Primis Financial Corp. Q3 FY2022 Earnings Call

Good day and welcome to today's Primis Financial Corporation Third Quarter Earnings Call. All lines have been muted to avoid background noise. Following the speakers' remarks, there will be a question-and-answer session. Thank you. I would now like to hand the conference over to Matthew Switzer, Chief Financial Officer. Please proceed, sir.

Good morning and thank you for joining us. Before we begin, please note that many of our comments during this call will be forward-looking statements, which involve risk and uncertainty. There are many factors that could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements. For further discussion of the company's risk factors and other important information regarding our forward-looking statements, please refer to our recent filings with the Securities and Exchange Commission, including our recently filed earnings release, which has also been posted to the Investor Relations section of our corporate site, www.primisbank.com. We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time. In addition, some of the financial measures that we may discuss this morning are non-GAAP financial measures. A reconciliation of the non-GAAP measures to the most comparable GAAP measures can be found in our earnings release. I will now turn the call over to our President and Chief Executive Officer, Dennis Zember.

Thank you, Matt, and thank you to all of you that have joined our third quarter conference call. I want to take a few moments and talk about some of the trends that we referenced in the press release and then discuss how this is driving our core earnings performance in the current quarter and what we expect looking out into 2023. The most notable item in the quarter is the investment in mortgage. We recruited very well this quarter and landed two very strong teams and some other strong producers. We brought this group with about $250 million to $300 million of production capacity, but we ended the quarter very close to our $1 billion goal. To illustrate the progress, we took about 178 applications in August before we recruited anybody. And in October so far, the first full month with just one of the two teams, we have taken about 430 applications. The other team is being onboarded now. At full capacity, we expect to end the quarter with about 550 to 600 applications per month, which should translate into about $75 million to $85 million per month of volume. We pay small signing bonuses, and we buy out the team's existing pipeline, and this accounted for about 80% of the group's operating loss. While we recruited the team in the quarter and paid the cost to onboard them, the team booked no loans, just built pipelines. So a lot of the revenue, or all of the revenue that we expect from these teams, will happen in the fourth quarter and beyond. The new level of production that we've built the mortgage company to is about what we expected. While we would like to continue expanding, we don't expect to continue adding costs like this into next year. We think the new level of production should produce EPS of about $0.24 per share and increase our total net income by about 20 basis points. We also began marketing the digital bank in a more pronounced manner alongside our core bank. In the first month, we had traction on all of the accounts. While it's small, I believe we could reach about $10 million in new customer deposits in just the first month, and I believe in a couple of quarters, the digital bank will be one of our largest branches. In the presentation that Matt put out last night, we listed some of the novel features of our product set, which is the first time we have consolidated that information in one place. When you combine those features with a progressive look and feel of the app and the delivery capabilities, we have a hyper-competitive offering that will undoubtedly grow our franchise in our core markets. Speaking of V1BE this quarter, we spent about $300,000 to $400,000 extra staffing up and investing in pipe, for two reasons. First, we wanted to expand the reach of the service and the operating hours. Secondly, we aimed to offer the service to other banks. The service costs a fraction, maybe 15% of what a full-service branch costs. Right now, there are community banks that want to expand to neighboring markets but cannot stomach a two-year period to breakeven. There are others that need to close branches but can't risk inconveniencing customers and losing deposits in this time when liquidity is drawing up. To date, we've done over 8,000 deliveries generally inside of 30 minutes, and we're on pace to do more than 1,000 per month. In my opinion, we need to position ourselves to export this to new markets where we estimate the breakeven to be only about $1.5 million in new deposits. Bringing other banks into the concept will only help us with that strategy. These items cost us about $1.6 million in the current quarter. Even with that extra investment in these areas, we posted the highest pretax pre-provision earnings we've had in several years. For the current quarter of 2022, we are reporting pretax pre-provision income of $9.9 million or about a 1.2% ROA. This is up substantially from a year ago when we reported $8.5 million and an associated ROA of only 72 basis points. Driving that higher was growth in revenue of about 46% over last year, excluding PPP fees, and an improvement in the margin from 2.87% to 3.57% in the current quarter, both of which resulted from an improvement in earning asset mix as well as a very low and controllable deposit beta. I'm pleased with all the progress we're making, and I'm also pleased with the increase in revenue and pretax pre-provision metrics. However, we need to improve the reported ROA, and I see a clear pathway to achieving that. I know the mortgage team will move to profitability very quickly. Panacea will continue to enhance its returns. Our provision for loan losses associated with growth will moderate. We're not going to have provisions for model changes for much longer. Nothing is guaranteed in this industry, but I feel very confident that all of these strategies are progressing positively and will produce the higher returns we anticipate. Lastly, before I turn it back to Matt, I want to comment on the loan-to-deposit ratio and where I see that headed. We've spent the last two years with ample liquidity and benefiting from significant growth in deposits. Concurrently, we were implementing new strategies in Five and with the digital bank that could help us grow deposits when the easy capital disappears. I know we finished the quarter at 101% loan-to-deposit, but I believe our deposit strategies have just as much, if not more, potential than our loan strategies. Given the rate and liquidity environment the industry is facing, I believe these are coming online at just the right time. We expect the digital bank to continue to grow alongside the core bank, and I don't anticipate loan-to-deposit ratios over 100% for much longer. Okay. With that, I will turn it over to Matt for some comments on the numbers.

Thank you, Dennis. As a reminder, a full description of our third-quarter results can be found in our earnings release and third-quarter earnings presentation, both of which can be found on our website. Earnings from continuing operations for the third quarter were $5.1 million or $0.20 per diluted share, compared to $5 million or $0.20 per diluted share in the second quarter. Excluding one-time items, earnings in the third quarter were $5.3 million or $0.21 per diluted share versus $6 million or $0.24 in the second quarter. Total assets were $3.36 billion at September 30, up slightly from June 30. Excluding PPP loans and loans held for sale, loan balances grew 18% annualized in the quarter. Growth was primarily driven by Panacea and Life Premium Finance in Q3. We expect growth in the fourth quarter in the loan portfolio, albeit at a seasonally slower pace. Deposits were up almost 4% annualized in Q3, while the mix continued to improve. Non-interest-bearing deposits are at 25.4%, which is a record for our bank. Looking out over the next few quarters, we are confident we have the ability to keep growing deposits amid industry pressures. As Dennis alluded to, we have branches in strong markets, enhanced by our V1BE service, a digital platform with unique deposit account features, and the nationwide brand in Panacea, all of which we plan to leverage for funding. Net interest income saw strong growth in the quarter, increasing to $27.5 million from $24.6 million in Q2, marking an 11.6% linked quarter growth. Our reported margin was 3.57% for the third quarter or 3.58%, excluding the effects of PPP, up 24 basis points and 23 basis points, respectively, from the second quarter. Yield on earning assets expanded by 42 basis points, while cost of deposits and cost of funds increased by 13 basis points and 18 basis points, respectively, from Q2. Our deposit beta this year remains low at only 4% cycle to date. Non-interest income increased to $5.6 million from $2.6 million linked quarter, largely due to a full quarter of premise mortgage. The premise mortgage management team has done an incredible job recruiting to the platform, with two substantial teams added largely in the third quarter. With these additions, we are projecting originations of over $1 billion next year, up from roughly $300 million this year, with meaningful additions to non-interest income and overall profitability. Non-interest income also included a gain this quarter for an increase in credit indemnification asset of approximately $1.2 million tied to a segment of our loan portfolio. Non-interest expense included a number of items this quarter, including $308,000 in branch closure costs, $311,000 in expenses for unfunded commitments, and a full quarter of mortgage expenses, which included the build-out of origination teams, as Dennis discussed previously. Excluding these items and recovery or expense for unfunded commitments, non-interest expense was $20 million, up from $18.5 million last quarter. The increase was driven by lower deferred costs from lower commercial lending volumes in Q3, which impacted us by roughly $500,000, an increase in fraud losses of roughly $250,000, and increased marketing and advertising for the new digital platform and V1BE, combined at roughly $300,000. Additionally, there were increased professional costs of roughly $250,000 plus additional investments in our lines of business. Many of these expenses will be lower going forward. We will also start to benefit by approximately $500,000 in savings starting in the fourth quarter due to the renegotiation of our main data processing contract. Our provision for credit losses was $2.89 million in Q3 versus $408,000 in Q2. The provision was driven by three factors: loan growth we experienced in the quarter, weakening economic forecasts included in our CECL models, and an increase in specific reserves tied to one non-accrual loan. We also had net charge-offs in Q3 of $1.1 million, largely tied to one credit that already had specific reserves established against it in previous quarters. As a result, our allowance for credit losses to gross loans, excluding PPP, increased slightly to 1.17% at September 30 from 1.16% at June 30. Nonperforming assets net of SBA guarantees increased by $17.3 million in Q3, primarily due to one relationship largely comprised of three assisted living facilities. This relationship was rated special mention last quarter and was downgraded and placed on non-accrual in Q3. We are working with the borrower to dispose of the properties, and current appraisals indicate we are fully collateralized. Our operating efficiency ratio was approximately 71% in the third quarter, essentially flat from Q2. Excluding the impact of mortgage, our operating efficiency ratio would have been approximately 65% in Q3. We consolidated two branches in Q3, bringing the total for the year to eight. With the data processing savings highlighted above, plus additional efficiency improvements we are pursuing, we continue to believe we can drive the operating efficiency on a combined basis below 65% as we finish 2022. As Dennis mentioned, pretax pre-provision operating ROA was 120 basis points in Q3, up from 100 basis points in Q2. Excluding the investment in mortgage, this ratio would have been approximately 10 basis points higher in the quarter. Our various business lines continue to ramp up profitability quickly. Similar to the efficiency ratio discussion, we are confident that pretax, pre-provision ROA and return on assets will continue to see meaningful improvement in the near future. With that, operator, we can now open the line to questions.

Your first question comes from the line of Freddie Strickland with Janney Montgomery Scott. Your line is open.

Hey, good morning. Just wanted to start with deposit trends. I know you guys gave a little bit of color with the digital bank. But I was just curious, in terms of new deposit trends and funding new accounts, do you have visibility into new core funding going into next year? And how much of that comes from the digital bank versus the regular bank operations?

That's a great question, Frank. So the digital bank, as you recall, went live to the broader public at the very end of July. We were slow to advertise it heavily while we made sure all the final details were resolved. We really didn't start advertising the digital bank and those products until midway through the third quarter. As we stand today, I believe we are at approximately $8 million in deposits on that platform already. We feel pretty good that the products we've got there, combined with some novel features and V1BE, will lead to some solid growth in the digital platform in the fourth quarter and into next year.

Will that trend with checking accounts?

Yes. And I would point out, right now, the only products live are consumer accounts. We don't even have business live yet. So that $8 million is all consumer funding. Business should be live early next year. I think to your question too, the core bank has almost $3 billion of deposits, a little under that. In a normal year, given our exposure in Richmond, Northern Virginia, D.C., and Southern Maryland out to Hampton Roads, I feel those are good markets. In a normal year, you'd expect us to grow, perhaps looking at about 7% to 9% without being too aggressive or focused solely on rates. I think the industry is facing roughly 10% traction in deposits, so it might be hard for the core bank to grow. I believe all core banks are going to struggle with growth, as we've seen this quarter. The digital bank is different. I don’t want to declare victory too soon, but I believe it is the factor that will change the tenor of our liability side next year. It's relatively small now, but if you consider the cost of funds for new customers at the digital bank against where we are loaning money, we are pushing net interest margins higher than what we reported this quarter. So the entire strategy itself is beneficial for our margins and will enhance our growth rate in deposits. One last comment on deposits: I highlighted this earlier, but Panacea has a little over $13 million in deposits at the end of the third quarter. Their push for deposits, especially with commercial customers, is strong. They have nearly 100% penetration with a deposit account amongst their commercial customers. However, deposit gathering has not been as great of a focus compared to building out their business in other areas to this point. Yet, they have a significant built-in customer base and reach that we plan to leverage aggressively soon.

Got it. That's helpful. I appreciate all the color. And just switching gears to expenses, does the expense growth we saw in the third quarter continue? Or do we see sort of a slowdown on that line from here? I know you guided towards 65%, I think you said in the fourth quarter. I was also curious where you think efficiency can go in the longer term just as revenues begin to rise as well?

There are two parts to that question. We should not see growth in the fourth quarter; rather, we're expecting to bring expenses down in the fourth quarter. Many of those items were not purely nonrecurring but should not appear regularly in our financials. Longer term, we aim for efficiencies to drop below 60% to the mid-50s in the core bank. Excluding mortgage, which is by definition a higher efficiency business additive to ROA because it's not heavy on assets, we are driving the Community Bank and the rest of our business lines to low to mid-50s. Anaya should be below 50, while Life Premium Finance should be well below 50, leading to a consolidated community bank efficiency ratio around the lower part of that range.

Got it. That's helpful. Speaking of mortgage, I know you provided a little bit of guidance on what you think you're going to see there. Do you see opportunities to pick up good producers from other banks as they exit the space? It sounds like you've done this in the past quarter. Is there more potential to do so given the downturn in mortgage? Can you also explain how mortgage expands absent an external market shift in rates?

There's a lot of opportunity to grow the mortgage segment. Honestly, I believe we have a strong team, good leadership, and promising infrastructure that is on its way to being great. I am an admirer of the mortgage industry, but I am aware that we need to be cautious too. I feel we've captured two exceptional teams in great markets. I believe we could potentially do that seven or eight more times before June of next year, but I don't think we should rush into it. Instead, we need to incubate these two teams, drive them to profitability, and ensure we achieve the results we expect before we start expanding further. The industry is retracting, good teams are available now, and many teams are looking for good homes as reputable as ours.

At least we are answering the phone.

Exactly. Exactly.

Got it. That makes sense. And can you detail a little about what you see in terms of profitability across your various subsidiaries in 2023 and 2024? Are some segments looking like they'll perform better than others?

I think the core bank, in a typical credit environment, should probably yield about 1% to 1.15% ROA. Our premium finance division should achieve a 150% to 175% ROA. As I mentioned, we expect an efficiency ratio below 50% from that segment. Panacea's ROA will likely be around 125% to 150%, although it may take longer to reach because we want to invest in their deposit infrastructure. Ultimately, we aim for Panacea to become the nation's first full-service digital bank for medical practitioners. I estimate that mortgage could yield a pretax output of somewhere in the 75 to 80 basis point range on production, with $1 billion of production equating to approximately $7.5 million pretax income. Scaling mortgage from $1 billion to $3 billion can enhance potential earnings further. While the digital bank focuses primarily on deposits, it will have a minimal cost of funds and very low operational expenditures, resulting in significant bottom line impact.

That is precisely what I was looking for. I appreciate it. Just one last question from me. Can you provide an overview of customer sentiment and economic outlook? Have you noticed any changes in customer behavior given all the talk of recession recently?

At present, I've been conversing with a few customers over the last few weeks. Many appear more hyper-aware of what may come. I don't think we've observed significant signs of a recession, yet we still remain cautious. Customers are concerned because they've heard about impending recession, but we have not yet seen any anecdotal signs to justify that concern. In our board meeting last week, we discussed a credit that we resolved in Q3, and while we foreclosed and sold it, we got out of the loan 100%. That isn't what everyone seems worried about; they're worried about being underwater 10% or 20% on credit, which has not transpired yet.

That summarizes what I've heard from other banks—everyone sounds aware of the situation but not seeing direct effects in their surroundings. Would you say that aligns with your observations?

Right.

Thanks for clarifying the inquiries. I appreciate the thorough responses.

Thank you.

There are no further questions at this time. I would like to turn the call back over to Dennis Zember.

I appreciate everybody's attendance today. If you have any questions or comments, Matt and I will be available. Reach out via email or telephone, and we will do what we can. Thank you, and have a good weekend.

This concludes today's conference call. You may now disconnect.