Earnings Call Transcript - PFBC Q1 2023

Operator, Operator

Good day, and welcome to the Preferred Bank First Quarter 2023 Earnings Conference Call. Please do note that this event is being recorded today. I would now like to turn the conference over to Larry Clark of Financial Profiles. Please go ahead, sir.

Larry Clark, Financial Profiles

Hello, everyone, and thank you for joining us to discuss Preferred Bank's financial results for the first quarter ended March 31, 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 the bank files with the 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.

Li Yu, CEO

Thank you. Good morning. I'm very pleased to report the first quarter net income of $38.1 million or $2.61 per share. We are satisfied with the results that were achieved during this very stressful quarter. The events of March truly humbled all of us in the banking industry. Personally, I'm very sad to see two good-sized banks go away in just a matter of hours, especially when both banks had certain expertise in sizable industries, and they had been serving these industries diligently for the past 20 to 30 years, only to see those customers as the first ones to run. In any event, the events taught us a lot. Personally, I have the following observations: the definition of transactional accounts as core deposits needs to be revisited. True, the deposits are there, but only during good times. In a stressed environment, they seem to be the first to run. I'm very pleased with our PCD portfolio, not because we know exactly how much it costs us and how long we can keep them, but during this difficult period, we have not seen one TCD run out. The golden rule of not borrowing short and lending long or investment loan ideals is tough in practice. Throughout the years, I don't know how many times we have faced the disappointment of our officers, knowing their loans would result in a loss to low fixed-rate mortgages. But now, as we look back, it seems that all the agony was worth it to have a better balance. We now must respect government risk even more as bankers. If you recall in 2021, when we were all convinced that the country's inflation was transitory, how many of us prepared for a near 500 basis point interest rate increase? And now, as managers of a publicly traded bank, we face each quarter with the potential of earnings beating or missing expectations. Sometimes, I can't help but think that what may be good for short-term fixed rates may not necessarily be good for the long-term health of the bank's operations or balance sheet. I wish all of our investing public would focus more on the bank's balance sheet and consistency in long-term operational goals. Having expressed my personal opinion, I now must report to you on the deposit situation. During the three working days in March, March 9, March 11, March 12, and March 13, Preferred Bank experienced deposit outflows. The good news is that we had a total of less than ten accounts pull money out. The bad news is that three of them were significantly large. For the quarter, our deposits decreased by 2.7%. As of yesterday evening, which is April 18, we have seen our deposits increase by 1%. We're working very hard to regain the deposits we lost because most of these customers have a borrowing relationship with us. However, during the process, we have received many heartwarming phone calls from our customers telling us that they have confidence in our balance sheet, capital, and especially our earnings. With their confidence, I also believe it's our shareholders' wish. We will continue to maintain a flexible balance sheet, good liquidity, and control our overhead as we always do. We will continue to operate Preferred Bank with a simple business model. Thank you very much. I'm ready for your questions.

Operator, Operator

Our first question will come from Matthew Clark with Piper Sandler.

Matthew Clark, Analyst

Regarding the available liquidity, you have $1.5 billion in cash and borrowings relative to uninsured deposits, which are just under $2.7 billion. What is your plan or target for coverage? It seems like you're considering pledging more loans, but are there options on the securities side since they account for only about 6% of assets that could be used for pledging?

Li Yu, CEO

Thank you very much. We are taking a two-way approach. We are scheduled to convert the enhanced insurance coverage. Do we have a schedule for the second quarter? Currently, we have around $600 million in customers that we will be converting to SEDAR and ICS. This should reduce our uninsured deposits by about 35% to 36%, assuming the total deposit amount remains the same. In the meantime, we have roughly estimated an additional borrowing capacity of about $600 million from the Federal Reserve and the Federal Home Loan Bank. This will bring our total capacity or liquidity to between $2.5 billion and $2.7 billion, as these two numbers are very close. As a bank, I’m not sure if it's crucial to cover every uninsured dollar with off-balance-sheet liquidity. However, I believe the key is to have a solid operation to earn our customers' trust. By June 30, we expect both numbers to converge.

Matthew Clark, Analyst

Okay. Great. And then just kind of a related question. In terms of your incremental balance sheet composition going forward, is this higher cash level likely to kind of stick around? I know it's above average to begin with. But I guess what I'm also trying to get at is, do borrowings continue to increase from here with some potential deposit pressure? And I guess, it somewhat also depends on your loan growth outlook. I mean, balances were slightly lower. So I'm just trying to get a sense for the moving parts of the balance sheet going forward.

Li Yu, CEO

Well, based on what I understand from the industry today, and based on what I'm reading, especially from you guys and all the other information available, the deposit situation is probably more of a concern for everybody compared to the loan area. True, loan demand is down as reported across several sources. But I think the uncertainty of deposits will last for a while. At Preferred Bank, we are closely watching the trend in the second quarter. We are not in a hurry to put up a lot of loans just to earn extra dollars, okay? As opposed to maintaining good liquidity and safety. Frankly, I think we are making enough money to weather this.

Edward Czajka, CFO

Clearly.

Matthew Clark, Analyst

Yes, no doubt. And then just on the cost of deposits or spot rate on deposits at the end of March. I don't know if you have that ad or even the monthly average for the month of March on deposit costs as well as the average NIM in the month of March?

Edward Czajka, CFO

The net interest margin in March was $467 million. Cost of deposits was $263 million.

Matthew Clark, Analyst

Okay. Great. And then last one for me. Just some cautionary commentary on office commercial real estate in the press release, not a surprise. Since everybody is talking about it. But can you size up your exposure there and also give us some additional details and characteristics, owner versus non-owner, average loan size, what's downtown kind of considered metro downtown or more at risk? And how LTVs are at origination versus maybe some new appraisals you're getting in, rent rolls, what your plans are for borrowers that renew that want less space? I could go on. But any granularity there would be helpful.

Li Yu, CEO

Okay. We have roughly about 10% of our total loan portfolio in office properties, office loans, okay? But of this amount, roughly $8 million is in the downtown area. We have been avoiding, especially the Los Angeles area for the past 20 years. Most of our office properties are in urban suburban areas of California, especially in Los Angeles, where there's a lot more stability. And when we have the $8 million in the downtown area, it's really in San Francisco, which is leased on a long-term basis to a notable university. It is very well underwritten with a loan-to-value ratio of probably less than 40%. In any event, I would have Nick bring you up to date on some of our underwriting features that we have on these properties.

Nick Pi, Chief Credit Officer

Yes. Thank you, Mr. Yu. Matthew, our entire portfolio at this time is pretty stable and resilient. The key aspects of our underwriting are a little different than other regional banks. We prioritize two major areas: location and strong sponsorship. We avoid metro areas like Los Angeles downtown, focusing more on office loans near residential needs or other urban areas. Even if the property has weak cash flow, we ensure strong sponsorship. We don't see any immediate threats to our office portfolio or commercial real estate side.

Li Yu, CEO

To follow up on that, we don't have any non-accrual or classified loans, nor even 30 to 89-day past dues in the office sector.

Operator, Operator

And our next question will come from Andrew Terrell with Stephens.

Robert Terrell, Analyst

Maybe just following up on the last point. I think it's pretty reassuring to hear that only $8 million or so that would be considered true kind of downtown type office. I guess, the 10% of total loans are office properties. Can you size up maybe the chunkiness within that? Like what's the size of the largest one, two, or three type loans in the office category?

Li Yu, CEO

Well, the largest one or two loans are approximately $40 million each. Our average total loan is $4.1 million in our office properties, with an average LTV of 61% at the entrance. Many of these loans were underwritten thoroughly, especially the larger ones. One of the office buildings, valued at around $50 million, is located in one of the busiest areas of Los Angeles, combining creative and entertainment ventures. The first floor houses upscale restaurants that are doing well, while the second and third floors are rented to a prominent company supported by bank credit. The next largest one is also in a high-demand area, and the ownership has shifted to major players who have a strong reputation. The third property is in a high-value area, Newport Beach, where a group has purchased an office building and is in the process of converting it into apartments. At present, it is empty but was originally categorized as an office building when it was financed.

Robert Terrell, Analyst

I appreciate the additional details. I would like to revisit the deposit flows. For the quarter, could you provide information on the decline in interest-bearing demand deposits, which I believe fell by about $540 million from the previous quarter? Did this decline include a shift to time deposits, or were these simply withdrawals from the bank? I'm trying to understand how much of this change was related to geographic spread across the deposit segments versus lost relationships or customers who left the bank.

Li Yu, CEO

Ed, do you want to answer that?

Edward Czajka, CFO

Yes. From what we know, it's not so much relationships lost but rather paring down balances. Many of those were centered in very few accounts. These depositors have fiduciary obligations concerning their funds, and so, following what happened with Signature and Silicon Valley, they moved funds as they felt it was in their best interest. We've been in constant contact with all of them, and are working to either get them into a reciprocal deposit program to bring them back or to engage with their senior leadership about what we're doing to mitigate the risks highlighted by these two bank failures. We feel good about that process, and we also expect to bring back many deposits due to credit relationships with us.

Robert Terrell, Analyst

Yes. Okay. Very good. And to the point, I think it was mentioned at the start of the call, deposits quarter-to-date were up 1%. I guess within that, should we expect that the bulk of that is driven by time deposits? And what I'm specifically getting at is the NIB flows since quarter end. Does it feel like there's been any deceleration in the drawdown of NIBs?

Edward Czajka, CFO

Most definitely since the end of the quarter, Andrew. That's a good question. What we've seen since the end of the quarter is more of a business-as-usual situation while also explaining why we see a 1% uptick from the end of the quarter. I think we will have much better news to report at June 30 regarding this subject.

Li Yu, CEO

Johnny, would you add to that? I mean, the nature of deposits shows an increase in the first half of the quarter.

Johnny Hsu, Deputy COO

Yes, I think the nature of deposit inflows has returned to business as usual for many of our clients. We're working on regaining some of the deposit losses, as I mentioned, but many deposits coming in reflect standard client activities.

Operator, Operator

And our next question will come from Gary Tenner with D.A. Davidson.

Clark Wright, Analyst

This is Clark Wright on for Gary Tenner. Quickly, if I could. You previously indicated you had asked regulators for approval regarding a $150 million stock buyback. Could you provide any color on how you are thinking about capital and the buyback right now, given your valuation near tangible book value and the potential for getting that buyback approved by regulators?

Li Yu, CEO

Let me first describe the process. In order to get the regulators' approval, we need to share the approval for the buyback. That's with the state of California. We have completed our proxy statement, which has just been released, and are asking for shareholder approval for a $150 million buyback authorization. From that point, we will decide when and how much of the buyback will occur, and once that decision is made, we will request the board regulator's approval. Usually, it takes about two weeks in the past couple of months for that approval. So we are preparing for that. Legally, we are getting ready, but operationally, I can confidently say we're going to buy back stock because it's cheap in our opinion. We're selling at 5.2 times 2023 earnings, which is obviously advantageous for us. However, in the meantime, we must focus on liquidity issues and the public perception of instability in the banking sector. We will be very careful in the second quarter to ensure we have sufficient liquidity before proceeding. Long-term, we do expect to buy back stock, unless our stock price doubles; maybe we wouldn't do that. We're hopeful that our stock value trajectory will benefit our shareholders.

Clark Wright, Analyst

And then just in terms of loan growth for the full year, how are you thinking about it considering the economic uncertainty and contraction observed in the fourth quarter and first quarter?

Li Yu, CEO

Loan growth has a three-dimensional situation. I can't give any specific guidance on that because I truly do not know. On the micro side, we are seeing reduced loan demand, especially following the banking crisis, which changed many investors' priorities. Activity has slowed down, although payoffs are still ongoing with familiar names paying us off at 5% for 10-year mortgages. However, we don't adjust our corporate strategy based on that. Overall, the macro side also presents questions about our ability to acquire deposits as we used to; the environment factors into how much we need to pay to attract them. Presently, we are witnessing fierce competition for deposits. If you ask me again in May, I will likely have a better outlook. Right now, I lack clarity on that point; I apologize.

Clark Wright, Analyst

No worries; understood. Lastly, can you speak to SBA production and demand trends? It looks like you had a gain on sale of SBA and resumed selling. Can you point to some of the demand trends going on as well as the gain on sale premiums?

Li Yu, CEO

Okay. Wellington, would you like to answer that?

Wellington Chen, President & COO

The SBA is definitely a new initiative. We are moving forward cautiously and methodically, especially in the current situation. We do have a solid SBA pipeline, and we believe that for small businesses, this is something we will continue to pursue.

Operator, Operator

And our next question will come from David Feaster with Raymond James.

David Feaster, Analyst

Maybe just following up, I know the loan question is hard to answer, but may I ask it a little differently? You've done a phenomenal job pricing loans and getting paid for the risks you are taking. I understand you might not have as much of an appetite for credit here, but where, and in which segments, are you still seeing good risk-adjusted returns? What segments are still able to pencil profitably, and is it market-dependent or geographic?

Li Yu, CEO

What we are seeing right now is less about category and more about individuals. We still have individual customers with projects that they want to pursue, okay? Right now, it seems to be where there's good underwriting for C&I transactions; we don't see a huge growth factor right now because of the interest rate situation. However, on the real estate side, we do see ongoing projects where people need to purchase or develop. These are the individual cases, which are subject to very intense underwriting based on the loan. These present the risk-return opportunity we're willing to pursue—unless there is a good return, we will refrain. We prefer maintaining good liquidity as the situation stands. Long-term, as you all know, there are significant amounts of CMBS experiencing maturity over the next few years. Reports indicate many of these will be remargined, forclosed, or rearranged. Based on our experience, every few years, these situations present opportunities. We are prepared to target some of those remargined items.

David Feaster, Analyst

That makes sense. Regarding the CRE projects you're referring to, how is pricing in those types of deals? What are you able to price them at currently?

Li Yu, CEO

We generally price based on prime, usually around prime plus half. That's our current practice.

David Feaster, Analyst

You all have been one of the most rate-sensitive banks around, and you've done admirably. I want to ask how you think about managing your rate sensitivity at this point in the cycle and if you might consider taking some rate sensitivity off the table, and what strategies might that entail?

Li Yu, CEO

We have several initiatives to do that. One avenue is considering converting some loans into fixed rates for customers who desire it, but the rate has to be acceptable to us. Several customers have already expressed interest in this. Secondly, almost all of our floating-rate loans have a floor currently averaging over 6%. While some older loans are around 4%, newer loans are in the 7% range. These measures effectively serve as a management tool during a decreasing rate environment. We've previously shared charts showing that during rate reductions, Preferred Bank's earnings increased.

David Feaster, Analyst

That makes sense. Lastly, given potential revenue headwinds from rising deposit costs due to the rate environment and inflationary pressures, how do you think about expenses in the near term?

Li Yu, CEO

We are continually looking at opportunities. We have previously committed to opening a couple of new branches; one lease has just been signed. The growth will result largely from adding personnel, and we will continue to pursue that. As long as there are opportunities for expansion in big operations and office openings, we will seize them. I don't see anything negative right now.

Edward Czajka, CFO

Yes. Probably going to be just slightly above $20 million, David.

Operator, Operator

And our next question will come from Tim Coffey with Janney.

Timothy Coffey, Analyst

Ed, I was wondering if you could talk a little bit about the brokered CD market at this point? Are you looking to add more to the market given what you've discussed earlier?

Edward Czajka, CFO

I'm sorry, can you repeat the question specifically regarding brokered CDs?

Timothy Coffey, Analyst

Are you planning to add more? Or do you believe you have done enough?

Edward Czajka, CFO

No, we are not looking to add more. We have completed our plans regarding that. We took out the FHLB advance as well. I don’t envision replacing that once it matures. However, we can't predict the future, but assuming things progress the way we expect, we won't renew that. The broker market has calmed down since the crisis.

Timothy Coffey, Analyst

Yes, it has. If we see rates roll over by the back half of this year, do you think you'll start to see more activity in terms of loans?

Li Yu, CEO

Yes, as rates decrease, our production usually sees a significant uptick.

Operator, Operator

And our next question will be a follow-up from Matthew Clark with Piper Sandler.

Matthew Clark, Analyst

I just wanted to get an update on the health of your variable rate borrowers. Given that you have 80% to 85% of your loans at variable rates, you've seen loan yields rise by 300 basis points from their lows. How do debt service coverage ratios look, and how might you be working with certain segments of those borrowers to manage the increased debt service?

Li Yu, CEO

At present time, I must say, we are not having any issues, but I'd rather have Nick answer that.

Nick Pi, Chief Credit Officer

As Mr. Yu mentioned, we do not see any issues occurring at this time.

Edward Czajka, CFO

Matthew, I think that leads to another point I want to mention. It's interesting, as Mr. Yu talked about the coming CMBS debt cliff, with $1.5 trillion of debt due over the next three years. Most banks are still waiting for this cliff while ours, being 80% prime-based, has already transitioned through. To the fact that delinquencies are almost zero, and non-accruals are nearly nonexistent, it bodes well to show the strength of our credit quality.

Matthew Clark, Analyst

Great, yes. And then just lastly for me, can you clarify the non-interest expense run rate outlook? Ed, you mentioned slightly above $20 million run rate. I assume that's the high end of the range you're anticipating this year?

Edward Czajka, CFO

I would call that the middle part of the range, Matthew. There are inflation and wage pressures continuing as well.

Matthew Clark, Analyst

Okay. Do you want to adjust that range?

Edward Czajka, CFO

No. I'm good with it.

Operator, Operator

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

Li Yu, CEO

Thank you for your attention. It's interesting to have everyone asking about the upcoming CRE crisis, especially in the office building sector. It reminds me of my personal experiences over the last four years, which started with retail issues and evolved into the pandemic and hospitality struggles. It seems that now office issues are leading the conversation. Although it may sound funny, it feels like it’s the flavor of the year. We've been fortunate to avoid serious difficulties with our underwriting standards, as we've previously explained how we approach underwriting for hotels and retail, focusing specifically to avoid mall situations. We emphasize neighborhood centers which are essential for everyday needs. I remain optimistic about our portfolio as we navigate this current state. Thank you very much for attending, and I appreciate your support.

Operator, Operator

The conference has now concluded. Thank you very much for attending today's presentation, and you may now disconnect your lines.