Valley National Bancorp (NYSE:VLY)
Q3 2007 Earnings Call
October 18, 200711:00 am ET
Gerald Lipkin - Chairman, CEO, President
Alan Eskow - CFO
Al Engel - EVP
Dianne Grenz - IR
Michael Cohen – Sunova Capital
Collyn Gilbert - Stifel Nicolaus
John Pancari – JP Morgan
Welcome to the third quarter 2007 earnings releaseconference call. (Operator Instructions) I would now like to turn theconference over to your host, Gerald Lipkin. Please go ahead.
Good morning and welcome to our third quarter 2007 earningsconference call. I'd like to turn the meeting over for a brief moment to DianneGrenz to read our forward-looking statement.
Today's presentation may contain forward-looking statementsregarding the financial condition, results of operation and business of Valley.Those statements are not historical facts and may include expressions aboutValley's confidence and strategies, management's expectations about earnings,the direction of interest rates, effective tax rates, new and existing programsand products, relationships, opportunities, technology, the economy, marketconditions and the impact of management's adoption and interpretation andimplementation of new accounting pronouncements.
These forward-looking statements involve certain risks anduncertainties. Actual results may differ materially from the results theforward-looking statements contemplate. Written information concerning factorsthat could cause results to differ materially from the results theforward-looking statements contemplate can be found in Valley's press releasefor today's conference call, Valley's Form 10-K for the year ending December31, 2006, as well as in Valley's other recent SEC filings. Valley assumes noobligation for updating these forward-looking statements.
Thank you, Dianne. For some time, macroeconomic forces, suchas the level and slope of the yield curve, have negatively impacted theperformance of many financial institutions, Valley included. Although the slopeof the curve has begun to normalize, the economic environment invites criticismfor a number of banks and the manner in which they had chosen to grow theirbalance sheet. Banks that elected high growth strategies, irrespective of thetype and quality of assets originated will inevitably suffer material creditlosses and erosion of shareholder value.
The growth in Valley's earning assets during the last fewyears has been constrained due to the fact that the yield curve combined withirrational risk-based loan pricing and embracing of sub-prime credits, whichbecame prevalent in the marketplace.
In order to maintain a balance sheet composition nimbleenough to react to changes in the level of interest rates and other marketconditions, we delevered the investment portfolio by nearly $500 million duringthe last two years. In addition, we attempted to refrain from expanding theloan portfolio with sub-prime credits, whose performance has already becomeproblematic.
We have continuously operated Valley under the auspice thatunderwriting standards, as opposed to asset growth, is the driving factoraffecting long-term bank profitability. Remember: in banking, it's the returnof the principal, not the return on the principal that defines the first ruleof lending.
For the third quarter of 2007, Valley's non-performingassets to total loan ratio was 0.39% compared to 0.42% during the same period ayear ago, and 0.38% in the second quarter. Valley's delinquency rates, whichtypically provide an indication as to looming credit difficulties, remain verylow. Loans delinquent in excess of 30 days are 0.79% as of September 30, 2007, less than the 0.8% reportedlast quarter. Home equity delinquencies at Valley are insignificant at 0.07%.Only $387,000 -- or six loans of Valley's home equity portfolio totaling morethan $1.5 billion -- are delinquent as of September 30, 2007 and none are in foreclosure.
Exclusive of our SBA portfolio, which is largely guaranteedby the U.S.government, our commercial lending portfolio, which is approximately $4.5billion in outstanding balances, is a 30-day delinquency rate of only 0.8%. Ourresidential mortgage portfolio, consisting of approximately 9,000 loans, orover $1.9 billion, had total delinquencies as of September 30th of only 0.23%.
To further support management's analysis of the creditquality within the portfolio, upon request, a third party conducted an independentportfolio review. The analysis resulted in a summary portfolio data whichreflects a current portfolio average FICO score of 744 and a present marketloan to value ratio of 42.65%, a decrease from 60.2% at origination.
Our conservative residential lending approach is once againproving itself correct. While as a lender, we recognize that some loans willinevitably become problematic, we believe our historical approach to lendingshould continue to translate into continued profitability, modest loan problemsand above-average returns to our shareholders.
During the quarter, Valley produced net income of $36.5million compared to $43.9 million in the year-ago period. Last year's numbers,however, included a non-recurring $11.2 million reduction in income taxexpense. Diluted earnings per share for the quarter were $0.30 compared to$0.36 per share for the same quarter of 2006, which then included the $0.09 pershare attributable to the aforementioned reduction in income tax expense.
Our return on average shareholder tangible equity of 20.18%not only ranks Valley among the highest performers within the industry;additionally, it marks the 26th consecutive quarter we have generated a returnon tangible equity in excess of 20%.
We continue to focus on strategic alternatives which enhancethe franchise value in long-term earnings opportunities for the bank. Two yearsago, we embarked on a branch expansion program in which we allocated over $75million of capital toward De Novo branch strategy. By the end of 2010, weexpect to have added over 50 new branches to our network and will have expandedthe franchise into new geographic territories.
During 2007, we opened our first two branches in Brooklynand by year end, intend to have our first office in Queens.To date, combined deposits in our two Brooklyn branchesstand at over $65 million, none of which includes transfers from other areas.
We continue to observe outstanding loan growth through ourauto dealer lending network. During the third quarter we originated over 14,000new loans, an increase of 110% from the same period a year ago and an increaseof 10.5% just from the prior quarter. Many of the new originations areattributable to our geographic expansion efforts. Our focus is on expanding thesize of the pond in which we originate loans as opposed to the depth in whichwe generate new production.
We would like to remind our listeners that under a formerprogram with a large insurance company, utilizing our current infrastructure,we originated and serviced a large volume of loans from Maineto Florida. At that time, up to90% of our auto portfolio came from outside of New Jersey.Accordingly, this is not taking us into territory where we haven't beensuccessful in the past. The average FICO score for new loans originated in thethird quarter was 748. Approximately 43% of our new auto production is derivedfrom States other than New Jersey.With the hiring of our first consumer auto loan dealer sales representative inthe State of Connecticut, our currentdealer lending geographic presence now stands at five states, with a goal ofadding two to three additionalstates each year for the next several years.
Although the macroeconomic factors continue to create achallenging operating environment, we are optimistic about the long-termearnings opportunities for the bank. Our balance sheet is strong and flexible.Our strategic focus of allocating capital and resources to expand thegeographic presence of the franchise should pay dividends in the future. Althoughshort-term earnings may suffer as a result of our expansion strategies, theyare the right measure for the long-term wellbeing of the bank; and mostimportantly, our shareholders.
I am now going to call upon Alan Eskow, who will provide alittle more insight into the third quarter financial results.
Total assets remained relatively flat on an annual basis. Wehad increased approximately 4.0% annualized from the sequential quarter. Thelinked-quarter growth of $120 million reflects increases in the loan portfolioof $191 million, partially funded by a decrease in the Fed funds sold position.The loan growth includes a short-term $140 million credit facility which wasoriginated relatively late in the quarter and we anticipate will pay off beforeyear end.
Loan growth continues to be constrained due to thedisruption in the mortgage market. Since the beginning of the year, ourcommercial construction portfolio has declined nearly $120 million as thedemand for new residential developments has waned and many of our largedevelopers remain on the sideline until market conditions improve. Overall,exclusive of the $140 million short-term origination, commercial lendingactivity remains light.
Although new commercial line commitments have increased over8% year-to-date, line usage has decreased from 39% to 37%, resulting in amarginal increase in outstandings. Line usage is somewhat less than normallevels as a result of reduced drawdowns on construction loans combined with ahigher degree of liquidity for some of our customers. This excess liquidity onour customers' own balance sheets not only reduces the bank's outstanding loanportfolio, but also in addition negatively impacts the bank's demand depositbalances.
As Gerry mentioned earlier, much of our loan growth isattributable to the expansion of our automobile dealer network. During the last12 months, the portfolio has increased nearly $200 million, or 16%, and weanticipate continued strong growth in future quarters.
Sequential quarter total deposits of $8.4 billion increasedby $107 million, mainly the result of the aforementioned short-term loancollateralized by a certificate of deposit. Exclusive of this CD, depositsdecreased $33 million, reflecting management's decision to utilize the bank'sFed funds sold position to fund loan growth, as opposed to increasing higher cost,rate sensitive deposits. Demand deposits decreased approximately $100 million,mainly as a result of the seasonality of many of our larger commercialcustomers.
In addition, on an annual basis, the decrease was in partdue to the conversion of over $50 million from demand deposits tointerest-bearing repo sweep accounts, which are reported as short-termborrowings on the balance sheet.
The net interest margin remained relatively flat at 3.43%from the prior quarter and the same period one year ago. Linked-quarter averageinterest earning assets decreased $15 million, primarily due to the funding of $75million in BOLI during the latter half of the second quarter. This income ofapproximately $1.2 million previously recognized as interest income is nowshown as non-interest income.
Total earning asset yields continue to increase, mainly as aresult of the increased liquidity in the investment portfolio, combined with anincrease in deferred fee income on loans. The increase in the cost of depositsof 12 basis points from the second quarter is mainly caused by the positiveinitiatives which typically accompany De Novo branch openings.
Net income for the quarter of $36.5 million decreased $3.2million from the second quarter. The decrease was principally a result ofnon-recurring net gains on fair market value adjustments realized in the priorquarter.
Net interest income on a linked-quarter basis decreased alittle under $700,000. The decrease was largely a result of a reduction inearning assets combined with a slight decrease in the net interest margin.
For the first nine months of 2007, net interest income wasnegatively impacted by approximately $4 million as a result of De Novo branchexpansion campaign and share repurchases. We have allocated over $75 million offree capital for the branch expansion initiative, which on a comparative basiscould have been used to fund loan growth.
Additionally, operating costs for these branches, whichyear-to-date exceeds $4.6 million, adversely impacts the efficiency ratio andoperating leverage. While we believe we will see a long-term increase in netincome, currently operating revenue and net income are negatively impacted. Ona linked-quarter basis, exclusive of the fair market value adjustments realizedin the second quarter, both non-interest income and non-interest expense wererelatively flat.
The effective income tax rate of approximately 24% was flatwith the prior quarter. On an annual basis, income tax expense increased $11.4million, resulting from an income tax reserve reduction realized in the sameperiod one year ago. We anticipate our effective tax rate to increasemoderately to 25% in the fourth quarter. However, the rate could vary as aresult of alterations in the composition of Valley's income, change in tax lawsand different tax strategies.
Credit quality remains strong. Net charge-offs on alinked-quarter basis decreased by $282,000 resulting in a net charge-off toaverage loan ratio of 0.14%. To demonstrate the stability of Valley'sunderwriting standards, on only two occasions in this decade has our quarterlynet charge-off to average loan ratio exceeded 30 basis points.
Total non-performing assets remained relatively flat fromthe prior quarter at $32.3 million. The reserve for credit losses as apercentage of total loans decreased from 0.91% to 0.89%. The allowance forcredit losses is determined from a myriad of factors including: delinquencylevels, historical and current net charge-offs, and growth in loans, to name afew. Based on the composition of the loan portfolio at September 30, 2007 combined with delinquencylevels, the level of the allowance calculated as of September 30 was deemed adequatein support of the quarterly provision. The current accounting rules do notallow for matching of net charge-offs to the provision quarterly, withouttaking into account all of the above factors.
Valley's capital ratios increased slightly on a linked-quarterbasis. During the period, we called another $20.6 million of our trustpreferred securities. In addition, we repurchased 130,000 shares of Valleystock at an average cost of $21.96. For the year, we purchased nearly 1.3million shares at a cost of $31.4 million.
With this, I conclude my prepared remarks and we will nowopen the floor to questions.
Your first question comes from Michael Cohen - SunovaCapital.
Michael Cohen - Sunova Capital
Can you talk in little bit more about the auto growth andthe underlying credit adjudication process? You guys have obviously proven tobe very good underwriters of all types of things in the past. Auto is one ofthose things that banks historically have had spotty track records with; notnecessarily implicating you in that. Could you provide some commentary on that?
Sure. The bank has been in the indirect automobile lendingbusiness now for close to 60 years. We did it both through a dealer network andthrough a referral system coming from a large insurance company. The largeinsurance company took the business in-house about eight or ten years ago, andwe began expanding our indirect originations. We only buy A paper. We go at itrather slowly with new dealers. We felt that we could expand our dealer networkby putting reps on the road, about three years ago, which we did and it hasproven itself very successful. We have opened up numerous new automobiledealers that are sending us referrals.
We underwrite each and every loan. On new and used paper, wefind that we have approximately the same success rate. We have right now about600 dealers that we are buying paper from. Again, we only buy the A paper atthis point. I know I've spoken in the past of an arrangement that we areworking on, which I'm constantly told is very close to conclusion, with a largeWall Street house that is interested in buying our Alt-A paper that we turndown. We do all the underwriting on it; we just don't book it. We turn it downif it doesn't FICO high enough or if the credit doesn't come high enough.
We eyeball virtually every credit that comes into the bankthough so we spend a lot of time underwriting it. We are using the exact samesystems today that we used when we had the large insurance company referringpaper to us. The same people are still with us, fortunately, that were herethen. We are giving the loans the same level of scrutiny and maybe we are justlucky, but we have been lucky for 60 years in that we've never had seriousdelinquencies coming out of the portfolio.
Michael Cohen - Sunova Capital
That is great tohear. Where are you in terms of LTVs and length of term? I know some of the bigauto lenders have pushed some of those things up; perhaps to irrational levels,over the course of the last 12 to 24 months.
Most of ourunderwriting is at the 60-month level, although the average length of loan inthe portfolio is about 30 months, 32 months. Al Engel is with us, he runs the auto.
One of the areas I'mresponsible for is our auto lending portfolio. While you always get pressurefrom the auto community to buy long and buy deep, it is a matter of fullyassessing the risk profile of each individual applicant to determine how muchrisk you are willing to place on that particular transaction. While we do havecomputer models that assist us in evaluating that, we still decision every loanwith a human looking at the transaction. This has allowed us to in some cases,buy deep; in other cases, we buy very conservatively. It is very individuallyassessed based upon the credit profile of every individual loan we look at.
Your next question comes from Collyn Gilbert - StifelNicolaus.
Collyn Gilbert -Stifel Nicolaus
A follow-up on the Indirect discussion. You've been in thebusiness for 60 years. What are the biggest risks in the business, as you lookout? How are you managing the business differently today than maybe you wouldhave six years ago, just given the stress that we are obviously seeing on theconsumer?
Our business biggestrisk, Collyn, based upon how we underwrite the loans, is fraud. We monitorpretty closely, we have people who look at all of the paper coming in. If westart to get an elevation in delinquencies coming from a particular dealer, wewill either look more tightly before we will buy from that dealer or we willjust shut down the dealer. We very frequently shut down dealers that we are nothappy with the type of paper they are sending us.
We are an A paper buyer. So the collection of A paperusually runs pretty well. It is the fraud aspect that is always the biggestproblem.
Collyn Gilbert -Stifel Nicolaus
How have the spreads in the business changed in the last sixmonths to a year? How do you see those spreads playing out in the next sixmonths to a year?
With the GMAC, Ford Motor Credit going to private capitalsources, we've started to see a little bit of pricing power coming back intothe market, although the market remains very competitive. Looking at theearnings releases of many of our competitors in the indirect space, it appearssome of them are getting some hits from losses, so it may cause them to price alittle bit more responsibly in the risk versus rate equation. We think thatpricing power is on our side as we move forward into 2008.
Collyn Gilbert -Stifel Nicolaus
Gerry, you guys have, I think, done a great job in terms ofthe whole notion of risk-adjusted returns. As you look at your business model,is the reason that you're pushing this is not just because you do think thatthe risk-adjusted returns are more favorable in this space relative to theother business lines you have?
Yes. We are actuallynot pushing this any harder than we are pushing our commercial lending or ourresidential mortgage lending. I don't want to give the wrong impression. It isjust that this seems to be an area that we are able to show the best growth atthis time, so we are focusing on this aspect of our portfolio.
I am very comfortable with the paper that we are getting,how we underwrite it. We are not expanding quickly. We are doing this on aninch-by-inch basis, so to speak. We don't look to add 15 new states in one fellswoop; we are doing them one or two at a time. Once we are comfortable with thepaper we are getting from that location, we will then move on to add anotherlocation. Again remember, we are only buying A paper. So my concern is somebodyis trying to fraudulently slip B paper or C paper in through as A paper, butthe way we underwrite and the way we eyeball the credit, it is going to becomeapparent very quickly if somebody is doing something that they shouldn't be.
Collyn Gilbert -Stifel Nicolaus
How are the De Novo branches doing? Alan, in your comments,you had mentioned a lot of the deposit pricing pressures came from justpromotions running in the new branch. But how are the deposit flows looking,especially in the Brooklyn/Queens market?
Brooklyn, I mentioned in my commentsthat we've opened two offices so far this year, and those two offices have over$65 million. One of them is only open about 90 days and one of them opened onJanuary 2nd. So we are pleased with the growth that we are seeing from depositsin that area. All of the branches have generated reasonable growth in theirdeposits, some a little stronger than others. We actually have a couple in New Jersey that are giving New Yorka pretty good run for their growth.
In our New Jerseybranches, we are seeing some growth up around the $20 million mark in a coupleof months, so we are doing pretty well, we are pretty satisfied with the De Novosthat we're opening at the moment. But it obviously comes at a cost, which iswhat we tried to indicate. But we also look at new branch openings as somethingthat migrate towards a normal branch over a number of years. So day 1, the costmay be higher than we would like to see but by the time we get three or fouryears into the branch, we begin to see more demand deposits coming in, moresavings accounts coming in which tends to bring down the overall cost of thosebranches.
The other area withthe regard to the branches is the commercial loan growth. Commercial loangrowth will come through the new branches; that doesn't come as rapidly asdeposit growth. In some cases, we open a new branch in a new territory where wehave been approaching clients in the past and they've been on the fence, andnow they are the low-hanging fruit. But it takes a while before you can buildup a sizable commercial portfolio out of the new territories. We are quitehopeful in our expectations that will take place over the next couple of years.
Collyn Gilbert -Stifel Nicolaus
Just a quick final question on if you see any anticipatedfallout in the Commerce-TD deal?
No comment. I thinkwhat we expect to happen there will be no different than any other acquisitionthat takes place in our marketplace. There is always somebody who is unhappywith the fact that change is taking place and there may be opportunities forus.
Collyn Gilbert -Stifel Nicolaus
You don't necessarily have any kind of targeted campaign,marketing campaign?
I don't want toaddress anything that we are doing.
Your next question comes from John Pancari – JP Morgan.
John Pancari - JPMorgan
Could you give us some additional color on commercial loandemand in New York, particularlywith your jewelry borrowers?
We did mention that line usage is down a bit this year ascompared to other years. I don't know if that as much a reflection on theeconomy as the fact that they are actually doing quite well and they arecollecting their receivables and they have less of a demand for funds. But wehave seen some decrease in their demand for funding, but I'm not so sure thatis a bad sign; it may be the opposite way. It may actually be a positive signin that they are doing well.
John Pancari - JPMorgan
How about competitive pressures on that front here in New York?
Why are we different than anyplace else in the country? Itis very strong. The competitive pressures for commercial lending has continuedto be very strong. Not much else you can comment on that.
John Pancari - JPMorgan
In terms of credit trends in this New York portfolio, again, any change in your outlookthere?
(Operator Instructions) At this time, there are no otherquestions.
Thank you all for coming to the conference call thismorning.
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