ConnectOne Bancorp, Inc. (NASDAQ:CNOB) Q3 2019 Results Earnings Conference Call October 24, 2019 10:00 AM ET
Siya Vansia - Former VP, Marketing
Frank Sorrentino - Chairman and Chief Executive Officer
Bill Burns - Chief Financial Officer
Conference Call Participants
Collyn Gilbert - KBW
Greetings and welcome to the ConnectOne Bancorp's Third-Quarter 2019 Earnings Call. [Operator instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Siya Vansia. Thank you. You may begin.
[AUDIO GAP] To review ConnectOne's results for the third-quarter 2019 and to update you on recent developments. On today's conference call will be Frank Sorrentino, Chairman and Chief Executive Officer; and Bill Burns, Chief Financial Officer. The results, as well as notice of this conference call on a listen-only basis over the Internet, were distributed this morning in a press release that has been covered by the financial media.
At this time, let me remind you that certain statements and assumptions in this conference call contain or are based upon forward-looking information and are being made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.
Such forward-looking statements are subject to numerous assumptions, uncertainties and known or unknown risks, which could cause actual results to differ materially from those anticipated. These risk factors are more fully discussed in the company's filings with the Securities and Exchange Commission. The forward-looking statements included in this conference call are only made as of the date of this call, and the company is not obligated to publicly update or revise them.
In addition, certain terms used in this call are non-GAAP financial measures, reconciliations of which are provided in the company's earnings release and the accompanying tables or schedules, which have been filed on Form 8-K with the SEC on October 24, 2019, and may also be accessed through the company's website at ir.connectonebank.com.
Each listener is encouraged to review those reconciliations provided in the earnings release together with all other information provided in the release.
I will now turn the call over to Frank Sorrentino. Frank, please go ahead.
Thank you, Siya, and good morning, everyone. Thank you for joining us today. We delivered record performance this quarter, demonstrating our ability to drive value during a challenging interest rate and operating environment.
Let's start with some of the key financial highlights.
Net income was $21.7 million for the quarter, which was a record, increasing by 12.5% from the second quarter. Organic growth was strong, with average deposits increasing by 15% sequentially and average loans increasing by 10%, both on an annualized basis.
Return on assets exceeded 1.4%, and return on tangible common equity was 16%, return metrics that we are very pleased with. Our efficiency ratio improved for the second consecutive quarter to 41.1%, and we remain one of the industry's most cost-efficient banks.
Net interest margin widened by 14 basis points sequentially, while most of the industry is experiencing contraction, reflecting strong core business growth and sound balance sheet management. And lastly, our capital ratios increased while tangible book value per share increased by 4% in one quarter to $15.60. We remain committed to several key elements that have contributed to our success, including profitable organic growth, a disciplined M&A strategy, prudent credit underwriting, increasing our investment in technology and stewardship of our shareholders capital. The results of these commitments are clearly demonstrated in our strong third quarter performance, and we remain well-positioned for the remainder of 2019 and into the first half of 2020.
In terms of strategic developments, the last several months have been very exciting and busy, highlighted by our FinTech acquisition of BoeFly and our definitive agreement to acquire Bancorp of New Jersey, a $1 billion commercial bank.
The Bank of New Jersey acquisition is extremely compelling from an operating, market and financial perspective, and we believe it's a natural fit for ConnectOne. Let's recap some of those benefits. ConnectOne picks up approximately $800 million of deposits right in our backyard.
The transaction provides tremendous cost savings and economies of scale, and we modeled very conservative cost save estimates that we believe will prove higher as eight of their nine branches are within walking distance of ConnectOne's branches.
From a growth perspective, the acquisition increases in market opportunities by leveraging our expanded product base and technology for our new clients. It's a very low-risk transaction given our overlapping geographic footprint, strong cultural alignment and deep knowledge of the institution, the market and client base. Finally, with $7 billion of pro forma assets, this will enhance our franchise value by adding scale while strengthening our scarcity value.
Regarding next steps, the approval process is proceeding as planned. We remain encouraged regarding the regulatory approvals, as well as the momentum we're building in preparing for the integration process. It remains on track to close early in 2020, and we'll keep you informed as we progress.
Regarding our acquisition of BoeFly. The integration there has gone very smoothly, and we've made some investments to enhance and rebuild some of the infrastructure. While we continue to expect that the financial impact of the acquisition on our 2019 results will be minimal, we do expect the platform to augment ConnectOne's fee income, already adding approximately $200,000 in fees in the third quarter and to generate profitable SBA lending opportunities.
Additionally, by establishing a national presence in the digital market space -- marketplace, we believe there's a meaningful upside to enhance ConnectOne's digital strategy. As we scale and extend our competitive position, we're committed to utilizing technology to remain one of the most efficient banks in the nation and continue to invest in our digital infrastructure.
Strategically, the investments we're making in our business are driving growth and underpinning solid earnings today, but more importantly, for our future. ConnectOne's performance, especially our operating efficiency, reflect the benefits of these initiatives.
We'll also continue to rationalize our physical footprint. During the past quarter, we closed the retail location in Madison, New Jersey with minimal impact to our clients as the next location is within two miles of it.
We also converted a former branch in Oakland, New Jersey into a modern style flexible office space. It features flex space for a segment of our workforce, and in this case, a revenue-generating theme and conference space that our clients can reserve and utilize for their businesses.
Looking ahead, we'll continue to evaluate all of our brick-and-mortar strategy. And so with that as a strategic overview, I'm going to turn the call over to Bill to provide more details on this quarter's performance. Go ahead, Bill.
Okay. Thanks, Frank. So as Frank mentioned, it was a great quarter, one where we hit on all cylinders. So let's get right into it by starting with the hottest topic, that's the net interest margin.
So ConnectOne's NIM widened significantly, while, as you know, most of the industry is experiencing margin compression. In a nutshell, it comes down to this: our balance sheet is well-positioned; and our core businesses are growing quite nicely, and it's also been helped by our acquisition of Greater Hudson. So digging down a little deeper, there are three main factors working in concert. First, it was an improvement in the yield in our loan portfolio, which increased by eight basis points sequentially.
A good portion of this was attributable to higher profitability in C&I and construction lending with higher balances and more fees. In addition, we remain disciplined on the pricing of new loans, which has contributed to overall wider spreads.
And finally, there was an increase in prepayment penalties, although this was offset partially by a decrease in purchase accounting accretion. Second, our cost of funds fell by seven basis points.
As we've mentioned before, we've been ahead of the curve in terms of deposit pricing, reducing our rate in anticipation of rather than after Fed cuts. We did this very successfully over the past two cuts, while for the upcoming one, we are taking a more measured approach.
And so I've been asked by investors, what kind of runoff have you experienced with those rate reductions? Well, the answer has so far has been there hasn't been any runoff. In fact, we've had very strong growth during the quarter in core deposits.
Average interest-bearing deposits increased more than 5% sequentially, that's more than 20% annualized, and this has allowed us to reduce higher cost borrowings. And third, I want to remind you that we had announced a mini restructuring late in the second quarter. We've already announced this. In it, some higher rate Federal Home Loan Bank borrowings were paid off, and we utilized swaps to extend funding at very attractive forward rates.
That restructuring added about two basis points to the margin. So going forward, our goal as always is to remain as neutral as possible to shift some interest rates. I still believe there will be some pressures on the margin, especially on the assets side where competition remains fierce and rate cuts take their full effect. Nevertheless, we remain optimistic we can maintain the mark in this range with just possibly some slight compression.
Let's now move on to non-interest income. Those who follow us know that fee income historically at least has not contributed much to our results, but we have been making strides in building non-interest sources of revenue. First, we've had some success enhancing fee revenue on deposits. Second, we are capitalizing on our strong commercial loan origination capabilities by originating for sale certain commercial real estate loans.
We reported about $200,000 of gains on sale of commercial loans in the quarter. We've got another $30-plus million in principal balance in the pipeline that we anticipate we sold for a gain in the fourth quarter. And going forward, the amount of loan sales will be based on market conditions. And in 2020, we expect additional revenue from SBA loan sales.
Third, with regard to non-interest revenue, we've got BoeFly. On the bottom-line basis, this FinTech subsidiary is running approximately at breakeven, and in the third quarter contributed about $200,000 in fees. We intend to continue to invest in BoeFly in order to grow that business and increase the value of the subsidiary. In the near and medium term, we expect it to add both revenue and expense to our operating metrics.
Okay. Now let's move -- let me move to operating expenses. We may have some non-recurring items in there, including merger charges and the FDIC credit. When you take those out, looking at it on a core basis, expenses were up about 5% sequentially after being down slightly in the second quarter.
That increase is related to additional staff, including BoeFly, as well as an increase in compensation accruals. And despite the increases in expenses in the quarter, our efficiency ratio improved once again, and I believe we can operate for the immediate future in the very low 40% range, and we have a longer-term goal to be sub-40%. Note that we closed the bridge during the third quarter without any deposit runoff, and we'll continue to look for ways to rationalize brick and mortar. In terms of the provision for loan losses now, it was $2 million for the quarter, up a little bit from the second quarter.
We had a few individual somewhat charge-offs totaling a little under $1 million. But even with those, the annualized charge-off ratio was only seven basis points for the quarter.
Let me turn to CECL for a moment. We continue our work on CECL to be compliant come 2020, but I'm not ready to disclose the number at this time.
I believe that puts us in the same camp as most of the industry. I do expect, however, that CECL implementation will add to our reserves, but don't forget we are a commercial focus lender and any reserves related to consumer lending portfolios will be minimal.
On the tax line, our effective tax rate remains at about 23%. Expect that to continue for the fourth quarter of 2019.
While the rate could tick up a percentage point or two next year depending on portion of factors. I want to talk a little bit about our capital position. We continue to build capital in the quarter as we had strong earnings, and we're essentially out of the box on repurchases due to the S4 filing with the Bank of New Jersey deal. So the holding company tangible common equity ratio increased for the seventh consecutive quarter and is now over 9%.
We are comfortable with that ratio as low as a 8.5%., so we continue to have a lot of flexibility, which is a nice place to be. Looking into next year, a potential CECL implementation charge and the cash portion of the bank of New Jersey transaction will utilize some of the excess capital and still expect we will have capital to fund organic growth, recommence stock repurchases and to review our cash dividend policy early next year.
And I'm going to turn it back over to Frank now.
Well, thank you, Bill. Great. As you heard, we reported a record quarter that reflects our commitment to drive value and our consistent focus on ConnectOne strategic plan, which includes disciplined pricing, organic growth and a focus on credit quality. ConnectOne also continues to make investments in technology to remain competitive and create efficiencies.
We believe there are attractive opportunities for financial institutions to expand their digital strategy by partnering with FinTech companies who either offer delivery channels for financial products and services or offer solutions to streamline and enhance backend processes.
We also believe banks like ConnectOne are playing a critical role in bringing innovation to our clients through those partnerships. We have a substantial client base. We have revenue generation capability and an established track record of operating within the required regulatory framework that would be necessary.
We look forward to benefiting from those partnerships with FinTech companies and the enhancements that they can provide. As we look ahead through the remainder of the year and into 2020, I'd like to reiterate a few key points.
We continue to grow organically even in tough environments and still see our growth rate in the high single digits for the year. We're a skilled acquirer with a track record of integrating both traditional and FinTech-focused transactions quickly and effectively.
We continue to enhance our efficiency, both internally through tech and through processes and externally through reduced friction from the banking process for the benefit of our clients. And we're continuing to transform our -- by expanding our digital channels and becoming more technologically focused. As I stated, we're a well-positioned bank for the future, and today, we're capitalizing on the investments we've made. In a competitive market, ConnectOne is playing offense.
With that, we're happy to take your questions. Operator?
Thank you. [Operator Instructions] Our first question comes from Collyn Gilbert with KBW. Please go ahead.
Thanks. Good morning, gentlemen. If we could -- if you could just talk a little bit more in terms of your outlook for growth. I mean you guys are on the loan side, saw great results this quarter and especially impressive is kind of the pricing that you're able to hold onto.
I know, Bill, you'd indicated that you're likely to see pressure in the fourth quarter as it relates to that. But just broadly kind of where you're seeing the growth, the type of loans you're seeing maybe the pricing and structures that you're putting on the balance sheet today.
I guess, I'll start there, Collyn. I think we're seeing the growth coming from all the different areas that we've invested in here at ConnectOne. Certainly, the market in which we serve is a great place to be, notwithstanding everything that you read about in the newspaper. The New York metro market is still a pretty robust environment to do business.
Yes, it's competitive. Yes. You have to weed through a lot of things to get at better products. But for the most part, we have a lot of incoming calls.
Our existing client base is very accustomed to the service levels that they receive here at ConnectOne. And we've told the market time and time again that that does result in some higher pricing for us. People will pay for a better experience, and I think we're seeing the results of that today.
And I'll just also add that there has been a shift in the composition of the portfolio away from multifamily. So if you look back a few quarters, we were 34%, 35% of the portfolio. That's below 30% now. We are lending less in that area because of the loan spreads and the competition.
We're not out of the market, but we're going to pick and choose and only do transactions where there's a decent spread and relationship.
Okay. That's helpful. And along those lines, Bill in the decline, you guys saw quarter-to-quarter in the CRE book, how much of that was multifamily reductions? Or do you have a sense of how much the multifamily will pay down?
Most of the decline -- without the numbers directly in front of me, most of the decline is from the multifamily runoff.
Okay. And the...
That does not mean we're not doing multifamily loans, it's just more coming than going on.
Yes. Got it. Okay. And just curious in terms of the dynamic that you saw this quarter in terms of loan yield runoff versus loan yield origination.
Well, I think there are pressures with lower rates that will start to see a decline in the asset yield. I know it was up for this quarter, but we're probably going to see both declines in asset yields and decline in funding yields. And that leads to my outlook for the margin being about stable.
Okay. And then just in terms of your comment kind of maybe taking a little bit of a cautious or just a pause here as it relates to further deposit cuts. What -- can you talk about sort of, yes, how you're thinking about the strategy there broadly on the deposit pricing side? And what maybe caused you then to reaccelerate deposit rate cuts?
Well, I think, look, we've been very successful. And when we're successful, we have a lot of flexibility. And so I think we can given that we've cut rates a couple of times, we can just wait a little bit. I do expect further cuts in the deposit rates when the fed moves.
Okay. Okay. Great. I will leave it there. Thanks guys.
[Operator instructions] There are no further questions at this time. I would like to turn the floor over to management for closing comments.
Well, thank you, everyone, for joining this conference call today. And we look forward to reporting our results at year end. Again, thank you, everyone, for joining.
This concludes today’s teleconference. Thank you for your participation.