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Boston Private Financial Holdings Inc  (NASDAQ:BPFH)
Q3 2018 Earnings Conference Call
Oct. 18, 2018, 8:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning and welcome to the Boston Private Financial Holdings Third Quarter 2018 Earnings Conference Call. All participants will be in listen-only mode. (Operator Instructions) Please note this event is being recorded.

Now let's turn the conference over to your host today, Adam Bromley. Please go ahead.

Adam Bromley -- Director of IR

Thank you Keith and good morning everyone. This is Adam Bromley, Director of IR of Boston Private Financial Holdings. We welcome you to this conference call to discuss our third quarter 2018 earnings. Our call this morning includes references to an earnings presentation, which can be found in the Investor Relations section of our website, bostonprivate.com. Joining me this morning are Clay Deutsch, CEO; and Steve Gaven, CFO.

Additional factors that could cause Boston Private's results to differ materially from those described in the forward-looking statements can be found in the company's filings submitted to the SEC. All subsequent written and oral forward-looking statements attributed about Boston Private or any person acting on our behalf are roughly qualified by these cautionary statements. Boston Private does not undertake any obligation to update any forward-looking statements to reflect circumstances or events that occur after the forward-looking statements are made.

With that I will now turn it over to Clay Deutsch.

Clayton G. Deutsch -- CEO

Thank you Adam, good morning everyone. Thanks for joining our call this morning. In addition to reporting quarterly earnings, we made a number of announcements last night that will improve our return profile, simplify our business, and create flexibility to return capital to shareholders while reinvesting in our core business.

First, I'd like to start with our third quarter operating results highlights. In the third quarter, our Company generated GAAP net income of $18 million or $0.20 per share. These results included a $5.8 million restructuring charge related to an efficiency initiative recently launched. Excluding this restructuring charge, third quarter diluted EPS was $0.25 a share, return on average common equity was 12.1% and return on average tangible common equity was 14.2%.

Before turning to the main body of our call, I would like to briefly discuss third quarter results, the impact of a significant cost reduction effort, the divestiture of a Wealth Advisory affiliate and capital redeployment.

First, we believe core operating performance improved in the third quarter. The Company's financial performance on an operating basis reflects positive operating leverage of 410 basis points and pre-tax, pre-provision growth of 16% linked quarter. Second, deposit volumes build, with average balances increasing 6% linked quarter. We reduced our loan to deposit ratio from 105% to 100%. Third, new business trends at Boston Private Wealth remain quite robust with $394 million of new business and a new record-high positive $315 million of net flows. New business generation was balanced across regions and distribution channels. Boston Private Wealth posted an EBITDA margin of 20%, up from 11% last quarter.

While working hard on third quarter performance, we in parallel designed and implemented a substantial cost restructuring effort. Actions already taken in early October drove a $5.8 million restructuring charge and will result in a simplified management structure and streamlined staff that will deliver operational efficiencies and expense reduction. We expect full year annual cost savings of approximately $11 million from these moves.

In a separate release last night, we announced our intention to divest Bingham, Osborn & Scarborough, one of our Wealth Advisory affiliates. The divestiture of BOS, together with Anchor Capital in the previous quarter provided the Company with the flexibility to accelerate share repurchase activity in the fourth quarter through our already approved $20 million authorization, while stepping up organic and inorganic investment across our integrated wealth management and private banking platform. We remain committed to managing our common equity Tier 1 capital ratio to a range of 9.5% to 10.5%.

With these highlights, I'd like to turn the call over to Steve for more detail and then I'll come back. Steve?

Steven Gaven -- CFO

Thanks Clay, and good morning everyone. My comments begin on Slide 3, where we show you summary of our financial highlights from the third quarter. This quarter, we reported GAAP net income of $18 million or $0.20 per share. Our operating results, which exclude the restructuring expense, net of tax, show operating net income of $22.5 million or $0.25 per share and an operating return on average common equity of 12.1%.

Slide 4 shows our third quarter results on a reported basis under GAAP. As you will recall, we closed on our agreement to sell ownership in Anchor on April 13, 2018. Anchor's results remain consolidated in the Company's reported results through the closing date of April 13, 2018 and prior periods.

Overall GAAP results improved during the quarter, primarily due to a $12.7 million income tax expense during the second quarter results, associated with the divestiture of Anchor, partially offset by the restructuring expense in the current quarter results. The Company's effective tax rate during the quarter was 22.4%. We estimate the tax rate to be closer to 22% going forward. To enhance comparability in analyzing financial trends, we have excluded Anchor results from certain financial information in the upcoming slides.

Slide 5 shows the consolidated income statement excluding Anchor. Pretax, pre-provision income increased 14% year-over-year, driven by 410 basis points of positive operating leverage. Operating net income increased 20% year-over-year, due to a larger provision credit and a lower tax expense. This was partially offset by the loss of Westfield Capital Management revenue share.

Slide 6 shows consolidated revenue trends. Total operating revenue, excluding Anchor for the quarter was $92 million, a 4% increase, both linked quarter and year-over-year. Net interest income increased 5% year-over-year and 4% linked quarter to $59.6 million. The current quarter included $1 million of interest recoveries. Excluding the interest recoveries, core net interest income increased 4% year-over-year and 2% linked quarter.

On slide 7 we show a detailed breakout of our consolidated expenses on a GAAP basis. Total expenses declined on a year-over-year basis as a result of the Anchor divestiture, while linked quarter the increase was driven by a third quarter restructuring expense.

Slide 8 shows a detailed breakout of consolidated expenses, excluding the restructuring charges in the third quarter and Anchor in prior periods. Total adjusted operating expense decreased 1% linked quarter, primarily driven by a decline in information technology investment. Expenses remained flat year-over-year due to lower compensation, offset by higher levels of information technology investment and occupancy and equipment. The current quarter includes approximately $700,000 (ph) of bonus unwinds from the efficiency program. As Clay mentioned earlier, the restructuring charge is related to a Companywide efficiency initiative and consists primarily of severance and other compensation related expenses. We believe our actions associated with this charge will result in approximately $11 million of savings annually. The go-forward expense savings will be fully realized in 2019. We have included financials for BOS on a year-to-date and last 12 month basis at the end of the slide deck to assist in reconciling the impact of the transaction to your models.

Slide 9 shows the past five quarters of average loan balances in deposit balances by type. Total average loans during the quarter increased 6% year-over-year to $6.7 billion. Residential lending showed continued strength, increasing 11% year-over-year. Average total deposits during the quarter increased 5% year-over-year and 6% linked quarter to $6.7 billion. The linked quarter increase in deposits was driven by growth in money market accounts and demand deposit accounts, as the average loan-to-deposit ratio for the quarter returned to 100%.

Slide 10 shows a five-quarter trend of net interest income and net interest margin for the consolidated Company. Core net interest income, which excludes interest recovered on previous non-accrual loans and FTE adjustments, increased 4% year-over-year to $58.7 million. Core net interest margin on a fully taxable equivalent basis decreased 1 basis point linked quarter to 288 basis points. The decline during the third quarter was primarily driven by increased funding costs, partially offset by increasing yields on interest earning assets and lower borrowing volumes.

On a linked quarter basis, our total cost of deposits increased 15 basis points from 53 basis points to 68 basis points. The Bank's cost of interest bearing deposits increased 22 basis points from 76 basis points to 98 basis points. And our all-in cost of funds, including DDA and wholesale borrowing, increased 11 basis points from 75 basis points to 86 basis points.

Slide 11 provides detail on our asset quality. This quarter, we booked a $900,000 provision credit, which was driven primarily by loan recoveries and loan balance declines, partially offset by an increase in criticized and classified loans. The chart below shows asset quality metrics during the quarter with criticized loans finishing the quarter at $135 million. Criticized loans are 8% lower compared to the third quarter of 2017. The 18% linked quarter increase was driven by an increase in Southern California special mention loans, and San Francisco Bay Area accruing substandard loans. ALLL as a percent of total loans remained flat at 109 basis points compared to the previous quarter.

On Slide 12, we show the private banking segment, excluding the wealth management and trust portion of our Bank. Total revenue at the Bank increased 5% year-over-year, driven by net interest income. Excluding restructuring, operating net income increased 15% linked quarter and 21% year-over-year.

I will now turn it back to Clay to discuss our Wealth Management and Trust, Investment Management, and Wealth Advisory segments.

Clayton G. Deutsch -- CEO

Thank you, Steve. Slide 13 contains financial information for the Wealth Management and Trust segment, which operates under the Boston Private Wealth brand. During the third quarter, Boston Private Wealth demonstrated continued strength in new business generation with $394 million of new assets under management. Net flows during the quarter were positive $315 million, as a result of strong new business, offset by very low client attrition.

Slide 14 shows financial results for the Wealth Management and Trust segment. Total revenue increased 3% linked quarter, driven primarily by higher levels of assets under management and the full revenue realization of strong second quarter inflows. Adjusting operating expenses -- adjusted operating expenses, excuse me, which include -- which exclude restructuring, decreased 6% linked quarter and 12% year-over-year, driven by decreased compensation. Segment EBITDA on an operating basis was 20%, an improvement from a 11% last quarter.

Slide 15 shows AUM net follows for all of our business segments. During the third quarter, the Investment Management segment showed net flows of positive $45 million and the Wealth Advisory segment had net flows of negative $18 million. On a consolidated basis, overall Company net flows were positive $342 million.

On slide 16, we show our Investment Management segment, excluding contributions from Anchor Capital. Segment EBITDA margins of 32% are above our Corporate EBITDA target of 30%.

Moving to Slide 17, our Wealth Advisors reported net income of $2.6 million, up 2% linked quarter, and 33% year-over-year. Third quarter 2018 segment EBITDA margin of 34% exceeds our Corporate target of 30%.

This concludes our prepared commentary on our third quarter 2018 reported results. Let's open up the line and we'll entertain your questions.

Questions and Answers:

Operator

(Operator Instructions) Chris McGratty, KBW.

Christopher McGratty -- Keefe Bruyette & Woods Inc. -- Analyst

Hey, Clay. Quick question, maybe just start with the implications of the actions on BOS. I think, Clay you said you have $20 million of buyback authorized previously. Could you help us maybe see what the pro forma capital ratio is? Not sure if there's any goodwill adjustments to that, that would run through the P&L. But I think you said 9.5%, 10.5% is your Tier 1 common target. Do you have the pro forma for that in TCE/TA and kind of how you're thinking about buybacks above and beyond the $20 million that you have?

Steven Gaven -- CFO

Yes, I guess, Chris, I'll take the question on kind of target capital ratios. Really, what we managed to is the CET1 ratio, right. So we printed 11.14% in the quarter, and when you adjust for BOS that gets you about to a 11.7%. And as Clay mentioned in the prepared remarks, we're still committed to managing to that 9.5% to 10.5%. In terms of the share repurchases, Clay, I don't know if you -- there's anything you want to add, but like we said, we have the $20 million authorization. We're going to continue to look at all our options, but we haven't really said anything more than that to this point.

Christopher McGratty -- Keefe Bruyette & Woods Inc. -- Analyst

Okay. I mean there are, I guess, a couple of million dollars of lost earnings from the sale. And I think what you did last time with Anchor is, you took the TruPS out. Is it fair to assume, or I guess how would you steer the Street toward managing the capital, aside from -- you know, we are not going to put in acquisitions into the model, we can talk about that. But managing the capital levels with the share buyback. I mean, your stock has been pressured like most banks this year and just wonder at this level that you think the buyback is a great use of capital.

Clayton G. Deutsch -- CEO

Yes, Chris. There are two destinations that we're very interested in for capital, we do think at these levels. As you know, I've been not a big fan of share repurchase historically as a return of capital device, we've achieved that through an escalating dividend. I will say at these levels in the sector and with our own stock price, I think share repurchase is a shareholder appealing way to reset the share count.

The second destination, the success of our wealth franchise is publicly visible and we're becoming a pretty attractive destination for inbound inquiries from attractive firms and wealth practices that will be very interested in coming our way and joining our model. And that's not a new theme. I've been saying to -- or following for several years that we're committed to building a really high quality wealth and private banking franchise. And as we do that we're very attracted to organic investment, but also M&A-enabled expansion of the reach of our wealth business and our private banking and trust capabilities. So, to your point, you can't model non-specific acquisitions. But those few broad areas are pretty appealing to us. So there will be -- we'll have more to say about our share repurchase intentions and we'll also have more to say about how we're thinking about M&A as a reinvestment opportunity.

Christopher McGratty -- Keefe Bruyette & Woods Inc. -- Analyst

Okay, that's great color. Is there a -- just a quick modeling follow-up. Is there any below-the-line adjustment from the sale, like you did with Westfield years back (inaudible). Is there anything -- or is it all just kind of a clean cut?

Clayton G. Deutsch -- CEO

Yes. (inaudible) Why don't you just walk through the economic highlights (multiple speakers).

Steven Gaven -- CFO

Yes, the last two divestitures we've done, Chris, it's just -- there will be some adjustments. We book everything upfront and then to the extent there's differences versus what we booked at the time of sale, it'll get adjusted through other income, but it's not going to be like the Westfield transaction where there is a specific discrete line item accreting over the revenue share period. We've booked all that upfront the same way we did with Anchor.

Christopher McGratty -- Keefe Bruyette & Woods Inc. -- Analyst

Okay. And Steve, is there an adjustment to your intangibles, just kind of a quick one there, given the sale? is there anything that goes away with the sale?

Steven Gaven -- CFO

Yes, there's about $18 million (ph) of goodwill and intangibles that will be consolidated.

Operator

Alex Twerdahl, Sandler O'Neill.

Alexander Twerdahl -- Sandler O'Neill -- Analyst

Just to kind of follow up on this -- the discussion about the divestiture of Bingham, Osborn. It's sort of based on what we can determine from the -- from what you guys have provided. It's going to cost about $0.04 of earnings next year. That's what I'm coming up with. But how should we really think about sort of the lost earnings in context of, one, how much will we get back from that earn-out over the next -- I guess on an annual basis? And then secondly, is the intention really to use the tools you mentioned, the repurchase and possibly some acquisitions to get this transaction back to earnings neutral as quickly as possible?

Steven Gaven -- CFO

Yes, Alex, this is Steve. So, you won't see earnings accrete the way you do with the Westfield transaction on an ongoing basis. So that loss of $0.04 that you're referring to that's what it will be on a go-forward basis. But you're right, I mean, through looking at the share repurchase opportunities and then M&A opportunities that's really -- along with organic investment opportunities -- that's what will be the earnings replacement. Unlike Anchor where we had kind of an equal trade and retiring to trough, there's not that opportunity right now. So it's really about investing in the core business and opportunistically buying back shares to get EPS back -- back to where we want it to be.

Alexander Twerdahl -- Sandler O'Neill -- Analyst

Okay, thanks. And then, Clay, on last quarter's call you discussed the possibility of an expense initiative. But I believe you said that it would be to defend margins in the case of a lower reset of revenue development. So in what context should we really take the expense reduction initiatives? I mean, should we now be thinking about loan and deposit growth at a lower pace in the future? Can you maybe just talk about that a little bit?

Clayton G. Deutsch -- CEO

Well, it's a two-part question. First, the primary motive for the expense reduction was simply to better equip us to generate target returns in an increasingly competitive environment. You all are reading the sector prints that I'm reading. Every participant in our sector is experiencing a deposit-driven, rate-driven NIM squeeze. I'm pleased that this quarter we showed an ability to make real headway on the deposit build and we did it with, I think a fair amount of demonstrated pricing discipline and that's reflected in NIM. Nevertheless, this isn't a one-quarter war and we're trying very hard to gird ourselves to generate operating leverage and tow the line much closer to target returns than what you saw in the second quarter.

Our return performance in the second quarter was unacceptable. So, we work very hard on the expense side of the ledger. Long term, the advance of the Company is going to be driven by expansion of the wealth business and disciplined growth with the balance sheet on both the loan and deposit side of the ledger. So, of all the good things happening in the third quarter, I think the most fundamental thing I'm watching is our now demonstrated progress, advancing high-quality deposit build, that's the fuel upon which we'll continue to expand the revenue strength of the Company.

Alexander Twerdahl -- Sandler O'Neill -- Analyst

Okay. So, some of the targets that you put out in the past for loan generation, for example, the 8% to 10%, are you willing to stick to those targets? Or do you think that they need to be dialed back just a little bit, given the competition that you just cited?

Clayton G. Deutsch -- CEO

We still like those targets, the gating factor is going to be deposit build. I mean, as you saw in the quarter, we will not tolerate a loan-to-deposit ratio of 105%. That's not a good number. So, our loan book development in the third quarter does reflect a slight rollback by our self-restraint by us, to better manage asset build with what we're demonstrating on the deposit side. So, our targets remain our targets, but the gating factor for you all to watch and for our shareholders to watch is how we're doing on deposit development.

Operator

(Operator Instructions) Michael Young, SunTrust.

Michael Young -- SunTrust -- Analyst

Just wanted to ask a quick follow-up on the last question regarding loan growth and deposit build. You guys have a good bit of seasonality in that throughout the year related to tax payments. I assume that view is kind of over an annual period versus on a quarter-to-quarter basis in terms of, If deposits flow out in second quarter, we shouldn't expect softer loan growth, you will just kind of back-fill with higher cost deposits for a period of time?

Steven Gaven -- CFO

That depends, Michael. I mean, yes, typically we have the back half where it starts to build at a more rapid rate. I think what you're seeing just in this environment, there is growth challenges and I think everyone's facing them. So, you did see the loan growth dial back kind of in line with deposit growth. What we have done in the second half of 2018 with an eye toward 2019 is we launched a raft of deposit initiatives, both across the personal client base and the business client base to hopefully drive us back toward those high single-digit growth rates that we want to achieve. So, yes, you did see a little bit of a slowdown near term, just given the amount of seasonality we had, which was a little more severe than typical in the first half. And then, like I said, we've launched a bunch of initiatives to kind of keep the momentum that we've built in the third quarter going.

Michael Young -- SunTrust -- Analyst

Okay. And Clay, just on the efficiency initiative or the expense reduction, I guess, in just trying to zoom out a little bit, in 2017 you kind of made a larger reinvestment into the business that I think increased the expense run rate by about $5 million to $6 million coming into this year, to drive operating leverage and now we're pulling a significant amount of costs outgoing into 2019. So, just trying to understand, is that a pivoting of kind of the staffing levels toward more revenue production, or is this kind of an unwind of what was invested that maybe hasn't materialized into better revenue?

Clayton G. Deutsch -- CEO

Yes, I'd frame it not as a pivot or an unwind, in the sense that we did step up our investment in client-facing business developing, revenue producing staff and we have not unwound those investments. And we also stepped up our investment in our technology and operating platform and we have not unwound those investments. The offset is we have taken a very hard look at Corporate structure, top-to-bottom, end-to-end and what you see in the just announced restructuring and the associated $11 million is not an unwind of our business building or technology investments. It's taking a very fresh look at the staffing intensity of our management team, of our functions, of our business, of our business model and a streamlining of all of that. So, while I appreciate from the outside, it's all one cost base. But I view it as a very different -- a very different pool of spending that we've taken a very hard look at this time around. I want to emphasize it's not an unwind of our client generating, revenue generating investments. We're pretty happy with the growth tempo we've established from those moves.

Michael Young -- SunTrust -- Analyst

And one last one if I can, just on the Wealth Management and Trust net flows. Can you give a little more color around the strength the last two quarters, if there's been any change in any pricing that's helped drive that or there is this just kind of hitting the streets with more fee, more advertising and getting more in the door?

Steven Gaven -- CFO

Michael, I'll take that and then Clay will add, but I think what you're seeing is in the wealth business, just really strong performance across all our distribution channels, all our regions, kind of clicking on all cylinders at this point. So this was something when we set out and did the Banyan acquisition, this is what we envisioned from a growth profile of the Firm, being able to do $800 billion, $900 billion of gross new business a year on a repeatable basis. And what you're seeing is, across the franchise, just really good pipeline activity coming from the bank, coming from our custody referral partners and that momentum continued and we feel really good about keeping that momentum going forward.

We did see some pricing -- lower pricing in the past two quarters. It wasn't -- the volume wasn't price driven, it was more the nature of the relationship. They were just larger relationships that just generally price at lower rates. So it's not that we're out there cutting pricing to get AUM, that was just kind of idiosyncratic attributes in the last two quarters. But pricing has been pretty steady for that business and we expect that to continue.

Clayton G. Deutsch -- CEO

The only thing I'd add to that, I agree with all that, those of you who have been in the Company, I'm speaking now to shareholders, for a while, know that one of the most persistent work efforts in the Company has been our intention to build a really high quality wealth management business that would become a very appealing destination for clients and prospects. That's been an enduring theme, we've been very hard at work on that, really going all the way back to late 2014 and early 2015. And I think what you're seeing in new business generation is just the realization of all that effort. Happily, it's not pricing, what's really driving new business at these kind of unprecedented levels is all of our channel-facing efforts are now performing in terms of prospect flow and client flow, both new clients as well as client development.

So we're seeing really, really good client attraction through our custody channel partners, through our direct sales efforts, through our center of influence referral programs and importantly, through our own Boston Private Bank channel. So I'm really pleased with the AUM development and new business profile and client profile that we're now presenting, as we report quarter-to-quarter. I think it's fundamental and I think it's going to do very good things for us.

Operator

Thank you. And as there are no more questions at the present time, I would like to return the floor to Clayton Deutsch for any closing comments.

Clayton G. Deutsch -- CEO

I want to thank all of you for dialing in. A lot to talk about this quarter, but I'm pretty pleased with our progress on multiple fronts and we're going to stay hard at it. These themes will persist as we go into the fourth quarter. Thank you all for your interest.

Operator

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

Duration: 34 minutes

Call participants:

Adam Bromley -- Director of IR

Clayton G. Deutsch -- CEO

Steven Gaven -- CFO

Christopher McGratty -- Keefe Bruyette & Woods Inc. -- Analyst

Alexander Twerdahl -- Sandler O'Neill -- Analyst

Michael Young -- SunTrust -- Analyst

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