Preferred Bank (PFBC) Q4 2022 Earnings Report, Transcript and Summary

Good day, and welcome to the Preferred Bank Fourth Quarter 2022 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Jeff Haas of Financial Profiles. Please go ahead.

Hello, everyone, and thank you for joining us to discuss Preferred Bank's financial results for the fourth quarter ended December 31, 2022. With me today from management are Chairman and CEO, Li Yu; President and Chief Operating Officer, Wellington Chen; Chief Financial Officer, Edward Czajka; Chief Credit Officer, Nick Pi; and Deputy Chief Operating Officer, Johnny Hsu. Management will provide a brief summary of the results, and then we will open up the call to your questions. During the course of this conference call, statements made by management may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based upon specific assumptions that may or may not prove correct. Forward-looking statements are also subject to known and unknown risks, uncertainties and other factors relating to Preferred Bank's operations and business environment, all of which are difficult to predict and many of which are beyond the control of Preferred Bank. For a detailed description of these risks and uncertainties, please refer to the SEC required documents the bank files with the Federal Deposit Insurance Corporation, or FDIC. If any of these uncertainties materialize or any of these assumptions prove incorrect, Preferred Bank's results could differ materially from its expectations as set forth in these statements. Preferred Bank assumes no obligation to update such forward-looking statements. At this time, I'd like to turn the call over to Mr. Li Yu. Please go ahead.

Thank you very much. Thank you, ladies and gentlemen, for attending our earnings conference. I am very pleased to report that we have another record quarter of earnings. Fourth quarter 2022 net income was $39.6 million or $2.71 a share, which compares very favorably with prior quarter and prior year. Because of this increased earning power, our Board has announced a 28% increase in dividend in December and to be --start to be payable in January. Growth in interest income has outpaced the growth in deposit costs. Consequently, our net interest margin expanded to 4.75% for the quarter. However, towards the latter part of the quarter, we have seen that the deposit cost increase has accelerated. We believe the catching up and this process will continue into first quarter of 2023 at least. Many of our customers are continuing to manage their money by moving their deposits from lower cost to higher costs. And then we see the market continues to offer higher deposits nearly every day -- deposit cost every day. Going forward, to grow deposits at a reasonable cost will be a challenge and will be the thing that we must do. Sequentially, this quarter has net loan increase of 1.3% and a deposit increase of 1.9%. Deposit -- I mean, loan demand has tapered down or moderated since third quarter of 2022, and we believe it will be carry-over well into the first quarter at least. Our customers generally find it just more prudent in their operations. And then in terms of -- especially in terms of new transactions or new initiative committed. Because of our high earning capabilities, liquidity and capital ratio both improved from the previous quarter. And we believe our current liquidity level and capital level can easily handle our gross -- foreseeable gross need in the year 2023. Benefited by the net interest income increase, our efficiency ratio coming at 26%. Even when we consider included a $1.8 million of OREO items. Going forward, in 2023, expenses is expected to increase. General wage inflation is the main thing. The increase includes FDIC premium -- new premium assessment, two new --at least two new planned bank branches, some planned addition to SAF and also a fully operatable SBA department that will be fully operative in 2023. Our attention since early 2022, but I'm sure that you can see on my previous earnings release report, since 2022, we've been very focused on credit matters. I'm also pleased to report that both NPAs and NPL has improved from the third quarter. At December 31, they are at a lower level than September 30. In fact, in early January, we have resolved another $5.3 million of fully collected -- another $5.3 million of nonperforming loans. Effectively, as of today, our December 31, nonperforming loans is only $200,000. In a very good early indicator of credit quality is our 30 to 89 days past due loans. I'm also pleased to report at December 31, the amount totaled only approximately $4 million. Based upon a report published by Bank of America, our third quarter return on tangible common equity is 23.6% which ranked us the second among all California public traded banks over $2 billion. We believe our fourth quarter performance will lend us apart from the same situation at least. Because of our business spa model and because we are a business bank serving business and private clients, our motto does not that allow us to necessarily become a very low cost -- deposit cost operator. But however, if you add noninterest expense to the deposit costs, which will give us the total cost of operation. For years, we have been the lowest among our peer group. We believe or I believe, okay, the high earning power and the low effective total cost will be the best defense facing a recessionary economy. We are optimistic about 2023, but we'll be very careful. Thank you. I'm ready for your questions.

[Operator Instructions] Our first question comes from Matthew Clark with Piper Sandler. Please go ahead with your question.

Wanted to start on noninterest expense and clarify some of your guidance around the growth this year. I assume it excludes the OREO-related costs in '22, roughly, I think, $2.9 million. Maybe you can speak to the run rate going forward and how you think that run rate might progress throughout the year?

Well, this must answered by Ed which is in the budgeting process.

Yes. Matthew. Yes. So if we pull out the OREO costs in Q4, we were just under $18 million on a run rate. Going forward, at least for Q1, which is always a little bit of an aberration for us because of certain costs in Q1, we're looking at probably the low end at about $18.6 million in high end, just under $20 million in terms of noninterest expense. Going forward from there, it will probably be somewhat similar, although you'll have a slow ramp rate in terms of the growth in noninterest expense.

Yes. Got it. Okay. And then shifting to the margin. Do you have the spot rate on interest-bearing deposits at the end of the year?

Total interest-bearing deposits, not at the end of the year, but for the month of December were 247 -- 2.47%.

Okay. And do you happen to have the -- since you have the average for the month of December, you have the average margin in December?

Yes. The margin for December was 4.83%.

Okay. Thank you. And then just on the overall outlook on interest-bearing deposit costs. We heard your comments earlier, Mr. Yu about things accelerating toward the end of the quarter. How are -- what are your thoughts on -- where your beta might settle out through the cycle, assuming we get another 50 basis points from the Fed here and were done relative to last cycle, I think you were in the mid-50s.

Yes. Well, my thoughts is that -- from my experience is that we will continue to see the market competitors paying more interest. And we, as a small fish in the big pond, we just have to follow the trend and do our part in the same thing and hopefully that try to manage it more closely. Now actually, you'd be surprised some of the largest institutions back in November before the December rate, they're already offering one year, I mean, like a certificate deposit at 5%, okay, and I can list -- a whole list for you. We have gathered that. So going forward, is these big institutions, what the market rate they set, what market they prepare. We just try to catch up. And we have no idea what they would do so on. But based on my experiences, I think the first quarter, the deposit costs are further accelerating increases as compared to fourth quarter. And then our margin -- in my opinion, it's not at or near top, okay, in the cycle. And obviously, margin itself has to do with the leverage too, depending on how much it grows in loans, how much gross deposits you have, in general, the spread, I think, is among the top that it's starting in fourth quarter. Which not to say in this -- in the first quarter, we're not be able to earn a very handsome margin, you know.

Our next question comes from Andrew Terrell with Stephens. Please go ahead with your question.

I wanted to start on just deposits, specifically noninterest-bearing -- if I look, I think your mix is around 21%,22% noninterest-bearing deposits as a percentage of total. I'm just trying to get a sense of, I guess, what you're seeing so far in 1Q in terms of noninterest-bearing deposit flows. And then what your sense is on where we could see noninterest-bearing deposits bottom out?

The answer is we don't know. That's one of the reasons why we say we have no control of our margin going forward because we see customers continue to manage their money. They either pay off their loans or they just reduce their loans, save interest cost or in many cases, where customers using the excess cash to payoff their real estate loan because they consider 8% or 7.5% unbearable, okay? So this trend will continue. And this is also that more people will recognize that their money can earn over 4%. Now, they want to move to TCDs and other things, okay? So this kind of movement and I try to look at other press even as big as JPMorgan, they've no idea, okay? What this migration process would be. So this is one sector situation. Another one situation, I can never tell how the big banks set their price situation and become the main competitor for deposits because they've huge market share. So we just have to follow and lot to do with their funding condition or the overall tightness about the fund. So this is really the very important wirecard going into 2023.

Yes. Understood. I appreciate the color there. Maybe if I could move over to just outlook on provision and reserve moving forward? I guess, how are you thinking about allowance levels moving through 2023?

Well, our general philosophy is we have been building up our reserve at the year-end. We will take every quarter, take a look and generally stay conservative. Take a look and to see whether that number is going to be increased or needed or stayed approximately the same. Of course, we have to subject to CECL methodology and so some of the situation is to go through a calculation process. So in generally speaking, if we based on the credit metrics as of now, I have to say we're over reserved, but we don't know what the coming economy will be. So we stay at the level. I understand some of our direct competitors has reserved less than maybe basis points, okay, that they have the same type of business as we do, but we believe that we need to be stay at this level for now.

Yes. Okay. Maybe sticking on credit. I'm just looking at loan yields, call it, near 7% -- just south of 7% in the fourth quarter. Obviously, really good for the margin. But I guess, any color on how debt service coverage profiles have changed at your borrowers, just given the increase in loan yields and any loans that you've had to restructure as a result of rising rates or any that you foresee having to restructure? Just any kind of incremental color there would be helpful.

Well, I have Nick answer that first and then I'll add on to it.

Andrew, this is Nick speaking. And for our TDR, we only have two small loans on our TDR lease, combined with only $1.5 million is belonging to one of the relationship and they're paying. Everything seems okay. And definitely for Fed's rapid rate increases and our borrower, I believe they do have some pressures on that service coverage ratio side. However, most of our loans, we have a very strong -- financially strong sponsorship behind it. And that you can see from our past year report, and we don't have that many past due under 30 to 90 days. And also nonperforming loan, we only have one mortgage loan as Mr. Yu mentioned previously, it's only a $280,000 around. That's it. So basically, our credit quality is still quite stable comparing to our previous quarters, and we expect that to be the situation and definitely there are still many, many economy uncertainties ahead of us in 2023, such as honorable energy or food supplies, inflation costs, weakening the purchase power and the rapid rate increase and fast QT side. All those kind of things are really give us uncertainties for this market and the management continues to maintain a kind of a moderate risk posture for factoring the reserve requirements at this time.

Again, it's just pretty much that I've said at this time, if based on metric makers today, we are over reserved. Okay. That's my personal opinion. But however, in general, we have been trying to consider the recessionary economy, what the effect would be.

Our next question comes from Gary Tenner with D.A. Davidson. Please go ahead with your question.

Two questions. First, on the commercial construction segment, relatively small but had a couple of quarters of decline before increasing this quarter on an end-of-period basis. Just wondering if you could talk about kind of the committed pipeline that might fund over the course of the next year? And if there's -- does that number-- does the period end number continue to trend down? Was the fourth quarter a bit of an aberration there or anything else to think about?

Nick will give you more color on that, but some of the fluctuations here then is because in the past, we have pandemic slowed down many of the projects, okay? Many of us has restarted and obviously, the summertime has been the greatest time to increase the construction, okay. So Nick.

Yes, our construction portfolio, we try to manage this portfolio under 10%. During the past quarter, I believe this is around 8%, and this quarter dropped to -- a little bit dropped to below 8%. And just to give a little bit more color on our construction loans because we don't do many construction loans, which is not a desirable products. Most of our construction loans actually is from the existing loans, and we try to slow down a little bit, especially for those condo projects and those kind of things because there's a lot of uncertainties in the economy. So we try to slow down. However, all of our construction loans at the origination, we try to base on our increased projections to have interest reserve. So we are doing construction very conservatively compared to our peer groups.

Okay, thanks. And then a question for Ed. There's obviously a lot of conjecture out there in terms of what happens to rates, how long they stay at elevated levels when the Fed does stop tightening. Just wondering, given the amount of progress you've made in terms of asset yields year-to-date or in 2022, any updated thoughts on how you might kind of manage the balance sheet to lock in some of those benefits looking forward to a timeframe where the Fed does start to cut right?

Well, I don't -- I'm not going to speak for the production side, but I know we have had a lot of discussions around, as you know, Gary, about 80% of the book is floating rate. So there have been a lot of discussions around. And making headway into doing some more fixed rate lending at this time, given the overall level of interest rates, this would kind of be the opportune time to start doing more fixed rate lending. However, that still presents a challenge, obviously, as we've talked about already, the activity has slowed down – economic activity has slowed down. But I can let -- Mr. Yu, do you want to speak to more on that?

Well, I think in overall fund management situation, we have a -- most of the floating rate loans, in fact, substantially all our floating rate loan has a floor. The floor sort of protects us from the fluctuation okay, the cognitive cost by the rate situation. And obviously, that during this high interest return, it will be sometimes a bit advantages to do selectively a few fixed rate loans. But the floor really puts us in the situation that -- I mean, that we can have time to adjust a bit along with the rate -- interest cost rate decreases. So going forward, we just have paved every step of the way, just like way is going up, we've built up the sensitive balance sheet.

Just as a follow-up to that, to the degree that you've got new loans working through the pipeline, which, as you pointed out, I mean, that's slowed down dramatically. Are your customers more interested in variable rate loans because the customer has a sense that rates are going to fall quickly. Is that kind of the general view of your customer base that I think that, that will pivot quickly to the downside?

Customers are probably more interested in this day as a floating rate loans because presumably talking about real estate, I'm not talking about C&I, okay? Because they forecast, they listen to forecast by all the economists who is indicating that rate will come down at latter part of this year or early next year, okay? And to them, it's the short-term situation.

Our next question comes from David Feaster with Raymond James. Please go ahead with your question.

I wanted to touch on some of the expansionary plans that you touched on early in the call. Maybe specifically starting with the SBA department, just curious the plans for that, whether your plans are to retain production or sell it, maybe the time line for the build-out and maybe where you're going to be focused from a regional perspective?

Okay. SBA department was started latter part of 2022 with the skeleton crew, okay? And then we are going through to be getting our PLP position. We've never been a preferred lender before, okay? So we expect the PLP position will be granted early part of this year, okay? So as far as the plan of the way you return, retain something like that, Wellington, you want to answer that?

Thank you, Mr. Yu. David, our plan is to -- as we fund the SBA loan, we will just sell it to the secondary target.

Okay. Do you have any early expectations in terms of production? Or is it kind of a wait-and-see?

It's a wait-and-see, especially with current economy and current situation. The SBA with a recessionary economy, SBA tends to slow down. A lot of people, actually, the market has slowed down. But we're just looking at to go about methodically and just very careful since it's a new product that we have, although we have experienced team and the team leader.

So you got a tailwinds on the fee income side, but wouldn't expect a huge contribution this year.

Yes, sir.

Okay. And then maybe just touching on the branch expansion side. Just curious, is -- are the branches a part of the Texas expansion in those LPOs? And maybe if you could just give us an update on where we are in Texas, how growth and demand and pipelines are trending there?

Texas is going to be converted into a branch within about from LPO to a branch in about two months. Right now, we're all busy in working on these things, okay? Pipeline does not change that much from last year to this year, a long outstanding. In fact, we currently are in a situation, the entire bank is looking at things very carefully, okay. Another branch, we have signed a lease. I think we've really signed. We're committed, okay? We think it will be in the Southern California in a very good location. We're working very closely on that, but we have budgeted it already. That's what I mean. So going forward, in the remainder of the year, as new opportunities come up, we just grab it. And if there's a new personnel that to be hired, we're not going to be worried about its budget, we're just going to hire them.

That's music to Ed's ears. And so the other thing is I wanted to touch on is you guys have been very good stewards of capital and you have a very strong capital position ahead of a potential credit cycle. But if we step back and think about a potentially slower pace of loan growth in your incredibly high levels of profitability, you're going to be accreting capital at a really rapid pace. We talked about a couple of growth initiatives. Just curious about your capital priorities here. We've seen some dividend growth. And again, carrying significant levels of excess capital into a credit cycle is not a bad thing. But just was curious whether there's any appetite to increase capital return or other capital priorities?

Thank you for asking the question, recognizing all that, okay? We -- because we are a state chartered bank reporting -- I mean, without a holding company, any capital raising is requiring a capital buyback, capital transaction was required. Shareholder approval, which is required by the state regulator. So every time we want to buy back from stock, if we want to go through the whole process, that's 9 months process. So this year, what we're going to do is we just got the Board approval to submit for shareholder approval during our proxy season. For pre-approving a total amount of stock buyback. And then we will go to the state wherever ready to act on that. And generally speaking is that the majority of opinion of the Board, is that at the beginning of the year, we need to be a little bit more careful in watching the economy and have the capital ready if the economy for some strange reason turns out, okay? So once it is clear, then we expect to return things to our shareholders.

Our next question comes from Tim Coffey with Janney. Please go ahead with your question.

Yes, I had a question about the cash on balance sheet. It still remains at elevated levels. And I'm wondering does the uncertainty about customer liquidity behavior outweigh the opportunity to reinvest that in securities.

Well, that's a very good question. As you know, Tim, we have kept inordinately large amount of cash on the balance sheet actually since the financial crisis. So we've always had a fairly large cash position. One thing we actually did do during the fourth quarter is we did invest some of that excess cash in the treasury market at where what I consider to be extremely attractive yields. And I think we may do some here in the near future in order to lock in some of those -- some of that additional yield rather than have cash float along with the Fed's interest rate decisions.

Okay. Okay. That's helpful. And then curious about what you're seeing from competitors. Clearly, your customers have started to express some cautiousness in terms of the lending behavior. I'm wondering, are your competitors, are you seeing them pull back from the market or otherwise tightened their credit boxes?

Well, first of all, strangely enough, they're all like us they're looking for opportunities, but they were very prudent, okay? But there are competitors doing things at this point of time, which requires to research onto it, okay? There's one of the largest bank in California is offering -- still offering customers a seven years fixed rate, okay, CRE loans at low 6%, very low 6% and without pre-payment penalty. So they are willing to grab business by forgiving the interest income. So we're looking at that. We lost a number of accounts to them, but we're still looking at that and to see how we can compete with this kind of situation. I guess there's always going to be low, I should say, people that you cannot compete with. We lost another loan to credit union, 5.25% in five years, which -- fixed rate. We just can't compete. We don't -- happen things every day.

Okay. So you're still seeing irrational activity. Okay. All right. Those were my questions. Thank you very much.

This concludes our question-and-answer session. I would like to turn the conference over to Li Yu for any closing remarks.

Well, actually, the question-and-answer is all pointing out the things we want to further clarified. So thank you very much for your time. And as I said, we are optimistic but we would be careful. Thank you.

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