Five Star Bancorp Q2 FY2024 Earnings Call

Good afternoon, everyone, and welcome to the Five Star Bancorp's Second Quarter 2024 Earnings Webcast. Please note that this is a closed conference call, you are encouraged to listen via the webcast. 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, events 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, 2022, and quarterly report on Form 10-Q for the quarter ending September 30, 2023. And in particular, the information set forth in Item 1A, Risk Factors in those reports. Please refer to Slide 2 of the presentation, which includes disclaimers regarding forward-looking statements, industry data and non-GAAP financial information included in the presentation. Reconciliations of non-GAAP financial measures to their most directly comparable GAAP figures are included in the appendix to the presentation. Please note this event is being recorded. At this time, I'd like to turn the conference call over to James Beckwith, Five Star Bancorp's President and CEO. Please go ahead.

Thank you for joining us to review Five Star Bancorp's financial results for the second quarter of 2024. 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. Our organic growth story continued in the second quarter with a successful close of our public offering, resulting in the issuance of 3,967,500 additional shares of common stock with net proceeds of approximately $80.9 million, allowing us to continue our momentum in the San Francisco Bay Area. We added 5 more seasoned professionals to support this expansion and also continue to add new core deposit accounts and relationships as seen in the increase of non-wholesale deposits of $118.3 million during the 3 months ended June 30, 2024. Despite continued external headwinds, we maintained our ability to conservatively underwrite as evidenced by a 50% loan to value on commercial real estate, manage expenses with our 44% efficiency ratio and delivered value to our shareholders with our $0.20 per share dividend for the first quarter and second quarter of 2024. The second quarter of 2024 exhibited continued execution of our growth strategy and efforts to position for future growth as evidenced by our earnings, expense management and balance sheet trends during the quarter. Additionally, we saw a positive turn in margin compression and loans, total assets and deposits have grown since prior periods. Our pipeline continues to remain solid at the end of the second quarter of 2024. Within verticals we have historically operated in, as presented in the loan portfolio diversification slide. Loans held for investment increased during the quarter by $162.2 million or 5.2% from the prior quarter primarily relating to the purchase of loans with the consumer concentration of the loan portfolio, representing $73.3 million of the increase. Total originations during the quarter were approximately $390 million, while payoffs and paydowns were $72.8 million and $155 million, respectively. Asset quality continues to remain strong. Though nonperforming loans increased in the beginning of the third quarter of 2023, they continue to represent only 0.06% of the portfolio at the end of the quarter. At the end of the second quarter, the allowance for credit losses totaled $35.4 million, we recorded a $2 million provision for credit losses during the quarter, with loan growth and increases in net charge-offs as the leading drivers. The allowance for credit losses to total loans held for investment was 1.08% at quarter end. Loans designated as substandard totaled approximately $1.9 million at the end of the quarter, which is unchanged from the end of the previous quarter. During the second quarter, deposits increased by $193.9 million or 6.56% as compared to the previous quarter. Noninterest-bearing deposits as a percent of total deposits at the end of the second quarter decreased slightly from 26.2% to 26.2% from 27.7% at the end of the previous quarter. As noted earlier, we are pleased we had a net non-wholesale deposit inflows for the 3 months ended June 30, 2024. Our ability to grow deposit accounts supports our differentiated customer-centric model that our customers trust and value as seen through the mix of high dollar accounts and the duration of certain customer relationships, we believe we had a reliable core deposit base. To offer more detail on our deposit composition, I want to highlight that deposit relationships totaling at least $5 million constituted approximately 60% of total deposits and the average age of these accounts was approximately 8 years. Local agency depositors accounted for approximately 22% of deposits as of June 30, 2024. Overall, deposit balances have increased when compared to the prior quarter. Wholesale deposits, which we define as broker deposits and public time deposits, increased by $75.5 million. Non-wholesale deposits increased by $118.3 million, driven by a $110 million increase in non-wholesale interest-bearing deposits and an $8.3 million increase in noninterest-bearing deposits. Cost of total deposits was 247 basis points during the second quarter, a decrease of 6 basis points from the first quarter. We continue to be well capitalized with all capital ratios well above regulatory thresholds for the quarter. The additional common stock issued through the public offering that closed in April of 2024 is noticeable in our capital ratios for the second quarter. Our common equity Tier 1 ratio increased from 9.13% to 11.28% between March 31, 2024, and June 30, 2024. On July 18, our Board declared a cash dividend of $0.20 per share on the company's loading common stock expected to be paid on August 12, 2024 to shareholders of record as of August 5, 2024. On that note, I will hand it over to Heather to discuss the results of operations.

Thank you, James, and hello, everyone. Net income for the quarter was $10.8 million. Return on average assets was 1.23%, and return on average equity was 11.72%. Average loan yield for the quarter was 5.83%, representing an increase of 12 basis points over the prior quarter. Our net interest margin was 3.39% for the quarter, while net interest margin for the prior quarter was 3.14%, with loan growth at higher yields and decreased reliance on wholesale deposits as the primary drivers. As a result of changes in interest rates and other factors, our other comprehensive income was $0.2 million during the 3 months ended June 30, 2024, as unrealized losses, net of tax effect decreased on available-for-sale debt securities from $12.4 million as of March 31 to $12.2 million as of June 30, 2024. Noninterest income decreased to $1.6 million in the second quarter from $1.8 million in the previous quarter due primarily to a reduction in gains from distributions received on equity investments and venture-backed funds during the 3 months ended June 30, 2024. This decrease was partially offset by an increase in gains on the sale of loans during the 3 months ended June 30. Noninterest expense grew by $0.8 million in the 3 months ended June 30 compared to the 3 months ended March 31, primarily due to increases in commissions related to higher loan production, travel, conferences and professional membership fees and sponsorships and donations during the quarter. Now that we've 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 second quarter results. Five Star Bank has a reputation built on trust, speed to serve and certainty of execution, which supports our clients' success. Our financial performance is the result of a truly differentiated customer experience which continues to power 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. As we continue to lean into 2024, we are guided by a continued focus on shareholder value as we monitor market conditions. We are confident in the company's resilience in any environment and remain focused on the future and our long-term strategy. We will continue to execute on our organic growth 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 that you might have.

Our first question today comes from Andrew Terrell from Stephens.

Maybe just to start off, can you talk a little bit about the consumer loan purchase in the quarter, kind of what these loans were specifically? What kind of the yield and the credit profile looks like there? And then just more broadly talk about the strategy behind it, particularly kind of considering the recent capital raise and what it feels like is a ramping kind of organic growth profile?

Sure. These loans were originated by Bankers Health Group, BHG. Their credit profile is very strong. I think I'm going to say mid-750 FICOs. These are professional individuals throughout the United States. We've been involved with BHG for several years now and have had a really strong credit experience with loans that we purchased from them. We're buying them, Andrew, at an 8.25% yield. That was kind of the average yield for purchases in Q2. And they've been operating like this for several years now very strong franchise, a lot of banks throughout the United States utilize them. We first got into it by wanting to make sure that we had appropriate coverage for our small business loans from a CRA perspective. And that's expanded given our favorable credit experience with them. So it's a shot in the arm. Certainly, we're not going to rely on it in terms of overall growth of the loan portfolio, but it's additive, and it's coming on at a nice margin, nice rate, nice yield and we like the credit characteristics.

Yes, understood. Do you have any specific timing regarding the purchase throughout the quarter? I'm trying to get a better sense of it. Loan yields have increased by 12 basis points in this quarter, which certainly helps. I'm looking to understand if there's any carry-forward effect on the loan yields into the third quarter.

Yes, you'll notice that was largely completed in the second half of the quarter, and I believe that will continue into the third quarter of 2024. We may explore doing more of that, but only time will tell. However, it will definitely contribute positively to overall loan yields. There are also several other factors influencing our loan yields. The loans we are considering outside of the BHG purchase are priced between 7.5% and 8.25%. Additionally, we experienced a strong quarter for loan originations beyond what I would categorize as a wholesale approach. We are also observing some paydowns in the portfolio, as lower-rate loans are being paid off. Overall, this is positively impacting loan yields, as reflected in our second quarter results.

Yes. Got it. Okay. And then last for me, really quickly, just the SBA gain on sale income picked up this quarter. I was hoping you could just maybe update us as to what you're seeing within that business? Is this kind of a lift upward in 2Q durable and then just overall kind of expectations?

Yes, we don't expect it to be durable. In fact, we've kind of turned the sales of the origination function. So our expectations about gains on a go-forward basis are certainly less in Q3 and Q4 than we saw in the first half of the year. So we've diminished the import of that business. We're still an active lender, but we're not going to be originating any near the levels of volumes we've had historically. Our efforts from a loan origination perspective are really what we're doing now in the Bay Area and in all our other verticals in terms of putting on credit. So gain on sales will definitely diminish. You're probably running from $50,000 to $100,000 for the remainder of the year on a monthly basis.

And our next question comes from Gary Tenner from D.A. Davidson.

First, I wanted to ask about the expense run rate. Decent quarter-over-quarter pickup. It doesn't look like there was anything particularly unusual in the numbers. So I was curious for your thoughts for the back half of the year here.

Yes. So I was a little short. I think whenever we did our estimate, we had a few more events and just overall conferences that we attended in Q2. So that drove our expenses a little higher. So I think for the run rate for the rest of the year, you can add about $250,000 per quarter to what we incurred in Q2. I think that will be a good run rate for the rest of the year. We do have some exciting things happening in Q3. We'll do our big celebration for our grand opening of our San Francisco branch in September. So we'll have that as an added expense and then employee celebrations and things like that. So I think $250,000 would be a good run rate each quarter of additional expense.

Okay. I appreciate it. And then on the deposit side, you talked about the split between kind of the net growth in non-wholesale deposits, which was positive for the quarter. But obviously, the loan growth will outpace that. So I'm just trying to get a sense of kind of your target comfort level on wholesale funding percentage, where you are right now? And I guess similar question around the loan deposit ratio, which is a little over 100% right now.

Sure. We will continue to rely on wholesale deposits as a means of funding. Toward the end of the quarter, we added a $75 million corporate deposit. We expect rates to decline, which may make this type of funding more appealing as the year progresses. It is an option for us, and we could have a loan-to-deposit ratio that is significantly lower than it is currently since we have the capability to do so. Our focus is on acting prudently to protect our margin while ensuring we maintain adequate liquidity to support the new loans. Historically, we've maintained a loan-to-deposit ratio below 100%, and we are now aiming for a target of 95%. We could easily achieve that tomorrow if we wished, but we are really focused on growing our core deposits, and we have seen success in that area. We just need to persist, and hopefully, we will see more progress in Q3 and Q4.

And our next question comes from Woody Lay from KBW.

Wanted to start on the deposit growth you saw with the Bay Area team. I mean, it was really strong in the quarter. Could you just sort of walk through the traction you're getting in those markets and how you expect growth to trend in the back half of the year in the Bay Area?

We expect it to be similar or even higher than it was in Q2 as we move into Q3 and Q4. We've brought on a lot of new talent, including some significant producers with a strong track record from their previous financial institutions. We're pleased with the traction we're gaining in the Bay Area. While San Francisco and the wider region are experiencing some challenges, especially in San Jose, it remains relatively stable and presents opportunities for us. The transition that JPMorgan Chase underwent over the Memorial Day weekend from the old FRB platform to its own did not go as smoothly as anticipated, according to feedback from our prospects. We believe we can capitalize on this transition, particularly since we've recruited many former First Republic employees who have established relationships. We are optimistic about our growth potential in that market, and we're dedicating significant time to it. Our grand opening for our offices in the Downtown Financial District of San Francisco is set for the last week of September, and we're currently engaged in extensive outreach efforts. These are exciting times for us in that area.

That's great to hear. Any commentary on the loan growth trends you're seeing in those markets?

Let's see. We've had, in terms of the teams that we brought in, total loan commitments of $85 million. That's not all outstanding, but that's what we're seeing. We do expect for that operation to be a net contributor to liquidity of the overall entity. Our pipelines in terms of our composite pipelines down there are very strong, and our loan pipeline down there is very strong. So we're excited about the good work that our new team members are putting in down there. And it's just a great group of new clients that we're bringing on. And it's exciting to see that market traction down there. Our leader down there, DJ Kurtze, is doing a great job, and we appreciate what the whole team is doing down there.

That's great to hear. Maybe we can shift to discussing the margin. It increased significantly in the second quarter. What is the outlook for the third quarter? I'm trying to understand what the potential could be in the third quarter if we experience another increase. What are the expectations?

I think it's going to kind of moderate a little bit. We're thinking 3.40% to 3.45% for the third quarter, hopefully we'll be able to do better than that, but that's what our sense of it is right now. In terms of our margin, it is impacted by a greater reliance or greater outstanding of wholesale deposits because you're fundamentally getting those deposits right on the marginal cost, which is right now about 5.25%. The extent that we do more of that will have an impact on our margin. We hope that our core deposit generation will accelerate in the third quarter. But that's our sense of it right now, Woody, is 3.40% to 3.45%.

Good luck with the grand opening.

At this time, I don’t see any further questions. I’d like to hand it back to management for any closing comments.

Great. Thank you. Five Star Bancorp is on a continued path of 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 successes we share with our employees and shareholders. These successes include numerous ratings and awards. In the first half of 2024, we were recognized with the 2024 Greater Sacramento Economic Council Sustainability Award, and 2023 Raymond James Community Cup Bankers Cup. Additionally, we were listed among S&P Global Markets Intelligence 2023 top 20 best-performing community banks in the nation. Our company leadership was also recognized in the first half of 2024 with the Sacramento Business Journal Women Who Mean Business Award, a Sacramento Business Journal C-suite Award, a National Association of Women Business Owners Outstanding Women Leadership Executive Board, and Independent Community Bankers of America 40 under 40: Emerging Community Bank Leaders award. Five Star Bank continues to be a driving force of economic development, a trusted resource for our customers, and a committed advocate for our communities. We look forward to speaking with you again in October to discuss earnings for the third quarter of 2024. Have a great day, and thank you for listening.

Ladies and gentlemen, that does conclude today's conference call and presentation. We thank you for joining. You may now disconnect your lines.