Provident Financial Services, Inc. (PFS) Q3 2017 Earnings Report, Transcript and Summary

Good morning, and welcome to the Provident Financial Services, Inc. Third Quarter Earnings Conference Call. All participants will be in 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 now will turn the conference over to Leonard Gleason. Please go ahead, sir.

Thank you, Keith. Good morning, ladies and gentlemen, and thank you for joining us today. The presenters for our third quarter earnings call are Chris Martin, Chairman, President and CEO; and Tom Lyons, our Executive Vice President and Chief Financial Officer. Before beginning a review of our financial results, we ask that you please take note of our standard caution as to any forward-looking statements that may be made during the course of today's call. Our full disclaimer can be found in the text of this morning's earnings release, which has been posted to the Investor Relations page on our website provident.bank. Now, I’m pleased to introduce Chris Martin who will offer his perspective on our third quarter results. Chris?

Thank you, Leonard, and good morning, everyone. PFS continued its strong and consistent performance with record revenues, record net income and earnings per share of $0.41 for Q3. Our annualized return on average assets reached 1.11% for the quarter, with the corresponding return on average tangible equity of 12%. Our assets at September 30, 2017, totaled $9.5 billion, as our net loan growth was affected by increase in payoffs despite strong origination activity during the most recent quarter. The loan pipeline has never been larger with a diversified mix of CRE and C&I loans. The competition is, in our opinion, reaching for volume as credit, covenants, or lack thereof, terms and structure are very aggressive and are not adequately pricing in risk. We continue to adhere to our established ROE target and credit discipline, choosing to only bank those deals that meet our criteria. Noninterest-bearing and interest-bearing core deposit growth continued in the quarter, and our total cost of deposits increased by only 2 basis points to 30 basis points. Our core deposits were 91% of total deposit at September 30, 2017. Asset quality improved, although net charge-offs were slightly above our norm for the quarter. All metrics continue to improve as we remediate problem assets expeditiously as possible. We achieved an efficiency ratio of 54.2% for the quarter, with expenses to average assets at 1.93%. As we have discussed in our previous calls, preparation and costs related to crossing the $10 billion asset threshold continue to be incurred while we interact with legislators in Washington and our regulators to address the arbitrary asset levels set forth in Dodd-Frank. And we are close to finalizing the sale-leaseback of 12 of our own branch locations, which we anticipate completing later this year. Branches still matter, and we continue to evaluate our network, keeping in mind the ever- increasing digital channel and utilization rates. So consolidation, repositioning, relocating and retrofitting our branches is a never-ending endeavor. The need for technological advancement in meeting our customer's expectations and remaining relevant is also a strategic pillar for Provident. And we anticipate moving our person-to-person money transfer offering to Zelle in Q1 of 2018. Our new loan pricing model will be fully operational in Q4, and we already have our new asset liability model in place to assist with our stress testing dry run in anticipation of going over the $10 billion threshold. While we continued to seek growth organically, our strong capital position enables us to consider expansion into new and/or continuous markets or to increase scale within our current footprint via whole bank or wealth management acquisitions. The partnership, whether with an asset management company or a bank, must be accompanied by quality management staff and accretive to our stockholders long-term value. Our stance continues to be to make strategic and financial sense and is in our collective interest we will be engaged to. The macroeconomic outlook is mainly a positive one, with political partisanship still holding back the reins of growth. Our business clients are increasingly more optimistic than in the recent past. They envision tight performance a major impetus to better financial performance than in any time since the great recession. If there's any hesitancy for CapEx or investments in infrastructure, it is due to geopolitical issues accompanied by the acrimonious behavior of our elected representatives in Washington. We see the fed raising rates in December by another 25 basis points. In the interim, the unwinding of the feds $4 trillion balance sheet has already begun, which may incrementally steepen the yield curve. The posture of the administration in terms or regulatory reform is encouraging, and changes in leadership positions within the regulatory agencies bode well for changing the tone toward a more collaborative and constructive process. With that, I'll pass the call to Tom for some additional details.

Thank you, Chris. And good morning, everyone. As Chris noted, Provident enjoyed our most profitable quarter ever, with net income of $26.6 million or $0.41 per share compared to $24.4 million and $0.38 per share for the trailing quarter. This was a $3.7 million or $0.05 per share increase compared with the third quarter of 2016. Revenues against that record is net interest income reached a new quarterly high at $70 million. While loan balances were essentially flat, our net interest margin expanded 5 basis points versus the trailing quarter to 3.22%. The margin benefited from stable funding costs, favorable repricing of variable rate assets and higher new loan origination rates. Looking ahead, the loan pipeline is currently a record level, and the pipeline rate continues to exceed the loan portfolio rate at 4.21%. We anticipate additional expansion of the net interest margin throughout the remainder of 2017 in the first half of 2018. We provided $500,000 for loan losses this quarter, a decrease from $1.7 million in the prior quarter. While net charge-offs increased to $3.1 million on an annualized 17 basis points of average loans, asset quality metrics for the remaining portfolio continue to improve with nonaccruing loans decreasing $2.5 million versus the trailing quarter to $36.5 million or 0.52% of total loans. Delinquencies, criticized and classified loans and the portfolio weighted average risk rating all are at or near their best levels of the cycle, and the outlook for credit quality remains favorable. As a result, the required allowance loan losses to total loans fell to 86 basis points from 89 basis points at June 30. Noninterest income was $293,000 greater than the trailing quarter. As increases in loan level swap income, loan prepayment fees, deposit fees and gains on loan sales more than offset the $1.2 million reduction in income on bank-owned life insurance, which included death benefits recorded in the trailing quarter. Noninterest expense remained well-controlled at 1.93% of average assets, contributing to a 54% efficiency ratio for the quarter. Expenses decreased by the $1.1 million to $46.3 million, primarily as a result of the stock-based portion of the annual directors compensation recorded in the trailing quarter and lower nonperforming asset-related expenses. Income tax expense increased $1.5 million from the trailing quarter to $11.7 million, and our effective tax rate increased to 31% from 30%, reflecting an increase in realized and projected taxable income for the remainder of 2017. That concludes our prepared remarks. We'd be happy to respond to questions.

Yes, thank you. We will now begin the question-and-answer session. [Operator Instructions] And the next question comes from Mark Fitzgibbon with Sandler O'Neill and Partners.

Hey, guys good morning.

Good morning.

Good morning.

First question, Tom. Other income was up about $1 million from the second quarter levels and the first quarter levels. Is there anything unusual that caused that bump up?

No, it's the usual ends market had some volatility to them. Swap income was the biggest contributor there, and it was volume, not TDA assessment, that drove that. That was about $734,000 of the $1 million increase. And then the other piece that was large was loan prepayment fees. That was about $281,000 greater in the current quarter than in the trailing quarter.

Okay. Super. And then secondly, could you share with us what AUM levels were in the third quarter as well as the second quarter?

Yes, holding steady for both quarters at $2.3 billion, Mark.

Okay. And then what were total loan originations in the third quarter?

I guess conventional originations, if you want to look at that way, it would be about $338 million. That includes the advances on lines of credit. Some of which is new money. It could be first advances. That was another $602 million there. So really, what impacted the net growth was the high level of payoffs, primarily from sales of businesses, sales of properties, in some cases, construction loans that we had advances on that we never expected to get the permanent, because the permanent goes to life companies and agencies in certain cases. So we experience the highest level of payoffs for the year and actually, considerably, almost quite the level of payoffs we saw in the third quarter of 2016.

I guess what – I’m sorry, Tom. Go ahead.

I'm sorry. I was just saying the production was strong. It was actually better of the year and better than Q3 in 2016.

So roughly $900 million-ish of originations for the quarter, is that what I'm hearing?

Inclusive of line advances, that's correct.

So how should we think – like your pipeline, I think, going into the quarter was $1.950 billion. Did a lot of the pipeline not close or there's a lot of it fallout as – I guess, I'm just trying to get a sense for as we look at the pipeline today of, say, to $2.1 billion.

Right. I think that the $1.950 billion number, Mark, was commitments that were on advanced as opposed to pipeline, which is new loan originations. Pipeline, I think, was about $1.2 billion last quarter, $1.1 billion. It's $1.5 billion at the end of this quarter. Pull through rate probably gets you in the $800 million kind of range once you apply expected closing rates to that. The good news on that pipeline also is that the rate is 4.21 as opposed to our 4.08 portfolio rate, so that's going to be a contributor to margin expansion going forward.

Okay. And then maybe for you, Chris. I wonder if you could update us on your thinking about the M&A landscape. What you might be interested in perspective targets. I think in your opening comments, see said you'd be interested in marketing contiguous markets. Any color you could provide on that would be great.

No, I think like anything else, we're not worried about solving for $10 billion. We're always worried about doing a deal that's accretive and makes sense. So with that as a backdrop, I don't think we're going to be doing acquisitions in New Mexico or areas in the Midwest. We certainly like the markets in the Eastern Pennsylvania. We’d like to continue to expand that area. And certainly, within the North Central New Jersey area, we have not really done much in the south end of the state. And across the river, we’ve never said no, but we look at it with a different viewpoint.

Thank you.

Thank you.

Thanks, Mark.

Thank you. And the next question comes from Russell Gunther with D.A. Davidson.

Hey, good morning, guys.

Good morning.

Good morning.

I just want to follow-up on the margin comments you’ve made. Could you share with us what’s kind of baked into that anticipated expansion in 4Q through the first half of next year as it relates to additional fed fund increases beyond your expectation for December? And then where you think your deposit beta would be that’s kind of within that guidance as well?

Sure. We model two more increases from the fed on June and September next year currently. The deposit beta we show in our filings is still running at about 56% blended overall. Up to about 50%, we’re actually asset-sensitive. So depending on – I think we’re pretty conservative in those modeling assumptions. So to the extent we are conservative, we will continue to see margin expansion. I think we get some detail on the fact – I’m sure we get some detail on some of the breakout between how we allocate those deposit bases on a condensed level in our filings. But certain categories in the checking, the money market category, where we had assumed a 75% payoff, we just moved those down to 58%. That gets us to a breakeven kind of impact from rising rates. So anything less than that 50% deposit base overall, we win.

Yes. Okay, great. And I appreciate the color there. And then my last question would just be on loan growth, you guys gave some color on the pipeline. Could you share kind of where you think that will flow through within your loan buckets and then perhaps kind of geographic pockets of strength for you as well?

Well, we’re all over in the way of the State, and we follow our customers, and even in the Bucks County of Pennsylvania, we’re doing fairly well. We would like to see more in the valley as we go forward. The mix is all over. We are doing very well in the C&I space from our business banking group. The pull-through in that area is about 55%, 60%. So we’re being successful in that space. Middle-market deals are getting very aggressively priced with very covenant-light type of things. So there’s less of that pull-through. We look at some deals that start out really well, but they have five or six terms sheets from other institutions that are giving up on some passive credit or interest rate risk that we wouldn’t do. So I think we’re pretty much across the board. We see CRE. We’re having ABL. We have some good asset-based lending volumes. Residential and consumer lending has been slow, and that is something that’s been going on for a little while. Tom, would you like to add to this?

Just to add, there’s a nice mix in that pipeline as well, about 60% of variable versus 40% fixed consistent with our existing portfolio.

That’s great, guys. Okay. Thanks so much for the help.

Same to you.

Thank you. And next question comes from comes from Matt Schultheis with Boenning.

Good morning.

Good morning.

A couple of quick questions. If you can remind me what your estimated impact is from Durbin?

Durbin’s about $2.8 million.

Annually?

Yes.

Okay. And with regard to the sale-leaseback and anything else that you might be doing with your branches, are you actually looking at rationalizing your branch network closing, opening, moving? Or are you just going to do the sale-leaseback?

We do that all the time, Matt. We've been doing that for the last three years. I think we would continue to do that not just – this is absent the 12 sale-leaseback. We would continue to do that. We have leases coming due on locations. We look at consolidation opportunities. We look to really – I guess, over time, when you get a lease coming due, are we in a – normally, we're in the right markets and the right spot, but we may be on a facility that's twice the size as the – as branch traffic – we know foot traffic is definitely down substantially. And that would also go back to if you're doing an up-to-date of a branch that might be getting tired, whether it be carpet paints, you'll look at that opportunity and say, retrofit the branch. But that is always ongoing. The idea of having branches every mile doesn't exist anymore. And our digital acceptance is continuing every day. So we would look at opportunities to consolidate, and that's something we would always do.

Okay. And with regard to the sale-leaseback, as I recall, there's not really cost savings associated with this? It's more of almost a headache savings.

Yes, I think it's strategic advantage not being a landlord any further. I think that's what we're going to continue to go with until we get finalization on terms and complete the due diligence process. We will update you all in Q4 if anything changes there. But I think we're comfortable saying it's going to be a fairly neutral P&L event.

Okay, thank you.

I think I've got one, Matt. This is Chris again. The idea of – half the building will be rentable. We only have to take care of the other half as opposed to on the whole space.

Thanks.

Thank you. And the next question comes from Matthew Breese of Piper Jaffray.

Good morning, everybody.

Good morning.

Maybe just talk about the level of payoffs you see this quarter. Just curious if you had any thoughts around why that was, whether or not there was any underlying reasons, whether or not you think that'll continue. And then maybe time that into the loan pipeline, as far as net growth goes for the next couple of quarters, how do you think that will shake out?

So I think we're going to see some easing on the payoffs in Q4, although I didn't expect the level that we saw in Q3. Caveat that. But mostly, as I said, sales of businesses, some cases where equity has been replacing debt. Sales of properties, I looked through the details on that and didn't see a lot of situations where we were losing our status of being incumbent lender. We weren't losing refi to those folks. It was really more an exit. And as I said earlier, occasionally, where the permanent goes to an agency or life company and that was the expected outcome.

There's a lot of money out there. People are trying to maybe augment their margin compression with growth. And there are some deals that we see that get paid off, and we get the prepayment penalty but they're moving on to longer, more leveraged and less guaranteed and we think covenant-light. So they could have been saved but at levels that we don't think are really prudent. So we're sticking to our guns, and we have terms and conditions. And we think that we offer very competitive opportunities. On the other hand, I think Tom said it best, you can't manage stupid sometimes. So…

Understood. And then along with that, so you expect lower levels of payoffs, what kind of net growth can we see next quarter given the pipeline, either in dollars or percentage? Just kind of curious of the range there.

Well, we know it would be positive. The numbers are – what we see is anticipated payoffs in the quarter. We think our originations will dwarf out as opposed to any shrinkage. To put a number on it, it's always the question of closing on a line of credit but that might not be drawn down for that first period or so, but it definitely has the opportunity to do that. And same as in the construction phase. There are some places that are – some of our properties are moving along in a good clip and then they withdraws into our – the issuances more of the money, to get things finished up, we're going to be having.

I guess, as I'm looking through the detail here on the payoffs and production side, I think payoffs are about like $100 million more than typical for us. So if you maintain production, you can see that growth of $100 million there. And it would make sense.

Okay.

And the anticipated production remains strong from what I've heard from our guys going into Q4.

Okay. And then thinking about your deposit betas, the assumptions in the out years versus what we've seen recently, which is more promotional activity, a little bit of a pickup in beta, especially in your market. Can you just talk about what you're seeing from your competitors? Is it normal versus your model? Does it cause you to maybe challenge some of the assumptions in your model? Just wanted to get a sense for you guys have been through multiple cycles like this. Whether or not you would characterize this as kind of run-of-the-mill or something other than that.

I think the low betas speak to the quality of our deposit base and the emphasis we place on growing commercial relationships over the last several years. That said, we have a lot of over capitalized peers in the market that are bidding aggressively to lever that capital. Something we're very cognizant of. We try to stay very close to the market and the customer. Be proactive where we need to be and really try to manage on an exception basis rather than reprice the entire book. At some point, I expect, with additional fed moves, you're going to see some increase slope to that line of beta requirement. But I think we're well within what I'd expect to have happen when we model our results and our projections going forward.

Yes, I would – this is Chris. I would have expected some of the, I would say, smaller institutions to start pricing things up because they don't like to see deposits go the wrong direction. But it adds a more of a larger players splitting out special money market rates for short period of time, whether it be 90 days or 120 days. And then they can always revert back. Not a big switch necessarily, but definitely fine to fill a bucket, maybe fix the loan-to-deposit ratio, worried about their asset levels being matched up with borrowings. So everybody's balance sheet is unique. And as Tom said, we think that our commercial offering and our consumers know that it's been so low for so long that I think everybody is getting used to the new normal. But there'll be a point in time when they'll see a couple more fed increases that they will come in for more, and our group is very, very nimble in getting an answer to somebody if they come in with a request.

Right. Okay. My last one is just going back to the M&A discussion. How is deal flow look? How have conversation flow gone over the course of the year? We're not seeing a whole lot of activity in the Northeast, and I just want to get a sense for what's been coming across your desk. Is it more or less what you've seen in the recent past?

Well, there's not as many, I would say, having books. There's not as many deals that are just being in an auction kind of capacity. We're not seeing that where we did maybe four, five years ago. I think everybody is trying to anticipate the new normal. Is this economy going to do – chug along? Is there going to be tax relief? And can they grow through this? I think everybody's getting a little bit sure-footed of where their balance sheets are. Well, I don't – again, we talked to all of the investment bankers. We're always on that list. We have conversations with other entities and management teams. And there'll be a period of time we hope to be part of that conversation, but there's nothing that's eminent and there's not really a lot of people running to the exits at this stage.

Got it. Okay, that’s all I had. Thanks guys.

Thank you. And next question comes from Jake Civiello with RBC Capital Markets.

Hi, Chris. Hi, Tom.

How are you Jake.

Good, thanks. With the pipeline at record levels, is it reasonable to assume that swap income could remain elevated in the fourth quarter?

At this point, I don't think there's a lot of that pipeline that's being reflected in the swap closings. If I'm going to look volume-wide, then I think it looks pretty good for next quarter. I'd say that gains on loans sales, we have a significant amount of SBA loans that should close on the sales of guaranteed portions of about $600,000 on that. But the swaps at this point, I couldn't commit to.

Okay, that makes sense. And then I apologize if I missed this, but are you still targeting third quarter of 2018 for crossing through the $10 billion threshold?

We were targeting first quarter of 2018 probably six months ago. I would think that we're not going to engineer to not go through it. I'd love to say that we're going to have to continue that organic growth. So we're not really managing to it, Jake, so if there were a crossover time frame, we would make sure that it's not going to hurt us just by moving things up 30 days. We could do something from a balance sheet perspective to keep that pushed out to another quarter. Tom would a little bit more on the timing of that. So…

Yes, and I disagree that we're not intentionally trying to slow growth to manage through the number. Although if the growth puts us close to the end of the year, obviously, it serves us better to carryforward at the beginning of next year to save on the Durbin impact for another half year, and obviously, we will do that.

No, all that certainly makes sense. And then with the branch sale-leaseback transaction, combined with some of your other expense reduction efforts, can you envision a path where the efficiency ratio can approach maybe 50% towards – as we grant through 2018?

I would say not in this regulatory environment, no. Anything we say that we work on with cost-saves, it's also about efficiencies, it's also about meeting the customer needs. But the infrastructure spend on the digital to make sure you have the protection with cyber and I can say the compliance area, especially going over $10 billion, absent any change in regulation in Dodd-Frank, those numbers would be very, very difficult to get that much lower at all.

Yes, I guess there's a timing lag between investing in technology and seeing the efficiency yields from that, too. So as the world continues to evolve, we continue to make investments that kind of keeps the cap on the efficiency level you can get in the short term as well.

And to that last one, Tom, you mentioned implementation of Zelle early next year. Can you give any color that shows how your customer base is utilizing technology for what were once branch – in-branch transactions?

I don’t have any specifics in front of me, Jake. But I’m just thinking about the decision to move to Zelle and then we analyzed the number of folks in our customer base that are using our existing person-to-person payment models and as well as the folks who we can see who’s paying through Venmo and Square. And then certainly, a desire to continue to use that one, and we want to make sure we stay in front and have them see Provident when they make their payments and then continue to think about us. So that’s why we made that decision.

Okay, great. Thank you.

Thank you.

Thank you. And the last question comes from [indiscernible] with KBW.

Hi, guys this is Chris on for Collin today.

Hi.

So, I apologize, I missed the prepared remarks. But what was driving the reduction in operating expenses from the second quarter?

The biggest mover is we pay a portion of our annual directors’ compensation is in the form of stock, and that gets paid in the second quarter each year. That was about $900,000 of the reduction from Q2 to Q3. The biggest piece of the remainder was lower nonperforming asset-related expenses as we continue to see improvements in asset quality.

Okay. And that was coming through the other expenses line?

That’s correct.

Okay, great. And then in terms of credit, do you think there’s – pending any upticks or anything coming through, do you think there’s opportunity to bleed the reserve any further from here?

I kind of look for the reserve that we post on originated credits each quarter to get some sense of where I think it could finish. And looking back over the last seven quarters, the lowest reserve requirement on originated credit was 85 basis points and the highest was 115 basis points. This quarter was 90 basis points. So I guess what I’m say is absent any deterioration or further improvement in the existing portfolio, that’s kind of a level you’d expect to be at. A long answer to say not a lot of movement from this level.

All right. I think all the rest of my questions have been asked. Thank you guys.

Great, thank you.

Thank you. And as that was the last question, I would like to turn the call to Christopher Martin for any closing comments.

Well, we thank you for being on the call. And in closing, on behalf of myself and the Board of Directors, I’d like to congratulate all of our members of the Provident team for their efforts, which led to Provident Bank being recently named the Best Bank in New Jersey by Money Magazine. And our best wishes to all of you for our continued success. And we thank you for joining us today on the call, and we look forward to speaking to you again in 2018. Thank you and have a great day.

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