ConnectOne Bancorp, Inc. (CNOB) Earnings Call Transcript & Summary

Hello, and welcome to ConnectOne Bancorp Third Quarter 2024 Earnings Call. [Operator Instructions] At this time, it is now my pleasure to turn the call over to Siya Vansia, Chief Brand and Innovation Officer. You may begin.

Good morning, and welcome to today's conference call to review ConnectOne's results for the third quarter of 2024 and to update you on recent developments. On today's conference call will be Frank Sorrentino, Chairman and Chief Executive Officer; and Bill Burns, Senior Executive Vice President and Chief Financial Officer. I'd also like to caution you that we may make forward-looking statements during today's conference call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from expectations are detailed in our SEC filings. The forward-looking statements included in this conference call are only made as of the date of the 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 accompanying tables or schedules, which have been filed today on Form 8-K with the SEC and may also be accessed through the company's website. I will now turn the call over to Frank Sorrentino. Frank, please go ahead.

Thank you, Siya, and we appreciate everyone joining us this morning. So throughout 2024, we remain committed to our strategic priorities, including supporting our clients, extending our competitive position, driving profitable growth and investing in our valuable franchise. Before discussing our third quarter performance, I'd like to take a moment to review our recently announced merger agreement with First of Long Island Corporation. The prudently structured transaction brings 2 strong complementary financial institutions that are well positioned in their respective markets. Expected to close during the first half of 2025, we believe it's a compelling financially disciplined transaction that creates meaningful synergies and a significantly enhanced platform for continued growth. The feedback so far has been excellent. Since the announcement, I personally heard from many clients, employees and shareholders from both companies, and the response has been overwhelmingly positive. With the transaction, ConnectOne will size up to more than $14 billion in assets and $11 billion in loans and deposits. In addition, we'll have an improved balance sheet mix and expanded market reach. The transaction increases our pro forma market cap to $1.3 billion, placing us in a larger, higher valuation peer group while also leveraging the benefits of economic and market tailwinds already expected for our liability-sensitive positioning. Like ConnectOne, First of Long Island is commercially focused, with a highly compatible client-first culture and a strong credit track record. The teams are energized, and we expect to have a smooth process, with integration planning already well underway. This combination meaningfully enhances ConnectOne's presence on Long Island, a region we've been organically focusing on over the past few years. As a result of the merger, the combined franchise in Nassau and Suffolk Counties will immediately establish us as one of the top community banks on Long Island, furthering our position as a premier New York Metro community bank. In addition, the transaction is ripe with potential revenue synergies. There's minimal client overlap, and First of Long Island's client base and operating area is likely to be a sizable source of new business opportunities, both spread and fee-based. Some of those areas will include additional products and services, including residential mortgage origination and SBA lending, deeper commercial lending expertise, which will round out their C&I relationships and offer robust treasury solutions to enhance commercial deposits. And finally, just like at ConnectOne, there are numerous opportunities to leverage geographical synergies between our Southeast Florida team and First of Long Island's clients who have a presence in Florida. Next, turning to our 2024 third quarter operating performance. We remain laser-focused and committed to our client-first culture and relationship banking model. As we previously reported, we've been actively reducing our nonrelationship loans from our balance sheet during the first 9 months of 2024, and these efforts have served to improve our loan-to-deposit ratio and lower our CRE concentration. As such, there was a slight reduction in our portfolio this quarter, which really doesn't tell the whole story. Loan originations remain solid, and we continue to build a steady and diversified loan pipeline. Going forward, we expect loan growth may be relatively muted, slightly up or slightly down during the next 2 quarters. And beyond that, we see a return to mid- to high single-digit growth. Meanwhile, we continue to grow our core deposits through both existing and new client relationships. Average client deposits since the second quarter were up by approximately $130 million or 8% on an annualized basis, partially offset by a decline in average broker deposits of $60 million, and noninterest-bearing DDA continues trending upward. At the same time, the third quarter net interest margin on a core basis was flat. However, we ended the quarter with a spot margin wider, upwards of 10 basis points wider, as a result of the Fed's 50 basis point cut in September. Bill will provide some more detail on our current margin expansion in a few minutes. We're highly confident that ConnectOne is well positioned to drive increased profitability through the fourth quarter and into 2025 and post merger completion. Turning to credit. Coming off the transition away from a zero loss environment, the industry is starting to see isolated instances of credit impairment. At ConnectOne, we fared well, reflecting solid and consistent underwriting standards while also maintaining a proactive approach to portfolio management and selective credit resolutions. This lending and credit philosophy has served us very well. With that as a strategic overview, I'm going to turn the call over to Bill. Bill, take it away.

All right. Thanks, Frank. Good morning to everyone on the call. So I'm going to start right in there with the net interest margin, try to give you some color, both through the third quarter and where we are today and post the Fed's first rate cut. On a reporting or GAAP basis, the margin did compress slightly during the third quarter from the sequential second quarter. However, on a core basis, the margin was actually up slightly. The GAAP to core adjustments for the sequential quarter comparison include higher average cash in the third quarter, which took the margin down by 3 basis points this quarter, and in the second quarter, we had unusually high prepayment fees and nonaccrual interest income recapture, which took the margin up by about 4 basis points in that second quarter. So taking those 2 items into account, we calculate our core margin up slightly from quarter 2 after being up 2 basis points from quarter 1 and 3 basis points from the fourth quarter of 2023. So the margin has been expanding at a modest clip over the past 3 quarters. And going forward, we are now seeing more meaningful margin widening as the Fed has begun its interest rate cuts. The spot net interest margin as of today is up approximately 10 basis points, putting our projected fourth quarter margin at about 2.80%. Now let me dive a little deeper into our margin projections. As of today, the spot cost of our total deposits is nearly 20 basis points lower than it was during the third quarter. That resulted from a 40 basis point lowering of rates on nearly $3.7 billion of non-maturity interest-bearing deposits, and that's about 50% of our total deposit base. On the asset side, we have a much lower amount that's repricing immediately. Just 19% of our loan book or $1.5 billion is pure floating rate, which repriced downward immediately by 50 basis points late in the third quarter. So if you do the math on just those 2 items, it calculates out to about 9 basis point margin improvement as of today. But that's not all. We have several other items working to our advantage, namely got continued growth in core deposits with noninterest-bearing demand growing since the end of the third quarter. CDs will continue to be renewed at lower rates over time, with approximately $200 million maturing each month. The rates on CDs returning over the next 12 months averaged 4.75%, so you could figure about a 50 basis points improvement on that. And we have some $1.5 billion of adjustable rate commercial loans, which most commonly reset at 5-year intervals, and they will reprice upward over the next couple of years. And then finally, the spread between newly originated loans recently being booked at rates above 7%, maybe 7.50%, is about 100 basis points more than loans coming off. The impact so far has been less significant than it could be, but that's going to grow as loan originations increase. Other than that, I'm going to refrain right now from specific guidance for 2025. We've got a lot of tailwinds out here, which are helping, but I want to be cautious, especially in light of uncertain Fed cut timing as well as competitive pressures that could slow down our deposit betas in a decreasing rate environment. Now I want to comment a little further on the transaction with First of Long Island. We've all seen a lot of mergers, but this one, in my opinion, is as compelling as they come, checks all the boxes: pricing discipline, acceleration of our strategy, and it's a great cultural fit. And adding to some of Frank's previous comments, the First of Long Island balance sheet is highly complementary, accelerating the positive trends ConnectOne has been realizing over the past couple of years. This transaction lowers our CRE composition by 5 percentage points and lowers our loan-to-deposit ratio by 5 percentage points. It improves our noninterest-bearing deposit composition also by 5 percentage points, from 17% to 22%. And then our allowance for credit loss percentage will be strengthened. We are at 1.02% today, and that ratio jumps to 1.33% on a pro forma basis. And that higher loan loss ratio, combined with First of Long Island's well-known pristine asset quality, creates an enviable credit reserve position. Like ConnectOne, First of Long Island is also positioned to benefit from lower short-term rates, resulting in no change to our forecast of widening net interest margin. In addition, First of Long Island's 35-plus branch retail network will enhance our ability to drive additional revenue opportunities, particularly in residential and SBA lending. And lastly, I want to mention that, that interest rate mark of 6.5% when we announced the deal is likely to improve to lower market rates today and the passage of time. And right now, we estimate a 1 percentage point drop in that rate mark. Now turning back to ConnectOne on a stand-alone basis. I just want to comment on a few items. Core noninterest income and expenses are each expected to increase modestly in the fourth quarter and into early 2025, and our credit quality remains sound, with the level of nonaccrual loans and charge-offs fluctuating but remaining within our expectations. We had a modest uptick in nonaccrual loans. One loan was paid off while 2 were placed on nonaccrual, but both of those are secured and appropriately valued. Criticized and classified totals increased to 2.2% of total loans, largely a result of loan modifications that were re-rated to special mention. Those loans are well secured and on a path to full restoration. And before turning it back to Frank, I want to emphasize that our capital, CRE concentration and loan-to-deposit ratios have been trending in a positive direction over the past year. These favorable trends are expected to continue pre-merger and then accelerate post-closing. So Frank, back to you now.

Thanks, Bill. So to wrap things up, our earnings profile remains solid. Our balance sheet and credit are in a good place, and we remain focused on our relationship-driven business model. We look forward to the transaction with First of Long Island, the growth opportunities related to that expansion, ongoing market opportunities that drive organic growth. Our combined efforts all contribute to building ConnectOne Bank into a highly valuable franchise that's well positioned to take advantage of our expanded market opportunities, driving sustainable go-forward growth. I want to thank you again for joining us today, and now we'd be happy to respond to any questions. Operator?

[Operator Instructions] Our first question comes from Matt Breese with Stephens Inc.

Frank, just wanted to clarify. You discussed loan growth being a bit muted here near term before accelerating back to a mid-single digit, high single-digit pace. Can you just clarify around timing? Is it more muted for another 2, 3 quarters? Or is it expected to be longer than that?

Matt, I think there's a couple of things that go into that. One, I think as you've seen across the banking sector, the economy is a little bit on the slow side relative to loan growth. C&I generation is sort of slow, although it is beginning to come back to life. CRE originations are definitely down in a lot of different areas. We are seeing some increases in places like construction and some of the owner-occupied areas. And we are, because of our internal efforts in conjunction with that, being a bit disciplined about renewals for nonrelationship-type clients. So while we have a pretty strong pipeline and we see it growing over time, we're also -- that's also being offset somewhat by some of the relationships or non-relationships, rather, that we're trying to work out of the company. I don't think that goes beyond another quarter or maybe 2. I'm not even sure if it goes out that far. I do see signs of a pickup, both organically because of ConnectOne's efforts, but also because of the combined efforts with First of Long Island. So I would expect, certainly by the second quarter of 2025, that we would, again, regain our more normalized growth path. It could come sooner. I could be wrong. A lot of it depends on how quickly payoffs come in and how quickly loans close and what the balances are at closing date. But maybe I'm being a little bit conservative here pushing out 2 quarters, but probably for the next quarter or so, I would say could be slightly up, slightly down.

Okay. And then Bill, just turning to the NIM, I would just love to hear your thoughts and expectations around loan and deposit betas, if we follow kind of the Fed dot plot and whether or not you expect those figures to be fairly similar to what they were on the upcycle.

Yes. Our betas were a little bit higher on the upside cycle. So it just gives us more room to keep those betas high on the way down. And we were, as I think I mentioned in the call, 80% beta for the first shift. Going forward, I forgot you get a question on that, it could range anywhere from 60% to 100%, the beta, on the next cut, okay? So I'm sticking with the 80% beta for now.

Okay. And then last one for me. With the deal, there was talk of, I think it was $100 million sub debt raised. Could you just update us on whether this remains intact, timing expectations on pricing and whether or not this kind of remains the chosen course of capital, just given how expensive the sub debt has been recently?

Yes. Look, the expectation is to do that transaction a little bit before closing, so sometime in the, hopefully, in the first quarter of next year. We have a $75 million sub debt repricing. I think it's in June or July. And so we'll probably put those 2 together for a $175 million offering then. I think right now, the rates are 8.50% to 8.75%. Hopefully, they'll come down that. But whatever it is in your models, I think we'll be committed to doing it at those levels.

The next question comes from Dan Tamayo with Raymond James.

Yes, maybe first just a clarification. I know you guys mentioned the spot net interest margin was up 10 basis points. Can you just give us a sense for what that was? I'm not sure if you were saying up from prior 3 months or from the third quarter average.

Yes. So from -- yes, from the third quarter average is what I'm talking to. There's always some fluctuation in noncore items, but I feel comfortable with the spot margin plus the way the other items are coming through that we could get to 2.80% for the fourth quarter, and that right now is assuming one more cut.

Okay. So 2.77% end of the third quarter, you're saying 2.80% in the fourth quarter with one more cut. So it seems like...

With one more cut and other things that are working to our favor, okay? Because we have more CDs repricing. There's a whole bunch of things going into the margin. But when I put it all together, we're coming out as a projection of 2.80%. So possibly a little bit lower, but also possibly a little bit higher.

Okay. Okay. And I guess a related question. In the third quarter, it looks like loan yields were actually down a little bit. Just curious what drove that, given that the...

Well, it wasn't really on a coupon basis, but it was because of having -- we had a large nonaccrual interest recapture. So that had a lot to do with that part. And obviously, the 50 basis points cut did reduce loan yields at the end of the quarter. So I think I may have said on the call, we had like, right now, it's a 20 basis point reduction in the deposit costs and a 10 basis point reduction in the loan from the cut.

Okay. All right. That's helpful. And then finally, just moving over to credit. So just looking at the criticized loans, doing some back-of-the-envelope math, it looks like that number was up a decent amount in the third quarter. I wonder if you could provide any color on the drivers of that number.

Yes. We just -- we did some loan modifications that put the loans into special mention, which is the best of the classified and criticized categories. And those loans are -- we, in our view, are in a better position and will be restored in due course.

And these were -- you mentioned a CRE loan, I think, relative to a year ago in the release. How much of that move was that one loan?

I don't recall, Dan. In this release or the prior release?