Earnings Call Transcript - BANC Q3 2022

Operator, Operator

Hello and welcome to Banc of California's Third Quarter Earnings Conference Call. After today's presentation, there will be an opportunity for questions. Today's call is being recorded and a copy of the recording will be available later today on the company's Investor Relations website. Today's presentation will also include non-GAAP measures. The reconciliation for these and additional required information is available in the earnings press release, which can be found on the company's Investor Relations website. The reference presentation is also available on the company's Investor Relations website. Before we begin, we would like to direct everyone to the company's safe harbor statement on forward-looking statements included in both the earnings release and the earnings presentation. I would now like to turn the conference call over to Mr. Jared Wolff, Banc of California's President and Chief Executive Officer. Please go ahead, sir.

Jared Wolff, CEO

Good morning, and welcome to Banc of California's third quarter earnings call. Joining me on today's call is Lynn Hopkins, our Chief Financial Officer, who will talk in more detail about our quarterly results. During the third quarter, we continued to capitalize on the core strength of our franchise, which is our ability to deliver on clients' needs in our markets in an exceptional way. This enables us to consistently add new commercial clients and expand existing relationships, which resulted in growth of noninterest-bearing deposits despite a rapidly rising rate environment that has put a premium on low-cost deposits. The rapid increase in rates and expectation of further rate increases has made for a challenging operating environment, but our core earnings power demonstrated our ability to continue to drive earnings despite a slightly smaller balance sheet, which was primarily a result of lower warehouse balances. Our strong earnings power, combined with the actions we took during the first quarter to mitigate the impact of rising rates on our investment portfolio resulted in growth in tangible book value per share this quarter, excluding the impact of the Deepstack acquisition and even as we continue to implement our stock repurchase program. We recorded another quarter of core double-digit annualized loan growth, excluding warehouse. We experienced a pullback in loan demand toward the latter part of the quarter, as the expectation of further rate hikes weighed on economic activity. While this resulted in a pipeline slowdown in our overall loan fundings coming in below the level we had experienced in the first half of the year, our loan production was at higher rates and the repricing on our variable rate loans resulted in a 19 basis point increase in our average loan yields compared to the prior quarter. Excluding both warehouse and SFR purchases, we had annualized commercial loan growth of 11% during the third quarter. As expected, mortgage warehouse line utilization continued to decline, which we were able to partially offset with purchases of high-quality SFR loans through the relationships with our warehouse clients. Our warehouse unit is best-in-class and continues to manage our portfolio very well. I'm particularly pleased that on an adjusted earnings basis, we were able to earn about the same amount of money as the prior quarter despite a smaller balance sheet. This is consistent with our stated plans to diversify our lending without a decline in earnings. While our margin was flat for the quarter, our margin is expected to expand based on our asset sensitivity to further support earnings growth going forward. The strength of our deposit franchise continues to show through, as noninterest-bearing deposits held at 38% on average for the quarter and grew to 40% at the end of the quarter. During the third quarter, we increased noninterest-bearing accounts by $117 million or 17% annualized. We will look to continue to replace certain deposit relationships and products with higher rate expectations, particularly those that are pegged to the Fed funds rate. This resulted in a decline in interest checking and money market account balances this quarter. Going forward, we will look to continue this growth in noninterest-bearing deposits while balancing our overall funding needs to support future loan growth. We added some longer-term fixed-rate funding in the form of FHLB advances and time deposits to strategically lock in some of our funding costs going forward as interest rates continue to rise. While this had the effect of increasing our cost of funds in the third quarter, we were still able to keep our net interest margin consistent with the prior quarter, which we believe puts us in a better position to realize margin expansion over the next year. While our loan-to-deposit ratio remains around 100%, we are able to manage our balance sheet efficiently, and we observed the net interest margin starting to expand in the latter part of the quarter. As I mentioned earlier, our warehouse business influences our loan-to-deposit ratio based on the variability of line utilization and the level of funding provided directly from this business line. On average, approximately a third to half of our warehouse lending is self-funded. For the third quarter, when warehouse loans and deposits are excluded, our loan-to-deposit ratio would decline from 100% to 96%. While the economy is showing signs of slowing, we have not seen any impact on our asset quality. We have stress tested our portfolio under a number of scenarios involving rising rates and lower valuations with a particular focus on credits that were underwritten three or four years ago that will be coming up for renewal in the next 12 to 24 months. Due to the conservative approach we take at initial underwriting, the stress tests indicate that our asset quality should remain strong even in adverse scenarios. While we continue to deliver strong financial results for our shareholders in the third quarter, we also took another significant step in building long-term franchise value with our acquisition of Deepstack Technologies and entry into the payments processing business. We closed the acquisition on September 15 and have made good progress on integrating Deepstack's technology into our internal platform. We remain on track to complete the integration by the end of Q4 or early Q1, at which point we will begin ramping up our business development efforts and growing the client base in targeted verticals that we expect will make this a high-margin business that also attracts noninterest-bearing deposits. Now let me hand it over to Lynn, who will provide more information on our financial performance.

Lynn Hopkins, CFO

Thanks, Jared. Please feel free to refer to our investor deck, which can be found on our Investor Relations website, as I review our third quarter performance. I'll start with some of the highlights of our income statement and then we'll move on to our balance sheet trends. Unless otherwise indicated, all prior period comparisons are with the second quarter of 2022. Our earnings release and investor presentation provide a great deal of information so I will limit my comments to some areas where additional discussion is warranted. Net income available to common stockholders for the third quarter was $24.2 million or $0.40 per diluted share. Our adjusted diluted earnings per share totaled $0.44 for the third quarter when net indemnified legal costs, acquisition costs and net losses on investments in alternative energy partnerships are excluded. Our net interest margin was unchanged from the prior quarter at 3.58%, as our overall earning asset yield increased by 29 basis points and our total cost of funds increased by 30 basis points. Our interest-earning asset yield increased to 4.33% due to higher yields on both loans and securities during the third quarter. Our average loan yield increased 19 basis points to 4.54% due primarily to higher average yields in our core C&I and warehouse portfolios. The average yield on securities increased 70 basis points to 3.38%, mainly due to the CLO portfolio resetting and reflecting the 125 basis points of Fed funds rate increases that occurred in May and June. With the additional increases in the Fed funds rate during the third quarter, we expect to see further increases in the yields on earning assets during the fourth quarter. Our average cost of funds was 79 basis points, and our average cost of deposits was 47 basis points for the third quarter, both up 30 basis points compared to the prior quarter. The increase in our average cost of deposits was primarily driven by rate increases in our money market and interest-bearing checking accounts, as well as the CDs that were added to lock in some longer-term funding, offset by the positive impact of maintaining average noninterest-bearing deposits at 38% for the linked quarters. Our noninterest income decreased $1.5 million from the prior quarter due mostly to lower income from equity investments that increased our other income by $2.1 million in the second quarter. This decrease was offset by higher loan servicing income, which we anticipate will continue at this increased level in the near term due to the purchase of mortgage servicing rights at the end of the second quarter and the impact of the higher rate environment on such earning assets. Our adjusted noninterest expense increased $247,000 from the prior quarter, primarily with the largest contributor being occupancy and equipment expense. At the end of the third quarter, we consolidated a branch, which is our third branch consolidation this year, generating an estimated $1.5 million in annualized cost savings. Looking ahead to the fourth quarter, we expect our noninterest expense to be in the range of $48 million to $50 million, including approximately $1 million related to Deepstack operations. The effective tax rate for the third quarter was 29.1%, slightly elevated from the prior quarter's rate of 27.9%. The higher effective tax rate decreased third quarter's net income by approximately $500,000. We continue to estimate our annual effective tax rate for 2022 to be approximately 28%. Turning to our balance sheet. Our total assets decreased by $133.5 million in the third quarter to $9.4 billion, while total equity increased by $2.9 million. The increase in total equity was primarily due to the $24 million in net earnings for the quarter, partially offset by higher net unrealized losses in the investment portfolio and capital actions. Our capital actions included common stock dividends and the repurchase of $13 million in common stock under the program we announced in the first quarter of 2022. At September 30, our tangible book value per common share was $13.79 compared to $14.05 at the end of the second quarter. The reduction in tangible book value per share was primarily due to the change in AOCI resulting from higher unrealized losses in the investment portfolio. Our noninterest-bearing deposits remained strong, averaging 38% for the quarter. We intentionally exited certain high-costing deposits in the money market and checking categories, which were replaced in part by longer-term fixed-rate funding through both FHLB advances and wholesale CDs, which we believe will help us better manage our cost of funds in a rising rate environment. This resulted in overall deposits decreasing $278 million during the quarter despite the growth in noninterest-bearing deposits and the CDs added in the quarter. Our credit quality remained solid in the third quarter with nonperforming loans decreasing $1.8 million to $42.7 million at the end of the third quarter. At September 30, 66% of our nonperforming loans were in current payment status but were classified as nonperforming for other reasons or had an SBA government guarantee. We did not record a provision for credit losses in the third quarter given the lower loan balances and favorable trends in asset quality, which offset any impact from weaker economic forecasts. Our allowance for credit losses at the end of the third quarter totaled $98.8 million, and our allowance to total loans coverage ratio stood at 1.36%, which is slightly higher than at the end of the prior quarter. Excluding our warehouse loans, which have a lower relative risk level in our reserve methodology, the ACL coverage ratio stood at 1.47% at September 30. Our ACL and nonperforming loan ratio remained healthy at 232%. At this time, I'll turn the presentation back over to Jared.

Jared Wolff, CEO

Thank you, Lynn. Through the first nine months of the year, we have already delivered on the goals and strategic objectives that we set for 2022. We successfully integrated the Pacific Mercantile Bank acquisition and exceeded our projected level of cost savings. We've continued growing our targeted areas of lending, resulting in loan growth excluding warehouse that has already exceeded our expectations for the full year. We have a strong core deposit franchise with stable and growing noninterest-bearing deposits from commercial clients that continue to increase as a percentage of total deposits. We've capitalized on our asset sensitivity and realized significant expansion in our net interest margin since January, expecting our earnings to benefit from further rate hikes ahead. We've effectively managed expense levels while continuing to add banking talent, expand attractive verticals, and invest in our technology initiatives. We've optimized our use of capital through the redemption of our Series E preferred stock and returned more capital to shareholders through our stock repurchase program, while still growing our CET1 ratio and TCE ratio on a year-over-year basis, remaining very well capitalized and well positioned to manage through economic slowdowns. With the acquisition of Deepstack and our entry into the payments processing business, we have advanced our goal of elevating the client experience and becoming the hub of their financial services ecosystem while adding a business that we expect to provide a consistent high-margin source of fee income, increase the diversification of our revenue mix, grow noninterest-bearing deposits, enhance our business development efforts, and contribute to further increases in our level of profitability and franchise value. Despite the uncertainty in the economy, we expect earnings growth ahead, fueled by a strong and stable base of non-issuing deposits, a solid core loan engine, and asset sensitivity. We continue to add new client relationships that should contribute to further growth in our core loan portfolios and noninterest-bearing deposits. In the coming year, we believe our payments business will become a meaningful contributor. Based on everything we have accomplished this year, we are optimistic about the opportunities to continue profitably growing our franchise in the coming quarters and years ahead while creating additional value for shareholders. Thank you for listening, and with that, operator, let's go ahead now and open up the line for questions.

Timur Braziler, Analyst

Hi, good morning.

Jared Wolff, CEO

Good morning.

Timur Braziler, Analyst

Maybe just starting on balance sheet size. Can you give us your expectations for mainly loans and deposits going forward? How much more of a drag should we expect warehouse to be here in the next couple of quarters? And then similarly on the deposit side. I know you guys took some initiatives to get some hotter money off the balance sheet this quarter. What should we look at or what should we look for on the deposit side as far as side as well?

Jared Wolff, CEO

Thanks, Timur. It's hard to note where warehouse is going to settle down. In the quarter, we were able to continue to fuel loan growth, but we were pretty conservative in the second half. Borrowers obviously were hesitant with rising rates, and there was a little bit of a pause on the real estate side, but we had the opportunity to do plenty of loans. It was better to be a little cautious, and I think that's going to be our posture through the end of the year. It's hard to see the balance sheet shrinking at this point as things have leveled out. We're all expecting another rate increase in November, but things feel like they have stabilized a little bit. I can't predict where we're going to be, but I think we can keep the balance sheet flat. We see ourselves making more money going forward, and there are good opportunities in the investment portfolio. So it feels like we can stay flat, if not grow.

Timur Braziler, Analyst

Okay. And then on the deposit side, that's really impressive what you've been able to do on DDA. You know, 40%, how sustainable is that? We've heard from other banks this quarter, even those that have been able to grow DDA, that there is some seasonality built in, and it's unlikely those balances will remain. Is that reasonable in this environment? Is there any pressure that you're seeing from your client base, either looking to move money elsewhere or wanting some sort of ECR or some other alternative for rates?

Jared Wolff, CEO

It is a challenging environment, and I'm really pleased with what our teams have been able to accomplish. The key for us, we do expect balances to flow out as the economy contracts a little bit, which is what the Fed intends. Some balances may not replenish, which is why one of our focuses is on bringing in new relationships to the bank. We added a slide to the deck showing a dramatic change in terms of bringing new commercial accounts and relationships to the company. It demonstrates we've been doing it very successfully over a long period. While we can't control the balances within clients' accounts, we expect our overall deposit analysis to grow. I want to be clear; we are focused on trends over the course of the year. We had a solid quarter. We expanded our noninterest-bearing deposits, and we protected our tangible book value, which does not get enough credit. We kept our net interest margin flat even though we locked in long-term fixed-rate funding. We didn't hit the earnings expectations due to a slowdown and decline in warehouse. Still, remaining earnings relatively flat on a smaller balance sheet shows we are improving our quality of earnings. So, in terms of expectations for growing noninterest-bearing deposits or low-cost checking, I believe we will do it. However, I can't tell you quarter-over-quarter if it will decline or increase a little bit. But over the course of the year, we will continue to have positive trends.

Timur Braziler, Analyst

Okay. And then maybe one last one if I can. Just looking at warehouse specifically, loan balances have gone down. It seems the deposit side of that relationship has been quite resilient. Are you seeing those deposits that were brought in during peak warehouse balances? Are those all still sticking around, or are you seeing that kind of one-third to one-half funding on the new base? And then to the extent that they are sticking around, how much of a risk is that for them to exit the system, and what type of scenario would drive that?

Jared Wolff, CEO

We have a very resilient warehouse business with a strong team. We continue to expect our warehouse business to be funded one-third to half by balances that it holds. There seems to be very good stability for us in those balances, whether from existing clients or new relationships. It's all fungible money, but we don't expect that to change. If the business grows, we expect that one-third to half will be self-funded; if it shrinks, we expect the same. That answered your question.

Timur Braziler, Analyst

It does. Thank you. I'll step back.

Jared Wolff, CEO

Thank you, Timur.

Operator, Operator

The next question comes from David Feaster with Raymond James. Please go ahead.

David Feaster, Analyst

Good morning, everybody.

Jared Wolff, CEO

Good morning.

David Feaster, Analyst

I just wanted to touch on Deepstack. You guys gave a little bit of color on when the integration is expected and maybe a little bit on the expense front. Could you walk us through your roadmap for this business? What are you currently working on? And how do we get to the point where you're going to generate the revenues you expect? Can you help quantify the revenues that could come from this and talk about the pipeline of clients you are currently engaging?

Jared Wolff, CEO

Thanks for the question, David. The roadmap includes finishing the integration of Deepstack into our company. Currently, all transactions are processed through a third-party bank. We are finishing the integration so that we can process transactions on our own system. We're doing a soft launch this quarter, with the expectation that we'll go live early next quarter, at which point we will be able to start bringing on clients in our pipeline directly. I can't set expectations regarding numbers just yet, as it depends on timing. Once we go live, it will be easier to sequence client onboarding and sizing. The opportunity with Deepstack is meaningful. Moreover, we believe it will provide value to our existing clients. There’s a landscape of new relationships we can bring to the bank targeting services for ISVs, which we think will attract deposits given the nature of the transactions.

David Feaster, Analyst

And when do you think you could start seeing some deposit growth from that? If revenues start mid to late next year, is it really a 2024 event when you could start getting that?

Jared Wolff, CEO

It will absolutely be in 2023. We'll see deposits come in as we bring on clients because of the average balances for the transactions. It will obviously build but should begin impacting next year.

David Feaster, Analyst

Okay. And maybe just touching on demand and how the pipeline is trending. I'm curious what you're seeing across your footprint. It sounds like the slowdown in originations was more strategic rather than higher rates decelerating demand. Just curious about your outlook on that front. What do you expect to be the key drivers of growth considering your more cautious outlook? Do you think it will still be multifamily and single-family residential in the near term?

Jared Wolff, CEO

I don’t see us in the market to buy single-family anytime soon. We feel our focus is fairly full there and it has stabilized the balance sheet as warehouse scales back. Surprisingly, in the markets where we operate, things are pretty resilient. Health care deals continue, and we have good momentum on the entertainment side where deals are still happening. There’s a lot of activity, and we’re just being cautious in stress-tested areas like manufacturing and logistics given inventory build-up. While the Fed intends for the economy to slow, we still see borrowing demand. However, we see the smart play as being careful and protecting the franchise for the long term.

David Feaster, Analyst

Got it. That's good. And then maybe just one last question from me. Just touching on hires, you guys have done a phenomenal job hiring new producers over the past several quarters and adding to new verticals. Just curious how you think about hiring new producers given where we are and what you have going on with Deepstack.

Jared Wolff, CEO

100%. That’s an active part of our business. I had lunch yesterday with someone at a competitor just to make sure we were in front of each other. We will continue to hire talent because we can absorb it. We have a very talented team. For producers and high-quality people, we will continue to add talent.

David Feaster, Analyst

Good. Thanks, everybody.

Jared Wolff, CEO

Thank you, David.

Operator, Operator

Our next question comes from Gary Tenner with D.A. Davidson. Please go ahead.

Gary Tenner, Analyst

Thanks. Good morning.

Jared Wolff, CEO

Good morning, Gary.

Gary Tenner, Analyst

Hey, good morning. You said a few times that the back half of the third quarter loan growth was intentionally slowed ex-warehouse. As you think about fourth quarter and even early next year, does that translate to low single-digit loan growth ex-warehouse for a couple of quarters as you're replacing runoff and bridge loans with new production? Or do you think the organic strength of the business will yield something better than that?

Jared Wolff, CEO

It's hard for me to know, but I don't think that's unreasonable. The economy is slowing down. If we grew double-digit annualized loan growth next quarter, that would surprise me. I think low single digits or even flat are not unreasonable expectations. You don't need to be growing your balance sheet to be making more money. You can be flat and redeploy to a securities portfolio that can yield better. Your margins should expand, as we expect ours to do.

Gary Tenner, Analyst

Okay. I appreciate that. And then regarding the securities portfolio, given where rates are now, would you reinvest cash flows from runoff, or would you consider applying pressure on the funding side?

Jared Wolff, CEO

We've been analyzing that for a while. Lynn, what are your thoughts?

Lynn Hopkins, CFO

I think on the securities portfolio side, with the higher rates, prepayment speeds have slowed. But there is an opportunity for cash flows that are coming off to be reinvested. There is also opportunity for cash flows from other loan portfolios to be deployed into securities for higher yields. Additionally, there’s strategic value in taking down higher-cost variable rate deposits as we grow our noninterest-bearing deposit base. All of this points to margin expansion.

Jared Wolff, CEO

There’s also an opportunity to sell lower-yielding securities and offset that with higher-yielding instruments that would benefit investors long-term. We're considering all options that will benefit investors overall, looking at both short-term and long-term impacts.

Gary Tenner, Analyst

Got it. Appreciate that. Last question, just regarding capital and buybacks. You remain active this quarter; I think you've got around $19 million or so left in the authorization. Given the uncertainty in the environment, how do you view the opportunity to press on the buyback versus being cautious?

Jared Wolff, CEO

We have a lot of capital, and I wouldn't hesitate to use it to buy back stock at attractive valuations. My concern is not making a dent with buybacks, which is why we consider the contribution to our program. However, we have many other uses for capital to generate a high return. But buying back stock is certainly attractive given the values we’re seeing.

Gary Tenner, Analyst

Thank you.

Jared Wolff, CEO

Thank you.

Operator, Operator

Our next question comes from Kelly Motta with KBW. Please go ahead.

Kelly Motta, Analyst

Hi. Thank you. Maybe we could circle back to funding. You mentioned layering in some longer-term fixed-rate funding, some brokered CDs and FHLB. Could you provide more color on what specifically you added in terms of rate and term?

Jared Wolff, CEO

Lynn, do you want to take that?

Lynn Hopkins, CFO

Yes. It was a combination of brokered deposits and FHLB term advances. There was a little bit more inversion in the yield curve so we have about $900 million in these wholesale funds. The FHLB advances are closer to three years with an average rate just under 3%. The recent additions were five-year terms at about 3.70%. Our brokered CDs are shorter-term, averaging around one year, with an average rate close to 2.70%.

Kelly Motta, Analyst

Okay, got it. That allowed you to roll off some of the hotter money. Do you think that after the actions you took this quarter to reset the core deposit base that most of that higher rate money is gone and you're good with what you have? Or is there still potential outflows into the fourth quarter?

Lynn Hopkins, CFO

Several things happened in the quarter. With the higher rates and the pullback on warehouse balances, we were able to let go of some higher-cost deposits. We expect to keep our core deposits and manage any potential growth. It's a long answer to say that I think there's an opportunity to continue to grow our core deposits.

Jared Wolff, CEO

I want to ensure we're clear—if there's another opportunity to lock in fixed-rate funding, we will likely take it if it makes sense. There’s also the possibility of future opportunities.

Kelly Motta, Analyst

Got it. Thank you. One last question for me. I think you mentioned that margin exited the quarter higher than the average rate. Do you have an ending spot NIM on that?

Jared Wolff, CEO

We didn't publish that because a quarter doesn't make a trend. What we saw was stable, and we think that we're asset-sensitive. Everything indicates we will earn more as rates go up, but it’s hard to predict how quickly that will happen. While our marginal trend should continue to expand, we don't want to guide on specific margins.

Kelly Motta, Analyst

Got it. Thank you. I'll step back.

Jared Wolff, CEO

To be cautious, yes. Thanks.

Operator, Operator

Our next question comes from Tony Coffee. Please go ahead.

Unidentified Analyst, Analyst

Great. Thank you. Morning, everybody.

Jared Wolff, CEO

Good morning.

Unidentified Analyst, Analyst

Just got a question on the allowance. Given where it is right now, in conjunction with your outlook on the credit market and the structure of the non-accruals, do you feel like this is a sufficient level as the allowance is right now? Or do you think it needs to be higher?

Jared Wolff, CEO

We believe it is sufficient. We've stress-tested our portfolio, and we don't see any credit concerns. Our portfolio is very well underwritten and secure. So we believe our allowance is healthy.

Unidentified Analyst, Analyst

Okay. And regarding the efficiency ratio, I think that was previously expected to improve. Has the interest rate environment changed that outlook at all?

Lynn Hopkins, CFO

I think there remains room for improvement, and based on our investment in Deepstack and the higher interest rates, I'd expect our efficiency ratio to remain stable or slightly improve.

Unidentified Analyst, Analyst

Okay. Those are my questions. Thank you very much.

Jared Wolff, CEO

Thanks.

Lynn Hopkins, CFO

I apologize; I got disconnected at the end of Kelly's question. So I did join back in with Tim.

Operator, Operator

And the next is a follow-up from Timur Braziler. Please go ahead.

Timur Braziler, Analyst

Hi. Thanks for the follow-up. Just one more for me. It looks like the spot rate on deposits isn't too different than the reported 47 basis points, so 56 basis point spot rate versus the 47. Is that any indication that some of the higher deposit costs were implemented earlier in the quarter and then betas slowed throughout the quarter? And how should we be thinking about the pace of deposit betas going into the fourth quarter and then through '23?

Lynn Hopkins, CFO

Great question and observation. With the rapid increase in interest rates and how we've managed the deposit base with growth in noninterest-bearing, exiting some of our variable rate deposits moderated our deposit betas around 25%. With the last rate hike in September, I think our deposit betas will likely remain in that 25% to 30% range. Keeping in mind that with 40% noninterest-bearing deposits, we can handle fluctuations in the spot rate.

Timur Braziler, Analyst

Great. Thanks for the clarifications.

Jared Wolff, CEO

Thank you.

Operator, Operator

This concludes the question-and-answer session, and the conference has also now concluded. Thank you for attending today's presentation. You may now disconnect.