Richard Wayne - President, CEO & Director Jean-Pierre Lapointe - CFO & Treasurer

Alexander Twerdahl - Sandler O'Neill + Partners

Good morning, and thank you all for joining us today. I'm Rick Wayne, the Chief Executive Officer of Northeast Bancorp, and with me on the call is JP Lapointe, our Chief Financial Officer.

After the close of the market yesterday, for the first quarter of fiscal 2019, we announced quarterly net income of $4.5 million or $0.49 per diluted common share, 12.8% return on equity, 1.5% return on assets and an efficiency ratio of 58.8%. As will be discussed in more detail, we had significant growth in our higher-yielding LASG portfolio, strong volume in our SBA portfolio and a decline in nonperforming assets with continued disciplined expense management.

Turning to Slide 3. During the first quarter, bank-wide, we generated $136.3 million of loans, including $105.9 million in our Loan Acquisition and Servicing Group or LASG.

LASG loan production included $71.1 million of originated loans and $34.8 million of purchased loans. Of the $71.1 million of originated loans, 93% were variable rate and 85% were indexed to prime with the weighted average yield of 7.48% as of September 30.

For the quarter, the LASG portfolio had net growth of $20 million or 2.9% compared to the linked quarter or 11.6% on an annualized basis. Additionally, we generated $18.9 million of loans in our SBA division, all of which were loans secured by hotels, demonstrated the continued build out of our SBA hotel vertical.

We generated a net gain of $851,000 on the sale of $12.3 million of SBA loans. Net interest margin for the quarter was 4.9%, and our total return on purchased loans for the quarter was 9.5%, which included $1.5 million of transactional income.

Turning to Slide 4. As we have discussed in the past, under a regulatory commitment made in connection with the 2010 merger, purchased loans are limited to 40% of total loans.

Loan purchasing capacity decreased to $92.7 million as of September 30, as a result of the growth in the LASG purchased portfolio during the quarter. Loan purchasing capacity increases or decreases depending upon the relative amount of purchased and originated loans on our balance sheet at any given point in time.

Now on Slide 5, under another regulatory commitment, nonowner occupied commercial real estate loans are limited to 300% of total capital. As of September 30, capacity under this condition was $120.2 million.

Moving on to Slide 6. Of the $105.9 million invested by LASG for the quarter, $34.8 million were purchased loans and $71.1 million were originated loans.

Purchased loans for the quarter have unpaid principal balances of $37.1 million, representing a purchase price of 93.9%. As frequently mentioned in these investor calls, loan purchasing is transactional and can vary sometimes significantly from quarter-to-quarter.

Since the merger in 2010, LASG has invested an aggregate of $1.6 billion consisting of approximately $762 million of purchased loans and approximately $880 million of originated loans. During the past quarter we reviewed loans with $179.3 million of unpaid principal balances and bid on loans with $54.4 million of UPB.

And we purchased loans with UPB of $37.1 million at 93.9% or $34.8 million invested. The $34.8 million invested consisted of 58 loans acquired in 5 separate transactions.

As I've said before, we remain disciplined in our selection, underwriting and bidding on loan pools and singularly focused on building a quality portfolio. Moving on to Slide 7.

At the end of the quarter, the discount on purchased loans was $36.4 million as compared to $37.1 million at June 30. The change is primarily due to $34.8 million of purchases with the related $2.3 million discount offset by regularly scheduled accretion as well as purchased loan payoffs and pay downs in the quarter.

Purchased loan payoffs generated $1 million -- $1.5 million of transactional income. Approximately 85% of the $36.4 million discount is expected to be realized over the remaining life of the purchased loans through scheduled accretion.

The nonaccretable portion of the discount represents contractual cash flows that in our estimation may not be collectible. Turning to Slide 8, we provide detail on returns from the LASG portfolio.

For the quarter, the purchased portfolio generated a total return of 9.5%, reflecting transactional income of $1.5 million from unscheduled loan payoffs and sales, which was lower than the average of $2.4 million of transactional income and the weighted average return of 11.7% for the prior 4 quarters. As discussed in the past, transactional income realized on the purchased portfolio as well as the amount of loans purchased may not be consistent from quarter-to-quarter.

The LASG originated portfolio generated a return of 7.4% in the quarter. Turning to Slide 9, we provide statistics on the LASG portfolio as of September 30.

Of significance, as noted in the chart in the top right, the purchased loan portfolio has a net investment basis of 89%, consistent with the linked quarter. On an invested basis, the average loan size is approximately $733,000, and 85% of the portfolio consisted of loans with an investment size less than $6 million.

The loan portfolio has a diverse collateral type, primarily focused on retail and mixed used, industrial, hospitality, multifamily and office. By geography, the largest concentrations are in California and New York with 17% and 15% of the portfolio, respectively.

Our collateral is geographically diverse with collateral in 42 states. Turning to Slide 10, one of the benefits of the SBA program is the ability to sell the guaranteed portion of the loan and often at a substantial premium.

For a variety of reasons SBA loans closed in one quarter are sometimes sold in the subsequent quarter. In the current quarter, we closed $18.9 million of SBA loans, of which $18.6 million were funded.

Additionally, the company sold $12.3 million of the guaranteed portion of loans in the secondary market, of which $7.4 million were originated in the current quarter and $4.9 million were originated in prior quarters. For the quarter ended September 30, the net gains on sale, including the capitalized servicing asset, was $851,000.

On Slide 11, we show the detail of the SBA sale pipeline as it stands at September 30. The bank holds $1.4 million in SBA loans held for sale, which represents the guaranteed portion of SBA loans, which have closed and are fully funded at quarter end.

There is also an additional $12.8 million in the guaranteed portion of SBA loans that have closed and will be fully funded in subsequent quarters. In total, this represents an additional $14.2 million in future SBA guarantee loan sales before considering any loan production in future quarters.

And now I'd like to turn it over to JP, who will discuss in more details our financial results, after which we will be happy to answer your questions. JP?

Thanks, Rick, and good morning, everyone. I'm picking up on Slide 12 to provide more information on our financial results.

Net income for the quarter was $4.5 million or $0.49 per diluted common share. Diluted earnings per share were up $0.01 from the quarter ended June 30, 2018, which I shall refer to as the linked quarter, and down $0.01 from the quarter ended September 30, 2017, which I shall refer to as a comparable prior year quarter.

The increase of $0.01 from the linked quarter was due to higher interest income, which amounted to $18.8 million in the current quarter compared to $18 million in the linked quarter, as a result of higher average balances in the LASG and SBA portfolios. This was offset by higher interest expense of $4.4 million in the current quarter compared to $3.6 million in the linked quarter as a result of higher cost of deposits to fund loan originations.

Noninterest income was down $405,000 from the linked quarter due to no gain on sale of other loans as there were no other loans were sold during the current quarter, offset by higher loan servicing fees in the current quarter. Noninterest expense had a favorable variance of $123,000 compared to the linked quarter due to lower salary and employee benefit cost, offset by higher loan expense.

Additionally, we saw the benefit of the lower federal corporate income tax rate in the current quarter, which drove income tax expense down to $1.5 million or an effective tax rate of 24.8% as compared to $2.3 million or an effective tax rate of 34.5% in the linked quarter. The decrease from the comparable prior year quarter of $0.01 was due to an increase in deposit funding costs, which increased $1.5 million along with an increase in noninterest expense of $641,000, primarily due to higher salary and employee benefit cost and an increase in other noninterest expense from the quarterly valuation of servicing rights as well as the decrease in noninterest income of $404,000 primarily due to lower gains on sales of SBA and residential loans.

These were offset by higher interest income of $18.8 million compared to $16.2 million from higher average balances in the LASG and SBA portfolios as well as a lower effective tax rate. The tax rate for both the current quarter and the comparable prior year quarter included income tax benefits recognized under ASU 2016-09, whereby the tax effects of vested stock awards or exercise stock options are treated as discrete items in the reporting period in which they occur.

The tax benefits recognized in the quarter decreased by $637,000 compared to the comparable prior year quarter. Turning to Slide 13.

Over the past year we have seen net loan portfolio growth of $127.6 million. The majority of the growth over the last 12 months comes from our LASG portfolio with $410.2 million of purchases and originations.

As shown in the chart, in the trailing 12-month period, we have closed $56.2 million of SBA loans and sold $32.4 million of the guaranteed piece portion of these loans into the secondary market. While bank-wide loan production has been strong over the trailing 12 months, increases have been significantly offset by pay downs and amortization in the purchased and originated portfolios, which amounted to $306.2 million over the trailing 12 months.

These results are further detailed on Slide 14, which shows the composition of the loan portfolio over the most recent 5 quarters. The net loan growth over this time is primarily driven by the strength of the LASG portfolio, which had net loan growth of $137 million or 24% since September 30, 2017.

In the current quarter, LASG originated $71.1 million of loans and purchased loans with a recorded investment amounting to $34.8 million. Turning to funding on Slide 15.

In order to fund loan growth, we've had net deposit growth of $153 million or 18% over the trailing 12-month period. Over the past year, all of the deposit types, excluding demand deposits, have seen growth.

However, the majority of the growth has been within our time deposit products. Despite the growth in the time deposit products, our nonmaturity accounts, which include money market, savings and demand deposit products, as a percent of total deposits, remains high at 57% as of September 30, 2018, as compared to 65% of total deposits at September 30, 2017.

Slide 16 shows trends in the main components of our income. Compared to the linked quarter, base net interest income increased $436,000 due to higher average balances in the LASG and SBA portfolios along with higher rates earned on our loans as majority of our LASG originated and SBA portfolios are tied to the prime interest rate.

Base interest income increased $1.3 million due to the increase in the average balance of the LASG and SBA portfolios and the increase in the prime interest rate, which was net offset by increased funding costs, which increased $844,000 from the linked quarter. Transactional interest income from the purchased loan portfolio decreased by $485,000 compared to the linked quarter.

The purchased portfolio had a return of 9.5% in the current quarter compared to 11.5% in the linked quarter. The increase in net interest income before loan loss provision from the comparable prior year quarter is largely attributable to an increase in base net interest income of $2.4 million due to a higher average balances in the LASG portfolio and higher rates earned on the loans in this portfolio, offset by lower transactional interest income from the purchased portfolio.

The 9.5% return in the purchased portfolio in the current quarter is down from 12.3% in the comparable prior year quarter due to higher transactional interest income amounts in the comparable prior year quarter. The lower purchase yield was more than offset by higher average balances in the current quarter as compared to the comparable prior year quarter.

Compared to the comparable prior year quarter, base interest income increased $3.9 million, while funding cost increased $1.5 million. Noninterest income decreased by $405,000 over the linked quarter, primarily due to the decrease of $402,000 in gain on sale of other loans and $182,000 decrease in gain on the sale of SBA loans, partially offset by a smaller loss recognized on the sale of real-estate owned and higher loan servicing fees compared to the linked quarter.

Noninterest income is down to $404,000 from the comparable prior year quarter primarily due to a decrease in the gains on sale of SBA loans $158,000 due to lower pricing in the SBA guarantee market in the current quarter and a decrease in the gain on sale of residential loans $117,000 due to lower volume sold in the current quarter. These results are further detailed on Slide 17, which shows trends in total revenue and noninterest expense over the past 5 quarters.

Compared to the linked quarter, total revenue has decreased by $454,000, primarily due to the decrease in gain on sale of other loans of $402,000. Additionally, noninterest expense decreased by $123,000 from the linked quarter, primarily due to lower compensation expense due to lower incentive compensation cost as compared to linked quarter, which was offset by higher loan expense in the current quarter.

Total revenue has helped us achieve an annualized return on equity of 12.8%, a return on assets of 1.5%, along with an efficiency ratio of 58.8% in the current quarter. Compared to the comparable prior year quarter, total revenue has increased by $644,000, while noninterest expense has increased by $641,000.

The increase in revenue is primarily due to an increase in base net interest income due to higher average balances in the LASG originated and purchased portfolios, offset by a decrease in gains from the sale of SBA loans. The increase in noninterest expense compared to the comparable prior year quarter is primarily due to a $255,000 increase in compensation expense due to increased employee compensation and a $167,000 increase in other noninterest expense, primarily due to the quarterly valuation of servicing rights.

Slide 18 provides additional information on trends and yields, average balances and our net interest margin, which was 4.93% in the current quarter as compared to 5.28% in the linked quarter and 5.13% in the comparable prior year quarter. As previously discussed, the net interest margin, which decreased from the linked quarter, is largely driven by an increase in base and interest income, offset by higher cost of deposits and average deposit balances as well as lower transactional interest income from the purchased loan portfolio.

Additionally, the average balance of loans for the current quarter was $894 million as compared to $825 million in the linked quarter of $773 million in the comparable prior year quarter, primarily due to growth in the LASG originated and purchased portfolios. Slide 19 provides a snapshot of our asset-quality metrics.

Compared to the linked quarter, nonperforming loans to total loans has decreased to 1.30% from 1.37%, and nonperforming assets to total assets has decreased to 1.08% from 1.23%. These metrics have also both decreased compared to June 30, 2017.

In the top right-hand corner, classified commercial loans were $8.9 million, as of September 30, 2018, a slight decrease from $9.1 million in the linked quarter. Finally, as noted in the chart on the bottom right-hand corner of the slide, annualized net charge-offs to average loan balances have remained at very low levels over the past several years and were 4 basis points in the current quarter, consistent with the linked quarter.

Overall, our allowance coverage has continued to increase and appears appropriate to address the risk in our loan portfolio. That concludes our prepared remarks.

At this time, we would like to open up the call to Q&A.

I'm first off wondering if you could, Rick, give us a little bit more commentary or color on sort of what you're seeing in the SBA line? I appreciate you kind of given us sort of color on what the pipeline looks for potential gains going into the fourth quarter, maybe the pipeline as well for originations as well as kind of whether or not you saw -- think there's maybe seasonality that impacted the third quarter.

And then also maybe a little bit more about how you're thinking about that gain on sale, which seems like it took kind of a step back in the calendar third quarter relative to where we've seen it over the last couple of years, really.

Just so I get it, Alex, your first question is, what do we see in the market originations. And then the second one, when we expect for pricing in this -- the quarter that we're in now or the following quarter.

Yes.

Well, I thought -- first of all, that our almost $19 million of originations was actually quite good. There is some seasonality in the summer months and while -- close to $19 million, I thought was -- we thought was a strong number for that.

I can tell you though that to kind of think about the future, it's a very, very competitive marketplace for SBA loans. We have seen in our own case in the hotel vertical that for loans of the quality that we want to book, the pricing is not -- I'll tell you what the pricing is, pricing is more between prime 1.5% to 1.75% and a couple of points to the brokers.

And as you go back a while ago, say a year or 1.5 years, the pricing on those loans was more like prime plus 2.25%. So the reason that is recurring, of course, is there are a lot of lenders chasing that business.

There are 3,000 or 4,000 banks that do SBA loans. There's maybe -- I don't know this exact number exactly, but directionally -- and most of those are doing in their local marketplace, there's maybe 100 that do -- as we do, they do them nationally.

And there's a lot of competition, which is driving down the pricing, and also frankly driving down the availability. Business is getting tougher.

Secondly, on the question of pricing, we're also seeing -- and I'm sure you're seeing this with banks that you follow, the premiums that buyers are willing to pay are going down. By way of example, I have this somewhere, in the current quarter, when you look at our gain, which includes both the gain and the servicing asset created, it was 7% of loans sold and it was 9.5% in the linked quarter.

So that -- I don't want to be totally gloomy about that, because we're pleased with the inroads we're looking to in the hotel vertical. You -- as you know well, we missed -- we moved from a BDO model to focusing more on a vertical model.

And when you compare that number with what we had done when the BDO and the quality of it, it's gotten better -- much better, I would say. But that's how I would describe the -- fairly describe the state of affairs in the SBA world.

Okay, that's some helpful color. And then maybe give us a little bit more color on the funding pressure that you're seeing this quarter.

Obviously, the whole industry is seeing higher rates translate to higher deposit costs. But this quarter specifically were there some longer durations CDs or something you put on that kind of impacted that more than what you've seen or maybe talk about how you're planning to address and think about the funding side of the balance sheet over the next couple of quarters.

So this quarter as we grew and as JP mentioned, most of our funding came from term deposits, CDs that were running in our ableBanking channel and most of that is come from 1 year CDs that are currently priced at 2.70%. And that's on the -- obviously on the expensive side, kind of the focus first on the good news and then talk about the cost of it.

As we have a condition that we need to fund our loans with core deposits, so we don't have the liberty of going to borrow money. I suspect borrowings would to be roughly the same.

The good news is because make so much money on the asset side, we're able to pay those rates and we're able to attract money at those rates. So we're able to fund ourselves, but we need to pay up for it.

One of the other things that is unique about our bank is that because we have to fund our loans with core deposits, we need to inventory money. And so we have a lot more cash on hand than probably other banks that you look at.

And that money that we're paying 2.74%, until we can deploy it in loans where it's sitting at Fed at 2.20%. So we have 50 basis points of negative spread on the extra cash that we carry.

And given that we're in the business of buying loans and that is somewhat transactional, we need to -- even inventory, if you have more cash than others. So I think we see -- tell me, confirm JP that is right.

I want to say that our funding costs on deposits went up 25 basis points last quarter compared to the linked quarter. And -- but I would also point out on that or I would amplify because I've said it once -- I've said it before that when you look at our portfolio, our originated portfolio where we funded $71 million, most of which -- 91% or 92% of which tied to -- is variable, mostly tied to prime, that had a rate at September 30 after adjusting of 7.5%.

So one of the reasons, Alex, that as you noted in your as usual well-written report, that there's some compression on net interest income. But some chunk of that really has to do with the fact that our balance sheets -- I would -- not artificially higher, but needs to be higher because of the deposit requirements and we're losing 50 basis points on that.

But when you look at the spreads on our loan book, on our originated book, having loans at the end of the quarter that are variable that are yielding 7.50%, I think -- we think is terrific. The main reason, the very main reason that from an earning perspective this quarter was not as good frankly as we like to see is because our transactional income was $1.5 million compared to an average of $2.4 million over the preceding 4 quarters.

And that on an after-tax basis is almost $0.09. And I know you know this but I'll remind -- just say it so the other listeners on the call will hear it, the differences is, if we have a loan that's paid off on September 30 and there's discount that goes into the -- that quarter and it if pays off on October 1, it goes into the following quarter.

And so we've invested $700 million or so in purchased loans with yields between 11% and 12% and this quarter was 9.5%. We sold a lot of discount on the books and a lot of it's timing.

I know we get judged quarter by quarter, so I'm not attempting to rationalize. I'm only trying to make the point that -- as we say but it's got that the term of being the truth and that purchase business both in the amount of loans you buy and the transactional income can vary quarter-by-quarter.

I didn't say lumpy because we say that all the time, but it really can vary quarter by quarter. And for that I apologize for a very long-winded answer to your very precise question, but I wanted to touch on some of the things that I know are of interest to you.

I think that you certainly have some lines that can be somewhat lumpy and some quarters they all hit -- fire at the same time and some quarters they all kind of don't fire at the same time. So just -- to the point on the LASG originated loans, which I know most of those are prime based and have been repricing higher, but just relative to the June quarter, the yields were kind of flat.

Was there something that kind of inflated the June quarter's yield on the LASG originated loans to make that kind of not seem as asset sensitive as it is?

I'm going to need some help from somebody here to answer that. Can you?

What was...

7.53%

Is 7.43% this quarter, last quarter was 7.45%?

Anyone know -- there must have been some fee income in there because the -- I'll have to look at more closely. I don't want to -- I don't have the answer to that as we sit here with that, but I will take a look at our public information where there will be an answer to that and will have something more to say on it.

I don't want to mumble through it here. It's certainly within the realm of possibility that on our loans there's a little bit of price compression on -- we may have done some more loans that were prime plus 2.5% and now maybe some are -- have prime plus 2% in the mix.

But we have public information on that, I will be able to figure out.

Got it. But we would expect that portfolio based on the September hike to be yielding higher in the final quarter -- the final calendar quarter of the year relative to how we saw this quarter, correct?

Yes, and I would say just that the -- virtually all of the originated portfolio in our variables generally tied prime. The only -- there's two things that can affect the question that you're asking.

One is, was there some amount of an exit fee or some kind of -- something that went into that interest income in the prior quarter. And secondly, sometimes we do loans at prime plus 2%, sometimes prime plus 2.5%.

There could be some of that in the mix. But it's -- they're still very good numbers and it's notable.

But let me just use that as a launching point pad to make one more point, which I intended to earlier. When you touch on this in your report, one of the things I think that is important to point out and I think very significant in -- as we're building our earnings and the quality of the earnings.

For those of you who have the slide deck, if you look on Page 16 of the deck, we have a slide that shows the components of our net interest income quarter by quarter. And we break it up into base net interest income, which is the blue bar and transactional interest income, which is the -- comes from generally from prepays.

And you can see that in the quarter that ended September 30, our base net interest income was, call it, $12.9 million income and $12.9 million with a bit of rounding. If you go back just a year ago to the first quarter of -- fiscal quarter of fiscal year '18, it was $10.5 million.

So it went up $2.4 million, the base net interest income in that time period. Why does that happen?

That happens because we're building our portfolio. By way of example, our average loan balance for the quarter, if you go to Slide 18, for the quarter that ended on September 30, the average loan book was $895 million.

The average loan book in the quarter that ended June 30 was $825 million. That's $75 million increase in our average loan size and a big chunk of -- you look quarter- to quarter-end, you wouldn't see that as clearly.

But a lot of the loans were booked at the very end -- in the month of June. So between June and September, we've grown our loan book significantly.

And so therefore transactional income is important. Yield on our purchased loan book is important.

But one of our goals is to build a high-yielding, high-quality loan book so we can add more consistent and predictable earnings, even with this quarter with transactional income $900,000 lower than last quarter and SBA gains $200,000 lower, we still had a very -- in my opinion a very strong quarter. Not to our potential, but earning almost 13% ROE and 1.5% ROA and efficiency ratio of 58% and 59%.

Compared to most banks, pretty strong with lots of loan growth capacity.

My final question is just, JP, you gave some color on the tax rate this quarter, how should we be modeling that for the remainder of the year, excluding the impact of the -- what happened this quarter?

Sure, Alex. I think for the year we should be -- excluding discrete items should be somewhere around 27% for tax rate going forward, so somewhere around there should be appropriate.

Thank you, and thank you all for listening, participating, reviewing our material every quarter. We try and provide more visibility into our company so you can understand it more.

I hope that the Q&A with Alex and some of my expanded answers were helpful and not tedious for you. I try to provide some color to what's going on, and look forward to talking to you in our next call.

And as always, if you have suggestions on items you like us to provide some more visibility into, and we can, we would be happy to do it. And with that I wish all of you a very nice day and week.

Thank you.