Preferred Bank Q4 FY2020 Earnings Call

Good day and welcome to the Preferred Bank Fourth Quarter 2020 Earnings Conference Call. All participants will be in a 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, Andrew. Hello everyone, and thank you for joining us to discuss Preferred Bank's financial results for the fourth quarter ended December 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 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. Good morning, ladies and gentlemen. I'm very pleased to report that for the fourth quarter of 2020, Preferred Bank’s net income was $20.8 million or $1.40 a share. This is a new record for our bank. On a pre-tax, pre-provision basis, 2020 is also a record year for Preferred Bank. This quarter’s net income, net interest income, and net interest margin are all enhanced by two relatively non-recurring items. First of all, there was a recovery of interest of $473,000. The next item is fees earned from our now-terminated mainstream lending program, which amounted to $499,000. Net interest margin came in for the quarter at 3.66%, which is 4 basis points better than the previous quarter. But without these non-recurring items, it would have been 3.58%, 4 basis points better. Again, this quarter, the reduction of interest costs outpaced the moderation of loan yields. Looking ahead, we shall have continued interest cost savings in the first quarter, as roughly $330 million of time certificates of deposits will be repricing for roughly 50 basis points savings. Our quarter's net income was negatively affected by a loss on securities sales of $660,000. For the quarter, loan growth was $86 million or 2.2% sequentially, which is very encouraging after a long drought during the pandemic. We have seen that our customers seem to be much more positive about our nation's economy. The fourth-quarter loan pipeline has really picked up. Deposits, however, grew only slightly at $28 million, and liquidity at the bank remains very good. Perhaps the most reassuring aspect for us is the improvement in our credit posture. After nearly a year of uncertainty related to the pandemic, we are finally seeing things getting better. Specifically, deferred loans have now reduced to $28 million compared to the peak of $610 million, with most of these deferments being partial, allowing us to collect interest while deferring principal. Total non-accrual loans have been reduced to $20.5 million. Loans that are 30 to 89 days past due, which usually signal early credit issues, stand at $4.1 million. There were no loans that were 90 days past due. Total classified loans are now $55 million, including a $23 million TDR that is performing. At December 31, total reserves stand at 1.6%. We will always be cautious regarding our operating expenses. The efficiency ratio came in at 29.9% for the quarter. With the availability of the vaccine, despite the chaotic situation in Los Angeles County, we believe things will be much better, and we anticipate that 2021 will be a good year for Preferred Bank. Thank you. I am ready for your questions.

At this time, we will now begin the question and answer session. We will pause momentarily to assemble our roster. The first question comes from Nick Cucharale of Piper Sandler. Please go ahead.

Good day, gentlemen. Hope you all are well.

Thank you. We are.

Good, good. So first, a nice rebound in loan growth this quarter specifically in CRE balances. What was the production broad-based across your geographies? I'm just trying to get a sense that the activity was specific to one area’s markets, given the differences in pandemic-related impact across the country?

Yes, it's across all geographies. Wellington, do you want to first provide some color on that?

Yes. Hi, Nick. This is Wellington. Production is pretty evenly distributed between our geographical footprints, including Southern California, Norco, as well as the East Coast and New York area. It’s very well balanced.

Great. And then secondly on the margin, I appreciate you calling out the one-time items than the maturity schedule. Even so you posted core NIM expansion. Do you feel like you still have some room for declining liability costs to outpace erosion in asset yields for the next couple of quarters or is that going to be challenging to maintain?

Yes, there will be. Liability costs will generally follow a very positive trend. First of all, in the first quarter, we have $330 million of PCD maturity, which will be repriced probably 50 basis points or less. The second quarter may see a little bit of residual effect from the first quarter, but it will depend on whether market interest rates change due to competition. We are highly likely to see refinancing our subordinated debt, and at the end of the second quarter, the residual results at today's market conditions should reasonably present good savings. So we are positive regarding our interest cost outlook.

That's great color. An impressive work on driving the modifications down this quarter, no hotel loans and deferrals was especially positive to see when it comes to asset quality in the current portfolio. What is particularly top of mind for you? What are you guys worried about?

We are concerned about the possibility of prolonged lockdowns. Many individuals seeking deferments have had to use their savings, particularly those who have experienced losses due to job losses or closed businesses. They have been struggling for quite some time. In our situation, we have benefited from originating loans at low loan-to-value ratios. If you examine the table we provided, most of them are in the 50s. Furthermore, since 1995, nearly all our loans have required a sponsorship or personal guarantee. We are diligent in assessing the cash flow of these individuals. We have made strides in cutting costs across all categories. However, those most impacted may have gone almost a year without revenue and will require assistance in managing their payments going forward.

Okay. And then lastly, for me, a big step up in fee income from letters of credit. Do you expect that line to stay elevated at this level in the coming quarters or revert back to where it was earlier last year?

We think it's going to be relatively stable, but Wellington, feel free to provide additional color on that.

Nick, I believe that based on our pipeline, it should remain relatively stable.

The next question comes from Timothy Coffey of Janney. Please go ahead.

Thank you. Good morning, everybody.

Hi.

Hi, Mr. Yu. We look at capital loan growth this quarter. Is that a reflection of people getting off the sidelines and getting back to business or was this a bit ahead of expectations?

Well, some individuals are getting off the sidelines. However, the pandemic has made it very challenging to do business with new parties. But we had hired and have seen new requests coming in. We obviously remain highly alert, but there are new requests that represent new activity for us.

Okay. What does the loan growth tell you about the potential for growth next year, especially as states like California start to reopen?

It's always challenging to forecast loan growth quarter by quarter. However, based on our activities in the fourth quarter, we achieved a total of outstanding loans amounting to $300 million in new loans within that period, representing a commitment of $375 million. We hope that activity will carry over into the first quarter. That said, it will depend on when the lockdown restrictions are lifted, as our interactions with customers require close contact. There are variables, but we are generally feeling positive about moving forward.

And among the customers you serve and loans you like to originate, what's the competition level like right now?

I'll let Wellington answer that first, and then I have some personal observations.

Hi, Tim. This is Wellington. I think competition remains pretty stiff out there. We have many competitors offering extremely low interest rates, but it’s uncertain how they can sustain that. Nonetheless, we strive to maintain discipline and continue to be selective, which has always been part of our business strategy.

Tim, this is Li Yu. We are currently facing significant competition from banks in our territory with assets from $50 million to $150 million. Many of our clients are high-net-worth individuals who also provide additional business to those banks. We are seeing some refinance loans offered below 3% fixed for 10 years, rates that are below our net interest margin. While we admire their capabilities, we have chosen not to match those offers.

That's very helpful. And then looking at expenses, will there be potential upward pressure on expenses if the economy starts to reopen from additional travel and marketing?

Hey, Tim. This is Ed. Looking forward, as we anticipate profitability to improve in 2021 over 2020, you will see the salary and benefits expenses increase over the year, because our bonus accrual is directly tied to the bank's profitability. More specifically to your query regarding reopening and travel costs, those are not expected to be significantly material for us as a company because our workforce is relatively small compared to our asset size. When examining line items, we actually benefited this year in areas like business development and promotion, as well as office supplies and equipment, which have seen year-over-year decreases. Going forward, there will be increased expenses, but they are unlikely to be material.

Tim, I’d like to add that the management team is positioned for growth again because we feel optimistic about 2021. As a result, we will be stepping up our efforts to find new locations, branches, and other opportunities. As a result, throughout the year, our personnel expenses may increase in our production personnel, leading to larger long-term benefits if we are successful.

Yes, of course. Well, thank you very much. That's exceptionally helpful.

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

Hi, good morning, everybody.

Hi.

I just wanted to follow up on your last comment about new offices. I'm curious if there are any new markets that you might be interested in for organic expansion and how you are thinking about that.

Yes, we traditionally focus on organic markets that align with our capacity to lend to a team of producers. We usually seek out able bankers and establish a team of supporting staff to kick-start a business in line with any branch we open, even in the Los Angeles area. There are many new locations in California that we are interested in, which represent vibrant business centers. Our challenge is locating suitable personnel, so when we see these opportunities, we view them as new organic expansion efforts.

Okay. And in terms of asset quality, you have continued to improve your defensive posture, which is evident. We've also seen the reserve ratio continue to grow. Given the improved economic outlook and credit quality, how do you think about the opportunity to potentially release reserves? At what point would you feel comfortable doing so, and what do you consider a more normalized reserve ratio?

Well, I am observing trends. If asset quality does not deteriorate, I can foresee a reduction in provisions, potentially to minimal levels, and perhaps we could release some reserves later in the year. However, this will depend on how the situation evolves. It will also be influenced by the growth rate we experience. Generally speaking, based on our current performance, I expect that our provisional expense this year will be comparatively low.

Okay, that makes sense. I’m curious also about historically being asset sensitive. How does that compare today, considering liquidity and the impact of floors? How has your asset sensitivity changed, and how do you envisage managing that going forward?

Ed, do you want to tackle this question first?

Sure. The interest rate situation right now is very interesting due to a divergence between the long and short end of the curve, which seems to be steepening. Relative to our balance sheet, we are quite asset sensitive on an overnight basis, as we have a significant amount of cash. Furthermore, approximately 80% of our loan book is floating rate. With approximately 70% of these having floors, many are currently below their floors. It may take one to three quarters for us to see the yields on the asset side accelerate as rates rise. From a quantitative standpoint, we still maintain significant asset sensitivity.

Currently, 80% of our loans are floating rate with floors. Many are under their floors, and while we anticipate upward rate changes, it is difficult to say when the Fed will act. Perhaps 25 to 50 basis points. Until then, we expect some of our loans will rise to the new rate. On the defensive side, we have a large $1.6 billion TCD portfolio that will reprice gradually, which should somewhat offset the impact of the rate increase. Historically, we've been cautious about managing these aspects.

Okay, that's all. Thanks, everybody.

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

Good morning.

Hi.

I just wanted to follow up on yields here. What were the origination yields for the quarter?

For the quarter, we are originating loans at an average rate of 4.85%. The payoffs were a bit higher, approximately 30 basis points more. This was one of the primary reasons we experienced moderate yield compression.

Okay, that's helpful. And on the CD side, where are your current offering rates?

Hi Steve, this is Ed. Our offering rate on a one-year CD is right around 50 basis points, which is consistent for six months and three months as well.

Steve, it's worth noting that in the first quarter, we opted not to match some key CDs due to our high liquidity. A strategic decision was made as the bank currently has a lot of cash earning minimal interest.

Right. Okay, that's helpful. In terms of capital, growth appears to continue this quarter and should build in 2021. What are your thoughts on potential capital deployment?

As we continue to achieve these levels of earnings, coupled with slight improvements, we will be considering an increase in dividends, which is something we are dedicated to recommending to the board. Additionally, capital deployment will largely depend on loan growth. Should we succeed in returning to pre-pandemic levels, our capital redeployment will largely come through lending growth. If we're unable to achieve original loan growth, we will consider buybacks. I'm currently evaluating how immediate buybacks would affect our current capital levels. Our primary capital level is slightly over 10%. This is part of our ongoing assessment.

Okay, great. That's very helpful. Thank you very much.

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 very much for your attention. As I mentioned earlier, we had a strong quarter, and we hope it continues into next year. Hopefully, all of us will be emerging from the pandemic soon and returning to our normal lives, which is perhaps more significant than the bank’s performance. So let’s all wish for the best in 2021. Thank you.

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