CNOB - NASDAQ

Thank you for standing by. At this time, I'd like to welcome everyone to the ConnectOne Bancorp, Inc. Second Quarter 2024 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. I'd now like to turn the call over to Siya Vansia, Chief Brand and Innovation Officer. Please go ahead.

Good morning and welcome to today's conference call to review ConnectOne's results for the second quarter of 2024 and to update you on recent developments. On today's call will be Frank Sorrentino, Chairman and Chief Executive Officer; and Bill Burns, Senior Executive Vice President and Chief Financial Officer. I'd also like to caution you that we may make forward-looking statements during today's conference call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from expectations are detailed in our SEC filings. The forward-looking statements included in this conference call are only 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 8-K with the SEC and may also be accessed through the company's website. I will now turn the call over to Frank Sorrentino. Frank, please go ahead.

Thank you, Siya. We appreciate everyone joining us this morning. Navigating through the second quarter of 2024 with our commitment to playing offense, we delivered on our stated objectives. Supporting our clients remain the top priority for ConnectOne. As I've often reiterated, our relationship banking business model has allowed us to strengthen and expand our client base, enter new markets and grow across various sectors. This disciplined philosophy also played a role expediting the exiting of non-relationship business in the first half of this year. Reflecting this commitment, ConnectOne's second quarter results were solid, and we believe we are in the early stages of an upswing. This position is further bolstered by the tailwinds forming in our industry, which includes the expectation for lower short-term rates, combined with improved market liquidity and recent cyclical rotation into regional banking. With that said, let's take a closer look at our recent operating performance. Driven by the efforts of our team and our dedication to the objectives we outlined at the start of the year, we're seeing continued deposit growth from both existing clients as well as through the continued onboarding of new clients across New York, New Jersey and our Florida markets. We're optimistic that this trend will continue throughout the remainder of the year. Bill will walk us through some additional details in a few minutes. I'd like to note that while reported deposits remained flat, client deposits increased while brokered deposits decreased. Turning to lending. Quarterly origination levels are continuing at an annualized run rate in excess of $1 billion with C&I accounting for nearly half of that production. Notwithstanding the strong origination volume, our loan portfolio decreased sequentially, reflecting higher-than-usual pay-downs and payoffs. This was driven by our strategy to actively manage non-relationship loans off our balance sheet and is intended to not only improve our loan-to-deposit ratio, but also enhance our loan mix. Our credit metrics remain healthy. And for the quarter, nonaccrual loans declined while our criticized and classified loans as well as our delinquencies remained quite low. Next, during the quarter, we saw an increase in our net interest margin, which widened by eight basis points sequentially. And looking ahead, we expect continued net interest margin expansion. And Bill, of course, will cover this in more detail. We continued momentum in driving sources of noninterest income and seeing improvements in a number of areas, including both BoeFly and our SBA platform. In addition, we also foresee potential future fee income opportunities through our lending platform. We expect this momentum to continue as we invest in each of these areas. As of June 30th of 2024, our capital and our tangible book value per share increased once again continuing to build capital flexibility along with a fortified balance sheet. Additionally, we declared a quarterly cash dividend of $0.18 a share that will be paid in early September. And with a common dividend payout ratio currently below 40%, we believe ConnectOne's dividend remains well positioned. So in summary, we remain deliberate and methodical in our approach to navigating through a challenging time, all while remaining committed to our clients. Our discipline is paying off, and we believe we are just beginning to see those benefits. I'll now turn it over to Bill, who will give us a little more depth and some color on our results.

Great. Thanks, Frank. Good morning to everyone on the call. As Frank just mentioned, we believe we are in the beginning stages of a return to our historical profitability levels and metrics. And you may remember on last year's call, I made several opening statements. I'm happy to report that all of them are on track. First item I stated last quarter was that the margin had stabilized, and that we projected a wider net interest margin going forward, and that turned out to be true. Our margin improved by eight basis points. Second, we emphasized a balance sheet focus on relationship based business. We executed on that in the current quarter, helping to improve the net interest margin, lower our loan-to-deposit ratio, which declined to less than 108% from 111% at year-end, and it also improved our CRE concentration ratio. Third, we focused on capital and asset quality. Our capital ratios and tangible book value per share increased once again. Nonaccruals declined, reserve coverage increased and other credit quality measures remain in historically strong positions. And fourth, I will emphasize again that although we are just below the $10 billion asset threshold, we have already crossed that bridge from a regulatory oversight perspective. The actual crossing of $10 billion in assets, which we forecast to happen middle of next year, will have a little impact on the bank. Let me now dive a little deeper into the margin performance and outlook. I'm going to start with the liability side of the equation. Average noninterest-bearing demand deposits were roughly flat, while the additional liquidity provided by client deposit growth and a lower loan portfolio was used to pay down upwards of $175 million of Federal Home Loan Bank borrowings. Those actions reduced our cost of non-deposit funding by approximately 50 basis points. So although we did experience some increase in our total cost of deposits, that increase was offset by the benefit realized from the wholesale paydowns, resulting in flat funding costs versus the sequential quarter. And further, with the strong client deposit growth, we lowered our broker deposits outstanding by about $70 million. Meanwhile, on the asset side, the rate earned on our loans increased by nine basis points. Now about half that increase resulted from the collection of back interest and yield related fees, but our loan portfolio yield continues to increase. Let's turn to the outlook for our net interest margin. Going forward, and without any consideration whatsoever to Fed rate cuts, we project a similar trajectory to this quarter with the net interest margin widening a few basis points per quarter. And that's because the portfolio yield will tend to increase faster than our deposit costs. On top of that, as we've guided before, there should probably be another five basis points of improvement for each Fed rate cut, the first of which is expected in September. So taking those numbers, those projections out to the end of 2025, our margin could easily surpass 3% or probably on a core basis in the high 2.68, 2.69 and would likely result in pretax pre-provision return on assets ranging near or above 1.5% and returns on tangible common equity back into double-digits. Switching now to loan portfolio value. The loan portfolio was down a little bit this quarter, but our estimate for the rest of '24 calls for a slow portfolio growth, I'd say, in the 1% to 2% range. And that reflects about $1 billion or more of annualized originations, offset by payoffs and paydowns. Going forward, the level of loan paydowns are likely to normalize from the elevated level we experienced in the second quarter, the net result being slight gain and slow growth in the loan portfolio. Turning to noninterest income. It was a strong quarter. That was buoyed by a gain on the sale of one large non-relationship loan. So for the quarter, gains on sale were a bit elevated, but we still see growth in our SBA lending platform, and BoeFly has been building momentum on its core fee income as well as being a feeder for the SBA gains on sale. In terms of operating expense, we did guide in the last call to being up about 1.5%. We were up 1.4% sequentially. And that continues to be the run rate we're currently experiencing and expecting. Capital ratios, they increased across the board, led by the holding company tangible common equity ratio that increased by 21 basis points to 9.46%, reflecting retained earnings and effective management and hedging of our securities portfolio. Meanwhile, the bank leverage ratio increased to 11.3%, very, very strong in our view. Stock repurchases for the quarter were subdued, but we expect to complete our current share repurchase program of approximately 640,000 shares by the end of this year. And even with the higher current market pricing, we believe it to be attractive to continue the stock repurchase program. Asset quality remains sound. Nonaccrual loans declined for the third consecutive quarter, while allowance coverage increased, albeit slightly. Our CECL provisioning for the quarter took into account several items, including charge-offs, a decline in loan balances, improving Moody's economic forecast, and lastly, I would say, an increase in qualitative factors to take into account increased risks that are not inherent in the CECL model, and that facilitated an increase in overall reserve coverage. We continue to track and monitor repricing stress on the portfolio and credit quality there remains sound. There certainly could be select credits that come under stress from time to time, not to be unexpected, but our team has done a stellar job managing the portfolio and we don't expect any significant issues. The effective tax rate was just a tad under 26% for the quarter, that rate could increase slightly, especially if we see strong momentum in pretax revenue growth. In summary, we're pleased with the quarter's results. We see improved performance ahead resulting from a number of factors. First, margin improvement, slow and prudent relationship-based loan growth, noninterest income growth and continued operating efficiency as we leverage our platform. We'll also continue our focus on increasing client deposits, a lower loan-to-deposit ratio and a continued trend towards lower CRE concentration. So I'm going to turn it back over to Frank for closing comments and we will be happy to open up the lines for questions. Frank?

Thanks, Bill. In summary, I'm pleased with ConnectOne's performance over the second quarter. We started the year committed to a few key objectives. First, the focus on core relationships; second, expand our C&I initiatives; and third, invest in opportunities to drive noninterest income. I'm proud of our team for remaining dedicated to these objectives and that disciplined approach positions us to capitalize on the upswing. We believe this upswing will continue as we look ahead and we will be further bolstered by the changing interest rate environment, the investments we've made in new markets, including the expansion in Long Island as well as the continued momentum of team members we've onboarded over the past few quarters. We're moving into the second half of the year well positioned and prepared to consistently execute on our long-term objectives. As always, we appreciate your interest in ConnectOne, and thanks again for joining us today. Operator, would you now open the line for questions?

[Operator Instructions] Your first question comes from the line of Tim Switzer with KBW. Your line is open.

Hey, good morning. Thank you for taking my question.

Good morning.

Hey, Tim.

Yes. I was wondering, have you guys had an opportunity yet, you maybe discussed this a little bit last quarter, but kind of selectively lower deposit rates in certain categories or certain markets or promo rates. What's the customer response you've seen on that?

Well, it's a great question, and we certainly are thinking and anticipating the ability to lower rates and that will help us as it will help other banks. We are going to be careful as we always have before and manage client expectations and maintain our strong client base. So I'd say it's a work in progress, but we are paying a lot of focus towards that.

Okay. Great. And I appreciate all the forward.

Tim, let me just add, when rates are actually cut, obviously, there'll be a greater opportunity to lower rates.

Right, right. Okay. And I appreciate all the forward commentary you guys had on the margin and revenue outlook. What about on the expense side? Are there levers you're going to pull and say we don't get the rate cuts we're expecting, revenue doesn't improve quite as much. And then vice versa are there like some investments you guys would like to make if earnings begin to improve here?

Well, there are certain investments we've been making and when those investments are put into place, those expenses start growing. And so we have some of that going forward. And therefore, that's part of my projection for increased expenses as we put new investments into service, if you will. Certainly, we can make adjustments on the level of staff and obviously, incentive compensation accruals. So there is some flexibility into the expenses we report depending on revenue growth. And we've said this in the past, it does, the amount of revenue growth does influence the amount of expenses. And I think that's a good thing, keeps us as an efficient company from a reporting basis.

Awesome. That's all for me. Thank you.

Yes.

Your next question comes from the line of Frank Schiraldi with Piper Sandler. Your line is open.

Good morning.

Hey, Frank.

I wonder if you could just talk a little bit, Bill, about strong customer deposit growth in the quarter. And so any guardrails in terms of expectations around deposit growth in the back half of the year? Is it just that you expect it to exceed loan growth and therefore move loan-to-deposit ratio in the right direction? Or any sort of guardrails you can give around expectations there?

Well, the trend is looking good. Over the past more than one quarter, two or three quarters, I think we've outpaced the market in terms of deposit growth. I think the Fed has eased up a little bit on liquidity as well. So everyone should be seeing some types of deposit growth. So our projections include that level of deposit growth, which is in excess of the guidance that I gave you on loan growth. So things could change, of course. But right now, we're expecting more client deposits than loan growth, leading to lower loan-to-deposit ratios.

Okay. And then I guess the cost of funds maybe looked like it bottomed in the quarter. I mean paydowns and payoffs, you still got some pressure on deposit costs, I would imagine. So could you either talk about your expectation? Just setting aside a potential rate cut of either what the blended rate of deposits coming out in the quarter was or just what you anticipate maybe in terms of basis points, you could continue to see on the deposit cost side.

Well, on the non-deposit funding, we obviously had a dramatic improvement there. I would expect some more of that but not the same magnitude. Same token on the increase in deposit side, that's slowing down. But I'm just being conservative here, and I don't want to say for sure right now that deposit costs will not go up, but it is slight. So overall I feel confident that the rate on our assets will improve at a greater rate than the cost of total funding.

Okay. And then if I could, just lastly, on the 1% to 2% loan growth, I guess that it provides room for continued paydowns and payoffs and continued reduction in CRE balances, I guess, in the near term. Any sort of specifics on goals or expectations of where the CRE concentration levels could trend to over the next several quarters?

Listen, we see a declining trend, but not a seismatic shift overnight. But we do believe it's prudent to continue to show lower levels of CRE concentration.

The business model just provides for that.

It provides that right.

Our emphasis on C&I lending and the types of businesses that we're looking at is both being reflected in that increase in deposits as well as that trend. There's no hard line in the sand that we feel we have to get to, but we just believe over time, having a lower CRE concentration is just healthy for the bank and provides for the types of business that provide the types of deposits we want and the client relationships we want. So it all sort of works hand-in-hand.

It's sort of been a focus, right? Investor community feels is a focus from regulatory agencies to force lower CRE concentration. We've always had a high CRE concentration. We're not feeling a ton of that pressure, but we recognize that the investor community looks at it that way. So in general we like to see directionally a change in that ratio that being lower.

Okay. All right. Great. Thanks for all the color.

Thanks, Frank.

[Operator Instructions] Our next question comes from the line of Daniel Tamayo with Raymond James. Your line is open.

Thank you. Good morning, guys.

Good morning, Daniel.

Good morning, Daniel.

So just not to be a dead horse here, but just a clarification on the NIM guidance. Are you assuming further wholesale reductions like kind of a rotation from FHLB into deposits in that guidance or is that it depend on loan growth like how do you think that plays out in terms of balance sheet mix?

Well, a little bit more. There were some significant declines in the Federal Home Loan Bank borrowing lines. Keep in mind that there are some timing issues here. We may have excess liquidity, but those Federal Home Loan banks have not matured quite yet. So in the short term, it's hard to say exactly what the benefit is going to be. But over the longer term, we'd like to see more deposits, more client deposits, less broker and less wholesale funding. Having a slow loan growth in the 1% to 2% range helps with regard to those items.

Okay. So maybe a longer-term trend of reducing it, but not anything near term, that would be.

One part of me is extremely optimistic. When you look at our balance sheet, there's a lot of reasons to believe we're going to have expanding margins. But I want to be conservative here because we just don't know how competition is going to react. And at the end of the day, clients come first. So we're going to make sure that we use whatever flexibility we have to maintain client relationships.

Understood. And then I guess on capital, so you talked about continuing buybacks in the back half of the year. You've got the authorization there. How should we think about what the right level of capital is for you? Obviously, the TCE is strong, the total risk base is strong. But I mean, is there a ratio that is the most important to you, is that changing, people are talking more about the total now? How should we think about what the right level of capital is into the future as capital grows and things improve for the business?

I try to avoid giving specific guidance as to what the right capital level is. First off, I'm a big believer in tangible common equity is the most important at all the company is the most important capital ratio to look at. However, there's lots of other ones with guidance limits, well-capitalized levels, capital cushions, and we try to manage that stack in such a way that they all have similar cushions. But going forward, we feel really comfortable with the position we're in. And if need be, if we needed to leverage our capital, we have the ability to do so in a moderate way. I don't see our 9.5% TCE ratio going down to 8.5% very soon. But if it dropped 20 or 30 basis points because of some opportunity or potentially some acquisition, that would be a good thing, and that would be fine.

Got it. All right. And then maybe just switching gears here. There was a little bit of an increase in classified loans, it looks like up to 150 of loans. Just curious if you could provide any detail on what drove that?

Yes. Got to keep in mind that 150 is at a historically low level. It just was at like the best level ever beforehand. So don't view it as that specific change did not lead to the real potential for additional charges, okay? It's still is a low level.

Yes. Okay. So it's still kind of normalization happening.

Yes, I would say so.

All right. Thanks for all the color. Appreciate it.

All right.

Our next question comes from the line of Matt Breese with Stephens. Your line is open.

Hey, good morning.

Okay. Not last. Last but not least.

I'll take that as a compliment. I was hoping to dive into the NIM a little bit. Bill, could you provide what the percentage of pure floating rate loans today are on the balance sheet? What's the yield on those? I'm trying to get a sense for, on the opposite side, what fixed rate looks like and what fixed rate loan yields are?

Yeah, I know you're trying to figure out what our margin is going forward. It's relatively low the pure floating at 20% of the loans and it has a handle right now of about 9%. We also have adjustable rate loans and those will continue to price upward over time. It's something like another 10% in the next year or so followed by 10 plus percent more in '26 and '27. So we're a liability-sensitive company and we'll benefit from lower rates as our lots of our deposits or funding will decline in value. And over time, we will see even with rate cuts, we should see increases in the yield on our loan portfolio. So if you look out and everything looks perfect, we could be in a really good spot in 1.5 years, 2 years, 3.50 or above in margin. I temper that in that we don't know for sure what the rate curve is going to look like. We don't know for sure what competition is going to be like. But we're going to stick to what we do best, and that is a disciplined approach to loan originations. The pricing must be relevant and must surpass our risk-adjusted return hurdles and banks that put on loans at low spreads get burnt, and that's not us.

Understood. And where you are putting on commercial real estate loans? What are new loan yields versus what's rolling off and?

8%, 7%. What would you say, Steve? 7% to 8%. It fluctuates depending on what deals we do.

And roll off in the low 5s or 4s?

Yes, about that. Now there's less turnover than there was a couple of years ago. So it has an effect but lower effect than it once did.

Okay. And then I guess the same set of questions on the liability side. What is the duration of borrowings and CDs at this point? And are you starting to price CDs a little bit lower than where they were at their peak?

We're just in the beginning stages of being more aggressive on CD repricing. The benefit is slight because, right, a lot of the rates that are on our books now are already on a high level. But we're starting to, I want to say, play around with lowering rates, being careful not to lose deposit balances. But it's worked in our favor before to be ahead of the curve. If rates are going to be cut in September, we don't really need to wait till that date. We can implement that a month before, which is coming up pretty soon.

Okay. Two other quick ones. The first one is just the fee income picked up quite a bit this quarter, especially in the other income areas. What drove that? And how sustainable is it?

Right. So like I mentioned in the call, we did have, there was one fairly large loan that was a non-relationship loan that we were able to sell for a gain, and we made a decision, it was a good idea to get off the balance sheet and book that gain. So the gains on sale were elevated for the quarter. But having said that, underlying in the SBA piece, I'm looking for $500,000 or more next quarter and continue to build that. Part of that build comes from boots on the ground, but also BoeFly, which can add another $200,000 to $300,000 per quarter in gains.

So would it be fair to run other income and call it $1 million range per quarter?

I'm looking at our financial statement. What was the total quarterly noninterest income? This quarter?

Total was $4,399 million and other income was $1,277 million.

Right. Yes, I would say, the net gain on sale of loan -- sales should be a little bit lower going forward, but the deposit loan and other income could be up a little as well as the BOLI as we are in the process of restructuring some of that. So probably a little bit down from the June quarter, but up from the quarter before.

Okay. And then you have $75 million of subdebt reaching its call date next year. The step-up is going to be pretty significant in cost. I just want to be curious what your plans for that are? Is there going to be a kind of a preemptive subdebt raise? Or are you going to just let it roll into its floating period?

We're thinking about it. We're watching it and we'll have to figure out what is the best thing to do when the time comes.

Okay. I will leave it there. Thank you for taking all my questions.

Okay. Thanks, Matt.

Thank you. I'll now turn the call back over to management for closing remarks.

Well, thank you, everyone. We thank you again for your time today and we look forward to speaking with you again during the third quarter conference call in a few months. Everybody, enjoy your summer and have a great day.