Eagle Bancorp, Inc. (EGBN) Q3 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to Eagle Bancorp's Third Quarter 2018 Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Charles Levingston, Chief Financial Officer of Eagle Bancorp. Sir, please begin.

Thank you. Good morning, this is Charles Levingston, Chief Financial Officer of Eagle Bancorp. Before we begin the presentation, I would like to remind everyone that some of the comments made during this call may be considered forward-looking statements. Our Form 10-K for the 2017 fiscal year, our quarterly reports on Form 10-Q and current reports on Form 8-K identify certain factors that could cause the company's actual results to differ materially from those projected in any forward-looking statements made this morning. The company does not undertake to update any forward-looking statements as a result of new information or future events or developments. Our periodic reports are available from the company or online on the company's website or the SEC website. I would like to remind you that while we think that our prospects for continued growth and performance are good, it is our policy not to establish with the markets any earnings, margin or balance sheet guidance. Now, I would like to introduce Ron Paul, the CEO and Chairman of Eagle Bancorp.

Thank you, Charles. I would like to welcome all of you to our earnings call for the third consecutive - for the third quarter of 2018. We appreciate you calling in this morning and your continued interest in EagleBank. As usual, Jan Williams, our Chief Credit Officer, is also on the call this morning. Jan and Charles will be available later in the call for questions. I am pleased to announce that we achieved another quarter of record quality earnings. Net income for the third quarter was $38.9 million, a 30% increase over the $29.9 million in earnings for the third quarter of 2017. Fully diluted net income per share was $1.13 for the quarter, also a 30% increase over $0.87 per diluted share for the third quarter a year ago. Our trend of long-term performance is the result of our continued, consistent approach to management of all key performance indicators, which lead to a high level of profitability and growth in earnings per share. We are extremely proud that our strategies have resulted in the achievement of a return on average assets of 1.93% and a return on average common equity of 14.85% for the quarter. As we have stated many times on these calls, our strategy is not to concentrate on only one performance factor, but produce balanced results across all performance indicators with the focus on growth in earnings per share. This approach has led to strong performance across-the-board including top line revenue growth of 4% for the quarter, driven by a superior net interest margin of 4.14% and healthy loan and deposit growth. For the quarter, we had a very attractive efficiency ratio of 36.37% and continue to maintain excellent asset quality in our loan portfolio with NPAs to total assets of only 20 basis points and net charge-offs of only five basis points of assets annualized. This collective performance has resulted in our consistent growth and profitability, measures with the most important, being earnings per share. As always, we are very much focused on increasing profitability than just growing the size of our balance sheet. We are extremely proud to have approved upon an already favorable level of profitability. Return on average assets increased to 1.93% for the third quarter of 2018 from 1.66% in the third quarter of 2017. Return on average common equity was 14.85% as compared to 12.86% for the third quarter of last year. Return on average tangible common equity was strong at 16.54%. The return on equity results are very strong when you recognize that our shareholders' equity increased $128 million over last year, another byproduct of our strong net income creating consistent additions to our retained earnings. The net interest margin from the third quarter was 4.14%, which was equal to the margin of the third quarter of 2017 and down only one basis point from 4.15% in the second quarter of 2018. Our NIM continues to be very favorable and well above our industry and peer averages. At the current rate environment, there is a lot of focus on deposit costs. At EagleBank, we are focused on both the overall cost of the funds and our yield on earning assets. It is our margin that drives our continued growth in net income, not just this one part of the equation. Our deposit beta is related to our business model as is commercially oriented bank in a major Metropolitan market. Our business model allows us to be very efficient, operating with only a few well-placed branches. Our commercial customers have large average account balances for both loans and deposits, which also enhances our efficiency. Our model, which is driven by the deposit mix from our commercial customers with operating accounts and compensating balance requirements, is what allows us to maintain a 33.7% of our deposits in DDA accounts. That level of DDAs have been consistent for several years and has not changed despite the rising rate environment over the last two years. Some banks business models focus on the retail sector, and they've made benefit from a lower cost of funds. In most cases, this benefit is more than offset by both lower asset yields and by the cost of expensive branch networks. Additionally, many retail-focused banks operate in less attractive markets with far less opportunity to generate the quality loans, with high yields that we produce in the Washington, D.C. Metropolitan area. Those loans are really the key to our business model, which gives us an asset beta, which is far superior to our peer group. Although the past two years, as the Fed has been raising short-term rates, we've been consistently increasing the average yield on our loan portfolio. This has been driven by two factors: one, the composition of our portfolio, which is short-term duration and is 64% variable or adjustable rate; and two, by our disciplined pricing approach on the net $1.4 billion of new loans added during that two year period. We could build a larger branch system, but our analysis indicates that operating cost would be more than offset any reduction in the cost of funds. We would rather build franchise value by continuing to invest in technology, both with the operational efficiency and data security, which is what our commercial customers really want and paying slightly higher rates for deposits to acquire and retain customers, who see the value in our relationship for our strategy. Getting back to margin, we don't focus on just deposit rate on loan yields, but on the bigger picture of return on average earning assets and to the cost of all funding sources. Case in point, the rising rate environment has enhanced the yield in our securities portfolio and our liquidity as well as loan rates. The important result is that for the third quarter of 2018, the yield on average earning assets was 5.21%, up 47 basis points over 4.74% in the third quarter of 2017. Over the same 1-year period, the composite cost of funds also increased 47 basis points to 1.07%. In addition, the advantage of having 34% of deposits in DDAs provides a significant benefit to the margin. In comparison, interest income for the third quarter of 2018 increased by $19.6 million over the third quarter of 2017, while interest expense over the same period was up only $10.6 million. In comparing the third quarter to the linked second quarter of 2018, interest income increased $6.1 million, while interest expense increased only $3 million. However, we need to be realistic and recognize that while maintaining the margin at the current level will be difficult. We still are in a rising rate environment and a very competitive market, both for loan pricing and cost of funds, so we expect to see continued pressure on the margin. During the third quarter, we achieved loan growth of $194 million on a point-to-point basis, a growth rate of 2.9%. Average loans for the quarter showed an increase of 12% over the third quarter of 2017 and growth in the average balances of 1.2% over the preceding second quarter of 2018. As you can surmise from those statistics, a lot of the loan funding came late in the quarter. The largest increases during the quarter were in CRE income-producing loans and in C&I loans. Construction loans were relatively flat for the period. C&I loans, including owner-occupied loans make up 35% of the portfolio and are our fastest-growing loan category. We have seen 18% growth in that segment over the last year and see more opportunities for attractive relationships, combining loans, deposits and treasury management services. Average deposits for the third quarter increased 11% over the third quarter of 2017 and 3% over the second quarter of 2018. Point-to-point deposit growth for the period was $104 million or growth of about 1.7%. Average deposits for the quarter were higher than the level as of September 30. It is our practice to focus more on average loan and deposit levels for any period than the period end number because the average balance really drives the net interest income and expense for the period. As I mentioned before, DDA accounts were 33.7% of average deposits for the third quarter and continue to have a significant beneficial impact on the margin. We are able to maintain this level of DDA deposits, partly due to the compensating balance requirements contained in our loan agreements. We continue to feel customer demand and competitive pressure on rates for interest-bearing deposits, however, the pressure was not as intense as we experienced in the second quarter. Because of our strong customer relationships, we were able to carefully monitor the market and adjust our pricing. The benefit is that while we saw the cost of interest-bearing deposits increased 42 basis points for the second quarter, we limited the increase to 20 basis points in the third quarter. We continue to adhere to our basic ALCO strategy of maintaining a moderate position for rate sensitivity and avoid taking excessive interest rate risk over the long term. We are slightly asset-sensitive, with a short duration on the loan portfolio and 64% of the loan portfolio in variable or adjustable rate loans. In our last earnings call in July, we discussed, in the second quarter of the year, we had modestly increased the average level of CDs in our deposit mix by $235 million to lock in our cost of funds for those longer-term deposits. We followed the strategy again in the third quarter by adding another $97 million in average CDs, based on the rate we paid, we're very happy about the decision and how it has helped our ALCO positioning in the current rising rate environment. The third quarter demonstrates again, our continued attention to operating leverage and maintaining a favorable efficiency ratio. For the quarter, top line revenue increased 10% over the third quarter of 2017, while noninterest expense was only up 6% over the same period a year ago. For the third quarter of 2018, total revenue increased by 4% over the second quarter while noninterest expense for the third quarter was reduced by $700,000 or 2% as compared to the second quarter of this year. The decrease in expenses from the second quarter of this year to the third quarter resulted primarily from chewing up compensation accruals. As with many expenses, we adjust our accrual rate quarterly based on our year-to-date trends. The efficiency ratio was 36.37% for the third quarter of 2018, as compared to 37.49% for the third quarter of 2018 and 38.59% in the second quarter of this year. Prudent expense management is a key piece of our strategy, and we continually measure our expense levels. We definitely benefit from our branch light strategy, which gives us the ability to continue building our infrastructure and developing appropriate, technical and human resources to approach the $10 billion threshold. We will always focus on productivity, but it will continue - but we'll continue investing in high-quality personnel, training and IT and security systems to support the growth of the bank. Noninterest income during the third quarter was disappointing, at $5.7 million for the period as compared to $6.8 million in the third quarter of 2017. The largest contributor of revenue for the quarter was from normal fees and service charges of $2.7 million. The gain on sale of residential mortgages was $1.4 million for the quarter as compared to $1.7 million for the third quarter of 2017. The softness in residential mortgage activity is due to the higher interest rate environment and is consistent with industry trends. The disappointments have been in the lack of gain on sale from our SBA group and the FHA group we initiated in 2016. The experienced of moving loans through the HUD, and FHA approval process has proven to be much more difficult and protractive than anticipated. Nevertheless, the FHA group has a very strong pipeline of transactions at this point, and we expect to see the revenue from the securitization and sale of those loans in 2019. We continue our strong, consistent performance for all credit quality indicators. At September 30, 2018, NPAs as a percentage of total assets was 20 basis points, decrease from 24 basis points a year ago and as compared to 16 basis points at July 30, 2018. Nonperforming loans were 22 basis points of total loans at the end of the third quarter as compared to 27 basis points at September 30, 2017 and 16 basis points at June 30, 2018. We continue to constantly evaluate our portfolio and take an aggressive approach to placing loans on nonaccrual status. Net charge-offs for the third quarter of 2018 were five basis points as compared to a net zero charge-offs in the third quarter of 2017. On an annualized basis, net charge-offs were 5 basis points for 2018 year-to-date. The allowance for loan losses was 1% of total loans at the end of the third quarter. The provision expense for the quarter was $2.4 million, consistent with our allowance methodology, the current economic climate and our minimal charge-off history. At September 30, 2018, the coverage ratio was 452% as compared to 379% at September 30, 2017. We believe that we are adequately reserved, and then our coverage ratio is in excess of averages for the industry in peer group mix. The demographic and economic factors for the Washington region are stronger than they have been in years. Washington area economy is the fifth largest in the country with gross regional product of $529 billion. Region added 65,000 net new jobs in the months ending August 31. A significant factor is that once again the largest job gains are in the professional service sector, which has the highest-paying jobs, the next largest sector, health care and education. While Federal employment in the area is slightly down, overall federal spending has significantly increased as more work is being awarded to government contractors. Federal contracts for the goods and services awarded during the past year totaled $78 billion in this region. That is just short of the all-time high back in 2010 during the Obama Stimulus Program. While the contracts mentioned were awarded in the fiscal year just ending on September 30, a considerable amount of those funds will be expended during the next 12 to 18 months. More importantly, the private sector continues its growth trends as we see increases in Internet and data storage tech companies in Northern Virginia and the biotech sector in Montgomery County, Maryland. A major factor during the employment growth and need for office and lab space is highly educated workforce in the Washington area. The tech companies have run into a shortage of talent in San Francisco, Silicon Valley and Seattle, so they are expanding here in the Washington area, where we have a surplus of well-educated millennials. The nature of the work is centered on cybersecurity, cloud-based processing and data storage and artificial intelligence. This trend has been percolating for the last 12 to 18 months and will continue to be a significant driver of employment growth and development, particularly in Northern Virginia. The expectation is for development of an additional 2 million square feet of space, which will be a combination of office, data center, industrial and multifamily. The most recent forecast for the regional economy is very strong with GRP growth expected at about 3% through the remainder of 2018 and increasing 10% in 2019. Regarding commercial real estate, the demand for office space has been very firm, with absorption of about 2 million square feet of space expected this year. In the district, strong demand has driven up the values of Class B buildings, which properties have traditionally been our sweet spot. The pace of multifamily and residential development has slowed somewhat, new building permits are down in the region, which matches the national trend. You can see why we are confident about the continued growth and strength of the Washington region. The dynamic nature and strength of the market is why we continue to see loan demand and have a substantial pipeline of new business with unfunded commitments of $2.3 billion. However, we continue to maintain our loan pricing discipline and our strong underwriting standards, which have been cornerstones of our long-term success. Based upon the demand and activity in the market, we could be generating loan growth at a much faster pace. However, we will not meet the pricing being offered by the debt funds and other irrational competitors, and we will not alter our underwriting methods of portfolio management practices just to produce balance sheet growth. We continue to carefully monitor activity across the region and in each of the submarkets. The key to EagleBank's underwriting has always been that we study and understand the various submarkets within the region, be it Northern Virginia, suburban Maryland or in a district and monitor and control our portfolio composition by product type, industry and location. We will not vary from this methodology. We are successfully growing our book of C&I and owner-occupied loans, but we are mindful of the level of CRE loans in the portfolio. We are pleased to note that as we continue to be an active lender, our concentration ratios have been decreasing due to the consistent increases in retained earnings from our high level of profitability. We have always maintained a strong capital position and are committed to continuing that practice. At September 30, our total risk-based capital ratio was 15.74% as compared to 15.3% at September 30, 2017. Our Tier 1 capital ratio at the end of the third quarter is 12.13% and tangible common equity was 12.01%, improved from 11.35% a year ago. The recently released FDIC deposit market share statistics for the Washington Metropolitan area showed that for the 12 months ending June 30, 2018, the total market grew by 5% and EagleBank grew by 6.6% and that will still hold the largest market share in deposits of any community bank headquartered in the Washington Metropolitan area. This is despite all of the recent M&A activity in the region. We still hold the enviable position of being large enough to be in the primary relationship bank for sizable companies and quality developers but not too large to provide tailored solutions to our customers' needs. We are still nimble and have the entrepreneurial spirit and offer a service level of certainty of execution that the national and larger regional banks cannot match. That spirit, which we provide to our customers and offer to the market, combined with our disciplined approach to managing the fundamentals of the bank every day is what will allow us to continue the growth and success of our company. Thank you, again, for joining in the call this morning and for your continued support of EagleBank. This concludes my formal remarks, and we'll be pleased to take any questions at this time.

[Operator Instructions]. Our first question comes from Catherine Mealor of KBW.

Maybe first on growth, really nice growth this quarter, can you talk a little bit about your outlook for growth for the rest of this year maybe into next? And are there any large paydowns that you foresee that could impact fourth quarter growth just as you see it today?

Yes, Catherine, the lumpiness of the loan growth and loan payoffs is consistent and will be consistent. As far as large payoffs, we're constantly getting large payoffs, and we're putting on respectably large size loans. So it's very, very difficult to predict. I will say that the payoffs that we're getting are not payoffs as a result of the loan going somewhere else, it's as expected. So it might be to a Fannie or a Freddie type product on a multifamily product - project or might be new insurance company. So we're losing - we're getting those payoffs as we expected.

Got it. Okay. And so would you - as you kind of think about your growth and think about managing your margin and your credit risk, I mean, is it - kind of low double-digit growth still a growth rate that you target? Or do you feel like, moving forward, kind of, we're back into the high single-digit range as you try to - again, try to keep the margin where it is and monitor credit risk?

We still believe that with the competitive nature out there and the extraordinary pricing that we're seeing from insurance companies, form debt funds that the high single digits is our expectation.

Okay. Great. And that one thing on the margin. I guess, I have two questions on the margin. The first is just on the loan yields side, saw some really nice increases in your loan yields as you talked about in your prepared remarks. Can you remind us, what percentage of your 64% variable is LIBOR versus prime? And in a quarter, like this past quarter, where we didn't see much moving in LIBOR, is it fair to expect a greater increase in loan yields, in further quarters where we have further rate hikes and maybe a more pronounced move in LIBOR?

Yes, Catherine, the percentage of loans in our overall portfolio is about 44% that are indexed to LIBOR. We did see LIBOR move up about 14 basis points in the quarter on average, 17 basis points point-to-point in the quarter. We're also - obviously, we've seen - loans are being booked at higher rates this year relative to the prior years. For the first nine months of 2017 versus the first nine months of 2018, we were about 50 basis points higher in the loans we're booking. But yes, that sensitivity is going to continue to benefit us as we see more market moves in LIBOR and anticipating continued rate increases.

And is that - that 44%, is that on total loans or 44% of the 64%?

On total loans.

Got it. Okay. Okay, great. And then on the other side of the balance sheet on the funding side, we've seen some big mix shift in your findings, so if - and really, we've seen money market deposits come down, I think about 11% or so since year-end and then the balance has come in CDs and noninterest-bearing deposit. So how do you think about that mix shift going forward? Is this a similar type of mix shift that we should see in the coming quarters?

It may - I wouldn't think it - as dramatic as a change is that, but I think this is somewhat indicative of the changing marketplace and sabers being rewarded now these days for investing in instruments like CDs. I would expect to see shifts around the industry in a similar fashion as CDs have come kind of back into vogue. So I think that CDs are going continue to be an important part of our funding mix going forward. To the extent that you're going to see a more significant wholesale shift, I don't necessarily think that that's quite the case, obviously, those CDs provide us with the opportunity to lock in some attractive pricing. I'm pretty happy with the pricing locked in, in the second quarter with that CD campaign, and I expect I'll be pleased as rates continue to rise with what we've done here in the third quarter.

Our next question comes from Casey Whitman of Sandler O'Neill.

So you commented in your release on some expenses being put toward preparing to cross $10 billion, just - can you remind us where you are in that process? And then - and I realize, it's going to be probably small for you, but can you give us a sense for what we can expect the impact would be at this point on the revenue side?

Yes. In terms of the impact on the expense side - trying not to answer directly, but the impact we've seen, I think we're seeing - what we saw this quarter is probably - is likely indicative, all things equal of what we're going to see going forward in the near term in terms of the buildout. Again, it's - hiring additional personnel to address that second line of defense from that ERM perspective, so more people are in the kind of the audit and risk functions and obviously, more investment in technology as the spotlight continues to brighten on that front. So I think that, that's where - really where you're seeing that impact in terms of preparing to cross that $10 billion threshold.

Okay. And yes, I guess I was wondering just in terms of interchange revenues, would we expect a pretty...

Got you. Right. I think given the commercial nature of our institution, sorry, Casey, I didn't quite understand initially. On the - I think that impact will likely be relatively modest given the commercial nature of our model. My back of envelope, and this is a little stale, but it was somewhere in the neighborhood of about $1 million annually, that interchange revenue would - that driven impact would be so that's kind of where we're at.

Helpful. All right. And then moving on to credit, just wondering can you give us any color, you had a modest uptick in nonaccruals loans, but I guess just more broadly, are you seeing any early warning signs over the next credit cycles in your markets? Or everything's still good there?

Casey, I think our portfolio, on the whole, is performing quite well. The uptick, I think, is really a product being at such low levels to start with, that any move, a couple million dollars really has the percentage impact larger than you would expect if we were traveling from 25 to 28 basis points. But I think on the whole, we haven't seen any erosion in credit quality, but nevertheless, we're being very proactive and just making sure that our underwriting standards are consistent and strong. And I think we're in a good shape as far as credit goes. You'll probably remember the last downturn and over the years, we may have had some upticks in nonperforming assets from time to time, but ultimately, they have not resulted in charge-offs, so I think on the whole, we're feeling pretty confident about where we are.

Our next question comes from Steve Comery of G. Research.

Just want to ask about loan yields, they're up nicely to 5.6% on an average - 5.69% on an average basis. I was wondering if you can kind of give us a feel for where originations are coming on during the quarter.

Yes. So on the quarter, we had originations coming on just a little over 5% on average, that's the coupon rate before we're seeing the impact of deferred fees in cost, but you can add another cost of 35 basis points or so on top of that for the yields.

Okay. That's helpful. And then I just wanted to circle back to the comment Ron made during the prepared remarks, and that was about loan sales and kind of the process was hard in the FHA. I was kind of wondering if you could give a little more detail there on exactly like what the issues have been, how you're working through them. And kind of, what your expectations going forward are?

Sure. The FHA/HUD process is very, very cumbersome. It's reams and reams of paper and reams and reams of questions that are asked on a regular basis. We have our top quality people that are constantly up in New York, working with HUD and FHA on the processing but it is a long struggle to get there, it's very profitable so it's certainly worth the enormous amount of effort. And it's also building the reputation that we can do that within this market. So we feel good about it, but it is a very cumbersome process.

Okay. I mean, do you think you're sort of developing any ability to work through this easier? Or is it just kind of the same?

Probably a little bit of both. I think that we have experienced people that are in that department that understand what the process is, but nevertheless, depending on who's looking at the package, you're continuously getting more and more questions.

Okay. Fair enough, so it sounds like it's just the nature of the process rather than anything you guys are doing specifically?

Very, very much. So it's kind of like the residential side a while ago, where you would send a package to somebody and then they would take it back for one question that you didn't answer right or didn't fill in the blank. So it's just a cumbersome process but it's absolutely worth the effort.

Our next question comes from Joe Stephens of Stephens Capital.

Ron, first of all really good quarter. Most of my questions were already asked and answered, but you even said yourself that you were not pleased with your noninterest income growth, so could you just give us a few thoughts on that?

Sure. The noninterest income that we expect from the FHA/HUD program is something that we continuously think that we're going to be getting quarter-after-quarter, and it just slips because of the process that we just mentioned. On the residential side, the market is getting more and more competitive with online product, so that's been difficult. And then on the SBA side, it's interesting that a lot of our competition is taking some of the loans that we feel very strongly, should the SBA, and they are putting it into their portfolio, and we won't do that. So our SBA income has slipped. But it's mainly the FHA program that was the disappointment.

At this time, I'd like to turn the call back over to Mr. Ron Paul for closing remarks.

Thank you all again for attending our call and looking forward to speaking to you at the end of next quarter. Thank you very much.