Bridgewater Bancshares Inc Q3 FY2023 Earnings Call

Good morning, and welcome to the Bridgewater Bancshares 2023 Third Quarter Earnings Call. My name is Debbie, and I'll be your conference operator today. All participants have been placed in listen-only mode. After Bridgewater's opening remarks, there will be a question-and-answer session. Please note that today's call is being recorded. At this time, I would like to introduce Justin Horstman, Director of Investor Relations to begin the conference call. Please go ahead.

Thank you, Debbie. And good morning, everyone. Joining me on today's call are Jerry Baack, Chairman, President and Chief Executive Officer; Joe Chybowski, Chief Financial Officer; Jeff Shellberg, Chief Credit Officer; and Nick Place, Chief Lending Officer. In just a few moments, we will provide an overview of our 2023 third quarter financial results. We will be referencing a slide presentation that is available on the Investor Relations section of Bridgewater's website. Following our opening remarks, we will open the call for questions. During today's presentation, we may make projections or other forward-looking statements regarding future events or the future financial performance of the company. We caution that such statements are predictions and that actual results may differ materially. Please see the forward-looking statement disclosure in our 2023 third quarter earnings release for more information about risks and uncertainties which may affect us. The information we will provide today is as of and for the period ended September 30, 2023, and we undertake no duty to update the information. We may also disclose non-GAAP financial measures during this call. We believe certain non-GAAP financial measures, in addition to the related GAAP measures, provide meaningful information to investors to help them understand the company's operating performance and trends and to facilitate comparisons with the performance of our peers. We caution that these disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP. Please see our 2023 third quarter earnings release for reconciliations of non-GAAP disclosures to the comparable GAAP measures. I would now like to turn the call over to Bridgewater's Chairman, President and CEO, Jerry Baack.

Thank you, Justin, and thank you everyone for joining us today. I'll start with a quick overview of the third quarter, which had several encouraging trends. First, after net interest margin compression began to slow in the last quarter, we're pleased to begin seeing stability in the margin during the third quarter. While the margin declined eight basis points quarter-over-quarter, we saw signs of stabilization on a month-to-month basis throughout the quarter. Joe will talk more about the margin dynamics shortly. Second, given the prolonged higher interest rate environment, we've been focused on enhancing our balance sheet composition to set us apart for longer-term profitability and success. Concentrated efforts are being made to build our deposit base, reduce our reliance on higher-cost borrowings, and slow our pace of loan growth in the near term. For the second consecutive quarter, we saw improvements in our overall funding base as core deposits increased 11% on an annualized basis and total borrowings declined 30% from the second quarter with no overnight borrowings at quarter-end. While we have a long track record of generating robust and profitable loan growth over the years, we have intentionally slowed the pace of loan growth in 2023 and actually saw balances decline slightly in the third quarter. While this was due in part to an uptick in payoffs and paydowns during the quarter, we are also being more thoughtful about our growth in the current environment. As a result, we expect more limited loan growth in the near term, combined with growing deposits and capital, reducing the loan deposit ratio and stabilizing the net interest margin. This will give us the ability to generate profitable growth when the environment becomes more favorable. Bridgewater has always been a growth engine and we certainly don't see that changing. However, we believe being more selective today will position us better for the long term. Expenses remain very well controlled on a year-to-year basis. However, as expected, we saw an increase in non-interest expense in the third quarter, primarily related to ongoing investments we're making in our people. Lastly, asset quality remains superb with just one basis point of net charge-offs, consistently low levels of non-performing assets, and stable levels of watch and substandard loans. While we continue to be proactive and diligent on this front, we remain pleased with the performance and quality of our loan portfolio. In addition to these encouraging trends, our overall focus remained on driving steady, tangible book value growth for our shareholders, which we have done for 27 consecutive quarters. In fact, only 12% of banks between $3 billion and $10 billion in assets have been able to grow tangible book value each of the past eight quarters. Before I hand it over to Joe, I want to take a minute to share some additional insights into other activities happening across the bank. The BWB culture remains a focus. Engaged team members translate to better service, less turnover, and ultimately a more committed workforce. We see great engagement with our team members. Participation in events including health and wellness, mentorship, diversity, equity, and inclusion, and volunteering remains high and turnover remains well below industry norms. We continue to receive recognition locally and nationally for our culture. In addition, we are continuing to proactively engage with existing and potential clients, which includes expanded outreach to targeted verticals in commercial and industrial sectors. We indicated at the beginning of the year that commercial and industrial sectors were a focus for us and we're making inroads in certain niche areas where we have strong connections, like women-led businesses and entrepreneurs and companies running on the EOS operating system. Networking is something we do better than anyone and we are using this strength to extend outreach into these opportunities. While we are still in the early stages, we have had early success in creating new commercial and industrial opportunities. Being efficient has always been important to BWB. Investments in technology, specifically streamlining workflows are creating efficiencies across the business. Investments in our project management function are ensuring we execute effectively on large internal initiatives and reap the rewards as soon as possible. While the overall environment remains challenging for many banks, I remain very optimistic about how Bridgewater is positioned moving forward. With that, I'm going to turn it over to Joe.

Thank you, Jerry. Turning to Slide 4, the net interest margin declined just eight basis points to 2.32% for the third quarter. This compared to our September standalone margin of 2.30%, which was down just three basis points from the standalone margin of 2.33% in June. Even more encouraging is the margin showed signs of stabilization on a month-to-month basis during the quarter. The chart in the bottom right shows the trend in monthly core margin compression, which excludes loan fees as they can be lumpy from month to month. After seeing several months of mid-teens margin compression in late 2022 and early 2023, we saw gradual slowing begin in the second quarter of 2023. This trend continued into the third quarter with the core margin remaining relatively stable throughout July, August, and September. This was driven by a moderation in rising funding costs as core deposits grew and borrowings declined, coupled with the continued slow but steady increase in earning asset yields. We expect the quarterly margin to stabilize over the near term as the compression continues to slow, keeping in mind that funding costs are and will remain under pressure given other market alternatives. As we've mentioned in the past, the margin outlook is dependent on several factors including future changes in interest rates, the shape of the yield curve, and the pace of core deposit growth. Slide 5 shows the various components of the margin. Portfolio loan yields moved higher and should continue to do so for the foreseeable future. As we look ahead, we have over $500 million of fixed and adjustable-rate loans scheduled to reprice over the next year, and nearly $600 million of variable rate loans efficiently floating. Another factor here is loan fees, which have had around a ten basis point impact on the aggregate portfolio loan yields over the past few quarters. However, this is down meaningfully from our 30 basis point run rate in mid-2022 as payoffs have declined and subsequent deferred loan origination fee realization as well. In addition to loan yields, the yield on our securities portfolio has also continued to increase, up 15 basis points from the second quarter to 4.39%. While loan growth has been more muted, we have continued to grow the securities book with period-end balances up 11% annualized during the third quarter. Keep in mind that we do not have any health and maturity securities. While rising funding costs continued to outpace earning asset yields, the rising cost of funds has slowed meaningfully. This was largely due to strong core deposit growth and a decrease in our reliance on borrowings and overnight money. In fact, our overall funding costs increased just 19 basis points in the third quarter, compared to a 50 basis point increase in the second quarter. That said, funding costs are still under pressure, and we expect to see deposit costs continue to move slowly higher, given competition from other banks and non-bank alternatives, and the Fed's uncertain interest rate outlook. Turning to Slide 6, we have demonstrated a long track record of strong revenue and profitability. While this has been a more challenging revenue environment due in part to our spread-based model, we saw signs of stabilization in the third quarter both in terms of net interest income and total revenue. Non-interest income increased in the third quarter, primarily due to $493,000 of FHLB prepayment income, similar to what we saw in the first quarter. Turning to Slide 7, expenses have remained very well controlled year-to-date. After a 6.7% decline in the first quarter and an increase of just 1.4% in the second quarter, we indicated that we would see an increased pace in the second half of the year. This was the case as non-interest expense increased 6.7% in the third quarter, the majority of which was related to incentives across the entire employee base. Historically, our non-interest expense growth has tracked closely with asset growth. On a year-to-date basis, non-interest expense in 2023 is up just 6% from 2022, below our year-over-year asset growth of 10.4%. Even with our expense discipline, our efficiency ratio has increased into the mid-50% range due to the ongoing revenue headwinds. We still maintain a highly efficient operating model relative to other banks and expect that to remain the case. Overall, we feel good about our ability to control expenses while still making key investments in the business and our people. With that, I'll turn it over to Nick.

Thanks, Joe. Turning to Slide 8, deposit growth was a highlight for the second consecutive quarter. Total deposits increased 10.8% annualized during the quarter, including $70 million of core deposit growth or 11% annualized. To supplement our core deposit growth, we added $27 million of broker deposits consistent with the funding strategy we've had in place since the bank was founded. When combined with core deposits, this helped to offset the liquidation of $195 million of higher-cost overnight borrowings during the quarter. In terms of our deposit growth outlook, it's important to remember that the nature of our deposit base results in longer client acquisition and onboarding times. We remain confident in our ability to continue deposit momentum over time as our pipelines remain strong. However, deposit growth can fluctuate quite a bit from quarter to quarter with the growth often not being linear. That said, over the past two quarters, we have added over $115 million of core deposits, which speaks to the strength of our bank, our brand in the Twin Cities, and the relationships we have developed with our clients. Turning to Slide 9, loan growth came in lower than we were expecting as balances declined 1.5% annualized during the quarter. This was largely due to higher than expected payoffs and pay downs, which increased $67 million from the second quarter. Had payoffs and paydowns remained consistent with second quarter levels, loan growth would have been 5.6% annualized, much closer to our expectations. However, as Jerry mentioned earlier, we have taken a more thoughtful approach to our near-term growth strategy to optimize profitability over the longer term. This includes a continued focus on supporting our core clients in the current environment while being more selective on new client relationships. We are still seeing loan demand in the market that would support a higher growth rate today, but to do so, we would need to compromise on pricing and bring in more higher-cost funding. Given where we are in the credit cycle, it doesn't make sense from a profitability standpoint. Ultimately, this presents a good opportunity for us to continue building on our deposit momentum and improve our loan-to-deposit ratio in the near term. In fact, over the past two quarters, we have lowered our loan-to-deposit ratio from 108% to 101%. As this ratio improves, we will be better positioned to deploy capital into more robust loan growth when the environment is more favorable. Turning to Slide 10, you can see that while new loan originations and advances have declined, year-over-year, they rebounded over 20% in the third quarter. Payoffs and paydowns have been on a similar trajectory with steady declines over the past year. But as we've mentioned, there was a notable increase in the third quarter as interest rates began to stabilize. We also continue to use loan participation as a tool to manage our loan growth, including the sale of $134 million year-to-date. On Slide 11, you can see there was not a lot of movement in the various loan portfolios given relatively stable loan balances during the quarter. The movement we did see was primarily related to balances migrating from construction to multifamily as these projects completed their construction phase. Overall, we remain comfortable with the diversification we have across our loan portfolio. With that, I'll turn it over to Jeff.

Thanks, Nick. Turning to Slide 12, we continue to feel good about our asset quality. As non-performing assets remained at very low levels, making up just 0.02% of total assets at the end of September, net charge-offs were just one basis point with cumulative net charge-offs of just $446,000 since 2019. We again had virtually no loans 30 to 89 days past due. All of this is largely due to our measured risk selection, consistent underwriting standards, active credit oversight, and experienced lending and credit teams. While we are still not seeing early signs of credit weakness, the higher-for-longer interest rate environment is putting pressure on businesses, which will likely result in credit normalization over time. We also remain well-reserved at 1.36% of gross loans. We had no provision for credit losses during the quarter, given the stable loan balances, but we did have a negative $600,000 provision for unfunded commitments, which are primarily construction loans. As we continue to fund these commitments, and with our limited loan growth outlook, we would expect to continue to see lower provisions in the near term, depending on the economic conditions and our overall credit quality. On Slide 13, you can see that our watch and substandard loans remained relatively stable during the quarter. Overall we feel good about the risk profile of the portfolio and feel it is well positioned moving forward. Turning to Slide 14, we provide some more information on our commercial real estate and office portfolios. The majority of our non-owner occupied commercial real estate book is fixed rate which helps from a repricing risk standpoint. We continue to actively engage with our clients that have maturing loans or resetting rates over the next 12 months to identify possible cash flow strains and recommend solutions early in the process if necessary. We have completed this process for loans maturing or repricing in 2023 and are now focusing on our 2024 loans. As of quarter-end, we had $195 million in non-owner occupied commercial real estate office exposure, which is about 5% of total loans. This includes only four loans located in the central business districts totaling $35 million. We continue to monitor this portfolio closely and we feel good about the outlook given the lower average loan amount, diversified client base, and primarily Midwestern suburban office exposure. Overall, we haven't noticed any material changes in these portfolios, since the last quarter and they continue to perform well. I'll now turn it back over to Joe.

Thanks, Jeff. Turning to Slide 15, you can see that our liquidity profile has continued to improve throughout the year. At the end of the third quarter, we had $2.2 billion of on and off-balance sheet liquidity, a robust 2.7 times the level of our uninsured deposits. Slide 16 highlights our tangible book value growth and strong capital ratios. Tangible book value per share increased another 1.8% to $12.37 in the third quarter. We continue to demonstrate an ability to consistently grow tangible book value through various market ups and downs. From a capital standpoint, we saw an increase in all of our capital ratios for the second consecutive quarter, including tangible common equity, which increased from 7.39% to 7.61%, and CET1, which increased to over 9%. We are focused on continuing to build these ratios over time, given our more moderated pace of loan growth and continued earnings retention. From a capital priority standpoint, organic growth remains our primary focus. Beyond that, we continue to review and monitor potential mergers and acquisitions opportunities. We also have a $25 million stock repurchase program that was approved by the Board in 2022, which we will continue to evaluate going forward. Turning to Slide 17, I'll summarize our thoughts on our near-term outlook. Coming into the year, we expected high single-digit loan growth in 2023. We are relatively in line running on a year-to-date annualized basis at around 6%. However, given the persistent high interest rate environment, we expect limited loan growth in the near term as we focus on building our funding base to be able to deploy in a more favorable lending environment. As Nick mentioned, we expect core deposit growth to continue to trend up over time. But I'll reiterate, it's not linear on a link-quarter basis, given the nature of our deposit base. Our current loan-to-deposit ratio of 101% has declined back into our target range of 95% to 105%. As we moderate loan growth, we'd like to see that ratio continue to trend toward the bottom end of that range in the near term. We would expect margin stabilization over the near term as the quarterly compression continues to slow. Obviously, there are still a lot of moving pieces, including ongoing funding pressures, but we are pleased with the progress and where we are from a margin standpoint. On the expense front, we expect to see ongoing non-interest expense growth as we feel it is important to continue investing in the business and our people to support future growth opportunities. Expense growth has typically aligned with asset growth, but we would expect that to be the case for the full year of 2023. We also expect lower levels of provision expense given the slower pace of loan growth, unfunded commitments continuing to fund and a moderation in the volume of newly originated projects with unfunded commitments. I'll now turn it back over to Jerry.

Thanks, Joe. Finishing off on Slide 18, despite the challenging macroeconomic environment, the strategic priorities we identified at the beginning of the year are still in place and we have shared those with you today. We have made good progress on each of them. I would also reiterate our continued ability to grow tangible book value. The current banking environment has presented several challenges, including meaningful margin compression and a slower pace of loan growth than we have been used to. But despite all of that, we have been able to continue compounding tangible book value. This remains a focus for us and a key way in which we drive shareholder value through economic cycles. With that, we will open this up for questions.

We will now begin the question-and-answer session. The first question comes from Jeff Rulis with D.A. Davidson. Please go ahead.

Thanks. Good morning. Looking at the limited growth, I just want to kind of probe through that a little bit. You guys were pretty clear on it. Just want to gauge the level of participations if you have any visibility on pay downs or amortization schedule ahead to try to figure out sort of where we are. How long we might have limited net growth or where that turn may be if possible?

Good morning, Jeff. This is Nick. Much of the participation we funded during the quarter was related to previously originated loans that included construction transactions. We have reduced our selling of participations on new transactions to help support the long-term growth we are aiming for. Overall, we feel positive about the quarter, even though balances were slightly down; actual advances and originations increased from the previous quarter. There were some fluctuations due to increased payoffs, some of which were delayed from the second quarter to the third, and others were moved up from the fourth to the third. Looking at our pipeline and payoffs, it appears to be more similar to earlier in the year. As we project forward, it seems that the fluctuations in Q3 were somewhat exaggerated.

And Nick, I don't know if you could hazard a guess for ‘24 expectations on net growth. Would we be in the mid-to-high single digits, or do you think we revert to kind of historical Bridgewater over a couple of quarters?

No, I think your first thought there is right. I think as we look farther out throughout 2024, that feels like that mid-single digits is kind of where we're looking at it. I mean, like we've always mentioned, our growth isn't always perfectly smooth and linear. It may sort of be lumpy at times and in all likelihood, just given where we're at, it would likely be more heavily weighted toward the back half of the year as we're thinking through it.

Got it. Maybe switching gears, Joe. I appreciate the comments on kind of that historical coupling of asset growth and expense growth, but assets were down in the quarter and expenses up 7% linked that's kind of a near-term job, but I'm trying to rationalize where expenses head in the next couple of quarters relative to, if loan growth is going to be pretty muted, just want to get a sense for, and some of that expense-based you can't control with sort of the FDIC side, but just kind of near-term and then even a similar question as, Nick, just kind of expense growth in ‘24, do you think we'll revert back to kind of historical pairing of asset growth and cost growth?

Yes, I think you're thinking about it in the right way, Jeff. I think we look at it more over the year and over the long haul. And as we've always said, that relationship has held up, whether it's on a growth rate basis or if you look at non-interest expense to average assets, that ratio, if you take a step back and look at it on the full-year, that's relatively in line. So to Nick's point, mid-single digit loan growth next year, I'd also expect expenses to run in line with that. It's hard from a quarter-over-quarter basis; we don't think about it that way. We just think about it more over the long haul. And as we guided last quarter, we expected a step up in the third quarter on a link quarter basis. But again, looking back on a year-to-date basis, it's only 6%. And if you think of asset growth over the last year, it's 10%. So that relationship remains intact.

And maybe a credit-related question just on some curious second-guessing on multifamily loans of late, just in kind of listening to some other calls. I saw that 37% of the portfolio; maybe just a question on kind of the long-term viability of that sector, which has been very historically clean. Just want to kind of revisit from your end, how you feel about your comfort level with the multifamily segment in general.

Well, great question. And like you said, there has been a lot of press out there on the just overall national multifamily market recently. We feel good about the portfolio. We feel good about the Twin Cities market. We've talked to you about this before, but the market in the Twin Cities has always been much more stable characteristics in terms of rent growth and occupancy levels, and has never really been a boom bust market. There was a recent report just nationally on multifamily that we're trying to gauge overbuilt market by looking at the number of units under construction relative to the total inventory in the market. The Twin Cities came in at 5%, which was lower than the national average. So I think it tells you that it's just not being overbuilt. Also, with some of the pressures on the single-family market with the lack of inventory on the market and interest rate environment floating up, that votes well for the multifamily market as well in terms of the need for housing. With that said, with our covenant testing and interest rates floating up, we have seen some compression in debt service coverage ratios of projects. We expect that will be somewhat short-term and then over the long term that will come back to a more normalized ratio. I guess the last thing I want to add is just that affordable housing units represent a significant portion of our market, and like everywhere, the Twin Cities is lacking in affordable units. So I think that is another just data point that reflects stabilization in the portfolio.

And if I could, Jeff, just overall outside of multifamily, just with that credit in general, your thoughts, your watch list balances down a bit substandard up a bit. Employed NPAs and net charge-offs continue to be pretty great. But overall, kind of body language on credit?

No, just no, feel good. We're probably more dialed in to the portfolio between covenant testing and looking at repricing of loans. I think that that's probably a lot of banks are looking at that the same way as one of the bigger risk factors out there. As I mentioned in the deck, we show this, we have a lot of fixed-rate products because of our commercial real estate focus. So that helps from a repricing standpoint. But we're just continuing to dive in wherever we can in order to try to identify potential risk factors that would impact the portfolio. But right now we're not seeing too much.

Great. I appreciate it. I'll step back.

This concludes our question-and-answer session. I would like to turn the call back over to Jerry Baack for any closing remarks.

Thanks for joining the call today. We at BWB remain optimistic about the future and we are seeing encouraging trends and continue to push our strong culture, our brand, our network, and events. We have some of the best clients, I think, in the nation, and of course, our employees too. Thank you for your time today, and we'll talk to you next quarter. Goodbye.

This concludes the presentation. Thank you for attending today's conference. You may now disconnect.