Provident Financial Services, Inc. (PFS) Q3 2018 Earnings Conference Call Transcript

Provident Financial Services, Inc. (PFS 5.16%)
Q3 2018 Earnings Conference Call
Oct. 26, 2018, 10:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning, and welcome to the Provident Financial Services, Inc. third quarter earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the * key followed by 0. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press * then 1 on your touchtone phone. To withdraw your question, please press * then 2. Please note this event is being recorded. I would now like to turn the conference over to Leonard Gleason, Investor Relations Officer. Mr. Gleason, please go ahead.

Leonard G. Gleason -- Senior Vice President and Investor Relations Officer

Thank you, Anita. Good morning, ladies and gentlemen. Thank you for joining us. The presenters for our third quarter earnings call are Chris Martin, Chairman, President, and CEO; and Tom Lyons, Executive Vice President and Chief Financial Officer of Provident.

Before beginning their review of our financial results, we ask that you please take note of our standard caution as to any forward-looking statements that may be made during the course of today's call. Our full disclaimer can be found in the text of this morning's earnings release, which has been posted to the Investor Relations page on our website provident.bank. Now, I am pleased to introduce Chris Martin who will offer his perspective on our third-quarter results. Chris?

Christopher Martin -- President and Chief Executive Officer

Thanks, Len. Good morning, everyone. Our third-quarter results included continued net interest margin expansion, record revenues, and record earnings driven by higher yield on loans as the Federal Reserve continued to raise short-term interest rates. We achieved record annualized returns on average assets and tangible equity at 1.45% and 15.47%, respectively.

We remain focused on future earnings growth, stable-to-improving credit quality, and continued expense discipline. The competition for quality loans remains fierce, and we continue to see credit structure and pricing in the market that is not commensurate with the risk and leverage we are comfortable with. We won't overreach for loan growth.

Loan payoffs this quarter exceeded those of the first part of the year, and are driven by a number of factors, such as competition from non-bank lenders, including private equity firms, as well as sales of businesses or real estate by our borrowers. We have confidence in the quality and strength of our loan pipeline and continue to seek C&I growth.

Core deposits were relatively stable, as non-interest bearing deposits grew at a better than 9% annualized rate. Deposit growth on the margin has been a challenge as competition continues to ratchet up rates to fund outsized loan growth. We have offered CD promotions on a selective basis since market rates are cheaper than overnight borrowings.

Expenses remain well controlled, and operating efficiency improved. We are reassessing our operating processes and pursuing automation to reduce representative tasks and improve our basic operating infrastructure to gain efficiencies. We are also spending time and investing dollars on technological initiatives and new product development, including Zelle and a small business automated platform that will both likely be available in early 2019.

With regard to M&A, we continue to assess opportunities and have conversations, although nothing is currently actionable. We believe the challenges of enhanced regulatory oversight and required investment in technology will continue to impact smaller institutions' bottom line and spur consolidation.

On the outlook for Q4 in 2019, the market is lining up for a December rate hike, and for more rate hikes next year. The U.S. and regional economies are strong with low unemployment, stronger consumer spending, growing wages, and improving confidence, despite the political vitriol in Washington preceding the midterm elections. For the most part, our clients remain optimistic and have been experiencing better operating results. With that, I'll turn it over to Tom for more detail.

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

Thank you, Chris. Good morning, everyone. Net income was a record $35.5 million for the third quarter of 2018 or $0.54 per diluted share, compared with $19.2 million or $0.30 per share for the trailing quarter, and $26.6 million or $0.41 per share for the third quarter of 2017. Current quarter earnings were driven by record revenue of $91.7 million, as interest income and net interest income both achieved record levels. Our net interest margin expanded 5 basis points versus the trailing quarter, as our earning asset yield increased 10 basis points, while the cost of interest-bearing liabilities increased 8 basis points.

Further helping the margin, non-interest bearing deposits grew $33 million or an annualized 9.1%, and average stockholder's equity increased $13 million for the quarter. Note that our reported margin is core, with prepayment fees excluded and reported as non-interest income. Pre-tax, pre-provision earnings also set a record of $45 million, an increase of approximately 15% when compared with both the trailing quarter and the third quarter of 2017. Performance versus the trailing quarter was further helped by a lower loan loss provision and year-over-year earnings also benefited from a lower tax rate, improving net income compared with the third quarter of 2017 by a total of 34%.

While growth was against constrained by a high rate of payoffs, net outflows on lines of credit, and maintenance of credit and pricing discipline, loan originations were 34% better than the trailing quarter, and 10% better than in the third quarter of 2017. The pipeline remains strong at $1.1 billion, while the pipeline rate has increased 28 basis points since last quarter to 4.95%, exceeding the loan portfolio rate of 4.38%.

Based on our strong loan pipeline, 90% core and non-interest bearing deposit funding, and the variable rate nature of many of our assets, we anticipate a strong economy and additional Fed rate increases will contribute to further expansion of our net interest margin in the near term. Further impacting our outstanding loans during the quarter, we made the decision to exist asset-based lending, and sold the majority of the portfolio, resulting in a gain on sale of $257,000.

In a related transaction, we wrote down an impaired asset base loan to the value realizable in a discounted note sale, resulting in a charge-off of $6.3 million. The $1.3 million remaining balance of that impaired loan was included in non-accruing loans at September 30th and sold after quarter end with no further loss. This latter transaction resulted in a somewhat elevated annualized net charge-off rate of 32 basis points for the quarter.

Credit metrics on the remaining loan portfolio were strong, with the weighted risk average rating improved and non-performing assets declining to 36 basis points of total assets at quarter end. The allowance for loan losses to total loans decreased to 75 basis points from 81 basis points at June 30th, while the allowance as a percentage of nonaccrual loans increased 185% from 180% at June 30th as a result of improved credit quality and the withdrawal from asset-based lending.

Non-interest income increased by $2.1 million versus the trailing quarter to $15.9 million, as loan prepayment fees increased by $800,000, a benefit claim on bank-owned life insurance of $700,000 was realized, and gains on loan sales and loan levels swap income each increased by $400,000. Non-interest expenses fell to an annualized 1.9% of average assets, contributing to a 51% efficiency ratio for the quarter.

Expenses decreased by $2.1 million to $46.7 million versus the trailing quarter, primarily as a result of director stock compensation recognized in Q2, and lower occupancy, compensation, and other expenses. Our effective tax rate was consistent with the trailing quarter at 19.5%. We recently concluded a cross-segregation study on certain capital improvements and will record a related reduction in income tax expense of $1.9 million in the fourth quarter of 2018. We continue to assess with our tax professionals the impact of the change in New Jersey corporate business tax law that we discussed on our last earnings call. That concludes our prepared remarks. We'd be happy to respond to questions.

Questions and Answers:

Operator

We will now begin the question-and-answer session. To ask a question, you may press * then 1 on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press * then 2. The first question today comes from Mark Fitzgibbon with Sandler, O'Neill. Please go ahead.

Mark Fitzgibbon -- Sandler, O'Neill & Partners -- Analyst

Hey, guys. Good morning.

Christopher Martin -- President and Chief Executive Officer

Good morning.

Mark Fitzgibbon -- Sandler, O'Neill & Partners -- Analyst

It absolutely pains me to say it, but you had a pretty good quarter. Tom, just to follow up on your tax comments. I heard what you said about the $1.9 million in the fourth quarter. Previously you had given guidance at 27% effective rate for 2019. Do you still feel that's the right level?

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

Let's say a preliminary assessment, and there's still a lot of ongoing review. We did discuss that last quarter. We are continuing to discuss with our tax compliance professionals, as well as legal folks. There have been a number of technical changes, corrections that were published early in the fourth quarter. There's potential for additional technical changes to come through, so it's still under review. But I figure the range is somewhere -- that's kind of the high end of the range at 27%. And the low end would be we get to maintain roughly around the 20% level.

Mark Fitzgibbon -- Sandler, O'Neill & Partners -- Analyst

And then secondly on the margin, given the intense deposit competition in New Jersey, do you think the magnitude of the margin expansion that we could see in coming quarters as significant as what we saw this quarter?

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

I think it'll cut back from this. I'm looking at about 2 basis points a quarter for the next 3 or 4.

Mark Fitzgibbon -- Sandler, O'Neill & Partners -- Analyst

Okay. Then it looked like there's obviously some seasonality in the fee line in the third quarter there. What do you think fee and expense trends are likely to normalize at in the fourth quarter?

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

So the volatile items on the income side were loan prepayment fees, which were up about $800,000 versus the trailing quarter at roughly $1.3 million. Wouldn't mind if that backed off a little bit and we got to retain a little bit more of the loan portfolio. Payoffs were an issue for us in terms of trying to grow the balance sheet. We did have a BOLI claim, which about $700,000. BOLI is starting to kick up a little bit though.

Credit rates are moving up as rates [inaudible] a little bit better income production there too. Gains on loan sales were higher by about $400,000 versus the trailing quarter. A piece of that was the sale of the ABL portfolio. I wouldn't expect that to recur, so you might see some reduction there. Then we had good profit on swaps, which is just kind of quarter-to-quarter depending on customer preference and when the loans are closing, so that's a tough one to predict. But that was about $395,000 better than the trailing quarter.

Mark Fitzgibbon -- Sandler, O'Neill & Partners -- Analyst

Then on expenses?

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

On the expense side, I'm thinking like 47% to 47.5% for the fourth quarter. We came in lower than I expected for Q3. I think some of our estimates around the cost of CECL implementation and some of the stress-testing work we've been doing have proven to be a little bit conservative. Occupancy also came in lower than I anticipated. I think there were more in the way of, believe it or not, snow and ice removal trailing costs in Q2, as well as some non-recurring, non-capitalizable repairs and maintenance expenses that happened in Q2. So we saw more of a benefit there than I had anticipated. I think we also got a little bit more benefit in the comp line than I was thinking originally from the reduction in employer payroll taxes, as well as incentive stock compensation from the market being under pressure incentive stock was lower on stuff like [inaudible] costs which are dependent on the stock price.

Mark Fitzgibbon -- Sandler, O'Neill & Partners -- Analyst

Thank you.

Christopher Martin -- President and Chief Executive Officer

Thank you.

Operator

The next question comes from Collin Gilbert with KBW. Please go ahead.

Collyn Gilbert -- Keefe, Bruyette & Woods -- Analyst

Good morning, guys.

Christopher Martin -- President and Chief Executive Officer

Good morning.

Collyn Gilbert -- Keefe, Bruyette & Woods -- Analyst

Just starting on the loan outlook, you both alluded to it in your comments, just about the level of pay downs that you're seeing. Can you give us any insight as to how you're thinking about growth as we go into '19? Obviously, I know pay downs are going to be perhaps an unknown variable, but just for what you do know and what you are seeing. Chris, I know mentioned the C&I pipeline is really strong, but just give us a little bit of framework as to what you're seeing out there in terms of potential loan demand.

Christopher Martin -- President and Chief Executive Officer

Well, I think we have opportunities, and the demand is there. We don't see business as expanding like you would think with this economy. I think everybody is playing it a little closer to the vest. They've also had improved balance sheets and cash on hand so they can utilize their own cash versus borrowing. Certainly, on the line usage, we're not seeing it as much as we thought we would see. The other side is all the areas with our commercial real estate and C&I groups. We're still getting a lot of looks.

On the other hand, some of them are, as we said in our comments, are at levels that we don't think are commensurate. We're not going to do some heavy leverage lending that some may want. But I think we're all saying what the market is giving us, with the pipeline still pretty strong and solid. I think we continue to think we're doing the right process, as opposed to reaching for growth. I think the payoffs should abate in the future, I'm hoping. Then, Tom, I'll yield to you on that.

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

I'll just offer we did see nice production growth. It was 10% better than the year-ago third quarter, and 34% better than it was in Q2. So the usual expected pickup toward the end of the year. Fourth quarter has traditionally been quite strong for us. So as you said, the wild card is what level of payoffs do we see, and that's really hard to predict at this point.

Collyn Gilbert -- Keefe, Bruyette & Woods -- Analyst

Okay. That's helpful. Then, Tom, just in your NIM outlook there, maybe 2 basis points or so of expansion over the next couple quarters. What is going into that assumption? I mean, I presume obviously a gradual increase in funding costs, in the betas. But is that assuming -- it's got to be assuming some balance sheet growth, I'm guessing? Or just talk a little bit about maybe the drivers of how you're seeing that NIM being able to continue to expand.

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

I don't know if it's much driven by growth, although that is in there, but I think we're pretty modest in our growth assumptions, as it is by the variable nature of the book. It's a short-duration loan book. It's 2.3 years. It's about 60% floating and variable rate, adjustable rate loans. So it's the asset repricing more so than growth that drives the expansion, as well as I think our reasonable assumptions around the deposit betas, which continue to run lower than most of the group, given the quality of our deposit base.

Collyn Gilbert -- Keefe, Bruyette & Woods -- Analyst

Okay. Then just in terms of what you're doing on the deposit side. Where you're seeing, you're being more aggressive, either in terms of rate or product to get the growth or just how you're thinking about how you want to fund the balance sheet today and into the future.

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

I guess the shift we've seen in recent quarters has been more of a customer performance for time deposits and a willingness on our part to compete for some of those because of the increase in rate on overnight borrowings. So we've done a 13-month promotion I think I talked about in previous quarters, that pulled in a nice amount of dollars. We did another 13-month to targeted non-customers. Then we also did a 7-month customer appreciation day thing, which was a one-day, new-money-only that pulled in a lot of dollars as well. So that's really the strategic shift that we've actually implemented so far. We continue to review our product set and obviously try to stay as close to the market and the customer as we can to defend our deposit base and obviously manage our costs as best we can.

Christopher Martin -- President and Chief Executive Officer

Collyn, this is Chris. I think the other side of that is that the next few rate rises I think it starts to become more material for people who have been sitting on the sidelines and vice versa on some of our competitive brethren that are funding a lot of their loan production with money market instruments. As rates rise, they're going to have to continue to make those; otherwise, they will run off to others. So I think that the next batch of deposit betas will be a little bit more accelerated than the previous.

Collyn Gilbert -- Keefe, Bruyette & Woods -- Analyst

Okay. Then just curious, Tom, on the promotions that you mentioned, the two 13-month and the 7-month, roughly, at what cost were you having to offer those promotions?

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

The initial 13 was 1.75%. I think we went to 2.25% on the second one, and the 7-month was at 2.05%.

Collyn Gilbert -- Keefe, Bruyette & Woods -- Analyst

Okay, so pretty low. Okay, good. Then just on the decision to exit the ABL business this quarter. Can you just talk about the decision around that? And then I know you obviously had loan sales this quarter, but any other flow-through of impact from getting out of that business?

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

I think it's one of the reasons why we saw the allowance level dip because it freed up some allowance once we decided to exit that business and sold off, and obviously, unfortunately, some of the charge-offs related to that. That was a decision based on some personnel departures, as well as some of the risk characteristics which we were no longer comfortable with. The large charge-off that we saw in Q2 was an asset-based loan, and we did suffer this impairment on a decision to go ahead and bite the bullet and exit one that we weren't comfortable with holding at this point in the cycle.

Collyn Gilbert -- Keefe, Bruyette & Woods -- Analyst

Okay. So no, the expense, any kind of related expense reduction on the operating side is already in the run rate?

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

That's in the run rate, yes.

Collyn Gilbert -- Keefe, Bruyette & Woods -- Analyst

Okay. Then just one final question. Sorry. Decline in occupancy. That's been coming down for the last few quarters. What's driving that? I know you mentioned the snow removal, but that seems, well, anyway.

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

That was about $400,000, right? It's from quarter-to-quarter, so that actually was like a couple hundred thousand dollars that still remained in Q2. That's not all of it, obviously, but it was a piece of it. And the other stuff, as I said, was some non-recurring repair and maintenance items that were non-capitalizable. We did [inaudible] last year that had some impact as well, but that's kind of been filtering through.

Christopher Martin -- President and Chief Executive Officer

And Collyn, going forward obviously we always do, I guess we'll call it required regentrification of the branches over every year. So there'll be a few branches that are online. Also, ATM machines with all the issues going on with skimmers and EMV and things that are going on. So we're trying to protect ourselves by modernizing the equipment we have and/or replacing, which will be more sophisticated equipment to want to help customers but also ward off, those are probably costs that'll be ongoing, but not material.

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

So, yeah, that's a fair point. That balance with the aging facilities also that have depreciation expense reducing.

Collyn Gilbert -- Keefe, Bruyette & Woods -- Analyst

Got it, OK. All right, that's helpful. Thanks, guys.

Christopher Martin -- President and Chief Executive Officer

Thank you.

Operator

Next question comes from Matthew Breese with Piper Jaffray. Please go ahead.

Matthew Breese -- Piper Jaffray & Co. -- Analyst

Good morning.

Christopher Martin -- President and Chief Executive Officer

Good morning, Matt.

Matthew Breese -- Piper Jaffray & Co. -- Analyst

A couple of just other questions. There was an article out there yesterday, one of the banks in your market actually, the CEO noted that there's been some pressure by the auditors for banks to disclose some of the early CECL impacts in the 10-Ks. Are you seeing that at all or could we hear sooner or later what CECL could look like?

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

I think there are requirements to disclose where you are in the process. You have to put information out as it becomes available. So we are working toward that process. We're not prepared to disclose an estimate at this point, but we will be updating as to where we are in the process of adoption.

Matthew Breese -- Piper Jaffray & Co. -- Analyst

Understood. When throughout '19 might we have some good idea of what the CECL impact from a dollars perspective will be?

Christopher Martin -- President and Chief Executive Officer

Probably between the second and third quarter as we run models, and then we verify them. I think that's when you'd probably see most of the impact. Unless we can certainly do some exercises with the regulators and in Washington to try to phase this in over a three-year period, which it's starting the conversation. And obviously, the large banks are leading that charge.

Matthew Breese -- Piper Jaffray & Co. -- Analyst

Okay, all right. I think, Chris, I thought your M&A comment was interesting. You said nothing was actionable. I guess I was just hoping you could flesh that out a little bit more. I'm curious if you could describe the scope of the market for banks for sale right now. Is there an active market of banks for sale in your market? Could you frame for us as well the market of potential buyers? How is that all shaking out?

Christopher Martin -- President and Chief Executive Officer

First thing, I'll look over at my counsel, and he'll probably say, are you -- no. But I think everybody is looking at things in the way of this has been a good market, a good economy. And if you're not getting the growth and/or the costs keep coming up, that there's certainly more conversations going on. On the other hand, I think as people get comfortable with the reduction of tax rate, they feel that their runway is there, and so that kind of mutes those conversations. When I say actionable, obviously if we thought there was something, we would probably be involved right now. We have been not necessarily on the sidelines. We continue to see that as part of our capital management strategy and exercise that accordingly.

Matthew Breese -- Piper Jaffray & Co. -- Analyst

Understood. Okay. That's all I had. Thank you.

Christopher Martin -- President and Chief Executive Officer

Thank you.

Operator

Next question comes from Russell Gunther with D.A. Davidson. Please go ahead.

Russell Gunther -- D.A. Davidson & Co. -- Analyst

Good morning, guys.

Christopher Martin -- President and Chief Executive Officer

Hi, Russell.

Russell Gunther -- D.A. Davidson & Co. -- Analyst

Just wanted to circle up on the pay downs again. Could you guys quantify sort of what that was this quarter and how much above where you would traditionally expect to see in a more normal quarter at this point?

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

Payoffs were about $235 million for Q3, compared to $227 million in Q3 of '17, and about $161 million in the trailing quarter.

Russell Gunther -- D.A. Davidson & Co. -- Analyst

Okay, great. Thanks, Tom. Then I'm sorry if I missed this, but the size of the ABL portfolio that you guys exited. What was that? Where does it stand today? Then maybe just a little history from you as to when you got into that and why you're getting out?

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

Sure, I'll give you the numbers, and maybe Chris will want to touch on the history. But at the beginning of the year, the commitments were $181 million. Outstanding was $142 million. At 9/30, we still have about $50 million committed and $40 million outstanding that we're working to wind down the rest of the way. The sale in the third quarter was about $25 million.

Russell Gunther -- D.A. Davidson & Co. -- Analyst

Okay, great.

Christopher Martin -- President and Chief Executive Officer

Then going back, the ABL, we booked a bit of the portfolio from another institution that was performing at basically a par. Then we got the team with it and at that point, from 2015 to basically now, we just felt that it wasn't running as we thought it would. Performance wasn't there. At that point, we said the directional -- we also were not getting the growth that we anticipated with that. So when we parsed through the personnel and some of the issues, we finally said this is not -- we thought it would be a great opportunity, which on its face it was, but then it ended up being not necessarily the way we wanted to go and to redeploy and get another team in and everything else, we felt the best thing to do was exit and to move on to the normal lending that you'd expect.

Russell Gunther -- D.A. Davidson & Co. -- Analyst

All right, great. Thanks for the color, guys. Then just last one on the M&A front. Hearing that there's nothing actionable, but big picture, does Pennsylvania make more sense to you for potential targets based on how the New Jersey tax code shakes out?

Christopher Martin -- President and Chief Executive Officer

I think that we're not going to discriminate between the markets that we're in on anything contiguous. I think Pennsylvania has a lot more of smaller institutions that have little, the market shares that might be something that we would like to continue that conversation. New Jersey is, certainly there's less institutions that match up to what make sense. So not to say we're saying no to anything else, but we certainly look at both markets at an equal approach.

Russell Gunther -- D.A. Davidson & Co. -- Analyst

Okay, great. Thanks for taking my questions.

Christopher Martin -- President and Chief Executive Officer

Thank you.

Operator

The next question is a follow-up from Collyn Gilbert with KBW. Please go ahead.

Collyn Gilbert -- Keefe, Bruyette & Woods -- Analyst

Russell just asked my question on the M&A interest versus, PA versus New Jersey. So I'm all set. Thanks.

Christopher Martin -- President and Chief Executive Officer

Thank you.

Operator

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

Christopher Martin -- President and Chief Executive Officer

Thank you. As we look past the midterms, which is no small feat, we see a solid economy with positive prospects. Rates should continue to rise slowly in lock-step with inflation, and we are at full employment. All positives which we hope will carry the momentum as we prepare for 2019 and beyond. We wish everybody a great fall season. Thank you very much.

Operator

This conference is now concluded. Thank you for attending today's presentation. You may now disconnect.

Duration: 26 minutes

Call participants:

Christopher Martin -- President and Chief Executive Officer

Thomas M. Lyons -- Executive Vice President and Chief Financial Officer

Leonard G. Gleason -- Senior Vice President and Investor Relations Officer

Mark Fitzgibbon -- Sandler, O'Neill & Partners -- Analyst

Collyn Gilbert -- Keefe, Bruyette & Woods -- Analyst

Matthew Breese -- Piper Jaffray & Co. -- Analyst

Russell Gunther -- D.A. Davidson & Co. -- Analyst

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