Preferred Bank Q2 FY2023 Earnings Call

Good morning. And welcome to the Preferred Bank’s Second Quarter 2023 Earnings 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 like now to turn the conference over to Jeff Haas of Financial Profiles. Please go ahead.

Thank you, Allan. Hello, everyone. And thank you for joining us to discuss Preferred Bank’s financial results for the second quarter ended June 30, 2023. 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 their 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. Good morning. I am very pleased to report that the second quarter net income of Preferred Bank was $37.9 million or $2.61 a share. For the quarter, our deposit has increased $181 million under a very challenging environment. During the quarter, we have seen strong movement of deposits from lower cost deposits to higher cost deposits, and thankfully, as of June 30th, this movement seems to have moderated. Our bank’s uninsured deposits is 39.9% at June 30th, while liquidity coverage was 41.2%. Since early March, we have been working very hard to help the customer to restructure their deposits to be under the schedule FDIC insurance limit by using CEDAR and using ICS. And we will continue to do so. But during the quarter, we have learned a lot of comments that are quite heartwarming. Loan growth for the quarter was $61 million. The high interest rate environment has obviously depressed loan demand. And the further increase in interest rate will likely to further depress demand. Our credit quality was stable. At June 30th, our total non-performing loans is less than $1 million, where the total non-performing assets is 0.33 basis points. Classified assets is pretty stable compared to the previous quarter and there were no charge-offs during the quarter. We made additional provisions to increase our reserve ratio to 1.4%, and during the quarter, we also written down our OREO assets for $1.9 million. Recently, we have received a lot of inquiries regarding our exposure in the city of San Francisco, which we have a total loan exposure of $114 million in the city. As you all know, San Francisco is a tale of two cities, where you have trouble in the downtown commercial area, while the other part of the city is at least business as usual. Our total exposure in those troubled areas is $34 million as of June 30th. Preferred Bank has a very asset-sensitive loan portfolio. Therefore, our net interest income has been resilient these quarters. We have always operated with a simple business model. We have always kept our margin reasonable and our operating costs low. With our strong operating cash flow, we will begin to buy back our own stock. At June 30th, the total stock repurchased was 281,000 shares. As of yesterday afternoon, the total repurchase is a little over 500,000 shares. Thank you very much. I am ready for your questions.

Our first question comes from Matthew Clark from Piper Sandler. Go ahead.

Hey. Good morning. Thanks for the questions. Maybe just starting with the margin, can you give us the spot rate on deposits at the end of June and then maybe the average margin in the month of June as well?

Ed, do you want to...

Sure.

Okay.

Yeah. The total cost of deposits for June, Matthew, was 3.24, and the margin was just below 4.5.

Okay. And that 3.24 is the month of June or is that the end of June?

That’s the month.

Okay. Okay. And then thinking through the funding side of the equation and assuming you still have some loan growth, even though it’s likely to slow. It seems like you don’t need to borrow given all the cash on the balance sheet. Is that the lever you are willing to pull, if necessary, if deposit growth doesn’t materialize? Are you willing to take down cash to fund loans?

Well, we probably do not need to borrow from Federal Home Loan Bank or other reserve banks anymore. But our cash flow is over $1 billion, by June 30th. So that should be more than enough to handle any loan growth, which I don’t really expect to be any significant increase at all?

Yeah. We have one of the highest cash to deposit and cash to assets ratios in our peer group. So I think we would be comfortable funding some incremental loan growth out of our cash.

Okay. Great. And then just on expenses, I mean, you had the OREO write-down, but that’s unlikely going forward from here. So what are your thoughts on the expense run rate in the second half?

You…

Yeah.

… take a stab at that?

Yeah. In looking at the first blush, I am looking at a run rate going forward of probably around $19 million a quarter excluding OREO costs.

Yeah. Okay. Great. Thank you.

Our next question comes from Andrew Terrell with Stephens. Go ahead.

Hey. Good morning.

Good morning.

Hi.

Good morning.

I wanted to ask on the $34 million of loans in Downtown San Francisco that are mentioned. What types of properties are these? How many make up that $34 million? Is it one or two or a handful of credits and then any color on the LTV amounts or operating stats, as well as the reserve against that $34 million?

Okay. We have seven loans comprised of $34 million. Of these seven loans, mostly they are residential properties. There is one office property. The dollar amount is a little less than $900,000. With these seven loans, we have just reviewed and they are not classified or criticized, mostly the residentials.

Okay. Understood. And then on the classified assets, it looks like those are pretty stable quarter-on-quarter, any changes in special mentions that occurred in the second quarter?

Well, Nick, do you want to answer that?

Special mention loans, the size of that is pretty similar to Q1 at around $60 million at this time.

Okay. Got it. And then just a clarification point maybe on the buyback, I know the full authorization was for $150 million, but if I recall, I think the initial release said that the first leg of the repurchase program was for $50 million. It sounds like you guys are pretty active on the buyback front even coming into the third quarter. I am just curious, is there any kind of incremental authorization you need to utilize the remaining $100 million or can you utilize the full $150 million of the shareholder approved buyback?

I don’t think we need any further approvals because our regulatory approval is for $150 million.

Yes.

More so it is the Board of Directors determination offering to use our cash flow again.

Okay. Understood. I appreciate it. Congrats on your quarter.

Thank you.

Our next question comes from Gary Tenner with D.A. Davidson. Go ahead.

Thanks. Good morning. Excuse me. On that buyback question, I don’t think I saw it in the press release, I apologize if I missed it, but of the 281,000 shares repurchased in the second quarter, what was the average purchase price?

It was around $55 and just to bring everyone up to speed currently, we have repurchased about 501,000 shares for about $28 million through yesterday.

Thank you, Ed. Can you provide any additional details? You mentioned that the deposit migration has slowed. Your non-interest-bearing deposits are around 16% of period-end balances. Do you feel confident in maintaining that level, or do you anticipate any changes that might reduce that percentage?

For the month of June, the migration of non-interest-bearing deposits has been reasonably stable. The other cost increases are related to our large TCD portfolio. The amount maturing and being repriced or replaced is a little over $1.2 billion in the third quarter, with replacement costs expected to be about 1% to 1.25% higher. We anticipate having only one bond in the July quarter, so the cost should rise in the third quarter, but it is expected to be relatively mild. If there is one rate increase in the third quarter, the impact on the net interest margin is likely to be quite mild.

Thank you for that. And since you mentioned the amount of time deposits that are going to mature in the third quarter, could you give us the number for the fourth quarter as well?

Yeah. We have not prepared for that yet, I guess.

Next quarter, Gary.

All right, guys. Thank you.

Sure.

Our next question comes from David Feaster with Raymond James. Go ahead.

Hey. Good morning, everybody.

Good morning, David.

Hi.

Maybe just touching on the loan side. In the press release, you talked about higher rates impacting demand, but in the past, you have also been pretty conservative. I am just curious how much of the slowdown in growth do you think truly is slowing demand versus less of an appetite for credit? And then just kind of what’s the pulse of your borrowers across your footprint, where are you seeing good risk-adjusted returns at this point and where are new loan yields coming in?

Well, okay. Well, Wellington, you add something then I will add to that.

All right. Hello, David. This is Wellington.

Hi.

I think that, I mean, you hit the nail on that. It’s both demand and the appetite.

Okay. And so where are you still seeing good opportunities today? I mean, are there any markets or segments that still look good from your standpoint?

David, right now, with the current environment you are almost all only to have at least 10% debt yield in order to qualify. There’s just not a whole lot of loans that qualify for those kinds of things. So naturally, there will be less applicants; and when we are still doing things, we have a group of very loyal customers. When they want to do something, they come to us, and we try our best to work with them to fulfill their needs. And that’s not to say next quarter when necessary planning to a certain degree of loan growth because this time I doubt how many of our fellow bankers can have an accurate crystal ball regarding the actual loan increase in the third quarter or fourth quarter. It’s so unclear as far as we are concerned.

Okay. That makes sense. And then maybe just going back to the funding side. I know you guys talked last quarter about really trying to get some of the depositors that were diversifying and moving out after the failures that just kind of panicked. Where are you at in bringing some of those guys back, or have you had success bringing them back, and I guess, could that be a tailwind for core deposit growth going forward?

We have observed that many customers who previously reduced their business with us have now returned. We haven’t been actively seeking a large number of new customers, primarily because there doesn’t appear to be many opportunities in the market, and the competition is quite fierce.

Yeah.

Yeah. A good point. And then last one, I just wanted to touch on the SBA department and kind of where we are with the build-out and the early read on that. Just look, the timing of that could be pretty good, just curious where we are there and whether you are still planning to sell or any appetite to retain?

Johnny, do you want to answer that?

Yeah. On the SBA department, we are currently in the application process. We have submitted our application for the delegated authority. So we anticipate ramping up the SBA section of our business in the second half of this year and going forward. And yes, we are still looking to sell what we originate from our portfolio in that department.

Okay. That’s helpful. All right. Thanks, everybody.

Our next question comes from Tim Coffey from Janney. Go ahead.

Thank you. Good morning, everybody. I have a question on the provision, relative to the credit metrics in terms of portfolio and actual charge-offs or not existing charge-off, net charge-off in the quarter. It seemed to be fairly large. If credit trends can remain consistent, do you see reserving at the same level going forward?

Well, personally, I mean, the guru of that is mix. Personally, I think, he is on the very, very cautious side regarding that. Okay, Nick, do you want to give a little more color on that?

Yeah. Tim, there’s a lot of things ahead of us still, I believe. Monitoring policies, rate increases or fluctuating economic conditions, high interest costs, pulling back consumer spending, or commercial investment, a lot of things are going on there. So a lot of people are talking about probably we are going to have a soft landing, but we really don’t know until what happens in the second half of this year. So we try to maintain a more moderate risk posture at this time. Additionally, regarding the CRE crisis or something like that, everybody is expecting that. Up to now, we are still okay. However, to be on the conservative side, we try to allocate a little bit more on the queue side to cover the CECL limitations.

Sure. Okay. Makes sense. I appreciate that color. And then, Ed, how should we think about margin going forward? Is June reflective of what you would expect to see for the rest of the quarter?

That’s a great question, Tim. Obviously, some of it is going to depend on what the Fed ends up doing at their upcoming meeting. So if we get a quarter-point hike, I think it would sustain and hold the margin relatively flat for another month or so. Otherwise, I would see some further compression, I would say, probably in the neighborhood of $440 million for Q3, somewhere around there.

Okay.

You are very, very predictive on that. There’s a leverage factor and how much can you deposit, how much you...

Yeah. Yeah. Obviously, yes. A lot of other factors too. Yeah.

To the extent you mentioned deposits during the second quarter, did you experience the most significant volatility earlier in the quarter or was it more evenly distributed throughout?

Volatility in terms of deposit pricing or balances or…

Balances.

I think a lot of that growth happened toward the end of the quarter on the deposit side.

Okay. Okay. And then this for Li. As you mentioned, you have a very asset-sensitive balance sheet, a lot of your loans repriced in a fairly short amount of time. I imagine the competition for those types of borrowers has gotten intense. Are you having to offer any concessions to retain those customers?

Yes. Naturally, attracting rate-sensitive customers and retaining existing ones is difficult. As I've often joked, we are heavily involved in public business, and it's evident that we've faced challenges because we remain committed to our approach of providing floating rate loans with a floor for downside protection. This commitment has meant occasionally missing out on loan opportunities to our competitors. Nonetheless, we have made a conscious decision to focus on aligning our assets and liabilities more effectively, and we remain steadfast in that strategy.

Okay. Well, great. Thank you. Those are all my questions. I appreciate your time.

Thank you.

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. This is truly one of the most challenging quarters we have had in our history and going into the quarter with a cloud over our head. So we hope the big picture improves and we hope that the rate increase soon will make inflation more manageable. It seems we are starting to see the light at the end of the tunnel. If that’s the case, I am obviously happy for everybody in our industry that we will be able to do things in a more normal way. Having said that, we are happy so far, and I think we are doing fine. Thank you.

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