OceanFirst Financial Corp. (OCFC) Q4 2013 Earnings Report, Transcript and Summary

Hello, and welcome to the OceanFirst Financial Corp. earnings conference call. [Operator Instructions] Please note that this event is being recorded. Now I would like to turn the conference over to Ms. Jill Hewitt, Senior Vice President and Investor Relations Officer. Ms. Hewitt, please go ahead.

Thank you, Keith. Good morning, and thank you all for joining us. I'm Jill Hewitt, Senior Vice President and Investor Relations Officer, and we will begin this morning's call with our forward-looking statements disclosure. On this call, representatives of OceanFirst may make forward-looking statements with respect to its financial condition, results of operations, business and prospects. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond OceanFirst's control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. OceanFirst undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In our earnings release, we have included our Safe Harbor statement disclaimer. We refer you to the statement in the earnings release and the statement is incorporated into this presentation. For a more complete discussion of certain risks and uncertainties affecting OceanFirst, please see the sections entitled Risk Factors and Management Discussion and Analysis of Financial Condition and Results of Operations set forth in OceanFirst's filings with the SEC. Thank you. And now I will turn the call over to our hosts this morning: Chief Executive Officer, John Garbarino; Chief Operating Officer, Christopher Maher; and Chief Financial Officer, Michael Fitzpatrick.

Thank you, Jill, and good morning to all who have been able to join in on our fourth quarter and year end 2013 earnings conference call today. OceanFirst has just concluded its 111th year of continuous operations and our 18th as a publicly traded company. Our earnings for the year were representative of solid financial performance, although the final quarterly results were somewhat atypical. During this call, we will discuss the reasons for this, primarily the strategic initiatives we implemented during the quarter and additional ALLL calculation adjustments we have made following the one-year anniversary of the landfall of Superstorm Sandy in the midsection of our market, which had a dramatic impact on our company operations. We appreciate your interest in our performance and are pleased to be able to review our latest operating results with you this morning. You've all had the opportunity to review the earnings release from last evening, and following our usual practice, we will not be disrespectful of your time, reciting a host of actual numbers from the release. Following my brief introductory comments, I'll turn the call over to President and Chief Operating Officer, Chris Maher, who will review the highlights from the quarter and year end and discuss the strategic initiatives that I reference. Chris will also call upon our Chief Risk Officer, David Howard, to review the ALLL adjustments from the quarter and their effect on our operations. Of course, diluted earnings per share were $0.11 for the quarter totaling $0.95 for the entire year, reflective of our fourth quarter initiatives, which had a $0.19 adverse impact on our core operating earnings. Our company's 68th consecutive quarterly cash dividend was declared and maintained at $0.12 per share, representing a comfortable and sensible 40% payout ratio of our core operating earnings, consistent with our capital management planning. Although we did not return additional capital to shareholders through share repurchases during this quarter, we do have 301,766 shares available for repurchase under the existing program adopted late in 2012. As we discussed in our third quarter conference call, although we still consider the repurchase of our shares from time to time to be an attractive proposition, to deploy excess capital in the short run, at current trading multiples, the incremental book value dilution associated with the retirement of shares weighs heavily against the accretive effect on our earnings per share. This tempers our enthusiasm to aggressively execute open market repurchases in the absence of any market imbalance in the supply and demand for our stock. Moreover, our strategic plan targets the development of incremental shareholder value through consistent growth in revenue and earnings. The renewed commercial loan growth we have generated over the past 2 years is extremely gratifying. Targeting this has the impetus to grow our balance sheet and revenue in 2014, and helping us to better leverage our strong capital position through our shareholders' benefit. I'll now ask Chris to provide some additional background on our operating results.

Thanks, John. My comments today will highlight our progress towards improving growth rates and the earnings profile of the company. Our actions in the fourth quarter were focused on improving the net interest margin while continuing to adapt our expense structure to support additional investment in new business generation, namely commercial lending and trust. The successful completion of the FHLB advance restructuring and 2 branch consolidations provide an opportunity to defray the investment and the talent we need to drive organic growth. While the FHLB restructuring is largely a treasury activity, the consolidation of branch offices required careful communication with long-term customers to ensure a smooth and seamless migration to new facilities. Our success in this effort is measured by the expense reduction but also measured by our ability to retain customers that we'd expect to serve for many years. Our retail group has carefully worked with impacted customers since the formal notification in September, and we're pleased to report virtually 100% of deposits are transitioned to the new facilities, including 85% of safe deposit box customers, allowing for cost savings without significant impact to our retail deposit base. In a related effort, the bank launched mobile Remote Deposit Capture, that is check capture via smartphone in the fourth quarter. This latest piece of our mobile banking infrastructure provided additional convenience for customers and the flexibility to make a material adjustment to branch service hours to further manage operating expense levels. While these initiatives will help to offset business development expenses, the branch hour changes were effective in mid-November and the branch closures were effective on December 28, so the actual impact of these initiatives will only be fully realized in the first quarter of 2014. When considering the redeployment of operating expenses, it is important to note that adding seasoned and professional business development staff to the commercial lending and trust organizations is a long-term strategy. Investments of this nature take time to become accretive to net income. Notwithstanding that, early results in loan origination, loan portfolio growth and assets under administration are encouraging. During the fourth quarter, 2 additional new hires were made to bring the commercial loan origination staff to a full strength of 11 calling officers and 13 credit support staff. While we continue to recruit credit support staff to support a growing commercial portfolio, the business development team required to produce commercial loan growth in 2014 is in place and assimilating well to our business model. Additional hires will be considered as opportunities arise, but we now have the team we need to materially increase commercial loan market share in our core markets. Investment in business development staff in commercial lending is demonstrating tangible results as the bank posted its third consecutive quarter of net loan portfolio growth, driven by commercial loan growth of $26.4 million, or an 18.8% on an annual basis. In addition to commercial loan growth, the pipeline of committed commercial loans more than doubled versus prior year, growing from $23 million at December 31, 2012, to $59 million at December 31, 2013. The yield related to the commercial pipeline is a respectable 4.39%, allowing commercial loan growth to replace maturing bonds at an average yield of 1.66%. In addition to commercial loan growth, the demand for residential construction-to-perm loan continues to grow. While still modest in relation to the bank's balance sheet, 84 construction-to-perm loans totaling $33.7 million were originated in 2013, with volumes increasing every quarter. An additional $10 million of these loans were in the pipeline at December 31, with an average yield of 4.07%. Interestingly, the majority of these loans are adjustable rate instruments, making them good additions to the bank's balance sheet. Our secondary recruiting focus has been trust and asset management. Trust and asset management revenue grew $662,000, or 44% from $1.5 million to $2.2 million from 2012 to 2013. Further, assets under administration grew 25% from $172 million at December 31, 2012, $216 million at December 31, 2013. I should also note that in an effort to provide additional detail regarding this business, our earnings release now includes a disclosure of assets under administration. While we are pleased with the growth levels into 2013, transforming this business into a more material revenue engine requires us to make additional investments into the business. In December, we announced the hiring of Craig Spengemen as Executive Vice President, Director of Trust and Asset Management. Craig joined the senior management team in January from Peapack-Gladstone Bank, where he spent 28 years building a $2.5 billion asset trust operation, that closely resembles the type of trust operation that would best complement our business. The trust business at OceanFirst is squarely targeted at providing support to the senior citizen communities in our market and to our growing portfolio of business owners. These target clients have investable assets typically below the minimum target of most wealth management firms, have a strong desire for straightforward investment advice, are risk-adverse and have a strong appetite for fee-based estate planning and estate settlement services. So while trust and asset management enjoyed a very solid year, we're pleased to have the opportunity to make a substantial investment in a proven -- in the ability to our business to a new level. As Craig builds this business, we expect to make additional hires to our trust business development team. With the recent additions to staff in commercial lending and trust, our business development team is approaching full capacity. Operating expense increases driven by hiring activities will now moderate as our focus shifts to assimilating the seasoned professionals that have joined our teams into the OceanFirst culture and to demonstrating incremental results in our key growth areas. Balanced against our growth objectives is an absolute requirement that new business be pursued within a prudent and conservative risk management program. The bank initially established enterprise risk management in 2013 and substantially upgraded capabilities -- I'm sorry, established the program in 2003, substantially upgraded capabilities in 2013, with the addition of David Howard as Chief Risk Officer. Dave joined the bank after a successful career in risk management with Guggenheim Partners, Financial Guaranty Insurance Company and Fitch Incorporated. Given the relatively modest loan loss provision for the fourth quarter and the need to evaluate the remaining allowance for loan and lease losses related to Superstorm Sandy, I'm going to ask Dave to spend a few minutes discussing changes to our ALLL position at year end.

Thanks, Chris. As part of the bank's well-developed enterprise risk management program, we've completed a special supplemental review of new risks inherent in the loan portfolio; considered the bank strategic priorities, identified by the board and management in the planning process last year; and we analyzed the reserves that are established in the allowance for loan and lease losses. This has led the bank has identified as 5 factors that affect the ALLL. First is Superstorm Sandy. In the fourth quarter of 2012, Sandy caused substantial property damage in the bank service area and disrupted operations for many of our business customers. In that quarter, the bank established a $1.8 million provision to cover the losses not yet identified. As of the fourth quarter of 2013, with a full year of performance since the storm, the uncertainty related to potential repayment problems was largely gone. Only a handful of our borrowers who suffered flood damage remain significantly delinquent, and we've charged-off or reserved for them. All of the other loans impacted by the storm are performing as expected thus the remaining reserves related to Sandy are no longer required. The second factor is flood insurance. In July 2012, Congress passed the Biggert-Waters Flood Insurance Reform Act, which makes a number of changes to the way the national flood insurance program is run, the most important of which is a requirement to raise rates to reflect true flood risk. The changes will mean premium rate increases for many of the bank's borrowers and for some, it may stress their ability to make their monthly payments. Secondarily, property values may suffer due to the increased cost of insurance, the cost of remediation or the cost or an ability to elevate the structure if necessary. Those borrowers most at risk have been identified and an additional risk factor has been applied to those loans to take that risk into consideration. While we expect flood insurance rate increases on many loans in our portfolio and significant increases on a small percentage, we do not expect large-scale delinquencies or defaults related to new flood insurance rates. This reserve is sized to cover only the handful of loans that may eventually default due to increased rates. I should note that the federal budget bill that was signed last Friday delays certain flood insurance rate hikes until September, and there are other bills proposing yet further delays. But it's virtually certain that risk-based pricing for flood insurance is coming. It's prudent to keep an additional reserve until the impact of risk-based premiums is clear or until any legislative changes become law and the bank's risk position changes. The third factor affecting the allowance is newly originated commercial loans. John and Chris have already discussed the new commercial lenders and the growth we're seeing from that area. Since the bank has historically experienced a very low rate of loss in commercial lending, we're increasing our reserve against unseasoned loans. It's important to note that we have not relaxed our underwriting standards and credit risk management continues to be strong. This is just an adjustment to account for the low historical observations and greater volumes being booked today. As the seasoned lenders that we've recently recruited become seasoned here at OceanFirst, and as performance of these loans becomes measurable, the need and amount of this additional reserve will be reevaluated. The fourth factor is construction-to-permanent lending. Residential lending unit has produced a fairly rapid expansion of the construction-to-permanent lending portfolio during 2013, directly attributable to Sandy repairs and rebuilds. The bank's residential loss history is largely based on traditional mortgage loans for homes that are ready to be occupied. The additional risk associated with these new construction loans albeit to owners, while it's an additional loss factor during the construction period. The last factor we will note is Chapter 7 bankruptcies. For consumer loans that have been discharged from a Chapter 7 bankruptcy filing, following an OCC guidance, the bank had previously established specific reserves based on the difference between the amount due and the realizable collateral valuations. These reserves were held indefinitely. Beginning with the fourth quarter, specific reserves will no longer be held if the borrower becomes current and remains so for 6 or more consecutive months, thereby indicating their willingness and ability to repay their debt. A vast majority of the bank's Chapter 7 accounts meet these criteria and the specific reserves will no longer be held. This change more closely aligns our treatment of Chapter 7 loans with troubled debt restructurings. Collectively, these factors result in the fourth quarter allowance being similar in dollar amounts as in previous quarters or more closely aligned with the year-end risk position of the bank. And I'll hand it back to John.

Thank you, David. So as you have heard, the initiatives we have taken during the past quarter have reinforced our belief that we have put the Sandy experience behind us, positioned ourselves well for the growth we see being generated and have utilized our enterprise risk management expertise to take all these actions with a strong degree of confidence in our future. With that, Chris, Mike, Dave and I would be pleased to take your questions this morning. Keith?

[Operator Instructions] And our first question comes from Frank Schiraldi with Sandler O'Neill.

Just a couple of questions. First, on the commercial loan growth, obviously, a pretty good result and wondering if you could talk a little bit about the drivers. Obviously, we have the hurricane Sandy recovery story, but also the new hires, that obviously could've driven some of that. So I just wanted to get your sense on drivers for that really strong loan growth.

Thanks, Frank, it's Chris. Yes, we'd kind of separate things into 2 categories. The commercial loan growth is more of a market share movement than Sandy related. So those credits tend to be credits that were held at other institutions. And as a result of the new commercial lenders, we've added -- we're -- we have the opportunity to look at more deals and talk to more centers of influence and see more volumes. So very little of that is net new loans in the market. They tend to be loans going from one bank to another. I would draw the distinction that the construction-to-perm loans is almost exclusively Sandy related, so those are residential in nature. Now we would hope that as the recovery matures, the residential lending might open up some opportunities for commercial lending down the road, but we have not seen that yet in the commercial book.

Okay. And then you talked, Chris, about pipelines for the end of the year or current pipelines. And I'm just wondering if you can talk maybe a little bit about -- I guess maybe I could go back and try to flush this out in past quarters, past years, but your experience in closings in terms of percentage of the pipeline that we couldn't anticipate gets onto the balance sheet?

Yes. Yes, I guess you're asking about pull-through rates and how much of the pipeline would we expect to see in the balance sheet, right?

Exactly.

Yes, it's always a little bit of a moving target, obviously, based on competitive situations. You always have the risk at the 11th hour, somebody comes in and drops their price or something and wins a deal. But the pipeline numbers we report are committed facilities. And typically, that's pretty far down the process. So the majority of them do translate into reasonably short term into loan originations. So if that -- that's helpful. But these are not prospects, these are people with term sheets and commitment issues and pricing agreed to. And that's not to say that we don't occasionally get an appraisal back we don't like or a price adjustment that we're not able to make. But the vast majority of those do translate into originations.

Okay, great. And then just finally, it sounded like you had mentioned that the hire -- the builds in terms of hiring could be sort of behind you for the most part. And first is that, did I hear correctly? And then secondly, the story, as you guys have talked about, is that you could -- we'll see some of the investments in some areas will be offset by cutting inefficiency elsewhere. So I'm just trying to hash out run rate for expenses, and if we could see some catch-up in terms of efficiency or inefficiencies taken out that could pull that lower and make 3Q a better run rate or is 4Q a better run rate going forward?

Okay. You get a little bit color on that. You heard right that the majority of our expected new hires in business development are behind us. We may make a couple of hires in trust this quarter, but that's -- we feel very comfortable with the commercial team. So I think when you look at the compensation run rate for the fourth quarter, that's a reasonably good run rate. There is a little mismatch in timing here, and the mismatch is that the expense reductions that we're able to take out of the branch closures really did not impact the fourth quarter, so you've got a little bit of an overstatement of facilities expense going forward and so probably some offsetting compensation as well, as we kind of rightsize the headcount there. So I would characterize is our expenses in the fourth quarter, probably a pretty good run rate going forward because we're going to have maybe a little bit more expense in terms of a couple of hires here and there, but then we're going to have the full benefit of the retail restructuring we did. So you certainly should see a flattening here. In terms of payback periods, I think we've said for a while, we know that the commercial lenders aren't going to pay back in the first couple of quarters they're here. But we would expect that within a year or so, they've built a portfolio up where they're covering the cost. So I think you'll see continued commercial loan growth and that will -- at a much less steep increase in expenses.

And the next question comes from Travis Lan with KBW.

Can you just talk a little bit about the increase in the commercial pipeline yield in the quarter, if that I was just mixed shift, or just totally tied to interest rate fluctuations?

It's probably a little bit of both. A little bit was mix shift, a little bit was higher rates; we are seeing, I would say, somewhere around maybe 1/8 to 1/4 improvement in the price environment for commercial lending. So I'd say, it was a little bit of both. I wouldn't attribute the whole thing to the market, but certainly, the market's priced a little better now than it was, say, going back to September.

Okay. And now that you have the commercial team largely in place, how do you guys quantify the potential opportunity for commercial originations in kind of a year that they would all be on the ground and at full capacity?

It's always a little bit of a moving target because market conditions are going to determine -- and our competitors will determine how what pricing and credit risk profile is getting done in the market. But I would tell you that our -- the past quarter where we were growing at about 18% and a -- 18.8%, we're pretty happy with that growth rate, we'd like to see that continue. I think that's sustainable. Some quarters might be a little bit higher than that or a little bit lower than that, but we feel very comfortable with that. We're also -- we're very aware that there's an amount of growth you can entertain while keeping the risk profile of the company static or the way you want it, and we're pleased to have Dave kind of talk a little bit about his role in the company in this earnings call. But we wouldn't necessarily want to move it too much faster than the fourth quarter. So we're very happy with the high-teens growth rate. That's not to say some quarters maybe we'll do 20% or 25% or some we may do 15%. If the risk profile or the credits or the pricing is not good, we're not going to -- we don't have our foot firm on the accelerator.

And certainly, Travis, the other wildcard there is the M&T-Hudson City deal. Because we're starting to see M&T, I mean this deal has languished for as long as it had. But we are started to see M&T in the commercial sector in our market. If and when that deal ever closes, we suspect they're going to have a much stronger presence and things might get a little more competitive than they even are today. But who knows when that's ever going to happen?

Right. Okay, that's really helpful color, guys. Then I guess, just a couple more. David, based on your comments, should we take it that with all the changes to the ALLL methodology and that the reserve is still effectively flat as a percentage of loan, that there is no kind of mass change, at least in kind of the bottom-line impacts of that?

Yes.

All right. And then just big picture, could you remind us what you think a normalized capitalized ratio is, and then how you think about the timeline to kind of get there? If it's more just balance sheet growth or you would -- I know you like the 40% payout ratio, but is there room for the dividend, or anything else you would consider?

Well, no. We have all those tools at our disposal, but our tool of preference here, coming out of the shed is obviously revenue growth and some balance sheet growth. I think we've made that clear for a number of years. We're just happy to be in the position where we can actually point to some success in that area. But we've always committed ourselves to a strong cash dividend payout ratio. We think 40% is the right number there and we plan to adhere to that general level. Our board also takes a look, from time to time, at stock share repurchase, but as I mentioned in my introductory comments over the last 2 calls now, the metrics associated with that become far less attractive as valuations increase. That's not to say that in the short run, we might execute that based upon a market imbalance and demand for the shares. So we treat that as opportunistic, but our tool of choice, again, is definitely to bring some value to the shareholders through some balance sheet revenue and earnings growth.

Right. And just in terms of kind of what you think kind is a normal PC ratio or would be a normal...

If I gave you a long enough question, you wouldn't hold me to that number because you know I'm not going to give it to you, Travis. Suffice it to say, we feel we still have some excess capital. We -- 953 tangible equities is more than we would optimally hold. So we have some room there. But it's a balancing act that's -- we don't think we'll be doing anything with regard to special dividends to try and move that quickly or anything along those lines if that's where we're going.

All right, no problem. And then just the last one is the tax rate. Do you expect that to kind of bounce back to the 34%, 35% range.

Yes, I would use 35% for next year. The only reason it went down to 28% was because the earnings were down, the pre-tax earnings were down and the denominator and our nontaxable items were basically the same for the third quarter and the fourth quarter, so when you divide it by a lower denominator, you get an unusually low tax rate. But the run rate for next -- for this year is 35%.

[Operator Instructions] And we do have a question from Matthew Kelley (sic) [Matthew Breese] with Sterne Agee.

This is actually Matthew Breese. Just getting back to the allowance and some of the changes there, I wanted to get a sense for looking forward and your thinking on the provision.

Matt, it depends on -- our thinking on the provision is, we prepare a comprehensive review of what we think should be in the allowance as of each quarter end, that Dave does. He considers all the risks in our portfolio, considers loss histories, et cetera, it's reviewed by our management and our board. And it's hard to say without knowing how much commercial loan growth we're going to have or what happens with our delinquencies or how loss histories may change, to say what the provision is going to be going forward. Because it's -- like I said, there's dozens of different factors that go into the calculation each quarter. I mean, suffice it to say that if we continue to develop commercial loans, that would be one factor that would increase the provision. But there are other factors that may offset that.

Okay. Is there an allowance level you guys feel comfortable going down to, or is the current level where you kind of want to hold it?

Allowance levels as compared to what? In terms of dollars, ratios?

In terms of loans measured by reserve to loans.

Reserve to loans? That's really -- we look at that at the end of the process. We look at the way that is and what the trend is on that, but it doesn't drive the process. I mean, like I say, our calculation is extremely comprehensive, it looks at loss histories, it looks at economic factors, real estate changes, unemployment in our market area. So there's dozens of factors that go into that. So the basic or arbitrary percentage of loans, we look at that at the end, but that's a small item in relation to the overall calculation.

Yes, Matt, I think that's one of the reasons we asked David to come on the call today since we made since significant changes here in the fourth quarter. To give you some idea of the complexity of the calculation and how it's particularly well-suited to our situation here in Monmouth in Ocean County, New Jersey, where David on a call in Omaha, Nebraska, it might be an entirely different analysis that he'd be performing.

Okay. And then maybe hopping to the net interest margin, which was obviously positively affected this quarter through the prepayment of the borrowings. Looking ahead, given the strength in loan growth and the transition out of securities into loans, do you expect that we'll -- we're at least at a stabilization point in the margin from here and -- I just wanted some commentary surrounding the overall margin and the outlook there.

Yes. Well, you can see some stabilization over the last 3 quarters. We had, actually, second and third quarter was very stable. And then the fourth quarter now, we saw the big jump, it was up 18 basis points from one quarter to the next. 11 of that was due to the Home Loan Bank prepayment, and the effect of that, the 7 basis points comes from other factors, and the biggest factor was the change in the mix, add securities into loans. So we do have some positive momentum now, excluding the Home Loan Bank restructuring. So we had 2 quarters where it was relatively flat, then we've seen some increase in the fourth quarter, so that's positive. So yes, I think it's safe to say that it's stabilized or maybe we have some tailwind that might help us grow in the future. The other thing we're seeing is prepayment levels, which have adversely impacted the allowance and the margin in previous periods that slowed up with respect to the 1-to-4 family mortgages and MBS, so that's positive as well. So I think as long as we can start -- continue to grow commercial loans and change the mix, then I think that the -- we may have some positive year end results.

[Operator Instructions] And as there is nothing else at the present time, I'd like to turn the call back over to John Garbarino for any closing remarks.

Thank you, Keith. So once again, let me thank you, all, for joining us this morning. We look forward to the opportunity of speaking with you again from beautiful but frigid New Jersey in the warmer spring time.

Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. Have a nice day.