Earnings Call Transcript - PFBC Q1 2022

Operator, Operator

Good afternoon. Welcome to the Preferred Bank 2022 First Quarter Earnings Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, today's event is being recorded. I would now like to turn the conference over to Larry Clark of Financial Profiles, Inc. Please go ahead, Larry.

Larry Clark, Investor Relations

Hello, everyone, and thank you for joining us to discuss Preferred Bank's financial results for the first quarter of 2022. With me today from management are Chairman and CEO, Li Yu; President and Chief Operating Officer, Wellington Chen; Chief Financial Officer, Ed 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 related 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. Good morning, ladies and gentlemen. I'm very pleased to report our first quarter net income of $26 million, $1.74 per fully diluted share. This is a 23% increase from the same quarter of the previous year. Loan growth was a highlight for this particular quarter. It increased by 4% on a linked-quarter basis and annualized at 16%. The fourth quarter loan origination momentum has carried over to the first quarter, though payoff activity moderated a bit, resulting in this performance in the quarter. Looking ahead, we are very encouraged by the applications for new loans that we have received thus far. Although these applications will be subject to higher standards of underwriting, we do believe that second quarter results could be quite positive. The positive growth for the quarter was moderate at 1.6% linked quarter or 6.4% annualized. This is well within our expectations in light of the Fed's activities. The higher loan production compared to lower deposit increases has allowed us to deploy some of our excess cash through better usage, which we think is proper financial statement engineering. Our margin has improved from the previous quarter by 14 basis points. This is partially due to the higher loan increase versus lower deposits that changed the leverage. Again, under the current interest rate rising scenario, we remain quite positive about our margin expansion. Preferred Bank has a very asset-sensitive balance sheet, and I have included some of the components of our assets for your information in the press release. On the liability side, we have $1.96 billion in deposit portfolios that are time certificates of deposit. These deposits carry an average life of 7.3 months, which means they will be repricing at a much slower pace than the interest-bearing transactional accounts. We have made improvements in our credit posture. Two of the larger legacy loans that are on a non-accrual basis have been with the bank for over two years. Finally, after months of court battles, we were finally awarded the chance to repossess these assets, and this happened just before the quarter end. Now, our loan portfolio is quite pristine, with only $2.2 million in non-accrual loans as of March 31, 2022. There was a charge-off in the quarter related to the charging off of the previously fully established reserve on those legacy loans. There were no income statement effects. It is almost certain that under the current inflationary environment, our operating expense will increase and continue to increase in the months and quarters to come. However, Preferred Bank has always been very focused on controlling our expenses, and we have reason to believe that our increases will be no higher than the industry norm. The first quarter non-interest expense was a little higher than previously guided in the January conference call, and I would like to apologize for the missed guidance here. The actual number for the first quarter will be the beginning of the new norm. Also, I'd like to alert you to our share counts on the fully diluted outstanding shares. It has increased this quarter, along with a price increase of our stock, and it will continue to change along with the value of our stock changing. All in all, we at Preferred Bank are happy with the first quarter and we hope to do even better in the upcoming quarters. Thank you, and I'm ready for your questions.

Operator, Operator

The first question comes from Gary Tenner with D.A. Davidson.

Gary Tenner, Analyst

Follow-up, Li, to your comments on the expense level as the new norm. If you kind of annualized the first quarter, you're around $65 million. That's 7%, 8% growth on top of 2021. Is that the general perspective on the full-year increase in expenses that you would expect? Or do you foresee any further upward pressures as we go through the course of the year?

Li Yu, CEO

Obviously, it's quite unpredictable with expenses growing in the future. There are several forces related to it. The number one focus is obviously inflation. What would it do for all of us, especially in the wage category? This also affects us with lease renewals, some of which have come due and are subject to increases. Another variable is the success of our recruiting efforts. You see, the more successful we are, the higher the expense level will be. So, we certainly hope that the expenses will increase because we have CECL. Generally speaking, first quarter was slightly higher than in the second quarter. But in this inflationary environment, we need to have flexibility in thinking.

Gary Tenner, Analyst

Just on the recruiting effort side, I know you guys are always looking to add quality people. Is there a particular geography or market that you're focused on today?

Li Yu, CEO

We are recruiting from our current geography, adding people all over. We are also eyeing a couple of new areas to put in a new branch. If we finalize the location, then we will be hiring a group of people in that particular location. I should have better information to report probably next quarter.

Gary Tenner, Analyst

Just last question from me, regarding operating leverage. You've provided some good detail on asset sensitivity as you did last quarter regarding adjustable-rate assets. It seems to me that you're still going to generate some positive operating leverage. However, with the increase in expenses, is it reasonable to expect that the efficiency ratio will stay over 30%? It dipped below that for a period last year. Is that what you would expect?

Li Yu, CEO

You mean the efficiency ratio?

Gary Tenner, Analyst

Yeah.

Li Yu, CEO

I would say there are two situations. One, you have increasing net interest income, which results from growth and margin expansion. These two aspects will create higher net interest income. Obviously, you will have high expenses, but we hope the combination of the two will be right around the 30% level. Within a certain range, obviously, we have been bouncing between 28% to about 35% over the months.

Operator, Operator

Our next question comes from Matthew Clark with Piper Sandler.

Matthew Clark, Analyst

Can we just start on the loan side of things? Are you able to quantify the new loan commitments in the quarter, how that compares to last, and payoffs as well? And maybe it's a three-part question, just any commentary on the pipeline and how that compares to the prior quarter or a year ago?

Li Yu, CEO

In the prior quarter, we had $360 million in new loan commitments outstanding at the quarter end. We had $250 million in payoffs. So, this particular quarter, the payoff has reduced from $250 million to $180 million with approximately the same activity on the origination side. So, this is the math.

Matthew Clark, Analyst

Any color on the pipeline this quarter, coming out of the quarter?

Li Yu, CEO

The pipeline is good, not any worse than the first or second quarter. As I mentioned earlier, nowadays, the underwriting standards are higher due to various stress tests and valuation situations in light of the inflation and rate increases, and we always keep in mind that after inflation, there might be a recession. Therefore, we have to be extremely careful now.

Matthew Clark, Analyst

On the margin outlook, thinking through the remix as it relates to deposit growth relative to loan growth: do you feel that loans to earning assets might continue to increase, assuming deposit growth trails, or do you feel that deposit growth should come back and start to better fund the loan growth?

Edward Czajka, CFO

Regarding Mr. Yu's earlier comments about the loan growth coming in lower than previous quarters and being within our expectations, I think you touched upon something we'll see throughout the year. With the M1 supply seemingly starting to shrink when the Fed ends its QE and also begins to raise rates, we're okay with a lower level of deposit growth and then fully utilizing cash in the balance toward the loan portfolio. This will obviously expand the margin and leverage the balance sheet.

Matthew Clark, Analyst

Just on the provision, there was a comment in the release that part of the basis for reducing reserves was an improving economic outlook. I would have thought that would have pointed to the opposite in terms of commentary and assumption. Should we assume that this reverses in the upcoming quarter with an increased provision?

Li Yu, CEO

I will ask Nick to answer that. I will add on.

Nick Pi, Chief Credit Officer

From the Federal Reserve's perspective, even though the current economy seems to be in an okay stage, we still have many uncertainties that we are concerned about, such as labor shortages, high inflation, supply chain interruptions, the quick rate increase environment, and the higher energy cost. Additionally, as Mr. Yu mentioned, there is an increased possibility of a future recession. So, even under that situation, we decided to bet on a little bit more reserve on the qualitative side this quarter. As Mr. Yu mentioned, we try to take a more cautious posture at this time.

Edward Czajka, CFO

Yeah, I think it's safe to say the release might have been larger had we had more optimistic economic predictions within the CECL model than what it actually turned out to be.

Matthew Clark, Analyst

The last question for me just on the letter of credit fees. How should we think about that activity in a rising rate environment and a slowdown in the macro environment?

Edward Czajka, CFO

I think it will probably be pretty stable.

Li Yu, CEO

You said stable, but I'd like to say sometimes it's very unpredictable because the customer has a need to come in. They open accounts, and we charge them a fee. So, the activity truly depends on customer-specific needs. It's hard to relate to any economic conditions. We've tried to find patterns on that. We haven't been successful at predicting it yet.

Operator, Operator

Our next question comes from Steve Moss with B. Riley Securities.

Steve Moss, Analyst

Maybe just start off with deposit pricing here. In the release, you guys spoke about CDs repricing at a slower pace. Just curious, what are you thinking for CD rates with the 50 basis point hike coming in May in all likelihood? Also, how are you thinking about deposit betas more broadly?

Edward Czajka, CFO

I'll start off. In terms of deposit growth going forward, I think we're okay with a lower level. However, in terms of deposit betas and rate changes, Steve, we're seeing an interesting trend – at least in my opinion. We're not seeing much movement at all on the retail side. Wholesale funding has moved significantly. It started moving in January, but retail funding is still – we receive rate surveys every two weeks that we analyze extensively. We are still seeing very few banks move beyond 40 to 50 basis points on a one-year CD. I believe this time around, with the economy and the consumer, businesses still have a lot of cash available. It will take some time to get that out of the system. As that happens, I think you'll slowly see banks start to raise their offered rates. Currently, we are just not seeing much movement. It feels like a Goldilocks moment right now at least for the time being.

Nick Pi, Chief Credit Officer

Ed and I review this weekly. So far, we are doing very well on the consumer side – on the retail side, I should say.

Edward Czajka, CFO

Also, many of those rates are negotiated anyway, so they're still fairly low.

Steve Moss, Analyst

In terms of just on the loan pipeline being strongest, what types of lending opportunities are you seeing? Obviously, you had good commercial real estate growth here this quarter. Just curious about the underlying types of properties you guys are lending on or expect to lend on here going forward. And when we think about loan growth for the year, are you thinking low teens type number ex-PPP?

Nick Pi, Chief Credit Officer

We're always looking for new talent, as Mr. Yu mentioned earlier. So, whether it's – we're looking for talents, and talents will lead where we're going to expand, whether it's Southern California, Northern California, or elsewhere. In terms of our current market and pipeline, I think post-pandemic, there are a lot of opportunities. People are looking to acquire property, and we're focusing on repositioning. So, we see a lot of opportunity in multifamily and industrial types of facilities.

Steve Moss, Analyst

In terms of the tighter underwriting standards here, just remind us regarding the debt service coverage or loan-to-values you guys are considering these days?

Wellington Chen, President & COO

Loan-to-value, based on our current data, is around 55% to 56%. This year, as Mr. Yu mentioned, we are conservatively underwriting loans with consideration of future rate increases. So, currently, it's around 1.2 and above.

Steve Moss, Analyst

One last question. It's a small one in terms of the OREO properties that you guys took over here. You mentioned resolving it shortly, just curious how quickly you think you can liquidate them.

Li Yu, CEO

We hope it was done yesterday. Fortunately, the property is well sought after. The broker has informed us that they believe the price is very advantageous to us under the current market conditions.

Operator, Operator

Our next question comes from Andrew Terrell with Stephens.

Andrew Terrell, Analyst

Maybe, Ed. Just to start off. I hear some of your comments on deposit growth expectations and the overall balance sheet leverage. There's still quite a bit of excess cash on the balance sheet today. Given the move in interest rates we've seen so far, is there any appetite or willingness to take a larger position in the securities book here?

Edward Czajka, CFO

I'll say, at this point, the answer is probably no. We made a little swing last September and bought nearly $200 million of monthly Ginnie floaters, which have actually performed quite well. However, we aim to utilize cash into the loan portfolio. Remember also that cash is going to rise in rate as the IOER rate moves in lockstep with Fed Funds, so we will see that cash benefit as well. Let me be clear: we are not going to forego deposit growth. We still believe in it, and it forms the foundation of the bank and its franchise value. We will see deposit growth this year, but we will not feel as pressured for it.

Andrew Terrell, Analyst

Looking at the core loan yields, I believe margins were down around 10 basis points this quarter. Anything unusual in the core loan yields, whether it's interest reversal, reduced fees, or anything else? Just anything non-core in the loan yields this quarter?

Li Yu, CEO

No, we don't have any issues.

Edward Czajka, CFO

However, I will say we did see a small uptick after mid-March Fed hike. We also observed this on the cash side, which is beneficial.

Andrew Terrell, Analyst

One last question for you, Mr. Yu. I know historically you've not been very active in bank M&A. I'm trying to get an updated perspective on whether you're seeing anything interesting on the M&A front, if there's any appetite, and whether it plays into your thinking about running the bank moving forward. Just any updated thoughts on bank M&A would be helpful.

Li Yu, CEO

The primary reason is that perhaps it's in our DNA to remain conservative regarding acquisitions. We continue to see intermediaries introducing deals to us for various reasons, whether it's pricing, talent, or geographic considerations, but we haven't had much success. There are a couple of deals that are close to step two, but they haven't materialized. In terms of our calculation regarding accretion requirements, ours is among the toughest in the industry. One reason is that when we can internally generate over 15% growth on average, the need for acquisitions to increase the balance sheet isn’t immediate, leading us to choose the most profitable path of organic growth. Should organic growth begin to fade or halt, we will reconsider how to enhance our institution's profitability. I hope any acquisition we pursue will be beneficial, as not every acquisition yields positive results, and this may not always be evident in financial statements.

Andrew Terrell, Analyst

Any color you can provide regarding the particulars you mentioned about internal EPS accretion or any IR threshold you need to meet or tangible book value earn-back? Any specifics you can offer on the financials you are targeting would be helpful.

Li Yu, CEO

Certainly, there are factors I'm considering. I don't focus heavily on IR; rather, I look at the EPS accretion. Additionally, I pay close attention to how much dilution occurs in the book value and the payback situation. Inflation means you are effectively pre-paying for years of earnings and hoping to recover this through efficiency and combined operations. We must be mindful that not every acquisition will be executed perfectly, so we look at this carefully concerning book value dilution. Congrats on a great quarter.

Operator, Operator

Our next question comes from Timothy Coffey with Janney.

Timothy Coffey, Analyst

Ed, the press release provided great detail on asset sensitivity of your balance sheet; you are one of the more asset-sensitive banks on the West Coast. Can you quantify what the gain to net interest income would be from a 50 basis point increase?

Edward Czajka, CFO

Off the top of my head, I can't quantify that right now. However, I believe that in a 100 basis point shock, we anticipate approximately 9% to 11% higher on an annualized basis.

Timothy Coffey, Analyst

Can I ask a question about the cadence of loan growth during the quarter? Did the rate increases pull forward any business towards, say, the March month relative to January/February?

Li Yu, CEO

I believe the rate increase has actually created more opportunities for us because previously we would often lose payoffs to individuals with lower-rate, fixed-rate loans, which were often set for 10 years. Some of these were fixed-rate loans where borrowers would pay interest only. As we considered the rate shifts, borrowers decided against taking fixed-rate loans. This change in perspective has leveled the competitive field, where our competitive advantage of high-touch, one-on-one service and customer relations begins to benefit us.

Timothy Coffey, Analyst

Do you expect pipeline fallout to decrease going forward based on the rates?

Li Yu, CEO

Yes, I believe it will decrease. However, we must also underwrite loans more carefully.

Timothy Coffey, Analyst

Regarding reserve levels, do you feel it's prudent to increase that ratio right now, or do you need to wait for more information before doing so?

Li Yu, CEO

Are we discussing our credit quality situation?

Edward Czajka, CFO

Yes.

Li Yu, CEO

I will respond in a different manner. I just reported to our board that we will begin an internal loan review again in the late second quarter or early third quarter, considering two situations. One is the ongoing high inflation and its potential effect on various customer industries or specific customers. We also need to assess the inflation situation relating to possible recession, deciding which of our customers may be affected. This bank-wide review will start in late second quarter or early third quarter, especially as we have examinations scheduled in late second quarter. We'd like to conduct our internal assessments first. On the CRE side, we've undergone many evaluations, and we plan to conduct similar evaluations in the third quarter to analyze which product lines are favored in the current market situation. However, it's safe to say, based on my past experience, that at the early stage of inflation, many discerning customers are looking to acquire real estate as they believe it serves as the best long-term protection against inflation. While we recognize this, we still need to conduct asset reviews.

Edward Czajka, CFO

To address your question depends on the results of the review that Mr. Yu described and how we look moving forward regarding the ACL.

Operator, Operator

Our next question comes from David Feaster with Raymond James.

David Feaster, Analyst

Mr. Yu, I wanted to follow up on your commentary regarding the competitive landscape. It appears more rational than it has been. However, as you consider your adjustable-rate loans, how effective have you been able to fully push through the 25 basis point increase on the $1.4 billion in loans that reprice immediately? With the competitive landscape, how do you think about your ability to push through the next couple of rate hikes? If we do anticipate a 50 basis point hike in the next two meetings, would you expect to see more payoffs and paydowns as competitors price lower? How do you think about your ability to raise rates on these loans?

Li Yu, CEO

Each cycle is unique. However, in this cycle, I see our margin, meaning the index number, is competitive with other competitors and what they offer. In other words, if the loan is appealing to customers, everyone else is offering similar rates. Therefore, I don't anticipate losing much business because many are compelled to raise rates due to market conditions. If a competitor decides to undercut the price, it could reflect their own economic rationale.

David Feaster, Analyst

Are you observing new loan yields improving? Have you noticed an inflection in new loan yields across portfolios?

Li Yu, CEO

In the last few quarters, I mentioned that our old loans paid off at rates generally anywhere from 75 basis points to 50 basis points higher than the loans being written. This quarter, that number has narrowed down to $0.26 or $0.27. I feel optimistic that in the second quarter, new loans will carry a better rate. On the C&I growth in the quarter, it was great to witness. I'm just curious if you think that was due to draws on existing lines as borrowers build inventories, or are you seeing an increased demand for new lines? Also, what feedback have you received from C&I clients? How has the C&I proportion of your pipeline changed? Has it increased, or is it still that 70/30 distribution we've discussed?

Wellington Chen, President & COO

Not much related to existing line drawdowns. We had a couple of good wins under new C&I relationships, and that’s primarily where the growth is coming from.

Operator, Operator

Our next question comes from Jordan Hymowitz with Philadelphia Financial.

Jordan Hymowitz, Analyst

Before I ask my question, Li and team, I just want to say I've covered you for 20-something years since the IPO. You've not only done a great job, but your integrity, thoughtfulness, and willingness to be transparent about performance, regardless of the circumstances, are really refreshing. You deserve great kudos. So, good job.

Li Yu, CEO

Thank you. You made my day.

Jordan Hymowitz, Analyst

I have a question regarding the follow-up to the previous M&A discussion. I'm not suggesting you should or shouldn't pursue any M&A, but considering RBB's Chairman has now resigned due to improprieties, rumors suggest they may or may not go on the market. Would that be a property, at a certain price, that piques your interest?

Li Yu, CEO

First and foremost, we are aware of the situation. Among the firms represented here, at least two or three have contacted me about this matter. However, none of them know them as well as I do. Many of the board members are my friends. The former chairman and former president and CEO were also longtime friends of mine. Hence, I understand the situation. Ultimately, it comes down to their expectations and how stable the company becomes after the current turmoil. All that considered, if their business can provide vibrant ongoing growth while still aligning with our pricing parameters, I'd consider it. However, I have to ensure that I can deliver a better future to our shareholders year after year. So, that’s a significant factor in my thinking.

Operator, Operator

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

Li Yu, CEO

Thank you very much for joining our conference. If you have any questions, please call Ed or me, mostly Ed than me. We would love to answer them. Thank you so much.

Operator, Operator

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