Earnings Call Transcript - PFBC Q3 2021

Operator, Operator

Good day, and welcome to the Preferred Bank Third Quarter 2021 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 now like to turn the conference over to Jeff Haas of Financial Profiles. Please go ahead.

Jeff Haas, Moderator

Thanks, Jason. Hello, everyone, and thank you for joining us to discuss Preferred Bank's financial results for the third quarter ended September 30, 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.

Li Yu, CEO

Thank you very much. Good morning, ladies and gentlemen. I am very pleased to report our third quarter net income of $26 million or $1.77 a share. Both are new records for Preferred Bank. Likewise, the return on average assets of 1.8% and return on equity of 18% are also recent highs. This quarter, we experienced significant deposit increases. Quarterly deposits increased nearly $400 million, on an annualized basis, a little over 33%. The important thing is that the quality of the deposit growth is good. 70% of the deposit growth is in the area of non-interest bearing demand deposits. Another 20% is in the area of interest bearing demand deposits and money market. Deposit costs improved moderately from the previous quarter, and I expect that trend to continue with a moderate improvement in the fourth quarter. Loans for the quarter increased $77 million or 7.1% annualized. This is lower than our previous quarters. However, looking at our pipelines, we originated $260 million of new loans this quarter, which is slightly better than previous quarters. The payoff for the quarter increased to $210 million, compared to the average of $150 million in the previous quarters. Loan yield moderated a little bit and is likely to continue to moderate, moderately compressing in the coming quarter. The net interest margin came in at 3.36%, which is lower than the previous quarter, but that was the result of oversized deposit growth. A bright spot this quarter was the non-interest income, which increased by $1.1 million largely due to increased letter of credit fees. Looking ahead, letter of credit fee income is likely to be satisfactory in the fourth quarter, but probably slightly less than the third quarter. My personal surprise came from our operating expense, which came in at 30.4%. We are starting to feel pressure from inflation and wage increases. I expect the full effect of inflation to gradually show up in the later quarters. Our credit quality is stable. There are no deferred payment loans under the CARES Act at this time, and PPP loans have been reduced to $65 million. The number of nonperforming loans remains steady, with only 7 nonperforming loans total, 2 of which are mortgage products. We are highly encouraged by the third quarter operating results despite the competitive loan environment and the slow progress in controlling the Delta virus, as well as the inflationary pressures, which although transitional, we don’t know how long this will last. I believe that all these factors will gradually improve in the coming days, and we at Preferred Bank are quite optimistic about our 2022 year. Thank you very much. I'm ready for your questions.

Operator, Operator

Our first question comes from Matthew Clark from Piper Sandler.

Matthew Clark, Analyst

Maybe just on the loan growth outlook and the pipeline. Sounds like the production is still very strong. The payoffs are obviously a little disappointing in some respects. What are your thoughts on payoffs going forward? And how would you describe the pipeline? I think last quarter, you mentioned it was satisfactory, but any other kind of additional color as to what you might mean by that would be helpful?

Li Yu, CEO

At this point in time, it's early October, I think our pipeline is probably equally, if not slightly better than the third quarter, which, as I indicated, had a pipeline better than previous quarters. However, there are elevated payoff activities. This low-interest environment has been prolonged, and many people are doing loans at yield rates less than our net interest margin but fixed for 5 or 10 years, which we think will be detrimental to our future. Given that the Fed is about to taper and possibly lift interest rates soon, we may choose not to compete because of these reasons, wanting to maintain a high-quality portfolio going forward.

Matthew Clark, Analyst

Okay. So maybe that elevated payoff activity continues, and maybe you do a little bit better in production. So maybe the growth rate is somewhere in between this quarter and your prior expectations of kind of low double digits or mid-teens?

Li Yu, CEO

It's challenging to make predictions at this moment. However, our cash flow suggests we consistently experience growth. We will strive to match the levels of the previous quarter and will put in significant effort. We plan to continue hiring and seeking new loan opportunities, but we also need the market to cooperate. The slowing pace of Delta control will likely impact transaction levels currently.

Matthew Clark, Analyst

Okay. Great. And then just the other one for me was on the letters of credit fees and the sustainability of that activity. Is that something you think you can replicate going forward, or do you feel like it was a little outsized?

Li Yu, CEO

I think the third quarter's performance is a little outsized, but the fourth quarter will be better than the second quarter but probably lower than the third quarter a little bit.

Operator, Operator

The next question comes from Gary Tenner from D.A. Davidson.

Gary Tenner, Analyst

A quick follow-up on the letter of credit fee question. Li, based on your comments, does the fourth quarter represent sort of a baseline that you might think about letter of credit fees going forward, considering potential seasonal impacts that might diminish going into the first quarter of 2022?

Li Yu, CEO

The nature of letter of credit is that we open it on a fee basis. There is a certain degree of volatility baked in. To the best we can tell, the fourth quarter will be slightly less than the third quarter. I hope in the first quarter we will be closer to the fourth quarter.

Gary Tenner, Analyst

Okay. And last quarter, I think, Ed, you highlighted payoffs as one of the risks that could offset the production, considering we are more of a transaction-oriented bank. I think this quarter we saw that reflected. Is there any room on the production side? I know you talked about some new hires a few quarters ago. Just your thoughts on the ability to outrun some of the payoffs?

Li Yu, CEO

Let me put it this way. When talking to our shareholders, we did our best. Looking at our past experiences, we always prioritize production. Right now, it's hard to predict due to the unpredictable nature of payoffs. Often they come without much notification. We update our list of payoffs and our pipeline weekly, which is a bank's top priority.

Gary Tenner, Analyst

Okay. And finally for me, it looks like you put a couple of hundred million dollars to work in the service portfolio during the quarter. But with the deposit flows you mentioned, the cash balances increased by a similar amount. Is there anything about maybe thinking about putting more of that to work at shorter-term yields that might not be as attractive as loan yields but won't lock in the rate for the period we discussed other banks were doing?

Edward Czajka, CFO

Yes. It's a difficult challenge, Gary, as you can imagine in this rate environment to try to go after yields. We're not necessarily going to pursue that aggressively. We put about $200 million to work in very short monthly Ginnie floaters, so we're not taking interest rate risk there. We may do a little more of that, but at this point, we don't want to go long with our bond portfolio. We’d prefer to lend it out as our first option. Additionally, regarding your previous question on hires and production, you may have already seen within the third quarter production numbers the effect of new hires we've made this year. We certainly look forward to increasing production as we move forward. But as Mr. Yu stated, it's a top priority for us, and we're doing our best.

Operator, Operator

Next question comes from Steve Moss from B. Riley.

Steve Moss, Analyst

Maybe just on loan pricing here. I’m curious about where new money yields are currently, and I noticed loan yields ticked up quarter-over-quarter. I know there's a little bit of an uptick in fees, but that doesn’t seem to explain the increasing yield quarter-over-quarter.

Li Yu, CEO

You had the number right in front of you, Ed.

Edward Czajka, CFO

Yes, as you recall, Steve, last quarter, we had a downward interest adjustment of almost $2.3 million. That was the primary driver. Overall, loan yields are holding up fairly well. The challenge is with the margin concerning the rest of the earning assets and the cash we have on hand.

Steve Moss, Analyst

Okay. And just out of curiosity, what's the yield on the Ginnie Mae you guys put on? Just curious about that rate?

Edward Czajka, CFO

I didn’t expect you to ask that in public. It's 45 basis points.

Steve Moss, Analyst

Okay. And what's the appetite to add more? With over $1 billion in cash, how do you plan on approaching that in the upcoming quarter?

Li Yu, CEO

We will certainly try to deploy that, but we have to weigh the interest rate trends going forward in the whole situation. Additionally, as the operator, we must be cognizant of tapering and what normalization will mean for the high liquidity that every bank is currently experiencing. We need to be careful with these aspects as some of our decisions are precautionary. We won't chase the last dollars at the risk of this kind.

Steve Moss, Analyst

Okay, understood. And in terms of expenses, you've mentioned inflationary pressure. How are you considering expenses for the fourth quarter and maybe into 2022?

Li Yu, CEO

My guess is expenses will be a bit higher, but Ed might have a different take on that.

Edward Czajka, CFO

No, I agree with you this time, sir. Expenses will likely increase. In this quarter, coming in under 15.4% was good given the environment we're in. However, as we move forward, wage pressures will continue to weigh on expenses, so they will likely increase incrementally.

Li Yu, CEO

Steve, wage pressure arises when people start to entice your employees away with higher offers. Thus, when hiring new staff, they come in at higher levels, and we are forced to adjust compensation for all staff. These factors will inevitably reflect in our expenses going forward, and every bank will face similar pressure.

Operator, Operator

The next question is from Andrew Terrell from Stephens.

Andrew Terrell, Analyst

I was hoping we could get an update on how business is trending over in Texas with your Houston office. Are things still on track to hit the $150 million in outstandings by the middle of next year? Also, are there any thoughts about potential new market expansion opportunities?

Li Yu, CEO

Wellington, unless you want to add, I'll answer first. We have had some turnover in Houston. The leader of the team has left for another position with a different bank, and one or two producers followed him. Currently, we have 3 loan staff in Houston, and they are continuing to produce. The overall expectation for the next six months has moderated but is still aligned with expenses and payroll related to that. We are actively hiring to strengthen the Houston operation. Once the new staff is onboard, we expect to reaccelerate growth.

Wellington Chen, President and COO

No, I think you covered the basics, and just to mention that the loan pipeline for Houston still looks pretty robust with good inventory. The team there is holding down production.

Andrew Terrell, Analyst

Okay. I noticed that your share valuation has improved a bit relative to where you were repurchasing during the third quarter. Any change in appetite for buybacks moving forward? Or should we still expect share repurchases?

Li Yu, CEO

Ed, do you want to report on that?

Edward Czajka, CFO

Sure, Andrew. We currently have a repurchase plan in place with a hard cap of $65 a share. We reached that limit around mid to late September, so we have not been active in the market since that time.

Li Yu, CEO

If our shares continue to improve, we will go to the Board for approval to increase the limit on our repurchase plan. However, our ability to generate earnings and bolster our capital level should be done before additional repurchases.

Andrew Terrell, Analyst

Understood. How are you feeling about the reserve at around 1.4% today? Do you think there's room for further reduction, or are you comfortable with the current level?

Li Yu, CEO

I can answer generally, then I'll have Nick add some detail. If you remember the pre-pandemic level, after the CECL conversion, our level was about 1.50%. Last year, the banking industry acted prudently by adding a substantial reserve. The factors affecting this view vary among banks, but everyone recognizes that economic conditions are improving. Each bank's CECL model depends on economic conditions. We do not know when we will return to the pre-CECL levels. However, I believe the quality of our reserves is strong, and if the economy does not deteriorate, we can eventually reach that level. Nick, do you have anything to add?

Nick Pi, Chief Credit Officer

I completely agree with Mr. Yu. With the improvement of economic conditions related to our CECL forecast, we believe there will be less stress on the reserve requirements in future quarters. However, this will depend on several moving factors, including loan growth, credit quality, GDP, and unemployment rates.

Li Yu, CEO

Indeed, the uncertainty surrounding the pandemic plays a role in this as well.

Nick Pi, Chief Credit Officer

So while this is our best estimate, ultimately our reserves should gradually reduce to around the 1.3% level, but that will depend on all aforementioned moving factors. We are uncertain how we will handle this over the next few quarters, but we expect to be in that range.

Operator, Operator

There are no more questions in the queue. This concludes our question-and-answer session. I'd like to turn the conference back over to Li Yu for any closing remarks.

Li Yu, CEO

Well, thank you very much for your interest in our bank, and we appreciate your support. We are not striving for perfection, but we aim to achieve above-average performance across all segments of our operations, striving to be placed in the high-performing category. We will continue our efforts in that direction. Thank you.

Operator, Operator

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