Bank of Hawaii - Q2 2023

Transcript

Operator (participant)

Good day, and thank you for standing by. Welcome to the Bank of Hawaii Corporation Q2 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star 11 on your telephone, and you will then hear an automated message advising your hand is raised. To withdraw your question, please press star 11 again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Cindy Wyrick, Director of Investor Relations. Please go ahead.

Cindy Wyrick (Director of Investor Relations)

Thank you. I'd like to welcome everyone and thank you for joining us today as we discuss the financial results for the Q2 of 2023. Joining me today is our CEO, Peter Ho, our CFO, Dean Shigemura, our Chief Risk Officer, Mary Sellers, and the newest member of our IR team, Chang Park. Before we get started, let me remind you that today's conference call will contain some forward-looking statements. While we believe our assumptions are reasonable, there are a variety of reasons that the actual results may differ materially from those projected. During the call today, we will be referencing a slide presentation as well as the earnings release, both of which are available on our website, boh.com, under the Investor Relations tab. Now I'd like to turn the call over to Peter Ho. Peter?

Peter S. Ho (Chairman, President and CEO)

Thanks, Cindy. Good morning or good afternoon, everyone. Thank you for your interest in Bank of Hawaii Corporation. I'll begin today's call with some general commentary on our results. I'll hand the call over to Mary to cover off on credit, which is a great story. Dean will get a little deeper into the financials. We'd be happy to entertain your questions. Bank of Hawaii delivered solid results for the Q2 of 2023. Total deposits grew in the quarter. We enhanced our liquidity position substantially with cash and immediately available credit lines. Credit remained a strength, with NPAs and net charge-offs of 8 bps and 4 bps, respectively. We recorded earnings per share of $1.12 for the quarter. Net interest income was negatively impacted by higher interest rates and attendant higher borrowing costs.

Fee income performed well during the quarter. Expenses were controlled both on a reported and normalized basis. Given the environment, expense management will continue to be a particular focus of ours going forward. Deposit quality is obviously a critical factor in today's environment. I thought I'd spend a little time reviewing Bank of Hawaii's exceptional deposit position. Our deposit story really begins with a deposit marketplace, which is different from nearly all other deposit markets in the country. 97% of the State of Hawaii's deposit base, as measured by the FDIC, is held by five local banks, all headquartered within the State of Hawaii and all having served the local community for many, many years.

It's not surprising that the events of early March with SVB and Signature Bank had a rather muted impact on the Hawaii marketplace as compared to the broader national small bank marketplace. We've built our deposit franchise over our 125-year history, one relationship at a time. Our deposit base is well-diversified and well-tendered. 49% of our deposits are with consumer clients, 39% with commercial customers, and 12% with municipalities. Even within these categories, we have further diversification by industry, income demographic, and government agency or jurisdiction. More than half of our deposits are from clients with whom we've been doing business with for 20 years or longer. Another 24% are from clients with whom we've been doing business with from between 10 and 20 years.

Given this backdrop, it's not surprising that our deposit performance through both the first and Q2s has been quite stable. Additionally, we've been able to maintain deposit stability while also keeping funding costs reasonably controlled. Our deposit beta for Q2 was 21%. In terms of additional liquidity, we improved our cash and immediately available lines of credit positions substantially to $8.5 billion by quarter end. brokered deposits are yet another form of liquidity available to us, although we do not currently have brokered deposits within our deposit mix as of quarter end. Given the stability of our deposit base and abundant backup liquidity in place, brokered deposits, however, are a solid tertiary liquidity option for us. I'll finish off with a little color on the Hawaiian economy. Our visitor industry continues to perform well.

Total visitor expenditures in May were up 19% from 2019 pre-pandemic levels. This level includes a still recovering Japan segment, which remains down 66% from pre-pandemic levels by spend. Oahu single-family home prices were down 4.5% in June from a year ago at $1,050,000. Inventory, however, remains tight at 17 average days on market, and 17 days on market and total inventory of 2.6 months. Hawaii's unemployment rate was down to 3% in June, compared to 3.7% at year-end. Now let me turn the call over to Mary.

Mary Sellers (CRO)

Thank you, Peter. Bank of Hawaii's lending philosophy is grounded in two fundamental tenets: lending in markets we know and to long-standing relationships we understand. While growing the loan portfolio in a safe and measured way over time, our focus is on ongoing disciplined portfolio management. We consistently, actively exit those products or segments that prove to have higher risk profiles, creating outside sized credit losses and volatility. In the consumer portfolio, these non-core segments included land and interest-only loans in our residential portfolios, purchased home equity pools, indirect auto loans originated in Oregon, our revolving personal flex line product, and our credit card portfolio. Similarly, in our commercial portfolio, we spent a number of years working out of a scored small business portfolio, a pool of non-relationship Shared National Credits, and a large ticket leasing portfolio.

Concurrently, we're continually focused on optimizing the risk profile within our core portfolio by biasing the mix within it to those products and segments that have proven to carry lower risk. This disciplined management, coupled with consistent conservative underwriting, has proven itself through lower net charge-off rates over the years, and positions our portfolio to continue to realize lower credit losses through different economic cycles. All of this is reflected on our portfolio construct today, which is built on long-tenured relationships, diversified by asset categories, with 60% consumer and 40% commercial, appropriately sized exposures, and 79% secured with real estate with a combined weighted average loan-to-value of 55%. Our commercial real estate portfolio, which represents 27% of the total loan portfolio, is diversified across various asset types.

The portfolio, built on relationships with demonstrated experience and financial capacity, is conservatively leveraged with a weighted average loan-to-value of 50%. Maturities across the commercial real estate portfolio remain very manageable, with 10% maturing prior to 2025. Our office portfolio is 2.7% of total loans and granular and has a weighted average loan-to-value of 56%. 26% of the portfolio is in the downtown Honolulu Central Business District. This segment has a 63% weighted average loan-to-value, and 47% of the exposure is further supported by repayment guarantees. 3% of the loans in the office segment are maturing through 2024. Tail risk in the commercial real estate portfolio remains modest, with just 0.8% having an LTV greater than 80%.

Our construction portfolio represents 2% of total loans, with the majority of this in low-income or affordable housing, which continues to be chronically undersupplied in our markets. Credit quality remained strong in the Q1, with net charge-offs of $1.4 million or 4 bps, annualized of total average loans and lease outstandings, down 4 bps for the linked quarter and up 2 bps year-over-year. Non-Performing Assets were $11.5 million or 8 bps, down 1 bps from the Q1 and down 4 bps year-over-year. All Non-Performing Assets are secured with real estate, with a weighted average loan-to-value of 57%. Loans delinquent 30 days or more remained stable at 22 bps at the end of the quarter.

Criticized loans as a percentage of total loans were 1.47%, up modestly for the linked quarter and year-over-year, comparable to 4Q 2019. At the end of the quarter, the allowance for credit losses was $145.4 million, up $1.8 million for the linked quarter, the ratio of the allowance to total loans and lease outstandings was flat at 1.04%. Given there were no significant changes in the economic forecast from the University of Hawaii Economic Research Organization, stable asset quality and modest growth. The allowance does continue to consider downside risk, including higher unemployment, inflation, and interest rates, as well as the general uncertainty in our environment. The reserve for unfunded commitments was $6.3 million, down $700,000 for the linked period.

I'll now turn the call over to Dean.

Dean Shigemura (Vice chairman and CFO)

Thank you, Mary. Net interest income was $124.3 million in the Q2, a decrease of $11.6 million linked quarter. Net interest margin was 2.22%, a decrease of 25 bps linked quarter. Linked quarter decreases in both net interest income and margin were primarily due to higher funding costs, partially offset by loan growth and higher asset yields, as the inverted yield curve and higher short-term rates continued to pressure our income and margin. We continued to exercise deposit pricing discipline, as evidenced by our deposit beta continuing to outperform that of peer banks. Nevertheless, deposit rates are expected to continue to rise, and we also expect a continued moderate mix shift from non-interest bearing into interest-bearing savings and time deposits.

We expect our cumulative deposit beta in this cycle will peak at approximately 30% in the fourth quarter, which, while higher than our historic beta of 20%, is still well below levels of peers. During the quarter, we continued remixing our loans by shifting to a greater floating and variable rate exposure, which now comprise approximately 60% of new loan originations, while allowing our investment portfolio to run off. We proactively added on-balance sheet liquidity as a mitigant against higher for longer short-term rates, although the higher liquidity negatively impacted our margin by approximately four bps.

On the liability side, we added $1.25 billion of fixed rate term funding at an average maturity of 2.5 years and average rate of 4.3%, and also increased our time deposit balances by $380 million at an average rate of 4.04%. In addition to our on-balance sheet actions, we added $200 million notional of pay fixed, receive floating swaps in the quarter to hedge a portion of our fixed rate loan exposure. From an earning asset perspective, net interest income and net interest margin are being supported by strong cash flow and overall asset repricing at higher rates. With $2.8 billion of annual cash flows from maturities and paydowns of loans and investments, we have ample opportunity to redeploy funds into higher yielding assets.

In addition to strong cash flow, loans and securities repricing, the added liquidity and interest rate swaps result in a further approximately $4.8 billion in assets that are repricing annually, which provides additional rate sensitivity. The yield on fixed rate maturities and paydowns of loans and investments in the Q2 was 3.8% and 2.1%, respectively. These cash flows continue to be reinvested predominantly into new loans, which are yielding approximately 7% or held in cash at the Fed, which pre-preserves liquidity and is currently yielding 5.25%. Non-interest income totaled $43.3 million in the Q2. Included in the results was a $1.5 million gain from the sale of a low-income housing tax credit investment.

The Q1 results included a $600,000 charge related to a change in the Visa Class B conversion ratio, which is reported as a contra revenue item in investment securities gains, losses. Adjusting for these items, non-interest income was $41.7 million in the Q2, an increase of $400,000 linked quarter and lower by $400,000 from the Q2 of 2022. Trends in transaction activity and asset management fees have improved off of lower levels, and we are starting to see modest growth. Core non-interest income is expected to be $41 million-$42 million per quarter for the remainder of the year, which is higher than our prior guidance. There will be a non-core charge of $800,000 in the third quarter from a further adjustment to the Visa Class B conversion ratio.

This $800,000 charge is not included in the core non-interest income guidance. During the Q2, as is our practice, we managed our expenses in a disciplined manner as inflationary conditions continued. Expenses in the Q2 was $104 million. Included in the Q1 were severance expenses of $3.1 million and seasonal payroll taxes and benefit expenses from incentive payouts, which totaled $4 million. Adjusting for the severance and seasonal payroll benefits and expenses in the Q1, expenses in the Q2 decreased by $800,000 linked quarter and were up $1.1 million from the Q2 of 2022. The year-over-year increase of 1.1% is well under the annual rate of inflation and included a considerable increase to the FDIC insurance rate, as well as annual employee merit increases.

Expenses in the third quarter are expected to be approximately the same as the Q2, but are expected to trend lower in the fourth quarter. While inflation continues to pressure expenses, reduced hiring, delaying non-core projects and other actions are being taken that moderate expense growth. To summarize the remainder of our financial performance, in the Q2 of 2023, net income was $46.1 million, and earnings per common share was $1.12. Our return on common equity was 14.95%, and our efficiency ratio was 62.07%. We recorded a provision for credit losses of $2.5 million this quarter. The effective tax rate in the Q2 was 24.57%, and the rate for the full year of 2023 is expected to be approximately 24.5%.

Our capital remains well within regulatory well-capitalized levels, with all regulatory capital ratios increasing from the prior quarter. We continue to maintain healthy excesses above the regulatory minimum well-capitalized requirements. During the Q2, we paid out $28 million in common to common shareholders and dividends and $2 million in preferred stock dividends. We did not repurchase shares of common stock during the quarter under our share repurchase program. Finally, our board declared a dividend of $0.70 per common share for the third quarter of 2023. Now we'll be happy to take your questions.

Operator (participant)

Thank you. At this time, we will conduct the question-and-answer session. As a reminder, to ask a question, you will need to press star one one on your telephone and wait for your name to be announced. To withdraw your question, please press star one one again. One moment while we compile the Q&A roster. Our first question comes from the line of Jeff Rulis with D.A. Davidson. Your line is open.

Jeff Rulis (Senior Research Analyst)

Thanks. Good morning.

Peter S. Ho (Chairman, President and CEO)

Hi, Jeff.

Jeff Rulis (Senior Research Analyst)

Maybe a question for Dean, just on the funding costs. I guess the cost of funds for the quarter at 1.08%, how does that compare at the end of the quarter? What was that number? If you have it as well, the monthly June margin overall?

Dean Shigemura (Vice chairman and CFO)

Yeah, the funding costs, overall, are you talking about just on the liability side, or?

Jeff Rulis (Senior Research Analyst)

Yeah, just cost of funding for the Q1, what was that at the quarter end, just spot rate?

Peter S. Ho (Chairman, President and CEO)

123.

Dean Shigemura (Vice chairman and CFO)

Yeah, 123. The margin for the quarter or for the month was 2.14%. Keep in mind that, when you adjust for the liquidity that we brought on during the quarter, that number is actually more like 2.20%. The liquidity did have a impact on our margin during the month.

Jeff Rulis (Senior Research Analyst)

Gotcha. Okay.

Peter S. Ho (Chairman, President and CEO)

Later in the quarter.

Dean Shigemura (Vice chairman and CFO)

Later in the quarter.

Peter S. Ho (Chairman, President and CEO)

Yeah.

Jeff Rulis (Senior Research Analyst)

Yeah. Okay. I wanted to circle back on the expenses that, you know, a pretty specific guide in the third quarter or the fourth quarter. Peter, in kind of the prepared remarks, it seems to suggest a little more, possibly, you know, could lean on that or manage that somewhat lower. I don't know if that changes. I think you've said for the full year, guidance was expenses up 3% off of 2022's core base. Has that changed at all, or is that more of a further out into 2024? Am I just reading into commentary about, you know, cost management?

Peter S. Ho (Chairman, President and CEO)

Yeah, Jeff, we're looking at expenses. Candidly, we see that line item as, you know, one of the controllable items that we have in an environment where, you know, margins and rates are challenged, fee income is likely to be what it's going to be. This is kind of a reasonable place for us to look. I would anticipate to see some impact of expense reductions later into this year. Certainly, by the fourth quarter and into next year. I'm not quite ready to kind of provide guidance on what those levels would be, but lower.

Jeff Rulis (Senior Research Analyst)

Okay. Yeah, just wanted to check in on that. I appreciate it. Just the last one on, Peter, you've also provided, and sorry, this is clunky. You've talked about a capital build. It's just the securities portfolio matures. I can't remember if it was a TCE, it was a one to two year organically, where that could build. Could you update us on kind of where you sit on that process or that direction of TCE?

Peter S. Ho (Chairman, President and CEO)

Not quite clear on the TCE piece. I mean, in generally, Jeff, you know, we're looking to build capital through obviously earnings retention, as well as, you know, taking a good hard look at the asset base of the company. Candidly, you know, the liquidity that we've built is running a little counter to capital build, if you will. I think that was obviously for good reason, you know, coming out of the SVB Signature situation in March. Reality, though, is our deposit base has been incredibly stable, and we have a pretty good size war chest of immediately available backup lines of credit.

The lever that may be available at this point is to bring down some of that $1.7 billion in cash that we're holding, which would improve capital slowly over time. Really, our capital plan is I would characterize it as an organic one at this point, with an emphasis on, you know, retaining earnings as well as managing the overall size of the balance sheet.

Jeff Rulis (Senior Research Analyst)

Great. Okay, I'll step back. Thanks.

Peter S. Ho (Chairman, President and CEO)

Thanks, Jeff.

Operator (participant)

Thank you. One moment for our next question. Our next question comes from the line of Andrew Liesch with Piper Sandler. Your line is open.

Andrew Liesch (Analyst)

Hey, good morning, everyone.

Dean Shigemura (Vice chairman and CFO)

Morning, Andrew.

Andrew Liesch (Analyst)

Just a quick question on this liquidity build, that came on later in the quarter. Has all that been deployed into earning assets, or, there's still some investments to be made on that front?

Dean Shigemura (Vice chairman and CFO)

It's primarily sitting in Fed Funds sold right now, so readily available liquidity on balance sheet for us. You know, the yield we're earning. It's at the Fed, so we're earning Fed Funds effective.

Andrew Liesch (Analyst)

Mm-hmm.

Dean Shigemura (Vice chairman and CFO)

We're also looking at.

Andrew Liesch (Analyst)

I mean.

Dean Shigemura (Vice chairman and CFO)

In terms of investments, that's where we're placing the funds.

Andrew Liesch (Analyst)

Got it. I mean, it seems it sounds like that the net effect on the margin will be lower, but on net interest income, maybe you're picking up a little bit NII?

Dean Shigemura (Vice chairman and CFO)

Yeah.

Andrew Liesch (Analyst)

Is that right?

Dean Shigemura (Vice chairman and CFO)

Right. Right. Yeah.

Peter S. Ho (Chairman, President and CEO)

Yeah.

Andrew Liesch (Analyst)

Got it.

Peter S. Ho (Chairman, President and CEO)

Yeah, that's exactly right. It's dilutive to margin, accretive to NII and dilutive to capital.

Andrew Liesch (Analyst)

Gotcha. All right. On loan growth going forward, it seems like you had some pretty good gains on the commercial side. I'm just curious what drove that? Looking out, I mean, how do you expect the total portfolio trend? Just modest, like low to mid single digit growth?

Peter S. Ho (Chairman, President and CEO)

Yeah, I think, you know, we had a good C&I quarter. Not sure that's necessarily replicable in the coming quarters. You know, we had growth in both commercial as well as consumer. What I would anticipate is likely loan growth to be flat at this point moving forward. Just seems like the consumer's slowed down a bit based on rate. Seems like commercial clients are, you know, sitting on their hands a bit on transactions. You know, hopefully, we'll see that change, you know, as more positive signals come out of the economy, hopefully. For now, feels reasonably muted, I think.

Andrew Liesch (Analyst)

Gotcha. Thanks for taking the questions. I will step back.

Peter S. Ho (Chairman, President and CEO)

Take care.

Operator (participant)

One moment for our next question. Our next question comes from the line of Kelly Motta with KBW. Your line is open.

Kelly Motta (Managing Director, Equity Research)

Hi, good morning. Thanks for the questions. I think I really appreciate the color around deposits and the updated outlook of for deposit betas. I believe in the commentary you suggested, some continued pressure on non-interest-bearing deposits. Just wondering what your outlook incorporates in terms of non-interest-bearing runoff into higher rate accounts and kind of where those could bottom in terms of, you know, a percentage of deposits as well as timing. Is this really the last quarter of it, or could there be a continuation, assuming we get another rate hike or two?

Dean Shigemura (Vice chairman and CFO)

The guidance around the beta, it does incorporate the mix shift, so some drawdown on the non-interest bearing into interest bearing deposits. That was at 30% peaking in the fourth quarter. You know, we're looking at it. Right now, we're at 29% non-interest bearing mix, coming down to maybe 27%, 26%, 27%.

Peter S. Ho (Chairman, President and CEO)

Yeah, Kelly, that would put us at about, interestingly, the midpoint between the pre-pandemic levels, which were, call it 30%-ish, and kind of the 2007 levels, where rates, you know, obviously were higher at kind of the mid-20s. Not knowing which, you know, kind of which base we'll head to, kind of we're thinking that's about a right way to handicap it. We do see some mix shift continuing into this quarter, the third quarter, potentially into the fourth. I would mention, however, that, you know, we have seen some flattening, a bit of flattening around that decline. It looks like June was down just over 1%, which compares to, you know, on average of the past year, down kind of like 2% per month.

That was an improvement. July is looking pretty flat right now, so we still have a few days left to the month. If that, if that holds true, that probably would be our best performance in about a year on a monthly basis.

Kelly Motta (Managing Director, Equity Research)

Got it. That's super helpful. In terms of the margin, I, the commentary of margin being about 2.14% for the month of June, which incorporates some of the liquidity build that you had. Can you just remind us when you put on you took on those fixed rate borrowings and threw on the cash in terms of the timing of that? Just wondering if that's fully reflected in that June margin. Kind of from here, as we look out, given your expectations for NIB declines and the commentary around deposit beta, how we should be thinking about the margin on a go-forward basis, assuming another rate hike or 2.

Dean Shigemura (Vice chairman and CFO)

Yeah. Okay. The term funding was placed, it was right in the middle part of May, so kind of right in the middle of the quarter. The June margin at 2.14% would have reflected the full impact of that liquidity. That's as you look out into the towards the end of the year, you know, we do expect the margin to bottom in the fourth quarter, and kind of decelerating from what we saw in the Q2. Kind of a gradual decrease and then bottoming in the fourth.

Kelly Motta (Managing Director, Equity Research)

Got it. appreciate that. You said you put on some swaps during the quarter. Can you just provide us a bit more color? Just trying to get some sense on how to model around that. I may have missed the amount and, of that, so that would just be helpful in terms of modeling.

Dean Shigemura (Vice chairman and CFO)

Sure. They were, it was $200 million notional, towards the end of the quarter that we put on. It's a pay fixed, receive floating swap, you know, hedging some of our fixed rate loans. About a 2 year, 2.5 year type of term.

Kelly Motta (Managing Director, Equity Research)

Okay, got it. Maybe last one for me, if I could sneak it in. With capital, I know you said you're in the rebuild mode. Just in terms of the dividend, I think you reiterated the $0.70 dividend, around earnings. Just wondering, how you guys feel about this level. Obviously, the earnings have come down, a bit with the margin. Wondering how you're feeling in terms of the comfort level of the payout, at this stage.

Peter S. Ho (Chairman, President and CEO)

Yeah. Kelly, the dividends obviously are strategic to us, and our desire is to maintain our dividend levels. Of course, that's earnings willing and interest rates willing, and inflation and credit and all of those factors. You know, our process is to assess that with our board at the end of every quarter. For now, our desire is to maintain that level.

Kelly Motta (Managing Director, Equity Research)

Thank you so much. I'll step back.

Peter S. Ho (Chairman, President and CEO)

Yeah, take care.

Operator (participant)

Thank you. That concludes the question and answer session. At this time, I would like to turn the call back to Cindy Wyrick for closing remarks.

Cindy Wyrick (Director of Investor Relations)

Thank you, everyone, again for joining us today and for your continued interest in Bank of Hawaii. As always, please feel free to reach out to either Chang or me if you have any additional questions or if you need further clarification on any of the topics discussed today. Thanks, everyone. Have a good day.

Operator (participant)

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.