OCFC - OceanFirst Financial: The Preferred Shares Offer A 14% Yield-To-(Likely) Call

2023-05-26 10:30:00 ET

Summary

• OceanFirst Financial focuses on New Jersey, New York, Pennsylvania, and Delaware.
• The net interest income remains robust but obviously shows a QoQ decline.
• I expect the net interest income to remain under pressure throughout this year as OceanFirst focuses on deposit retention.
• The preferred shares are trading at a 12% discount to principal right now.
• The preferred dividend will start to float in 2025, which would result in a double-digit preferred yield if the securities aren't called by then.

Introduction

A lot has happened since I last had a look at OceanFirst Financial (OCFC) in December last year . Regional banks have fallen out of favor with the investment community after seeing liquidity issues at some regional banks which subsequently collapsed. Additionally, the aggressive pace of interest rate increases by the Federal Reserve result in rapidly declining net interest income profiles as the interest expenses owed on deposits are increasing much faster than the loans on the balance sheet can be repriced. That lag is slowly suffocating the net interest income of a lot of the regional banks and OceanFirst is obviously feeling some pain as well. As the bank recently published its detailed financial report on its Q1 performance, I wanted to have another closer look at OceanFirst which focuses on the New Jersey, New York and Pennsylvania markets.

Keeping the fallout limited while focusing on liquidity

OceanFirst has actually done an excellent job when it comes to protecting its net interest income. It's one of the very few regional banks that saw net interest income actually increase compared to a year ago (excluding the banks who completed acquisitions during the year). As you can see below, the total interest income increased from $91M to $139M which was more than sufficient to offset the $33.5M increase in interest expenses. This caused the net interest income to increase by in excess of 15% to $98.8M.

That's an excellent achievement but this doesn't mean OceanFirst is out of the woods just yet. As explained in its presentation, the average cost of deposits was 0.88% during the first quarter , but this already had increased to 1.14% at the end of March. That being said, an increase of 30 basis points will reduce the net interest income by just $7.5M per quarter.

Of course it's unlikely the cost of deposits will top out at 1.18% (0.88% + 30 basis points), but it makes the current market dynamics easier to digest. The turning point of the net interest margins was reached sometime during the fourth quarter of last year and while the net interest income increase compared to the first quarter of last year looks great, let's not forget it represented a decrease on a QoQ basis as the net interest income and net interest margin came in at $106.5M and 3.64%, respectively, in the final quarter of last year.

In OceanFirst's case, all eyes will be on the net interest margin development as there's very little risk in the securities portfolio. As mentioned on the conference call:

[…]duration for the entire portfolio is just under four years. The unrealized loss position in the portfolio is modest. And even if the entire portfolio were to be mark-to-market using valuations as of March 31st, the impact will be limited to 50 basis-points of capital. Given our quarter-end CET1 ratio of 10%, the current value of the securities portfolio does not present a material risk to the company.

Again, this doesn't mean OceanFirst is a slam-dunk investment as the net interest margin will likely continue to contract, but I prefer the bank to make less money on the interest spread rather than pursuing higher yielding and riskier investments.

One of the qualities I appreciate most in OceanFirst's balance sheet is the strong loan book. The total amount of non-performing loans is not increasing and the percentage of non-performing loans to total loans and NPA versus total assets has remained pretty stable.

The LTV ratio in the commercial real estate segment is just 56% and the main risk can be found in the office segment. This represents about $1.1B in loans and has an average LTV ratio of almost 64%. That's definitely an element I will keep an eye on.

The preferred shares could be an interesting option

While the bank announced a quarterly dividend of $0.20 per share (representing a dividend yield of just over 5%), income-focused investors may be interested in the series of preferred shares issued by OceanFirst Financial. There are about 2.3 million preferred shares outstanding trading with (OCFCP) as ticker symbol. The OCFCP shares represent 1/40th of the $1000 liquidation preference shares mentioned below in the balance sheet.

The preferred shares have a non-cumulative preferred dividend of $1.75 per year (payable in four equal quarterly tranches) and as the preferred share is currently trading at $22 (88% of the principal value), the current yield is approximately 7.95%. An additional bonus is that these preferred shares will move to a floating rate in May 2025. The new floating rate will be the 3 month SOFR + 684.5 basis points per year. With the 3 month SOFR currently at 5.23% , the pro forma floating preferred dividend rate would increase to in excess of 12% based on the $25 principal value, and to in excess of 13.5% based on the current share price of $22/share.

This means that unless the 3 month SOFR collapses in the next two years, the likelihood of OCFC calling the preferred shares appears to be pretty high as I just can't imagine the bank willing to pay 12% on preferred equity. And as the total size of the issue is less than $60M (and less than 4% of the total amount of equity on the balance sheet), it should be pretty easy for OceanFirst to call these shares without jeopardizing the balance sheet quality.

This indicates the "yield to call" calculation could be very interesting here as well, and in OceanFirst's case, the yield to call is a whopping 14%. And if the securities don't get called, the preferred dividend yield will likely reset to a double digit anyway, even if the 3 month SOFR decreases from the current levels.

Investment thesis

Balance sheet wise, I don't see any issues for OceanFirst. The average duration of the securities portfolio is manageable and the difference between market value and book value does not pose a material risk to the bank. The main focus will now be on retaining customer deposits to ensure the liquidity levels of the bank remain strong: Approximately 22% of the total amount of deposits is held in cash and securities which is more than the total amount of unsecured deposits which total $1.86B.

I like the preferred shares of OceanFirst as the risk/reward ratio is pretty interesting. I realize the preferred dividends are non-cumulative so that's a risk. But considering the preferred shares are costing the bank just $1M per quarter in preferred dividend payments, I expect the preferred dividends will continue to be well-covered (in Q1, the bank only needed 3.5% of its net income and 2.75% of its pre-tax income to cover the preferred dividend).

I currently have no position in OceanFirst, but I will likely buy the preferred shares in the next few days.

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