Webster Financial’s (WBS) CEO Jim Smith on Q2 2017 Results – Earnings Call Transcript

Webster Financial Corporation (NYSE:WBS)

Q2 2017 Earnings Conference Call

July 21, 2017 09:00 AM ET

Executives

Jim Smith – Chairman and CEO

John Ciulla – President

Glenn MacInnes – EVP and CFO

Chad Wilkins – HSA Bank, President

Analysts

Jared Shaw – Wells Fargo

Steven Alexopoulos – JPMorgan

David Chiaverini – Wedbush Securities

Collyn Gilbert – KBW

Mark Fitzgibbon – Sandler O’Neill

Matthew Breese – Piper Jaffray

Casey Haire – Jefferies & Co.

Operator

Good morning, and welcome to the Webster Financial Corporation Second Quarter 2017 Results Conference Call. This conference is being recorded. Also, this presentation includes forward-looking statements within the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to Webster Financial’s condition, the results of operations, and business and financial performance. Webster has based these forward-looking statements on current expectations and projections about future events. Actual results might differ materially from those projected in the forward-looking statements.

Additional information concerning risks, uncertainties, assumptions, and other factors that can cause actual results to materially differ from those in the forward-looking statements is contained in Webster Financial’s public filings with the Securities and Exchange Commission, including our Form 8-K containing our earnings release for the second quarter of 2017.

I’ll now introduce your host, Jim Smith, Chairman and CEO of Webster. Please go ahead, sir.

Jim Smith

Thank you, Michel, and good morning, everyone. Thanks for joining Webster’s second quarter 2017 earnings call. President, John Ciulla; CFO, Glenn MacInnes; and I will review the quarter. And HSA Bank President, Chad Wilkins, will join us to take questions.

I’ll start this call by saluting and thanking Joe Savage who retired June 30, following 15 years of distinguish service to Webster. Joe had a distinctly positive impact on Webster overall and on commercial banking and particular. His principle and leadership consistently high performance and competitive spirit have left a lasting impact on our company and its culture.

Turning to highlights of the quarter on slide two, Webster again reported solid business and financial performance. Record levels of net interest income, pre-provision net revenue, pre-tax income and net income produced year-over-year earnings per share growth of 20%. Return on average common shareholders’ equity of 9.6%, I’m proud to report exceeded its cost. And the return on average tangible common shareholders’ equity reached 12.7% as our capital position strengthened further.

Among the highlights of the quarter were strong loan originations of over $1.4 billion. Commercial banking originations were particularly strong and once again accounted for more than 60% of the total, marking the 20th consecutive quarter of year-over-year double-digit growth in average commercial loans.

While loan payoffs remained elevated, they were again replaced with higher yielding loans. Higher yields on earnings assets are one important part of the story; low cost funding is another as HSA and transaction account deposit growth fully funded loan growth and deposit cost barely rose both linked quarter and year-over-year.

Combination of these positive forces drove the net interest margin higher. The true value of our funding base more than half of which is in HSA and transaction deposits is just starting to come into focus, and that value will only increase as rates rise.

Also contributing to the quarter’s strong performance are our continuing favorable credit trends, which combined with slower loan growth, produced the lowest quarterly loan loss provision in almost five years. While nonetheless maintaining stable coverage ratios.

Loan compelling example of positive asset quality trend and receiving the residential loan portfolios, where charge-offs on the nearly $11 billion of resi mortgage and home equity loans originated since 2008, which now accounts for 80% of our current portfolio are just 5 basis points live to-date.

Validating the sustainability of our improving performance is the fact that revenue grew for the 31ststraight quarter year-over-year. Again out stripping expense growth and generating positive operating leverage and an efficiency ratio with a six feet [ph] handle even as we continue to invest purposefully in differentiated strategies that have high economic profit potential, namely HSA Bank, the commercial banking expansion which John will discuss and retail expansion in Boston.

According to the Federal Reserve’s July day’s book economic activity expanded modestly in recent weeks in the Boston district, which includes Connecticut and the New York district as well consistent with our experience. I am under spell that prospects for future growth in our markets are good, which mirrors our view.

Turning briefly to strategy, HSA Bank continues to deliver strong performance, reflecting the significant investments we are making in Webster’s number one strategic priority. The long-term potential for health savings account shines evermore brightly, as more advisors, consultants, employers and individuals recognized a significant role HSA play in a holistic retirement planning strategy.

In order to maximize the extraordinary opportunity ahead, we continue to invest heavily in key initiatives including those related to operational excellence, customer service enhancements, product development and sales capabilities.

We have recently recruited several seasoned professionals to lead our sales and relationship teams and we have undertaken an in-depth initiative to improve our competitive positioning and sales methodology.

The material growth we are experiencing in the number and size of perspective employer client proposals reflects the measurable results of our strategy to acquire larger employers in order to expand the universe of potential new HSA account holders.

As we said in last quarter’s earnings call, the rate of expenses would be higher for some period of time, given the level of investment in this important initiative. So while revenue is growing by about 20% or so in 2017, expenses are growing at about the same rate, which is boosting net revenue, but keeping a temporary lid on operating leverage, which should begin to improve into next year.

Even though the Healthcare Bill didn’t clear the Senate this week, but one thing everyone seems to agree upon is the importance of HSAs as part of the eventual solution to the healthcare conundrum. Even without healthcare reform the focus on consumer directed healthcare by insurers and employers is intensifying. With eventual reform would come the likelihood that premium paid from HSAs would be tax deductible and contribution limits could double.

Pushing HSAs to a fundamentally different and imposing position, whereby they could become a competitive alternative to IRAs and 401(k) as a primary retirement savings vehicle, just think about that for a minute. A true game changer and HSA Bank is in position to reap the maximum benefit.

Separately our Boston expansion continues to show promise as total attributable deposits and loans reached $340 million and $240 million respectively. While the negative EPS effect this quarter was about $0.02, we are still on track for breakeven late next year.

I’ll turn it over to John Ciulla to report further on the quarter.

John Ciulla

Thanks, Jim. Good morning. I’ll begin on slide three, loan growth of $1 billion over the past year has been led by commercial categories, and has been fully funded by growth in transactional and health savings account deposits. Our strong growth in these core deposit categories, along with growth in non-transactional deposits has enabled us to maintain a loan-to-deposit ratio in the mid-80s over the past year.

Periodic and floating loans represent 70% of total loans, which has supported the 19% basis points increase in the net interest margin over the past year that Jim mentioned, and continues to position us well in a rising rate environment.

Turning to the line of business performance on slide four, as we noted on last quarter’s call, private banking financial performance is now included in the Commercial Banking financials. Commercial Banking continues to performing at a high level in a very competitive environment. Year-over-year, revenue was up 9.4% and PPNR is up 8.1%.

Loans grew 9.3% from the prior year’s second quarter on a spot basis, and over 10% when comparing year-over-year quarterly average balances. Despite solid origination activity, year-over-year loan growth was muted by a material increase in repayment activity in the quarter, primarily impacting our investment CRE and sponsor and specialty business units. Notwithstanding an industry wide softening a loan growth, we remain focused on achieving our 10% annual loan growth target over the long-term.

Deposits grew 10% year-over-year and the percentage of transactional deposits to total deposits remained solid at 59%. We are making progress in our strategic initiatives in Commercial Banking, mainly the successful metro market expansion strategy and middle market banking expanded industry segment activities and sponsor relationships further developing our sales and syndication capabilities, continued investment in people and product enhancements and positioning our wealth offering for business owners and investors across our core footprint.

Turning to slide five, HSA Bank delivered another solid quarter, when adjusted for the 2Q, 2016 impact of the JPM acquisition, revenue grew 21% and PPNR grew 30% over the same period last year. Much of the improvement was driven by increased interest income related to growth in deposits and improved deposit spread.

HSA Bank generated a number of key new employer wins in the quarter as our up market strategy is beginning to pay off. Total accounts were up 18% year-over-year as we added 100,000 new accounts in the quarter. Accounts grew marginally from the linked quarter due to seasonality, normal attrition of approximately 12%, and the timing of account closures relates to post-enrollment partner cleanup of unfunded accounts.

Total footings grew 20% year-over-year and now exceed $5.9 billion. Year-over-year deposits grew 16% and investments grew 39%. Deposit balances were impacted by a higher level of investment transfer versus the same period last year. As on a net basis, $53 million transferred from deposits to investments this quarter as compared to $33 million a year ago. The number of accountholders with investment accounts continues to increase and is approaching 3% of total accountholders.

Moving to slide six, Community Banking had a strong quarter, and has delivered PPNR growth of 7% year-over-year. Deposit balances grew by 6% compared to prior year, with transaction deposits as a percentage of total deposits nearing 40%, which helped keep the cost-to-deposits at 26 basis points.

Overall, loan balances grew by 3% with business loans growing 10% year-over-year. Yield on new loans improved by 45 basis points helping portfolio yields improve by 3 basis points overall. Year-over-year, revenues were up 4% with non-interest income growth of 2% driven by growth in mortgage banking and investment services income.

Community Banking is progressing along its transformation strategic roadmap. Continued focus on improving digital delivery drove year-over-year growth in digitally active households to 46% of total households. Self-service transaction as a percentage of total transactions reached 70%. We are investing in our digital banking infrastructure and optimizing the physical footprint. Eight banking centers were closed in the second quarter, resulting in a total branch footprint of 167 banking centers as of June 30th.

I’ll now turn it over to Glenn.

Glenn MacInnes

Thanks, John and good morning, everyone. I’ll begin on slide seven with the review of Webster’s average balance sheet, which totaled $26.2 million and increased 4.7% over prior year. This was almost entirely driven by commercial loan growth. The remainder of my comments will focus primarily on linked quarter comparisons key average balance sheet items.

Average commercial loans grew $207 million or 2.1% and represented most of the loan growth. Of this, commercial non-mortgage and commercial real estate were the key drivers. Consumer loans grew modestly at 0.2% this reflected growth of 1.4% in residential mortgages, which was offset by a 1.6% decline in other consumer categories.

Period end total loan balances were up 1% with commercial and consumer loans each up by approximately 1%. Average deposit growth of $320 million was broad based including increases of $108 million in savings balances from growth in Boston in seasonality, $86 million in health savings account balances and $67 million in interest bearing checking.

Excess deposits over loan funding contributed to a $200 million decrease in borrowings. Over the last two quarters average borrowings have decreased by $750 million at a cost of approximately 90 basis points. This resulted in a borrowings-to-asset ratio of 10.9% its lowest level in six years. And our loan-to-deposit ratio of 84.4% at June 30th is substantially below the March 31st New England Bank medium of 97%.

Common equity Tier 1 and tangible common equity ratios both improved supporting our strategy to grow primarily 100% risk weighted loans and tangible book value per share increased for the 9th consecutive quarter ending at $20.74 per share for a growth of 6.9% over prior year and a CAGR of 6.7% over the past two years.

Slide eight summarizes our Q2 income statement and factors contributing to record reported net income. Key earnings drivers for the quarter included record net interest income from continued loan growth and NIM expansion, increased non-interest income led by mortgage revenue and higher deposit service fees and modestly higher non-interest expense. I’ll provide more color on each of these categories in the subsequent slides.

One item I will highlight is the lower than anticipated provision expense. We had originally anticipated Q2’s provision to be in the $10 million to $12 million, driven by loan growth and asset quality. The provision of $7.3 million reflects lower than anticipated period-end loan balances a mix shift in originations this quarter toward consumer and further improvement in consumer credit. AOOO coverage was flat quarter-over-quarter at a 116 basis points.

Slide nine provides more detail on net interest income, which increased 11.8% from a year ago and 2.7% linked quarter. NIM expansion was driven by interest earning asset yields benefiting from higher market interest rates and continued deposit pricing discipline.

Higher loan yields accounted for 6 basis points of the NIM increase and the total loan yield above 4% was there for the first time in four years. And another 2 basis points came primarily from lower premium amortization and securities portfolio as a result of lower prepayments fees. These increases were partially offset by a 2 basis point impact from higher borrowings cost and a 1 basis point impact from higher deposit cost.

Slide 10 details non-interest income, which increased $1.5 million. The main driver was an increase of $1.1 million in mortgage banking revenue highlighted in days, which primarily reflects expansion in servicing valuations due to extended duration. We had modest increases in wealth and investment revenue and HSA fee income with a partial offset and lower loan related fees due to Q1 strength in syndication fees.

Slide 11 highlights our non-interest expenses spend, which had a linked quarter increase of $635,000. As anticipated the quarter had lower payroll related taxes, which were partially offset by annual merit increases and higher variable share price compensation. During the quarter there were $1.6 million in facilities optimization and severance related expenses versus $1.1 million in Q1. The $1.1 million of expense was below our initial expectations of $2.5 million.

As a result of revenue growth of almost 3% and modest expense growth our efficiency ratio improved to 60.6%. For additional detail please refer to the efficiency ratio slide on page 15.

Slide 12 highlights our key asset quality metrics. Non-performing loans highlighted in the upper left decreased $8 million, a net decline of $5 million in commercial primarily reflected pay-downs, charge-offs and returns to accrual, while a $3 million decline in consumer primarily reflected returns to accrual.

As discussed during our April earnings call NPLs had increased in Q1 as a result of three credit relationships totaling $34 million. All three credits are progressing as anticipated are in the process of being remediate. Commercial classified loans remain relatively stable at 3.42% of commercial loans and below our five year average of 3.85%. And the $7.3 million provision in the top line exceed a net charge-offs by $6.8 million. As a result the allowance increased to $199.6 million. And as I mentioned, our loan loss coverage remained at 116 basis points.

Lastly, net charge-offs were 16 basis points annualized and continue to be below our five year average of 31 basis points. Overall, our credit metrics remains stable and we maintain a positive forward view on asset quality.

Slide 13 provides our outlook for Q3. We expect the average loan growth to be in the range of 1.5% to 2.5% and we expect average interest earning assets to grow 1% and securities should be flat to slightly down. We expect NIM to be flat to up 2 basis points, driven by higher loan yields, partially offset by lower securities yields, as a result of higher premium amortization. Our projections assume no changes in market rates or deposits rates from today’s levels.

As a result we expect net interest income to increase between $3 million to $5 million. Non-interest income is likely to be up $1 million to $2 million. We expect the efficiency ratio to be in the range of 60% to 62%, given asset quality trends and our expectation for loan growth and portfolio mix, we expect the provision to be closure to Q1’s level. And we expect their tax rate on a non-FTE to be approximately 32%. Lastly, we expect our average diluted share count to be approximately 92.5 million shares.

With that I’ll turn the things back over to Jim.

Jim Smith

Glenn, thank you. I just want to underscore again that we produced the return on shareholders’ equity that exceeded our cost of capital. So we actually reported economic profit for the quarter and were quite please about that. Our strategic management framework, which I think you’re familiar with is a discipline whereby reinvest in businesses that add value for customers and maximize economic profits and shareholder value over time and we allocate our capital and our resources and prioritize our projects accordingly.

We’re excited about our financial performance and our strategic progress and our forward momentum. As you probably aware we’re planning an Investor Relations with special focused on HSA Bank for Wednesday, November 8th in New York City. We originally had announced it to be on the 9th we had to switch it for logistical reason. So, that will be November 8th, and we are very pleased with the initial response and look forward to seeing many of you then. Contact Terry Mangan if you have any questions.

I’ll now open for questions and comments.

Question-and-Answer Session

Operator

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Jared Shaw with Wells Fargo. Please proceed with your question.

Jared Shaw

Hi, good morning everybody.

Jim Smith

Good morning, Jared.

Jared Shaw

Maybe starting with the HSA, it sounds like this quarter the investment discussion sounds a little more aggressive you’re saying aggressive investment in this phase. Is that higher than where we were last quarter going into the end of year or is that just a continuation of what we think?

Jim Smith

This is a continuation and we did discuss this last quarter as well and had reviewed what some others investments maybe. And the point is that because we’re aggressive — investing aggressively in this business, which is our highest strategic priority. It will have an elevated level of expenses over some period of time, which is why you are not seeing the improvement in operating leverage. Though revenue is growing at 20%.

Jared Shaw

And then when you talk about the return or starting to see operating leverage in 2018, should we expect to see that in first quarter during the enrolment cycle? Or is that for the full year or by the end of the year?

Jim Smith

We’re not going to parse it finally Jared, but let’s just say year will be seeing it through 2018.

Glenn MacInnes

Jared hi it’s Glenn and I think part of the challenging Q1 is all the on boarding, collateral, alternative volume marginal cost associated with account volume. So, to Jim’s point I think you’ll see it not necessary in Q1, but thereafter.

Jared Shaw

Okay. And then on the elevated pay-downs that you had in the second how is it trending so far in third quarter? And then on your loan growth outlook for the quarter is that assuming that the loan mix stays flat from where we were the end of this quarter?

John Ciulla

Jared, it’s John, I would say it’s taught to call right now. I think we have a decent amount of prepayment activity plan for the quarter, but not quite as elevated. And I would say there is nothing that would change the mix I think it will still be sort of dominated a bit by Commercial Banking in terms of what drives are growth, as you know we are selling the vast majority of conforming residential mortgages.

But I think the mix you shouldn’t really look for a mix change and I would say prepayments maybe slightly lower as a percentage of originations from what we can see now, but it’s still way too early to make the call.

Jared Shaw

Okay. And then just finally for me, there has been a lot of negative news around the state of the Connecticut economy and Heartwood does that accelerate your desire to add geographic diversity to the loan book, through Boston and Philadelphia and DC and maybe other areas. Or are you comfortable with where we are right now with diversity?

Jim Smith

We are pretty comfortable with the approach that we are taking and have taken over a decade now actually we benefited from the fact that we have had contiguous expansion. Our Community Bank as well as more regional expansion in the Commercial Bank. So we think we are in a pretty good position but to your point is well taken Connecticut over the years has failed to fund its very generous retirement pharmacists, state workers and then overtime that’s translated to not investing adequately in the infrastructure and all that’s coming to head right now, which we think can be a positive.

And let’s remember the Connecticut is one of the top one or two wealthiest states in the country, we have the most productive workforce in the country, high quality of life, great educational system, there are a lot of things that are real assets for Connecticut. So we just have to address this problem.

And I think actually one positive income of the current budget debate is its forcing the legislature to make more responsible fiscal choices and could ultimately lead to higher confidence in a sustainable economic future.

And I would say regarding Heartwood, there has been a lot of talk about would they go back, but this is over about $50 million in total expenses for the next year or so. I just want to say I really admire the mayor for having the courage to be strong for what he believes in and in the end that’s the kind of attitude we need throughout this state in order to get to the best result.

I think John will have a comment on this too.

John Ciulla

Yes, Jared I’d just add. I chair this year’s CBIA which is the largest business association in the state and I think the memberships feels like we haven’t had this much consensus around something needing to get done. So I’d echo Jim’s comments, but I think people are confident that we’re closer to a solution than we have been before.

And while the situation is clearly muted growth, our customers from a credit performance perspective there is no delta between Connecticut and other areas and we’re still adding customers, I will give you just a Commercial Bank anecdote. I think we talked about average loan growth year-over-year in the Commercial Bank being around 10% and in Connecticut we’re up about 5.5%.

So we are not growing as quickly as in Connecticut, but there still is growth, and if you look back 10 years ago, across all of our loan categories we were probably 80% to 90% Connecticut and right now we’re hovering just below 50% in Connecticut. So you think about all the diversification we have done with Boston and providence and white planes in New York and Philadelphia we have done it smartly and it’s in order to everyone’s benefit that we have been doing that for the last 10 to 15 years.

Jared Shaw

Great, thanks for the color. Appreciate it.

Operator

Thank you. Our next question comes from the line of Steven Alexopoulos with JPMorgan. Please proceed with your question.

Steven Alexopoulos

Hey, good morning everybody.

Jim Smith

Good morning, Steve.

Steven Alexopoulos

I wanted to start on HSA Bank, you guys had very strong PPNR growth in the quarter, do you think 30% year-over-year growth is sustainable moving forward, even with the investments you are making back into the business?

Jim Smith

So I think that it did standout as an extraordinarily good quarter, there is a real seasonality quarter-by-quarter. So we’d say 30% is on the high side, I think we’re — we made the point that revenue will probably grow by about 20% in 2017, the expenses will grow at about the same rate. So you could take around as a guide for how PPNR may play out over the balance of the year.

John Ciulla

I think as you look into ‘18 Steve, it could be between 25% and 30% PPNR growth on a full year basis year-over-year.

Steven Alexopoulos

Yes, okay.

Jim Smith

Again numbering, yes some of that will come from operating leverage, but most of it will come from revenue growth.

Steven Alexopoulos

Yes, okay. And then looking at the slowdown of growth in deposits in accounts that we saw this quarter again looking at a year-over-year basis give a little bit of color of what drove the slowdown, these are the growth rates we should be expecting moving forward?

Jim Smith

I am going to ask Chad, to step into that question.

Chad Wilkins

Yes, good morning Steve. On the account side we had total account growth year-over-year of about 18%. And that was impacted slightly by the closure of about 20,000 accounts that should have fallen into 2016. So that was a little bit of a drag. And that was due to yes we were going through partner cleanup of unfunded accounts as we were heading into the end of last year and into the first quarter it just fell into the second quarter.

We shouldn’t expect to see that going forward, we’ve refined that process. But here, other question on what we should expect to see for the rest of the year. I think that in this range that we saw in second quarter is what we should expect on account growth.

On the deposit side, we had 20% footings growth year-over-year and about 16% deposit growth. That was impacted by a higher level of transfers from deposits into investments this year. And we’re not too surprised to see that, we’ve been promoting our HSA is obviously is a great vehicle to plan and save for your healthcare and retirement. And we’ve also improved some of the functionality to make it easier for accountholders to transfer funds into their investments. Both of these I think are competitive advantages we have in the marketplace.

Jim Smith

I’d like to add just one thing that, when you’re looking at comparability and you’re thinking about cleanups, it’s something we’re pretty disciplined about. In fact, we have only 6% of our accounts are unfunded. And you look at the industry, the average is above 20%.

Steven Alexopoulos

Okay, that’s helpful. Thank you. Just one final question on commercial loan growth, looking at the commercial pipeline, which you guys point out on slide four, why has the pipeline contracted so much here? And are you expecting a slowdown on commercial growth in the third quarter tied to that?

John Ciulla

Yes, it’s a great question, Steve. And I — we look at the pipeline. The number right now is really not that out of whack when you look at prior year same quarter, or you look at other factors. The one of the problems where our pipeline just to put it out there is that we’re very disciplined in sales force about it being greater than 50% probability of a close within 90 days.

And so if you look at the pipeline at the beginning of last quarter, our originations were doubled of what our pipeline was in Q2. So I would just — we look at it on a relative basis. I would say there definitely is softness, there definitely is more competition. But we had robust originations first quarter, second quarter in that $500 million plus range in the Commercial Bank.

And we’re confident I think that we can hit the 10% year-over-year annualized growth target in third and fourth quarter. The question is from a timing perspective, is it all in the fourth quarter, what happens in the third quarter. But I wouldn’t look at the pipeline I would say on a relative basis given the size of our franchise and the pipeline not expanding more. You are seeing what the Fed data is showing, which is a slight slowdown. But we feel like we’ve got enough arrows in the quiver and enough regional presence to continue to grow at double-digit.

Steven Alexopoulos

Thanks, John. And thanks everybody for the questions.

John Ciulla

Thank you, Steve.

Operator

Thank you. Our next question comes from David Chiaverini with Wedbush Securities. Please proceed with your question.

David Chiaverini

Hi, good morning.

Jim Smith

Good morning.

David Chiaverini

So, I wanted to follow up on the HSA. So looking at the economics, pre-provision net revenue per average account, last quarter well in the first quarter it was 26.99 and increased to 28 in the second quarter. What type of ramp should — can we expect in that line? And with the backdrop being that the percentage of accounts less than two year still is north of 50%.

Glenn MacInnes

Yes, so it’s Glenn, and thank you for the question. I think there is a lot of moving pieces in that. If you look at it on a per account basis, I think it’s hard to predict PPNR per account because the more successful we are particularly in enrollment rates and the added expense for collateral and onboarding pushed down the average account PPNR. So I’d be hesitant to answer or to provide a forecast on PPNR per account.

David Chiaverini

Okay, great. And shifting gears, the borrowing to add that you mentioned how it’s been trending down, which I think was a great trend. And with the securities guidance of that being flat to down. How low do you expect borrowing to (Inaudible) to go? In fact are you guys are going to take that down to below single-digit?

John Ciulla

I think where we are given that we’re at the lowest we’ve in six years, it will hover around that level. We feel comfortable with where we are from a balance sheet structure standpoint.

David Chiaverini

Okay. And then on the loan loss provision the guidance that it should be closer to the first quarter than the second quarter when looking forward. The first quarter was still much lower than the trend through 2016, looking out do you think that we’re going to get back to that 2016 quarterly trend as we get into 2018 or do you think the first quarter level is going to be where we’re going to be for the next few quarters?

Glenn MacInnes

Well again it’s going to be driven by mix and portfolio growth and I think the guidance going into Q3 is driven impart obviously by asset quality, but also the source of growth and it should shift whereas the first quarter to second quarter it was more residential in growth the shift will be more for the third and fourth quarter on the commercial side.

So I think we’re good at coverage ratio of 116 basis points, I think you could count us being around there. Obviously charge-offs are also going to impact that we’re at a five year historical low on that as well. So…

David Chiaverini

Okay. And then the last one for me is clarification on the loan growth that is the double-digit guidance that’s just for commercial rather than overall loan growth is it that the overall loan growth guidance over the long term at single-digit or I just wanted some clarification there.

Jim Smith

Yes it’s what we’re talking about double-digit clarification it’s commercial loan growth only. And so when you heard Glenn talk about its guidance on loan growth that’s the aggregate of all of our categories.

David Chiaverini

Thanks very much.

Jim Smith

Thank you.

Operator

Thank you. Our next question comes from the line of Collyn Gilbert with KBW. Please proceed with your question.

Collyn Gilbert

Thanks, good morning guys.

Jim Smith

Good morning, Collyn.

Collyn Gilbert

Just starting with HSA and just back to the point that you guys saw greater sort of shift or transition from deposits to investments this quarter and maybe an ongoing trend going forward, do you have expectations to how you see that relationship evolving over the next year or two?

Jim Smith

In terms of the…

Collyn Gilbert

Just the rate of deposits that might be going into investments.

Jim Smith

Sure so we saw in the last several months the number of our customers who have investment accounts is closing in on 3%. So it’s still relatively small portion of the overall population, but they have relatively high balances. And as you know they still keep around $5,000 or so in their account. So they are savings customers as well as investing customers and we have an industry leading offering of investment account.

So we do expect that we’ll be able to accommodate the desire for people to build those balances overtime. So we expect more existing customers to look at that as an option, some of the newer customers may as well. But remember that the total right now is less than 3%.

We expect that overtime that number probably move up closer to 5%. So you noted that we had $53 million shifted versus $33 million, which is a higher proportion than the growth in deposits overall. So it’s clear that the investment portion is going to grow faster than the deposit portion going forward, which is why we’re focused on total footings.

Collyn Gilbert

Okay, that’s helpful. And then just in terms of the outlook for 2018 again speaking on the HSA theme, I understand that you’re not in a position to necessarily quantify specifics, but maybe could you just talk a little bit more broadly big picture kind of what you see as variables to drive performance in 2018?

Jim Smith

Well performance will of course be driven by our success in on-boarding new larger employers, which will stimulate account growth as well as broaden the universe for our future account growth as well. We will continue to make these investments that we’ve been describing to you, which are a significant portion of the overall expense base through 2018 that will be overcome by revenue growth we think increasingly, which is why we think there could be some improvement in the operating leverage.

So I think the best guidance we can give right now is to say that we’re running an efficiency ratio that’s probably in the low 60s that ratio will probably improve as we start to generate some operating leverage in 2018.

Collyn Gilbert

Okay. So as we again lot of moving parts of the business I know and Glenn to your point on PPNR is a tough metric I think for us to sort of track given the seasonality, should we be in the shift that we’re seeing from investments to deposits should we be honing in maybe on kind of account growth is maybe the base line measure for sort of success and trajectory here do you think?

Jim Smith

I would say, you can step back and look at it from a total full year PPNR standpoint. And you could look at 2017 as having PPNR close to 20 plus little over 20% and then it ramping up in 2018. To Steven Alexopoulos’ question, somewhere between 25% and 30%. And I think that’s when you start hitting your stride as far as both on leverage on expense as well as account growth and balance growth.

Collyn Gilbert

Okay, okay. Okay, that’s helpful. And then just John, question for you, you had indicated that the yield on new loans was up 45 basis points. I’m sorry, I missed the timeframe that you were referring to, I presume…

John Ciulla

Yes, Collyn that was specific to business banking. So our $1 billion plus small business lending portfolio year-over-year and that yield and improvement occurred because of a change in mix to more longer term C&I away from some smaller owner occupied and investment CRE loans. As well as increases in LIBOR and more LIBOR based rates. So that was specific to that one portfolio.

Collyn Gilbert

Got it, okay. That’s helpful, okay. And then just finally on Boston, Jim, you had indicated that you guys expected breakeven to occur late next year. Do I misunderstand, I thought that that was going to be happening at the end of this year. Maybe just talk a little bit about some of the dynamics going on with Boston, if you could?

Jim Smith

Sure, I will Collyn. The fact that I think it was either a quarter or two ago, we indicated that our initial view had been that we could wear out the EPS drag at about a penny a quarter. And we said in the October call, that as we look ahead particularly given sensitivity on deposit pricing at all that, that probably would be about half a penny a quarter.

And if you play that out that put you in about the fourth quarter of 2018 for a breakeven. So we don’t want to go crazy on the deposit gathering side, but we do want to pick our spots and decide where we want to be aggressive. And we are seeing that our loan originations are benefiting from the fact that we have the retail presence in that market as well.

So we said, we’ll be at $1 billion in deposits and $0.5 billion in new loans by the end of the fifth year. We still are highly confident that will occur. And we’re moving along the path of getting to breakeven by at about half a penny a quarter. So we’re late 2018 on that and as I indicated the net drag into two was about $0.02 with an impact on the efficiency ratio of about 1.5%.

Collyn Gilbert

Okay. Okay, that’s helpful. Thank you, guys.

Operator

Thank you. Our next question comes from the line of Mark Fitzgibbon with Sandler O’Neill. Please proceed with your question.

Mark Fitzgibbon

Good morning, guys.

Jim Smith

Good morning, Mark.

Mark Fitzgibbon

The first question I had is sort of follow up to Collyn’s question. Could you — I know your goals of $1 billion in five years of loans and deposits in Boston. But where do you stand today? Can you update us on those balances?

Jim Smith

Sure, I indicated in my comments that we’re at $340 million in attributable deposits and $240 million in loans.

Mark Fitzgibbon

Okay, great. And then secondly on the HSA business, it looks like the number of accounts in the HSA business went down by about 13,000 during the quarter. Chad, could you sort of clarify what was driving that?

Chad Wilkins

Yes, good morning Mark. As we were preparing our Q2 results, we recognized an error that was made in our account number count in the first quarter. We included about 17,000 notional accounts in that number. We’re really just reporting out on HSA growth. So we back that out of the first quarter number. That’s really the cause of that to correct that error.

Mark Fitzgibbon

Okay, thank you.

Chad Wilkins

And the other thing I’d say that really wasn’t material to the period account growth. We were still at over 20% year-over-year growth for the period.

Jim Smith

And Mark I hope you heard earlier that we were talking about those that we do an account cleanup with our partners that also had an impact.

Mark Fitzgibbon

Thanks, Jim.

Operator

Thank you. Our next question comes from the line of Matthew Breese with Piper Jaffray. Please proceed with your question.

Matthew Breese

Good morning, everybody. I just wanted to talk a little bit about the margin trajectory longer term given the shape of the yield curve and perhaps the Fed not raising rates as quickly as we want. So I just wanted to get a sense for I know the margin next quarter is positive, but should we continue to see 1 to 2 basis points or flat to 2 basis points of expansion thereafter and for how long, if things are looking same?

Jim Smith

Yes, so if I look at the rates and I have to say nothing happens for the rest of the year, meaning Fed funds stay at 125 and the tenure [ph] stays at 225 and I work it all the way through the next increase we’re factoring on is a potential December 14th increase, but there is only like a 40% chance for that now.

But if I strip that out, you would still see NIM go up slightly in the third quarter and then slightly down 1 or 2 basis points over the next — into the fourth quarter. And really what’s driving that is we continue to benefit from the loan balances the yield on the loans continue to increase impart because of the June increase. So you would expect if our total loan yield was 404 you would expect that to go up going into the third and fourth quarter on the commercial, consumer and resi side. On the offset to that would be on the security side and it really driven by where the tenure is right now, and the fact that our securities yield will go down from 304 to 283.

And so that would be part of the offset, and of course the wild card is always going to be deposit costs and we haven’t seen anything moving beta besides government deposits in that, we wouldn’t expect that to happen if rates stay exactly where they are today.

Matthew Breese

Understood, okay. That’s great detail. And then loan growth this quarter compared to the outlook obviously an upward trend, I just wanted to get a sense for where the confidence is in terms of segment announces or geography, are you expecting better growth in some of your markets and what those are?

John Ciulla

Matt this is John. I don’t think we really have a sense, as we said you heard the discussion around Connecticut being a little bit weaker than some of our other markets. So that trend should continue depending on what happens in the state. But I don’t think there is any other specific geographies, Boston and New York have been really strong for us, Philadelphia on commercial real estate.

We continue to be really deliberate and cautious in new markets to make sure we are not sort of being the lowest common denominator in any market, but I think as we have talked about with asset based lending and equipment finance and commercial real estate and business banking and our sponsor in specialty with low our industry segments and our sponsor relationships. We have got for this portfolio of levers and in anyone quarter with episodic capital market activities and underwritings and transactions that we’re winning or losing.

We feel pretty confident that across the portfolio of activities, we will be able to hit that annualize double-digit loan growth. And that’s our target and if things continue to soften and soften that could change, but given where we are now and prepayments that we are looking at that’s still our target strategy.

Matthew Breese

Understood. And then maybe along those lines just looking at the pace of commercial real estate growth, which has slowed down a bit the last two quarters, should we expect that to reaccelerate? And as a second part to the question, how do you view the overall health of commercial real estate in various segments, but particularly retail, how is that holding up on for you?

John Ciulla

So, that’s a multi-part question, but I think commercial real estate has been more challenging it has been more competitive for the first time where we have seen non-bank shadow bank lenders and the C&I space were starting to see their funds go into commercial real estate because their investors are requiring lower returns or seeing more competitive new entrance into the competition we’re seeing life companies be more aggressive again.

So the number of high quality looks that we get are down slightly and the prepayment are also up a bit because we are seeing some of our investors decided to move in trade properties. And we don’t know really whether that’s a signal that they feel like values are full or what’s happening there. Credit quality remains extremely strong in the sector, we remain and are ahead of commercial loans, so I always was mentioned I recall Bill Ryan who has been doing this for a long time here.

Is remaining discipline with respect to this return, so we are not chasing bad quality deals or given away the store from the price perspective. So I think that one area as we go into the third and fourth quarter, may not have the 10% annualize loan growth, but again across the portfolio I think we can offset that.

With respect to retail, we have never been a strong retail ICRE lender it’s about in our Commercial Banking ICRE portfolio represents less than 15% — 15% of the in total portfolio that’s 15, and within that it’s mostly grocery anchored or necessity reset retail we don’t have a lot of discretionary retail or big box exposure. So, in our portfolio we don’t think that the retail is going to hurt actually very much, but certainly across the industry with respect to malls and some other retails there is going to be softness going forward.

Matthew Breese

Very helpful. That’s all I had. Thank you everybody.

Glenn MacInnes

Thank you.

Operator

Thank you. Our next question comes from the line of Casey Haire with Jefferies. Please proceed with your question.

Casey Haire

Thanks, good morning, guys. Nice improvement in the efficiency ratio this quarter. Glenn the guide for 3Q is pretty wide especially with NIM expectation up and more balance sheet growth. I’m just curious why the wide range and what’s stopped momentum from continuing, are you guys just giving yourselves run for investment into HSA or Boston, just a little color would be helpful?

Glenn MacInnes

Yes, good morning. Primarily it is in the HSA side where we continue to invest in the business. So, that will continue to keep the efficiency ratio a little high. And then we may see some softness on the fees we got it to $1 million to $2 million, but a lot of that’s contingent on commercial activity. And so we monitoring that and that’s sort of hard to predict whether that volume comes in, whether some syndicate or just swap fee income, thing like that that we’ve seen slowdown along with the commercial loan growth.

So, sort of hard to predict some of that we feel the net interest income as I’ve given guidance $3 million to $5 million goes pretty good right now. So, that’s really — those are really the drivers.

Casey Haire

Okay, great. And Glenn, you mentioned premium amortization as a headwind to the margin, what kind of forward curve do we need to see that premium amortization headwind abate?

Glenn MacInnes

So, I think from an amortization standpoint worth the slowdown in our speed came down to like 12.2, but if we had a plus 25 basis point movement in the curve that would flatten that out.

Casey Haire

Okay, great. And then just housekeeping question, I apologize if I missed this, what was the premium amortization in the second quarter and then whether there are any loan prepayment penalties implied in the yields in the second quarter?

Glenn MacInnes

We had about — the premium amortization in Q2 was a little over $10 million, which is down from Q1 11.2, but as you know the guidance going into Q3 is that it takes 60 to 90 days for rates to find their way answer the premium amortization. Second part of your question was on prepayment I think core Q1 and Q2 are basically flat.

Casey Haire

Okay, great. Thank you.

Operator

Thank you. And our next question comes from the line of Jared Shaw with Wells Fargo Securities. Please proceed with your question.

Jim Smith

Jared, good morning.

John Ciulla

Welcome back, Jared.

Jared Shaw

Just have a quick question on the HSA, PPNR. Did you change the FTP credit at all given the moving rates and if you did or didn’t would you anticipate, seeing that change over the next 12 month at all?

Jim Smith

So, I will give some color, so it does widening as we look at the forward curve, but by a couple of basis points and growing into Q2 I think the FTP rate was up probably about 5 basis points. And then that will fluctuate with LIBOR. So obviously as we saw the increase in LIBOR and the average LIBOR being up 22 basis points of some of that gets passed through the HSA.

Jared Shaw

Okay. So that 5 basis point increases that from first quarter or is that year-over-year?

Jim Smith

Q1 to Q2. So the way we look at funds transfer pricing as we have the transactional fees, which is primarily floating and tied to LIBOR and then we have a longer-term fees which is tied closer to the longer end of the curve or the FHLB curves. So there is two pieces to that, two components to that.

So when you have the LIBOR curve you get some portion. So if for instance the average one month LIBOR was up 22 basis points some portion of that finds its way into the HSA funds through this [ph] for pricing rate and then movement in the FHLB curve would also impact the rate.

Jared Shaw

Okay. And then I am assuming…

Jim Smith

And I’m sorry that it actually does widen going into 2018.

Jared Shaw

Okay. So, I guess one as that widens that you are incorporating that into your expectation for about 25% to 30% growth in PPNR in ‘18?

Jim Smith

Yes.

Jared Shaw

Okay. And then does that also impact the commercial lending and the community banking side as much or not as much?

Jim Smith

Yes, I think if you were to look at our total book and you were to say how much hours it’s put out I look at — if you look at loans we have about $6.2 billion that’s tied to one month LIBOR another $1.2 billion and this is on the lending side that’s tied to three month LIBOR and $2.6 billion that’s tied to prime. So those are all moving with short-term rates. And then if you go out from that the remaining fees the biggest part three to five years we have about $5.3 billion in loans.

So if I look at the total balance sheet on the asset side there’s about $6.6 billion that’s tied to one month LIBOR meaning that’s floating and about $1.7 billion to three month LIBOR and $2.6 billion to prime.

And so if you think of our earnings assets is $24.5 billion say, you can get a sense of how much is floating versus how much is tied to the longer end of the curve with the biggest portion obviously being on the security side, which is closely tied to the tenure.

Jared Shaw

Great, thanks a lot appreciate it.

Jim Smith

Thank you, Jared.

Operator

Thank you. There are no further questions at this time. I would like to turn the call back over to Mr. Jim Smith for closing remarks.

Jim Smith

Thank you, Michel. And thank you all for being with us today. Hope to see you in November.

Operator

Thank you this concludes today’s teleconference. You may disconnect your lines at this time, thank you for your participation and have a wonderful day.

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