ConnectOne Bancorp, Inc. (CNOB) Q4 2022 Earnings Report, Transcript and Summary

Greetings. Welcome to ConnectOne Bancorp Incorporated Fourth Quarter 2022 Earnings Call. At this time, all participants are in listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note, this conference is being recorded. At this time, I will now turn the conference over to Siya Vansia, Chief Brand and Innovation Officer. Siya, you may begin.

Good morning, and welcome to today's conference call to review ConnectOne's results for the fourth quarter of 2022 and to update you on recent developments. On today's conference 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, and good morning, everyone. We appreciate you joining us today. ConnectOne just completed another solid year. We generated high quality earnings, achieved extraordinary organic growth, gained traction in our markets and continue to digitize our infrastructure. As we think about our results, I'd like to emphasize our ongoing commitment to supporting our client's needs. Despite the ups and downs of interest rates or the economy, ConnectOne's client centric business model has continuously -- has continually served us well. And like I've always said, if we do that right and we do things for the right reasons, we can create long-term shareholder value. And so notwithstanding the challenging economic environment, we once again delivered strong financial performance for the quarter. Return on assets exceeded 1.3%, while our return on tangible common equity was nearly 15%. Our PPNR as a percent of assets exceeded 2%, the 10th consecutive quarter that PPNR has been higher than 2%. Tangible book value per share advanced another 4%. Our efficiency ratio again was below 40%. Capital ratios remained strong. And while much of the industry has experienced weakness here, our tangible common equity ratio stands at over 9% at year end. We also capped off a record year for both loan originations and deposits. Our loan portfolio increased over 19% year-over-year, while our deposits grew in excess of 16%, benefiting from the recent investments in our team, infrastructure and the digitization that we've shared over the last few quarters and seeing a healthy diversification in our portfolio. Our originations were spread amongst all segments of our markets, including Southeast Florida and Eastern Long Island with additional synergies driven through BoeFly in both SBA and non-SBA lending verticals. ConnectOne's strong performance in 2022 is a testament to the success of our culture, the technological foundation we've built and our relationship focused origination franchise. That said, it's important to note that despite consistent performance, each quarter has its own set of challenges and opportunities. Like many banks, we had a challenging quarter with respect to net interest margin. The deposit competition significantly increased reflecting the Fed's intensified battle with inflation. In addition to the rapid and significant rise in short term interest rates, quantitative tightening has removed liquidity from the financial markets, even if the economy continues to grow. As a result, by decreasing the money supply, there is an overall decline in deposits within the banking system and this has led to historically fierce competition for interest bearing deposits among both large and small banking institutions. With our loan portfolio -- while our loan portfolio rates are increasing at a nice pace around 50 basis points sequentially, credit spreads for bank loans continue to remain low from a historical perspective. And finally, while the inverted yield curve puts additional, albeit temporary pressure on the NIM, we made the decision to maintain and support our client relationships [indiscernible] main focus on serving our clients, supporting our staff, delivering value to our shareholders and improving and building upon our distinctive operating platform, all while maintaining our results oriented client centric culture. Our business model has performed well across a variety of economic interest rate environment. We always set ourselves apart by making it easier for our clients to do business with us, while empowering them with the latest technology to meet their evolving needs. And we enter 2023 well positioned to build on our strengths and achieve our long-term objectives. Speaking of technology, several of our investments are moving through to implementation and are focused on providing a better experience for our clients, while driving increased productivity and efficiency. Our partnership with MANTL to deploy a new modern omnichannel deposit origination platform is underway and this partnership allows us to expand our reach in supporting commercial, small business and consumer clients, while optimizing our workflows. Our partnership with Nymbus, the launch venture arm, the new branded business vertical on a lean and nimble cloud-based tool is nearing launch and will provide bespoke banking services designed to meet the demands of high growth venture backed technology companies. Turning to BoeFly, our online business lending marketplace, we continue to enhance its infrastructure, add new users, increase our client's overall workflow efficiency and drive revenue. Now turning to credit, our credit performance remained strong and while Bill will provide some additional detail shortly, we saw improvement in credit metrics during the fourth quarter. Our NPAs declined by more than 20%. Our delinquencies as a percentage of total loans remain near zero and we continue to prudently maintaining reserve levels commensurate with our organic growth and the changing macroeconomic forecast. We ended the year with a very strong capital position across all regulatory ratios, in addition to the cam -- tangible common equity ratio, which is hardly been impacted by AOCI. We've also been investing in our business. And as we enter 2023, I'm excited to build on the early successes we've seen from the launch of our new healthcare team and our expansion into Southeast Florida and Eastern Long Island markets. With that, we remain confident in our ability to drive value for our shareholders. And similar to previous years, that could include our board evaluating future dividend increases and reinforcing our belief that ConnectOne shares are undervalued potentially utilizing share repurchases, all subject to market conditions. So to wrap things up, we're dynamic, highly valuable franchise and we're pressing forward and leveraging our client first operating model. Enter 2023 with a deep capital base, strong earnings that can support multiple growth initiatives. And in short, I'm confident that we'll continue to produce opportunities for our clients, our team members, and our shareholders. We look forward to sharing our progress in the quarters ahead. And with that, I'll now turn the call over to Bill.

All right. Thank you, Frank. Good morning, everyone. I'm sure many of you are waiting my commentary on the net interest margin, both for the current quarter and give you some guidance for 2023. But before I get there, I'd like to review what was a stellar year for ConnectOne. Our operating earnings were a record representing 2.2% of average assets and they were up nearly 12% from the prior year. Period end loans grew by 19% and deposits by more than 16%. Our tangible book value per share increased another 8% in 2022 after increasing by 15% in 2021, that's close to 25% in two years. And that reflects not only our strong core earnings, but also effective management of our securities portfolio and the result in AOCI and the fact that we've grown organically and not through M&A. Credit quality, those metrics improved even further with our nonperforming asset ratio decreasing for the fifth consecutive quarter to 0.46%. And as many of you are aware, some of those non-performing assets include a small and declining exposure. We have tax medallions, which by the way already have a very comfortable reserve recurring value. Excluding those taxi loans, our NPA ratio was cut in half to 23 basis points. And delinquencies that is loans past due 30 days or more were next to nothing, just 2 basis points of total loans. Our net interest margin, which has been under pressure recently came in at 3.70% for the entire year, that's a record for ConnectOne and higher than most in the industry. And our efficiency ratio was 39% for the year even as we invest in technology, reward and build our staff and prepare for crossing the $10 billion threshold. So when you combine our strong growth with a wide margin, an efficient back office, strong credit and balance sheet management, the result is upper quartile, if not higher returns on asset, equity and tangible book value per share growth. And that kind of performance gives us the flexibility to manage for the long-term, which is nothing new at ConnectOne. For example, while some of the industry achieved efficiency by cutting costs, ConnectOne's best-in-class efficiency is based on strong revenue and a scalable operating platform as we invest opportunistically and where needed to ensure the long-term success for the company. In a similar light and turning to today's challenges, we reviewed the landscape and made a strategic decision to be more aggressive with deposit rate competition to proactively both retain our existing clients and grow our core commercial client base, which we believe will drive long term benefit. We are one of the top commercial and business banking franchises headquartered in the Metropolitan New York region. We don't focus on ancillary business lines that can be both volatile and troublesome, rather those businesses, segments, and clients we know and serve best. Now let's dive a little deeper into some of the factors impacting our margin, many of which either have or will be impacting many others in the banking industry. And as I said before, we had previously anticipated pressure on the margin, given that we're already operating at record highs. Now let's talk about the two primary tools to the Fed's disposal contained inflation, which are: one, increasing the Fed's funds target rate; and second, open market access to contract money supply. First, that short-term rate -- that rise in short-term rates has provided greater incentive to the positive, the transfer of balances out of noninterest bearing accounts. We are seeing this, the whole industry is experiencing it. And that intentional upward push on short-term rates had the effect of inverting the yield curve. And that too is putting pressure on loan spreads and margins. Second, the tightening of money supply, which results in increased competition for deposits, competition that heats up during the fourth quarter and that is essentially what is accelerating deposit betas. One more item impacting the margin is a significantly lower level of loan prepayments and therefore the associated prepayment penalty income is lower. These items have combined to cause a larger than expected compression to our margins. But keep in mind that net interest income for the quarter was about flat sequentially and is up 11% from a year ago. Now, going back to some of Frank's comments I want to reiterate, that although we carefully watch and are cognizant of Federal Reserve policy and do all we can to lessen the impact of economic condition, those things are somewhat out of our control and tend to be temporary. Where we are keenly focused is on managing things in our control, which is more specifically serving our clients. And we have been extremely effective at maintaining and solidifying strong client relationships and then capturing new market share, especially where clients are feeling particularly displaced by M&A. Ultimately, that will continue to make us a consistent earner, maintaining a prudent approach to growth in terms of both credit and spreads, managing our expenses and maintaining our culture, all those together over the long term will continue to drive shareholder value. Now looking ahead, we're going to continue to focus on gaining market share of market rates. We do believe things have calmed down slightly, however, there was still potential for several rate hikes and continued contraction in liquidity, so there will likely be continued pressure on the NIM in the short-term. However, when condition settles down, when the yield curve resumed its normal upwards stuff, we aim to be back to where we are today or even slightly above. Now moving to other items impacting the financials, we saw modest seasonal provisioning this quarter related to both organic loan growth and a slightly continued deterioration in Moody's economic forecast across a range of specific metrics. The quarter's charge offs relate to the successful workout of non-accrual loans identified and reserved for in previous periods. And therefore, it did not materially impact the provision this quarter and certainly are not any indication of an upward trend in charge offs, the net charge off rate for the year which is just 7 basis points. And just to reiterate, all indications at the present time point the solid asset quality metrics. As far as noninterest income, we are probably just a little light versus Street estimates, but we have a pipeline of SBA loan sale gains building through both BoeFly and traditional sources and we are optimistic that that will be increasing source of revenue for ConnectOne. In terms of other expenses, inflationary pressures persist and are impacting our numbers to some degree. As it's typical for ConnectOne, there usually is an increase in sequential expenses heading into a new year and I'm estimating that to be about 4% for quarter one. But I'm targeting relatively minor expense increases for the remainder of the year. We finished 2022 with the 13% increase in staff over that -- over the course of 2022. I expect that rate of staff increase to be much lower in '23. I also wanted to mention that we will be calling $75 million or 5.2% sub debt on February 1, in just a few days. We pre-funded that in 2021 with a non-cumulative preferred stock issuance. So we end the year with a nice capital level and assuming solid growth. We would plan to recommend dividend increases and stock repurchases for 2023. And that concludes my remarks. Back to Frank.

Thank you, Bill. So, as you all heard, we made some significant strides in 2022 and from market expansion through the addition of new talent and business lines and leading investments in technology and infrastructure. We certainly laid a lot of groundwork to capitalize on new growth opportunities in 2023. Even with the number of uncertainties hanging over the industry, our strategic priorities for 2023 are very clear. We're prepared and geared to continue to smartly gain market share. We have a dynamic team of bankers with a proven ability to execute. And I'd be remiss if I didn't acknowledge all of our team members who made 2022 the success that it is. We had a scalable operating model that continuously evolves by leveraging technology. We continue to view 2023 as a year that will be riped with opportunities for continued expansion of our prudent growth [Technical Difficulty] given the M&A disruption and our proven success at capitalizing in these moments. So we're excited for the future ahead. And in our view, ConnectOne continues to generate meaningful shareholder value and remains a very compelling investment opportunity. So thanks again and we're happy at this time to take your questions. Operator?

Thank you. [Operator Instructions] Thank you and your first question is from the line of Frank Schiraldi with Piper Sandler. Please proceed with your questions.

Good morning.

Hey, Frank.

Good morning, Frank.

Just wanted to start with the margin and I always looking for any color I can get, but, Bill, in terms of mentioning, we got a -- it looks like another couple of rate hikes potentially here early in 2023, at least that's what the forward curve is saying in them. You mentioned additional contraction from here. Just wondering if you can give any color on your thought either, just the deposit beta you guys are using now through cycle or alternatively where you expect the NIM could kind of bottom out if that's the trajectory of things in sort of the rate outlook?

Yeah. Listen, first, I think the major concern is the contraction of liquidity, which is forcing competition and we monitor that all the time and it continues -- that continues to strength our balance sheet and decrease the money supply even as the economy is growing. So everyone is facing that competition. And if they haven't faced it or their deposit betas are slow today, I believe that they will start to increase if the Fed continues that. In terms of our margin compression going forward, I think it's going to beat a little bit. I just want to be conservative here. We're putting loans on at 7%. We are still funding anywhere from 350 to 450. So the spreads on new business are pretty good. But again, I just want to be conservative because I think the Fed is continuing -- going to continue to be aggressive.

Okay. I guess, when we think about that 350 to 450 level of funding, just curious if you can put a little bit more color around what sort of duration you're focused on in terms of the CDs you're putting on the books? And if that's -- what it was in the quarter and if that's likely to continue --

Right, it's hard to say what the duration of all funding is going to be in the future, but what we're going into the marketplace is in the one to two year range for those CDs.

Okay. And has pricing kind of stabilized there at those levels?

Sorry, what would stabilize, the deposit pricing?

Yeah. For the -- for that [Technical Difficulty]

Listen, I believe so, there could be continued competition that could make things a little bit more difficult. And you know, there is always potential for outflows of noninterest bearing deposits, which I see you're seeing all your -- all the banks recovering as the same sort of situation is happening.

And then lastly, just on capital return, you mentioned the stronger capital side of things. You mentioned buyback and potential dividend increases. Is there -- where we sit today? What the stock rate is today? Is there preferred method of capital return? And also can you just remind us any sort of targets you had have on the -- into the TC or regulatory capital side for 2023?

Well, without getting into a specific target, I think that our capital generation is going towards seeing our asset growth. So there's going to be the ability to return capital. The second thing is, our dividend payout ratio remains one of the lowest out there around 19% or 20%. So we have room to move that dividend up just on that basis alone.

Okay. All right. I appreciate it. Thank you.

Yeah.

Thanks, Frank.

Our next question is from the line of Michael Perito with KBW. Please proceed with your questions.

Hey guys, good morning. Thanks for taking my question.

Good morning, Michael.

All right. So I follow-up to kind of the last line of questioning around [indiscernible] and Bill taking into account your expense guide kind of thoughts. I mean, is it fair to kind of summarize that by saying, obviously, this was the first quarter in a while where you guys saw the efficiency ratio dip over 40%, but it seems like it's going to be in that low 40% range for this year with the hope that maybe you could improve that a bit. Once the rate environment stabilizes and the rebound as you kind of guide -- kind of gave the build out towards Bill. Is that generally kind of a fair [indiscernible] be thinking about it at this point?

I think it could be that we are -- we've always said that we could be a little bit below 40%, a little bit above 40%. But over the longer term, I believe with our scalable operating platform that we're going to continue to drive that efficiency ratio down over time. Yes, it's impacted by the margin. And I did mention in my comments, when the yield curve returns to its natural state will be a lot better off and our margins will expand at that point?

Okay. And just on the growth piece, I apologize if I missed this specific number or view, but I felt like I kind of heard two different tones. There was a comment I think Bill you made about how you guys are going to be aggressive at maintaining customers at kind of building share, but then I think there was also a comment about environmentally like scaling growth back because of the funding environment. Maybe I misheard that latter one, but just -- can you remind us what the growth expectations are for 2023, just more specifically taking into account those kind of broader backdrops?

Yeah, I -- Mike, I'm sorry if there was any confusion, but from our perspective, we're not looking at growth as a function of the NIM. We're looking at supporting the existing clients we have, taking opportunities in the marketplace to grow new clients. And the NIM will be what the NIM will be. I know there are a number of institutions that have made the decision to allow large amounts of deposits to walk out the door, we just seem to feel that we are working too hard to gain high quality clients. We're not going to let them walk out the door and there is a price to pay for that. That being said, if you look at this economy and where we are and where we do see growth opportunities, there's just less of them in totality. We see opportunities within the marketplace, but I think 2023 is going to be a more challenging year for, not just us, for the economy, it’s the interest rate environment, it's the lack of liquidity, it's business formation, you name it, it's going to be a challenging year. I think we'll do well in it, but I don't know at what level. I wouldn't want to predict that we grow faster this year than last year or anything like that. So I think it's a combination of those things, but I think the fundamental message we want to get out and that both Bill and I talked to was this idea that we are going to stand by our clients irrespective of where the interest rate environment is.

Got it. That's helpful clarification, Frank. Thanks. And just -- where is the pipeline I guess today? And how does it look kind of by product or geography? Just curious if there's any more detail you can provide there?

Yeah. I mean, I would say that our pipeline is quite strong even today and it's still pretty well diversified across the various aspects of the different verticals that we typically lend in. There is a little bit more emphasis in the C&I space. We're seeing some improvements there, but I'm not sure it's big enough to make enormous change in the balance sheet, but there's definitely a higher focus there. And we are seeing probably more opportunities in some of those newer markets that we put some resources around or that we've made investments in, namely the Florida market, which has been performing extremely well for us, both in the size of the market we've created there and the loan to deposit ratio within that specific market as well as the Eastern Long Island market. Those markets have been pretty exciting for us to watch throughout and we're expecting really good things from both of those as we move into 2023. And additionally, all the other projects that we had around, whether it'd be a new vertical or a new place where we're putting emphasis, the healthcare business being an example of that.

Perfect. Thank you, guys, for addressing those. Appreciate it.

Thank you.

[Operator Instructions] The next question is from the line of Daniel Tamayo with Raymond James. Please proceed with your question.

Hey guys, good morning.

Hi, Dan.

Hi, Dan.

Maybe starting on the credit quality with reserves down to 1.12% here, just could get your thoughts on where you could see that ratio trending through the year given the economic uncertainty and the loan growth you're expecting?

Well, listen, with CECL, it's really contingent upon where the forecast come out. And for now, although some of those metrics, those forecasts are declining, especially in terms of -- projected GDP growth sales, those where the negatives are. But the unemployment rate is not really changing much in terms of economic forecast. Until you see that, you're not going to see a ton of provisioning around the industry. So I think there's a lot of misconceptions out there, but our CECL works and people think that it's how we feel about where reserve levels used to be. And I think most bankers would agree yet, wouldn't hurt to add to reserves, but that's not what CECL is really allowing these days. So other than having specific reserves for specific credits, which we don't have any, it's all really contingent upon this black box model. So if you think that at some point the unemployment rate forecast is going to increase, then you'll see fairly significant increases in reserving. If you don't, it's probably going to be pretty much benign.

Okay, great. And I appreciate that. My only other question is just around the $10 billion in asset threshold. And you're thinking that was likely you would cross this year, that's still the case or if that's changed at all with the economic forecasts?

I think there's a good chance we cross the $10 billion threshold. We've been preparing for it for a while. There are some costs associated with going over, but it's pretty small for ConnectOne, those costs, and we've been building for this along the way. So I don't really see too much change in our financial performance. And regardless of what's going -- one of the things I just want to add here is that, we've entered times before where things are a challenge, but we continue to produce year in year out very strong return metrics and credit quality metrics and I see no difference this coming year.

Great. I appreciate the color.

Our next question is from the line of Matthew Breese with Stephens. Please proceed with your question.

Good morning.

Hey, Matt.

Good morning, Matt.

I wanted to go back to the NIM and NII. Bill, historically we've discussed kind of in a higher rate environment where the NIM floor could be. I think you've mentioned that perhaps in that 350 range was a good floor. It feels a bit lower now. And just how -- touching on your incremental loan yields of 7% versus funding cost, it feels like incremental spreads are where the NIM is today or 100 bps lower quite a range.

Right.

So I was just hoping you could give us some updated thoughts on realistically where you think that NIM could floor.

Yeah. The thing that I have concerns about Matt is the increasing competition for deposits as the money supply continues to contract and it's still is. I watched this every week as the numbers come out. And so, you have a couple of things. You continue to have more competition for interest bearing deposits. And secondly, there continues to be a flow out of noninterest bearing deposits for all banks, not just us. And so, this happened, really started taking effect in the middle of the fourth quarter and it was much more severe than I expected, the competition for deposits. And I'm sure you're seeing in some other banks that you cover. So yes, on the margin right now, the new book -- the new business we're putting on is that spreads that are going to maintain our margins. I am just concerned about those other factors that could cause a little bit of pressure. But this is a temporary situation. Things should settle out. The yield curve being inverted does not help anybody. If the yield curve goes back to its normal shape and the long end remains higher than it was a year ago, we -- the banking industry and margins should be in good shape.

You had mentioned that incremental loan yield are in that 7% range, I am curious what are they rolling off at?

They're rolling off around about high 5% to 6%.

Okay. The other question just around NII, just thinking about 4Q NII $78 million, a little over $300 million annualized. Is that a number you think you can grow off of in 2023?

Yeah, I would expect that we will grow that. I’d say, that the growth in the balance sheet will exceed any percentage decline in the net interest margin.

Okay. I'm sorry if I missed this, Frank, your earlier commentary around. Did you mentioned any loan growth guidance for the year?

I did not. I mean, sitting here, I would tell you that based on our pipeline, based on what we see relative to payoffs, I would tell you that it would be my anticipation we'd be growing in probably mid to high single digits.

Okay. Other question is, I know credit quality metrics today look very solid. As I think about new paper coming on at 7%, I would think there is also changes in cap rates. I mean, do you have any underlying concerns with the ability to keep NPAs and charge offs at these levels just given the higher interest rate environment or should we expect some normalization in those figures?

I would tell you that this doesn't appear normal to me that all banks have virtually no delinquencies. I do think that there has to be some normalization around delinquency metrics and that there will be some level of credit issues going forward. I think it would be unrealistic to expect them to remain at zero. However, I do believe this is a very different environment than what we saw in 2008. I think real estate acts differently in this particular environment. I think there's a lot more capital in real estate transactions than they were before. I think the inflationary environment has put a lot more money in people's pockets. So I just think we're going to see different types of credit issues. I just don't have my crystal ball polished up to figure out where exactly that's going to happen, but I just -- just from history, it just can't stay at zero, something's got to break.

As you're underwriting new real estate, how have cap rates changed or trended and debt service coverage ratio has changed or trended. And I feel like you're alluding to there might be some different kind of performance change or MPA increase here, I'm just not quite sure where it is, is it on the valuation reset or the fundamentals of the property?

Yeah, I think there has been a valuation reset. And I do think that cap rates have gone up. And I think that's pretty apparent in lot of places. But debt service coverage ratios have remained pretty strong. Rents had gone up in the residential arena, the places where there is some weakness is, obviously, in office, not necessarily that the lease rates have come way down, but that the occupancies are lower and businesses are cutting back on the number of square feet that they need to operate their business efficiently. So I think there's a lot of challenges in there, but clearly cap rates are up. Valuations are either stable or down in a number of places. I think LTVs are still pretty strong relative to the industry as a whole. I don't know that there's been a whole lot of movement around that debt service coverage ratio. I mean, ours has been pretty consistent pretty much since we started the bank at the north of 125. And I think our average on the portfolio is closer to 150. So there's a lot of room in there for some level of weakness or temporary weakness. I think one of the areas that, of course, we watch very intently because it's -- a good part of our business is construction, because there's a lot going on there, not only with the cap rate, not only with what the potential debt service coverage ratio will be a completion, but the cost of the construction, inflationary pressures on the execution of getting a project on the timeframe in which to get it done, so those are things that we're watching very, very closely.

Understood. Okay, that's all I had for questions. I appreciate you taking them. Thank you.

Great, Matt. Thank you.

Thank you. At this time, I will turn the floor back to management for closing remarks.

Well, I want to thank everyone for taking the time today to hear our remarks about the fourth quarter of 2022 and we're excited to speak to you in the future quarters of 2023 as we continue our journey. Thank you all.

This will conclude today's conference. Thank you for your participation. You may now disconnect your lines at this time.