Joe Calabrese - Financial Relations Board Frank Sorrentino - Chairman and CEO Bill Burns - CFO.

Matthew Breese - Piper Jaffray William Wallace - Raymond James Collyn Gilbert - KBW.

Good day, and welcome to the ConnectOne Bancorp Incorporated First Quarter 2018 Earnings Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Joe Calabrese with the Financial Relations Board. Please go ahead, sir..

Thanks, Todd. Good morning. And welcome to today’s conference call to review ConnectOne’s results for the first quarter of 2018, and to update you on recent developments. On today’s conference call will be Frank Sorrentino, Chairman and Chief Executive Officer; and Bill Burns, 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. These risk factors are more fully discussed in the Company’s filings with the SEC.

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 of schedules, which have been filed on Form 8-K with the SEC on April 26, 2018, and may also be accessed through the Company’s website at ir.connectonebank.com.

Each listener is encouraged to review those reconciliations provided in the earnings release together with all other information provided in release. I will now turn the call over to Frank Sorrentino. Frank, please go ahead..

Thanks, Joe, and good morning. Thank you for participating in today’s conference call. So, while we’re pleased with our continued progress of our disciplined growth strategy, the first quarter of 2018 included a number of items detracting from our underlying core earnings strength. So, let me start by addressing those issues.

First, of course the taxi medallion portfolio. The Company took a significant charge reflecting the combination of lower transfer values, rising interest rates, and continued low lease rates effecting our valuation. While we’re disappointed with this write-down, it does get us to or at least close to the bottom of the valuation.

Second, we had a slower than expected deposit growth, some of which was seasonal that weighed on a number of our metrics including our net interest margin. And third, we have number of future facing initiatives that are temporarily impacting some of the current metrics including our margin and efficiency.

However, we expect these initiatives to pay dividends in the future as we continue to proactively transition the Company to enhance our banking relationships, strategically expand our footprint as well as face some of the evolving needs in the industry.

So, cutting through the noise, on an operating basis, we delivered an adjusted return on average assets in excess of 1.35 and an adjusted return on tangible common equity in excess of 16%. We also continued to maintain strong balance sheet. And although seasonally a slow quarter for ConnectOne, had solid 15% loan growth on an average basis.

We’re achieving progress in deposit gathering within our internet channel, driven by additional online marketing and increasing interest by our clients.

While this is still in start-up mode, we continue to strongly believe that banks will require more confidence in this area in the future, and it will also provide a platform to build deposits profitably and grow client relationships. From a lending perspective, we continue to have solid growth in a number of our key competencies.

We continue to see expansion of our C&I client relationships and are realizing solid momentum with a focus on certain areas including our independent schools and law offices. C&I remains very attractive for ConnectOne as this business channel offers attractive loan rates combined with deposit generation potential.

Our disciplined approach in construction lending provides a stable pipeline of new opportunities from existing clients. And we view our multifamily portfolio as a business line, complete with deposit relationships and banking service needs.

While the loan pipeline has slowed a bit, we still see attractive opportunities to service this area of the market and our clients continue to show willingness to pay a bit more for the service we provide. We also made progress in reducing our CRE concentration, down to 509% from 568 at the year-end of 2017.

While a significant portion of this progress came from the subordinated debt issuance in January, our aim is to further reduce the concentration over time, in a number of ways including additional C&I origination, residential originations, and as we’ve accomplished before, loan sales of non-relationship assets along with higher capital accretion levels.

Additionally, credit quality remained relatively stable during the first quarter outside of taxi. Regarding the operating environment during the quarter, it was an extremely competitive marketplace, both on the deposit side and on the loan side.

So, our core net interest margin contracted a bit more than we expected for a number of reasons that Bill will get into in detail later. To support our future growth, we remain committed to investing in our infrastructure and adding additional team members.

Specific to the infrastructure investments, we completed the first phase of our Encino platform rollout, which included digitizing the entire loan process, everything from document management to approvals to collaboration. This initiative enhances our sense of urgency culture, an element that has been our competitive advantage.

This allows us to continue our efficient operating model while utilizing technologies to improve any existing inefficiencies caused by manual processes and offers a robust data management and gathering solution. The second phase of our Encino rollout is now under way, which includes the addition of the deposit origination platform.

We also remain on track with our planned expansion into new markets within the New York City region where we believe our business model resonates. Our new office center in Melville, Long Island is now opened and has already exceeded our expectations.

We’re planning to expand our New York City office later this year and will accommodate additional staff and the growing importance of this location. And we’re planning to further expand our geographic footprint by opening a new office center in Astoria, Queens in the second half of ‘18.

Additionally, we continue to expand the knowledge base of the Company by adding talent to our team. Key staff hires this quarter included experienced loan officers and deposit gatherers.

In summary, the decisions we’re making, position us to continue our prudent growth strategy, enhance our competitive position and create long-term value for our shareholders. So, at this time, I would ask Bill Burns, our Chief Financial Officer, to review the details of our first quarter financial performance.

Bill?.

So, thank you, Frank. Let me start off with taxi. We took a $17 million pretax charge this quarter; it brings our exposure down to de minimis levels. Total carrying value is now just $29 million out of our $4 billion plus loan portfolio.

And valuation for medallion is now down to $216,000, reflecting our New York -- our overall New York City medallion portfolio, 95% of which are so called corporate and the expected cash return is more than 7% on our new carrying value. Loans will remain on non-accrual and will continue to apply all payments principal going forward.

As most of our investors are aware, over the course of the past few years, we’ve tried to be as conservative as we can within what is proper from the accounting standpoint. Our valuation has utilized the consistent approach, we’ve relied on TLC reported transfers as well as our in-house cash flow model.

What changed this quarter and what has led to the large charge is the number of transactions being reported, as well as the lower valuation of those transfers. With these two factors, we can now rely more on recent transfer values and therefore rely less on an assumption-driven cash flow analysis.

Our intent at the present time is to hold the loans and portfolio as they continue to cash flow well that could change in the future, but there’s nothing currently on the table. And although I can’t guarantee there would never be another charge here, if there were any charges, I do believe it will be very small.

Excluding the taxi charge now, our operating performance for the quarter reached record levels, reflecting return on tangible common equity that surpassed 16%.

We are of course aware that some of the improved performance is attributable to lower corporate tax rate, but given what is typically a more challenging quarter, the first quarter for ConnectOne, we’re pleased with these very strong results, reflecting continued growth, sound asset quality apart from taxi, a healthy albeit lower net interest margin, and operating efficiency that is among the best in the industry.

My expectation is that barring anything unforeseen, we are poised to improve on these results for the remainder of 2018, obviously on a GAAP basis, but on an operating basis as well. Let me next tackle the net interest margin, which was a bit noisy for the quarter.

Our NIM for the quarter contracted to about 3.25, and most of that contraction resulted from items that we anticipated and disclosed a quarter-ago. The expected variables included first purchase accounting, we always disclosed the benefits of purchase accounting and take them out of our core NIM metrics.

Purchase accounting contributed 7 basis points of the compression sequentially. Second, we issued a relatively large amount of sub debt, $75 million just a few months ago in January. The cost was approximately 5.25, slightly lengthened our funding sources and impacted our margin by about 5 basis points.

Third was the taxable equivalent adjustment and that contributed another 4 basis points. Not anticipated was a negative variance in yield related fees on loans, which include prepay fees as well as fees on lines of credit. These items fluctuate quite a bit from quarter-to-quarter and a sequential comparison contributed 6 basis points on contraction.

And then, I’ll tell you, as a growth Company, we were probably more negatively impacted than most from narrowing spreads. In other words, the marginal cost of funding increased at a greater rate than market yields on new business and we calculate that this impacted our margin by about three additional basis points.

So, digging a little bit further to our margin, we were hurt by deposit growth lagging loan growth. But, our beta on interest-bearing accounts was below 25% and the average coupon on our loan portfolio rose by about 7 basis points for the quarter, both of these were in line with our expectation.

And looking at the loan to deposit ratio, it’s a ratio that gets a lot of investor focus, not so much regulatory focus but an investor focus. It increased to 113% at quarter end. We are comfortable at this higher level but our goal remains to be at or near 110%.

Going forward, we are hopeful that spreads in new business will expand, and there are some indications that this already happening. However, should conditions persist, our core net interest margin could contract a point or two quarterly. I think, some of those non-recurring items can work to our advantage a little bit in the next quarter or two.

Let’s turn to the efficiency ratio, which rose sequentially from about 40% to 42.5% for the first quarter. Let me state emphatically, we remain an extremely efficient bank. Although up sequentially, the ratio was improved from 44% a year ago and this is always a little bit higher, this ratio for us in the first quarter.

We continue to leverage technology and rely on a branch wide model to drive economies of scale. We remain committed to investing in staff and technology and to geographic expansion, yet we still target revenue growth to exceed expense growth. This in our view will lead to an improving efficiency ratio on a year-over-year basis.

Wanted to mention the effective tax rate. I previously guided all of you to a 22% rate. I am revising that guidance to 21% and that’s based on a revaluation of companywide sources of income. So, for 2018, we expect to be at 21%; that’s exclusive of any equity based compensation tax benefits.

So, to sum up, our operating performance continues to be outstanding with ROA of nearly 1.40 and return on intangible common equity surpassing 16% with an expectation these returns will improve over the course of 2018. We lowered our CRE concentration by 60 percentage points and remain committed to managing our CRE to lower levels.

We raised our total risk-based capital ratio by 170 basis points to 12.64, further supporting future growth. The taxi medallion portfolio has now been written down to a near bottom valuation with cash flow estimated to be 7% or 8% on a carrying value on a go forward basis. Our loan to deposit growth outlook remains positive in the 10%, 15% range.

And one last point, while we have recently experienced a little bit of margin compression, we think it’s important to note that ConnectOne can drive superior returns that’s ROE into the high teens with a margin in the 3.25 range. And with that, I will turn the call back over to Frank..

Well, thanks, Bill. I just had a few closing remarks before we turn the conference call over to your questions. It was clearly a challenging quarter. As we assess our first quarter financial performance, we are certainly not pleased with the taxi medallion charge or the unanticipated portion of the margin compression.

Nevertheless though, we are pleased with the groundwork we are laying for the continued success of the business and are confident ConnectOne will deliver strong financial performance as we remain on track to achieve our objectives for 2018 including strong deposit and loan growth.

We are committed to enhancing our desirable franchise by expanding our geographic reach within the New York City metro region by attracting and retaining talent in the deposit and loan origination areas and by investing in technology to generate additional operating scale. We are poised to leverage off these key initiatives.

And leading into the second quarter and the remainder of the year, I am very confident we will succeed through the disciplined execution of our strategies. That concludes our formal remarks, and Bill and I look forward to answering any and all of your questions.

Operator?.

[Operator Instructions] Our first question comes from Matthew Breese with Piper Jaffray..

Good morning, guys..

Good morning, Matt..

Maybe just starting….

Good morning, Matt..

Good morning, Frank.

Just starting with expenses and just wanted to get a sense for what was core in expenses this quarter, what was seasonal, and how we should be thinking about the rest of the year, given some of the investments you are making?.

We’ve been able to keep year-over-year expenses below 10% growth rate. That’s been going on for many, many quarters, while our revenue has been increasing at above 10% clip. So, that’s not a bad place to start to look at where our expense growth is going forward. So, not sequentially but from the prior year..

Okay. I will keep that one in mind. And then, on the margin, I just wanted to get a sense for what you are seeing in terms of competition for deposits. How much more competitive have things gotten over the past 30, 90 days? And then, maybe stepping away from the margin discussion for a second and focusing on net interest income.

From here, what do you think the net interest income growth outlook for the year is like?.

Let me just -- Matt, so, our balance sheet, as it stands today has been acting pretty much the way we thought it would act relative to both the rate increases and what’s going on in the marketplace.

But, as you know, as a growth Company and the fact that we are growing or trying to grow at higher rates, everything that we are putting on at the margin is at the margin. And in that space, things are quite competitive. And so, we are seeing a lot of competition there. Seasonality does play a little bit of a role here.

The first quarter is always difficult for us in the various niches that we have and historically you will always see that. We generally start off the year quite slow. A lot of the businesses from a seasonal perspective move, deviate balances out right after the beginning of the year. And so, those things impacted the margin numbers.

We expect as the year goes on, we’re getting the benefit those rising rates on the asset side, and we should we able to combat the rising rates on the deposit side..

Okay. And then, on the loan growth outlook, it sounds like 10% to 15% is still intact.

Could you give us some sense of the pipeline today and characterize what we saw during the quarter? How much of that was driven by a pull forward in last year’s numbers versus really any sort of any stalling in growth for the year?.

Again, I think if you look historically at the Company over the last couple of years actually, you would see that we generally get a big year-end crush to do a lot of business typically for tax reasons our borrowers; balance sheets. This year was no exception for that.

We saw a lot of -- or very strong growth in the fourth quarter that typically moderates going into the first quarter. And then, generally, picks up steam as time goes on. So, I will tell you that I still feel confident about the guidance that we’re giving here about strong loan and deposit growth, going forward in 2018.

We are and we have said for the last couple of quarters that we’re seeing slower demand in the multi-family space. That’s not making us unhappy at this moment. We’re making that up in other places. And we’re being much more focused in what we are doing in that particular bucket of loans. .

Thank you. Our next question comes from William Wallace with Raymond James..

Thinking about the loans fees, what did they add to margin in the first quarter, what were the loan fees in the first quarter?.

So, the loan fees added about 15 basis points, they always add a lot, in the fourth quarter and 12 basis points in the first quarter. And prepayments fees went from 9 to 6. So, that’s a total drop of 6 basis points in those two areas..

If you look over the course of the year, is there may be like an average contribution that you get from the loan fees and the prepayments?.

Yes, there is. And I don’t have the number in front of me, but it was low in the first quarter..

Okay. So, obviously, it’s hard to predict, but all else equal….

Hard to predict but -- right..

…bounce back..

Right. Yes. That’s what I was saying that it was below the run-rate. And the fourth quarter is probably little bit above the run rate..

Okay. And then, in your commentary, Bill, you mentioned you could still see kind of taking out the noise around the loan fees and prepayments, 1 to 2 basis points of pressure on the margin.

Does that consider what you’re seeing in April or were you saying that if the environment worsens from what we saw curve-wise in the first quarter? In another words, what you are seeing today or through April, could that 1 to 2 basis points pressure be flat?.

Do you mean flat at 1 to 2 basis points or go back….

No.

In other words, because your margin will be flat if what you’re seeing quarter-to-date holds through for the rest of the quarter, outside of the noise around prepayments and loan fees, stripping all that out?.

Right now, I’m looking at 1 to 2 basis points of core compression. It really depends on what’s going out with market rates on loans. We’ve talked about this before about the beta on loans. And there has been a lag in re-pricing of loans. And that’s been impacting the new business that we’re putting on.

And as I mentioned in the call, companies that are growing are going to be impacted by that more than companies that are not growing..

Right, right exactly. Okay. And then….

And I want to add from an analytical perspective, we grew 15% in the first quarter. It’s not really, I know your model is based on what the month-end balance is, the yearend balance to today, but the margin is impacted by the average balance. And that was 15% growth in loans in the first quarter versus the fourth quarter, annually..

Right. So, did you see the loan production picking up pretty strongly in March, coming into the second quarter? Because the spot rate was less than 1%..

I’m not sure, what was the question..

Yes. So I do think that a lot of loan growth came late in the quarter. And we still see a very strong and pretty much consistent pipeline going forward for the rest of the year..

Yes. Okay, perfect. And then, my last question, on the efficiency, in the prepared remarks, you talked about an improvement year-over-year, still in the efficiency ratio. If I look at what you did in the fourth quarter, the way I calculate it was about 40%.

Do you think you could drive efficiency better than what we saw in the fourth quarter on an annual basis, maybe not this year but just in general do you think you can beat that based on your current….

I think, my best guess is to look at last year’s second quarter, and I think we can improve on that. You’ll see every year we get better each quarter, but it pops up in the first quarter. And this year, it popped up to 42.5% versus 44%, last year’s first quarter..

Okay. Thanks, gentlemen. I appreciate it..

If I just could one thing to that. So, while we certainly could and we certainly would want to, part of our strategy is also to look at how much investment we should make over time back into the Company around infrastructure, around some of the initiatives that we’re putting in which will pay even larger dividends in the future.

So, we could clearly get our efficiency ratio significantly lower from where it is today. But, that would mean, cutting our ability to spend for new infrastructure for the future. And so, we’re constantly weighing those decisions over time.

I think we’ve said in the past that we believe around the very high 30s, low 40s is the range in which we feel we should be operating at this moment in time, which provides the ability for us to invest in all those future looking and forward-looking infrastructure builds..

[Operator Instructions] We’ll take our next question from Collyn Gilbert with KBW..

Just following up on the discussion around the NIM, which realizing that it’s -- there is lumpy, there is some variability to that. More broadly though, Bill, how are you thinking about net interest income growth? I mean, I know obviously it fell this quarter.

I mean, I presume that that’s not going to be -- you are not anticipating declines going forward..

No..

Okay..

I think you’ve got project -- well, you’ve got to project loan growth and then whether or not you have any margin compression in there. That’s how you’re going to have to model it. .

Right, right.

But you’re anticipating as you kind of look at the broader balance sheet, like you will find a way to continue to grow net interest income growth, like that’s going to be a strategic objective?.

Absolutely and that’s going to drive our ROA and ROE up from the current 140, 16.5 or so up to a higher level..

Okay. And then….

And a lower efficiency ratio. Yes. .

Yes, okay. And so, Frank I think you had said it, maybe Bill you said it. But the fact that 3.25 margin still allows you all to generate a high return on….

Yes. .

Yes, okay. What are the drivers of that I guess, like what’s -- I mean because there is not a lot of -- you don’t have the leverage on the fee side. I am just trying to sort of think about. And this is again a little bit of a broader strategic question, right.

But so you guys are a growth company, the realization is that growth is being added at a marginally lower rate.

And I am just trying to understand where the levers are within the business model that really give you the confidence to get to that still maintain that high ROE business?.

Well, we’re going to improve from where we are now is by having a revenue increase really at a greater rate than the expense growth rate and our projections still show that. So, yes, there is going to be growth from increase in the loan portfolio, small increases in the securities portfolio.

And if there is margin compression that would take a little bit away from that revenue growth; we have loan sales in the past in the fourth quarter, we plan for some of those work going throughout the year. The tax rate is a little bit lower right now. And I am looking at it’s going to drive ROE into the high teens..

Okay, okay. All right. That’s helpful. And then just back to the loan pipeline.

What -- do you have what the composition of the pipeline is in terms of between among CRE, multi, C&I?.

Yes. So, it’s continued trends of what we have been seeing in the past few quarters, which is a de-emphasis on multifamily. And so we’ll continue to see growth in the -- a greater growth in commercial than you will in CRE. And that’s going to lead to lower CRE concentration metrics..

Okay..

As well as returns. Yes. .

Okay.

And do you have realized rates that are going to vary among loan tightness but the blended pipeline yield, loan yield?.

So, in the most recent quarter, the loan coupon was 475. .

Okay. That’s helpful. And then -- go ahead..

No. I am sure in the pipeline because it’s hard to say because its timing of when loans are going to close. So….

Okay. I guess, let me ask it differently.

Yes, go ahead..

Just to reflect any improvement in loan pricing, given the rate pickup in the last quarter, are you seeing your loan origination yields higher than you were in the fourth quarter? And if so, roughly how much higher?.

Well, I think that’s a good question, Collyn. We are seeing increases in the loan rates that we are booking as well as the pipeline. I think, the issue has been that hasn’t gone up as fast as it should, right? We talk about beta on loans. So that’s what’s impacting some of the results. I don’t think it’s overly significant.

It’s a couple of basis points of margin compression. And obviously, we are going to be mindful of that as we go forward deciding think what loans we’re going to book, not book, what our growth rate is going to be. .

Okay. And then, I guess as part two of that question is just trying to reconcile, you guys aren’t the only ones, right. So, I’d be mindful of. But the asset sensitivity, right, you’ve spoken about asset sensitivity. And I think what we are seeing, and I know that it’s a static analysis and quite frankly the disclosures we are finding are totally bogus.

But, even so, I think as you’ve described the balance sheet, you yourself have described as somewhat asset sensitive. So, just trying to reconcile that you are not -- you don’t have that tailwind.

And is it because -- what’s driving the fact that you are not seeing that tailwind?.

So, called beta on the loans is what’s driving the dynamic model..

Okay. So, the competitive pressure is keeping loans not….

Yes. The loans are going on at a lower rate. And of course liability mix affects the margin as well..

And then just one final question. Any thoughts -- let’s just say this environment doesn’t -- the competitiveness doesn’t subside and we are sitting in a similar situation at the end of the year that we are sitting in today.

Is there a point when you think about fee-based businesses or opportunities to sort of enhance that revenue mix a little bit more or do you feel like the efficiency that you get out of the branch network is truly legitimately enough to drive that high ROE?.

I think, we always look at what else we could be doing and how we can provide a better experience for our clients. But, we are always mindful -- we are committed to running in a efficient organization. And we have made certain decisions based on that.

And I think at the end of the day, that’s going to be a better strategy for us than trying to pursue what sometimes we call around here some hobby type businesses relative to us. There are other banks that maybe do these things well.

But, I don’t see right at this moment any business that would significantly contribute what the game plan is here for ConnectOne Bank. By the way, I don’t want to give any one the impression that our model is not functioning. We have a very strong pipeline going forward for the rest of the year.

We not only have clients and loans and deposits but a staff that want to join the Company. We are expanding on market area. We are doing a lot of things right. One quarter’s financial metric moving in a wrong direction doesn’t completely change the business model here.

And we think, we’ll be sitting in a better position as the year goes on as most years work. First quarter is generally the weakest. Yes, with the flux in how interest rates have moved recently, it’s negatively impacted ConnectOne’s business model. We think that will subside as the rest of the year moves on. And we think our plan is intact..

Management, at this time, we have no further questions. I will now turn it back over to you for closing remarks..

Well, thank you. Thanks for joining us on our first quarter earnings call. We appreciate everyone’s interest. We look forward to speaking to you again on our next conference call back in July. Thank you very much..

Thank you. Ladies and gentlemen, this concludes today’s conference. You may now disconnect your phone lines and have a great rest of the day..