Earnings Call Transcript - EQBK Q3 2022

Operator, Operator

Welcome to the Third Quarter 2022 Equity Bancshares Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Chris Navratil with Equity Bancshares. Please go ahead.

Chris Navratil, Executive

Good morning, and thank you for joining Equity Bancshares conference call, which will include a discussion and presentation of our third quarter 2022 results. Presentation slides to accompany our call are available for download at investor.equitybank.com by clicking the Presentation tab. You may also click the event icon for today's call posted at investor.equitybank.com to view the webcast player. If you are viewing this webcast on our webcast player, please note that slides will not automatically advance. Please reference Slide 1, including important information regarding forward-looking statements. From time to time, we may make forward-looking statements within today's call and actual results may vary. Following the presentation, we will allow time for questions and further discussion. Thank you all for joining us. With that, I'd like to turn it over to our Chairman and CEO, Brad Elliott.

Brad Elliott, Chairman and CEO

Thank you, Chris. Good morning. Welcome to our third quarter earnings call, and thank you for your interest in Equity Bancshares. With me on the call today is our CFO, Eric Newell; COO, Greg Kossover; and Chief Credit Officer, John Creech. Let me start by thanking the Equity team for their continued dedication to providing excellent customer service. The effort of our bankers can be seen as we delivered outstanding core earnings for the third time in 2022. As we completed the integration of our M&A transactions over recent years, we have worked to improve the operating team effectiveness and banker sales process. As we continue to improve on these, we will see further pull-through into our operating results. Our diluted EPS was $0.93 versus consensus of $0.80. Net interest income and net interest margin both increased, as we continue to realize the benefit from upward rate movement. We were active during the quarter with our buyback, completing our 2021 authorized plan and receiving regulatory non-objection for an additional 1 million shares to be used over the next period. With further emphasis on shareholder return, we increased our third quarter dividend by 25% to $0.10 per share. I'll let Eric talk with you about our financial results.

Eric Newell, CFO

Thank you, Brad, and good morning. Last night, we reported net income of $15.2 million or $0.93 per diluted share. Noninterest income, excluding the $540,000 gain on the branch sale in the second quarter, remained flat linked quarter at $9 million. Noninterest expenses, less merger costs, increased linked quarter to $32.1 million. We calculate core EPS to be $0.94 per diluted share. To reconcile GAAP earnings to core earnings in the quarter, simply remove merger expenses of $115,000. Our GAAP net income includes a release through the provision for loan losses of $136,000. The uncertainty of the economic environment and the continued impact on the economy of previous stimulus measures are reflected in the qualitative and economic components of our calculation, while the contribution of historical loss to the allowance for credit losses fell from June 30. The September 30 coverage of ACL to loan is 1.43%. I'll stop here for a moment and let John talk through our asset quality for the quarter. John?

John Creech, Chief Credit Officer

Thanks, Eric. We had another excellent quarter in credit and production with no measurable negative migration and continued improvement in classified assets as we completed the disposition of an aviation-related credit, reducing OREO and other assets. The classified asset ratio continued its downward trend to 11% of regulatory capital versus 13.1% linked quarter. Nonperforming assets declined 20% in the quarter to 59 basis points of total assets. On a linked quarter basis, substandard accruing loans decreased 20% and OREO and other decreased 63%. Our year-to-date net charge-offs were $2.1 million. At the end of the quarter, the allowance for credit losses remained 2 times greater than nonperforming loans. Despite rising rates and inflation, the loan portfolio continues to show strength with a low incidence of warning indicators. We are pleased with our third quarter results. Equity Bank has 2 credit officers, including Kristof Slupkowski, who help us maintain high underwriting standards and pricing discipline. Our markets in the Midwest remain robust and resilient. Our balance sheet provides a strong source of both asset and geographic diversity. Our borrowers continue to carry unprecedented levels of liquidity. Loan-to-value and line utilization levels remain low on our ag portfolio. Our hotel portfolio has recovered well from COVID and shows favorable levels of performance. The income-producing real estate portfolio evidenced solid cash flow performance, occupancy, and absorption levels. We're getting very acceptable levels of cash invested in all new projects financed. Like earlier production, newer loans have solid primary and secondary sources of repayment that are fairly uncorrelated. Borrowers continue to invest sizable cash ahead of loan dollars across projects of all sizes. Loan-to-values on new production remained favorable. It's rare that we make an exception to this requirement. We have been extremely diligent in pursuing pricing discipline, which we think will reward us in the future. Lastly, we continue to pay close attention to interest rate stress testing to ensure borrowers are able to sustain performance given the current economic environment. I'll turn it over to Greg for a discussion on production.

Gregory Kossover, COO

Thanks, John. Loan growth in the quarter was $32 million. Our year-to-date loan growth, excluding the branch sale and PPP totals 7%, including 17.1% annualized growth in commercial real estate and commercial and industrial. Our pipeline stands at $700 million today. As John said, we continue to exercise reasonable caution in terms and conditions on new and renewal loans. Noninterest income of $9 million was essentially flat quarter-over-quarter when excluding the gain on acquisition realized in the second quarter of $540,000. Service charges and fees were up 7% linked quarter with treasury fees and credit card income showing moderate increases. We continue to emphasize putting commercial cards in the hands of our clients and driving debit card utilization through marketing campaigns. We have growing pipelines that our health care services team has developed that will allow us to service their employees' HSAs and other tax-advantaged flexible spending accounts. Our bankers have done an excellent job improving the quality of our deposits as average noninterest-bearing balances for noninterest-bearing deposits, both for commercial and consumer accounts improved linked quarter.

Eric Newell, CFO

Net interest income totaled $41.9 million in the third quarter, increasing from $39.6 million in the linked quarter, representing a $2.4 million increase. Net interest margin increased 23 basis points to 3.62% in the quarter. You'll note in our slide deck, we had a 9 basis point contribution to NIM from purchase accounting, which is slightly larger than normal and the result of successful work from our loan teams resulting in acquired relationships. PPP loan fee and interest income are no longer meaningfully contributing to our financial results. We continue to successfully hike interest rates on loans, and we're seeing a higher yield as a result of nearly 60% of our loan portfolio having adjustable rates. During the third quarter, the coupon yields in the loan portfolio increased approximately 48 basis points to 4.87%. The cost of interest-bearing deposits increased 29 basis points to 57 basis points in the quarter. Two-thirds of the increase is attributed to our public equity deposits. You'll note a linked quarter decline in our demand and money market deposits, primarily due to a decline in public entity deposits, heavily influenced by seasonality. As Greg mentioned, relationship-driven account categories, especially noninterest-bearing demand deposit accounts, have seen growth in the number of accounts and in average balances per account. Noninterest expense was up $800,000 linked quarter. Professional fees were impacted by increased costs associated with the resolution of other repossessed assets that John discussed earlier. Our outlook slide introduces our preliminary view of 2023. The forecast does not contain any future rate increases. Brad?

Brad Elliott, Chairman and CEO

We remain dedicated to expanding current banking relationships and earning new relationships through delivering best-in-class products and services to all markets. We continue to practice discipline and growth, originating high-quality credits and diversifying noninterest income streams. As we look to deliver strong risk-adjusted returns to shareholders, we continue to have conversations with potential partners. We are steadfast in our approach to M&A and will not compromise on deal metrics to close a transaction. Our balance sheet, capital, and credit strength will benefit us as opportunities arise through the cycle. Our year-to-date performance and progress towards key strategic goals is a testament to the dynamic team we continue to build at Equity. I'm happy to share that Hetal Desai has joined as our Chief Risk Officer. Hetal Desai began her career with Citi and has served in risk management leadership positions with JPMorgan Chase, State Street Corporation and Santander. She is an excellent addition to our leadership team as we ready ourselves to take the next step in continued growth. And with that, we’re happy to take your questions.

Operator, Operator

Our first question comes from the line of Jeff Rulis with D.A. Davidson.

Jeffrey Rulis, Analyst

I would like to discuss Slide 17 regarding the outlook for Q4. There is an expected decrease of around $1 million in fee income, along with a potential increase of approximately $3 million in expenses. Can you provide insight into which fee areas are declining and what is driving the increase in expenses based on this guidance?

Eric Newell, CFO

On fee income, we don't forecast the mark-to-market benefit on derivatives that we've been enjoying throughout the year. So that's one of the main factors. If rates do rise again in the fourth quarter, it might give some benefit that we're currently not forecasting in fee income. On noninterest expense, there is an increase in the fourth quarter in the partnership expense associated with our tax credit, which is what has been driving our annual effective tax rate down for the year. That's a little bit higher in the fourth quarter than in the third quarter. Also, there's a modest increase in salaries and benefits for the incentive accrual based on year-to-date performance.

Jeffrey Rulis, Analyst

Okay. And if I look at kind of the '23 outlook on expenses, that seems to assume a lower run rate into '23. So again, maybe just some year-end salary and benefits but that would be expected to run rate 32%, 33% in beginning '23.

Eric Newell, CFO

That's the expectation, yes.

Jeffrey Rulis, Analyst

Okay. Got it. Maybe for John, I just wanted to kind of do the net charge-offs. Was the bulk of that primarily from the aviation credit?

John Creech, Chief Credit Officer

No. We had really already marked the aviation credit. It was just small minor charge-offs that you would sort of expect.

Jeffrey Rulis, Analyst

Okay. So maybe just a little lumpy. You had been single-digit kind of net charge-offs to loans, but again, nothing systemic or anything; it just was a grab bag of miscellaneous?

John Creech, Chief Credit Officer

No, that's exactly right. I would say that it still feels like a very below normal sort of number, and all these credit metrics are really strong and positive. It just feels like when you have such a low number for several quarters in a row, you would expect it to be a little inconsistent at some point.

Jeffrey Rulis, Analyst

Sure. Okay. Makes sense. And then just the last one. Just on more speculation on the deposit beta this cycle. Do you feel like the bank's better positioned this time around? And/or do you have a beta that you're assuming through this cycle, what you think you might get to on a deposit beta?

Eric Newell, CFO

We do think we're better positioned this cycle. Last cycle we had just closed on a deal and there was some deposit outflow. Our wholesale funding as a percent of total funding was higher than where we are today, which obviously has a higher beta in a rising rate environment. The composition of our funding in terms of the deposits is much more favorable. Our percentage of transaction accounts is higher than the last cycle. I couldn't speak to you where we were on the last cycle on the mix between community deposits total. But today, we're at 60% community deposits to total, and that really has helped us in containing our cost of funds.

Brad Elliott, Chairman and CEO

What I can tell you, Jeff, is that last time we were in the wrong part of the cycle with the transactions we had just completed. The bank we acquired in Tulsa relied heavily on wholesale funding. As we attempted to adjust that mix, which we excel at in generating core deposits, we simply did not have enough time to manage it effectively before the cycle shifted. This time, we are entering the cycle with a normal core deposit ratio for Equity Bank. I believe we will benefit from this upcycle in interest rates and margin expansion because of that.

Operator, Operator

Our next question comes from Terry McEvoy with Stephens.

Terence McEvoy, Analyst

Eric, thanks for mentioning that the margin outlook does not reflect the change in rates. However, the forward curve is assuming we get incremental rate hikes. Could you just talk about kind of the rate sensitivity? And you highlighted that variable-rate loan portfolio. But just to help us there. And I guess, within that margin guidance, kind of the accretion that you're expecting within that as well would be helpful.

Eric Newell, CFO

Sure, Terry. Looking back over the year at the changes in market rates alongside our net interest margin, I anticipate that any substantial shifts in market rates would typically lead to a 4%, 5%, or 6% increase in our net interest margin for every 25 basis points rise in market rates. This perspective comes from our past performance and how our assets and deposits have repriced. For the upcoming period, the accretion this quarter was slightly higher, but considering the assets we've acquired through mergers that are still on our balance sheet, I expect our net interest margin to increase by about 4 to 5 basis points moving forward.

Terence McEvoy, Analyst

And then maybe if you could talk about loan growth expectations in 2023, market sectors, parts of the commercial portfolio that you think are positioned for growth over the next 3 to 5 quarters?

Gregory Kossover, COO

Thanks for the question, Terry. We are currently finalizing our budget for 2023, and I anticipate that we will project loan growth between 7% to 9% or 7% to 10%. There are many opportunities left in our metro markets such as Kansas City, Tulsa, and Wichita, where we have a full team of bankers who are performing exceptionally well. Craig Anderson is effectively leading the sales and commercial lending teams. We have strong prospects in all of our community markets owing to the personnel we have put in place. We expect to see continued loan growth. As mentioned earlier by John, we believe we can achieve this without adjusting our credit standards. You can anticipate ongoing growth in commercial and industrial sectors, along with some opportunities in commercial real estate. We might also see some activity in agriculture. While some agricultural lines have been underutilized, it has been a positive outcome for our agricultural clients, which we are pleased about. We may experience a slight increase in 2023 from agriculture as things stabilize and borrowing needs arise. Overall, from our current perspective, the outlook appears favorable.

Operator, Operator

Our next question comes from Damon DelMonte with KBW.

Damon DelMonte, Analyst

Just a couple of quick questions here. I guess, first on the bit of outflows in the deposit this quarter. I saw you had increased your FHLB advances. What are your updated thoughts on Brilliant Bank? Have you kind of turned to that as a source of funding yet? Or are you still not actively promoting that?

Brad Elliott, Chairman and CEO

We are actively promoting that and are receiving funding as a result. As we increase our efforts, we're also learning how to improve our approach. I believe this will become a significant funding source for us as we open more accounts daily and progress along our learning curve. Some of the Federal Home Loan Bank advances are tied to the loan growth we’ve experienced and the demand that has created. The deposit outflows we saw are primarily due to the typical decline associated with municipal deposits, which are affected by taxation periods in December or June, leading to a reduction during those times. We anticipate similar inflows to recur in December. However, our core deposits are holding steady and showing growth over the quarter. Therefore, I don't see our deposit outflows as unusual. Do you have anything to add, Eric?

Eric Newell, CFO

Yes. We looked at our noninterest-bearing average balances, excluding municipal linked quarter as well as year-to-date, and those average balances have actually increased, which is a little bit surprising based on some of the thoughts of excess liquidity in the market causing those balances to go down thinking that they were going to go down. So, a nice surprise.

Damon DelMonte, Analyst

Got it. Okay. That's good information. Regarding credit, your comments about the current outlook were very positive. As you consider the reserve level, which decreased to 143 this quarter from 150, where do you envision that settling? And are there any estimates for a dollar range quarterly or as a percentage of loans? How should we think about the future provision?

Eric Newell, CFO

The way I look at provision, at least from a budgeting perspective, it has been this year, and likely into next year based on the information we have today is 20 basis points on average loans on an annualized basis. That could get you to a dollar amount of provision. In terms of the allowance for credit losses, we do believe it's adequate at this point. Just as a reminder, it is a model that we run in-house here. We have qualitative factors, which allows me to address some of the uncertainty in the economy and how it may potentially address or impact our customers and our balance sheet, despite us not seeing any concerning segments, as John mentioned in his prepared commentary. This leads to a historical loss factor in the model. Historical losses have been improving. Our probability of default metrics have been improving, which offsets to some extent the ACL that we have in the qualitative. We have the economic regression model that has some lags in it. There are still some COVID-impacted macroeconomic factors in our regression model. So when you put all that together and bake it, it gets us to that 143 basis points of coverage that we're reporting. Going forward, for modeling purposes, I would just use 20 basis points on an annualized basis on average loans.

Operator, Operator

Our next question comes from Andrew Liesch with Piper Sandler.

Andrew Liesch, Analyst

Just wondering if you can talk to the noninterest-bearing deposit growth? What drove that this quarter?

Eric Newell, CFO

We have continued to be very focused as an organization on our sales approach. As Greg mentioned in his commentary, we're really working to grow the number of operating and checking accounts that we have, as well as cross-selling our customers into products and services which will help drive fee income.

Brad Elliott, Chairman and CEO

Yes, the answer, Andrew, is it's granular. I mean, it's one checking account at a time. It's one treasury relationship at a time. Our teams are doing a great job, honestly, being focused on that. Craig Anderson has done a great job leading that charge along with all the other leaders in the organization. As we continue to get better at that, I think we have more opportunity that we have just started scratching the surface.

Andrew Liesch, Analyst

Got it. It's good to see in this environment. And then, Eric, I think you mentioned adjustable rate loans are 60%. How much of those are above floors at this point?

Eric Newell, CFO

Nearly all of them, more than 90% of them. The other metric that might be helpful. If you look at the total loan portfolio, 32%, 33% of it adjusts immediately. The reason that's important is that there's still some repricing opportunity in our loan portfolio from previous rate movement.

Andrew Liesch, Analyst

Got you. And then the last question I have is just on the buyback, the payout ratio here below 7%. How much do you look at that while gauging how much you want to buy back stock given that you sound like you have some pretty good growth opportunities? How should we be thinking about share repurchases going forward?

Eric Newell, CFO

Yes. The management team, along with the Board of Directors, we look at a payout ratio relative to earnings. So we add the value of the buyback and the common stock dividend together and compare that to earnings. If you do that math, previously, we were approaching a 100% payout, I think, in 2021. This year, we're being more conservative about that. We're not going to get close to the 100% payout. We do keep our eye on that tangible common ratio, but we believe that with our more conservative approach to the payout ratio, that allows us to provide room for growth as well.

Operator, Operator

Our next question comes from an unidentified analyst. I'm showing no further questions in queue at this time. This concludes today's conference call. Thank you for participating. You may now disconnect.