OceanFirst Financial Corp. (OCFC) Q1 2019 Earnings Report, Transcript and Summary

Good morning and welcome to the OceanFirst Financial Corporation Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Jill Hewitt. Please, go ahead.

Thank you, Andrea. Good morning, and thank you all for joining us. I'm Jill Hewitt, Senior Vice President and Investor Relations Officer at OceanFirst Financial Corp. We will begin this morning's call with our forward-looking statements disclosure. Please remember that many of our remarks today contain forward-looking statements, based on current expectations. Refer to our press release and other public filings, including the Risk Factors in our 10-K, where you will find factors that could cause actual results to differ materially from these forward-looking statements. Thank you. And now, I will turn the call over to our host this morning, Chairman and Chief Executive Officer, Christopher Maher.

Thank you, Jill, and good morning to all who have been able to join our first quarter 2019 earnings conference call today. This morning, I am joined by our Chief Operating Officer, Joe Lebel; and Chief Financial Officer, Mike Fitzpatrick. As always, we appreciate your interest in our performance and are pleased to be able to discuss our operating results with you. As has been our practice, we'll highlight a few key items, add some color to the results posted for the quarter, and then we look forward to taking your questions. In terms of financial results for the first quarter, diluted earnings per share were $0.42. Quarterly reported earnings were impacted by Capital Bank merger-related expenses and branch consolidation charges that totaled $4.4 million net of tax benefit. Excluding those amounts, core earnings per share were $0.51, a 13% increase over the core earnings of $0.45 in the first quarter of 2018. Core earnings per share was slightly lower than the fourth quarter of 2018, due to annual compensation of benefit cost increases, elevated professional fees and the addition of the Capital Bank operation, which will provide additional earnings power following systems integration and branch consolidations, which are scheduled through June this year. Regarding capital management for the quarter, the Board declared a cash dividend of $0.17, the company's 89th consecutive quarterly cash dividend. The $0.17 dividend represents a 33% payout of core earnings, allowing us to build capital levels, as we pursue a variety of opportunities to deploy that capital in growth initiatives. Over the quarter, company repurchased 159,307 shares at a weighted average price of $23.89. There are 1.1 million shares remaining under the existing repurchase program. Comparing our results against the first quarter of 2018 highlights the progress we've made to improve the performance profile of our business during a relatively challenging interest rate environment. Performance metrics include a strong net interest margin of 3.78%, improving 5 basis points compared to the prior year. A core return on assets of 1.32% is well ahead of the 1.19% posted in the first quarter of 2018. And the return on tangible common equity improved 39 basis points versus the prior year, reaching 14.46%. From a balance sheet perspective, comparisons versus the prior year period are also helpful. We continued to strengthen the company's position by several key measures. We preserved the strong liquidity position with a loan-to-deposit ratio of 95%, built tangible book value per share, which increased 6% as compared to the prior year; and increased the tangible common equity ratio by 42 basis points as compared to the prior year. Asset quality remains a key focus, as we consider the possibility of weaker economic conditions in the coming years. During the past few quarters, we've discussed our commitment to the credit risk management, even when that commitment dampened the loan growth. That discipline is evident in our continuing low level of non-performing assets, which totaled just 28 basis points of total assets and extremely modest net charge-offs, which totaled just 3 basis points on NOI basis. While we see no near-term threats in the current economic expansion, it is prudent to be prepared for a possible downside surprise. Over the coming quarters, our strategy is to drive further earnings growth by focusing and achieving synergies planned with the Capital Bank acquisition and by accessing continuous expansion markets as a source of additional loan growth. The expansion markets of metropolitan Philadelphia and New York City are well known to us and have been the source of limited lending activity over the past few years. Our knowledge of these markets and our methodical approach to expansion is consistent in our credit risk management discipline. Capitalizing on these expansion markets is a long-term strategy to build operating leverage through high-quality and highly valuable organic growth. Our geographic position provides the advantage of operating in an incredibly dense economically diverse part stretching from metropolitan Philadelphia to metropolitan New York City and simply the largest and most dense banking market in the United States. During 2018, much of our focus was on the integration of Sun and the completion of back office consolidations that impacted 100%. Completing these projects set the foundation to enter metropolitan areas from a position of strength. With that foundation which includes our now $8 billion balance sheet, excellent liquidity and strong sources of internally generated capital, we expect to be able to win market share in the largest commercial banks operating in those markets. As a reminder, our annual shareholder meeting is scheduled for 6 PM on May 29. A shareholder meeting will be held at our administrative offices in Red Bank, New Jersey. This year we're introducing a simultaneous webcast and we hope the added convenience of the webcast will encourage increased shareholder meeting. At this point, I'd like to turn the discussion over to Joe Lebel who will provide more details regarding the development of our business.

Thanks Chris. Loan production for the quarter was strong and exceeded our expectations with originations of $261 million. We had a headwind from our commercial teams, including some early activity from our newly acquired Capital Bank team members and our expanding Philadelphia region. While we expected portfolio growth to be back-end loaded in the second half of 2019, we were opportunistic and purchased a $100 million seasoned residential loan pool which bolstered our own originations and allowed us to grow the overall loan portfolio by $82 million net of the Capital Bank acquired loans. Much of the growth came at the end of the quarter and isn't yet reflected in the interest income stream. And more positively, many of our commercial closings had limited fundings in the first quarter which bodes well for subsequent quarters. In regard to our New York City region, as you know, we announced the hiring of Dan Harris as our new regional president. Dan comes to us with many years of experience and success in the New York market and is quickly building out a team which we expect to generate activity in the second half of the year. Dan has two lenders in New York City today, including one incumbent from our Sun Bank acquisition. We expect that team to grow. We are also pleased with the early success for our Philadelphia region expansion and expect solid second half results as that team gains traction. There are five lenders in the region today and we are finalizing our regional president candidate too and expect a second quarter announcement of the Philadelphia region president's election. In accordance to deposits, net of the Capital Bank acquisition, we saw a small increase of $27 million as seasonal movements in business core and government largely offset each other. As we noted last quarter, we had begun to proactively increase the rates in some of our larger treasury service clients and accordingly saw overall deposit cost increase by nine basis points. We believe the bulk of this actively managed repricing has been completed and costs should moderate. As Chris mentioned earlier, net interest margin is performing well as a result of our relationship banking model, disciplined loan and deposit pricing and bolstered by our expertise and client penetration in treasury management services. Given the challenging external rate environment on loans and deposits, our entry into new markets and reductions in purchase accounting, we expect our margins to slightly contract in the second quarter. Operating expenses increased $4 million in the quarter, net of M&A expenses, largely due to the addition of Capital Bank and increased compensation and benefit costs. Expenses are expected to trend downward as we gain efficiency from the coming systems conversion in June. In addition to the closing of three branches related to the Capital Bank acquisition, we have announced the consolidation of another three legacy OceanFirst branches which will occur in late July. Lastly, a quick update on AmiGo, our digital account visual online account; and NestEgg, our hybrid robo advisory account. Two initiatives that we had announced last quarter for roll out in 2019. Both products are meeting our expectations, but will not have a significant 2019 income statement impact. We will begin reporting NestEgg assets under administration as an additional wealth metric beginning in the second quarter. We expect more than 80% of our prior third-party financial advisory clients to migrate to the NestEgg platform, bringing assets under management at NestEgg to $400 million by the end of the third quarter, adoption of the NestEgg product for our retail client base has been better than expected. In summary, we expect slight contraction in the net interest margin as deposit cost moderate and loan yields are governed by our pricing discipline. The pace of organic growth should accelerate in the second half of 2019 as the Phillie and New York market teams build out. Operating expenses will trend down, although some of the expense decrease will be directed to building out the New York City, Philadelphia AmiGo and NestEgg initiatives. With that, I'll turn it back to Chris for the Q&A part of the call.

Thank you. At this point, Mike, Jill, and I would be pleased to take your questions.

We will now begin the question-and-answer session. [Operator Instructions] And our first question comes from Frank Schiraldi of Sandler O'Neill. Please go ahead.

Good morning.

Good morning, Frank.

Chris, I wondered if you could just follow-up on comments on loan growth, your thoughts here. Is it still -- sorry if I missed it, you might have said. But is it still the thinking of $50 million to $100 million a quarter? And if you don't get there on originated product, do you think it's likely you would backfill with a purchase?

Yeah, I think that guidance remains consistent. The backfilling is something we’ll do opportunistically. So we have to have a condition of being able to find portfolio that makes sense for us. So as it happened in the closing of the first quarter and toward the end of the quarter, we found a nice portfolio to add in and had the flexibility and the funding to do that. So it is possible that if we don't have the organic growth, we can't find a portfolio that it would execute. They have to been held our standards around pricing and credits but I think that guidance remains intact. I think by the second half of the year, we expect we’d be doing that predominantly again.

And what is your appetite also for participations with other banks of local borrowers?

So we for many years, we participated both on the buy and the sell side. So I think this one is a defining characteristics of our sector. We've worked collegially with many of our competitors from time-to-time. So we've maintained a portfolio, an active portfolio over years. That said it's not a primary business for us. We don't wanted to constitute too much of the loan book, because we think it's got less long-term value than the relationships that we only completely cover ourselves. So it's a relatively small percentage of the loan portfolio, and we expect to compensate.

Great. And then I know how the conversation came out on the New York state tax rates and the way the REIT structure is still taxed at the lower rates. Is there any change to that at all or any scuttlebutt on whether the state is basically accepting of that, or if it's still sort of something that they may be looking at?

Yeah, we’re not aware of any developments there. Specifically the budget conversation for the state heats up over the summer. So we're watching closely but we've not heard anything.

Okay. And then just ,finally I wondered if you would just give us a total purchase accounting accretion capital? And what's left from Sun that would be in the fair end to the margin in the quarter? And also sort of how that is scheduled to run off here?

Yeah. Frank, its 24 basis points of purchase accounting accretion in the margin. So that's about $4 million. $521,000 of that came over from Capital for the two months. And there's still some -- besides Sun, there's some from Cape and Ocean City, et cetera. But the New York was $521,000 from Capital. And in terms of the runoff, for this year, it's generally about $300,000 a quarter then it runs down through the next -- through the remainder of this year.

Okay. So that $500,000 from Capital, that's basically the delta between last quarter and this quarter's purchase accounting accretion?

That's the increase, and we had the Sun decrease. So...

Yeah. Last quarter purchase accounting was 23 basis points. So we had some accretion related to Capital, and then it winds down -- the rest of the book winds down every quarter. So it more or less offset each other. So we only had one basis points of accretion of increase in purchase accounting in the margin.

Great. Okay. Thank you.

Thanks, Frank.

Our next question comes from Will Curtiss of Hovde Group. Please go ahead.

Hey. Good morning.

Good morning, Will.

Frank just asked my question on the accretion. So I appreciate the color there. Wanted to ask -- go back to the expenses, and I think you've -- just wanted to clarify what you had said about the expense base. Just kind of looking for how that will trend in the next quarter too. And I suspect that given the deal -- the closing of this deal that you had a pretty full load in the first quarter. So just any help on the second quarter expense base will be great?

So I think when you think about our expense base in the first quarter, I pointed out we had a much higher-than-normal increase to our benefits expense this year that began January 1, and that's just helped benefits. We also calibrated all the compensation actions for the company beginning on January 1 as well, so that the annual merit increase is going to flow through. So we absorbed that in January, so that we would not have that recurring throughout the year. We did have some expenses related to our year-end audit that were a little bit elevated, that we had some expenses related to Capital. So I think this is kind of probably the high-watermark for the year for expenses. Now as we move forward, we have the branch consolidations, but I would caution those are happening in June. So you're really not going to see those expenses pull out until the third quarter. And then a portion of those expenses, as Joe said, we're going to allocate back to our expansion in Philadelphia and New York. So this is the high-watermarking expenses we do in quota sales for the executives. Mike anything you would add?

Yeah. For Capital, it was $1.4 million came in, in the first quarter that was for two months. So we'll see $700,000 increase in the next quarter -- in the second quarter, just with the extra month of Capital. Of course there will be revenue cost, extra month in revenue as well, but other than that Chris is on target. We expect that the first quarter increase from the fourth quarter will settle in, and the quarter number will be steady. And then we'll start taking costs out in the third quarter for branch consolidation.

Okay. Thank you very much. And then just the last one for me with the Capital Bank deal closed, Chris I'd be interested in getting any updates on how you view M&A or the potential for additional announcements this year? Also kind of general comments on what you are seeing in the market from an M&A perspective?

I think we had a lot of M&A news in the first quarter with some larger deals, but certainly got people with potential. We've had a lot of conversation going on, and there's always some level of conversation, probably a little more heightened than it was this time last year. But the end of the day, our view on acquisitions has not changed, meaning that we will look for opportunities that advance our business model. So we are looking for things that provide high-quality performance metrics like the Capital Bank acquisition, where you've got good strong earnings, where you have deposit funding aspect of things, where we find the opportunity to enhance the value of our existing franchise. That being said, we closed the Capital deal from announcement. The closure was 98 days. So we're pretty proud of that. We're comfortable that that integration is online. And to the extent, there are attractive things in the market today. You could expect that we will evaluate them carefully, and if they make sense. We feel comfortable engaging in further M&A activity if the opportunity arises.

Right. Thank you very much.

Our next question comes from Russell Gunther of DA Davidson. Please go ahead.

Hey, good morning, guys.

Good morning, Russell.

I wanted to follow-up on some loan growth conversations. So you guys had mentioned and we know you've been kind of lending a bit into the Philadelphia and New York metro area for a while. But could you quantify any contribution from some of the new hires this quarter? And then how you'd expect those guys to ramp throughout the rest of the year?

Russell, it's Joe. I'm pretty happy with the Philadelphia guys. We didn't expect that we'd see traction in the first quarter as they just started with us early in the year, but we closed over $25 million there in the first quarter. So -- and their pipelines are solid. So we're pretty happy with the early traction there and the ramp rate. Dan is in the process of building out his teams. So obviously, he's inherited one of the folks that we had at Sun, who's done well for us and Dan and I expect, we'll build that team fairly quickly. So I think he's going to be a little bit slower really forecasting for him as we've talked about prior second half of the year. I think Philadelphia can continue to be meaningful in the second quarter and just continue to go. Our original targets of net loan growth in that $100 million plus second half of the year I think remains on track.

That's very helpful, Joe. Thank you. And could you guys share how paydowns payoff activity trended this quarter versus last? If you could quantify that that would be helpful too?

Yes, it's -- it was much lower than it was in prior quarters, but we did take the opportunity to exit a few substandard credits that were performing, but not the type of credits we want to keep and those were in the moderate eight figures. So it did have some impact on overall growth.

Okay. Great. Thanks, Joe. And then lastly just a follow-up on the expenses. I appreciate the color you guys have shared already. Can we tie it together though in terms of core efficiency ratio target whether that's for 2019 or would it be achieved by the fourth quarter of this year? How are you -- how is that shaping up?

We think that we'll have more cost saves out from Capital and from our branch consolidation by the beginning of the fourth quarter. So the fourth quarter will be a good run rate and we think that we'll be approaching the low 50s at that point.

If have to look at both sides of the efficiency ratios so the costs will be coming up by then. And to Joe's comments about low growth if you're able to get a couple of hundred million dollars of the loan growth and you have the cost out then that helps us really tap out the efficiency ratio.

Very good. Thanks so much, guys. That’s it from me.

Thank you.

[Operator Instructions] And our next question will come from Sean Tobin of FIG Partners. Please go ahead.

Good morning, guys.

Good morning, Sean.

I guess can you just touch on the general health of the economy in your Southern New Jersey footprint? I know you said that most of your loan growth in 2019 is going to come from Philadelphia and New York, but do you see any coming from New Jersey?

The way we set things is reasonably positive across our market. So what we're hearing from our clients and what we're seeing in our annual financial reviews is that they are doing well. Actually one of the noteworthy outcomes of that is how far the relationship we might like them tomorrow, but our clients have strong balance sheets. They are having good years in terms of earnings performance and volumes are up. There might be a little bit less optimism that you saw maybe in the third quarter of last year, but not near as soon as the members were associated with year-end and the beginning of the year when the government shut-down and stronger concerns over in Paris. So as we look at kind of key bellwethers employment data in our markets is better. Real estate values are improving. Occupancy rates are higher. FICO scores are pretty good. Delinquencies are very low. So we have all those -- all the very positive signaling. I think one of the questions that was most of that data would be backward looking not forward looking. So we are watching obviously on a national level. The Fed is sending some signals with their pause. You can see that weakness in Asia leading to weakness in Europe with Brexit and Paris still not being resolved. So we're looking at this and saying we don't see any sign for concern today, but we see a bunch of reasons that 2020, 2021, maybe 2022 could be a little different. So, once you see exceedingly vigilant and make sure we continue the same kind of credit risk discipline as we had in the past. So, all the signals are good so far, but we're not thinking on this.

Got you. That's helpful. And then I guess switching gears to the buyback you have a little over one million shares remaining under approval. What are some of the thresholds that will determine how aggressive or not aggressive you'll be on that?

I mean look at buybacks we have similar lens of qualifications when we look other M&A except for buying ourselves. So, we think about tangible book value dilution. We think about earn-backs. We think about the IRRs of the transaction. And -- however, maybe you always know or hope you know yourself the best. So, our appetite to acquire share of our own stock will be probably a little bit stronger than buying share of someone else's stock through an M&A transaction. So, I think you take those discipline of saying, our transaction is simply about three-year earn-backs and potential book value dilution. We might go a little further to buy our own stock back. And then you can see while we have appetite for buy back the average price we were buying back in the first quarter was $124 a share which we think is a great opportunity to be with price of share.

Got it, okay. And then I guess lastly on the cost total deposits, we saw descent uptick this quarter. And you noted you see it moderating in the second quarter. If you were to look at kind of the second half of the year, could you even see that figure stabilizing?

It seems so at this point. It's very hard to look that far down the road of deposit costs. The cost increases that you saw in the first quarter reflects little more competitive business segments which is our treasury products. We have about $2 billion worth of deposits that have at least one treasury service with us. And obviously, those folks have higher average balances. They have the ability to sweep funds in and out of the bank and take advantage of short-term and overnight investments. So, throughout the fourth quarter and a little bit in the first quarter, we sat down very methodically with our largest deposit clients and worked out structures that we think are going to serve both our clients and ourselves well for the remainder of the year. So, we don't see a lot of pressure there and we certainly don't see the pace of pressure that we would have seen in the markets last year. So, the number of banks offering special rates in CDs and money markets although we don't participate in those that set a tone in the market and we're seeing much of that. So, you'll see a little bit of a lift in last of those increases going through this quarter. And then absent a change in the macro environment you probably see it more modestly than rest of it. On the other side, though, one of the downsides is the Fed pause. Some of our margin expansion has been driven by increases in the mix of the product. So, we're not going to have as much deposit pressure but we're also not getting the opportunities of that have loan rates involved.

Got it, makes sense. Thanks guys. Nice quarter.

All right. Thank you, Sean.

Our next question will come from Collyn Gilbert of KBW. Please go ahead.

Thanks. Good morning guys.

Good morning Collyn.

Just to dig into the loan book a little bit. So, the purchases that you guys made, the $100 million resi book that you bought this quarter, what was the weighted average yield on that?

About 4% Collyn.

Okay. And then of the $2 billion or so that you have on your books now on resi mortgages, how does that split between ARMs and fixed rates?

It's about two-thirds fixed rate.

Okay. And is there much of a rate differential between the fixed portion and the ARM portion at this point?

Yes, the fixed portion still out-yields the ARM portion, but the ARMs are catching up now with adjustments.

Okay. Okay. And then Joe just in terms of your expansion efforts here throughout some of these geographies, are you seeing much variation in loan pricing or structure among the Philly market moving to New York City and then legacy Southern Jersey markets?

Yes, we're going to see - we see already, obviously, pricing in New York is going to be a little bit tighter. We expected that as we started to build out the market expansion. I don't see much of a difference in the Philly market. And competition is everywhere. It's always in the structure in a variety of ways, but it's not something we're not -- it's not something we're afraid of or that we're not used to. So we know where our credit cut lives, and we will -- and remain pretty confident that we're still going to get the kind of credits that we want in the markets. It's driven by the folks that we obtain from the other companies. And Dan Harris is a good example. A lifelong New York guy. He understands the type of credit quality we want. We'll be more efficient and that can offset some of the pricing there.

Also if the markets have a -- markets are different in our competitive ability to get different kinds of loans. So but we always -- we love seeing our lending above owner-occupied CRE, where get those deposit balances in the last. I think that we're going to be more competitive in C&I in owner-occupied CRE in the markets like our core markets in the Philadelphia metro, where we've had a little longer contraction. Probably the early lending we'll do in New York will be a little bit more real estate centered, and that's okay with us, because we just -- we need to get different things from different markets.

Okay. Okay. That's very helpful. And then just on the expense discussion, so hearing you obviously the components and the expectation that expenses are going to start to decline as the year goes on. I guess ultimately it just -- it seems like you're settling on a little bit of higher level than what I thought. And maybe that ties into the efficiency comment Mike that you made. I think you said low 50s now by fourth quarter. I think in prior commentary has been closer to 50%. Maybe I'm slicing hairs. But just curious kind of more about the ability to get to that 50% definitive target, when you think you can do that.

Yes, I think, you're spot on Collyn, our investment in building out Philadelphia and New York has not been expensive. And because we have a focus on relationship talent, which is not inexpensive talent right, high-quality people and quarterly demand certain level of competition. And that's the biggest expense there. We're not building out retail branch networks or engaging in a lot of real estate transactions in either of those markets. So as we look towards this year, and think about the expenses we're investing -- or the investments we're making in Philadelphia and New York, those are going to be reasonably sized. Depending on how quickly the loan volume comes on, we do expect that the loan volume will more than cover that efficiency ratio going forward. But you may see -- we may not get the 50% this year because of that, maybe that's something we could get to in 2020.

Okay. Okay. That's helpful. And then just on capital, Chris, you just indicated given that where your pricing, where you guys bought back in the fourth quarter or this quarter less than 24. Just how are you kind of balancing buybacks, dividends? I mean, the organic growth is limited just given your capital build here.

Well, I think you -- the highest-quality growth if you think if the margins we're operating at, every dollar of organic growth you can do with those margins is going to be highly valued. Doesn’t give you the full [Indiscernible] so that's part of the thought behind mortgage service expansion in new markets. However, it's -- we're not going to use our excess capital. We don't expect it to be able to fully deploy that from organic growth. And dividend and the run rate we're going at there's a significant amount of capital that remains in the company. The second I think best thing to do with that would be to find accretive M&A transactions that could demonstrate a good track record of delivering value on those, but those are tricky. You have to make sure you find the right volumes. You have to make sure that you don't trip up. And you have to make sure you stick to the disciplines. And the reality is that multiples have changed a bit in the past six months to nine months, which changes the calculation on the fundamentals of how you responsibly price an acquisition. So we look at it, say, organic as best. M&A is a great second tool that we've used effectively in the past and we continue to. Then we've got our regular dividend and the buybacks and -- but if we were to think about things in longer spectrum organic M&A, the rate of dividends and buybacks [Indiscernible].

Okay. Okay. That's helpful. And then just I guess my final question just ties kind of more broadly on thinking about EPS growth for 2020. And I think as we sit today 2020's going to be the first year where you don't have any acquisitions. Let's assume of semi-stable NIM outlook maybe no change in rates and maybe the pickup now of some of the tailwinds of the lending efforts that you guys are making. What do you think kind of a reasonable target would be in EPS growth for 2020? And again, it's just I'm asking it because it's so much of historic has been so acquisitive-based that trying to get a sense of what you see or to see is the kind of the organic strength of the organization as it relates to EPS growth?

Yes, I think if you think about EPS growth is the organic component and then we feel we backfilled it with M&A as well. Organically, if we're growing loans at the level we're talking about growing them, it's going to be a relatively modest increase to EPS. So we're always looking to move that northwards and improve the value of the company. But if you took the math and there's a lot of good models out there of you and others. You add $400 million worth of loans on top of that, you're not going all of a sudden have a dramatic change in your earnings per share. However, if we're able to consistently deliver that increase and moving up period after period. And hopefully, we'll find the opportunity at some point this year next year through another accretive M&A deal. Those two things together are pretty powerful. And one of the internal things, we'd like to do over the long-term and it's not a short-term problem is we'd like to see, if we could compound the EPS growth somewhere around the 10% a year level. And it's a -- it's been kind of a long-term target for us. So look if we can do a little bit of buybacks, little bit of organic growth and maybe you got to fill in a piece of M&A here and there, I think that 10% over the longer term is an achievable target, but there may be years that you've only got 7% or 6%.

Okay. Okay. All right. That's helpful. Thanks guys.

All right. Thanks, Collyn.

Our next question comes from Erik Zwick of Boenning and Scattergood. Please go ahead.

Good morning.

Good morning, Erik.

First, looking at our recent loan pipeline trends the balances have declined since the middle of last year. Yet you've still been able to generate strong originations particularly on the commercial side. Can you talk about the factors that have allowed you to achieve such strong and improving pull-through rates?

I always get a little nervous when I look at points in time on the pipeline, because the pipeline especially in our core markets can be seasonal. I tend to look at stuff on a year-over-year basis on occasions. Quarter-over-quarter can be difficult. But I am cautiously optimistic by the continued improvement increase in the commercial pipeline, which is really the focus of the company, focus of the expansion, and I expect that to continue to grow. I'm happy with the net yields. I think you see some of that drop off a bit given the fact that you've seen I don't know the Fed come out, but also 5 and 10 year yields in the treasuries have dipped more than a bit over the last quarter. But on an overall basis, I think the resi pipeline tend to be seasonal in nature, but the commercial pipeline quarter-over-quarter has continued to improve. So I think that - and pull-through for us is normally pretty solid. So I'm cautiously optimistic as we move forward.

Thanks for that for the color there. And then are you able to provide any update on the resolution of the material weakness issue?

I can certainly give you some color on this -- on the issue. So in terms of the issue obviously, we were able to address to the point where we were comfortable certainly with the integrity of the financial statements that have the qualified opinion there. In order to clear that, we have to go through another cohort into our external auditor which in case is KPMG. Although, there is a mechanism that would allow us to clear that on an interim basis, so we could go through the test and we could do that, we've actually not been able to identify another public company, who's gone through that and the expense to do it. We've resolved the issue to our satisfaction in the first quarter. The work that we'll do during the course of the year, to make sure we will prepare for the next year in audit. So we would expect that you will not see that coming from formidable lift until our next full audit, which will be at year-end. That said it's not a distraction to our business. We were able to get our arms around it. And although, it did elevate expenses a little bit in the first quarter it's -- the action has been remediated. It's not something that we expect to have any material effect to the company over the course of this year.

Great. Thanks for taking my questions.

Thanks, Erik.

[Operator Instructions] And our next question will come from Matthew Breese of Piper Jaffray. Please go ahead.

Hey, good morning.

Good morning, Matt.

I wanted to circle back on the NIM color and the NIM guidance. Obviously, with accretable yield trending lower that's going to create a natural headline to the reported NIM. But what is the core NIM expected to do over the course of the year? Is that under pressure as well?

So it has not been under much pressure. So what you saw in the first quarter is probably a little stronger than we expect to see later in the year. But there is this process of the newly originated loans are coming in at better yields in the full portfolio. So as we rotate through that the core NIM absent the deposit price pressure should be slowly expanding. The question is will it expand enough to offset the GAAP NIM and the purchase accounting degree. That said, as Mike noted, the bogey is about $300,000 a quarter and we have gone down on that. So it's not a giant number and given the amount of originations, we expect to be doing in the second half of the year the organic growth in the loan book should be able to offset this. So I'm always a little cautious about -- we don't want to give any forward-looking guidance on net interest margin, because it moves around a little bit. But we don't see moving materially up or down over the course of the next several quarters. You could see three, four, five basis points in either direction, but you're not going to see a sustained increase or a sustained decrease in the GAAP NIM. You can see it kind of bouncing around.

Matt, the core NIM was 3.51% for the first quarter, that's up four basis points from the fourth quarter. So it actually expanded. We take that that excludes the purchase accounting and the prepayment fee. We call that non-core. So we don't think if the core NIM will surprised it. It expanded by four, but we think it will be pretty steady. I think the decline will come in the non-core items. The purchase accounting will run down like I said earlier. And the prepayment fees for us was slightly elevated in the first quarter. They were three basis points. Typically, that's only a basis point for us.

Okay. And Chris, maybe going back to your deposit commentary, it sounded a bit more optimistic if the Feds on pause towards the end of the year. But just thinking about your cost of deposits, it's still quite a bit lower than many of your peers will the structure -- even with the Fed cuts will the structural difference in your cost of funds versus peers put you more at risk for just a natural increase even if the Fed is on pause or cutting over a longer period of time?

We're not typically concerned about that. I'm going to walk you through why. I think the composition of deposits is incredibly important. So today we have very few CDs and we have virtually no -- near zero promotional money market accounts. We have not used either of those products to fund the bank for many years. So as a result, the deposits we have call them kind of at risk or the highest betas are just not on our balance sheet. We do have -- our large dollar depositors tend to be commercial entities and government entities. Those are the ones we have to be careful about and I think we got ahead of those in the last two quarters and look we had to increase some rates there and make sure we were being competitive. And there were cases where we had a large commercial depositor who might say hey, look I can squeeze $20 million out into fixed income funds. Give me a better rate I'll keep it here. So we got those deals and we need to work for our clients in the bank. So, if you think on the consumer side, we don't have a product structure that is particularly susceptible to those cost increases. And on the commercial side, we think that we have been kind of out in front of it. So there's certainly every risk that the cost of deposits may go up by five to 10 basis points a quarter. But you're right to point out, our deposit costs are much above than peer group. But that's a structural difference. It's not because of a lag or a market issue. We have all the same competitors across the street from all of our branches. And so I don't expect an acceleration on cost of deposits.

That's great color. Thank you. And then just thinking about the balance between growing the book through organic means and inorganic means such as the portfolio purchased this quarter and tying that into thinking about building franchise value I think organic growth is clearly a higher multiple garnering kind of way to grow the book. How do you balance those two things? And think about perhaps in this environment given how competitive things are why purchased loans may be aren't -- shouldn't have the negative connotation that they typically do?

You've got to look at a variety of things. There's everything in life right moderation is key. Overemphasizing any particular part of the business strategy. I'll tell you portfolio purchases are an effective way to deploy excess liquidity. We had the liquidity and we were able to deploy it. They can also be great way to watch and manage the interest rate position. So after spending the last several years preparing our company to be asset-sensitive, at the end of the day we don't want to take an interest rate risk position. We want to be relatively neutral. So we had the ability to put on some slightly longer dated assets and actually moderate our interest rate risk position closer to neutral. One comment I would make and the reason that on the participation side which we talked about earlier or the pool purchase side is that the loans are finding a good use of our liquidity. They will never be as good as our organic product. And for this reason, we are a relationship business. So when we're making our own commercial loans, the ability to fund those because commercial deposits of our client is a key part of our value proposition. So we won't, I think, opportunistically put cash to work but we have to continue to drive the company in relationship commercial loan originations that bring treasury services with them and bring deposit funding, bring other opportunities for our products. So, I think done in moderation it's fine. I think it is something that we were relying on with a much larger degree and longer term in nature that have cost to consumer.

Okay. Understood. My last one is just really in regards to CECL. If you can give us any color on where the first day kind of true-up reserve might shake out? And then as you've gone through the process, just thinking about the composition of your book residential and commercial real estate heavy given that dynamic versus some of the forward-looking aspects of CECL, does it force you to think about the strategy of the incremental loan a little bit different under the new methodology?

So, I'll make a few comments there. Obviously, we've been preparing for CECL for quite some time now and we feel very comfortable that we're on track for the implementation effective -- with the requirement to be effective in the next year. I don't suspect we're early enough, but I would imagine later in the year we'll give you more precise guidance around the impact of it. But I'll make a few comments to that. The first is that by nature of the way we built our business in the last few years a significant portion of our loan portfolio is acquired. And when you acquire that under a fair value structure, you're essentially using the same discipline that you would under CECL. So the majority of our loan book is an acquired loan book and is already marked as the life of the loan book. And you can see this when you think about our reserve balances. We have an allowance for loan losses, let's call, the range of $17 million. We have a unamortized purchase accounting credit margin in the range of $30 million. So the majority of our set asides for credit are actually in the purchase accounting side not in -- that's the reason our allowance was up -- low. I made that comment because if you think about our transition to CECL having more than half of the loan book effectively already there will dampen CECL's impact on us. The other thing is if you look at the historical loan losses obviously in the first quarter just three basis points. But if you go back over a very long period of time including the crisis, our loan losses were probably in the range of about 15 basis points. So if that's the long-term average and our loan book has about, call it, six-year life, you can kind of back into what you think the ballpark would be around reserves. If you look at the allowance in the credit market you have today it's not very far from that. So we don't expect the impact to be that material. The second question, though, is what does this mean for lending going forward. And I don't think none of us really know for sure, but you are going to start to see changes. The first is longer-dated loan instruments. So in our case take the residential loans. The life of the loan's loss potential on a long-term loan is going to be higher than a short-term loan. So, the embedded cost to provision for residential loan is going to be different than the embedded cost of the provision for a commercial loan. And I think this just continues that trend, multiyear trend around favoring commercial assets over consumer assets. So, I think, you see something only comes into effect next year. You're going to see a profitability pressure around long-dated assets which are predominantly consumer and more favorable treatment of commercial assets. So, that's not a new story for us. And you've seen at one point consumer assets was the majority what the bank did. They are now a significant minority and you've probably seen they have continued to go down that path.

That’s great color. I appreciate it Chris. Thanks for taking my questions.

Thanks, Matt.

[Operator Instructions] This concludes our question-and-answer session. I would like to turn the conference back over to Chris Maher for any closing remarks.

Great, thank you. With that, I'd like to thank everyone for their participation in the call this morning. We look forward to providing additional updates throughout the year. Thank you.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.