OceanFirst Financial Corp (OCFC) 2016 Q2 法說會逐字稿

Good day, and welcome to the OceanFirst Financial Corp Earnings Conference Call and Webcast. All participants will be in listen-only mode. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Ms. Jill Hewitt, Senior Vice President and Investor Relations. Please go ahead.

Thank you very much. Good morning and thank you all for joining us this morning. I'm Jill Hewitt, Senior Vice President and Investor Relations Officer at OceanFirst Financial Corp. We will begin this morning's call with our forward-looking statement disclosure. Please remember that many of our remarks today contain forward-looking statements based on current expectations. Refer to our press release and other public filings, including the Risk Factors in our 10-K where you will find factors that could cause actual results to differ materially from these forward-looking statements.

Thank you. And now I will turn the call over to our host, Chief Executive Officer, Christopher Maher. Chris?

Thank you. Jill, and good morning to all who've been able to join our second quarter 2016 earnings conference call today. This morning I'm joined by our Chief Financial Officer, Mike Fitzpatrick; Chief Lending Officer, Joe Lebel; and Chief Administrative Officer, Joe Iantosca.

As always, we appreciate your interest in our performance and are pleased to be able to discuss our operating results with you this morning. As has been our practice, we will highlight a few key items and add some color to the results posted for the quarter, then we look forward to taking your questions.

As part of our discussion this morning, I'll ask Joe Lebel to provide some comments regarding conditions in the commercial lending market and Joe Iantosca to comment regarding progress with our merger integration projects.

In terms of financial results for the second quarter, diluted earnings per share were $0.16, quarterly reported earnings were impacted by merger related expenses of $0.22 or $7.2 million pre-tax resulting in core earnings per share of $0.38. Core earnings increased 18% versus the prior quarter, largely driven by the first stage of efficiencies achieved through the Cape acquisition. The second stage of efficiencies will be fully realized in the first quarter of 2017 following the systems conversion and rebranding of the Cape branches, which was scheduled to be completed in October.

Regarding capital management for the quarter, the Board declared a cash dividend of $0.13, the Company's 78th consecutive quarterly cash dividend. The quarterly dividend represented an 81% payout of reported earnings, but just a 34% payout of core earnings, which is both conservative and below our historical payout range.

As a result of the purchase accounting impact of the Cape acquisition, tangible book value per share decreased a modest 4.4% to $13.14. A table detailing the fair value marks of the Cape transaction has been included in the earnings release. Those shares were repurchased during the second quarter as the Company elected to build capital and tangible book value and support the Cape bank acquisition that closed on May 2 and Ocean Shore acquisition that was announced on July 13.

As of June 30, the Company had 244,804 shares available for repurchase. The repurchase program remains active, however the Company expects to continue to prioritize dividends and building tangible book value in the coming quarters. Operating results for the quarter were strong, as core net income is tracking towards our short-term targets of a 1% return on assets and a 12% return on tangible common equity. In the coming quarters, we will have the opportunity to improve both these performance metrics, as the Cape acquisition will have a full three-month impacting the future quarters. In addition, during the fourth quarter of 2016 and the first quarter of 2017, we expect to realize the second stage of efficiencies to be realized from the Cape acquisition.

Second quarter organic loan production totaled $110 million, slightly less than the $113 million produced in the prior-year period. However, net loan growth was muted, primarily due to prepayments. While second quarter is typically a quarter with slow originations, we are seeing clear signs the credit standards in the market are eroding. This will likely result in more modest loan growth in the coming quarters. But I will leave the detailed discussion regarding lending markets to Joe Lebel.

Deposits continue to be a strong point as our relationship commercial lending focus, price discipline and the Cape acquisition supported strong deposit growth while maintaining an average deposit funding cost for just 25 basis points. Importantly, the loan-to-deposit ratio decreased from 101.3% to 97.6%, demonstrating the strategic funding available to support disciplined loan growth in the future.

Margins were another strong point, as the Cape acquisitions helped drive the net interest margin to 3.55%. While accretable yield from the transaction provided a strong lift, excluding purchase accounting accretion and prepayment fees, the core net interest margin increased by 10 basis points.

Expenses trended higher for the quarter, primarily due to the operation of an additional 22 branches for two months. Excluding the impact of merger related expenses and the deleveraging program, the quarterly run rate for operating expenses would have been $24 million if the Cape branches have been operated for the entire quarter.

Over the next three quarters, operating expenses may fluctuate more than normal as our bias is to ensure the bank's somewhat concurrent integration projects proceed smoothly and result in high levels of customer retention. The overlapping projects may cause a temporary increase in operating expenses, however, following the Cape conversion in October and the anticipated Ocean Shore integration in mid-2017, operating expenses could be prudently reduced to further enhance long-term profitability.

Credit quality continued to improve as non-performing loans decreased by $863,000 as compared to the prior quarter, representing just 48 basis points of total loans. The allowance coverage of non-performing loans increased to 108%, the highest level since 2007. Given the magnitude of the Cape acquisition, we thought it important to clearly identify, not only the allowance coverage of the legacy loan portfolio, but also the net unamortized credit mark against the purchased loan portfolio.

Credit marks in the form of the $16.7 million allowance for loan losses and a $27.3 million net unamortized fair value discount on purchased loans, when combined, total $44 million or 1.39% of the gross loan portfolio.

At this point, I thought it would be helpful for Joe Lebel to share some thoughts about the credit conditions at our market area and in considering those conditions, to give some guidance regarding expected loan portfolio growth in the coming quarters.

Thanks, Chris. This morning I'd like to provide some color regarding what we are seeing in the commercial lending space, in the external environment as well as some insight as to what we are doing internally. The good news is that most borrowers are performing well as businesses continued to recover from the Great Recession. However, the intense competition to lend against cash flow in real estate and to lend to profitable, well-established commercial clients has resulted in losing credit standards in the marketplace.

The external landscape remains competitive and dare I say, it more kind of (inaudible). After three years of double-digit commercial loan growth at OceanFirst, and then the eighth year of a tepid economic recovery, we are observing a measurable decline in prudently structured new loan opportunities from both existing clients and prospects.

Much has been written about investor CRE in general and the multi-family market place in particular, in regard to aggressive loan structures and overly accommodating pricing. We have observed a loosening of credit structures in the form of weakened or completely eliminated financial covenants, the return of significant cash out, non-recourse loans, interest-only amortization periods and extended repayment terms of up to 30 years.

Of particular concern, we have seen recent examples of this weaker underwriting characteristics collectively present in the very same transaction. This layering of risks was a primary determinant in the propensity for commercial loan defaults in the last crisis. In addition, many banks are stretching for loan growth in unfamiliar markets or new industries as they search for yield. Our conservative approach to commercial credit risk management will not change, which will reduce the rate of commercial loan production as long as these conditions continue.

In addition, we employ a disciplined and formal pricing model and simply won't enter into transactions that dilute the bank's profitability for the sake of growth. Internally, commercial loan originations in the second quarter, typically our slowest origination quarter, were up 2.9% versus the second quarter of 2015, while organic loan production for the first half of 2016 was down only 3% year-over-year. We have avoided or lost opportunities due to our vigilant focus on credit standards and maintenance of our expectations for pricing.

It is also important to note that we have undertaken a significant effort to reduce, not only nonperforming loans at an expedited price pace, but also to actively reduce potential problem assets we believe will be more vulnerable in the next downturn. These would be loans on our watch list or those habitually delinquent. We are also declining the request of certain borrowers to renegotiate the terms or financial covenants that allow them to borrow more money and over-leverage properties, particularly when we believe the additional leverage will put the borrower at undue risk.

Relative to the former Cape footprint, originations as expected have been slow as the transition to OceanFirst credit terms and pricing takes effect. We expect some run-off to occur in the short term before stabilizing the portfolio in 2017. However, our expectations for the former Cape franchise are on target.

Finally, we are cognizant that economic conditions remain somewhat uncertain, that's relating between weaknesses brought on by global economic uncertainty, and indications that the recovery is stabilizing as suggested by employment, auto and housing data. Economic conditions appear to be at a crossroads with two very different potential outcomes over the next 18 months to 24 months. Perhaps the US economy works its way through the global conditions and domestic concerns, resulting in consistent growth with real potential for Federal Reserve tightening or the economy may weaken under the weight of near-term challenges and slide into a modest recession.

A recession could create real issues in the credit markets, particularly in highly leveraged CRE that is especially susceptible to historically low cap rates and cash flow issues. In either of these scenarios, reducing the pace of loan growth in the coming couple of quarters could preserve the opportunity to expand more quickly when economic conditions provide better opportunities.

Despite pressure on prudent commercial loan structures and the potential for economic uncertainty, quality commercial loans can be made in all environments and our highly professional and deeply experienced commercial credit staff will allow us to originate commercial credits albeit, at slightly lower pace. In addition, we believe the Philadelphia metropolitan market will provide the opportunities to supplement -- opportunities (inaudible) in Central and Southern New Jersey. These opportunities are just not as abundant as they were in prior periods, so we expect overall loan growth will be modest in the coming quarters.

In summary, we remain active participants in the markets we serve and expect to grow the commercial portfolio in the second half of 2016, but at a slower, more methodical pace. Our concerns about the economic and competitive landscape will continue to impact our views on commercial portfolio growth for 2017. We remain committed to our credit standards and price discipline, acknowledging the near-term effect on portfolio growth and recognizing lending conditions will likely improve over time.

With that I will turn the call over to Joe Iantosca, who will comment regarding our integration plans and timelines for Cape Bank.

Thanks, Joe. The project of integrating Cape is progressing as planned. The integration team comprised of well over 70 professionals includes experienced internal and external resources that are well accustomed to the training and testing tasks before them. Activities [span] the gamut from the highly technical such as APM and hardware installation and conversions and system testing to employee training to marketing and rebranding.

All aspects of the projects are tracking as expected to the October systems consolidation and branch rebranding. The integration of Ocean City Home Bank will be our fourth acquisition project. Employees and external support staff engaged in this effort have now worked together through multiple integrations and are well prepared to address this integration with the same high level of professionalism and competency which we require. I won't take the time here to reiterate from last quarter's call the qualifications of key team members, but I will point out that the team leadership has been intentionally comprised of professionals experienced in multiple, concurrent, large scale integration projects. In addition, in each of these integrations, the primary data processing partner has been the same organization. Our partner FISERV has been cooperative and very responsive to our needs. We expect to engage some, but not all of the same team as we spin up the Ocean City Home integration, and we are thrilled to have the ability to tap additional highly experienced banking and integration professionals as we execute on that project plan. The team expected to be similar in size and scope to the Cape integration team, will be well prepared the consolidation efforts necessary for a legal close around year-end and we'll work to complete a mid-year 2017 full integration.

So to conclude, with the experienced professionals engaged and a solid team structure and based on our results to-date, we are confident in our capability to fully integrate the Cape operation in October and are prepared to do the same for the Ocean City Home project in a timely and effective manner following closing, delivering high quality products with extraordinary customer care to our Southern Division customers.

And with that, I'll turn the call back to Chris.

Thanks, Joe. At this point, Mike, Joe, Joe and I will be pleased to take your questions.

Andrew, could you remind everybody how to ask the question please?

We will now begin the question-and-answer session. (Operator Instructions)

Frank Schiraldi, Sandler O'Neill.

Just a few questions. First I want to ask on a loan growth front, so just in terms of overall growth in the short term here, given potential, I guess attrition within the book as well taking that into account, are you big guys basically saying that a flattish total loan growth over the next couple of quarters isn't a reasonable place to start expectations?

Yes, I don't think that would be unlikely. I think flattish to maybe low single digits depending on what market conditions deliver to us. So we anticipated some run-off when you go through the integration side of the Cape, but that's not to be a material impact. So it depends a little bit of market conditions, pipelines okay now, so I would say flat to low single digits is a reasonable expectation.

Okay. And I got the message on the markets, and the competition, but does this also reflect any changes to OceanFirst's underwriting versus last couple of years and now?

Yes, Frank, it's Joe Lebel. We've been fairly consistent with our underwriting standards and we don't plan to change them.

Yes, the only thing we might have done on the pricing side, Frank is we've elevated our expectations for returns on investor CRE, so we're still active in investor CRE, we think there are very good deals out there, but our minimum return hurdle through our price model, we kind of ramp that up a couple quarters back to make sure that those are precious dollars in your balance sheet, so when we're using them, we want to make sure that we're getting paid for it.

And then just switching gears to the NIM, the accretable yield in the quarter, which you guys highlighted in the release, how do we think about that going forward? I mean, is this more of a credit event at Cape or prepayments at Cape that boosted that this quarter or if you have a -- based on the pool, I mean, do you have a sense of what should be a more normalized accretable yield running through the margin?

Frank, that was not -- it was not affected by prepayments, so that was, what you saw was the accretion over the life of the loan and it comes in the earlier years and started running down. So if you're looking for the third quarter number, that would be about a $1.5 million, the fourth quarter number would be about $1.3 million in terms of accretion to the NIM. So it's consistent with where we are for the second quarter.

So that's a pretty run rate with 2Q. And then just finally just in terms of quarter-over-quarter, the tangible book value per share, where that came out and the 2Q versus 1Q, little bit better than I had anticipated and I know there's a lot else going on besides the closing of Cape, but just wondering when you did your final marks, if the dilution there looked -- if there was any change or if it was very similar to what you guys had reported when you announced the deal?

It's very similar to what we had expected when we announced the deal, obviously different categories when one way or the other, there was a little difference in pension mark as well, some of the real estate marks, but in all, it was about what we expected. I think you're seeing it in the second quarter, that's when closing happened, we have a couple of million dollars, maybe $2 million to $3 million worth of expenses that will be merger-related as we come off the core systems, so that will hit later in the year, although that will be expressed as tangible book value dilution, that's something that we've modeled when we looked at the way the dilution will work. So I think you are using [$4.4 million], we had thought might be plus or minus somewhere around 7%, maybe a little better than that, but that's not going to be a lot better.

David Bishop, FIG Partners.

A question in terms of maybe just -- in line of that the loan commentary, any change quarter-over-quarter in terms of your core markets in notion of Monmouth County that -- is of note that [reason] to that change or the cautious outlook?

Dave, this is Joe Lebel, I don't think there is any change in any one market particular, I think it's the landscape on totality basis. It's all over, everything we see in the footprint up here in our core markets and even in the Southern Division Cape market.

Yes. And if you sort of buy for Cape with the expected growth, would that shift move towards the Philly region over the near term here and is there a significant price differential on the loan side?

I think when you look at our markets, just on market density, which translates into market opportunity certainly Middlesex, Monmouth and then the counties down towards in Metro Philadelphia, have the densest location of businesses and probably the best lending opportunities on the commercial side. But that's just more about population density in number of companies. The pricing I think is a little different, the pricing tends to vary not as much by geography but by the size of the loan, with larger loans attracting more bidders. So I think as you kind of go up the scale, you're going to wind up having more bidders, which will translate into thinner pricing. And we see that kicking in probably when you get to the high-single digits, say to $10 million but then really kicking in on loans over say, $12 million to $15 million, you just have more people bidding, there's more reason to kind of shave the pricing on it. So a little bit of that winds up being geographic because in some of the markets we have smaller average loan sizes so they tend to be priced a little less competitive than we saw.

And then shifting gears on the credit side. I think last quarter in terms of you getting aggressive on managing (inaudible) assets, a little bit surprised (inaudible) more of a movement in terms of the total NPA total there, was that just a function of sort of getting the Cape acquisition behind you then getting more aggressive on managing out some of those NPLs and, I don't' know, if there's any read into the rise in the early stage delinquencies?

Sure. Let me start at the early stage delinquencies. There were two parts of that quarter-over-quarter change, that was about a $3 million lift from just delinquencies carried over from Cape, that's really a change. And then there was about -- it was a single commercial credit just over $4 million that's well secured, we're not concerned about that, just needs to pay us more quickly, so it's not a trend that we're concerned about.

As it relates to the total nonperforming pool, we are managing that downward, but we're also trying to be cognizant of collecting every dollar we can for the shareholders. So we're focused on it, we're trying to move that down quarter by quarter, we don't feel a need to accelerate it rapidly, but we are making it a priority to make sure that number is in line.

We also, into Joe's comments, some of this is not visible, it's folks that may come up for renewal, they get a competitive pricing offer that we think is too much leverage for someone who's had more delinquencies than you would have liked to have seen, when -- as they are coming up for renewal, we're allowing them to go elsewhere, which you wouldn't see in any of the credit metrics, but we think it's going to position us better in the event some conditions deteriorate down the road.

Collyn Gilbert, KBW.

So Chris, I apologize, maybe for beating a dead horse on this and part of it is kind of my short history with you guys, but just going back to your gross comments, maybe the outlook that you have today which on the side of it sounds fairly draconian, I don't want to use a strong word, so I'm just trying to sort of frame that with maybe your outlook for the back half of the year versus maybe what you were anticipating gross to look like, either going into the beginning of this year or maybe end of last year, just trying to sort of piece some of these comments together.

Sure. I believe we can help you. I think for a series of quarters, we saw double-digit increases in commercial loan book and we're able to do those quarter after quarter after quarter. And we started to see some weakening last quarter in these external conditions and we also kind of (inaudible) our attention to making sure that if we had renewals coming up and we should feel perfectly clear on the renewal, we might encourage them to move on to into another institution. Those headwinds are not severe, but they are having an impact, so now as we look to commercial loan growth, we're thinking that double-digits probably not achievable for the commercial book, there may be single-digits in the commercial book rational, which means that all the overall loan book might be low-single digits and then maybe quarters that you wind up being essentially flat next two or three quarters.

Combined with that is the natural process of working through the integration of the Cape book, which on a proportion was a very large loan book compared to the original OceanFirst loan book. So when all the dust settles out, we look at the external market, we look at what we'd like to do to manage our balance sheet over the coming quarters and the opportunity to improve earnings with leverage other than loan growth, we're not going to stretch on the loan side.

So I think where you would have seen solid double-digit increases to commercial loan book which were resulting in high single-digit increases to the overall loan book, you're probably seeing now single-digit increases the commercial book, which are low-single digit increases to the loan book in total. So I hope that helps.

Yes, that helps a lot. Okay then just maybe (inaudible) your comment on maybe looking at other areas, kind of outside of lending to generate earnings, is there I know you've got a lot in your plate, obviously you're integrating these two acquisitions, but outside of the deals, is there any initiatives that you're kind of looking towards either when you get kind of on the other side of these integrations as to where you think kind of some of earnings drivers are outside of the lending?

Absolutely, yes. The main one is that like many in our industry, we are thinking very hard about our retail distribution network. And with the right configuration that network is, so we are a Company that's gone pretty rapidly up to now 50 branches, closing with Ocean City Home Bank, we'll have about 61 branches and then this is not just related to Ocean City Home and the overlap with our southern division, but just a general comment that you wind up as a Company with 61 branches, that has to think through our 61 full service, fully staffed facilities, the right mix and are they in the right places and the right configuration for the future.

So I think we're going to be very conservative and very cautious about how we look at both the integration of Ocean City Home and our existing retail networks. But we think that probably beginning in 2017, and then continuing into 2018, there's an opportunity for a substantial shift in the way we deploy our retail resources and that could be provide a meaningful improvement to the P&L.

The second part of that it's a little bit more integration-related is, in my comments, I kind of hinted towards this, we are being reasonably liberal or maybe not as conservative as we usually are about operating expenses because we've got reasonable degree of risk in integrating two large companies and we want to make sure that we don't make any mistakes in that integration to preserve all those customer relationships, so I think later in 2017, because we'll be coming off the integrations, but also with the retail opportunity you've got an ability to really look at operating expenses, and maybe get them to be much more favorable.

And that actually moved into my second question, just on the expense side. So right your comments were that they'll be lumpy, likely elevated, can you quantify that a little bit tighter for us in terms of, I don't know, like a quarterly run rate or what the kind of linked quarter growth rate will look like on expenses here over the next few quarters?

I think it would have reduced, I would start with kind of the run rate if had operated the 22 branches for full quarters. You kind of start with about $24 million run rate and then I wouldn't be surprised if -- it's not going to be a giant number, but in any particular quarter, we might have a $0.5 million of expenses that we wouldn't otherwise have spent. I'm not sure that I would call them always merger-related expenses, for example, which is we -- still in video conferencing into all of our major facilities, that's not a giant number, but it is a number, it's something we wouldn't have done before, it's not a merger-related expense, but the ability to communicate well with people all throughout our geographies is really important. So I don't -- you're not going to see a wild deviation from the $24 million, but it's not going to be as predictable as it would be if you just kind of going quarter-to-quarter with the same kind of franchise.

Matthew Breeze, Piper Jaffray.

Just sticking with the expenses, Chris, when you expect to have all the noise behind you and show the true profitability of the bank with the most recent acquisitions?

Okay. So there will be -- so we're being very careful to report the merger-related expenses in a way that you can kind of understand what they are and when they're coming. The third quarter is going to be reasonably clean because we don't have a whole lot of activities coming, some merger-related expenses. Fourth quarter, we have the systems conversion, contract terminations and the final staff changes.

So the fourth quarter will have a little bit of noise and it's related to the Cape conversion. Then there is really just the two different quarters that we're going to have related to Ocean Shore and I can't be sure exactly when the closing will happen on that, depends on regulatory approvals, but you'll have, like we had with Cape, you'll have one point of noise when we close the Ocean City Home transaction and then about two quarter thereafter you'll have the conversion noise.

So what I'd like to tell you that I think essentially it will be done in the first half of 2017, some of the expense recognition may weaken to the third quarter of 2017, it depends a little bit on conversion timings and all that kind of stuff. But certainly the fourth quarter of 2017 would be completely clean and for the most part, third quarter of 2017, I would imagine would be clean or easily identifiable.

And then in terms of the pro forma branch count, you'd mentioned that there might be some changes to that in how the investments are made and where they are. Do you expect between now and the point that you just mentioned when we see clean expenses that there might be some changes to that as well, a lot happen over the same timeframe?

I think that in the beginning, and this is kind of long-term project that we've been working on and we will accelerate the work on the second half of the year. I think as we go into the first half of next year, we will have an idea of where we're going in terms of the branch roadmap and I think we'll be able to share more details then that will give you some order of magnitude on that. But we are going to be very careful not to go too quickly and I think one of our core franchise values is our deposit franchise. And we do not want to do anything that we put that deposit franchise at risk. So we'll be planning through the rest of this year, we may be talking with our investors about that beginning of next year, but I wouldn't expect material changes in that to happen until second half the 2017.

And you guys provided some really good detail on what's going on in the markets in terms of competition and lending conditions. Just curious if those pushing the envelope on loan terms, are they banks or insurance companies or credit unions and if they are banks, what kind of banks are they? Are they mutuals or the larger and universal banks or community banks like yourselves?

Matt, it's Joe Lebel. It's largely banks. We do see insurance companies in markets for those larger stables (inaudible) transactions that Chris mentioned when and we get over the $10 million, $15 million transaction, but that's to be expected. And I would tell you that it's fairly across the universe. We do see, in certain select geographies, the community banks that service certain geography, but we also see the regional and national players at certain levels on larger transactions.

I think, Chris one more, just over the last several years you've made several good hires on the lending side, through teams and individuals. How does the more cautious commentary on loan growth impact them?

Well, I think that one of things we've been able see is there are high quality people, have very good relationships, and they can deliver some volume in just about any market. So they may deliver a little less volume than they would into normal market conditions, but -- we have, we always have our eye out if we had the ability to add teams or individuals that fit our profile, which is long term highly experienced, true commercial lenders with relationships in portfolios, we would add them for sure. We've already added some credit support staff in our Southern Division to make sure the capabilities there are everything we want them to be. So we would have our eye in our traditional market, we certainly have our eye open in metropolitan Philadelphia, because we'd love to find some folks to ramp our team there. So I would say our posture is to continue to add those kinds of people that fit our model even though they might not be quite as productive as you might expect a year or two years ago. So we're still in the hunt for talent. We think the bank is driven by talent and we'll add them when we can find them.

This concludes our question-and-answer session. I would like to turn the conference back over to Christopher Maher, President and CEO for any closing remarks.

Okay. Once again thank you for joining us this morning for the call. We look forward to presenting additional updates as the year progresses. Thanks.

The conference has now concluded. Thank you for attending today's presentation, you may now disconnect.