Provident Financial Services, Inc. (PFS) Q3 2019 Earnings Report, Transcript and Summary

Good morning. Welcome to the Provident Financial Services, Inc. Third Quarter Earnings Conference Call. [Operator Instructions] Please note that this event is being recorded. I would now like to turn the conference over to Len Gleason, Investor Relations officer. Please go ahead.

Thank you, Debbie. Good morning, ladies and gentlemen. Thank you for joining us today. The presenters for our third quarter earnings call are Chris Martin, Chairman, President and CEO; and Tom Lyons, Senior Executive Vice President and Chief Financial Officer. Before beginning their 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 this morning's earnings release, which has been posted to the Investor Relations page on our website, provident.bank. Now it's my pleasure to introduce Chris Martin, who will offer his perspective on the quarter. Chris?

Thank you, Len, and good morning, everyone. Provident's operating results were impacted by margin compression, which is being experienced by a number of financial institutions in this lower interest rate environment as Fed policy has been supporting continued expansion in the economy and tempering impact of possible tariffs and geopolitical challenges. PFS' balance sheet remains strong and noninterest-bearing deposit growth in the third quarter helped to ameliorate the margin compression. We have also repriced negotiated deposit rates while being mindful of the overall business relationships we have with these customers. As Tom will detail, core margin impact was not as severe compared to the trailing quarter as we experienced a recovery in Q2, which had a onetime positive impact on the margin. Earnings per share improved in Q3 and our annualized return on assets was 1.26% for the quarter, while our return on average tangible equity was 12.97%. Margin compression will be the headwind going into 2020 as it appears the Fed policy will continue to be more accommodative. Rates have been volatile and the yield curve has flattened significantly over the past year. As always, net interest income will be influenced by a number of factors, including loan growth, pricing spreads, the level of rates and the slope of the yield curve. And because of our loan portfolio leans towards a more adjustable and variable rate versus fixed, we will be impacted by lower yields. We anticipate our net interest margin will decline by 2 to 4 basis points in the fourth quarter given the impact of the September and possible October rate cuts. Deposit pricing dynamics remain very competitive in our markets but we are now seeing less money market and special CD promotions. Pricing discipline for deposits appears to have returned to our markets but loan terms and conditions continue to be aggressive. We continue to maintain our credit standards and set loan pricing based on total return assessments. As for loan growth, commercial payoffs continued at an elevated level with over half refinanced away and the remainder paid off from the sale of the collateral property. The pipeline increased over the previous quarter, although we have to issue more term sheets to achieve pull-through levels. The level of private equity and insurance company and GSE involvement has tempered our growth expectations, so we select those opportunities that meet our return hurdles and credit criteria. And while we don't see a recession on the horizon any time soon, we are being cautious in selective areas for new loan originations. Credit quality has been uneven as we analyze relationships that are showing stress, in particular industry sectors that will not perform well in a mature business cycle. We are mindful that at some point, the economy will experience a credit downturn and we remain disciplined in terms of our loan origination quality and our credit parameters regardless of the competitive environment. Charge-offs were elevated during the quarter as we wrote off the commercial relationship that has been fully reserved for in Q2. We are not seeing systemic issues that materially change our conservative credit perspectives for the balance of 2019 or 2020. As for CECL, we are still in the implementation phase and the ultimate effect will depend on the composition of our loan portfolio, the portfolio's credit quality and economic conditions at the time of adoption as well as any adjustments and alterations to our models, methodology and other material assumptions. We are not yet at a point where we can disclose any impact to capital reserve levels. On the deposit front, average noninterest-bearing deposits increased $56 million versus the trailing quarter, accompanied by increases in average time deposits, money market and broker deposits, partially offsetting decreases in average NOW checking and savings deposits. Average borrowings increased in volume yet costs were lower by 5 basis points despite the impact of the repo market dislocation in September, which caused a material increase in rates for several days. Core deposits represent 87.9% of total deposits as of quarter end. Noninterest income improved during the quarter with the majority coming from fees on loan level swap transactions and loan prepayment fees. And our costs remain well contained with increases in comp and benefit costs, largely offset by decreased FDIC insurance expense and data processing costs. Our efficiency ratio for the quarter at September 30, 2019, was 54.31% and annualized net interest expense to average assets was 1.99% for the same time period. And we continue to manage our expenses, mindful that we will be required by regulators to further build upon our risk and compliance areas as we approach $10 billion in assets. We have also invested time and treasure in employing bots to perform repetitive processes, along with operational and decision-making improvements. We are investing in our digital channel to upgrade the customer experience and ability to self-serve, along with enhanced access to alternate payment channels. Customer behaviors continue to evolve and we must adapt to compete with the large money center banks and financial intermediaries. As for M&A, we have been involved but if you are not first, you are last. Our disciplined approach to acquisitions has always been about the enhancement of the combined entity, including management, culture and franchise value, while ensuring accretion of earnings and a reasonable earn back of the tangible book value dilution. We invested in ourselves by repurchasing over 670,000 shares of our stock this quarter during periods of market weakness. We evaluate the best use of our capital on a daily basis and continue to selectively look at many deal opportunities. We listen to and read our commercial clients and retail customers who continue to see moderate demand and no widespread issues related to trade uncertainty and interest rate movements. Not that optimism reigns supreme, but the core economy continues to perform above the expectations of many. And we feel our balance sheet is well positioned and will continue to grow within the limits of the economy and consumer confidence. With that, Tom will go over more details on the quarter. Tom?

Thank you, Chris, and good morning, everyone. Our net income was $31.4 million or $0.49 per diluted share, compared with $35.5 million or $0.54 per diluted share in the third quarter of 2018 and $24.4 million or $0.38 per diluted share in the trailing quarter. Current quarter revenue was consistent with last year's third quarter at $92 million. Our net interest margin contracted 19 basis points versus the trailing quarter and 15 basis points versus the same period last year. Recall that the trailing quarter margin was increased 10 basis points due to the recognition of $2.2 million in interest income from previously nonaccruing loans. Excluding the impact of the receipt of this nonaccrual loan interest in the trailing quarter, our core margin, which also excludes loan prepayment fees, contracted 9 basis points versus the trailing quarter. To combat this margin compression, we've begun repricing deposit accounts with negotiated exception rates with roughly $60 million reduced by 25 basis points effective August 1 and another $300 million reduced by 25 basis points effective October 1. We will continue to manage liability costs as rate environment evolves and competition becomes more rational. In addition, we continue to emphasize the acquisition of noninterest-bearing deposits, which grew $56 million on average on an annualized 15% versus the trailing quarter to $1.5 billion. Quarter-end loan totals decreased $27 million from June 30 as growth in CRE and construction loans was outpaced by net reductions in C&I, multifamily, consumer and residential mortgage loans. Loan originations excluding line of credit advances fell $56 million versus the trailing quarter to $354 million and payoffs remained elevated with $37 million more paying off in the current quarter than in the trailing quarter. The pipeline at September 30 increased to $1.1 billion from $979 million at the trailing quarter end. The pipeline rate, however, has decreased 45 basis points since last quarter to 4.11%. The lower pipeline rate reflects current market conditions and the decline in treasury rates. We intend to manage the balance sheet through December 31 to stay below the $10 billion asset threshold to avoid the Durbin impact on interchange revenues in 2020. Our provision for loan losses was $500,000 for the current quarter, compared with $9.5 million in the trailing quarter. Last quarter's elevated provision is largely driven by a $5.7 million credit to a commercial contractor that was fully reserved. The deterioration in that credit appears to have been the result of the borrower taking on larger projects, slow payments from customers and an apparent employee defalcation. That balance was charged off in the current quarter, driving our quarterly annualized net charge-offs as a percentage of average loans to 33 basis points. Overall credit metrics were stable this quarter with nonperforming assets totaling 42 basis points of total assets at quarter end. The allowance for loan losses to total loans decreased to 79 basis points from 86 basis points in the trailing quarter as a result of the aforementioned charge-off of a fully reserved balance. Noninterest income increased by $2.2 million versus the trailing quarter to $18 million. Loan level swap income increased $1.8 million and loan prepayment fees increased $644,000 versus the trailing quarter. Noninterest expenses were an annualized 1.99% of average assets for the quarter. Expenses were flat at $49.7 million versus the trailing quarter, helped by the recognition of the small bank assessment credit on FDIC insurance of $660,000 for the quarter. Our total remaining credit potentially realizable in future quarters is $1.8 million. Our effective tax rate decreased to 24% from 26.5% in the trailing quarter. The prior quarter tax rate was elevated as a result of increased provisioning related to the publication of a technical bulletin that specifies the treatment of real estate investment trusts, in connection with combined reporting from the New Jersey corporate business tax purposes. We are currently projecting an effective tax rate of approximately 24% for the remainder of 2019 and thereafter. That concludes our prepared remarks. We'd be happy to respond to questions.

[Operator Instructions] The first question comes from Mark Fitzgibbon with Sandler O'Neill + Partners.

Tom, just to clarify, did you say that there was $1.8 million in remaining FDIC assessment credit?

That's correct.

Okay. Super. And then secondly, I wonder if you could kind of break out some of the major items in the fee and other income lines from the linked quarter. What were some of the big deltas there?

Sure. Really just driven in 2 categories, Mark, 2 of the volatile categories. Prepayment fees on loans were up to $1.5 million from $873,000 in the trailing quarter, so that's $644,000 of it. And then the big piece was in the profit on swaps, $2.7 million for the current quarter versus $896,000 in the trailing quarter, so $1.8 million of improvement there.

I know they're volatile items, but how are you thinking about them for the fourth quarter? I mean are we...

Well, if I had a look at it from other income overall, I'd say probably $16 million to $17 million is kind of the midpoint kind of range of where we expect to land going forward.

Okay. And then you said you're going to keep the balance sheet under $10 billion for the rest of this year, which makes sense. Will you grow through it organically in the first quarter do you think assuming you don't find an acquisition?

I do believe by the end of the first quarter, we should be there, yes.

Yes, Mark, this is Chris. We have modeled it looks like in the first quarter towards the end of that, absent any extreme level of payoffs that we would go through in that first quarter. Timing of acquisition, as you know, is serendipity. We don't know when they will happen and if there is anything that there would make sense.

Okay. And then I apologize if I missed it, but did you indicate how much a 25 basis point cut would mean to your margin?

I think Chris covered it when he said probably 2 to 4 basis points in the back half of the year and that's expecting a cut next week and potentially one at the end of the period.

The next question is from Russell Gunther with D.A. Davidson.

Chris, could you elaborate a little bit on what you're referring to in terms of some of the selective areas where you've become a little bit more cautious?

Sure. We certainly have looked at the contractor area, some contractors we are -- we have pulled back over the last several months and some of them are doing fine. We just don't think the exposure makes sense in this late business cycle. And then also, in the hospitality industry, specifically hotels, watching that market a little bit. So the economy may start to get a little struggle, that's not an area where we want to be heading up. So those are the 2 areas that we are pretty much looking at reducing and/or keeping our exposure limited in the way of new originations.

Got it. Okay. Appreciate your thoughts there. And then I guess the flip side of that. Obviously, it's been a bit of a challenging environment for growth, but it sounds like you'll -- again, you said cross organically in the first quarter. Maybe just share a little bit about what the opportunities are in the loan growth outlook be it an asset class or geography?

Well, we're still seeing pretty good growth in the industrial space and especially in the warehouse area as that continued to grow. We don't get a lot of the permanent on the multifamily construction deals that we've been doing, so we try. The agencies are giving a lot more of interest-only period that we just don't think it's prudent and we don't have that capacity. Those are the 2 main areas, I think, that we have been focusing in on if there's opportunities in those spaces. And other than that, retail, a little bit and limited like in self-storage areas. But I think we kind of look at every package on its own merits and how it's structured from a credit perspective.

Very good. Okay. Got it. And then switching gears quickly. The release mentioned continued tech investments as well as around compliance. Just give us a sense for kind of what the franchise investment relates to there and how that may impact the expense run rate going forward.

I can comment on the run rate. I think we're going to tick up a little bit in Q4 with some final CECL implementation related costs so probably in the $50 million to $50.5 million kind of range for Q4. Expect to sustain that to a degree going forward. I think we're going to be able to offset with some of the in-house improvements, efficiency improvements we've made to largely offset some of the increases in the technology spend.

Yes. I think -- this is Chris again. We look at -- we've been spending money and hiring people, I think, in adapting to already being a $10 billion company. The regulators are here and they already worked along with us to make sure that we're trying to adhere to everything they're expecting and at that point, we have hired in the risk area, compliance area, certainly some scale. So they're already in some of our numbers to begin with. As Tom alluded to, it's going to be a little bit more CECL and then perfecting all these items and making sure we're in the right place on the back end, as I spoke to in my comments, using, again, some robotics to do some rudimentary things that are being done with a lot of people. We're able to do the better decisioning through our use of analytics and AI. And those are the expenses we like to actually put in because we think they're going to result in the operational efficiency going forward.

The next question is from Collyn Gilbert with KBW.

So Chris, just back to the comment you made on kind of loan growth and appetite. Along those lines, of the pipeline that you're -- that you've got currently and you indicated kind of a 4-point -- I think you said 4.11% loan yield. Can you just talk about sort of the mix of that, the structure of that and sort of how you see loan pricing trending as we kind of move into the next couple quarters if rates hold where they are?

Sure. I'll start and then let Tom talk about the yield. But it's pretty good mix and we like the diversification. So you're talking about CRE approximately $345 million in the pipeline. Our middle market is about $218 million in the pipeline. Business banking, meaning smaller type of C&I loans of $255 million. Our Pennsylvania area, which has a blend of both of the C&I areas of $176 million and then resi and consumer approximately $100 million. So it adds up to about $1 billion, $1.1 billion. But the rate coming in is definitely lower as we look at continuing to originate variable rate loans. Tom, maybe you could give some color on the rate of return.

Yes. Again, we hold to our return on equity targets and we use a loan pricing model. It's just very competitive out there and I think that's been one of the reasons why we've struggled a little bit. Maybe we're a little bit more disciplined than some other folks. We will compete on price. We always try to maintain structure, though, so that's why you saw the loan yields come in. And the average for the quarter were 4.22, it's down from 4.62 last quarter. So it's really reflecting current market conditions. I think the 10-year was down 66 basis points on average and the 1-month LIBOR was down, I think, 44 something like that over the quarter.

Okay. Okay. Are you seeing much -- I mean, big variations among those loan segments as it relates to pricing? I mean where are you kind of seeing your best pricing? And where are you seeing some of the lowest pricing?

In terms of just the highest yield, consumer would be the highest and commercial real estate is probably the best after that. In terms of return, I guess middle market and CRE are probably the best returns.

Okay. Okay. And then just in terms of the comment about the pull-through rate has declined. What -- just maybe talk a little bit about what's driving that or what -- why that's the case.

Well, we're -- I certainly think that in our commercial real estate area, most of the time if we've gone down a path on a term sheet we have it's pretty much baked that we're going to get and our clients know that they go down the path that we're pretty competitive. It's more in the C&I space and it's geographically indiscriminate, meaning Pennsylvania and New Jersey. There are levels in the C&I space that we just can't figure out how people would do a deal, just for instance, out in PA somebody was doing something at prime minus 65 basis points and with nonrecourse and no covenants. We don't think that's prudent. I don't think many would. But we think that our levels are trying to hold those people who are undercutting them. We try to stick to what makes sense. If the returns are there, we'll be involved. As Tom alluded to, pricing, yes, structure, no. I think that some of the -- it's just not worth the return. You can get that growth to offset your NIM compression but that will be short-lived.

Got it. Okay. Okay. That's helpful. And then just flipping to the funding side. You guys indicated where you're starting to drop pricing on $60 million and $300 million of deposits, but is there more to do on that? Or how do you sort of -- how are you thinking about kind of the aggressiveness with which you're going to drop deposits?

There is -- we're currently evaluating November 1 for another look. There's about $700 million that has what we call negotiated pricing, and that's not including the municipal portfolio. So there's some opportunities to bring rates down.

Okay. Just curious, what's the blended rate on your municipal book right now on the deposits?

We don't have that, Collyn. I think it's probably a little over 1.

Okay. Okay. All right. That's helpful. And then I guess just lastly, Chris, in your opening comments, I'm going to try to quote you, what you said, but on the M&A front, what did you say? You said if not first, you're last?

Yes.

I'm just curious what you meant by that.

Okay. Basically, if you don't -- if you come in close second, you don't win anything by not getting a deal done. So there is no second place. Either you win a deal or you don't win a deal. There's not many deals that you get called back in after the fact that, okay, the possible acquirer messes up and you get called back to the table. We have not seen that in our long history. So what I say is like we put in, we think, prudent and aggressive as it makes sense, but they say you were in second place, that really doesn't make you feel real good.

Got it. Okay. So it's just the pricing on the first bidder is so good that there's just no further discussion among others.

Well, I guess it always goes back to how the person may be being acquired looks at all the things they're supposed to, shareholder value, culture, management, positioning and the future because they're selling their interest to another entity. We think we match up to a lot of those and just happened to be somebody is a little bit more aggressive in their assumptions and/or have a lot more better cost saves that we don't.

To that point, do you think that the sellers are taking into consideration a lot of those qualitative factors that you're mentioning? Or do you think it seems to be more of a quantitative decision?

And I think quantitative has to be there but I think qualitative is giving everybody an opportunity to say I'd like a certain company or certain approach. So I think you have to have a good culture and a good management structure. I don't think anybody is just doing something from a math standpoint any longer.

Okay. Okay. And then just lastly just, Tom, on the repurchases. You guys obviously bought a nice slug this quarter. Should we assume a similar level going forward? And then how do you want -- how should we be thinking about that in 2020 once you start to really kind of restart the growth engine again?

Really, it's been market condition dependent. We stepped in when the market pricing got hit a bit. We try to look at that as a tangible book value dilution versus the earnings accretion and think about it in terms of creation or destruction of values using multiples on an earnings basis on a tangible basis and see where those normalize, where they 0 out is one way we look at it. And then we look -- give it a reasonableness test overall, what kind of price to tangible book we are paying back at and what the earn-back is on that for a risk-free transaction. So it really is market price dependent how much we step in.

The next question is from Steven Duong with RBC Capital Markets.

So just going back to the M&A, were you making the comment just particularly in a wealth management space or banking space?

Well, comments were mostly on the bank space of late.

Got it. Okay. Great. And then appreciate the color, the guide on the NIM. Can you remind us what your deposit beta was in the last cycle and if you think it will behave similarly in this current cycle?

It looks like -- you know what, I don't have my year to date with me because once we flipped the direction, I didn't print it out. I'm trying to remember. I think it was in the 30s, Steve, but I could get back to you on what the beta was through the rising cycle.

Okay. Great. And then just lastly, just back on the capital front, I guess you've done special dividends before. Is there a preference between special dividend versus buybacks?

I think that's true really just market price dependent. Whichever makes the most sense, we'll do it.

This concludes our question-and-answer session. The conference has now also concluded. Thank you for attending today's presentation. You may now disconnect.