KBRA Affirms Ratings for ConnectOne Bancorp, Inc. Following Acquisition Announcement

KBRA affirms the senior unsecured debt rating of BBB, the subordinated debt rating of BBB-, the preferred stock rating of BB+, and the short-term debt rating of K3 for Englewood Cliffs, New Jersey-based ConnectOne Bancorp, Inc. (NASDAQ: CNOB) ("ConnectOne" or "the company") following the recently proposed merger announcement with The First of Long Island Corporation (NASDAQ: FLIC). In addition, KBRA affirms the deposit and senior unsecured debt ratings of BBB+, the subordinated debt rating of BBB, and the short-term deposit and debt ratings of K2 for its subsidiary, ConnectOne Bank. The Outlook for all long-term ratings is Stable.

Key Credit Considerations

On September 5, 2024, ConnectOne Bancorp, Inc. and The First of Long Island Corporation announced the signing of a definitive merger agreement in which the companies are expected to combine in an all-stock transaction that is projected to close in 2Q25. The First of Long Island Corporation is expected to merge with and into ConnectOne, and FLIC’s bank subsidiary, The First National Bank of Long Island, will merge with and into ConnectOne Bank. The transaction was valued at $284 million or $12.40 per share based on the closing common stock price of $23.97 for CNOB on September 4, 2024, which reflects a price-to-tangible book value (TBV) of 74% based on FLIC’s TBV as of 2Q24. Altogether, this appears to be an economical deal for ConnectOne, with relatively attractive pricing considering recently priced KBRA rated bank deals, as well as FLIC’s strong core deposit base and exceptional asset quality performance over a long period of time. There are no changes expected to the executive management team following the closing of the transaction, though Christopher Becker, FLIC’s current CEO, is planning to serve as Vice Chairman of the combined Board of Directors. Moreover, two additional independent Board members from FLIC will join the combined Board. ConnectOne had plans to potentially organically surpass the $10 billion in asset threshold in 2025, though with the addition of FLIC’s $4.2 billion of assets, the company is projected to reach approximately $14.0 billion in assets on a pro forma basis. This provides meaningful scale and cost-savings to offset the incremental expenses and loss of revenues that are created from jumping over that hurdle, though admittedly, CNOB was not going to be overly impacted given its minimal amount of interchange income and proactive investments previously made into its compliance and operational risk functions.

From a geographical perspective, the proposed deal strengthens ConnectOne’s presence in the Long Island region, which we believe is a market that reflects favorable demographics and is economically diverse, and was a location that the company was actively growing in recent years, including its first branch opening in 2018. The combined institution will reflect more diversity, with total deposits situated in the New Jersey market decreasing from 91% to 62% on a pro forma basis. Moreover, Long Island is expected to reflect 30% of total deposits, including the 4th and 5th largest deposit market shares in Nassau and Suffolk counties, respectively, among banks with less than $100 billion in assets. With respect to the balance sheet, the combined institution will also reflect a more diverse loan portfolio, including a decreased concentration of CRE, which is projected to decrease to 63% of total loans from 68% on standalone basis for CNOB. While the exposure to investor CRE should remain relatively elevated at 476% of total risk-based capital versus 434% pre-merger (as of 2Q24), the concentration is expected to decrease with the anticipation of a subordinated debt issuance of $100 million prior to merger close. Moreover, the concentration should also naturally decline as capital ratios are rebuilt through internal capital generation following the closing of the transaction. Management plans to continue to emphasize C&I/business lending, which also has the potential to decrease the investor CRE exposure over time. ConnectOne’s deposit base is expected to be meaningfully enhanced by the addition of FLIC’s high-quality deposit franchise that has reflected a lower-beta through the cycle thus far, including an average cost of 2.18% during 2Q24, which is considerably lower than other NY metro peers and the median for KBRA publicly traded banks (2.40%). While the deposit base will remain slightly weaker than similarly rated peers, it will move closer to the peer average in terms of mix and overall costs (2.94% on a combined basis). The liquidity position is projected to improve as well, with the loan-to-deposit ratio falling to 104% on a pro forma basis, though will remain slightly higher than peers. Management noted that they are focused on reducing the ratio prospectively and through continued C&I growth and other deposit initiatives; the combined loan and deposit growth should be fairly robust entering 2025 – in the mid-to-high single digit range.

Given the positioning of both banks’ balance sheets, being primarily liability sensitive with regard to interest rate sensitivity, profitability has been relatively subdued in this higher interest rate environment, with both institutions reflecting considerable NIM compression since the start of the Fed’s QT measures. With that said, FLIC and CNOB both reported a NIM trough in 1Q24, with a reversion occurring in 2Q24. Moreover, ConnectOne and The First of Long Island Corporation are both expected to benefit in a declining rate environment, with both banks projected to experience 5 bps of NIM expansion for every 25 bp rate cut from the Fed. Taking that into consideration, as well as the cost-savings (35% of FLIC’s noninterest expense base), the combined company is expected to reflect ROA of ~1.0% in 2025. Moreover, over time, management expects to return to a more historical level of profitability as further rate cuts transpire and full cost-savings are realized. With regard to credit quality, both institutions have reflected solid metrics in recent years, including manageable NPA levels and nominal NCOs. Moreover, FLIC has reported pristine credit performance over a long period of time, including during the global financial crisis; the NCO ratio has averaged a modest 5 bps from 4Q07 to 2Q24. With the potential headwinds facing the CRE sector, we noted that the exposure is projected to remain above average, and notably the NYC rent-regulated (>50% of units) multifamily portfolio will grow to 7% of total loans, though remain at comfortable levels overall, in our view. Moreover, we believe that the due diligence process was comprehensive and the credit marks on that portfolio are conservative (~7.1% reserve). Additionally, the credit mark (~$67 million or 2.0% of loans) in totality when considering FLIC’s excellent asset quality track-record is considered ample (FLIC’s standalone LLR to total loans was ~0.9% as of 2Q24). Furthermore, management stated that the upcoming maturities in the rent-regulated portfolio are comparatively modest during 2024 and 2025, with the majority occurring in 2026 and 2027. Lastly, exposure to the troubled office sector will remain manageable at approximately 6% of total loans. Due to the material interest rate marks, which have the potential to decrease depending on the magnitude of rate cuts before closing in 2Q25, which are estimated to be $198 million or 6.1% of the loan portfolio at deal announcement, the capital ratios are projected to decrease, with the TCE and CET1 ratios falling to 7.9% and 9.8%, respectively. As previously mentioned, management is planning to issue $100 million of subordinated debt in 2025 prior to the close of the deal, which will be downstreamed to the bank and help reduce the CRE concentration (445% of total risk-based capital following the issuance). Management also plans to rebuild capital ratios post-merger, with the ability to add 50 bps to core capital measures annually. While we recognize that the TCE ratio will remain relatively in line with the rated peer average on a pro forma basis, KBRA expects the CET1 ratio to move closer to peer levels over time.

Rating Sensitivities

The affirmation of the ratings and maintenance of a Stable Outlook reflects our continued favorable view of CNOB’s historical credit quality performance, which KBRA expects to persist in future periods, and generally solid profitability measures over an extended period. Moreover, while we acknowledge that there are inherent risks with acquisitions, these are somewhat offset by management’s proven track-record with successfully integrating transactions and typically outperforming cost-savings targets. In addition, the ratings include our expectation that capital to be rebuilt to historical levels that are closer to peer averages following the transaction close. KBRA believes that the proposed merger provides numerous benefits to ConnectOne, including a more diversified branch network and loan portfolio, as well as a stronger funding and liquidity profile. Over the longer-term, if the transaction is effectively integrated, and management achieves its continued growth targets in C&I, which should bring further diversity and enhancements to the loan portfolio and deposit base, while rebuilding capital to historical levels, including growth in fee income, there could be positive rating momentum.Conversely, if the combined company encounters any unexpected credit problems, experiences degradation in the funding and liquidity position, which potentially causes profitability challenges, or does not rebuild capital as anticipated, then negative rating action could transpire.

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