Preferred Bank Q3 FY2020 Earnings Call

Good day and welcome to the Preferred Bank Third Quarter 2020 Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Jeff Haas of Financial Profiles. Please go ahead.

Thank you, Jason. Hello everyone, and thank you for joining us to discuss Preferred Bank's financial results for the third quarter ended September 30, 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 Deputy Chief Operating Officer, Johnny Hsu. 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 that 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'd like to turn the call over to Mr. Li Yu, please go ahead.

Thank you very much, ladies and gentlemen. Thank you for joining our earnings conference call. I am very pleased to report Preferred Bank's third quarter net income was $17.1 million or $1.15 per share. These numbers compare favorably with the prior two quarters. In fact, on the pre-provision pre-tax basis, third quarter net income and the nine months net income were a record high for our Bank. The quarter's improvement is largely due to a significant reduction in deposit costs and continued overhead control. Many people have always considered Preferred Bank as an asset-sensitive bank. But if you recall, about two quarters ago, I reported to you in our press release, we are transitioning to a liability-sensitive bank. I am very pleased that we have something to show you in this quarter. Deposit costs will continue to decline in the fourth quarter, but not at the same magnitude and pace as in the third quarter. For the quarter, our net interest margin was 3.54%, a 3 basis points reduction from the previous quarter, mainly due to a larger balance sheet and much increased excess cash on hand. However, on an ex-PPP basis, net interest margin actually improved to 3.61% from 3.59%. Third quarter deposits continued to grow 1.5% or $64 million. However, our loans declined by $14 million. I guess the prolonged lockdown in our main trade areas, which are Los Angeles, New York, and San Francisco, has affected the deal flow pipeline significantly. Today, much of our attention and focus is on credit matters. As of June 30th, we had some nonperforming loans totaling a little less than 50 basis points. We have decided to charge off a portion of them and we have also decided to reserve whatever exposure we can see for the full amount on a very conservative basis. Meanwhile, for the quarter, our loan loss provision was a larger number of $9 million. As a result, our credit bill continues to show some pressure. Total reserves to loans now stand at 1.58%. Regarding deferments, the total loans that received modifications under the CARES Act was $610 million. The balance at June 30 was $467 million and the balance at September 30 was $199 million. In the third quarter, we had a 53% reduction. We've also reached out to practically all of our borrowers inquiring about their plans, and we are very encouraged to learn that a majority of them indicated they are planning to resume their scheduled payments very soon. Therefore, the deferment balance at December 31 could be a very modest amount. For the third quarter, our return on equity was 13.7%. We at Preferred Bank are elated about this, not because the number represents a significant loan loss provision, but rather, we believe bigger earnings will give us bigger muscles to fight the uncertainties ahead. Thank you so much, and I'm ready for your questions.

We will now begin the question-and-answer session. First question comes from Nick Cucharale from Piper Sandler. Please go ahead.

Hi guys. How are you doing today?

Hello, Nick.

Thank you.

So you mentioned the increase in capitalized origination costs, due to higher loan production versus the second quarter. Can you quantify that impact? And bigger picture, can you share your outlook for operating expenses?

Hi, Nick, this is Ed. I'll take that one on. Loan originations were relatively flat on a quarter-to-quarter basis when we look at Q2 versus Q3. But what we really saw were the PPP loan fees that came in, and that's why we had the outsized capitalized credit costs under salary expense, and also that had a slight benefit under loan fee income as well. In terms of going forward, non-interest expense wise, we really don't make it a rule to give any kind of forward guidance. But obviously, I think we did an excellent job with respect to expense control in the current quarter. I would look for that to continue, as you know, that's what we're all about, and we actually breached a 30% efficiency ratio in this quarter. So I thought that was pretty impressive. But in terms of going forward, I think it's going to be fairly similar, probably up a little bit from Q3.

Sounds great. And I agree with your assessment. So this was the second quarter we saw C&I paydowns dampen the growth you achieved in the real estate book. You had the big draw on commercial lines in the first quarter, and now we're back towards the end of the 2019 level with respect to balances. Is your sense that commercial paydowns are in the final innings?

Well, I didn't quite fully grasp the question. I mean, are you asking whether the C&I balances will continue through? Actually, C&I balances this quarter have reduced by about $67 million, mostly due to customer pay downs. Our net production actually shows a little bit of net production. While new production versus the payoffs shows a balance of about $40 million, but because existing customers are using less of the loan amount, the quarterly total loan balance reduced by $14 million.

Okay. Your total capital ratio is up nearly 80 basis points from the end of the year. You continue to have strong internal capital generation, as you pointed out, even in spite of the big reserve builds. Can you help us think about your capital priorities, and specifically, if and when you may revisit a buyback?

We really are not, compared to our peer group, we have a low effect of our capital ratio. We have a designated peer group among our peers. At this point in time, our attention really has focused upon the uncertainties ahead of us. We just want to be well prepared for any kind of factors that can affect us. We will revisit that, provided that our loan growth does not restart. To restart the loan growth, there is no need to buy back stock. We can create more income for our shareholders by growing the bank.

Okay. And then lastly, the tax rate came down quite a bit this quarter, seems to be more a matter of timing rather than a structural change. How are you thinking about the tax rate going forward?

Nick, I'll take that one. This is Ed. Yes, the tax rate came down in Q3, and that was a true-up to the 2019 tax returns. So we would look for a somewhat similar tax rate in Q4, albeit probably up just a little bit. And then for 2021, excluding what happens with respect to the upcoming election, we would expect to head back to right around 29, 29.5 ETR.

That's great. Thanks so much for taking my questions.

The next question comes from Gary Tenner from DA Davidson. Please go ahead. Hello Gary, is your line on mute?

Sorry about that. Good morning. A couple of questions for me, I just wonder if you could provide any details on the charge-offs in the quarter? I didn't quite catch any detail that you have provided?

Yes, we had two larger loans, there were a couple of little insignificant ones. The larger loans were placed on non-accrual in the second quarter, and these loans are currently in the prolonged collection process. Although indications are that the latest appraisal value, which was a while ago, will still cover the loan, we believe the market value has slid down a bit. Due to the uncertainty of the collection process, we decided to proactively impact our reserves and reserve whatever exposure we can comply. So, I hope it's seen as a proactive move in preparing for 2021.

Okay, great. And on the previous question, in terms of comp, I think you said that you had the benefit this quarter that drove comp lower because the PPP fees came in this quarter. But wouldn't the deferred count have been better than the second quarter from a PPP perspective?

Well actually, a majority of it was - a lot of the fees received and the bookings took place in Q3, so it was after the end of June when a lot of that occurred. In addition to that, Gary, with respect to comp expense, bonus expense was also lower this quarter. And as you know, bonus expense and incentive comp expense is a component of the Bank's overall profitability.

All right. Thank you.

The next question comes from David Feaster from Raymond James. Please go ahead.

Hey, good morning everybody.

Hi, Dave.

Mr. Li Yu, I just wanted to follow up on your comments at the start, where you mentioned that new loan opportunities might be a bit less attractive in the current environment. Did I understand that correctly? And could you elaborate on why that is? Is it structure, pricing, or just uncertainty in the market? I'm curious about your thoughts on loan demand and your appetite for new credit?

Actually, you mentioned just about every possibility. But let me clarify. I mean new opportunities for hotel loans, we don't want to pursue them. New opportunities for retail loans are less than 50%. Even opportunities for some specialized products like office loans have become less attractive, especially in some of the areas where we are operating. And today, with the prolonged interest rate situation, people are also looking for loans priced at unreasonable levels. We believe the loan pricing is less dynamic, which impacts our ability to pursue many opportunities.

David, I want to add to what Mr. Yu said. A lot of the economic activity going on in the United States is very regionalized right now and very localized. If you look at what's going on in the south and the Midwest, it's far more vibrant than what's taking place in California. I mean, LA County is still under one of the strictest lockdowns in the entire country.

And New York.

So, as we look at lending opportunities, we have to analyze our local economy and what's going on there, rather than focusing on what might be more of a macro perspective.

That's a good point. So probably, I mean you guys are still - like you said, originations have been flattish. So probably some flattish to maybe modest contraction in loan balances in the short run, excluding PPP, which is obviously going to decline?

Well, actually, because we are sort of like a one-off type of loan company, it depends on the specialized loans that come to us. Early indications for the fourth quarter show the possibility of some production, but it is uncertain due to the payoff situation towards the end of the quarter. We are trying our best to manage our credit and maintain our profitability.

Yes. And kind of along those same lines, you guys have done a tremendous job defending the margin and reducing deposit costs. Excluding PPP, it was actually up quarter-over-quarter like you alluded to. But you mentioned that the incremental reduction in deposit cost is likely to be less in the near term. Do you believe you can continue to support loan yields and that deposit costs will outpace the declining loan yields we could see, thereby keeping the margin flat or potentially up? Or might you expect some further NIM compression, given the pricing challenges you mentioned?

Okay. The loan yield reduction in the third quarter is in the single-digit situation. I hope that in the fourth quarter, the reduction in interest costs will offset the loan yield reduction at least.

Okay. That's helpful. And then last one for me, you guys have done a terrific job on the deferral front. Deferrals are down significantly. How have deferrals trended since that September 30 level? Where are they today? How much of the balances are second deferrals versus those that are still on first deferrals? And does that $27 million deferral target that you laid out still hold true?

Well, why don't I let Johnny answer that question, and I'll add to it?

I think, hi David, this is Wellington. The deferrals you noted on the second report are included. This is it.

Okay. After your conversations, nothing has really changed in that $27 million kind of target that you laid out after all the discussions with your borrowers, we're still thinking minimal at the end of this?

Actually, David, if you read the text of our press release, it indicates there are still $4 million of new requests for deferrals as of September 30th. The question of deferrals comes in sporadically, but the number remains minor. Many of our customers have been paying out of pocket for some time, but since the lockdown is lasting longer than we originally anticipated, some are starting to have difficulty. In many cases, the new deferrals we're granting are only principal-only or partial interest. So if you examine these deferrals, 40% of our deferrals are partial deferrals. We are carefully studying everything and trying to exceed our underwriting principles in granting our deferrals.

Okay, that's helpful. Appreciate all the color, guys. Thank you.

The next question comes from Tim Coffey from Janney. Please go ahead.

Thanks. Good morning everybody and thanks for hosting the call today.

Thank you.

I want to follow up a little bit on the loan demand from your clients. If the restrictions were lifted tomorrow, would you expect to see a resurgence in demand for credit from your borrowers, or is it more that your borrowers are just hesitant right now to make new investments?

Well, my impression is that there is a lot of money on the sidelines, and people are just waiting to jump into things. Wellington, do you want to add to that?

I agree. There is certainly a lot of liquidity available. However, is it going to spike overnight? Probably not, as we're also going to be cautious and ramp things up gradually. But I think there is definitely potential if the pandemic were to end tomorrow. We will also need to consider our competitors to understand how the market reacts and the pricing of the loans.

Sure. Okay. That's helpful. Thank you. And just circling back on the deferrals; with the positive trajectory of the deferrals, are you done reserving, or is it a little too early to make that call?

Well, we have no discussions about reserves overall for the future. Let me respond to you this way. I have reached out to several of our shareholders. I asked, given our situation, our deferrals don't look that bad. In fact, you could say they look reasonably good. But what do you expect us to do under the uncertainty? There could be a second wave of issues. Today, government officials are stating that it may take six months before everything can normalize, so what if New York locks down for another six months and nothing can happen? A significant number of my shareholders have expressed that we should manage the bank in the safest and most conservative manner in the current environment. So, we will make some additional reserve adjustments. But again, we will keep our eyes open to see what the market condition is. While many banks may be reporting reduced provisions, we have been instructed by our shareholders to play it safe. Given that we still maintain a 13% return on investment, they seem satisfied.

Okay. That's helpful. And just if I could ask about CDs that might be repricing in this quarter. What is the yield on those, or the cost of those, and where is the market rate right now?

They are...

The $434 million should be renewed in the fourth quarter. The rate on that is 1.60%. Currently, our CD rate is in the 60 to 70 basis points range. So there will be some savings. But mind you, this $434 million is not really evenly renewed during the fourth quarter; a larger portion will be due in December.

The next question comes from Steve Moss from B. Riley FBR. Please go ahead.

Good morning. I guess just starting with credit here for a moment. With regard to the provisions, I'm curious how much the specific reserve is for the two larger credits here?

Well, I think we reserved approximately $6 million in addition to the charge-off.

Right. So then absent that specific reserve, your provision for the quarter would have been closer to $3 million, just as we think about economic impacts. Is that a fair way to think about it?

The charge-off really has no economic impact; the reserve is the one that has a significant impact. In other words, if we make a reserve of $5 million, the provision will be $5 million, okay. The charge-off next quarter is just a reduction of the reserve that was previously established.

Hang on. I'm sorry, let me - Steve. I'm sorry, I want to correct what Mr. Yu just mentioned. The specific reserves assigned to those two specific credits were $3.3 million when we look at the overall provision of $9 million. So the specific was $3.3 million, and then the charge-off on the two was $3.5 million.

The charge-off is already completed, okay, so it has already taken an additional $3 million.

Okay. So then as I think about your provisioning forecast moving forward, if the economic forecast remains stable, will the biggest driver of the provision going forward be any specific reserves you may have?

Yes. If the economic forecast shows improvement, we would definitely reduce the provision. If the deferment works out to be as we project, and there are no new surprises, it is possible that in 2021, we could release the reserve. However, given the situation presently, I don't believe any economist has provided a definitive answer on how the economy will perform.

Right. Just trying to consider the driver of the provision going forward.

The short-term forecast indicates that we may see some ongoing pressure on the property market. However, we will surely make adjustments based on prevailing indications.

That's helpful. The rest of my questions have been asked and answered, I appreciate that. Thank you.

Thank you.

The next question comes from Andrew Terrell from Stephens. Please go ahead.

Hey, good morning everyone. So most of my questions have been asked and answered already. Maybe do you guys have the balance of classified and criticized loans this quarter?

We do. Just a moment.

I do. Just hang on, I've got a lot of paper here. Hang on, here it is. Classified loans are $59 million, and overall criticized loans–including special mention loans plus criticized–total about $139 million.

That's helpful. Thank you. So within the table you provided in the release that breaks down the loan portfolio by bucket and gives the loan-to-value and debt service coverage, this is an extremely helpful breakdown. If I compare this quarter versus last quarter, most of the real estate bucket saw an uptick in loan-to-value by about 3% on average. I'm curious, is this more just an ebb and flow of the portfolios, or are you getting updated appraisals on properties right now? And if so, how are those valuations comparing to the previous ones in place?

Do you want to answer that, Edward?

Yes, I would say that it’s really a combination of both at this point, Andrew. There is certainly churn through there, even though the portfolio only moved $14 million. There is a fairly decent amount of activity going on with respect to pay-offs and new originations, as well as renewals. So on renewals, depending on length and size, appraisals are updated. Beyond that, it's as you said, it's the ebb and flow.

All right, thank you. And just last one for me, have you guys started submitting applications for the PPP forgiveness? And do you have any ballpark estimate of when you anticipate recognizing the fees?

Johnny, do you want to answer that?

Yes. We did submit forgiveness applications already, and a few have been processed in early October. We expect that to continue throughout the fourth quarter.

The fees are currently being amortized over the life of these loans. So the fee recognition at the end of this won't be that significant because we also have deferred costs to recognize.

Additionally, our total PPP is only $74 million, compared to $4 billion of loan portfolio. So in relative terms, it wouldn’t affect things that much.

Got it. Okay, thank you for taking my questions.

Next question is a follow-up from Nick Cucharale from Piper Sandler. Please go ahead.

Just a quick follow-up on the NIM. So point to point, you had a significant increase in cash balances at September 30th relative to June 30th. We are only a few weeks into the fourth quarter here, but has that excess liquidity started to come down materially at this point?

No. Slightly, hopefully on mark. The cash inflows and DDA are kind of sitting there right now, happy but not entirely satisfied.

Upside down.

That's very helpful. Thanks.

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

Well, thank you so very much for attending the conference. We hope to continue our operations under the current metrics, which have provided us with this level of profitability and the situation we would like to maintain. Thank you so much.

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