Earnings Call Transcript - PROV Q1 2021

Craig Blunden, Chairman and CEO

Thank you, Brad. Good morning, everyone. This is Craig Blunden, Chairman and CEO of Provident Financial Holdings. And on the call with me is Donavon Ternes, our President, Chief Operating and Chief Financial Officer. Before we begin, I have a brief administrative item to address. Our presentation today discusses the company's business outlook and will include forward-looking statements. Those statements include descriptions of management's plans, objectives or goals for future operations, products or services, forecasts of financial or other performance measures and statements about the company's general outlook for economic and business conditions. We also may make forward-looking statements during the question-and-answer period following management's presentation. These forward-looking statements are subject to a number of risks and uncertainties, and actual results may differ materially from those discussed today. Information on the risk factors that could cause actual results to differ from any forward-looking statement is available from the earnings release that was distributed yesterday, from the annual report on the Form 10-K for the year ended June 30, 2020, and from the Form 10-Qs and other SEC filings that are filed subsequent to the Form 10-K. Forward-looking statements are effective only as of the date they are made, and the company assumes no obligation to update this information. To begin with, thank you for your participating in our call. I hope that each of you has had an opportunity to review our earnings release, which describes our first quarter results. In the most recent quarter, we originated and purchased $48 million of loans held for investment, an increase from $44.2 million in the prior sequential quarter. During the quarter, we also experienced $66.3 million of loan principal payments and payoffs, which is up from the $56.5 million in the June 2020 quarter and still tempering the growth rate of loans held for investment. In the September 2020 quarter, it seems that mortgage markets have normalized to some degree, the competition is elevated for lower-credit risk products. Additionally, we're still cautious regarding single-family loan purchase packages, particularly seasoned production because it is difficult to complete due diligence on individual loans consistent with our underwriting requirements. For the 3 months ended September 30, 2020, loans held for investment decreased by approximately 2% in comparison to June 30, 2020, with declines in the single-family and multifamily categories, partly offset by growth in the construction and other loan categories. Current credit quality is holding up well, and you will note that early-stage delinquency balances were just $2,000 at September 30, 2020. In addition, nonperforming assets remain at very low levels and are just $4.5 million, which is down from the $4.9 million at June 30, 2020, and an 8% decline. However, the situation regarding the pandemic is fluid, and we may have negative implications for future credit quality, although it is difficult to discern and quantify the potential implications. Additionally, we anticipate that some loans currently in forbearance will be downgraded as a result of not being able to resume their monthly payments. I also wish to refer you to Slide 13 of our investor presentation, specifically Footnote 5 of the commercial real estate table. The footnote describes the composition of our commercial real estate secured loan portfolio and the balances that may be considered higher risk in the current environment. We continue to work with our borrowers to provide payment forbearance of up to 6 months. But note that new requests for forbearance have significantly declined from levels experienced in March, April, and May 2020. In the event forbearance is granted, the forbearance amount will be due and payable in full as a balloon payment at the end of the loan term or sooner if the loan becomes due and payable in full at an earlier date. We believe our forbearance plan meets the criteria promulgated by the CARES Act, the interagency regulatory guidance, and clarifying statements from the Financial Accounting Standards Board and the Securities and Exchange Commission. As a result, we believe that we qualify for the favorable provision cited in the guidance on the vast majority of forbearance loans. As of October 20, 2020, there are 22 single-family loans in forbearance with outstanding balances of approximately $7.9 million or 0.90% of gross loans held for investment and one mobile family loan in forbearance with an outstanding balance of approximately $455,000, or 0.05% of gross loans held for investment. You will note the significant decline in the number and balance of loans in forbearance on October 20, in comparison to the September 30, 2020, balances described in the earnings release as a result of those loans that resumed monthly payments in October. Additionally, as of October 20, just 7 loans scheduled to resume their monthly payments in October or November, with a combined principal balance of approximately $2.6 million, were granted an additional 3 months of forbearance relief. Six of the 7 loans, or approximately $2.2 million, will be classified as restructured loans and downgraded to nonperforming status in October. One of the 7 loans was previously downgraded and classified. Also for reference, we updated the information in the forbearance table on Slide 13 of the investor presentation to reflect the October 20, 2020, number and balances of loans in forbearance. We recorded a $220,000 provision for loan losses in the September 2020 quarter, primarily due to an increase in the qualitative components in our allowance for loan losses methodology in response to the pandemic, which has negatively impacted the current economic environment. You will note that we remain on the incurred loss model and have not adopted CECL. This means that our allowance methodology cannot be reasonably compared to CECL adopters. Our net interest margin compressed by 11 basis points for the quarter ended September 30, 2020, compared with the June 30 sequential quarter as a result of a 15 basis point decrease in the average yield on total interest-earning assets, partially offset by a 5 basis point decrease in the cost of total interest-bearing liabilities. The decline in the average yield on total interest assets was primarily the result of the sharp rise in liquidity, stemming from the significant increase in total deposits and invested at nominal yields. Our average cost of deposits decreased by 6 basis points to 24 basis points for the quarter ended September 30, 2020, compared to the June 30 sequential quarter, and we believe that further declines are likely given the current interest rate environment. The 2.84% net interest margin this quarter was also negatively impacted by approximately 5 basis points as a result of the increase in the amortization of the net deferred loan costs associated with the loan payoffs in the September quarter, in comparison to the average net deferred loan cost amortization of the previous 5 quarters. We continue to look for operating efficiencies throughout the company to lower operating expenses. Notably, our FTE count on September 30, 2020, decreased to 163 compared to 188 FTE on the same date last year, a 13% decline. As a result of fewer employees and other cost savings, operating expenses declined to approximately $7 million in the current quarter compared to approximately $7.2 million in the same quarter last year. Please note, though, that operating expenses in the September 2019 quarter last year had benefited from a $296,000 revision of our previously recognized loan settlement and lower deposit insurance expense of approximately $150,000, resulting from the FDIC implementation of a small bank assessment credit, neither of which were replicated this quarter. As a result, current operating expenses declined by approximately $700,000 or 9% from the adjusted operating expenses in the same quarter last year. Additionally, on a sequential quarter basis, operating expenses declined by approximately 3% after adjusting for the $575,000 benefit in the June 2020 quarter from the reversal of incentive compensation accruals not replicated in the September 2020 quarter. Our short-term strategy for balance sheet management is unchanged from last quarter. We believe that leveraging the balance sheet with prudent loan portfolio growth is the best course of action but executing on that strategy in the current environment may prove difficult. In the interim, we're redeploying excess liquidity and government-sponsored mortgage-backed securities with an estimated average life of approximately 4 years. We exceed well-capitalized capital ratios by a significant margin, allowing us to execute on our business plan and capital management goals without complications. We believe that maintaining our cash dividend is very important, and doing so takes priority over stock buyback activity. As a result, we did not repurchase any shares of common stock in the September 2020 quarter and wish to emphasize that safeguarding capital has become increasingly important in the current environment and is the wisest course of action until we can get better clarity on the current economic landscape. We encourage everyone to review our September 30 investor presentation posted on our website. You will find we've included slides regarding financial metrics, asset quality, and capital management, which we believe will give you additional insight on our strong financial foundation supporting the future growth of the company. We will now entertain any questions you may have regarding our financial results. Thank you. Brad?

Timothy Coffey, Analyst

I have a two-part question. What is your outlook for loan growth or loan demand over the next two quarters? Additionally, how does that influence your appetite for future MBS purchases?

Donavon Ternes, President, COO and CFO

Tim, I'll address that question. Firstly, when considering loan growth, I've been observing the results from various financial institutions this quarter. It appears that everyone is facing some challenges regarding loan growth, primarily due to the current economic environment. For us, part of our loan growth has stemmed from acquiring pools of loans from other institutions, which is particularly challenging with single-family products. This is because we have to re-evaluate all the borrowers and determine how the pandemic has affected their income. Consequently, single-family purchases are tough, leading to a decrease in our volume. We have encountered some multifamily and commercial real estate packages, which are easier to underwrite in this environment since their income is typically derived from the property. We can access current rent rolls, making the evaluation process simpler. However, loan growth remains limited across the industry, resulting in fewer available packages for purchase as many institutions prefer to retain them in their portfolios. Regarding our liquidity and the excess cash influx from deposits, we've shifted towards purchasing mortgage-backed securities with relatively short average lives. We favor this product because it provides cash flow over time and allows us to reinvest later. We've largely completed this process, and our liquidity balances have returned to levels consistent with pre-pandemic times. This transition into mortgage-backed securities has stabilized the impact on our net interest margin. In the September quarter, our net interest margin compressed by a smaller amount compared to the previous quarters, and we expect this trend to continue as our balance sheet is structured without excessive liquidity. We believe our current net interest margins might remain stable and could see slight expansion. In the event of contraction, it would also likely occur at a lesser rate than before. I apologize for covering more than just loan growth and mortgage-backed securities, but I thought it would provide useful context regarding our net interest margin.

Timothy Coffey, Analyst

No, I do. I mean that's kind of where the question was going anyway. What were the yields, the average yields on what you purchased in the MBS market this quarter?

Donavon Ternes, President, COO and CFO

The mortgage-backed securities are yielding anywhere from 60 to 90 basis points, call it, depending upon whether or not it's a 10-year fully amortizing, 15-year fully amortizing, 20-year fully amortizing or 30-year fully amortizing. So call it the high, just under 1%, I guess.

Timothy Coffey, Analyst

Okay. Regarding deposit costs, you mentioned they might decrease slightly, Craig, in your prepared remarks, but you're already at historic lows for the institution. Do you believe it's a moderate decline? Will you hover at the bottom, or do you think you can reduce it even further?

Donavon Ternes, President, COO and CFO

Yes, I don't know that they can go much lower because they were at 24 basis points for the quarter. But certainly, they can come lower because there are CDs embedded in those deposit costs. And as the CDs mature, they are coming down in rate and allowing us to reduce deposit costs. Secondarily, we're looking at our transaction accounts quite closely. And in many cases, we're in the single digits with respect to what we are paying on those deposits. But some of them are in the high single digits, so they can come down as well. I think quarter-over-quarter, we reduced the deposit costs by about 6 basis points. We still have some room to bring those deposit costs down. I don't know if it will be as much as 6 basis points. It's possible. But to some degree, it's dependent upon what we're seeing in liquidity needs and the like. Secondarily, we're running a bit higher liquidity than we normally run as a result of the pandemic, just to have balances available depending upon what depositors are going to do with the deposits that they brought into the bank over the last 6 months. There's some sense that, perhaps, some of those deposits are not necessarily permanent.

Timothy Coffey, Analyst

Moving on to a broader question with respect to cost of funds, we also have maturities coming up in essentially the next 4 months with respect to Federal Home Loan Bank advances. I believe $10 million is maturing in December. And then we have another $10 million maturing in January. Our anticipation is that the cost of those advances, if we were to replace them, would be much lower than what their existing costs are. And in the event that we essentially use excess liquidity to pay those advances off, that would also reduce our overall cost of funds as well as our Federal Home Loan Bank advance costs. Okay. That should be helpful, Don. And then just one last question from me, and it goes to the buybacks. What more do you need to see to allow you to start using the buyback? As we look at credit, it looks really good. Loan demand is what it is right now. But everything seems like you're going to have a stable capital for a while. So kind of what would it take to kind of reinstitute the buyback?

Craig Blunden, Chairman and CEO

Well, let me start on that one. I think we really just need to see where this is headed in the next few months. I think we'll know a lot more then. And I also believe the regulators are wondering the same thing and hoping that institutions will protect capital levels when it's still uncertain as to how this pandemic will all play out in the economy. So I think we still need to wait a bit and look and see where this is all headed, even though, as you've already mentioned, I don't remember we've ever seen credit quality and delinquency levels quite this good.

Donavon Ternes, President, COO and CFO

Yes. I would like to add that we are keeping an eye on the situation and having regular discussions with regulators, as expected. We have observed several institutions reinstating their buyback programs, with some even expanding them. This has occurred with the regulators' awareness, leading us to believe that they are somewhat open to institutions pursuing this route. As we consider the progress with our forbearance loans, which are now down to 23, we expect to complete this process this quarter, allowing us to gain clearer insights into the near-term effects on credit. However, it remains uncertain if there will be any intermediate impacts related to credit, especially with the CARES Act set to expire on December 31. We need to consider the potential implications for multifamily rents and some commercial real estate rents. Currently, the outlook seems very positive, and we are pleased with the situation, but we remain somewhat cautious in our understanding. Our regulators also appear to be taking a cautious approach in this regard.

Craig Blunden, Chairman and CEO

And I'm starting to wonder too. Tim, have you looked to see if there's a difference in regulator and the way they look at it for different institutions, whether they're state or the FDIC or whatever or versus OCC, I'm trying to get a sense of there's sort of different look depending on which regulator it is.

Timothy Coffey, Analyst

I had not.

Craig Blunden, Chairman and CEO

It's certainly top of mind, Tim, and it's something that we would like to implement as soon as we get comfortable doing so, obviously, given the fact that we think our credit outlook is relatively good in comparison to others, and our stock is trading at 80% or 75% of tangible book.

Brett Rabatin, Analyst

I wanted to first ask, just maybe switching topics for a second, just thinking about expense management and various banks are looking at branch networks and doing other things and spending money on technology. Can you maybe give us an update on your thoughts on expense management this year, and any plans you might have to change the dynamic with the franchise with branches or investing in technology? And any thoughts on the expense base?

Craig Blunden, Chairman and CEO

Do you want to take that, Donavon?

Donavon Ternes, President, COO and CFO

Sure. The first thing I want to highlight is that as of September 30, our full-time employees decreased to 163, which is a 13% drop from 188 the previous year on the same date. Notably, 15 out of the 25 FTE reductions occurred between June 30, 2020, and September 30, 2020, meaning more than half of the decrease happened in the September quarter. We anticipate some cost savings in salaries and benefits expenses in the upcoming quarters as a result. The $7 million in operating expenses for the quarter serves as a reasonable baseline, but there is still some potential for further reductions in that amount due to the changes made during the September quarter. Regarding our branch system, last year we closed one branch in La Quinta after evaluating the lease renewal. We are currently looking at each of our branches that are approaching lease expirations to determine what actions we might take. If branch consolidation is considered, it will likely be limited to branches within Riverside, as branches like Blythe cannot be consolidated with others, and we don't expect any changes there. Additionally, we own some of our branches, which have been in operation for a long time. Given the changing environment, the branch footprint can be reassessed. We may consider selling those locations and possibly relocating to leased or smaller spaces nearby. Managing operating expenses is a key priority for us. As shown on Slide 4 in our presentation, if we exclude some nonrecurring items and adjust accordingly, last year's Q1 operating expenses were $7.7 million, dropping to $7.6 million, then to $7.5 million, hitting $7.2 million in the June quarter, and now at $7 million in the current quarter. I expect a slight decrease in the December quarter as well, given our initiatives. However, our branch network size and location do not lend themselves to a broad overhaul, as we want to maintain our presence in the cities where we operate.

Brett Rabatin, Analyst

That's a great point. I wanted to revisit the comments about the current environment where investors are seeking high-quality assets. This has resulted in prepayments. Do you have any insight into whether this trend might slow down now that some of the higher-rate items have been resolved? Or do you believe that this level of prepayments is likely to persist at least in the near term?

Donavon Ternes, President, COO and CFO

I think prepays are likely to remain high in the near term. This isn't necessarily the case for our multifamily or commercial real estate portfolios, but our second-largest portfolio is single-family, where current rates are so low that essentially all our loans are in that category. Therefore, I expect elevated payoffs to continue for the foreseeable future given the current interest rates. This situation will put pressure on our origination and purchase platform, especially since we have generally maintained a conservative credit culture. As a result, we may need to exercise some growth discipline in the near term as we consider expanding our balance sheet and loan portfolio.

Brett Rabatin, Analyst

Okay. And then maybe just one last one from me. Just thinking about credit, and obviously, you're in a really good situation credit-wise. Is the provision from here, just thinking about the reserve levels, does the provision from here continue to dwindle down a little bit, assuming that the charge-offs remain minimal and the growth is challenged?

Donavon Ternes, President, COO and CFO

I think that's a reasonable point, Brett. In the March quarter, we adjusted our provisioning based on what we experienced, and that provision was larger than in the June quarter, which was in turn larger than the September quarter. Given our credit metrics and no substantial deterioration going forward, one could argue that our reserve is probably adequate without further provisioning. However, I want to note one aspect: in our prepared comments, we mentioned that seven loans due for repayment after forbearance were unable to start making payments, and we extended them. As a result, these loans were downgraded to nonperforming credits, which will be reflected in the December quarter since this occurred in October. This amounts to $2.2 million. Consequently, our nonperforming loans could rise from $4.5 million to $6.7 million as of December 31, based on the information we already have. While this indicates an increase in nonperforming loans, we believe that the impact from those seven loans is not significant due to their relatively low loan-to-value ratios, and the California housing market remains robust. Even if they were to deteriorate further, I don't anticipate significant charge-offs since we might transition from using discounted cash flows for reserves to depending on collateral. We could see some slight deterioration in the December quarter as these loans move out of forbearance into what could be a troubled debt restructuring, but we only have 23 loans remaining that could face this issue. Thus, I wouldn't expect much deterioration or provisioning related to that activity. Provided there is no deterioration in our multifamily or smaller commercial real estate portfolio, I think your point about our provisioning levels and current allowance is valid.

Matthew Clark, Analyst

Regarding net loan growth in single-family residential and multifamily sectors, it seems there is potential for a return to purchase activity as comfort levels increase. Given that prepayments are likely to stay high, is there an expectation that you could offset the runoff in those portfolios by resuming some purchases? Alternatively, should we anticipate that those balances might decline a bit more?

Donavon Ternes, President, COO and CFO

I believe the single-family portfolio may be more challenging to maintain at its current levels due to low mortgage rates and the difficulty in acquiring seasoned single-family portfolios during this time, especially with the pandemic and uncertainties surrounding borrower employment. If I consider which portfolio could be more at risk, I would suggest it is the single-family portfolio. We have observed transactions in the multifamily sector; for instance, we executed a small multifamily purchase of about $9 million in the September quarter, although it was less than in previous quarters. We are currently underwriting a package for the December quarter in multifamily, which appears to be an area where we might see some easing in credit markets and an availability of purchase packages. This could potentially relieve some of the pressure on our portfolio contraction and allow us to stabilize and eventually grow it again. Yes, they were in the high 3s with respect to the production volume.

Timothy Coffey, Analyst

Okay. Okay. And then just the last one from me. Criticized, classified, I think you talked about $2.2 million moving to nonaccrual this coming quarter. But can you speak to the kind of the level or the amount in criticized, classified this quarter versus last?

Donavon Ternes, President, COO and CFO

Sure. We actually saw a decrease in nonperformers during the September quarter compared to June. Our total classified assets also declined in that timeframe, reaching historically low levels. As of September 30, we did not have any delinquent loans; in fact, our delinquent loans were around $2,000, primarily from consumer accounts that were overdrawn. There were no 30-89 day delinquents, which are typically classified as nonperformers. Some loans are in forbearance, as we have explained, and there are others in forbearance scheduled for payments in October that may struggle to make their payments in November or December. However, they are not considered delinquent as of September 30, since they are part of our forbearance program in line with the CARES Act. As of October 20, there are 23 loans in this category. If their experience aligns with those that have resumed monthly payments, we would not anticipate a significant number to be reclassified downward or into the TDR categories, though some may. Overall, we do not expect substantial deterioration in nonperforming or classified assets based on our current observations, aside from the previously mentioned $2.2 million.

Craig Blunden, Chairman and CEO

All right. Well, I want to thank everyone for participating in our quarterly earnings call and look forward to speaking with all of you again next quarter. Thank you.

Operator, Operator

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