ConnectOne Bancorp (NASDAQ:CNOB) Q2 2020 Earnings Call

0:00 Good day and welcome to the Connect One Bancorp, Inc. second quarter 2020 earnings conference call. All participants will be in listen-only mode. Did you need assistance? Please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Miss Siya Vansia with Connect One. Please go ahead.

0:30 Good morning and welcome to today's conference call to review Connect One's results for the second quarter of 2020 and to update you on recent developments. On today's conference call will be Frank Sorrentino, Chairman and Chief Executive Officer, and Bill Burns, Executive Vice President and Chief Financial Officer. The results as well as notice of this conference call on a listen-only basis over the internet were distributed this morning in a press release that has been covered by the financial media. At this time, let me remind you that certain statements and assumptions in this conference call contain or are based upon forward-looking information and are being made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to numerous assumptions, uncertainties, and known or unknown risks, which could cause actual results to differ materially from those anticipated.

1:20 These risk factors are more fully discussed in the company's filings with the Securities and Exchange Commission. The forward-looking statements included in this conference call are made as of the date of this call and the company is not obligated to publicly update or revise them. In addition, certain terms used in this call are non-GAAP financial measures, reconciliations of which are provided in the company's earnings release and accompanying tables or schedules, which have been filed today on Form 8K with the SEC and may also be accessed through the company's website at ir.connect1bank.com. Each listener is encouraged to review those reconciliations provided in the earnings release together with all other information provided in the release. I will now turn the call over to Frank Sorrentino.

2:06 Frank, please go ahead.

2:08 Thank you, Siya, and good morning, everyone, and thank you for joining us on our conference call today. I hope you and your families have all been safe and healthy. We here at Connect One had a good second quarter, and I'm proud of how Connect One has responded to the current challenges the industry is facing in this uncertain economy. Looking at some of the key quarterly metrics for Connect One, we continue to generate very strong earnings, delivering earnings of 30 cents per share, which included 15 million of reserves, predominantly due to the uncertainty regarding the pandemic. The strength of our organization continues to be demonstrated by our strong pre-tax net operating revenue, which was in excess of 1.95% of total average assets, placing us among the strongest in the industry.

2:57 We also delivered on an improved net interest margin this quarter, resulting in sequential net interest income growth of 10% and over 30% on a year-over-year basis. While many other banks are experiencing margin contraction, and in some cases significant compression, we continue to demonstrate the ability to drive exceptionally strong organic earnings power. In regard to provisioning, we're essentially matching our reserves from the first quarter. We now have close to $28 million in reserves for issues related to the pandemic, should they arise, bringing our total reserves for loans to approximately 1.08%. Bill will have a little bit more to say about the provision and the reserves a little later on in this presentation.

3:44 Despite the large reserve build, we still managed to grow our tangible book value per share to $16.28. Overall, we continue to navigate through the pandemic in a solid, forward-looking fashion, which is a testament to the resilience of our team and our relationship banking model. Operationally, we've adopted a comprehensive return-to-work strategy With a heavy focus on leveraging our technology, including reopening our offices with enhanced contactless solutions. While we're taking gradual steps to return to normalcy, we've also learned through this pandemic how to best serve our clients, whether that's in person or through our digital channels. And in turn, our clients have shown less reliance on our physical locations.

4:33 The investments we've made in financial technology and in our infrastructure over the past few years has played a critical role in competitively positioning Connect One's virtual hybrid bank model, while the environment that COVID created has accelerated the transition to our digital banking products for many of our clients. Additionally, as we move into the future state of banking in the digital world, we're excited to further leverage our strong technological foundation to take advantage of new opportunities. Most recently, we partnered with Encino to launch a virtual portal to digitize the Paycheck Protection Program forgiveness process, which is now available to our borrowers under the program.

5:19 As you know, we were an active participant in the SBA's Paycheck Protection Program, funding over 470 million of loans. I'm very proud of our team for quickly responding to our clients' needs, especially in this time of crisis. You know, while some banks consider these loans as giving up economics, our Paycheck Protection Program loans are generally done with existing clients, and we believe it's a service necessary to provide in order to ensure the continuity of our clients' businesses. Bill will touch a little bit on the economic impacts of that program momentarily. On another front, FinTech, Bofly also performed very well, providing a new channel for lending in the Paycheck Protection Program. Separately from Connect One, they processed over $400 million in loans to over 15 banks, and we believe their growing momentum will extend beyond the Paycheck Protection Program as skills learned will be applied to pursuing additional opportunities in the future.

6:21 Bothwide generally has done best in times of higher than normal unemployment when folks who are laid off decide to start a business. And we expect to see a pickup in business there once stabilization begins with the COVID pandemic. We also worked with some of our borrowers by helping them through challenges that have resulted from the pandemic. As of June 30th, we had approximately 930 million in deferments. However, since the end of the second quarter, and many more. Connect One has a very low exposure to the hot-button industries such as transportation, energy, and hospitality, and our portfolio is underwritten with low LTVs and reasonable cap rates.

7:31 Additionally, overall COVID-19 trends have vastly improved in the Northeast since the onset of the pandemic earlier this year. Multifamily rent collections in the New Jersey market are tracking at approximately 95%, and restaurants in our market have been doing Pretty well in this transition. Home sales in our suburban markets in some cases are at near all-time highs and our construction portfolio is performing very well with projects moving to completion. Since our inception, Connect One has developed its expertise in commercial real estate and has committed to having a well-diversified loan portfolio. While overall loans are down slightly this quarter as a result of our conservative stance given the current environment, We're constantly looking at where we can get the best rate of return relative to the risk that we take in our company.

8:22 We also take great pride in our team's focus of expanding client relationships, and I'm pleased to note that total average deposits for the second quarter increased by 240 million, which is nearly 20% on an annualized basis. We've always been committed to being good stewards of our shareholders' capital resources, conservative in our financial commitments, and continue to return capital to shareholders through quarterly dividends. This approach has served us well. And in that regard, the board just declared our nine cent per share common dividend along with today's earnings release. While we expect a relatively flat balance sheet for the remainder of 2020, depending on the duration of this pandemic, we believe our balance sheet remains well positioned. We have sound growing capital levels and our position was further strengthened with the recent completion of a $75 million subordinated debt offering. A significant portion of that offering, upwards of $50 million, is intended to pay off existing subordinated debt.

9:25 So switching gears and taking a look at our acquisition of Bancorp of New Jersey, the final phase of our integration and conversion was completed virtually on May 4th with no delays. The transition's been seamless. and as we previously mentioned, we closed eight branches during the quarter. We also continue to evaluate all of our brick and mortar strategy and plan to close an additional four locations later this year. As we rationalize our physical footprint, we believe that Connect One's performance, especially our operating efficiency, will reflect the benefits of this initiative. In conclusion, we're diligently executing on our priorities and continue to use our full range of banking expertise to support our clients. I'm pleased with our second quarter results and the underlying fundamentals of the company.

10:14 And with that, as a strategic update, I'd like to now turn the call over to Bill to provide some more details on this quarter's performance. Bill?

10:23 Okay, thank you, Frank, and good morning, everyone. So we had another great quarter on an operating basis. Our pre-provision net operating revenue was up significantly on a sequential basis. We reached $37.5 million this quarter versus last 32.6 in the first quarter. That's an increase of $5 million. As a percentage of assets, that amounts to 1.95% for the quarter, as that metric continues to be in the upper end of our peer group, ranging from 175% to 2% consistently over the past five quarters. So the primary reason for the exceptionally strong performance this quarter was a $5 million increase in net interest income. Most of that, about four of the $5 million, was driven by PPP loans on our balance sheet.

11:08 and the remaining 1 million in positive variance being due to higher net interest margin. So the PPP fees are running through interest income over a nine month period on average. That creates a current yield on that portfolio in the low 5% range. Our core margin is directionally performing stronger than most. So I'll review with you again color on that. You may remember we did anticipate a widening margin in our last earnings call three months ago. So first off, We have a relatively small percentage of loans that reprice immediately, about $1 billion of our $6 billion loan portfolio. And of that $1 billion, virtually all have built-in floors. So although the average loan yields did decline, the decline was less than it was for most other banks, resulting in far less NIM pressure on the asset side of the balance sheet.

11:59 Next, even before the pandemic, we were anticipating a stable lower interest rate environment, and we had shifted Our wholesale funding towards shorter term structures. So with the Fed actions in the first quarter, those positions repriced immediately and significantly. And then finally, we've been aggressive in reducing deposit rates, probably leading the pack while still retaining and growing our core deposit base. Now, it is true that in the quarter, the NIM benefited from the PPP, and that was by upwards of 10 basis points. But the NIM also contracted by 10 basis points due to excess liquidity. So our margin was strong on a core basis. And frankly, any way you want to look at the NIM, we were strong. So going forward for the net interest margin, we have some moving parts, as is usually the case. Let me tell you what I can. First, the PPP will continue to help for a couple of quarters, then trail off concurrent with loan forgiveness timelines.

12:57 Our excess liquidity, we've already been working that down and removing that drag will improve margin immediately. And we still have some room for lower deposit rates, especially as CDs continue to run off. Over the next six months, 40% of the CD portfolio will mature. It carries a weighted average rate right now of 220. And so we'll have a choice when those mature whether we want to be competitive or let some of those CDs run off. Now offsetting those positive margin items is the recent subdebt offering. That's going to compress NIM by about five basis points in the third quarter, although that will come down to just two basis point compression once we pay off $50 million of sub-debt, and it's outstanding. We'll do that either later this year or early next year. And finally, I want to add there may be a bias towards lower loan origination rates versus the average yield in the portfolio, which would compress the margin.

13:49 But all in all, I see a relatively stable, if not slightly improving, margin for the rest of 2020. I want to make a couple of comments about Beaufly because there were a couple of items that impacted non-trust income and expense. First, we recorded $2.3 million in PPP referral fees. These were on loans referred by Beaufly to and originated by other banks. And next, offsetting that income in the quarter, we are accruing an adjustment to the valuation of the Beaufly acquisition due to all the PPP volume Connect One had. and that resulted in recognizing similar $2.3 million expense offsetting the fees. Let's turn now to credit and reserves. Our provision for loan losses was elevated and that was due to qualitative factors, namely an increase in the projected duration of the pandemic. We believe the $15 million total provision for the quarter is conservative, especially when we consider the positive trends in deferred loans.

14:49 And I want to add, when it comes to reserves, we'd much rather be ahead of the curve versus playing catch-up. I want to elaborate a little bit more on what Frank said about deferments, that more than 50% are coming off deferral. That's based on loans that have been reviewed so far, so that number is likely to get even better as all the deferment terms run their course. Our reserves as a percentage of loans has increased to 1.08 on a gap basis, if you will. But if you were to exclude the PPP loans, which have a 0% risk rating, and add back the purchase accounting discount, that ratio increases to approximately 1.25. The reserve ratio was only 0.75 at year end 2019. So we've had growth in both reserves and capital during the quarter, improving our fortress even further. to go along with ongoing strong net operating revenues successfully withstand any prolonged crisis. Our bank leverage ratio stands at a healthy 10.1%.

15:47 Just a couple of comments on expense growth and efficiency. Expense growth, I expect, will continue to be moderate as we have more Bank New Jersey expense saves coming and we are closing four more branches later this year. Having said that, There will likely be more back office expense associated with managing deferments and processing PPP forgiveness, as well as, as always, continued investment in technology and infrastructure. As far as the efficiency ratio goes, look, without our typical revenue growth, it will be challenging to improve where we are at the 41% or 42% level. But I feel confident that we can, at the worst, stay at that level. And I'm going to turn it back over to Frank for closing comments, and then we'll have some questions.

16:34 Great. Thank you, Bill. So while we've all seen the improvement in reports on businesses reopening, the nation and the banking industry still face considerable uncertainty about how long this pandemic will persist. The longer it persists, the more pressure there is on borrowers, and the higher the expectations may become for loans to become impaired. Nonetheless, we remain disciplined and steadfast in our belief that our experienced management team, strong balance sheet, and risk controls will help us successfully navigate this operating environment. We're confident that together we'll all get through this. And when we come out on the other side, Connect One will get back to executing on prudent growth trends and producing strong metrics as we've always focused on in the past.

17:25 And so with that, we're happy to take your questions. Operator? Thank you. We will now begin the question and answer session. To ask a question, you may press star on your touch-tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then 2. At this time, we will pause momentarily to assemble the roster. The first question today comes from Matthew Brees of Piper Joffrey. Please go ahead.

18:11 Good morning. Good morning, Matt. Hey, Bill, there's a lot of pluses and minuses to the NIM outlook. If we were to just say, you know, longer term, a year out or 18 months out, once we put behind us the deployment of liquidity, PPP, the subnet raise, lower deposit costs, where do you think the settling point in this environment for the core NIM is?

18:36 Well, like I said before, it's flat to up through this year. And then going into next year, it's going to depend on whether the economy is back, what the shape of the yield curve, how steep it is, where spreads are. And so it's really hard for me to predict. But I think we'll be starting off at a good place. Okay.

19:00 And then you had some very encouraging – Data Points on Deferrals Coming Due and the Cure Rate. In the case of those loans that aren't curing and therefore need an additional 90 days or whatever you're providing, could you just talk about with that book, what is it comprised of most typically and some of the underwriting characteristics in terms of LTVs or debt service coverage? Just want to get a sense for the stuff that needs additional help, what your protection against lost content looks like.

19:32 Well, the majority of it is collateralized loans that were underwritten with good LTVs. And so we feel we have a lot of cushion in those. And so, look, if there is a loss in those, I don't think it can be much. There's a small portion in CNI. We've stayed away from high-risk industries. There are strong borrower guarantees. and at the end of the day there's just probably a small portion in that bucket.

20:06 Okay, and then my last one is just obviously very strong fees from Bowfly that was matched with an expense. Does that acquisition adjustment, does that persist for a while or at some point does that trail off and if Bowfly continues to perform well they can drop more to the bottom line? How does that dynamic work?

20:29 Yes, yes. They dropped more to the bottom line. There could be a little bit more adjustment, but it's very small. And so, you know, the success will not be hurt materially by any adjustments to the acquisition price.

20:47 Okay. And just following the fee income discussion, so this quarter I view as more of one time because of PPP. Should we expect the income to trend back to that 2.5 or 2.7 million dollar kind of core run rate in the coming quarters?

21:07 Well, it could be a little bit lower. Yeah, for both sides. It could be a little bit lower because of the state of the economy and less activity going on. But we do feel confident in the long run. that both fight through the PP program has increased the distribution channels. And so on net, this is a good thing. The fees they generated from the PPP and the outlook for the future, and that's offset slightly by lower fees for their regular business through the duration of the crisis. Okay.

21:42 Just last one really quick. Tax rate is coming in about 14.5% the first two quarters of the year. Where do you expect that to be for the back half of the year and then in 2021?

21:52 Well, it depends on the level of, you know, pre-tax income. So, right, you know, it gets impacted by what the level of provisioning is. So the level of provisioning go lower, we're going to get back up to the, you know, 20% range. If it stays at this level, it'll sort of be consistent with what it was this quarter.

22:13 Understood. Okay. Thanks. That's all I had. Okay.

22:16 Thanks, Matt. Again, if you have a question, please press star then one. The next question comes from Chris O'Connell of KBW. Please go ahead.

22:29 Good morning. This is Craig O'Connell. I just wanted to start off on the expenses. I appreciate the guidance and the efficiency. Is the four additional branches, was that outside of the original cost-save plans for the acquisition? Yes.

22:50 That is separate from the acquisitions. So it's additional savings.

22:56 And do you have an idea of the timing of that or the plans for the timing in the back half of the year?

23:02 By the end of the year.

23:05 Okay. Any idea if it's going to be more weighted for the savings coming in in the third quarter or the fourth quarter?

23:18 The accounting has changed over the years. but it's more, you're right, there'll be more in the third quarter will accrue in the bottom line.

23:30 Got it. Okay, great. And then as for the, you know, you mentioned that you're already starting to work down the excess liquidity levels. Right. Is that, to our understanding, is that The non-interest-bearing deposits are coming down as well as customers utilize the PPP funds?

23:55 No, it's not the non-interest-bearing balances. Those have remained pretty constant. And that's really good news because they went up with the PPP program. And even as the PPP funds are being used, our non-interest-bearing demand balances are staying higher. So that's good news for profitability and the margin. In terms of liquidity coming off, we have the PPP borrowings. We'll save 35, 40 basis points on the liability side. If you're trying to calculate this, we're getting nine basis points and we're paying 35 basis points on it. So there's a negative spread.

24:38 Okay. That helps. Do you see the cash over the next... Two to three quarters coming back down to kind of that $135

24:50 million. I was going to say $150, but $135 is fine too. Okay, great.

24:58 And how are you guys assuming the trajectory for the PPP loan forgiveness?

25:06 Well, we are estimating on average a nine-month time frame. will reassess on October 1st for the fourth quarter. But right now we're amortizing it over a nine-month life, which results in a yield on the portfolio in the low fives.

25:28 Okay, great. And just last question, as for the – I know it hasn't been an issue in a while – But as for the remaining taxi portfolio, has anything changed with the pandemic in how you guys are looking at that portfolio?

25:52 Well, quantitatively, we have it valued at $150,000 a medallion. We understand there's some pressure on it now. We just don't know for sure. The valuation is based on the long-term outlook and not necessarily the short-term of the pandemic. So that's where we are right now. And I'm going to just say that. Any qualitative thoughts, Frank, on the prospect of the industry?

26:22 Yeah, I mean, it's just hard to determine what's ultimately going to happen there. The city is really operating at... 20 or 30% of its ultimate capacity in all forms of business there. So, you know, it's really hard. All forms of transportation in the city are, you know, negatively impacted right now. You know, the transportation network companies are down, you know, 70% or so. Guys are, you know, afraid to drive. The unemployment benefits are impacting. People not going to drive. They'd rather stay home and collect the extra $600. So until this pandemic sort of makes its way through, it's going to be really hard to determine what's happening. One of the encouraging things that we have seen in the last two weeks, though, is the number of taxi cabs that are getting onto the road are beginning to increase at a fairly steady pace. So we're certainly going to keep our eyes on that and keep well positioned to follow the trends there. But I think it's a little too early to make any determinations.

27:33 Got it. Understood. Appreciate the color. Thanks.

27:38 Okay. Thank you, Chris. This concludes our question and answer session. I would like to turn the conference back over to management for any closing remarks.

27:48 Thank you. Thanks for the questions. We really appreciate everyone taking the time and joining us on our second quarter conference call. We certainly look forward to speaking with you again at our next call. Thank you, everyone, and enjoy the rest of the summer. Conference is now concluded. Thank you for attending today's presentation. You may now disconnect.