Bank of NT Butterfield & Son Ltd (NTB) 2018 Q2 法說會逐字稿

Good morning.

My name is Austin, and I will be your conference operator today.

At this time, I would like to welcome everyone to the Second Quarter 2018 Earnings Call for The Bank of N.T. Butterfield & Son Limited.

(Operator Instructions)

I would now like to turn the call over to Noah Fields, Butterfield's Head of Investor Relations.

Thank you.

Good morning, everyone, and thank you for joining us today as we review Butterfield's Second Quarter 2018 Financial Results.

On the call, I'm joined by Butterfield's Chairman and Chief Executive Officer, Michael Collins; Chief Financial Officer, Michael Schrum; and Chief Operating Officer, Daniel Frumkin.

Following their prepared remarks, we will open the call up for a question-and-answer session.

Yesterday afternoon, we issued a press release announcing our second quarter 2018 results.

The press release, along with a slide presentation that we will refer to during our remarks on the call, are available on the Investor Relations section of our website at www.butterfieldgroup.com.

Before I turn the call over to Michael Collins, I would like to remind everyone that today's discussion will refer to certain non-GAAP measures which we believe are important in evaluating the company's performance.

For a reconciliation of these measures to U.S. GAAP, please refer to the earnings press release and slide presentation.

Today's call may also contain certain forward-looking statements which are subject to risks, uncertainties and other factors that may cause actual results to differ materially from those contemplated by these statements.

Additional information regarding these risks can be found in our SEC filings.

I will now turn the call over to Michael Collins.

Thank you, Noah, and thanks to everyone joining the call today.

Second quarter of 2018 continued to demonstrate the strength and value of Butterfield's specialized financial services platform.

We're located at well-regulated international financial centers, including Bermuda, Cayman and the Channel Islands, where we provide market-leading banking, trust and Asset Management services; the Bahamas, Singapore and Switzerland, where we focus on wealth management and trust services; and the U.K. where we offer residential lending services, exclusively to high net worth clients.

We are making progress towards closing the acquisition of Deutsche Bank's banking business that was announced in February, which includes adding new clients in our existing markets of Cayman and Guernsey.

We are also establishing a new bank in Jersey, where we've already received the requisite licenses to operate.

The Channel Islands segment represents an exciting growth opportunity for Butterfield due to its large corporate deposit and banking market along with the nature of the customer base is similar to Bermuda and Cayman.

Over time, we expect growing market share in this segment as Bermuda and Cayman represent finite and slower-growing markets, [relaying] Butterfield market shares.

We remain on track for the acquisition to close in stages throughout the second half of 2018.

Turning now to the quarterly highlights on Slide 4. Butterfield's favorable earnings momentum continued into the second quarter as our asset-sensitive balance sheet benefited from higher interest rate, while our growing noninterest income outpaced expenses.

We reported second quarter core net income of $51.7 million or $0.93 per diluted share, an increase of 14.8% compared to the prior quarter.

Our net interest margin increased 15 basis points in the quarter to 3.20%, while our cost of deposits increased 2 basis points to 14 basis points.

I'm pleased that we reported a cost-income ratio of 59% in the second quarter below our targeted 60%, and we'll continue to actively manage expenses in a prudent manner.

We reported a core return on average tangible common equity of 27.6% in the second quarter.

This return on equity is sustained by a long-standing leading market share in Bermuda and Cayman, where low-cost deposits underpin a successful and stable commercial and retail lending operation.

In addition, our banking business provides capital efficiencies and helps support our conservative and highly liquid balance sheet.

We remain committed to achieving positive results without taking outsize risks and staying within markets and lines of business that we know and can lead.

I'll now turn the call over to Michael Schrum to provide additional commentary on the second quarter financial results.

Thank you, and good morning, everyone.

I'll now cover the second quarter performance in further detail.

On Slide 6, we provide an overview of net interest income.

In the second quarter, net interest income increased $7.5 million or 9.4% to $87.4 million compared to the prior quarter.

The net interest margin of 3.2% increased 15 basis points from 3.05% in the last quarter, in line with expectations.

NIM grew due to higher volume and yields.

Interest earning assets averaged almost $11 billion with a yield of 3.39% as we continued to add new money to the investment portfolio in May 2018 when rates backed up.

Turning now to Slide 7, noninterest income increased 5.5% sequentially with the majority of the increase due to the newly acquired and integrated trust business.

Butterfield's fee income ratio of 32.7% (sic)[32.4%] remains a stable diversified and capital-efficient source of revenue.

Slide 8 provides details regarding Butterfield's core noninterest expenses of $77.6 million.

Expenses ticked slightly higher sequentially due to the new teams supporting the onboarded GTS business as expected.

As Michael mentioned, we've now been able to achieve our goal of 60% cost income ratio in the second quarter as we continue to maintain a strong cost focus across the bank.

Slide 9 provides the summary of relative regulatory capital and leverage capital levels.

In the second quarter, Butterfield's Basel III total capital ratio increased to 22.3% due to the issuance of replacement Tier 2 subordinated debt at marginally lower cost to common shareholders.

The issuance was part of our capital maintenance program.

All existing capital ratios are conservatively above regulatory minima, and we are able to fully support the announced Deutsche Bank banking and custody acquisition and integration with our existing capital footprint.

On a leverage capital basis, we expect this will be within the target range of 6% to 6.5% by the end of 2018 due to the on-boarding of the planned Deutsche Bank deposits.

The board also authorized a quarterly dividend of $0.38 per common share as in prior quarters.

Looking now at Slide 10, we present a snapshot of the bank's balance sheet which continues to focus on efficiency and profitability, while emphasizing conservative risk management practices.

We ended the quarter with total assets of $11 billion, an increase of 2.1% from the end of last year.

The continuing liquid nature of the balance sheet is evidenced by the circa 60% of assets in cash and cash equivalents, short-term investments and investment assets.

The closing deposit balances for the quarter were $9.7 billion, down slightly from $9.8 billion last quarter.

During the quarter, the average deposit balance ran higher at $10.1 billion compared to the $9.8 billion in the first quarter of 2018, due to transitory cash management requirements of some trust clients.

These reduced towards the end of the quarter.

As we've discussed previously, deposit balances can fluctuate quarter-to-quarter as our larger trust clients manage their commercial interests.

These transitory balances helped improve net interest income this quarter by approximately $1.4 million or between $0.02 and $0.03 of earnings per share.

Looking now at asset quality on Slide 11, our loan portfolio was $4 billion at the end of the second quarter.

As expected, loan balances increased only slightly by approximately $30 million from the prior quarter, due primarily to continued growth in our London residential mortgage portfolio.

The investment portfolio at $4.7 billion at the end of the second quarter represented a net increase of nearly $200 million from the previous quarter.

The recent rate volatility has allowed us to invest at an average yield on new money of 3.6% in the HTM portfolio through the purchase of conventional Ginnie Mae 30-year securities during the second quarter.

Our investment portfolio was comprised of 96.5% AAA-rated securities similar to the credit profile of last quarter.

Slide 12 demonstrates that Butterfield continues to remain more asset-sensitive than U.S. peers.

We expect to continue to reduce sensitivity and improve running book yield into a steeper yield curve environment over the coming periods, as the overall investment strategy remains unchanged.

Now I'll turn the call back over to Michael Collins, for closing remarks.

Thank you, Michael.

The second quarter demonstrated Butterfield's earnings power, which we intend to maintain through excellence across our retail, wealth management and custody products and services.

We plan to continue to position the balance sheet to improve interest income as well as manage our capital and liquidity conservatively.

We are very pleased with the progress we are making to integrate and close the Deutsche Bank acquisition, and we're working to identify other prospective targets.

We continue to engage in constructive dialogue with trust and banking businesses in our existing geographic market.

We plan to continue to build shareholder value through the maintenance of our leading positions in Bermuda and Cayman, and the build-out of our well-regarded franchise in high-quality international financial centers through both organic growth and acquisitions.

Thank you.

And with that, we'd be happy to take your questions.

Operator?

(Operator Instructions) And our first question today comes from Timur Braziler with Wells Fargo.

Maybe starting on the asset sensitivity profile, looking at the deposit book, obviously, betas there remain as good as we've seen anywhere in the space.

But looking at the non-interest-bearing DDA component, that's a decline now 2 consecutive quarters, I'm wondering if you are seeing any kind of shift in customer mentality?

And more broadly speaking, as we head into the back end of the year, kind of what are the expectations for deposit growth?

Yes, Timur.

It's Michael Schrum.

Yes, so great question.

As you noticed we had a modest 2 basis point increase in the cost of deposit if you blend out the interest-bearing deposits with the non-interest-bearing.

We have and are continuing to intend to offer a reasonably priced fixed rate product through asset maturity to the deposit liability side of the balance sheet, although that's not predominantly the market convention either in Bermuda and Cayman.

So we have seen sort of a little bit of a decline in the non-interest-bearing in favor of interest-bearing.

We do continue to review the flows every week to look for asset sensitivity -- sorry, to look for deposit betas, and so far, again, we haven't really seen any big moves by customers and we also delegate to all the relationship managers relationship-based pricing as required.

So I think -- looking out to the remainder of the year, if customer behavior continues to want to ladder out, then we will be very much in favor of that even at a slightly higher cost.

It allows us, obviously, greater flexibility on the asset side of the balance sheet.

And Timur, this is Michael Collins.

The 2 basis point increase to 14 basis points was really driven by one very large trust client.

So we are sort of tactical about deposit pricing for our bigger clients.

But we don't have to reprice the whole book as we've talked about in the past because of our marketing dynamics in Bermuda and Cayman.

Okay, that's helpful.

And just to clarify, the June rate hike, you do plan on passing that along through the resi portfolio, is that correct?

We did not.

It's the first time for the June rate hikes, first time we did not increase the Bermuda dollar base rate for residential mortgages.

We did for commercial, but not for residential.

So we increased consistently up to this point.

We took a breather in June.

But obviously, we're predicting, hoping for 2 more rate increases.

So we're starting to take the gas off a little bit on that side, but we're looking at probably doing every other one going forward, I would think; consistently we've been increasing, so we did not do that one.

And just to confirm again, that's actually what we put in the model is every other one.

What you're really seeing in the NIM expansion on the loan side this quarter is the lag effect, obviously, from the March hike -- sorry, from the December hike, and then you will -- sort of full quarter effect of that.

And then obviously at the short end of the curve, we've seen a significant improvement in NIM as well.

Okay.

Great.

And then maybe just switching gears to the GTS acquisition.

In the release it looks like you received a small refund as part of that deal, given some client attrition it seems like between announcement and closing.

I'm just wondering, what that deal's looked like thus far kind of relative to initial expectations?

And is there any additional risk that more clients end up transferring out of the legacy GTS?

So -- it's Dan.

So I think the deal was structured well, so that there was a relatively robust price adjustment for any shifts in revenue, which we sort of anticipated occurring which is why we negotiated the deal that way.

I think in terms of the closures, they were closures that were pretty well flagged to us ahead of time.

They were closed for various purposes.

Under the Deutsche Bank regime they were identified for closure, so that has worked through.

In terms of the clients that we've onboarded and interacted with, the reaction has been extremely positive.

So we're not anticipating any further reductions in the revenue line other than what was slated for closure and adjusted as part of the price.

In terms of the financial performance, it's a little below breakeven in the first quarter as we sort of [bet] it in.

Pretty much as we expected.

As we said, when it's fully stabilized, it will be accretive and it will grow over the next 5 years given the opportunities we get.

And we have started to see some introductions from the Deutsche Bank wealth managers that are really quite attractive.

In particular, one large one in Asia that we would not have gotten access to had it not been for our presence in Singapore and the Deutsche Bank relationship.

So I think it's pretty much as we would expect it.

We're glad we structured the deal the way we did.

Because it really made it an even more attractive acquisition for us from initial purchase price, and the revenue and expense that we guided initially and the accretion that we guided seems to be about right.

It still doesn't move the needle much, it's still very much a strategic acquisition.

Your next question comes from Will Nance with Goldman Sachs.

So -- maybe I'll start with a little bit of a longer-term question.

I think implied forwards are kind of seeing rates move towards, I guess, what some would call terminal rates over the next couple of years and you guys have seen a lot of margin expansion.

I guess, how do you think over the long-term about managing the volatility of earnings that comes with the short duration balance sheet?

And I guess, what are some of the steps that you would take to kind of insulate yourselves longer term?

Yes, great question.

Well, I think, I maybe to start off with the current asset sensitivity.

I mean we still have about a $1 billion of Ginnie floaters in the book yielding 245, so obviously, benefiting again from that sort of barbell structure, and we'll still remain pretty asset-sensitive or disposed to higher rates, particularly as we go into hopefully getting a bit of a steeper yield curve as well.

OCI remains relatively contained, so that's part of this balancing act, as we continue to go into maybe second half of the rate curve.

And duration is pretty short, but extending slightly.

We do get a fair amount of runoff in the book of repayments.

So in the quarter we did gross 400 or net 200, 360.

And I think that's as expected and maybe a little bit more aggressive than we had advertised per quarter.

But as you know, we kind of also paused a few quarters where the yield curve was just really, really flat.

I think the question around the structural asset sensitivity on the balance sheet is one that we are also looking at.

As you know, the A/D ratio really creates that sort of earnings and risk profile.

We probably can't eliminate that entirely through conventional duration management on the balance sheet.

And obviously, there are other ways of doing that through derivatives, et cetera, which unfortunately aren't as kind on a GAAP reporting basis.

But we're looking at all of those things.

In the meantime, obviously, we continue to grow the fee line which is very capital-efficient and nonsensitive to rates.

And we're also moving into the Channel Islands, which has a different rate cycle than the U.S. rate cycle.

So over time that will become a meaningful part of the equation as well.

But there is no real easy answer to the structural element.

I think so far we've managed mainly the tactical piece of that through staying short as rates started to come off and then laddering in as we're getting towards the top and -- but we're still looking at it, so I would say.

Got it.

That makes sense.

And then I guess, nice to see you guys getting the below 60% target now.

I guess, given we're still seeing a couple of rate rises, the commercial book reprices next quarter, acquisitions get more accretive, where are you guys thinking in terms of just a bit of thoughts on efficiency targets going forward?

So I think we're pretty cautious about where we think it would go simply because we know we have to continue to -- spending on compliance.

We're spending quite a bit more on cyber risk now.

So our risk trends over the last few years have been -- started with credit after the financial crisis then went into real focus on the AML and KYC, spent a lot of money there.

And now we're transitioning to really picking up spend on cyber.

So we need to continue to invest in the business, but just with our asset sensitivity and where we are in the cycle and our pricing power, we probably will see the efficiency ratio probably going down into the mid-50s, I would say, just based on the model that we operate.

But -- so I would say mid-50s, but we're going to continue to spend certainly on compliance and even more on cyber risk, but mid-50s, I think, is where I'd say.

Got it.

That's very helpful.

If I can just squeeze one more in.

Is there any -- do have any thoughts on just the cadence of client acquisition from the Deutsche acquisition?

And just how much we could see coming on next quarter versus the back half?

And you guys have given pretty detailed guidance on what that means when it does come over, I'm just going to get a sense of the timing?

So we have done -- it's Dan.

We have done a couple of rolling closings -- 2 rolling closings in Cayman, we've done 1 rolling closing in Guernsey.

The first rolling closing actually occurred was tiny in terms of the balances overall, but it did prove that we could make the transaction and the transition smooth for the clients.

So we moved about 91 clients, about $20 million in the first one, which was pre-quarter end.

And then since quarter end, we've done about another 60 or 70 clients, and about another $50 million or $60 million in Cayman.

So again that's working.

And Guernsey was very tiny.

We hope to see the first rolling closing in Jersey in August.

But again, I don't think you'll start to see substantial balances move until the fourth quarter, because a lot of the larger balances are tied to custody relationships.

And some of those custody relationships we need to work through.

Those transitions are slightly more difficult but in terms of getting the data feeds built right, in terms of the client onboarding, in terms of all of the CD, we have proven the concept and can do it in an automated fashion.

So we're really pleased with the progress we're making, but as we -- what we said, there will be a bit in the third quarter, I wouldn't expect much.

And you will see a more substantial number in the fourth quarter with maybe a small tail in January of next year.

(Operator Instructions) Your next question comes from Michael Perito with KBW.

I wanted to ask a question, kind of piggybacking one of the prior questions about expenses and as you guys -- as the trust business now is expanding its global reach, I know it's a very people-heavy business but is there any -- it sounds like maybe some additional -- some compliance and regulatory type investments being made for future growth.

But are there any other like kind of technology or anything like that on your radar in terms of kind of upgrading your trust platform as you guys presumably are expanding into a more global platform that we should be thinking about?

Mike, it's Dan.

So listen, no, I think is the short answer.

So I think at the core our current platforms are fit for purpose and scalable.

So we run Navision for trust.

It's a relatively known brand.

It's now installed on all our offices across the globe.

Everybody is using it and while we need to make further revisions and enhancements to it over time, I don't think it's a wholesale replacement, just revisions and enhancements.

In terms of the core banking infrastructure, the reality is, is our core banking infrastructure is again fit for purpose, actually relatively new.

So I don't envision us making many changes.

I'll let Michael talk about the characteristics around the depreciation schedule because that actually has a meaningful impact in terms of where we are reaching in that cycle.

So no we really have pretty good core kit that allows us to scale up as necessary.

So the Jersey banking assets we're getting are going to go on to the platform that we already use in Guernsey.

We already have that platform set up.

We've already proven it can take the asset.

The custody platform we're going to use in Jersey, is the same custody platform we are using in Guernsey.

It could be 10x, 20x the size we are today and still be the same platform.

The same is true in Bermuda and Cayman.

So there really isn't a big system spend required in terms of core architecture.

And I'll let Michael talk about the depreciation.

Yes.

Thanks, Dan.

So as Dan said, I think, we have a couple of version upgrades is how I put it which is not a new implementation in core banking system, but actually allowing our, particularly our commercial customers, better access online to upload payroll files via secure messaging, et cetera.

And a little bit of couple of upgrades on some of the apps that we're running as well, which are all going to be additionally benefiting customers in terms of access and certainly enhance that channel.

In terms of the core banking infrastructure, as Dan said, we implemented that in 2010 and the amortization or depreciation on that, it was a 10-year depreciation schedule.

So that should release on a net basis around $7 million annualized starting in 2020.

So I think that's a meaningful thing to keep an eye on as well.

And as we're not looking really to replace that infrastructure, but just to keep running it and upgrading it, there won't be any meaningful new coming in as a result of that.

Great.

Helpful.

And then I did get on a few minutes late, so if you guys made some comments about this, I apologize, but just on the capital front.

Can you -- maybe just remind us what kind of the state of opportunities is out there for you guys right now?

And then as you think about your capital ratios today, obviously they're going to build rather quickly.

At what point do you guys really start to kind of look at, internally anyway -- at what point do you really start to consider more aggressive stances with some other deployment options, whether it'd be dividends or share repurchases?

I mean, it doesn't seem like it'd be a near-term event because capital levels are fine today and there seems like there is a lot of acquisitions, but at what point if we get to the middle of next year and no acquisitions come to fruition, I mean, how do you guys think about that dynamic?

So, I think -- great question.

We had a good discussion about at the board meeting as well.

Obviously, we're enlarging the footprint of the company and providing some more resilience to the earnings and risk profile of the company.

As you see, our rate cap ratios have really primarily improved through the capital maintenance of the Tier 2, which really was just making it something more capital effective at lower cost.

So I think that was just something that was good to see and also good to see that we have access to that tier of capital, if we did find something more substantial in the acquisition space.

On a leverage basis we still -- we're above target levels, but we're still below U.S. peer levels.

I think I made some comments earlier about capitalizing the deposits that are coming on board which will put our leverage ratio down back into the 6% to 6.5% range, which we're very comfortable with given the credit -- sort of credit content of the balance sheet overall, being mainly a deposit-driven balance sheet.

Traditionally -- and this hasn't really changed -- traditionally, we've gone through our planning for the next 3 years in December and that gets approved by the board.

Clearly that plan is very much a bottom-up approach and we plan on existing interest rates not even market rate.

So we don't plan for rate increases; that's important for the cost discipline across the organization.

And then we kind of set the dividend at approximately 50% payout ratio as long as that remains a sustainable number through the cycle.

And that's sort of what we've done so far.

In terms of what other options we would consider, we do have the tactical buyback in play.

At the moment, it's 1 million shares, so it's pretty small in the overall scheme of things but it could help avoid some check-creep related to compensation schemes, et cetera.

We haven't done any repurchases because we kind of want to see where this acquisition lands.

Obviously in Q4, we've committed some capital into Jersey, and we're getting some capital back from London.

So that all seems to be kind of working its way through.

But we would also consider a special dividend, if we didn't find an accretive acquisition.

Obviously, I think, we've highlighted and we will continue to have dialogue around acquisitions.

But if it doesn't come through I think the board understands that we're not building a war chest here.

We want to get the money back to shareholders, and we remain disciplined around that.

Helpful.

And then just any color on kind of the pipeline of acquisition opportunities?

So -- it's Dan.

I continue to have various conversations.

I mean, it is late July coming into August.

So there is -- but there's conversations ongoing, both in the Channel Islands banking sector and with various trust companies.

Whether they bear fruit or not I don't know.

Mike, at the end of the day, we are trying to pull stuff out.

It is not like I get a bunch of deal books across my desk.

We really having to identify targets and really try to work our way in to make sure they realize we are a better strategic owner of the business than they are.

We will continue to push and see what we can find.

And at this time, I'm showing no further questions.

So I would like to turn the conference back over to Noah Fields for any closing remarks.

That concludes our call for today.

Thank you for joining us.

Have a great day.

The conference is now concluded.

Thank you for attending today's presentation.

You may now disconnect.