Earnings Call Transcript - FSBC Q4 2021

Operator, Operator

Welcome to the Five Star Bancorp Fourth Quarter and Year-End 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 a dial-in number 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, 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. Among other risks the ongoing COVID-19 pandemic may significantly affect the banking industry and the company's business prospects. The ultimate impact on the company's business and financial results will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic, its impact on the economy, the company’s customers and its business partners, effectiveness of COVID-19 vaccines, particularly as new variants emerge and actions taken by government authorities in response to the pandemic. 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 quarterly report on Form 10-Q for the quarter ended September 30, 2021. And in particular, the information set forth in Item 1A Risk Factors therein, please refer to slide two of the presentation, which include 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 their most directly comparable GAAP figures, which is included in the appendix to the presentation. Please note this event is being recorded. I'd now like to turn the presentation over to James Beckwith, Five Star Bancorp’s President and CEO. Please go ahead.

James Beckwith, President and CEO

Thank you for joining us to review Five Star Bancorp's financial results for the fourth quarter and year ended December 31, 2021. 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 our Executive Management Team. The fourth quarter of 2021 exhibited continued execution of our organic growth strategy following our IPO in May, 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 previous quarter and year-over-year. Our pipeline continues to remain substantial at the end of 2021 within the verticals we have historically operated in, as presented in the loan portfolio diversification slide. Non-PPP loans, a non-GAAP measurement that is reconciled in our press release grew during the quarter by $274.5 million or 16.7%, primarily within the manufactured home community, CRE retail, CRE industrial concentrations of the loan portfolio. Non-PPP loans grew by $563 million or 41.4% year-over-year, primarily in the manufactured home community, multifamily, CRE retail and CRE industrial concentrations of the loan portfolio. Approximately $39 million of PPP loans were forgiven during the quarter and $1.1 million of PPP fees and interest were recognized during the fourth quarter of 2021, leaving $22.1 million of PPP loans outstanding and $0.6 million of deferred fees to be recognized at year-end. For 2021, approximately $236 million of PPP loans were forgiven and $6.2 million of PPP fees and interest were recognized. We anticipate the full balance of PPP loans to be forgiven in the near term. Loan originations excluding PPP loans during Q4 were approximately $462 million, which is 65% higher than last quarter and payoffs, excluding PPP loans were $194 million, which was 87% higher than last quarter. Approximately $39 million of loans paid off in the fourth quarter were risk rated as watch or classified. During 2021 loan originations including excluding PPP loans were approximately $1.0 billion and payoffs excluding PPP loans were $479 million. Asset quality continues to remain strong with non-performing loans representing only 0.03% of the portfolio, consistent with the last several quarters. At year-end there were six loans totaling $12.2 million in aggregate on the COVID-19 deferment program. We anticipate all borrowers to return to their pre-COVID-19 contractual payment status after their COVID-19 deferments end. At the end of 2021, the allowance for loan losses totaled $23.2 million. We recorded a $1.5 million provision for loan losses during the fourth quarter for a total provision for loan losses of $1.7 million for the year. The ratio of the allowance for loan losses to total loans excluding PPP loans, a non-GAAP measure that is reconciled in our press release was 1.21% at year-end. Loans designated as watch and substandard totaled $8.6 million and $10.6 million respectively at the end of 2021, representing a decrease of approximately $12.5 million and $26.2 million respectively from the previous quarter and $15.6 million and $25.2 million respectively from the previous year-end. This reduced our reserves related to classified and watch loans by $0.5 million, which was offset by additional provisions for loan growth during the 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.

Heather Luck, Senior Vice President and Chief Financial Officer

Thank you, James, and hello everyone. During the fourth quarter deposits grew by $117.5 million or 5.4% as compared to the third quarter of 2021. During 2021 deposits grew by $501.9 million or 28.1% since the end of 2020, of which $201 million of the growth related to non-interest bearing deposits. Non-interest bearing deposits as a percent of total deposits for the fourth quarter decreased to 39.5% from 41.5% in the third quarter, but increased to 39.5% from 39.3% for 2021 when compared to 2020. We have had strong deposit growth over the last quarter and through the current quarter. Cost of total deposits was 8 basis points during the fourth quarter. We continue to be well capitalized with all capital ratios well above regulatory thresholds for the quarter and the year. Net income for the quarter was $11.3 million, return on average assets was 1.82% and return on average equity was 19.15%. Net income for the year was $42.4 million with return on average assets and return on average equity of 1.86% and 22.49% respectively. Average loan yield for Q4 2021 was 4.71% and average loan yields excluding PPP loans, a non-GAAP measure that’s reconciled in our presentation was 4.56%, representing a decline of 10 basis points over the prior quarter and 38 basis points over the prior year. The current low rate environment has continued to put pressure on loan yields, which we have been able to partially offset by a decline in cost of funds, which was 16 basis points for Q4 and 19 basis points for 2021 compared to 17 basis points for Q3 and 54 basis points for 2020. As a result of these factors, our net interest margin was 3.67% for the quarter, which included $1.1 million of PPP fees and interest recognized based on forgiven loans, while net interest margin for 2021 was 3.6%, which included $6.2 million PPP fees and interest recognized based on forgiven loans. Non-interest income decreased to $1.8 million in the fourth quarter from $2 million in the previous quarter, due primarily to a decrease in the gain on the sale of securities from lower volumes sold. Non-interest income decreased to $7.3 million for 2021 from $9.3 million in the previous year, primarily as a result of a decline in loan related fees, driven by a decrease in swap referral fees recognized in 2021 as compared to 2020. Non-interest expense increased to $9 million in the fourth quarter from $8.6 million in the previous quarter, driven largely by increased salaries and employee benefits and an increase in various other operating expenses, offset by a decrease in loan related expenses as Q3 included a $2,000 accrual for an SBA matter in the normal course of business, this did not recur in Q4. Non-interest expense increased to $36.0 million in 2021 from $28.3 million in 2020, primarily due to increases in salaries and employee benefits and increased commissions due to loan and deposit growth, as well as increased professional services for matters related to our IPO. 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. 2021 was a remarkable year of growth, renewed purpose, and commitment to our customers, employees, shareholders and the communities we serve. Most banks offer similar if not the same products. However, no other bank has our engaged team, our speed to serve, or our certainty of execution. No other bank has our commitment to treating customers with empathetic spirit, understanding and care. We are proud to have earned the trust of those we serve. This trust has made Five Star Bank an exceptionally attractive organization for business development officers and supporting operational and lending staff to work, engage and experience their own success. 2021 was an exciting year as evidenced by a robust pipeline, record growth in loans and deposits, new expanded product offerings, new technology and the build-out of our verticals, all of which are enhanced by a deep sense of shared purpose. We look forward to continued organic growth in the capital region in the Northern California market. We appreciate your time today, this concludes today's presentation now. Now, Heather and I will be happy to take any questions that you might have.

Operator, Operator

We will now begin the question-and-answer session. Our first question comes from Stuart Lotz from KBW. Please go ahead.

Stuart Lotz, Analyst

Hey, James and Heather. How are you guys doing.

James Beckwith, President and CEO

Great. How are you?

Stuart Lotz, Analyst

Doing well. So if I could just start off on the growth outlook, this quarter was exceptional. Your full year growth ended at 45%. Tough to imagine you guys can repeat that next year, but just trying to get a better feel for where current pipeline standing right now? And maybe what your initial expectation for year-over-year growth in 2022 looks like?

James Beckwith, President and CEO

Sure. Thanks, Stuart. Certainly, 2021 was an exceptional year and it has been somewhat challenging to replicate that. However, we remain optimistic as we move into 2022. Our current outlook is for low double-digit growth in both loans and deposits. I believe we will have greater clarity on these numbers by the end of the first quarter regarding our direction. We have been working to address a couple of issues from an earnings and balance sheet growth perspective, specifically the reduced revenue from PPP loans, which has negatively impacted earnings, and an income tax provision that we are becoming more comfortable with as we enter 2022. We are focusing on overcoming these two factors affecting our earnings by driving loan growth, and we feel that we’ve made significant progress in that area. However, we will have better visibility on our progress by the end of the first quarter and a clearer sense of our expectations for the remainder of the year. There is some uncertainty about potential actions from the Fed and their impact on interest rates. We believe this will primarily affect the short end of the curve rather than the long end. We will see how that develops, but we are prepared and believe we can benefit from any increases on the short end. I hope this answers your question.

Stuart Lotz, Analyst

No, that's very helpful. And I guess kind of pivoting on your remarks of the Fed. Heather, I mean, how do you think about asset sensitivity for you guys? I mean, I think if I look at your disclosures, about 7% to 8% of your earning asset base is variable rate and then last cycle looks like interest bearing deposit cost peaks right around 120 basis points. So any kind of color on your asset sensitivity? And how quickly we should see your loan portfolio reprice higher if we do get a Fed hike here in March.

Heather Luck, Senior Vice President and Chief Financial Officer

We are asset sensitive and currently have a significant cash position of approximately $425 million that will be repriced immediately. For 2022 and 2023, we have around $67 million in loans tied to the five-year treasury that will reprice this year and $79 million set to reprice next year. We anticipate benefiting from a rising rate environment, estimating an increase of about $75,000 a month depending on when the Fed raises interest rates. Overall, across all loans set to reprice in the next two years, we only need a 20 to 25 basis point increase to lift those loans off their floors. This positions us well for any upcoming rate hikes.

James Beckwith, President and CEO

So, Heather, that $75,000 a month is really kind of tied into a 25 basis point move. So there is more moves than that, Stuart. You can see the resulting impact. And when the Fed continues this move, we'll have those loans come off their floors, which could be pretty favorable for us. So we like where we are with respect to a Fed move and Fed moves, we're not sure how many there are going to be. I heard the other day a securities analyst said there were going to be seven over the next few years. So I think there is a lot of wide degree of opinion, if you will, with respect to what the Fed might do.

Stuart Lotz, Analyst

Okay. And just a follow-up there. Would you be able to quantify what portion of your portfolio would reprice after one hike? And then, what percentage of the portfolios would reprice if we do get a, say, a 50 basis point hike in March?

James Beckwith, President and CEO

We have approximately $110 million in swaps linked to LIBOR that will adjust immediately, as we are aligned with one-month LIBOR. We expect to see an impact in the range of $60 million to $70 million from prime-based loans that will also adjust. Additionally, we have our cash position to consider. When you combine all these factors, you can see the overall effect.

Stuart Lotz, Analyst

Great.

James Beckwith, President and CEO

The next 25 basis points move will likely influence the remaining prime-based loans.

Heather Luck, Senior Vice President and Chief Financial Officer

The loans are linked to the 5-year treasury, with about $45 million set to reprice between the second and third quarters. There is a smaller amount of $9.3 million that will reprice in the first quarter, but the majority will occur in the second and third quarters.

Stuart Lotz, Analyst

Tying that altogether, I think the core margin saw some nice expansion this quarter. The growth in the securities book was minimal; it primarily resulted from significant loan growth. How do you envision the progression of your core margin throughout 2022, and how many rate hikes are currently factored into your baseline budget? Additionally, could you quantify the potential upside if we experience, for instance, four to six hikes this year?

James Beckwith, President and CEO

That could be very beneficial to us. This is a high-level overview of what the numbers might indicate. If you have around $600 million to $700 million worth of assets that you're planning to reprice, you can do the calculations. On the liability side, we expect some increase in our cost of funds, although that's always a complicated issue. We also have a substantial government portfolio, about $400 million, linked to the market, which could see an increase, although it’s a lagging index. Each quarter-point move translates to approximately $75,000 a month. You can do the math.

Stuart Lotz, Analyst

Sorry, maybe just one more from me. Kind of the core expense growth outlook this year backing out the IPO expenses and some other one-time comp, you were at about 20% annualized growth rate. How are you thinking about core expense growth rate in 2022 if we do see pretty strong double-digit loan growth as well as just traditional expense inflation, given the competitive environment right now?

Heather Luck, Senior Vice President and Chief Financial Officer

We experienced some challenges in 2020 due to the IPO and various initiatives, but our infrastructure is largely established in terms of personnel and technology. We have new initiatives planned for 2022. By the end of the year, our non-interest expense as a percentage of assets was approximately 1.42%, and we expect to maintain that percentage within the range of 1.42% to 1.45% in our budget. We hope this provides some clarity on our non-interest expenses.

James Beckwith, President and CEO

Stuart, we currently do not have any significant hiring plans to expand any units or bring in additional staff. Our team is well established. We believe that we have a considerable amount of operational efficiency as we continue to acquire income-generating assets. Therefore, I think that's a reasonable estimate at this time. Looking back, 2021 was a strong year, although it presented some challenges in financial reporting. After the first quarter, our financials should become clearer, as that will also be the first quarter operating under full C Corporation status.

Stuart Lotz, Analyst

Awesome. Thank you for taking my questions today. I will hop back in the queue.

Heather Luck, Senior Vice President and Chief Financial Officer

Thank you, Stuart.

Operator, Operator

Our next question comes from Andrew Terrell from Stephens. Please go ahead.

Andrew Terrell, Analyst

Hey, James. Hey, Heather.

James Beckwith, President and CEO

Hi, Andrew.

Heather Luck, Senior Vice President and Chief Financial Officer

Hi, Andrew.

Andrew Terrell, Analyst

Hey, James, I apologize if I missed this, but could you maybe size up just for the pipeline for new loans that’s kind of heading into the first quarter. I think it was about $330 million, if I recall, heading into 4Q?

James Beckwith, President and CEO

Yes, we're slightly lower than that at this moment. However, we believe it is on an upward trend. The fourth quarter was outstanding, and it remains very substantial. As we look at January, it's off to a good start. Given our strong market presence in various sectors, we are confident in our ability to maintain solid performance in new loan production. Currently, we are guiding to less than 40% year-over-year growth, but I am optimistic about the opportunities for 2021. To specifically address your question, I think we're just a little lower than the pipeline we had in the fourth quarter.

Andrew Terrell, Analyst

Okay. Very good. Thank you. And maybe just thinking about the constituents of what will drive the net growth in 2022. I think Manufactured Housing is around 27% of the loan portfolio today. Can you just remind us, I guess, the internal kinds of cap, if any, you place on that portfolio as a percentage of total loans? And should we expect that to be kind of less of a growth driver moving forward, just in terms of absolute dollars?

James Beckwith, President and CEO

Sure. In our concentration methodology, our capital limits guide how we allocate percentages across various asset classes. We still have some capacity for our manufactured home communities, but we are beginning to identify other opportunities within the portfolio, particularly in multifamily, which excites us. Additionally, we see potential in the industrial commercial real estate sector and the faith-based sector as well. We aim for all sectors to grow at the same rate and dollar amount, although sometimes one sector may advance faster than others. However, all these markets are currently strong. The manufactured home community stands out as the most in-demand asset class, which we view positively, and we will continue to assess it for credit quality. I don't foresee any constraints affecting our sectors at this time, Andrew, regarding scaling back.

Andrew Terrell, Analyst

I appreciate it. Regarding SBA gain on sale income, I noticed in the release that it might be lower this quarter due to some actions by the SBA. Should we expect the dollar amount of loans sold to increase from here? Is there any reason to believe you can't return to the levels of $17 million or $18 million in loan sales per quarter, as seen in 2019 and 2020? I would like updated expectations on SBA volume and gain on sale margins as we move into 2022.

James Beckwith, President and CEO

Sure. It's probably the most difficult vertical to predict in terms of volume and revenue. And we're hoping towards the Q3 and Q4 we will get back to those particular levels of volume, but our bread and butter was doing the $350,000 over last 7, 8, 10 years, equipment loans. That market just really hasn't come back yet. And despite all efforts, I think that the PPP loan process and the idle loan process has really presented up other opportunities for those borrowers that were traditionally looking at those types of credits or that type of funding. And I think that hangover, if you will, from that type of lending, the PPP loans and also the idle loans, it's going to take a while to work through. So we've reduced our expectations with respect to what we expect to see. If we do see it, it will be a nice surprise. So in terms of getting back to where we want for, we're all hopeful we'll be able to get back to that level, but in the latter half of the year.

Andrew Terrell, Analyst

Okay, very good. And Heather, just a housekeeping question, just given some of the noise on the tax rate. Do you have a good kind of expected tax rate we should be using for 2022?

Heather Luck, Senior Vice President and Chief Financial Officer

I do. Yes. And that was another noisy piece of the income statement this year. So our statutory tax rate is 29.56%. However, if you consider the benefits like our tax exempt income, things like that. We're estimating about 29.26% for the year.

Andrew Terrell, Analyst

Okay, perfect. I'll step back in the queue. Thank you for taking my questions and congrats on a good quarter.

Heather Luck, Senior Vice President and Chief Financial Officer

Thank you.

James Beckwith, President and CEO

Thank you, Andrew.

Operator, Operator

Our next question comes from Gary Tenner from D.A. Davidson. Please go ahead.

Gary Tenner, Analyst

Thanks, good morning. A couple of questions. I wanted to just ask about the loan deposit ratio. It dipped under 80% for the first few quarters of this year and then this fourth quarter with the combination of strong loan growth and more moderate deposit growth back up into the mid '80s. Just curious if you could remind us where you kind of like to optimally manage the balance sheet too from that perspective.

James Beckwith, President and CEO

Given our capital position, which is enabling us to maybe push that number a little bit, we could operate between 90% and 95%, and that would probably be optimal from an earnings perspective. So we'll see how that goes. But that would provide some upside in terms of margin and also net interest income for us.

Gary Tenner, Analyst

In terms of this fourth quarter, core loan yield is down a little bit, what was the new loan production weighted average yield in the quarter?

Heather Luck, Senior Vice President and Chief Financial Officer

Yeah. So the weighted average rate for Q4 was 3.98%. The majority of our loans are in multi-family and CRE non-owner occupied and those have heard more around like low fours, high threes.

Gary Tenner, Analyst

And then just one last question from me, on the expense side. I appreciate kind of the range you provided, Heather, on the expense to average asset range. I seem to recall in the past you've kind of talked about maybe moderating or modifying the accruals for commissions, because I think you tend to have a much higher kind of commission run-rate towards the end of the year as your lenders hit their goals and exceed their goals. As we think of the progression over the course of 2023, is the progression that we saw in 2022 is what you'd expect or would you think it will be a little more moderate quarter to quarter?

James Beckwith, President and CEO

I believe our commission structure is evolving as we transition from a private to a public company. We're improving our ability to manage accruals. Since we have a tiered commission structure and additional bonuses tied to interest rate and demand deposit growth, which are calculated in the fourth quarter, there will always be a higher level of commissions in Q4 compared to other quarters. However, outside of that, we expect things to run relatively smoothly.

Gary Tenner, Analyst

Thank you very much.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to management for any closing remarks.

James Beckwith, President and CEO

Great, thank you. I want to thank everyone for joining us as we discuss the quarterly and annual results. Today's presentation demonstrated that Five Star Bancorp is continuing on a path of robust organic growth. We are attracting and retaining talent while preserving a culture, driven by the speed to serve and uncertainty of execution. Importantly, our customers trust us and have direct access to us at all times. This is a key differentiator in our market and a driver of customer acquisition as evidenced by the strength of our growing pipeline. Purpose and integrity driven banking are foundational to who we are. We continue to build meaningful relationships as we serve our shareholders, customers, employees, and community. Please contact me or Heather if you have any other questions. We look forward to speaking with you again after our first quarter to discuss earnings for the first quarter of 2022. Have a great day. And thank you for listening.

Operator, Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.