Five Star Bancorp Q3 FY2022 Earnings Call

Good day, everyone. And welcome to the Five Star Bancorp Third Quarter Earnings Webcast. Please note, this is a closed conference call and you are encouraged to listen via the webcast. After today’s presentation, there will be an opportunity for those provided with dial-in numbers to ask questions. Before we get started, let me remind you that today’s meeting will include some forward-looking statements within the meaning of applicable securities laws. These forward-looking statements relate to, among other things, current plans, expectations, and events including the continuing impact of the COVID-19 pandemic and industry trends that may affect the company’s future operating results and financial position. Such statements involve risks and uncertainties and future activities and results may differ materially from these expectations. For a more complete discussion of the risks and uncertainties that may cause actual results to differ materially from the company’s forward-looking statements, please see the company’s annual report on Form 10-K for the year ended December 31, 2021, and in particular the information set forth in Item 1A Risk Factors therein. Please refer to slide two of the presentation, which includes disclaimers regarding forward-looking statements, industry data, and non-GAAP financial information included in this presentation, as well as reconciliations to non-GAAP financial measures to the most directly comparable GAAP figures, which is included in the appendix to the presentation. Please note this event is being recorded. And at this time, I’d like to turn the floor over to James Beckwith, Five Star Bancorp President and CEO. Please go ahead.

Thank you for joining us to review Five Star Bancorp’s financial results for the third quarter of 2022. Joining me today is Heather Luck, Senior Vice President and Chief Financial Officer. Our comments today will refer to the financial information that was included in the earnings announcement released yesterday. To obtain a copy of the release, please visit our website at fivestarbank.com and click on the Investor Relations tab. In the company overview section, we have provided a brief overview of our geographic footprint and executive management team. The third quarter of 2022 exhibited continued execution of our organic growth strategy, as evidenced by our earnings, expense management, and balance sheet trends during the quarter. Additionally, loans, deposits, and total assets have consistently grown since the prior periods. Our pipeline continues to remain substantial at the end of the third quarter of 2022 within the verticals we have historically operated in, as presented in the loan portfolio diversification slide. Loans held for investment increased during the quarter by $202.5 million or 8.51% from the prior quarter, primarily within the commercial real estate concentration of the loan portfolio. Loan originations during the quarter were approximately $321.3 million and payoffs were $118.7 million. All PPP loans have been forgiven or paid off by the borrower as of September 30, 2022. Asset quality continues to remain strong with non-performing loans representing only 0.02% of the portfolio, slightly decreasing from the last several quarters. At quarter end, there were no loans on COVID-19 deferments. At the end of the third quarter, the allowance for loan losses totaled $27.8 million. We recorded a $2.3 million provision for loan losses during the quarter, primarily related to loan growth. The ratio of the allowance for loan losses to total loans was 1.08% at quarter end. Loans designated as substandard totaled approximately $0.5 million at the end of the quarter, representing a decrease in substandard loans of approximately $0.8 million from the previous quarter. Now that we have discussed the loan portfolio, I will hand it over to Heather to discuss deposits, capital, and the results of operations.

Thank you, James, and hello, everyone. During the third quarter, deposits increased by $113 million or 4.52% as compared to the previous quarter. Non-interest-bearing deposits as a percent of total deposits at the end of the third quarter decreased to 39% from 40.2% at the end of the previous quarter. We have had strong deposit growth over the last several quarters with deposit balances increasing when compared to the prior quarter. Non-interest-bearing deposits increased by $14.6 million, while interest-bearing deposits increased by $98.5 million. The cost of total deposits was 43 basis points during the third quarter. We continue to be well capitalized with all capital ratios well above regulatory thresholds for the quarter. Additionally, we completed a private placement of $75 million in aggregate principal amount of fixed to floating rate subordinated notes due September 1, 2032 on August 17th. The proceeds received from the subordinated notes, net of debt issuance costs and required debt servicing reserves will be used to redeem $28.8 million of previously existing subordinated notes on December 15, 2022, with the remaining $39 million downstream to Five Star Bank during the quarter. Net income for the quarter was $11.7 million, return on average assets was 1.6%, and return on average equity was 19.35%. New loan originations drove increases in the daily average balance of loans period-over-period. Average loan yield for the quarter was 4.74%, representing an increase of 27 basis points over the prior quarter. As a result of these factors, our net interest margin was 3.84% for the quarter, while net interest margin for the prior quarter was 3.7%. The change in the yield curve as a result of interest rate hikes that occurred during the quarter had a negative impact on the company’s accumulated other comprehensive income, during the quarter and the amount of $4.7 million, primarily in our mortgage-backed and municipal securities portfolios were resulting in decreases to each of those portfolios of $3 million and $1.7 million, respectively. This further decline in tangible book value per share, which is a non-GAAP financial measure discussed in our press release. This decline was offset by increases to tangible book value per share due to an increase in equity as a result of net income earned in the quarter for a net increase in tangible book value per share of $0.35. Non-interest income decreased to $1.5 million in the third quarter from $2 million in the previous quarter, due primarily to a $0.3 million decrease in gain on sale of loans relating to lower volumes of loans sold during the quarter and a $0.2 million decrease in loan-related fees due to lower swap referral fees earned during the quarter. Non-interest expense remained relatively flat quarter-over-quarter, with increased professional services of $0.2 million related to legal expenses incurred for corporate organizational matters completed in 2022, offset by declines in other operating expenses, a $0.3 million related to reduced travel expenses incurred during the quarter related to attendance of professional events, conferences, and other business-related travel combined with a $0.1 million of lower loan-related expenses incurred. Now that we have discussed the overall results of operations, I will now hand it back to James to provide some closing remarks.

Thank you, Heather. I want to thank everyone for joining us as we discuss the third quarter results. The strength of the Bank’s third quarter financial results is emblematic of a reputation built on trust, speed to serve, and certainty of execution, which support our client’s success. Our financial results are also the result of a truly differentiated customer experience, which powers the demand for Five Star Bank’s relationship-based services. We attribute sustained success to our prudent business model and treating customers with an empathetic spirit, understanding, and care. We are very proud to have earned the trust of those we serve including our shareholders. Looking to the remainder of 2022 and 2023, we will be guided by a focus on shareholder value as we monitor market conditions. We are confident in the company’s resilience in any interest rate environment and we will continue to execute on our organic growth strategy and disciplined business practices, which we believe will benefit our customers, employees, community, and shareholders. We appreciate your time today. This concludes today’s presentation. Now Heather and I will be happy to take any questions you might have.

And our first question today comes from Andrew Terrell from Stephens. Please go ahead with your question.

Hey. Good morning, James. Good morning, Heather.

Good morning, Andrew. How you doing?

Good. How are you guys?

We are here bright and shiny.

Good. Good. Thanks for the time. Maybe if I could start, James, on loan growth came in I think a bit better than we anticipated this quarter and maybe a bit better than we spoke about on last quarter’s call, I think your comments about strength and resiliency in the pipeline. I am just curious if you could maybe provide us kind of expectation for growth in the fourth quarter. I am assuming we should think about a moderation from here, but would love to hear your thoughts on kind of the cadence of loan growth moving forward and then any specific areas of the portfolio that you think will drive that strength?

We experienced strong loan growth in the third quarter, and as we begin the fourth quarter, we don't anticipate our loan growth to be as high, but it should still be respectable. Currently, our pipeline is much smaller compared to its peak. We have noticed a slowdown across all our segments and verticals, indicating that the prospects for loan growth at Five Star Bank are diminishing, although we still expect decent growth. We are comfortable projecting an annualized loan growth of 10% to 15% as we complete 2022 and transition into 2023. In the commercial real estate sector, cap rates and interest rates have risen, resulting in a decrease in deal volume across all segments, which will likely contribute to a slowdown in loan growth. The business remains, but not to the same extent as it was during the first three quarters of 2022.

Yeah. Understood. I appreciate that. And as you think about kind of being comfortable in the 10% to 15% loan growth range, on the other side of the balance sheet, I know deposit growth has been kind of tougher across the industry the past couple of quarters. Do you think going forward you can kind of core fund that level of loan growth and can you maybe speak to just what you are seeing from a deposit perspective within your growth pipeline?

Sure. We believe we can fund that with core deposits for the remainder of the year and also as we roll into 2023. What gets me comfortable about that statement, Andrew, is that we have a very well-developed business development team. We have 20 people that, that’s what they do, that’s their job and we think we are unique in that respect. And we have the right incentives, we have the right technology, and we have the right service capability to really grow our core deposits. So I feel pretty confident that we will be able to do that. Certainly, it’s an area of emphasis right now, it’s probably top of the number one thing that we are trying to do right now is grow deposits, grow core deposits. So it’s really got all of our attention and in all of our efforts to do that. So I feel very confident that we will be able to achieve that. And probably in the neighborhood of, I am going to say, slightly more than our loan growth, that’s what we are planning in 2023 to have a deposit growth of anywhere between 2% to 4% greater than our loan growth.

Okay.

And probably in the neighborhood of, I am going say, slightly more than our loan growth, that’s what we are planning in 2023 to have a deposit growth of anywhere between 2% to 4% greater than our loan growth.

Okay. Very good. That’s helpful color. I appreciate it. Maybe if I could shift gears, Heather, on the non-interest expense, I think, came in a bit better than we were forecasting. I am curious kind of your expectations. I know there’s probably a lot of moving pieces of inflation and everything, just curious, your expectations on the expense base, is this a good kind of run rate heading into the fourth quarter and then can you remind us how we should think about kind of the cadence the expenses throughout the year in 2023?

Sure. So, really Q3 was a really good proxy for where we think expenses are going to land for Q4 from a salaries perspective. The wildcard is usually just timing of travel and timing of attendance of professional events. So I believe Q3 should be a good proxy and then you can kind of take that ratio of the expenses as a percent of total assets and kind of just walk it forward with that. I think that would be a good method for your model. One item I do want to highlight, though, that we will see in Q4 is, we will be recognizing about $300,000 of additional subordinated note debt issuance costs when we redeemed the original tranches of the subordinated notes, those were previously amortized to the maturity date rather than the call date, so we will be recognizing about $300,000 there.

Just to add on to that, Andrew, if I could, I think you are aware of this, is that we do have to carry on that $28.8 million of subordinated notes all the way through December 15th. So we will be dealing with that in the fourth quarter but not in 2023. So just want to make sure you are aware of that.

Yeah. Absolutely. I appreciate the flag. Okay. Thanks for taking my questions. Congrats on a good quarter and I will hop back in the queue.

Thank you.

And our next question comes from Gary Tenner from D.A. Davidson. Please go ahead with your question.

Thanks. Good morning. I wanted to revisit the questions about loan deposit growth for the third quarter. James, during last quarter's call, as well as during the quarter itself, there were comments about the deposit pipeline outpacing the loan pipeline, along with an expectation that this quarter would allow for matching the growth of loans with that deposit. I'm curious, your deposit growth was clearly strong and last quarter was flat, so it’s stronger than that. Did the loan growth or net loan growth this quarter end up being more of a positive surprise compared to the deposit growth being disappointing?

Sure. It’s a very dynamic situation regarding the deal flow we are experiencing. We often engage in loans ranging from $5 million to $10 million that can significantly impact our operations. These opportunities arise frequently, and we take advantage of them when they are priced appropriately, well-structured, and backed by strong sponsorship, ensuring they are relatively safe loans. This aspect has been a pleasant surprise for us. However, as we currently stand, we still have a robust deposit pipeline that exceeds our loan pipeline considerably. This situation persists. While it may seem optimistic, I can affirm that building core deposits takes significantly longer than issuing loans. The industry recognizes this as well. Onboarding a major customer, for instance, can require a considerable amount of time, sometimes ranging from six to nine months for substantial deposit customers. Nevertheless, I remain quite confident in our ability to grow core deposits moving forward, especially in 2023, where we anticipate our deposit growth to surpass our loan growth.

I appreciate that. I am sure once those deposits are in the door, they are quite sticky, but I think conversion from pipeline to bringing them in-house might be a little more fickle, is that a fair comment?

It takes longer.

Okay, Heather, regarding the $300,000 in sub-debt costs that you mentioned for redemption, will that be classified as a non-interest expense or will it be accounted for under interest income?

That will be through interest income.

Okay.

$300,000.

Great. Thank you.

Yeah.

Our next question comes from Woody Lay from KBW. Please go ahead with your question.

Hey. Good morning, guys.

Good morning.

The interest bearing deposit beta was a little over 30% in the quarter from my calculation. Do you think it’s fair to expect that deposit beta to trend up in the quarters ahead or is this a pretty good run rate going forward?

We have analyzed it both quarterly and monthly. I believe that a 30% beta remains a reasonable estimate, as our pricing is tailored specifically for each customer. Consequently, while it may peak in value on a monthly basis, it will stabilize around 30% for the quarter.

Got it. And then I know there will be some noise in the NIM just with the debt issuance and redemption. But stripping out those moving parts, how should we think about the NIM going forward? Do you think it relatively stable or could we see some additional expansion from here?

We anticipate a range between 3.8% and 3.9% as we move into 2023, and that’s what we are planning for. It's important for us to execute on this. While it’s not necessarily difficult to predict, we do need to take into account how we price our funding costs. As mentioned, our pricing relationships with deposit customers are unique, especially in a rising rate environment. We believe we can sustain a 30% deposit beta and maintain our margins within the 3.8% to 3.9% range moving forward.

That good to hear. And then last just shifting to credit, credit remained super clean from an NPA and classified loan point of view. As you talk to your borrowers, how are you feeling about the credit environment as we head into the fourth quarter?

We feel optimistic but also cautious. We understand that some of our borrowers might be experiencing stress. However, it’s important to consider the makeup of our loan portfolio. A significant portion consists of mobile home community loans, which we believe are stable across different economic conditions. We anticipate that this asset class will perform better during a recession compared to others. Thus, we feel somewhat protected. Our office segment is concerning but is not our primary focus in commercial real estate; in fact, it ranks quite low at this time and is manageable. We are concentrating on that area and believe we have strong credits with solid sponsorship. We are confident in our credit quality at this moment, but we are aware of potential challenges ahead. We want to ensure that we are adequately reserving and are prepared to respond quickly to any credit issues to mitigate risks.

All right. That’s great color. That’s all from me. Thanks, guys.

Thank you.

And our next question is a follow-up from Andrew Terrell from Stephens. Please go with your follow-up.

Hey. Thanks for the follow-up. I wanted to dovetail off the last question on credit. I am just curious if you are altering any of your underwriting standards kind of tightening the range at all and kind of go forward credit or have you made changes more recently in terms of kind of portfolio monitoring just contemplating kind of the current backdrop?

We have adjusted our deal terms by increasing our spreads, which means that borrowers wishing to work with us will need to invest more in each deal. As a result, their down payments and sponsorship will need to be more substantial. While we have strong underwriting practices already in place, the increase in spreads is meant to address interest rate risk. As we continue to extend credit, we want to ensure that it's very solid. There are opportunities out there, but they need to be high-quality ones.

Yeah. Okay. And then on capital CET1 ratio kind of low 9% territory this quarter. Can you just remind us what your targeted capital metric is, and I guess, given kind of the current backdrop and your expectation for balance sheet growth moving forward, is it fair to think that the capital ratio is kind of across the board build from this level?

Yeah. As we look at our plan going out, Heather, we are right in the middle of our planning process looking at our plan going out for five years. So we believe we will be able to grow our capital levels with a 10% loan growth factor. So we are comfortable with that, that scenario given our current payout ratios. So we think that we will be building tangible book value and regulatory capital.

Yeah. And do you have kind of target metric, whether it’s CET1 or total capital, just any targeted capital metric that you focus on?

Well, historically, we have been very oriented towards total capital. We like it to be you know north of 11%, target 11.5% to 12% Tier 1 capital. Now that we did another round of subordinated debt, we are focused on trying to grow that to 10%. We are not there yet. It’s going to take a few quarters to get there but that’s our goal.

Okay. Thanks for the follow-ups.

Ladies and gentlemen, with that, we have reached the end of today’s question-and-answer session. I’d like to turn the floor back over to management for any closing remarks.

Great. Thank you. Five Star Bancorp is on a continued path of robust organic growth as we execute on strategic initiatives, which include growing our verticals and geographies, while attracting and retaining talent, our people, technology, operating efficiencies, conservative underwriting practices, and expense management have also contributed to the success we share with our employees and shareholders. At Five Star Bancorp we seize opportunities, embrace challenges and value the intrinsic reward of serving others. We look forward to speaking with you again in January to discuss earnings for the fourth quarter of 2022. Have a great day and thank you for listening.

And with that, we will conclude today’s presentation. We do thank you for joining. You may now disconnect your lines.