?

Well, I'm just talking in general about what we see in our market, Steve. We saw one-year CDs spike up to around 110, 115 when this all broke, when the lockdown first happened. I think that was around mid-March, because there was a general sense that banks were all going to go out and get liquidity as all lines were going to be drawn. Well, that abated and that really didn’t happen. So, now we’re seeing one-year in the 65 to 70 basis point range.

Okay, that's helpful. All right. Well, thank you very much. Appreciate that.

The next question we have will come from Gary Tenner of D.A. Davidson.

Thanks, good morning. I wanted to try to get a better handle on the intra-quarter workings on the margin and how to think about it going forward. Given the expansion in the quarter, is it fair to assume that the margin actually expanded even more than that over the first couple of months of the year before then falling below that number towards the end of March?

Yes, obviously, that’s the case. Ed, do you want to add onto it?

Yes, January and February were probably just slightly above the 370 number and then we didn’t get the drastic cuts until the middle of March, and then the final cut, I believe, was on March 18. The effect was certainly muted within the first quarter. We were in a situation where deposit costs were continuing to decline while asset yields were holding steady, and then, of course, middle of March, asset yields dropped. We saw a benefit from January and February, but there was a decline in March in terms of the overall margin.

Okay. So again, to follow on that then, the second quarter, should we expect to see the full quarter's impact from the March cuts even though you had expansion for the full quarter in Q1? The second quarter should likely be the bottom and could get offset by lower funding costs; is that fair?

Yes, generically that's the pattern.

Okay. Sorry about that. The other question I had I think has already been answered, so thank you.

Thank you, sir. Our next question comes from Tim Coffey of Janney.

Thanks. Good morning, gentlemen.

Hi, Tim.

In the release, you said that you were offering deferrals mostly to the hotel and restaurant portfolio through the end of March. I'm wondering into April, did you expand the criteria for who you might offer deferments to?

Who wants to answer that? Nick, do you want to answer that?

Sure. Just to give you a little more color regarding our total deferred payment requests as of today, we have received requests from borrowers on a number of loans, totaling 43. The total amount is around $239 million. So, among those requests, some are for interest only, some are for principal deferment, and some request both principal and interest deferment. For the hotel portion, special purpose hotels are part of those requests, totaling $140 million, around 28% of our hotel portfolio at this time.

Okay. And the deferments you mentioned were six-month terms?

We are initially offering three-month terms, and then we can provide another three months later as an option. Yes, we have started to receive requests for deferrals beyond just hotels, particularly in the retail sector. We’re also seeing some deferment requests from smaller apartment complexes, particularly in the New York area, where some tenants are unable to pay.

And remind me again how much of the multifamily portfolio is in New York?

Well, I don't have that breakdown for you. I only have deferral amounts.

Okay, not a problem. Thank you. And then where are you on the PPP program? I know you mentioned in the press release that you started to accept applications. I'm wondering if you had any numbers on how many have been approved for funding before the funds ran out and how many you might have in the pipeline right now?

Okay. Wellington, please take the question.

Hi, Tim. This is Wellington. As you know, we were not SBA-approved lenders going into the first round. However, we have an obligation to take care of our customers. So, we contracted a third-party processor to manage the application process for our customers. After a little over a week into the PPP program, we finally received SBA approval. Unfortunately, we only had a little bit less than a day to process the applications internally. So, we are gearing up for the second round. Currently, we are looking at just under about 300 total applications, counting both us and the third-party processor.

As for the funded approvals so far, we have around 40 applications approved for funding.

Yes, from the 40 that are approved, the total amount is about $24 million. We have around 250 more in the queue for the second round.

Okay. And do you have any dollar amounts on the 40 that were approved for funding?

Yes, the 40 are approximately $24 million.

Okay. Would you think the average application amount on the other 250 would be about the same?

It will be lower. The average will be lower since the 40 include a larger loan that skews the average.

Right. And then just on your appetite to hold these on the balance sheet, I can't imagine it would be significant, given what the yield is. So, would you look to resolve them as quickly as you can?

We certainly want to assist our customers. Whenever requests come in, we immediately try to process them. That’s why we engaged a third-party processor to handle applications for our clients initially. We believe we can manage the situation. Although there haven't been many requests, they continue to come in. I don't think fee income will materially change the second quarter's picture, and I don't foresee it affecting net interest margin significantly because of its proportion.

Tim, to add to that, we will likely hold them on the balance sheet and work with our customers to resolve these by June.

Okay, if I can, what is the fee to the third-party processor?

We have zero fee income. They receive all the fees.

I appreciate that.

The next question we have is from Gary Tenner of D.A. Davidson.

Thanks. I just had a follow-up on the PPP question. I guess I was a little confused. Of the loans that the third-party processor went through the application process for, will those still be on your balance sheet, or are those going to not even go through Preferred Bank ultimately?

Yes, those will be on our balance sheet, Gary.

Those will be. Okay. All right, thank you.

We're showing no further questions at this time. We will go ahead and conclude our question-and-answer session. I would now like to turn the conference call back over to the management team for any closing remarks.

Well, thank you very much for joining our earnings conference. This has been a truly challenging quarter for everyone. I join every one of you in hoping everyone stays healthy and safe, and hope that our country improves soon. Thank you.

And we thank you, sir, and the rest of the management team for your time today. Again, the conference call is now concluded. Thank you again, everyone. Take care, and have a great day. You may disconnect your lines.