RBB Bancorp Q2 FY2023 Earnings Call

Good day, everyone, and welcome to the RBB Bancorp results for the Second Quarter of 2023. At this time, all participants have been placed on a listen-only mode and we will open the floor for your questions and comments after the presentation. It is now my pleasure to turn the floor over to your host, Catherine Wei. Ma'am, the floor is yours.

Thank you. Good day, everyone, and thank you for joining us to discuss RBB Bancorp's results for the second quarter of 2023. With me today is Chief Executive Officer, David Morris; President and Chief Banking Officer, Johnny Lee; Chief Financial Officer, Alex Ko; Chief Credit Officer, Jeffrey Yeh; Chief Administrative Officer, Gary Fan; and Chief Risk Officer, Vincent Liu. David, Johnny and Alex will briefly summarize the results, which can be found in the earnings press release and investor presentation that are available on our Investor Relations website and then we'll open up the call to your questions. During 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 and uncertainties and other factors relating to RBB Bancorp's operations and business environment, all of which are difficult to predict and many of which are beyond the control of the company. For a detailed discussion of these risks and uncertainties, please refer to the documents the company has filed with the SEC. If any of these uncertainties materialize or any of these assumptions prove incorrect, RBB Bancorp's results could differ materially from its expectations as set forth in these statements. The company assumes no obligation to update such forward-looking statements unless required by law. Now, I'd like to turn the call over to David Morris. David?

Thank you, Catherine. Good day, everyone, and thank you for joining us today. First thing's first, I would like to welcome Johnny Lee to the Royal Business Bank family as President and Chief Banking Officer and say how pleased we are to have someone with his experience and reputation join us in a leadership role. Johnny's hiring is one of the more visible steps we've taken over the past 15 months to strengthen our management team, enhance our Board of Directors and adopt industry-leading corporate governance policies. These actions are summarized on page 3 of our earnings presentation. Since I was named CEO in February of last year, we have added a new President, Chief Financial Officer, Chief Administrative Officer, SBA Manager, Commercial Lending Manager, and an East Coast Head of Branch Banking. These additions to the RBB team have deepened our management bench and improved our ability to run a nationwide banking franchise. In addition to the new employees, we enhanced our Board of Directors with six new directors with extensive regulatory, executive leadership, wealth management, risk management and community banking experience. Of our 10 directors, nine, including our Chairman, are classified as independent directors. We also adopted new corporate governance policies and standards, which include enhanced director independence standards, an independent Board Chair, updated Board committee charters, and a new code of ethics. I want to mention these actions because I think they show how serious we are about serving our community, increasing shareholder value, and preventing a repeat of the events that led to the departure of former employees and directors. We are hopeful that folks will look at us not as the bank we were a year ago, but as the bank we are today. With all that said, I think it's important to address a couple of items in the quarter before I hand it over to Alex. First, we are aware of the increase in nonperforming loans. While nonperforming loans increased in the second quarter, classified, special mention, and loans delinquent between 30 and 90 days decreased from the last quarter. Specifically, special mention for the loans decreased significantly to $24 million from $89 million in the past quarter. Second, we strengthened our liquidity and are well on our way to bring the bank's loan-to-deposit ratio down to our sub-95% target. These efforts have resulted in a decrease in loans, as we have slowed our lending, tightened credit, and increased our liquidity over the past few quarters. We continue to lend to our core customers and expect Chinese experience and C&I lending will create new opportunities to originate loans that come with significant deposits. Now, I'll hand the call over to Johnny, who will make a few comments before handing it over to Alex to discuss the financial results. Johnny?

Thank you, David. I'd just like to say how excited I am to join Royal Business Bank as President and Chief Banking Officer. I've been here for a little more than a month and have been impressed by the energy and dedication of the whole team. We have a real opportunity to continue to build on a successful track record of the bank and to build shareholder value. As David mentioned, I believe my 33 years of experience in C&I lending will expand opportunities to diversify our loan portfolio while adding cost deposits. I look forward to meeting many of you in person to report on our progress in the quarters to come. With that, I'll hand it over to Alex who will discuss the financial results. Alex?

Thank you, Johnny. Slide 4 has a summary of second quarter results. Increasing loan yield drove another quarter of record interest income but were offset by an increase in interest expenses. As a result, net income for the quarter was stable at $10.9 million or $0.58 per share. Non-interest income of $2.5 million increased slightly from the first quarter as the $271,000 increase in service charges offset a $125,000 decline in loan servicing fees. Non-interest expenses decreased $394,000 due to decreases in salaries and legal expenses offset by increases in occupancy, data processing, and regulatory assessments. The second quarter net interest margin of 3.37% decreased 43 basis points from the last quarter as deposit cost increases continue to outpace loan yield increases. Slide 5 includes summary balance sheet information. You can see that the biggest change was net loans held for investment, which decreased by $146 million. As we began to see the impact from the slowdown in originations, we discussed last quarter. All loan category balances declined with the exception of residential mortgages, which increased slightly. The net loan-to-deposit ratio at the end of the second quarter was 99%. So we were pleased with our progress on this important goal. Our yield on average earning assets increased to 6.01% in the second quarter, which was a 17 basis point increase from the last quarter and a 135 basis point increase from the second quarter of 2022. The increase in yield from last quarter was due to increasing yield on virtually all of our interest-earning assets. Starting on Slide 6 of the earnings presentation, we provide additional detail about our loan portfolio, which totaled $3.2 billion at the end of the second quarter, with an annualized yield of 6.23%. Commercial real estate loans comprised 45% of our loans, and Slides 7 and 8 have some details about our exposure. Our CRE office portfolio is relatively small at $45 million and has an average weighted loan-to-deposit ratio of 57%. Our CRE loans consist of 44% multifamily loans. Slide 9 has a snapshot of our $1.55 billion residential mortgage portfolio, which mostly consists of non-QM mortgages in Rio and California. Moving on to Slide 11, our total deposit balance increased steadily for the last two quarters. Average interest-bearing deposits increased by $217 million due to increases in time deposits. Average non-interest-bearing deposits declined at a slower pace than last quarter. We have had a steady decline in uninsured deposits, which now stands at 29% of total deposits, partially due to converting to SEDAR's deposits. Our average cost of interest-bearing deposits for the quarter was 3.47%, up 72 basis points from the prior quarter and a slight decline from the 82 basis point increase we saw in the first quarter. We continue to expect the pace of increases in deposit costs to slow in future quarters. Moving on to credit, as detailed on Slide 12, non-performing loans increased to $42.5 million from $26.4 million from the last quarter due to primarily three loans totaling $17.8 million. One of these loans is a CRE office loan, and two of them are residential mortgage loans. Also during the second quarter, 13 loans totaling $3.5 million were removed from the nonperforming category, with seven of them totaling $3.1 million paying off and five of them totaling $100,000 being charged off. As David mentioned and you can see on Slide 14, we saw a $68.5 million decline in special mention and classified loans in the second quarter. The largest part of this improvement was an upgrade of a $55 million multifamily construction loan. The company recorded a $380,000 provision for credit losses, which when combined with a decline in loans outstanding took our allowance for credit losses to 1.35% of total loans. As noted on Slide 15, non-interest income increased slightly from the last quarter, mainly due to an increase in deposit service fees. Slide 16 shows detail of operating expenses. Our efficiency ratio slightly increased mainly due to reduced net interest income offset by a decrease in salary and employee benefit expenses. The non-interest expenses to average asset ratio improved slightly to 0.46%, mainly reflecting the reduction of non-interest expense quarter-over-quarter. Our capital levels remain strong, with all capital ratios well above regulatory well-capitalized ratios, which we believe is prudent given the market risk. With that, we are happy to take your questions. Operator, please open up the call.

Your first question is coming from Kelly Motta from KBW. Your line is live.

Hi, good morning. Thanks for the questions. I think maybe I'll kick it off with your broader comments on building the bench. I know you guys have done a tremendous job adding independent members to the Board, as well as adding to the bench on the management team. Just wondering, as you look at what you've done and brought on, do you feel like you have the team in place now to execute on the next stages, or are you still looking to add executives in some areas?

Kelly, this is Dave. Good morning. I believe that as far as our executive management team, we have everybody on board. We do have some holes. For example, we need to have a C&I lender that we would need to put on in a couple of other positions like that within the organization.

Great. And then on the loan growth front, I believe your release and commentary suggested that you're pulling back in some non-core areas, maybe non-core regions. Can you expand on kind of where you are more specifically where you're pulling back, as well as where you continue to see good risk-adjusted returns? And also, as we look towards the second half of the year, loan balances are down. I know you've laid out where you want to get to on your loan-to-deposit ratio. How much of that comes from just pulling back on loan growth as we look towards the back half of the year?

Okay. I will attempt to answer the first and second part. When we say non-core growth, we're talking about customers who do not have a core relationship with us, meaning they do not have a deposit relationship with us also or their main deposit relationship. And many of these are out of our market, maybe in the state of Washington, Oregon, Texas, and so forth. We're also paring back in some of our other areas of non-core business like our auto lending; we have ceased auto lending. And we're bringing down mortgage a little bit also. We are not growing mortgage like we used to. As far as the second part of your question, most of our decreases are coming in both areas, but most of the decrease in our loan-to-deposit ratio is probably going to be from the loans rolling off in those areas that I talked about earlier. While at the same time, we're going to probably bring on $40 million a quarter or so in deposits. So that's what's going on.

Got it. And then maybe last question for me, and then I'll let others into the queue. But on the noninterest-bearing deposits, I know you had some larger sort of accounts and there have been declines over the past several quarters now, some of that letting go of some of those customers that aren't core to your business. But just as we look ahead, where do you see noninterest-bearing settling as a percentage of deposits? They're at 18% now. And is that pace of noninterest-bearing runoff showing any signs of slowing? Any sort of color around the details of those would be helpful as we look ahead.

Kelly, yes, we definitely see the trend of that slowing. I think ultimately with Johnny coming on board and with some of the new management team, that's the primary focus of our deposit growth for the remainder of this year, where like every other bank trying to deal with the market shifts and the way that we're looking at our current customer base. The investments we're making in people, systems, products, and services, that's all in line to help us grow the noninterest-bearing deposit segment of our broad deposit book. So, that's something I don't think you'll see immediate results in the next 30, 45 days, but I would expect us to see some positive momentum before the end of this calendar year.

Thank you. Your next question is coming from Nathan Race from Piper Sandler. Your line is live.

Yes. Hi everyone. Good morning. Thanks for taking the questions. A question on some of the term two dynamics in the quarter. Cash balances remain fairly high, but you're also able to bring down your FHLB advances in the quarter. So just curious to hear how we should kind of think about those two areas going forward.

Sure, Nathan. It's great to talk to you. You're correct that we have a strategy to reduce our loan-to-deposit ratio at the bank level. We're on track to manage the growth of loans while also seeing continued increases in deposits. We are investing excess amounts in securities and enhancing our liquidity as reflected in our cash and due from banks. Compared to the same quarter last year, we have seen about a $22 million increase. I believe it's wise to maintain our cash and liquidity at this level. It may slightly decrease as we transition our funding strategy while growing loans in Q4, but I am comfortable with cash levels around $240 million to $250 million, as that's sufficient. Additionally, our investment securities increased significantly from last quarter, by nearly $100 million. We are employing a barbell strategy to ensure liquidity in the short term while also increasing our interest income.

Right. Got it. And then maybe changing gears and thinking about the expense run rate. I think, last quarter we were talking about being closer to $17 million in the back half of this year. Just curious with the decrease in comp that we saw this quarter relative to the still relatively high legal costs. How should we think about those two areas in particular relative to the guidance toward the last quarter?

Sure. Yes. We did say that. We are expecting professional fees, especially legal fees, to go down. Yes, it did go down, but not to the level of the decrease that we expected actually happened this quarter. But I think going forward the run rate we expect that will continue to go down. To give you a magnitude of the legal fees and other professional fees over the last six months, we incurred about $3 million of legal fees, which I do not think will continue going forward. It will be reduced. One thing to note is, obviously, there is some insurance coverage that will reimburse certain expenses, which include certain legal fees as well. So I would expect to continue to report the growth on a total basis of our expenses related to legal matters. You will see some elevated levels, but not to the level of Q2 or Q1, but some expenses going forward. I would expect like $18 million plus/minus as the run rate that I can foresee for now. Some legal fees and those kinds of things might be out of management's control. But I would feel comfortable in the neighborhood of an $18 million run rate for non-interest expense.

Okay. Great. That's very helpful. And then just any additional details you can provide on the office commercial real estate loan that moved to non-accrual in the quarter? I appreciate all the details in the deck but just any additional color in terms of occupancy rates and how you guys are working through that credit in particular?

Yes, maybe I can attempt. Jeffrey is here with me, so Jeff you can definitely chime in. We try to have more details about the CRE office portfolio. Nathan, we provide slightly more details in the earnings presentation on page seven, which have loan-to-deposit distribution and also by regional breakdown. But actually, office exposure itself, we have a very minimum $45 million total, which is 1.5% of our total loans. So, that's I believe to start with it, we have a small amount of exposure. However, one loan that migrated into non-accrual loans this quarter happened to be an office portfolio. We performed an impairment analysis, which is about a 90% net loan-to-value ratio. There is another reserve or loss context based on the appraisal we have. We believe that it is a kind of isolated one-off office portfolio because I don't see any other office-type portfolios in our even small portfolio having a similar nature of risk content. We are watching closely because office space itself is an industry-wide high-risk carrier. I'd just give you a little bit more color, overall office portfolio we have average weighted loan-to-deposit is very low like 57%. So one-off 90% that NPL is a kind of one-off item. We have low loan-to-deposit again like 57%. Also, 80% or more is all in the areas that we serve in the young New Jersey area.

Okay. Got it, very helpful. And if I could just ask one more on capital management priorities. I imagine you guys want to continue to build excess capital in this type of environment. But also just curious your updated thoughts on when maybe share repurchases might resume and the ongoing SEC investigation that was indicated has had any impact on your timing or ability to resume share repurchases?

We don't know the timing on the share repurchases at this time, but we want to start repurchasing as soon as we can.

Thank you. Your next question is coming from Andrew Terrell from Stephens. Your line is live.

Hey, good morning.

Hey, Andrew.

If I could just follow up on the office loan. I understand that the portfolio overall is very small. It looks like it's very well underwritten here. For the one office loan that went non-performing, it sounded like the LTV is right around 90%. I was just curious, before the updated appraisal, what was the LTV beforehand? So, I guess in other words, what was the kind of value degradation the property saw?

Yes. Hi, this is Jeffrey. Before it was reappraised, the LTV was about 65%. We did a new appraisal because of the drop in operating income. The building is 100% occupied, and the reason for the drop is mainly because the tenant negotiated for lower rent, which impacted the value because if you're using the income approach to evaluate a property, plus there is a short-term rental disagreement. That's the reason why we put it into NPL, just for your information.

Understood. That's very helpful color. I appreciate it. And then maybe on the other side of the credit front, it was good to see the special mention improvement this quarter. I want to make sure I heard correctly. Was it one specific multifamily construction loan for $55 million or a handful of multifamily construction deals for that aggregate amount that drove the decrease in special mentions?

Yes, that is correct. There has been a significant reduction in special mention due to this property. To provide some details, the property is completely finished and they are moving on to the next project. The first project is over 90% leased, while the second project has just been completed and is currently in the pre-leasing phase. Additionally, because the property is located in a strong market area, they have already secured commitments from other financial institutions to take over the loan. The situation is very positive, which is why we upgraded this loan from special mention.

I understand, and I appreciate the clarity. It's encouraging to see that improvement. David, I want to revisit your comments about loan growth and the potential for letting some non-core items roll off. You mentioned out-of-market lending, and I'm curious about how much of that is in your portfolio, specifically how much you consider out of market. Additionally, could you clarify how much you view as non-core? I'm trying to understand your target of approximately $40 million per quarter in deposit growth. Looking ahead, do you anticipate a similar amount of loan decreases in the next few quarters, or have you mostly addressed the non-core segment by now?

First of all, I don't think we'll have as much come off the books next quarter as we have this past quarter. I'm going to pass this over to Jeffrey who has the concentration report that can tell you what we have in different states and how much we project to roll off. Unfortunately, Andrew, that $55 million loan we just talked about is actually a core customer of ours, but we could not compete on rate. The rate was significantly lower, so we do not play the rate game. Unfortunately, that customer is taking one of these loans. We have other loans with them to another bank.

This is Jeffrey again. Out-of-market or out-of-area loans, which we define as loans without a complete relationship like lending and deposits, are part of our risk strategy to gradually phase out. To give you some insight into our out-of-state lending, we had approximately $400 million at the beginning of the year, which has now been reduced to about $320 million in just six months. This shows our commitment to executing this plan.

And so is that $320 million remaining kind of the last of what you would deem non-core?

We will consider most of them non-core as long as they do not have a total relationship with us, especially the deposit relationship.

Yeah. Understood. Okay. Thank you for taking the question. I'll step back in the queue.

Thank you. Your next question is coming from Tim Coffey from Janney. Your line is live.

Good morning, everybody. David, Alex, do you have any kind of visibility into when margin might trough, say is that something later this year or early next year?

Well, Tim, we know that about $1 billion of CDs are set to renew in the third and fourth quarter. They're currently priced at around 4%, so we don't anticipate a significant repricing issue. We've kept our offering rates on CDs steady since January or February of this year. I believe it will be more towards the end of this year or early next year when we might see any decreases in rates, which could lead to some improvement in our margin. Alex, do you have any additional insights on that?

Sure. That's a great point. Just one point to add, there's obviously a deposit lagging impact. We have seen quite a big increase on the market rate in the beginning of the year and the last year Q4 and Q3, but those were kind of repriced already or will continue to reprice this quarter and the next two quarters. Once that kind of repricing sets in, I think we will have a much more normalized deposit cost. We will also have an increase on the asset side. As you know, we have decreased our earning assets with good reasons, strategic reasons. With the help from Johnny and the team going back to the market for variable rate loans and other good earning assets, it will definitely help our net interest margin going forward. I would say next quarter, Q3, we'll have compression. But again, as David kind of alluded, it’s not to the level of what we have seen in this quarter. We have a 33 basis point compression. I don't think it will be at that level. It will be less, but it will continue. I'm hoping by the end of the year, starting next year something, we would like to see the kind of bouncing back of our net interest margin.

Okay. And Alex, do you have a spot rate for interest-bearing deposits for June?

Yes, I do have. I have a spot rate for money market is 2.73%. For CDs, less than $20,000 is 3.83%, and deposits over $250,000 is 4.5%.

Okay, great. Thank you very much for that. David, switching gears, do you have any visibility on when the SEC inquiry might conclude? It's not uncommon that the SEC will launch an investigation and then never close it.

I don't know if I can really answer that question, Tim, because I really don't know either. I can tell you that it's progressing enough to where we felt very comfortable announcing publicly and I think to share what we can say about what's going on.

Okay. That's fair. And then just a final question for me. On the three loans added to non-performers in this quarter, were any of them out of your primary service area?

There – the three of them, two of them are residential mortgages, and they are in our area. One, as for your information, the LTV is about 59, the other one like is 67-66, which we think is covered. The other one is the one that I mentioned about our office, that is out of state, but that is in...

It's in Springfield, Illinois, which is technically out of our market area, but we do have branches in that state.

Thank you. Your next question is coming from Kelly Motta from KBW. Your line is live.

Hi, thanks for the follow-up. Kind of on that note of the investigation. Just wondering if there's any implication at all for the pending gateway deal? And if you could remind us when that deal needs to be renegotiated, when the contract is up, Dave?

The contract expires on September 30. That's all I can say about Gateway right now.

Thank you. Your next question is coming from Nathan Race from Piper Sandler. Your line is live.

Yes. I appreciate you guys taking the follow-up as well. I just want to clarify on the margin expectations. I know there's a handful of moving parts to it. But Alex, it sounds like you expect the pace of compression to slow the next couple of quarters. Can you just kind of circle back on how you're thinking about the trajectory during Q3 and Q4 of this year?

Yes. Sure. I would like to say one more time. Yes, it will compress, but not to the level that we have experienced in Q2 and Q1. Q2 we have a 33 basis point margin compression; maybe half of that. I don't have a real crystal quantifying it, but I would say it will be substantially lower than the 33 basis point compression that we experienced in Q2. Going forward, Q3 probably it will be compressed and Q4 maybe. But I'm hoping that Q1 of next year we might see the expansion.

Okay. Great. And then just lastly, on kind of the reserve outlook. It sounds like you're all secure in that office commercial real estate loan that moved to non-accrual in the quarter. You guys obviously had a nice increase in your ACL here in 2Q. Should we expect the reserve to continue to grow at this point, or just how do you guys kind of think about future provisioning in light of maybe some continued loan shrinkage near term and then maybe a return to growth in Q4?

I will start by addressing your question, but Jeffrey may add to it. I believe our allowance coverage ratio for Q2 is in a good place, and I am comfortable with it. The provision of $380,000 this quarter is due to a $146 million decrease in our portfolio. If we calculate the potential impact based on our ACL coverage of 1.35%, that translates to a $2.1 million provision for credit losses. This quarter, we have a positive provision of $380,000 for credit losses. This is partly due to economic uncertainties and a slight increase in non-performing loans, although we have seen improvements in other classifications. We want to be cautious with our ACL coverage. Our allowance coverage ratio of 1.35% compared to our peers seems adequate. Moving forward, we are not looking to increase the reserve unless necessary and will keep a close eye on credit conditions. The increase in non-accrual loans might be an isolated incident, and we are taking it seriously by strengthening our underwriting criteria. We will keep track of the allowance coverage ratio, but I don't foresee the need to continue building the reserve unless there is a downturn in the macroeconomy.

Yes, I think that is definitely.

Yes, I would agree with what Alex said.

Thank you. Your final question is coming from Ben Gerlinger from Hovde Group. Your line is live.

Good morning, everyone.

Hi, Ben.

During the course of this call, there's been a rumor that two Los Angeles competitors are likely to announce a merger sometime soon. I was curious just on overall deposit pricing in the Los Angeles area. Have you seen anything material, any sort of outsized pricing where people are kind of scrambling to retain their clients, or is it really not that impactful on overall deposit costs?

I don't see anything like what you're talking about.

Got you. Fair enough. And then, I mean, a lot of we've added a few different questions about the margin and potentially speaking, let's call it around the end of the year, or excuse me, the margin troughing around the end of the year before rebounding higher. I was curious if you'd be open to sharing potentially where you think that NIM is? I get that it's a bit cloudy out there over the next six months, especially with pricing and mix shifts. But just curious if you'd be open to sharing where your margin potentially troughed at least in your model today?

There are many factors influencing deposit pricing. We will continue to grow, focusing on noninterest-bearing deposits while also increasing our deposits, which will incur costs. Our target is a 95% bank-level net loan-to-deposit ratio. It's challenging to provide an accurate net interest margin projection for the end of the year or the first quarter due to these complexities. This includes not only deposits but also loans; as mentioned, we will engage in competitive pricing for loans, but we won't sacrifice stability for growth by offering high loan rates. Therefore, it's difficult for me to give precise guidance on our net interest margin at this time.

Okay. Fair enough. I fully understand. I appreciate the color. That's it for me.

Any others?

Thank you. That concludes our Q&A session. I will now hand the conference back to our host for closing remarks. Please go ahead.

Once again, thank you all for joining us today. We look forward to speaking to many of you in the coming days and weeks. Have a great afternoon.

Thank you everyone. This concludes today's event. You may disconnect at this time and have a wonderful day. Thank you for your participation.