Earnings Call Transcript - FSBC Q2 2022

Operator, Operator

Welcome to the Five Star Bancorp Second 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 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 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 may result 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 2 of the presentation, which includes disclaimers regarding forward-looking statements, industry data and non-GAAP financial information included in this presentation as well as reconciliation 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 would now like to turn the presentation over to James Beckwith, Five Star Bancorp 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 second quarter of 2022. Joining me here 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 second 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 and deposits and total assets have consistently grown since the prior periods. Our pipeline continues to remain substantial at the end of the second quarter of 2022. Within the verticals, we have historically operated in, as presented in the loan portfolio diversification slide. Non-PPP loans held for investment, a non-GAAP measure that is reconciled in our press release, increased during the quarter by $301.9 million, or 14.52% from the prior quarter, primarily within the commercial real estate concentration of the loan portfolio. All PPP loans have been forgiven, paid off by the borrower or charged off as of June 30, 2022. Loan originations excluding PPP loans during the quarter were approximately $440.5 million and payoffs excluding PPP loans were $138.1 million. Additionally, $1.5 million of PPP loans were forgiven, ultimately resulting in a net increase in loans of $300.4 million from the prior quarter. Asset quality continues to remain strong, with non-performing loans representing 0.02% of the portfolio, slightly decreasing from the last several quarters. At quarter end, there were two loans totaling $0.1 million in the aggregate on COVID-19 deferment. We anticipate all borrowers to return to their pre-COVID-19 contractual payment status after their COVID-19 deferments end. At the end of the second quarter, the allowance for loan losses totaled $25.8 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, excluding PPP loans, a non-GAAP measure that is reconciled in our press release, was 1.08% at quarter end. Loans designated as substandard totaled $1.2 million at the end of the quarter, representing a decrease in substandard loans of approximately $1.8 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.

Heather Luck, Senior Vice President and CFO

Thank you, James, and hello, everyone. During the second quarter, deposits decreased slightly by $1.8 million, or 4.07% compared to the previous quarter. Non-interest bearing deposits as a percent of total deposits at the end of the second quarter increased to 40.2% from 37.6% at the end of the previous quarter. We've had strong deposit growth over the last several quarters with deposit balances remaining relatively consistent from the prior quarter. Non-interest bearing deposits increased by $64.8 million, while interest-bearing deposits decreased by $66.6 million. The cost of total deposits was 17 basis points during the second quarter. We continue to be well capitalized, with all capital ratios well above regulatory thresholds for the quarter. Net income for the quarter was $10 million. Return on average assets was 1.45%, and return on average equity was 17.2%. New loan originations drove increases in the daily average balance of loans period over period. Additionally, the company recognized $24,000 of PPP income based on forgiven loans during the quarter. Average loan yield for the quarter was 4.47%, representing a decrease of 6 basis points over the prior quarter. As a result of these factors, our net interest margin was 3.7% for the quarter, while the net interest margin for the prior quarter was 3.6%, which also included $600,000 of PPP income recognized based on forgiven loans. 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 in the amount of $5.5 million, primarily in our mortgage-backed and municipal securities portfolio, resulting in decreases to each of those portfolios of $7.3 million and $5.2 million, respectively. This caused a 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 a slight increase in equity as a result of net income earned in the quarter paired with a decline in total shares outstanding at the end of the period as a result of various stock forfeitures that occurred during the quarter. This resulted in a net increase in tangible book value per share of $0.12. Non-interest income decreased to $2 million in the second quarter from $2.2 million in the previous quarter, due primarily to a decrease in other income as a result of a $300,000 gain recorded on a distribution received on an investment in a venture-backed fund in the prior quarter, which did not recur during the current quarter. This decrease was partially offset by an increase in loan-related fees of $200,000 due to an increase in swap referral fees recognized during the quarter. Non-interest expense increased to $10.2 million in the second quarter from $9.6 million in the previous quarter, driven largely by an increase in other operating expenses as a result of an increase in travel related to attendance of professional events, conferences, and other business-related travel during the quarter. Now that we have discussed the overall results of operations, I will 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 today as we discuss the second quarter results. The strength of the bank's second quarter financial results continues to be emblematic of a reputation built on trust, speed to serve, and certainty of execution which supports our clients' success. Our financial results are also a result of a truly differentiated customer experience, which powers the demand for Five Star Bank's relationship-based services. We are pleased to have recently received a Super Premier rating from The Findley Reports and an IDC rating of Superior. Additionally, the company's Bauer rating is a 5-star rating. We attribute these ratings 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 second half of 2022, 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 interest rate environment and will continue to execute 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 that you might have.

Operator, Operator

We will now begin the question-and-answer session. Our first question comes from Andrew Terrell with Stephens. Please go ahead with your question.

Andrew Terrell, Analyst

Hey. Good morning.

James Beckwith, President and CEO

Good morning, Andrew.

Heather Luck, Senior Vice President and CFO

Good morning.

Andrew Terrell, Analyst

James, maybe just to start, this was just an exceptional growth quarter. I was hoping you could discuss maybe how the pipeline or give us a sense of where the pipeline in the third quarter was shaping up versus the prior quarter or are you seeing any kind of a slowdown given the move up in rates we've seen? And then, I would assume also on the other end, payoffs are slowing down as well. So hopefully, you could just provide us kind of updated expectations on how overall net growth shapes up in the second half of the year?

James Beckwith, President and CEO

Sure. Our loan pipeline is less than what it was when we entered into the second quarter by a fair amount. Our deposit pipeline has actually grown, so where we sit today is that our deposit pipeline is substantially larger than our loan pipeline. I think it's safe to say that it will be very difficult for us to experience the same amount of loan growth in the second half of the year as we saw in the first half. The deal flow has slowed, but it's still there. We're still very busy. But I don't think we're going to experience the same degree of loan growth that we saw in the first half of the year and in particular the second quarter for Q3 and Q4 as we go out. So expectations are probably a 5% to 10% loan growth for the remainder of the year and probably if we perform well on the deposit side, deposit growth between 10% to 15% for the remainder of the year. We have a lot of large relationships that we're onboarding right now. And we're excited about those opportunities and everything else that the market is bringing us right now.

Andrew Terrell, Analyst

Great. That's really encouraging to hear, especially on the deposit growth front. I think last quarter, we might have talked about loan yields, I think potentially laying down a bit for the next couple of quarters just before expanding, as a function of kind of the pipeline funding up. I was just hoping to get a sense of where new originations came on at during the second quarter? And then I would imagine just given the volatility in rates upward that we've seen that you're kind of funding loan growth at a higher yield now. Just hoping to get a sense of kind of trajectory of the loan yields?

Heather Luck, Senior Vice President and CFO

Yeah. So I can take that, Andrew. For Q2, our weighted average rate was about 4.65% and then driving that primarily with our fundings in the multi-family concentration, which came in about 4.57%, that was pretty much the bulk of the funding for the period. I'll let James provide some color around.

James Beckwith, President and CEO

Sure. The loans that we're approving in committee over the last month are substantially all of which had five handles on it. So we are pricing up, naturally speaking. We're a spread shop and we spread off the five-year or the 10-year with our CRE lending. And so we are seeing the actual rates on those deals being higher than our loan yield that we currently have in our loan portfolio. So it's our expectations that loan yields will grow based upon the amount of volume that we put on, so which is nice to see. For the longest period of time, Andrew, we were making loans that were yielding less than what was in the portfolio, which is not a winning strategy per se, but we think that that's turned around.

Andrew Terrell, Analyst

Yeah. Okay. Got it. Maybe sticking on kind of the margin, if I look at the move in the interest-bearing deposit costs this quarter, I guess if I just run the math, I get to like 20% interest-bearing deposit beta for 2Q. Maybe for Heather, do you think that beta should kind of hold around 20% through the rate cycle? Or are you seeing deposit rate competition kind of more meaningfully accelerate so far in the third quarter? And then can you just remind us overall of where you kind of target the deposit beta through the cycle?

Heather Luck, Senior Vice President and CFO

Sure. Yeah. So we actually use an internal estimate of about 30% for our betas on deposits. We do have our large governmental book that kind of holds that steady as we have inflows and outflows. So we're kind of using 30% as our estimate.

Andrew Terrell, Analyst

Got it. Okay. And then do you have the spot either interest-bearing or total deposit costs that at June 30?

Heather Luck, Senior Vice President and CFO

Well, total cost of deposits at June 30 was 22 basis points. But, we could kind of see that almost doubling by the end of September just given the composition of our deposit book and the rising rates on the lease rates that we tie our governmental book to. So all-in that go up to 44 basis points to 50 basis points by the end of Q3.

James Beckwith, President and CEO

It's important to highlight that we do not have a very detailed deposit base. Instead, we maintain many large relationships, each of which has negotiated pricing. This makes it challenging to predict overall outcomes. We are responsive to pricing changes, and with each Federal Reserve rate adjustment, there is increased pressure on some of our interest-bearing deposits to rise. However, each relationship is unique regarding its negotiated pricing.

Andrew Terrell, Analyst

Okay, understood. Well, I'll step back in the queue. I appreciate you taking my questions.

James Beckwith, President and CEO

Sure.

Operator, Operator

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

Gary Tenner, Analyst

Thanks. Good morning, everybody.

James Beckwith, President and CEO

Hey, Gary.

Gary Tenner, Analyst

Hey. I appreciate the thoughts on the deposit pipeline. Obviously, with the loan deposit ratio creeping up as it did during the quarter it should help moderate it a bit. Can you give us a sense as to kind of what the rate of that deposit pipeline looks like? I know Heather you just provided some thoughts on where deposits could go by the end of the quarter, but just curious kind of what the marginal cost of funding looks like right now?

James Beckwith, President and CEO

So many commercial accounts are probably at or slightly above where we are at the end of the second quarter. I expect that to be new production. We anticipate continued growth in our non-interest-bearing deposits. There was a substantial increase in the first half of the year, with over $100 million in non-interest-bearing deposits through June 30. This tends to drive down costs, and our pipeline is filled with similar opportunities. As we take advantage of market conditions, especially with major players and merger-related entities, it has been a positive benefit for us.

Gary Tenner, Analyst

Got it. Thank you. On the fee side, obviously, pretty steep drop that we seen at your institution and others, as it relates to SBA premiums. Any thoughts to kind of keeping more on portfolio given how low those premiums are or does balance sheet management and funding dictate that you continue to sell?

James Beckwith, President and CEO

That's a great question. We've never kept any SBA loans in our portfolio. We've always originated them for sale, and I expect that will continue. There are some notable developments with the SBA. They are significantly increasing their maximum pricing. We haven't decided how we want to respond yet, and it's a wait-and-see approach regarding how investors, the buyers of our loans, react to these pricing increases, which are 50 to 100 basis points above the maximum pricing allowed by the SBA. I'm not sure about the policy behind it, but I believe it will be implemented in the first week of August, which could impact premiums. Currently, we're uncertain about what that will look like. As you mentioned, premiums have decreased. However, our SBA function remains very profitable. While we would like to see higher volumes, they are what they are, and we will continue to sell.

Gary Tenner, Analyst

Great. And then lastly for me, I think historically your comp programs set up to where as your development officers kind of hit their numbers. You have that ramp of comp in the back half of the year. And I think particularly with your thoughts on the pipeline, which I know is a big part of that incentive program. Should we expect to see sort of that upward trajectory again in the back half of this year based on how that pipeline looks?

James Beckwith, President and CEO

Well, I think we do have some special incentives for deposits. With the loan production, the first half of the year was $0.75 billion. So a lot of guys are already at the highest tier. I'm going to say at least half of them are. And so Q2 commissions were pretty good for them. We're happy to be able to do that. But I think that you probably could see some slightly less consistent with last year in terms of commission growth. But it all depends on how well we execute on the deposit side in terms of new accounts and new relationships.

Gary Tenner, Analyst

Okay. Thanks for taking my questions. Our next question comes from Stuart Lotz with KBW. Please go ahead with your question.

Stuart Lotz, Analyst

Hey, guys. Good morning. How's it going?

James Beckwith, President and CEO

Hey, Stuart. How are you doing?

Heather Luck, Senior Vice President and CFO

Good morning.

Stuart Lotz, Analyst

James, could you quantify your loan growth outlook? I appreciate the pullback just given the backdrop. But this quarter, $300 million and I think over the last about four quarters, you've averaged above a 30% annualized growth. So just in terms of dollar amounts, how are you thinking about the growth pipeline for the back half?

James Beckwith, President and CEO

Probably in the neighborhood of $100 million to $125 million per quarter, remainder of the year. Is that helpful?

Stuart Lotz, Analyst

Yeah. And I mean just given the mix in recent quarters has really come from the manufactured housing book or manufactured comp book, we expect that to continue to drive the growth from here or do you anticipate pulling back just given the concentration issues?

James Beckwith, President and CEO

We don't. Yeah. Good. Thank you. But we don't anticipate pulling back in terms of that particular vertical and lending into that space. We really like the credit characteristics. We like the granularity, geographic granularity associated with that business. And we just think that that asset class based upon our research has always performed well in any type of economic environment and in particular a downturn. So we think that we're well protected in terms of lending into that space, so we don't plan to stop or modify what we're doing. But we'll say that the market has slowed. I think there's less acquisition, park acquisition going on, and I think rates have clicked up. So buyer and seller expectations are maybe they're a little the widespread than they once were with cap rates rising. So we've definitely seen a slowdown in that business, but it's still pretty decent.

Stuart Lotz, Analyst

Okay. Got it. Great. And maybe, warming in a capital question, I think historically, you've operated with the CRE as high as about 700% of total risk-based capital and kind of by my math this quarter, you guys are kind of back in that range. So any thoughts about potential capital? I know you're looking at potential sub debt rates at some point to reprice your existing sub debt, but just want to get your thoughts on how high you're willing to let that ratio go before looking to raise some additional capital for growth?

James Beckwith, President and CEO

Well, Stuart, as you know, we've always discussed our plans to execute on that refinance, and I believe our thinking remains consistent in that regard. Therefore, there is an expectation that we could complete it by the end of the year, which could provide us with additional capital and help lower the concentration levels for commercial real estate that you mentioned.

Stuart Lotz, Analyst

Would you consider raising equity capital given the current strength of the currency and the high pricing of subordinated debt? What factors might influence the choice between the two options going forward?

James Beckwith, President and CEO

Well, that's a good question. So let's do the math together if we could. We're nowhere near a 125% double leverage ratio right now. We kind of like that number as a ceiling, Stuart. So you could probably back into that in terms of what the additional or what size would be if we did a sub debt deal number one. If we're making 17% after a $2.3 million provision on equity. I think that my understanding in the current sub debt market in terms of an interest rate we do pretty well with that, don't you think?

Stuart Lotz, Analyst

Yes. I would agree. Just given kind of what we've seen, I mean obviously there's been a pullback in that market, but just given the strength of your currency from a price intangible book standpoint, I feel like common equity might make sense at these levels too?

James Beckwith, President and CEO

Sure. We want to make sure that we don't have blinders on with respect to capital at all. We want to make sure that we comprehend any opportunity that might be out there in the marketplace. And we are trading at what I think is a pretty nice premium to book, which not everybody enjoys. So definitely hear you when you say where our valuations are favorable with respect to future equity raises.

Stuart Lotz, Analyst

Appreciate all your color there. Maybe one more for Heather. Just turning back to expenses. Do you have what the deferred loan origination costs were this quarter and maybe if you could kind of hone in on a run rate for what you think the third-quarter expense base could be?

Heather Luck, Senior Vice President and CFO

Let me quickly follow up on that. I don't think we broke that out in the earnings release for you all, but I believe we did.

Stuart Lotz, Analyst

May have misheard.

Heather Luck, Senior Vice President and CFO

Let me pull that up for you one moment. Actually, I will get back to you on that one. We can move in and out of the queue, and I will hold on for you.

Andrew Terrell, Analyst

Okay, perfect. Thanks for the follow-up questions.

Operator, Operator

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

James Beckwith, President and CEO

Great. Thank you. Five Star Bancorp is on a continued path of robust organic growth as we execute on the 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 and embrace challenges and value the intrinsic reward of serving others. We look forward to speaking with you again in October to discuss earnings for the third quarter of 2022. Have a great day and thank you for listening.

Operator, Operator

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