Preferred Bank Q3 FY2024 Earnings Call

Good day, and welcome to the Preferred Bank Third Quarter 2024 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, this event is being recorded. I would now like to turn the conference over to Jeff Haas of Financial Profiles. Please go ahead.

Thanks, Wyatt. Hello, everyone. Thank you for joining us to discuss Preferred Bank's financial results for the third quarter ended September 30, 2024. With me today from management are Chairman and CEO, Li Yu; President and Chief Operating Officer, Wellington Chen; Chief Financial Officer, Edward Czajka; and Chief Credit Officer, Nick Pi. 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, Jeff. Good morning. I'm very pleased to report that Preferred Bank's third-quarter net income was $33.6 million or $2.46 a share. The highlight of this quarter is a successful reduction of our non-performing loans, which resulted in no charge-offs, but an $800,000 interest recovery. Criticized loans, however, have increased quite largely due to one relationship. Currently, we believe this increase in criticized loans is a temporary event. Net non-interest expense has increased somewhat unexpectedly, but that was the reason that we have made a valuation charge of $1.7 million on our OREO. This OREO is currently in escrow and scheduled to be closed later this month. Loan demand seemed to have increased and payoff slowdown. Our net increase in loans for the quarter is a little bit over 10% on an annualized basis. Deposits, however, decreased slightly from last quarter by $11 million. Admittedly, Preferred Bank has started to monitor the deposits portfolio since early September to avoid competing for the higher-cost deposits. As a result, the cost of deposits has reduced slightly in the third quarter from the second quarter. Net interest margin improved due to the deposit cost decrease and also because of a change in the leverage in our loan to deposit relationship. The efficiency ratio of 30.6% is a little higher than previous quarters. But if we disregard the nonrecurring events of the valuation charge in OREO, the efficiency ratio would be about 28.5%. As of September 30, Preferred Bank's loan portfolio consists of 26% fixed-rate loans and 74% floating-rate loans, with most of them having a floor. We believe our loan sensitivity is in reasonable balance with the sensitivity of our deposits portfolio. I would like to point out that our TCD portfolio has a different nature that it would reduce in a smaller amount in the earlier months and catch up to reduce cost in bigger dollar amounts at the later stage of the TCD. We are happy to see that finally we see the federal government’s rate cut, and we project that there will probably be continuous moderate rate cuts going forward. We’ll stay focused on that. Thank you very much. Now I'm ready for your questions.

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

Hey, good morning, everyone. Thanks for the questions. Wanted to start on the margin and get a sense for what the average was in the month of September with or without the recovery and then the spot rate on deposits at the end of September, if you had it, if not the month of September.

Hi, Matthew, the margin for the month of September, excluding the recovery was 4.03%. The cost of deposits spot at the end of September was 3.96%.

Great. Okay. And then on the floating rate loans, the 74%, I think, of the total mix is floating. I think you mentioned in the release that most of them have floors. But can you give us some more details on specifically how much of those floating and variable rate loans have floors and where those levels are?

Right. So of the 74% that are floating, 99% have floors. However, they're at various stages. We have approximately 22% to 23% of those floors within 75 to 100 basis points of their actual rate, and the remainder of those are over 100 basis points from their current stated rate.

Okay. Thank you. And then what's your outlook on your loan and deposit beta this cycle, this easing cycle, assuming we get the rate cuts that the forward curve is suggesting? Do you think we match what you did on the way up, or do you feel like it might be a little less than that on either side of the balance sheet?

I would say a lot of it, Matthew, depends on the pace. If we get a steady 25 basis points every couple of months, that is really for us an ideal scenario because it will allow us to better match the repricing of liabilities with the repricing of the assets. If we get a steady downward trend in that regard, I would expect the margin to hold up better than it would under a scenario of sharper cuts.

Okay. Great. And then did you buy back any stock this quarter? And what's your appetite going forward?

We did. We bought back, I think, around 110,000 shares. I apologize. I actually don't have that number. We haven't been in the market for a while because the price has exceeded what we're wanting to pay right now.

Got it. Thank you.

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

Hey, good morning.

Hi, Andrew.

Just a follow-up on the floating rate loans, the 74% of total. Can you just remind us the split between prime versus SOFR or any other indices that those are tied to?

Of the 74%, probably 90% of those are prime-based, with the remainder being SOFR or treasury-based.

Maybe not as high as 90%, but a close scale, maybe in the 80s now. We haven’t really calculated that yet.

Yeah. Okay. But fair to think that the vast majority are prime.

Right.

I wanted to ask about the end-of-period composition of deposits. The interest-bearing demand deposits decreased significantly this quarter, by around $330 million. It appears there may have been some shift towards time deposits. Could you provide some details on the fluctuations we observed in the interest-bearing demand deposits?

Yes, we are switching some of the higher-priced interest-bearing demand deposits for money market rates and then tried to time it up and replace them with TCDs at a rate that we feel is more favorable. Now we started to do that in early September before even the rate cuts.

Andrew, some of the money market deposits that we had were considered to be brokered deposits, and those were paying a higher cost than brokered CDs were. So we basically flipped from a brokered money market to brokered CDs at the same time, not increasing our total broker.

Got it. Okay. That makes sense. I appreciate it. Can you remind us about the launching point for the spot rate in deposits for the fourth quarter? Can you tell us the amount of time deposits that will be up for renewal in that quarter? I understand it may fluctuate based on the Fed's actions in November and December, but what is your strategy for renewing new CDs today in terms of yield or cost?

Yeah. So we have almost $1.2 billion of CDs maturing in the fourth quarter at an average rate of 5.07%. And today, we are paying anywhere from 3.45% up to 4.5%.

4.5%, yeah.

In that range. So we would expect to see some pretty good savings because that's a big chunk. That's 36% of our CDs maturing in that quarter.

Andrew, nowadays, the CD pattern is that everybody is paying higher rates for three-month CDs and then sort of like moderate down all the way to one-year level. I guess everybody in our immediate peer group is watching and making very frequent moves from time to time. So we just have to react to that.

Yeah, totally understood. I appreciate it. And then maybe just I'll take a stab at it. I know it's probably a complex number to arrive at. But just any sense on, given some of the timing dynamics from the floating rate loans versus the CD repricing that will occur in the fourth quarter, any sense on kind of where the margin shakes out in the short term, the fourth quarter?

That's a really good question. And like you said, Andrew, it really depends on the timing. But given where we're at right now, I guess I would expect to see the high 3s, north of 3.85% for the fourth quarter.

Yeah. Got it. Okay. So maybe some normalization, then as the deposits reprice, stabilization from there.

Right.

Okay. Thank you for taking the questions. I'll hop back in the queue.

Thank you.

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

Thanks. Good morning. Thought I'd kind of shift over to the other side of the balance sheet. You've had improving loan growth each of the last two quarters, and I think the press release noted some increased activity as the Fed cut rates in September. So can you talk about kind of pipelines and activity levels from a lending perspective as we're looking into the fourth quarter?

Okay. Wellington, you want to answer the first and see any avenues?

Yeah. So you mentioned in the earnings release that loan demand has been surging since the Fed dropped the rate, and we believe that loan activity is there. I think the biggest issue for us, not just that demand, is the payout. Competition, payout from competition or customer selling assets is what we are facing. We are basically not just entertaining new loan demand, but at the same time defending our existing good loan relationships.

Anything to add, Johnny?

No, I think Wellington said it right. With the anticipated rate decreases, we need to defend our portfolio.

Gary, that marketplace, obviously, towards the real estate side has changed greatly because of the rate change. All our rates, including the fixed rates, being offered now are at lower levels than before. That certainly is expected to improve the transactions in the marketplace. To what extent, what time to cut, the economy itself has to tell us a little later. We're still waiting to see how the economy plays out.

Great. I appreciate that. And then with the commentary about tightening up, I guess, on the rate paid on deposits in the quarter, kind of flat deposits versus the loan growth in that loan deposit ratio moving up to 95% or so. Can you talk about how you're thinking about managing that side of things from the ability to fund loan growth on a go-forward basis, but maintaining disciplined pricing on the deposit side?

Well, I guess that the deposit feel that we all have seems to be eased up quite a bit. Building up deposits is becoming more of a normal event. So to support the loan growth, we obviously compete whenever we see the marketplace open. Preferred Bank has always been competitive in getting deposits, so we think we will get the necessary number to fund the growth.

And I think on the expense side this quarter came a little bit higher just because of the OREO charge in the quarter than what you had guided to on the July call. Can you give us a sense of where the fourth quarter operating expense line might check out?

Yeah, not much change, Gary. I would look for us to be between 20.5% to 21% for Q4. Might be slightly below that, but I would doubt it.

Thank you.

Sure.

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

Hey, good morning, everybody.

Good morning.

Maybe can you just touch on the credit side a little bit? I was hoping you could give a little bit of color on the increase in the credit size. I appreciate the commentary about some of those already being resolved. Just kind of curious what you're seeing there. And then just broadly, what you're seeing on the credit front in the CRE world and anything you're watching more closely?

Nick, add on to it and correct me. Let me first follow up on what we have written down. Actually, it wasn't just for one relationship, we had a good reduction in the quarter with our criticized loans and non-performing loans. The one relationship formatted to have a late payment irregularity. So we proactively tried to downgrade it. After downgrading that, four of the seven loans have been brought current. The other three, we were told, should be current depending on the successful completion of their capital calls. So some of those loans are a relationship with multiple partners, and they are running through capital calls on most of them. The other three should complete the capital calls this month; they hope to. We've had this customer for many areas even before the pandemic days and throughout that period of time and through the high-interest rate time, they have always been paying. So they are finally running into some slowness recently. All these loans are guaranteed by several very substantial people, and we have a low LTV in the mid-60s and reasonably high DCR. The DCR will be better than 1.1 after the next two rate cuts, and the property itself is pretty good. It's retail property, a neighborhood shopping center basically and multifamilies; all of them still command a good cap rate nowadays. In fact, retail shopping center cap rates have been improving. We feel this situation will resolve itself very soon. Nick, do you want to add to that?

Just for your information, David, for these two retail centers, they are both around 95% occupancy. The property itself is pretty good. Just like Mr. Li Yu mentioned, if we exclude this one-off situation, the rest of our criticized loans should be around $52 million, which is much less than last quarter. Since the pandemic, we have been really watching our credit very closely, and presently, I believe that the credit quality is still considered very stable and resilient at this time.

Okay. That's helpful; that's really good color. And then maybe going back to the growth front, it's great to see the growth. It's encouraging to see what you guys have been able to do, especially the acceleration. I hear that there's still a lot of competition on the West Coast. I'm curious if you could touch on the competitive landscape. You guys have been really disciplined on your loan pricing. I'm curious where loan pricing is in your market. Are you starting to hear some prepays and payoffs just given the competitive landscape? Kind of how that plays into your thoughts on growth next year. Would you expect to kind of reaccelerate, or could that be a headwind and keep us around that low double-digits, high single-digits type of pace?

The general feeling is that with the reducing rates today, the new loan opportunities will increase. Likewise, the pace of the payoff, which is the easiest for the competition, just to try to poach loans from other institutions. We see people are starting to price their loans about as much as 1% below the fixed-rate loans. We are facing this every day. I have experienced this for my entire 32 years at this bank. It is up to us as a team to adjust ourselves from time to time in the marketplace. Regarding production, Wellington and Johnny have added a number of new producers. In the last few earnings calls, we mentioned new teams and new locations being added. So we have more of a body count, especially on the loan production side. We expect to be fully competitive in exploring new opportunities in the marketplace, so it's a matter of finding more loans to counter the possibly increasing pace of loan payoffs.

That's a good point. And if I recall, one of the places that you've been focused on is Silicon Valley. I'm curious if you could give us an update there. What other opportunities, what markets are you interested in, and where have you had success hiring?

Silicon Valley has just started. Usually, it takes about six months for any loan to be bought back. There are a few loans already being brought in Silicon Valley, and we feel that the growth of Silicon Valley will be more or less like steady growth in the first two years. If we are lucky enough, it will take off after two years. There are many other places; we mentioned that we enlarged our Manhattan operation to be a full branch. We hope that we are now operating in Manhattan in the center of town in one of the prime locations we believe. We are expecting activity there to be as vibrant as in the last few years and hopefully even improving. We are constantly looking for new locations, but it's predicated on finding the right people. As you know, David, finding bankers with a proven track record is probably one of the biggest challenges facing community bankers.

Thank you for the detailed information on the margin. Given the forward curve, how do you perceive the trajectory for next year? You mentioned significant repricing opportunities. When do you expect to hit the lowest point, perhaps around mid-2025? Additionally, do you believe you will be able to achieve net interest income growth in 2025 even with potential rate cuts?

Well, that's a crystal ball question, David, but I'll take a stab at it. As I said earlier, the pace of rate changes is really critical. If we get 25 basis points a quarter, or 25 basis points every two months, that's a good situation for us in that it allows us to move liability prices somewhat commensurate with asset yields. The margin will remain more intact than it otherwise would have if we experienced accelerated rate cuts. That being said, I look back to the last quarter before the rate increases started, which was the fourth quarter of ‘21, and we posted a 3.28% margin. If we land at a level where we're around 3.0% to 3.5% Fed funds, I don't see why we cannot maintain a margin north of 3.50%, perhaps 3.50% to 3.75%, when it all shakes out, if this sort of ends in mid-2025 or late-2025.

Don't promise too much.

I'm not promising; I'm just giving my thoughts.

You can't find a market. You can only compete with the market.

No, that's great. It's just super helpful to help us think through it and manage expectations. So I appreciate the color.

You're welcome.

Okay, this concludes our question-and-answer session. I would like to turn the conference back over to Li Yu, Chairman and CEO, for any closing remarks.

Thank you. To manage the constant change in the interest rate environment is certainly one of the things that our job and my competitors' job involves. Here at Preferred Bank, we have done a few things. If you remember, just at the beginning of 2023, our fixed rate loans were at the low-teen level, probably 11% to 12%. Since then, we have been working on selectively refinancing our loans to fixed rates and, hopefully, in the declining rate interest environment, that will give us better protection going into the future. We feel confident in this approach.

This concludes our conference. Thank you for attending today's presentation. You may now disconnect.