Primis Financial Corp. Q3 FY2024 Earnings Call

Thank you for joining us. My name is Ian, and I will be your conference operator today. I would like to welcome everyone to the Primis Financial Corp. Third Quarter Earnings Call. Now, I will hand the call over to Matt Switzer, Chief Financial Officer. You may begin your conference.

Good morning, and thank you for joining us for Primis Financial Corp's. 2024 third quarter webcast and conference call. 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. Further discussion of the company's risk factors and other important information regarding our forward-looking statements are part of 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, 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. How a non-GAAP measure relates to the most comparable GAAP measure will be discussed when the non-GAAP measure is used if not readily apparent. I will now turn the call over to our President and Chief Executive Officer, Dennis Zember.

Thank you, Matt. Good morning, and thank you to everyone who has joined our call. Our results this quarter reflect the correction of the accounting error on the consumer loan portfolio and the impact of using the multiunit accounting method for this portfolio. As Matt will elaborate on, this method requires us to recognize credit costs upfront with a full CECL reserve, while the impact of credit support is recognized only when received, usually in the latter part of the portfolio’s average life. Additionally, not all revenue is recognized, especially during promotional periods for the loans. We are currently working diligently to catch up on all of our 10-Qs, aiming to be fully current with our SEC filings by mid-November. Furthermore, as noted in our NT filings, we still have an ongoing consultation with the SEC's Chief Accountants office regarding the accounting for this portfolio, and while we hope for a resolution soon, we cannot predict the outcome. The issues stemming from this consumer portfolio are unfortunate, as these loans only account for about 5% to 6% of total loans. It is unfortunate because aside from this portfolio and our delayed filings, we have made significant progress with our strategy. For instance, the core bank's contribution to our results continues to enhance. For this quarter, the core bank's cost of deposits was 2.21%, up from 1.97% a year ago. Following the recent rate cut, we adjusted promptly to maintain our margin and net interest income. Moving forward, we have $1.1 billion in deposits anticipated to adjust further this quarter. The core bank's cost of deposits remains consistently 40 to 50 basis points lower than our community bank peers in the Mid-Atlantic due to the strong relationships we maintain with our customers, our technology like V1BE providing significant convenience to commercial clients, and the advantages of our digital platform. Additionally, the core bank is building new relationship pipelines at an impressive speed. While we maintain our focus on existing clients, a majority of our efforts and incentive funds are directed toward establishing new commercial relationships. The pace of new relationship development is three times what it was a year ago, with most of the momentum coming in the latter half of this year. This indicates that the community bank can significantly drive our growth and operating results. Regarding Panacea, when we launched the division, it was initially intended solely as a consumer loan vertical. However, we have since refined the model and developed distinct digital capabilities that also emphasize deposits and commercial lending activities. Tyler's team achieved several notable wins this quarter, gaining endorsements from large national medical associations and new commercial deposits at the quarter's end, which could translate to up to $20 million in noninterest-bearing balances once accounts are fully transitioned and funded. Our development of ancillary financial services to complement our loan and deposit relationships is progressing rapidly, and early adoption signs are promising. We saw significant momentum with our mortgage team, locking $277 million in mortgage loans this quarter, a 67% increase compared to the same quarter in 2023, resulting in an annualized production pace of over $1 billion for the first time. While we anticipate a slower fourth quarter compared to the second and third quarters, the year-over-year growth in production speaks to both our recruiting success and to the general momentum in the industry. Currently, we have our best recruiting pipeline since launching this platform in 2022, and combined with the industry momentum, we are confident of seeing enhanced contributions to our return on assets and earnings per share from this division. Our announcement regarding Life Premium Finance is positive but bittersweet. It is great for the three gentlemen we recruited in 2021 who brought ambition and developed a platform with strong relationships and reputation in their industry. The potential in this division likely exceeds my entire balance sheet, and it required a fitting home, such as what we announced. We will reduce a similar volume of deposits immediately and shrink total assets by about 10%. We expect this move alone to enhance the tangible common equity ratio by approximately 75 basis points and improve our net interest margin by 6 to 7 basis points right away, with an additional 5 basis points margin uplift expected over the next few quarters as some remaining assets run off. The real benefit from our announcement pertains to the mortgage warehouse; we recently recruited a team from a large bank exiting the space alongside an acquisition, and we are swiftly onboarding their client base. Fortunately, we already had the software and had completed significant engineering with our smaller warehouse clients. However, what we previously lacked was leadership and a team with the necessary relationships and vision. I am confident we can replace the entire Life Premium portfolio in the coming quarters. Currently, the yields we are offering in the warehouse are 160 basis points higher than our existing Life Premium yields. Even conservatively assuming that only 80% of that increase is sustained as we build capacity, we are looking at almost a 20 basis points margin increase and about a 13 basis points improvement in our return on assets. The baseline operating expenses in this division are not materially different from those in Life Premium, and we believe credit costs will remain similar. This was a significant opportunity for our company, and my perspective on the operational ratios that Matt and I aim for has become much clearer after this move. In terms of credit quality, we concluded the quarter with only 25 basis points of nonperforming assets, which has remained steady over the last few quarters and is half of what it was in the third quarter of 2023. We do not hold any other real estate and have seen little migration among the grades. This quarter, we cautiously downgraded one commercial real estate property that was slow to lease and affected by vacancies in nearby properties. Our borrower has covered all cost overruns, has never missed a payment, and has pledged additional collateral. However, our appraisals showed that the cap rate nearly doubled since origination, so we recorded a provision for the small shortfall in collateral values. I do not anticipate a loss on this asset or migration into nonperforming status and believe we may have downgraded it just as cap rates on commercial real estate were at their peak.

All right. With that, Matt, I will turn it over to you for some comments. Thanks, Dennis. As a reminder, a summary of our financial results can be found in our press release and investor presentation, both of which can be found in our 8-K filed with the SEC last evening and placed on our corporate website. This quarter, instead of repeating information found in those sources, I'm going to attempt to walk through some of the impacts of the recent accounting changes in order to help highlight underlying trends in our results. As Dennis mentioned, our results for the current period and prior periods include the impact of corrected accounting for a third-party originated consumer loan portfolio. As detailed in our recently filed 10-K, these changes require the following: The subset of loans with promotional features don't accrue interest until the end of the promotional period. Deferred interest on these loans that exit the promotional phase is largely recognized all at once with a modest discount that is accreted over time. Third-party reimbursement for waived interest under our agreement on promotional loans that pay off early is recorded in fee income instead of interest income. We record a derivative value representing the fair value of expected interest reimbursements mark-to-market each period with changes in that value recognized through noninterest income. And all credit costs are fully recognized, including estimated life-of-loan losses under CECL, while potential credit enhancements from the consumer program are recognized as received. Reported pretax pre-provision earnings can be found in our earnings release and includes the effects of the Panacea Financial Holdings consolidation as in previous periods. Adjusting for effects of this consolidation and nonrecurring items, core pretax pre-provision earnings were $10 million in the third quarter versus $9.4 million before the change in accounting in the second quarter. Adjustment amounts for both PFH consolidation and nonrecurring items can both be found in our press release and investor presentation. This quarter, the various interest income and expense items for the consumer program we've previously discussed contributed a net of $4.5 million to pretax pre-provision earnings in the third quarter versus $3.2 million in the second quarter. Under our previous accounting, contribution from this portfolio would have been $3.8 million or $700,000 less than reported this quarter. Last quarter, that would have been $4.5 million or $1.3 million higher than reported. Adjusting for these differences, core pretax pre-provision earnings were $9.3 million in the third quarter versus $10.6 million last quarter. A substantial portion of the volatility in reported earnings is due to the timing of interest recognition on promotional loans where we are required to defer to the end of the promotion. We recognized $3 million of interest catch-up in the third quarter for promotional loans that exited the period and began amortizing, up substantially from $0.5 million in the second quarter. As a result, our reported margin was 2.97% in the third quarter, up from 2.72% in the second quarter. Adjusting for the effects of the timing differences, our margin would have been 2.83% in the third quarter, down only 3 basis points from the second quarter. We also recognized $2.5 million of interest reimbursement from our third-party partner for promotional loans that paid off early in the third quarter, up from $1.5 million last quarter, all of which is reflected in noninterest income and not in interest income or margin. We have $60 million of promotional loans deferring interest at September 30 with $17 million and $21 million reaching the end of their promotional periods in the fourth quarter and first quarter of 2025, respectively. Lastly, I do want to spend a minute on noninterest expense. As we highlighted in our earnings release and investor presentation, reported noninterest expense was $31 million, which included $2.7 million of consolidated PFH expenses or $28.4 million net compared to $27.4 million last quarter. Mortgage expenses were $6.4 million in the third quarter, up from $6.1 million last quarter on higher volume. Excluding these expenses as well as nonrecurring items, core bank expenses were $19.8 million, down from $20.1 million last quarter and in line with our 5-quarter average. We are laser-focused on controlling expenses and generating operating leverage as we move past our accounting noise and look to grow revenue meaningfully in 2025.

Our first question comes from Russell Gunther with Stephens Inc. Your line is open.

Hi, this is Nick filling in for Russell Gunther. I just wanted to start off with your core expense outlook. Could you give a little guidance on that given the puts and takes of the Premium Finance sale and new hires around mortgage warehouse?

Should be relatively flat, Nick.

Okay. And then regarding the mortgage warehouse, do you plan to separate those loans out from a modeling perspective?

I think we would likely present it in a manner similar to our other operating segments. When you mention modeling, are you referring to aspects like loan loss reserving or interest rate risk?

…or margin?

Yes, that's what I mean, loan loss reserves.

Yes. I mean it's going to be not that material in the fourth quarter, depending on how the next couple of weeks go. But as we move through '25, we will certainly break out as much information as possible so you can get a sense for the trends.

Okay. That makes sense. If I recall, the presentation mentioned it would be either in the fourth quarter of 2024 or the first quarter of 2025. I was just wondering if there has been a significant growth rate on those mortgage warehouse loans.

What are you referring to in the fourth quarter or first quarter?

When you start breaking out and disclosing the mortgage warehouse loans. That's what I...

I think we're making great progress in attracting their customers. Typically, the fourth and first quarters are slower periods in the mortgage industry, so now is an ideal time to reach out to customers. They left their previous bank with around 215 customers, and after being here for about three weeks, we've increased that number to almost 24 customers. Our goal is to reach about 75 customers by the end of the year, and we're working hard to achieve that. As we move into early next year, we expect to continue adding more. Currently, we’re managing approximately $375 million in Life Premium loans, and we anticipate another $50 million may be reduced by the middle of next year. Therefore, we're looking to replace roughly $400 million to $450 million in Life Premium loans with these mortgage warehouse loans. For next year, I'm confident that our average mortgage warehouse book will be around $400 million for the entire year.

Okay. Great. That makes sense. And now on to ROA. So you previously laid out a target for a sustainable 1% ROA. Can you walk us or walk me through the glide path to when you think you guys are going to get there?

I believe we have a solid opportunity to achieve that in the latter half of 2025. A part of this will depend on whether we receive the change in accounting we anticipate, which could reduce some of the volatility we're currently facing. If we don't, we may still experience volatility, but it should primarily last only a couple more quarters as it is mainly related to these promotional loans, which tend to diminish quickly over the next two to three quarters. Setting that aside, we are moving off a substantial portfolio but expect to replace it almost dollar for dollar by mid-2025, likely at higher interest rates and improved profitability. When you combine this with some effective cost savings and our usual retail mortgage operations, we project better performance next year. We also anticipate that the core bank will contribute more and that we will see margin expansion on a core basis. While I can't specify all the basis points of contribution from these various factors, we believe that, overall, this positions us to reach at least a 1% return on assets.

There are many factors at play, but the momentum we have in mortgage, specifically the quarter-over-quarter growth in locked loans and revenues, is promising. If this trend continues into next year, it could contribute another 7 to 10 basis points. Additionally, trading Life Premium for the warehouse opportunity is likely to add about 13 basis points. No doubt, as rates decline, with $1 billion in deposits still pending repricing this quarter, the sensitivity to falling rates on our liability side will enhance our margin and return on assets. The energy and enthusiasm we have for the potential figures you mentioned or even better are quite positive. I'll leave it there.

No, that's perfect. That helps a lot. And that's it all my questions. Thanks for answering them.

Your next question comes from the line of Christopher Marinac with Janney Montgomery Scott.

Hi, good morning. Thanks for hosting us. Matt, I have a quick housekeeping question. The numbers we see in the press release and the quarterly reports reflect the new information and will be verified once the Qs are filed. Is that correct?

Yes. And those are all the quarters restated for the change in accounting. So it's all been pushed backwards.

Perfect. That's what I thought. Okay, great. I just wanted to be 100% sure. The criticized loan numbers were stable this quarter. Do you see any movement from that? And does the way that the consumer portfolio behave impact those at all?

No, those are not reflected in those. Those loans are typical consumer loans; they reach 90 days and then they charge off.

That's what I thought. Okay. And then the trends on just general movements in commercial criticized and substandard loans?

Aside from the two credits, one major and one minor that moved from special mention to substandard this quarter, we are not observing significant inflows. We have been monitoring both credits for a while, so their status is not unexpected. However, the valuation we relied on for setting the reserve on the larger loan was a bit surprising, but we believe it is very conservative, and our customers continue to make payments. Unfortunately, we still need to use the appraisal as it comes in. Other than that, I cannot recall any credits that have transitioned into a problem category or begun to show increased risk that we were not already aware of or keeping an eye on.

Great. Thank you for that color. And then another question just goes back to the cost of funds. Should that rate that we see this quarter be sort of a peak and then it works itself down? And do you have a thought, I guess, in terms of how betas may play out looking forward the next four to five quarters?

For the first part of your question, yes, I mean, we saw cost of funds tick down in September. So it basically peaked in August. As to betas, some of it's going to depend on, I think, what happens with the next Fed cut. It feels like competitors have lower rates, and we have to, particularly in the core bank for the higher rate stuff, that have been kind of the upper end of the cost structure. We were pretty aggressive moving some of those down. I think our overall beta for the core bank is probably 20% maybe after the last move. If the Fed doesn't cut, I think we'll have an opportunity actually to continue to incrementally keep moving stuff down and get some more beta on the first Fed cut. If they do cut again, we're still going to cut, but some of it is dictated by the competitive environment and what they're doing with their rates. Not as many people seem to have been aggressive cutting after that first move.

Chris, one more thing. Matt and I have been monitoring our digital deposits, and while we did implement a few changes on the digital side, we haven't made many adjustments overall. Currently, we have around $915 million to $920 million in digital deposits. We are planning a small upgrade to the customer experience in about a month. Additionally, we want to be cautious about future rate hikes and avoid being overly aggressive with our rates. We also have broker deposits maturing in December. There is $1 billion in deposits on our balance sheet that did not get affected by the recent rate cut, and we plan to address this in the upcoming quarter, as we want more clarity on the Fed's actions and to complete our conversion. Regarding your question about whether we've peaked, it's clear that we have. We're looking to maximize our opportunities before potentially engaging in earnings assets with the mortgage warehouse, while remaining prudent. However, you can expect to see a noticeable improvement in our cost of funds.

We have taken a measured approach with existing deposits in the digital bank, but we have reduced rates for new funds coming in, and we are still able to attract those new deposits. This strategy allows us to lower the cost of the digital platform without being overly aggressive with current accounts.

Okay. Great. Yes, I was going to ask about the new inflows that you saw, you sort of addressed that. And it sounds like if there is a difference on beta versus digital versus the core bank, it's hard to really talk about that today, give a few more quarters and sort of circle back on how the experience is.

Yes.

Okay, great. Thanks for all the information today, as always, and I appreciate you hosting the call.

Thanks Chris.

There are no further questions at this time. I'll hand things back over to Dennis Zember, CEO, for some final remarks.

All right. Thank you again for your participation and your interest. If you have any questions or comments, of course, Matt and I are around all the time. So just give us a call, text or e-mail, and we'll get back to you. Thank you. Have a great weekend.

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