Preferred Bank Q4 FY2021 Earnings Call

Hello, and welcome to the Preferred Bank Fourth Quarter and Full-Year 2021 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, today's event is being recorded. I would now like to turn the conference over to Jeff Haas of Financial Profiles. Mr. Haas, please go ahead.

Thank you, Keith. Hello, everyone, and thank you for joining us to discuss Preferred Bank's financial results for the Fourth Quarter ended December 31st, 2021. With me today from management are Chairman and CEO, Li Yu, President and Chief Operating Officer, Wellington Chen, Chief Financial Officer, Edward Czajka, Chief Credit Officer, Nick Pi, 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 would like to turn the call over to Mr. Li Yu. Please go ahead.

Thank you very much. Good morning, everyone. I'm very pleased to report Preferred Bank's fourth quarter net income of $26 million or $1.80 a share. The full-year earning of $95 million or $6.41 a share. The pretax pre-provision revenue, or PTPP, together with total assets, loans, and deposits, all of these are bank records. In the fourth quarter, loan growth was 2.9% sequentially and annual loan growth was 10.5%. We've had a very, very active fourth quarter for loan production. We generated $587 million of total commitments, with $456 million outstanding SGM, which doubles the prior quarter’s production. Unfortunately, payoffs also more than doubled the prior quarters at $333 million. For the full year, we originated $1.7 billion of new commitments, with $1.26 billion outstanding SGM. However, again, payoff is $890 million. Looking ahead, we have a decent pipeline as of now, but the payoffs will remain a challenge. I personally am very comfortable with our staff's ability to originate new loans. You see, Preferred Bank is a customer loan shop. Much of our production depends on our one-on-one contact with the customer face-to-face, but the pandemic has taken much of that away from us. And I believe going forward with the economy gradually getting better and the pandemic easing, we should be reasonably optimistic about our production level, although it could be lumpy between quarters. On the deposit side, we have little deposit growth in the fourth quarter, but the whole year growth is about $17.6 million or nearly $800 million. It is very comforting that most of this growth, or 90%, is on the transactional side, which is of lower cost. Our net interest margin was lower than the previous quarter, but that was mainly because the changes in assets are leveraged, as our loan yield remained pretty stable between quarters. Looking ahead, as we have 85% of the loans that are floating, that should work well in a rate-rising environment. One good news to us is that in the assets quality side, aside from the $9.2 million resolution and the $23 million payoff that I mentioned in our press release, we're on our way to advance another loan of over $4 million from the NPL level to the OIU level that can be sold shortly after. Also, we're looking to resolve another $4 million of loans which will be paid back as we can see right now. So by the end of the first quarter, I hope our loan quality would be even better than the fourth quarter. For the year 2022, obviously, we still have challenges with Omicron. It's hard to predict when the pandemic will ease up on us, and there are also challenges with a high inflation economy, which may take time to quiet down. But we're confident that our country will eventually deal with these issues effectively. Our job is to prepare ourselves as well as possible, and then to be alert every step along the way. So thank you very much, and I'm ready for your questions.

Thank you. At this time, we'll begin the question-and-answer session. At this time, we will pause momentarily to sum up the roster. The first question comes from Matthew Clark with Piper Sandler.

Hey, good morning.

Good morning, Mr. Clark.

Maybe just starting on expenses. Nice decline in comp expense this quarter. But you also had some cautious commentary in the release around inflation, more specifically wage inflation. What are your thoughts on the run rate, Ed, and just overall expense growth for the year?

Yes. So fourth quarter was good in terms of expense control, Matthew. We would expect going forward, as you know, first quarter is always a little bit of a headwind for us on the non-interest expense side due to the payout of incentive compensation. But comparing linked quarters from Q3 to Q4, incentive compensation expense was lower in Q4. The capitalized loan costs were higher in Q4, and as you know, that's credited to salary expense because we capitalized the loan costs and amortize them over the life of the loan. In terms of first quarter run rates, my guess, Matthew, would be anywhere between $15.2 million and $15.5 million.

Okay. And do you think it trails off like it has historically through the balance of the year?

That remains to be seen. The big wildcard there, Matthew, is on the compensation side, specifically for us recruiting. If we're successful in recruiting in the first couple of quarters of the year, you likely will not see that trail off. However, if not, you probably will see it trail off a little bit. Fortunately, we're not terribly subject to inflationary pressures as it relates to non-interest expense, with the exception of salaries and a few other items.

Got it. Okay. And then, just on the loan pipeline, I think Mr. Yu, you said it's looking decent. When you think about it or when you look at the pipeline, do you think about the year ahead? Is that still enough to get you to high single-digits to low double-digits growth or should we think about something different?

That first base, and I'm on to it, okay.

Hi, Matt. This is Wellington. I think the pipeline is decent to robust, especially as we continue to have a strategic target to hire a new relationship manager. Looking at the pattern from last year, I hope our new region and the new hire that we brought in will work out well. The big wildcard, as Mr. Yu mentioned, is the runoff. So we just have to run faster than the runoff, and then we'll navigate that wildcard.

Matt, as I said, one thing I'm relying upon is our staff's capability. We did originate $1.7 billion of total new loans in 2021, which is a very high number considering our total loan size. None of us have a crystal ball to say how much it will be. I just feel that the economy is getting better, and we should be doing better.

Great. And then just on the margin outlook, knowing the loan growth was weighted toward the end of the quarter. Would it be fair to assume that the remix is benefiting the margin in the upcoming quarter, and then can you give us some more color behind the loan pricing that has held up relatively well here and the source of the commercial real estate growth, the types of properties you guys are being able to finance of late?

I will give you the loan pricing information and our Ted Ed will give you the movement on the margin situation. Actually, the loans for the whole year were made at anywhere from 50 basis points to 100 basis points less than the loans that were being paid off. It was higher in the beginning of the year, and by the end of the year, it narrowed down to about roughly 50 basis points. I have reason to believe the first quarter will see this difference narrowed even further. This is a national trend based on the interest rate environment and competition in banking. If you have a portfolio loan and you do nothing about it, you will continuously see that going down because payoffs will drive that. So what we try to do is generate enough new loans to hopefully bring our total net interest income to a level that is acceptable for our shareholders.

Yeah, in terms of the margin, we ended the last quarter at 3.28%, and as we talked about, a lot of that is due to the deleveraging effect during the quarter with the preponderance of the loan growth occurring in the latter part of the quarter, and the deposit growth going on throughout the quarter deleveraged the balance sheet. This led to another decline in the margin. That said, going forward, we would expect with a higher earning asset base, we certainly expect net interest income to grow, and that's what we really focus on. In terms of the margin, or mathematical output, I would say it's going to be probably flat to just slightly expanding a little bit in Q1.

Great. Thank you.

Thank you.

Thank you. The next question comes from Andrew Terrell with Stephens.

Hey, good morning.

Hi, Andrew.

I appreciate the guidance on expenses; it's really helpful. Maybe just thinking about it more holistically if expenses normalize a bit higher to start the year and maybe stay there throughout the year, and we also have an improving rate backdrop and they're clearly very asset sensitive. Just taking those pieces together, is there any reason we shouldn't think that you can manage the efficiency ratio at or below that 30% level, kind of like we saw this quarter?

Well, yeah. 28.8% surpassed our own expectations, Andrew, but I don't see any reason why we can't keep that in the low 30s. That shouldn't be a problem at all.

And I just have to add on this. You see, the efficiency ratio is a function of net interest income. If the rates are rising, the net interest income is likely to increase. When expenses are stable, there's less of a movement than the interest incomes, so it's likely that we can maintain that efficiency ratio.

Okay, thanks. And yeah, clearly impressive at 28%. Could you guys maybe provide us an update on how progress is going for the Houston, Texas LPO?

Okay. You want an update on Houston?

Houston update. We have in terms of our headcount right now, we have three individuals and we're looking to hire three more coming on board towards the end of this month. So I think with that in mind, our mentality is always looking for a productive relationship manager who can bring in business. So it’s going in the right direction, Houston under the leadership of a veteran. We feel quite optimistic.

Andrew, I also want to add a little bit from a strategic point of view. From the Board of Directors' view, Houston represents a diversification. It is a very small percentage of our total production and loan portfolio. We've always been careful when entering a new market; we don't want to pursue explosive growth. One reason is our Chief Credit Officer believes that explosive growth can be problematic. We will be actively growing the Houston office because it's a good market. Unfortunately, the pandemic has limited our ability to visit the office and support it. So we are growing according to our plan, pretty much in line with that.

Andrew, just to add on to that, they finished the year ahead of our expectations, and that's a very inexpensive piece of real estate to operate as well. So we feel good about it.

Right. Okay. I appreciate it. That's it for me. Thank you for taking my questions and congrats on a good quarter.

Thank you.

Thank you. The next question comes from Gary Tenner with D. A. Davidson.

Thanks. Good morning. I had a follow-up on the expense guide, Ed, for the first quarter of $15.2 million and $15.5 million. If we look at it year-over-year, that's in line, if not below what the first quarter of 2021 looked like. I'm just wondering as you think about the commentary on wage inflation and everything we're hearing in the economy in general here, why that would be the case, and if it is related to the capitalized cost benefit of having increased production potentially this quarter versus where it was in the first quarter of '21 or something else?

That's part of it, Gary. The other thing we did is we accrued some of the payroll taxes that are going to be coming due in February when we pay out the annual incentive compensation. Our payroll tax expense does go up, so we did accrue some of that in 2021. That’s why you won't see that quite as high. In addition, FDIC premiums actually come down for the bank as our risk profile has improved relative to non-performing assets.

Also, first quarter is when we raise salaries for our staff, beginning on March 1st. So it’s not immediately going to create a big impact.

Okay. That's helpful. And then the second question I had just on the fee side; the third quarter was a strong quarter on labor credit fees. I think you talked about fourth quarter being lower, but it was below where it was in the first half of the year. As we're looking out to 2022, knowing that there's going to be some volatility probably in that line item, how are you thinking about that line of business today versus maybe how you were thinking about it when we talked in October?

Anybody wants to answer that? Wellington, do you want to answer that?

Yes, Gary. On the letter of credit fee side, I think we should view similar or probably greater than what we did in 2021. In fact, we have officers who are already connecting with their sources. That's something we will pursue. On the other types of services, deposit services, we believe that in our forecast, it will surpass what we had in 2021.

In addition, Gary, thanks, Wellington. Service charges on deposits continue to increase, which often doesn’t get a lot of notice because it's not a big line item, but year-over-year service charges increased by 30%, which is due to a number of programs that we have initiated internally to take advantage of the larger DDA base we now have.

All right. Thank you.

Thank you. The next question comes from Steve Moss with B. Riley Securities.

Good morning.

Good morning.

Maybe just starting with circling back to loan yields here. There’s been a relatively stable quarter-over-quarter trend. Mr. Yu, I heard you talk about pricing coming down. Just curious if there were any unusual fees or extra fees in the loan yield this quarter?

No. As a matter of fact, I think we actually had a small reversal of interest income of about $60,000 on a couple of loans. So there’s been nothing unusual in the interest income on loans. In fact, looking at loan yields over the past four quarters, our average loan yield is only down 12 basis points against this backdrop.

Okay. The previous obvious strong passive growth is evident. I mean, it’s twice the amount of the loan growth and also the pattern of the passive loans and loan growth changes out, affecting net interest margin quarter-by-quarter. But again, as I’ve said, we will spend much more time focusing on net interest income.

Right. Okay. And maybe just sticking with the inputs to the margin, just curious; we’ve had a move up in rates. What is your appetite for any additional securities purchases, if at all, given you're holding over a billion in cash?

Let me address that. We should consider buying a couple more securities.

We did actually, Gary, as you can see in Q4, we added to the bond portfolio about $190 million. That's Ginnie Mae monthly floaters, which are very short in terms of duration. From here on, I’ve been looking at the average balance sheet since March; we’ve added $500 million in cash on the balance sheet just in the last nine months. At this point, we would probably be pretty reluctant to put any decent part of that to work. We really look for the IOER rate to be increased as Fed fund rates go up, and then that's going to certainly help.

Right. And maybe just on that point on rates, I think if I recall correctly, the floors are about 50 basis points in the money. I'm just curious what percentage of loans have in the money for us.

As of right now, floating rate represents about 86% of the book, and of the floating rate, about 84% have a floor. When we're looking at the first rate increase, we’re looking at about $800 million, a little over $800 million of the loan portfolio that will move up with the first rate increase. As we go to 50, 75, it gets greater.

Well, running pull-forward is one thing, and I want to add that we have $50 million in cash on hand, which will move across as well. A portion of the securities accounting for $250 million will also move along with rate changes. So calculated, we have about $2.45 million in assets sensitive to rate changes. Our immediate sensitive liability is $2.06 million from money market, and interest-bearing DDA. The remaining part is TCD, which is $1.9 billion and will experience rate increases monthly over a 12-month maturity schedule. So we're expecting gradual increases across the board. I personally hope, with some luck and management, that when the rate moves, we should do a little better along the way with further increases.

Okay.

Did that answer your question?

Yes. That's very helpful. And then maybe just one last question for me. Going back to the loan pipeline, just curious about the mix of business you're seeing in the pipeline coming up.

Okay. Either one of you want to answer that?

Well, I think the business right now is about 70% CRE related and 30% on the CNI side. Johnny, anything else?

Yeah.

After C&I includes mortgage, the mortgage typically represents a small percentage increase. That has always been consistent in our business line, where we keep somewhere around 28% to 31% for C&I loans over the last few years.

Right. All right. Well, good quarter, and thank you very much.

Thank you.

Thank you. The next question comes from David Feaster with Raymond James.

Hey, this is Eric Specter on behalf of David Feaster. Congrats on a great quarter. It's really great to see the quality improvement and the further improvement early in 2022. Just curious how you think about reserves and the provision going forward, and what you would expect to decrease back to that 1.24% level, which is the post-Day 1 CECL level. So if you can just give a quick update on that, that'd be great.

First of all, we're going to provide you with the official answer regarding the reserve from Nick, who has to respond to the CPAs and so on regarding the reserve levels.

Sure. As Mr. Yu mentioned earlier, our asset quality is heading in a really positive direction starting out in 2022. By the end of this quarter, I believe both our classified and also special mentioned loans will drop substantially. However, we’re still watching a number of concerns, primarily supply chain disruptions and high inflation, which Mr. Li mentioned. The Fed is trying to increase rates several times this year. There’s also potential asset bubbles that occurred due to low cap rates, with everyone chasing property. However, our key underwriting focuses on current value instead of letting the asset bubble guide us, creating a cushion for our existing loans. For new loans, we are closely monitoring as well. And as Mr. Yu noted, Omicron and pandemic-related labor shortages, among other factors, put pressure on economic growth. Overall, our portfolio is getting better, and as these issues resolve, our normal range is around 1.2%, plus or minus. Right now, we’re at 1.37% and evaluating how to get to around 1.15%. There are many qualitative factors involved that we’re still assessing, so we’ll review this each quarter. Ideally, maintaining very strong credit quality might allow us to even go below 1.15%, but we have to take it step by step.

Yes. Very true.

Am I getting in trouble with our CEO?

You're good.

Great. Thank you. I also want to do a quick follow-up on loan demand across your footprint, where you're seeing opportunities, and the potential for de novo expansion as well. I would like to hear where you're most interested.

Okay. Either of you want to discuss the opportunities?

While I think the opportunity is, we never expand into a territory just for geographic location; we look at the talent we have. For example, in Houston, we entered that market because we were able to recruit an experienced group of bankers, which has been beneficial.

In terms of your question, Eric, on the demand, I think demand is pretty consistent across our geographic footprint, whether it's Houston, New York, or Northern and Southern California. We’re always looking for opportunities for expansion, but we have to find the right team and the right people. That's always been our philosophy.

Great. Thank you. One more question, if you don't mind. I'm curious about your thoughts on capital deployment opportunities. Organic growth remains paramount, but I'm curious about your appetite for buybacks or dividend growth?

Well, I should discuss buybacks. In terms of rewarding our shareholders, we were always advised that buyback can be beneficial. However, after we buy back shares, our net worth diminishes. Since many of you value our stock based on book values, is buying back shares really rewarding our remaining shareholders? I'm continually asking this question. We have done buybacks before, and I guess your buyback will present to the market and eventually impact our PE-based pricing. So yes, we will continue to do that when we have excess capital available and we see growth not requiring this capital.

Great. Thank you. Congrats again on a great quarter.

Thank you.

Thank you. And this concludes the question-and-answer session. I would now like to turn the call over to Li Yu, Chairman and CEO, for closing comments.

Well, thank you very much. Considering that we're still in the middle of the pandemic, and what the country has gone through in the last two years, we are fortunate to have the operating results we have discussed today. If we base it on whatever the Fed is saying, or Mr. Jamie Dimon is stating, the upcoming rate-rising environment will more likely benefit a rate-sensitive bank like ours. However, we will be cautious every step of the way moving forward. Thank you so much.

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