Preferred Bank Q4 FY2022 Earnings Call

Good day, and welcome to the Preferred Bank Fourth Quarter 2022 Earnings Conference Call. 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.

Hello, everyone, and thank you for joining us to discuss Preferred Bank's financial results for the fourth quarter ended December 31, 2022. 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 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. Thank you, ladies and gentlemen, for attending our earnings conference. I am very pleased to report that we have another record quarter of earnings. Fourth quarter 2022 net income was $39.6 million or $2.71 a share, which compares very favorably with prior quarter and prior year. Because of this increased earning power, our Board has announced a 28% increase in dividend in December, which will start to be payable in January. Growth in interest income has outpaced the growth in deposit costs. Consequently, our net interest margin expanded to 4.75% for the quarter. However, towards the latter part of the quarter, we have seen that the deposit cost increase has accelerated. We believe this catching up process will continue into the first quarter of 2023 at least. Many of our customers are continuing to manage their money by moving their deposits from lower cost to higher cost. We see that the market continues to offer higher yields every day. Going forward, growing deposits at a reasonable cost will be a challenge and will be something that we must address. Sequentially, this quarter has net loan increase of 1.3% and a deposit increase of 1.9%. Loan demand has moderated since the third quarter of 2022, and we believe this trend will carry over into the first quarter at least. Our customers generally find it more prudent in their operations, especially in terms of new transactions or new initiatives. Due to our high earning capabilities, our liquidity and capital ratios both improved from the previous quarter. We believe our current liquidity and capital levels can easily handle any foreseeable needs in 2023. Benefiting from the net interest income increase, our efficiency ratio is 26%, even when we consider a $1.8 million of OREO items. Looking ahead to 2023, expenses are expected to increase, primarily due to general wage inflation. The increase includes FDIC premium assessments, at least two new planned bank branches, planned additions to SAF, and a fully operational SBA department that will be fully operational in 2023. Since early 2022, we've been very focused on credit matters. I'm also pleased to report that both NPAs and NPL have improved from the third quarter. As of December 31, they are at lower levels than on September 30. In fact, we resolved another $5.3 million of nonperforming loans in early January. Effectively, as of today, our December 31 nonperforming loans are only $200,000. An important early indicator of credit quality is the amount of loans that are 30 to 89 days past due, which totaled approximately $4 million as of December 31. Based on a report published by Bank of America, our third quarter return on tangible common equity is 23.6%, which ranked us second among all California publicly traded banks with assets over $2 billion. We believe our fourth quarter performance will set us apart from similar situations at least. We are a business bank serving business and private clients; hence, our model does not allow us to necessarily be a very low cost deposit operator. However, if you add noninterest expenses to deposit costs, we have remained competitive in terms of the total cost of operations. Historically, we have had the lowest costs among our peer group. The combination of our high earning power and low effective total cost will provide the best defense against a recessionary economy. We are optimistic about 2023, but will remain cautious. Thank you. I'm ready for your questions.

Our first question comes from Matthew Clark with Piper Sandler. Please go ahead with your question.

Wanted to start on noninterest expense and clarify some of your guidance around the growth this year. I assume it excludes the OREO-related costs in '22, roughly, I think, $2.9 million. Maybe you can speak to the run rate going forward and how you think that run rate might progress throughout the year?

Well, this must be answered by Ed, which is in the budgeting process.

Yes. Matthew. Yes. So if we pull out the OREO costs in Q4, we were just under $18 million on a run rate. Going forward, at least for Q1, which is always a bit of an aberration for us because of certain costs in Q1, we're looking at probably the low end at about $18.6 million and the high end, just under $20 million in terms of noninterest expense. Going forward from there, it will probably be somewhat similar, although you'll have a slow ramp rate in terms of the growth in noninterest expense.

Yes. Got it. Okay. And then shifting to the margin. Do you have the spot rate on interest-bearing deposits at the end of the year?

Total interest-bearing deposits, not at the end of the year, but for the month of December were 2.47%.

Okay. Since you have the average for December, do you also have the average margin for that month?

Yes. The margin for December was 4.83%.

Okay. Thank you. And then just on the overall outlook on interest-bearing deposit costs. We heard your comments earlier, Mr. Yu, about things accelerating toward the end of the quarter. What are your thoughts on where your beta might settle out through the cycle, assuming we get another 50 basis points from the Fed here and are done relative to your last cycle? I think you were in the mid-50s.

Yes. Well, my thoughts are that from my experience, we will continue to see market competitors paying more interest, and we, as a small fish in the big pond, just have to follow the trend and do our part while trying to manage it more closely. You’d be surprised, some of the largest institutions back in November before the December rate hike were already offering one-year certificates of deposit at 5%. We are just trying to catch up. We have no idea what they will do, but based on my experience, I think that in the first quarter, the deposit costs will increase further as compared to the fourth quarter. Our margin, in my opinion, is not at or near the top in the cycle. However, that does not mean in the first quarter we won't be able to earn a very handsome margin.

Our next question comes from Andrew Terrell with Stephens. Please go ahead with your question.

I wanted to start on just deposits, specifically noninterest-bearing. If I look, I think your mix is around 21%, 22% noninterest-bearing deposits as a percentage of total. I'm just trying to get a sense of what you're seeing so far in 1Q in terms of noninterest-bearing deposit flows. And then what your sense is on where we could see noninterest-bearing deposits bottom out?

The answer is we don't know. That's one of the reasons why we say we have no control of our margin going forward because we see customers continue to manage their money, either paying off their loans or reducing their loans to save on interest costs, or in many cases, customers are using excess cash to pay off their real estate loans because they consider 8% or 7.5% unbearable. This trend will continue. More people are recognizing that their money can earn over 4%, so they want to move to TCDs and other instruments. This migration process is something I'm trying to track, even among larger institutions like JPMorgan, and they have no idea what this process will look like either. So this is a precarious situation going into 2023.

Yes. Understood. I appreciate the color there. Maybe if I could move over to just outlook on provision and reserve moving forward? I guess, how are you thinking about allowance levels moving through 2023?

Well, our general philosophy has been to build up our reserve at the year-end. We will review this every quarter and generally stay conservative in our assessments. Of course, we must adhere to CECL methodology, so some situations will go through a calculation process. Generally speaking, based on our current credit metrics, I believe we are over-reserved, but we don't know what the economy will bring. Therefore, we will keep our reserves at the current level for now.

Yes. Okay. Maybe sticking on credit. I'm just looking at loan yields, near 7% in the fourth quarter. Obviously, that's really good for the margin. But any color on how debt service coverage profiles have changed at your borrowers, given the increase in loan yields? Any loans that you've had to restructure as a result of rising rates or any that you foresee having to restructure? Any additional color there would be helpful.

Well, I’ll let Nick answer that first, and then I'll add on.

Andrew, this is Nick speaking. For our TDR, we only have two small loans on our TDR list, combined totaling only $1.5 million from one relationship, and they're paying as expected. Everything seems okay. Of course, with the Fed's rapid rate increases, our borrowers face some pressures on their debt service coverage ratios. However, most of our loans are backed by financially strong sponsors, and you can see from our past year report that we don't have many delinquencies under 30 to 90 days. Additionally, as Mr. Yu mentioned earlier, we only have one mortgage loan that's nonperforming, which is around $280,000. Overall, our credit quality remains stable compared to previous quarters. However, there are many economic uncertainties ahead of us in 2023, such as energy or food supply issues, inflation costs, and the rapid rate increases affecting purchasing power. All these factors contribute to uncertainties in the market, and we intend to maintain a moderate risk posture concerning our reserve requirements at this time.

Again, it's pretty much what I said earlier. Based on the current metrics, we are over-reserved. That's my personal opinion. However, we must remain cautious and consider the potential effects of a recessionary economy.

Our next question comes from Gary Tenner with D.A. Davidson. Please go ahead with your question.

Two questions. First, on the commercial construction segment, relatively small but had a couple of quarters of decline before increasing this quarter on an end-of-period basis. Just wondering if you could talk about the committed pipeline that might fund over the course of the next year? Does the period-end number continue to trend down? Was the fourth quarter a bit of an aberration there or anything else to think about?

Nick will provide more details on that, but some of the fluctuations we've seen are due to the pandemic slowing down many projects. Many of these projects have restarted, and of course, summertime has always been a busy time for construction. So, Nick?

Yes. Our construction portfolio is managed to stay under 10%. In the past quarter, we were around 8%, and this quarter has dropped slightly below 8%. To give a bit more context, most of our construction loans stem from existing loans, and we have been cautious, particularly regarding condo projects, due to uncertainties in the economy. We are managing this portion very conservatively compared to our peer groups.

Okay, thanks. And then a question for Ed. There's obviously a lot of conjecture out there in terms of what happens to rates, how long they stay at elevated levels before the Fed stops tightening. Just wondering, given the amount of progress you've made in terms of asset yields year-to-date or in 2022, any updated thoughts on how you might manage the balance sheet to lock in some of those benefits looking forward to a timeframe where the Fed does start to cut?

I'm not going to speak for the production side, but we have had a lot of discussions around this. Approximately 80% of the loan book is floating rate, so there have been various discussions about the potential to do more fixed-rate lending at this time, given the overall level of interest rates. This could be the ideal time to start considering more fixed-rate loans. However, that presents challenges, as we have already mentioned, with economic activity having slowed down. Mr. Yu, would you like to elaborate on that?

In overall fund management, most of our floating rate loans, in fact, virtually all of them, have a floor. This floor protects us from fluctuations in costs brought on by rate situations. During this period of high interest, it may be advantageous to selectively offer a few fixed-rate loans. However, our floors give us the space to adjust as interest rates decrease. Going forward, we intend to navigate this carefully, just like we have during this period of increase, by making informed decisions in our balance sheet management.

Just as a follow-up to that: regarding new loans, are your customers more interested in variable rate loans because they believe rates will fall quickly? Is that the general sentiment among your customer base?

Customers currently appear more interested in floating rate loans because they anticipate, based on forecasts from various economists, that rates will decrease in the latter part of this year or early next year. Their interest lies primarily in the short-term situation.

Our next question comes from David Feaster with Raymond James. Please go ahead with your question.

I wanted to touch on some of the expansionary plans that you mentioned early in the call. Specifically starting with the SBA department, do you have plans to retain production or sell it? What does your timeline for the build-out look like, and where will you focus regionally?

The SBA department was initiated in the latter part of 2022 with a skeleton crew. We are working on acquiring our PLP position, which we have not held before. We expect to be granted the PLP position early this year. As for whether we will retain or sell the loans, Wellington, would you like to answer that?

Thank you, Mr. Yu. Our plan is to sell the SBA loans to a secondary market as we fund them.

Okay. Do you have any early expectations in terms of production, or is it kind of a wait-and-see situation?

It's a wait-and-see scenario, especially with the current economic conditions. The SBA market tends to slow down during a recession. We are proceeding methodically and carefully, as this is a new product for us, although we have an experienced team leading it.

So you anticipate tailwinds from fee income but don’t expect a significant contribution this year?

Yes, sir.

Okay. And then just touching on the branch expansion side — are the branches part of the Texas expansion in those LPOs? Could you give us an update on where we are in Texas, and how growth, demand, and pipelines are trending there?

Texas will be converted from an LPO to a branch in approximately two months. We are currently focused on this transition. The pipeline has not changed significantly from last year to this year; it remains stable. We have signed a lease for another branch in Southern California in a very favorable location, and we are actively working on that while also complying with our budgeting requirements.

That’s music to Ed's ears. Additionally, you have been prudent capital stewards, holding a strong capital position ahead of a potential credit cycle. With a slower pace of loan growth and high profitability, you will be accreting capital at a rapid pace. We discussed a couple of growth initiatives. I'm curious about your capital priorities. You've mentioned dividend growth, but given significant excess capital during a credit cycle, is there an appetite to increase capital returns or other capital priorities?

Thank you for recognizing that. As a state-chartered bank operating without a holding company, any capital raising or buyback transactions require shareholder approval, which involves a lengthy process dictated by our state regulator. This year, we have received the Board's approval to present a proposal for shareholder approval during our proxy season for a pre-approved total stock buyback amount. Once it's clear that conditions allow, we expect to return capital to our shareholders.

Our next question comes from Tim Coffey with Janney. Please go ahead with your question.

Yes, I had a question about the cash on your balance sheet. It still remains at elevated levels. I'm wondering if the uncertainty about customer liquidity behavior outweighs the opportunity to reinvest that in securities?

That's a very good question. As you know, Tim, we have maintained a large amount of cash on our balance sheet since the financial crisis. We've habitually held a significant cash position. During the fourth quarter, we invested some of that excess cash in the treasury market at what I consider to be very attractive yields. We may look to do more of this soon to secure additional yields rather than letting cash remain stagnant amid the Fed's interest rate decisions.

Okay. That's helpful. I'm also curious about what you’re seeing from competitors. Obviously, your customers have begun to express some cautiousness in terms of borrowing behavior. Are you seeing your competitors pull back from the market or tighten their credit boxes?

Strangely, all competitors, like us, are looking for opportunities while remaining prudent. Some competitors are actively pursuing business; for instance, one of the largest banks in California is offering seven-year fixed-rate commercial real estate loans at a low 6% without pre-payment penalties. They are willing to sacrifice some interest income to grab business. We have lost a number of accounts to them but continue to assess how we can remain competitive in these circumstances. There will always be competitors whose pricing strategies make them hard to compete against.

Okay. So you’re still witnessing some irrational activity. Thank you very much.

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

Well, actually, the questions asked were all addressing points we wanted to clarify further. So thank you very much for your time. As I've stated, we are optimistic but will remain cautious.

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