Earnings Call Transcript - FSBC Q2 2023

Operator, Operator

Good day, everyone. Welcome to the Five Star Bancorp Second Quarter Earnings Webcast. Before we begin, I want to remind you that today's meeting will include forward-looking statements regarding our current plans, expectations, events, and industry trends that could impact the company's future operating results and financial position. These statements come with risks and uncertainties, and actual results may differ significantly from these expectations. For a detailed discussion on the risks and uncertainties that might lead to actual results differing from our forward-looking statements, please refer to our annual report on Form 10-K for the year ended December 31, 2022, and our quarterly report on Form 10-Q for the quarter ending March 31, 2023, particularly the information in Item 1A, Risk Factors. Additionally, please look at Slide 2 of the presentation for disclaimers related to forward-looking statements, industry data, and non-GAAP financial information, along with reconciliations to the most comparable GAAP figures found in the appendix of the presentation. Please be aware that this event is being recorded. Now, I would like to hand it over to James Beckwith, President and CEO of Five Star Bancorp. Please go ahead, sir.

James Beckwith, President and CEO

Thank you for joining us to review Five Star Bancorp's financial results for the second quarter of 2023. 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. During the 3 months ended June 30, 2023, our return on average assets and return on average equity were 1.55% and 19.29%, respectively, positioning us to remain near the top of our peer group. In the second quarter, we announced our expansion into the San Francisco Bay Area market. Our organic growth story also continued in the second quarter with the addition of new deposit accounts and relationships as seen in the growth of non-broker deposits of $25 million in the 3 months ended June 2023. Despite headwinds on the horizon, our ability to conservatively underwrite, manage expenses and deliver value to shareholders continues. We believe we are well-positioned to continue to endure and succeed as conditions change. In the company overview section, we have provided a brief overview of our geographic footprint and executive management team. The second quarter of 2023 exhibited continued execution of our 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 solid at the end of the second quarter of 2023 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 $57.6 million or 2.01% from the prior quarter, primarily within the commercial real estate concentration of the loan portfolio. Loan originations during the quarter were approximately $254.4 million and payoffs were $196.8 million. Asset quality continues to remain strong with nonperforming loans representing only 0.01% of the portfolio, remaining largely unchanged from the last several quarters. At the end of the second quarter, the allowance for credit losses totaled $34 million. We recorded a $1.3 million provision for credit losses during the quarter, primarily related to loan growth, loan type mix and updates to the macroeconomic environment. The ratio of the allowance for credit losses to total loans held for investment was 1.16% at quarter end. Loans designated as substandard totaled approximately $0.3 million at the end of the quarter, which was a decrease from $0.4 million at the end of previous quarter. Now that we've discussed the loan portfolio, we continue on to deposits and capital. During the second quarter, deposits increased by $9.3 million or 0.32% as compared to the previous quarter. Noninterest-bearing deposits as a percentage of total deposits at the end of the second quarter decreased slightly to 28.5% from 28.6% at the end of the previous quarter. We'll 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 on these accounts was approximately 9 years. Local agency depositors accounted for approximately 25% of deposits as of June 30, 2023. As noted earlier, we are pleased that we had a net deposit inflow for the 3 months ended June 30, 2023, including inflows during the month of June. Our ability to grow deposit count 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, which we believe we have a reliable core deposit base. Overall, deposit balances have increased when compared to the prior quarter. Non-broker deposits increased by $25 million, interest-bearing deposits increased by $12.3 million and noninterest-bearing deposits decreased by $3 million. The cost of total deposits was 192 basis points during the second quarter. We continue to be well capitalized with all capital ratios well above regulatory thresholds for the quarter. Our common equity Tier 1 ratio increased from 9.02% to 9.07% between March 31, 2023, and June 30, 2023. On Friday, July 21, we announced a declaration by our Board of a cash dividend of $0.20 per share on the company's voting common stock expected to be paid on August 14, 2023, to shareholders of record as of August 7, 2023. On that note, I will hand it over to Heather to discuss results of operations.

Heather Luck, Senior Vice President and CFO

Thank you, James, and hello, everyone. Net income for the quarter was $12.7 million, return on average assets was 1.55% and return on average equity was 19.29%. Average loan yield for the quarter was 5.5%, representing an increase of 14 basis points over the prior quarter as rate increases continued in May 2023, the third increase this year. Our net interest margin was 3.45% for the quarter, while net interest margin for the prior quarter was 3.75%. The most recent Fed rate increases continue to put pressure on deposit costs. As a result of changes in interest rates and other factors, our other comprehensive loss was $1 million during the 3 months ended June 30, 2023, as unrealized losses, net of tax effect, increased on available-for-sale debt securities from $12 million as of March 31, 2023, to $13 million as of June 30, 2023. Noninterest income increased to $2.8 million in the second quarter from $1.4 million in the previous quarter due primarily to a $1.3 million gain in other income recognized on distributions received on investments and venture-backed funds during the 3 months ended June 30, 2023. Noninterest expense grew by $0.9 million in the 3 months ended June 30, 2023, as compared to the 3 months ended March 31, 2023, primarily due to increases of $500,000 in operating expenses largely related to seasonal travel and conference fees, $300,000 in advertising and promotional for business development expenses and $100,000 in data processing and software corresponding with growth of the bank, partially offset by a $200,000 decrease in salaries and employee benefits. Now that we've discussed the overall results of operations, I'll now hand it back to James to provide some closing remarks.

James Beckwith, President and CEO

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 support 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. In the second quarter, our efforts were recognized as we received the Raymond James Community Bankers Cup for 2022, which was created to award community banks that are building long-term shareholder value. Looking to the remainder of 2023, we will be 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 we'll continue to execute on our organic growth strategy and disciplined business practices which we believe will benefit our customers, our 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 may have.

Operator, Operator

Our first question today comes from Andrew Terrell from Stephens.

Robert Terrell, Analyst

James, if I could just start on the team hired this quarter, maybe getting into some of the specifics. Just how many frontline bankers or BDOs came with the team? How does that compare to the size of your current BDO staff? And then what type of book of business on both the loan and the deposit side do you think this team can build over time?

James Beckwith, President and CEO

Sure. To date, we've hired five people, three of whom are experienced business development officers and two are in a relationship manager role. So far, that's what we've accomplished in that particular market, and we anticipate doing more. We'll keep everyone updated on that. The book of business they are targeting closely aligns with our depository perspective. These individuals are deposit-focused business development officers. On the lending side, I expect they will probably engage in some commercial real estate lending, particularly owner-occupied commercial real estate lending. That's the focus they have had in their careers, and they have been very successful.

Robert Terrell, Analyst

Okay. Very good. And then on the expense front, Heather, I know the expenses stepped up just a little bit this quarter, and obviously, some hiring and capitalizing on end market opportunities for you guys. Just can you maybe help us out with thinking about the expense run rate moving forward?

Heather Luck, Senior Vice President and CFO

Yes. So if you shave off probably about $100,000 from what we incurred in Q2, that would be a good run rate for the remainder of the year for expenses.

Robert Terrell, Analyst

Got it. And then James, I heard your prepared remarks, just on the strength of the pipeline heading into the third quarter. It sounded like referencing loans specifically, and perhaps you've got some tailwinds with some C&I-oriented bankers. But just what about the pipeline on the deposit side? How does that compare to the lending pipeline heading into the back half of the year? And then how should we think about the incremental mix of the deposit growth from here?

James Beckwith, President and CEO

The deposit pipeline remains significantly higher than our loan pipeline, which is very encouraging. We anticipate this pipeline will continue to expand, aided by our team in San Francisco and our efforts in the capital region. The mix is likely to focus more on noninterest-bearing deposits and liquidity for the businesses we onboard. Many commercial accounts have both operating accounts and liquidity sources, and we expect to see growth in these areas. Additionally, we might observe a reduction in wholesale deposits as the year progresses. Our goal is to eliminate our broker deposit book by December 31, which has already decreased from March 21 to June 30.

Heather Luck, Senior Vice President and CFO

We declined broker deposits during the second quarter by $15 million. And then we've also continued to pay down the broker deposits since quarter end.

James Beckwith, President and CEO

Yes. So I think what we're trying to do is kind of diminish that wholesale aspect, if you will, Andrew, of our deposit mix. And I think we've had some success, and we're looking forward to more success in those particular deposit mix structures.

Robert Terrell, Analyst

I appreciate it. No, it was great to see that in the second quarter.

Operator, Operator

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

Gary Tenner, Analyst

I wanted to kind of ask another question regarding the deposit versus loan pipeline. I know coming into the year and even during April earnings, the commentary about the size of the deposit pipeline versus loan pipeline was pretty significantly weighted towards deposits. I think at one point you had maybe 2x in the deposit pipeline versus loans. Obviously, a lot of unusual times here in the second quarter. So I'm not trying to hold you to that number in terms of the relative growth. But obviously, it didn't translate to core deposit growth outweighing or outpacing net loan growth in the quarter. So I'm just wondering, James, if you could comment about kind of churn within the deposit portfolio, maybe intra-quarter trends in the core deposit book just to give us a sense of kind of what the quarter looked like from April...

James Beckwith, President and CEO

Sure. As we mentioned earlier, there's been a slight decrease in broker deposits, which is a positive trend we expect to continue for the rest of the year. It's interesting to compare deposit pipelines to loan pipelines. Loans are booked much more quickly than new deposit relationships. To quantify this, deposit pipelines generally have a duration about twice as long as loan pipelines. For instance, booking a loan typically takes about 60 to 65 days, while establishing a deposit relationship can take twice as long or even three times as long. This is why it's crucial for our deposit pipeline to be significantly larger than our loan pipeline. In the second quarter, we observed loan growth outpacing deposit growth. However, year-to-date, our deposit growth is slightly ahead at 5.3% compared to loan growth at 4.9%. We are aiming for 10% deposit growth and 8% loan growth for the year, and we are not far from reaching those targets. As we progress, we plan to replace some wholesale deposits with more stable core deposits. While overall deposit growth may not be substantial, the composition will change, which is our goal. It's a competitive environment, making it more challenging to achieve deposit growth compared to loans. However, we are improving our relationship onboarding process. We have a dedicated team of relationship managers and business development officers, currently totaling 21, excluding me and Mike Rizzo. We are optimistic about our system-wide initiatives and have successfully acquired new large deposit relationships, which we believe will continue to grow for the rest of the year.

Gary Tenner, Analyst

I appreciate the thoughts there. Can you provide the interest-bearing deposit spot rate as of June 30? And if possible, could you also share the core interest-bearing deposits, if that information is available?

Heather Luck, Senior Vice President and CFO

Yes. So the spot rate was 2.04 at the end of the quarter. And that's just our interest-bearing all-in.

James Beckwith, President and CEO

That's everything. Yes, full deposit costs.

Operator, Operator

Our next question comes from Wood Lay from KBW.

Wood Lay, Analyst

Just wanted to follow up on the deposit and maybe NIM outlook based on that spot rate. So it looks like a lot of the heavy lifting was done sort of towards the beginning of the quarter. I mean, do you think the NIM can begin to stabilize here coming into the next quarter?

James Beckwith, President and CEO

Yes, we anticipate that there may be a slight additional decline in NIM in the third quarter, likely falling between 3.3 to 3.35. I believe that’s where it will stabilize. This will largely depend on how quickly we can execute our deposit pipeline. We do expect NIM to decrease to that level in the third quarter.

Wood Lay, Analyst

Got it. Assuming we reach a stable rate period, how do you think the NIM will react? Do you believe it will mostly hold steady, or with the loans you're bringing on, do you think we could see increases in a stable interest rate environment?

James Beckwith, President and CEO

We expect that this will represent a stable range in the third and fourth quarters. Looking ahead to 2024, we anticipate seeing an improvement of 10 to 15 basis points from that level, assuming the Fed stops its rate adjustments at that point. Currently, we do not expect any declines in the federal funds rate, which we believe will allow us to stabilize. If there were any declines, it could lead to a significant improvement in our net interest margin.

Wood Lay, Analyst

Right. That makes a little sense. And then last for me, more just a housekeeping item, but I know there was some noise in the tax rate for the quarter. Just on a go-forward basis, do you expect that to increase back up closer to the 29% level?

Heather Luck, Senior Vice President and CFO

We are targeting a tax rate of approximately 29.03%. This is our forecast. We conducted a state tax study in the second half of the year, and we will have some amended returns and new state returns to file. Moving forward, we expect our tax rate to remain around 29.03%.

Operator, Operator

And our next question is a follow-up from Andrew Terrell from Stephens.

Robert Terrell, Analyst

Thank you for the follow-up questions. I'm reviewing the loan originations for the quarter, and they appear to be quite healthy, showing a solid increase compared to the first quarter. However, both payoffs and paydowns also rose significantly. I was wondering, James, if there was anything unusual regarding payoffs or paydowns this quarter?

James Beckwith, President and CEO

We recently experienced a significant payoff of an office loan, which was welcomed news. There's typically a fair amount of churn within our MHC portfolio as our operator investors adjust their holdings. This is a usual occurrence, along with normal amortizations, but we did see some notable payoffs, which we appreciate. As these loans payoff, they generally have lower rates, allowing us to reinvest in higher-rate loans. We believe this strategy will benefit our margins in the long run. However, I don't expect to see the same level of loan originations in Q3 as we did in Q2; I anticipate a decrease. Nevertheless, we still project an 8% loan growth for the entire year.

Heather Luck, Senior Vice President and CFO

Yes. So those were originated at about 7.77%.

Robert Terrell, Analyst

Okay. Understood. James, given the 8% loan growth rate, it appears that your capital position should increase modestly from here, but it also seems like there are some growth tailwinds supporting you. I would like to hear your updated thoughts on your current capital position.

James Beckwith, President and CEO

We aim to increase our common tangible equity relative to our risk-weighted assets, and this remains our primary focus. We noticed a slight improvement in the second quarter, which aligns with our goals. We believe we can sustain this growth, targeting 8% growth in loans and 10% growth in deposits. We are confident in maintaining and growing our capital position. If we see opportunities for deposit growth that surpasses our expectations, we will seize them. We realize this may necessitate additional capital, and as you know, we filed a $250 million shelf registration in Q1, which is valid for three years. While we don’t currently feel the need to tap into the capital markets, we acknowledge that there have been improvements recently. For now, our priority is to continue growing our common tangible equity in relation to our risk-weighted assets.

Operator, Operator

And ladies and gentlemen, that will conclude our question-and-answer session. At this time, I'd like to turn the floor back over to management for any closing remarks.

James Beckwith, President and CEO

Great. Thank you. Five Star Bank is on a continued growth path 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. Recent successes include the company earning the #1 ranking on the S&P Global Market Intelligence annual rankings of 2022's best-performing community banks in the nation with assets between $3 billion and $10 billion. We are very pleased to be recognized and believe this ranking builds upon the trust we have created with our customers and communities. The company also has a Bauer Financial Superior Rating of 5 out of 5 and an IDC Superior Rating of 300 out of 300. The company has also a super premier performing bank with The Findley Reports. We are a driving force for economic development, a trusted resource for our customers and a committed advocate of our community. We look forward to speaking with you again in October to discuss earnings for the third quarter of 2023. Have a great day, and thank you for listening.

Operator, Operator

Ladies and gentlemen, the conference has now concluded. We thank you for attending today's presentation. You may now disconnect your lines.