Bank OZK Q4 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Bank OZK Fourth Quarter 2020 Earnings Conference Call. At this time, all participants’ lines are in a listen-only mode. After the speakers presentation, there will be a question-and-answer session. Please be advised that today’s conference is being recorded. I’ll now handle the conference over to your speaker today, Mr. Tim Hicks. Sir, you may begin.

Good morning. I'm Tim Hicks, Chief Credit and Administrative Officer for Bank OZK. Thank you for joining our call this morning and participating in our question-and-answer session. In today's Q&A session, we may make forward-looking statements about our expectations, estimates and outlook for the future. Please refer to our earnings release, management comments, and other public filings for more information on the various factors and risks that may cause actual results or outcomes to vary from those projected in or implied by such forward-looking statements. Joining me on the call to take your questions are George Gleason, Chairman and CEO; Greg McKinney, Chief Financial Officer; and Brannon Hamblen, President and COO of our Real Estate Specialties Group. To make the most efficient use of the time we have for this call, we’d ask that you please limit your questions to one or two at a time and then re-enter the queue for any follow-up questions if needed. We will now open up the lines for your questions. Let me ask our operator, Crystal to remind our listeners how to queue in for questions.

Thank you. And our first question comes from Ken Zerbe from Morgan Stanley. Your line is open.

First question, you obviously had fantastic NIM this quarter. So congratulations on that. But it did seem from your prepared remarks that both the purchase and non-purchase yields may have some unusual positive items this quarter. Can you just talk about how much of that NIM is sustainable on a go forward basis? Thanks.

Ken, you're correct and we wanted to be clear in our remarks that there was a bit left on both pieces of that, particularly on the purchase loans. I think Tim mentioned that was about $1.7 million more than what we would consider a normal run right now. Those numbers tend to bounce around quarter to quarter, so what's normal is hard to determine. However, our special assets team did a great job collecting some loans that were previously charged off in special assets and collecting interest on some loans that were previously in non-accrual status, which really reflected their good work. That helped lift that number up to an unusually good number, and you can see on the chart from the management comments that was one of our highest net interest margin numbers in that purchase portfolio in quite a while. So there was that lift from approximately $1.7 million or $2 million. We did have probably a bit higher level than normal, but again, normal is hard to define. We did have some short-term extension fees and minimum interest earned on loans in the non-purchase portfolio contributing to these results, but overall, there was a healthy trend in the NIM and the core spread, even with those factors considered. So we were pleased with the results.

Perfect, yeah that was very good. The other question I had in terms of loan growth is: At what point do we get past the headwinds of the elevated payoffs? I know that COVID obviously delayed some projects, and I read your comments in the release; it just feels like these payoffs have been a headwind for probably far longer than they should have been. Thanks.

Well, of course, 2016 and 2017 were really large origination years which created a lot of pay-off headwinds in 2019, sort of around two to three years after a lot of those significant origination years. We got through last year and expect a lot of payoffs in 2020, with the slowing of completion of construction projects due to shelter-in-place orders delaying the transition from financing to permanent financing. This has pushed payoffs out, and we began to see quite a bit of that come back to the table in Q4. It is very likely that we will see record levels of payoffs in 2021, partly due to those payoffs pushed from 2020 and what we would normally experience in 2021. So we know this challenge exists for the year. We've got to work hard to find quality loans that meet our high standards without sacrificing quality or pricing to keep our pipelines full and originate enough to offset those payoffs. So this year will be unusually challenging from a payoff perspective because we will not only get what we would normally see but also an overflow from 2020. This pandemic-related delay in payoffs presents a challenge, but the encouraging thing is our RESG originations ended the year at a strong level. Even with all the noise from the pandemic in 2020, our RESG originations were slightly better than in 2019. We have good pipelines going into the new year, so we have to continue producing weekly, monthly, and quarterly.

All right, perfect. Thank you very much.

Thank you. And our next question comes from Timur Braziler from Wells Fargo. Your line is open.

Maybe looking at the other side of the equation and looking at the good growth you've seen in unfunded commitments over the past couple of quarters, is that indicative of sponsors getting more comfortable and re-engaging, and I guess which segments within RESG are you seeing that growth come through?

Brannon, you want to take that? That's a RESG question for sure.

Sure, Timur. Thank you for the question. Yes, there is an element of that. As we've come through COVID, the initial shock was strong and affected a lot of people's thinking. But as we've previously noted, the sponsors we deal with are sophisticated. They're not going to throw their plans aside forever. COVID notwithstanding, and we are starting to see, gradually, an increase in activity. I don't want to overstate that; there are still projects that remain sidelined. However, in the Southeast and the Southwest, we have seen a lot of activity. We've talked about some significant demographic shifts, including migration from the Northeast, particularly to the South and Southern Florida. These trends continue to strengthen, and there are still underlying demands that justify a lot of new development. While I wouldn't say everybody is operating at full capacity, and some are waiting to see how things develop, our ability to achieve growth has remained strong. We have been active in lending despite the pandemic, and our reliability has been key to maintaining a strong pipeline. Additionally, we've had success in other Northeast markets like Boston, Cambridge, and D.C. We are also increasing our life sciences lending, particularly in high-demand areas due to the current pandemic. We’ve been pushing hard into those product types and see good opportunities for growth.

Okay. Thank you.

You can see that in a lot of what Brannon was discussing in figure 34, summarizing the distribution of loans. New York has been coming down for several quarters due to challenges in finding new opportunities, significantly impacted by the COVID market. We're likely down about $1.3 billion from where we were in New York. But if you look at the other active geographies—all around the $800 million to $900 million range, including Boston, Philadelphia, and D.C.—the New York office services those markets, and that is growing. Miami and Tampa rank high, as does Phoenix, highlighting the emergence of these new geographies and business opportunities. I think our team has done an excellent job of seeing where opportunities lie and pursuing deals that make sense.

Okay. Thank you. As a follow up question, looking at the liquidity bill: cash provisions are about a $1 billion higher year-over-year. Loan growth seems pressured with some headwinds from continued pay downs. What do you expect for that liquidity? How quickly can that be deployed, and can margins remain sustainable given your liquidity levels? Especially with the tailwinds received from the one-time items in the fourth quarter?

I would kind of turn that question around and say we were very pleased with the margin results we've achieved over the last couple of quarters, particularly in the recent quarter where we had nice margin expansion while holding a higher level of cash and securities than we’ve probably ever held. You mentioned the cash position being much higher year-over-year. The securities portfolio is also significantly elevated, and the pledged securities amounts are lower than they were. In general, our liquidity position is very strong, which is positive. However, when your money in Fed funds is at 10 basis points and you're investing in short-term high-quality securities yielding slightly more, it doesn't significantly impact the margin. So while our liquidity is a source of strength, it may weigh on our actual margins. We want to maintain this strong liquidity position as it secures our balance sheet. It's a valid question, but we wish the market allowed for better investment options. Given the current low-interest environments and the flat curve, we find few incentives to change our approach.

Understood. Thank you very much.

Thank you.

Thank you. And our next question comes from Matt Olney from Stephens. Your line is open.

Great thanks for taking my question. I want to circle back on the organic loan growth discussion and the management commentary regarding the major segments. It seems like there are different drivers with headwinds in RV, Marine, Community Bank, and RESG, but it appears that the total non-purchase loan growth ex-PPP could be relatively flat in 2021 compared to 2020. I just want to make sure I'm thinking about this right.

I don't know that we’re giving specific guidance on whether that's flat or up a little or what. However, here’s a little more color that may be helpful: the community bank segment is very challenging right now. Small banks are desperate for loans and have become very aggressive with credit and rates in recent quarters. We are committed to maintaining our credit standards, holding our equity down payment standards, and not giving on minimum pricing, regardless of aggressive competition. We have been losing business in the community bank sector to competitors that are letting these standards slip, which has resulted in shrinking that lending category. We also retooled our direct unit last year and were on the sidelines for about six months. That was a necessary decision allowing us to build a better business model that we began rolling out in Q4. Although building momentum takes time, I expect to see a slower growth rate compared to 2018-2019. However, we anticipate returning to positive growth in the back half of 2021. The loans booked now still demonstrate strong collateral quality and should continue yielding good spreads with lower premiums. Despite possible paydowns in the first half of 2021, we anticipate a more favorable outlook for the back half of the year. The RESG should be our main source of growth in 2021 as it has shown historically, but we still need to focus on finding quality deals to close, while navigating a challenging landscape.

Okay that's great. Thank you for the commentary, and as a follow-up, I want to ask about excess capital since overall levels remain excellent. If asset growth is less material in 2021 compared to previous years, what are your thoughts around a potential share buyback program to deploy some of that excess capital?

That's an important question and certainly something that is being discussed internally. We've articulated holding significant amounts of excess capital as a buffer for potential economic turbulence that could create opportunities. While we have encountered some turbulence resulting in limited opportunistic purchases, the rapid monetary and fiscal policy responses have reduced the prospects for significant opportunities to materialize. We could still find opportunities to utilize our surplus capital down the line. However, looking at better ways to deploy that capital is becoming increasingly necessary.

Thank you. Our next question comes from Catherine Mealor from KBW. Your line is open.

I really love your bubble charts; I think they really help illustrate the diversity in your loan portfolio. Turning to figure 40 regarding the RESG office portfolio, can you provide some details on a couple of very large New York office properties—specifically their low leverage at only 30%? Also, there's a large Los Angeles office property in the blue; could you provide insight there? Additionally, could you elaborate on the new office property in Dallas that has a higher LTV than the average portfolio? Do you see this as a trend toward higher leverage in new originations, or is that more credit specific?

Let me address the Dallas credit before turning it over to Brannon for New York and LA. The new loan in Dallas is one that we made to a party that was a mass lender on an office building loan in Dallas. The sponsor surrendered that building to the mass lender. Our loan to the mass lender is around 70% or slightly higher than the new appraised value of that property. It is cash flowing, but the sponsor chose not to contest their position on that building. This shows the quality of the structure in our transactions. For those not as familiar with commercial real estate, mass lenders being involved often lowers the overall risk. Brannon, do you want to add more details on the New York and LA properties?

Sure, George. Regarding our New York office exposures, we have four office loans in that area. One of those was well-leased at 95%, and we recently expanded another lease by about 26,000 to 27,000 square feet during the quarter. The other two largest office buildings in that area are working on leases that are advanced but not yet signed. In Los Angeles, the large property you're seeing originated earlier in 2020 is undergoing transitional execution. The timeline may extend longer due to the ongoing impact of COVID, but we are optimistic about that property's future potential.

That’s very helpful color. On one of the discussions earlier, typically, we see elevated loan fees during periods of time with elevated paydowns. Would it be accurate to anticipate a fairly high level of loan fees this year based on the expected paydowns in 2021?

That's a good question, Catherine, and the scenario is somewhat complex. A lot of what generates loan fees on payoffs is the situation where the loan was for 36 months, and it pays off at 24 months. You may recall that we previously discussed the increasing speed with which loans were being paid off. Recently, due to the pandemic causing construction delays, those payoffs were extended, which means we lose some of the extra yield we expect at the end of the loan term. However, in many cases, we do collect additional fees for 90-day or 180-day extensions, and since that varies from month to month, it does add some extra income. Therefore, while we expect some payoffs in 2021, it remains uncertain how that will translate into loan fees. It’s complicated, and we’ll have to monitor it closely.

Thank you. Our next question comes from Brian Martin from Janney Montgomery Scott. Your line is open.

I wanted to find out more regarding margins. George, you highlighted onetime positive items this quarter while the margin itself saw a nice improvement due to the declining cost of deposits. Considering this reset, can you discuss the underlying factors influencing margins going forward, particularly as you anticipate continued declines in funding costs?

Tim, would you like to take that, or shall I?

Thanks for the question. We've provided a couple of figures in our core spread that you can look through. We’re pleased with the reduction in costs for interest-bearing deposits across the last few quarters. We achieved an 18 basis point decrease, with this quarter showing significant improvement. Looking at our maturity schedules, there’s potential for further reduction in the next couple of quarters. Both quarters have seen a heavy weighted average close to 100 basis points, yet the weighted average rate of new and renewed time deposits dropped to 56 basis points. We quite likely still have room for movement there in the next few months. On the flip side, our reinvestment rates on securities pose a headwind for our yield on the investment securities book. As mentioned, our purchase loan yield reached its highest level seen in several years, with variations contingent on conditions prior to CECL adoption varying across quarters. Many moving parts will affect our net interest margins, but the outlook for a decline in interest-bearing deposit costs remains promising. We'll continue to be cognizant of spreads on our non-purchase originations; they are favorable compared to previous years, though not as good as they were immediately after the pandemic began.

Great. Just to follow up, where are you seeing non-purchase loan origination currently, especially within RESG?

Regarding new originations, I can tell you that our spreads on new loans being booked today aren’t quite as strong as they were at the height of the pandemic when rates fell. We were the only lenders in that space at the time so the spreads increased significantly then. However, in comparison to what we experienced two years ago, the spreads produced today are greater than they were back in 2019. We’re not expecting to see as strong results as what we had last year and expect to start seeing the benefits from those spreads in 2021 and 2022. Brannon, do you agree with that assessment?

Yes, that assessment is accurate.

Perfect. One other question I have is about the classified and criticized loans; was there much movement in that area this quarter, and could you shed light on trends you've seen?

Yes, we had a very strong quarter regarding credit quality. Although we did have a charge-off of 14 basis points, which is excellent. Our non-performing loans remain stable, with small increases in non-performing assets due to loans coming off of their deferral periods. We have some senior living facilities that struggled during the pandemic with occupancy, but in general, our monitored category remains stable. Special mention levels are still favorable and have only slightly increased from Q3, which indicates our direction remains stable at very low levels.

And our next question comes from Stephen Scouten from Piper Sandler. Your line is open.

Thanks everyone. As a starting point, could you discuss expenses? In previous calls, you’ve mentioned additional professional fees, hires, and consultants that may present some cost relief. I was impressed with the expense results this quarter—can you discuss the direction strategies you foresee in 2021? Could we expect normal growth of 3% to 5%?

Thanks for the question, Stephen. We've been sharing our use of consultants and professional fees in the early part of this year, and you did notice a decrease in these expenses during Q4 as we wrapped up those projects. We've shifted gears to use our internal resources for these projects, which has proven more cost-effective. We anticipate some seasonality in occupancy expenses during the summer months but that won’t be overly significant. We'll also be continuing to ensure our staffing aligns with strategic objectives, focusing on optimal placement for all team members while adding talent where necessary. I suggest our expense levels from Q4 provide a decent starting point for 2021. That said, we generally see a natural rise in expenses during Q1 due to salary pay raises, health insurance, etc. However, we have worked diligently this year to reduce its impact, so I wouldn't expect a significant ramp-up in costs.

Thank you. Regarding RESG structure, you brought up specifics with the Dallas transaction where you collaborated with the mezz lender to provide support. I want to know if you can comment further on the Union Square property in New York and any protections in place. The intensity of your loan structure is often underappreciated, particularly with minimum interest levels and interest reserves. How many loans benefit from such protective measures, and can you provide insight into the length of those arrangements?

I appreciate your recognition of the strength in our loan structuring. And it is essential; our focus on maintaining—asset quality is job number one—we won’t sacrifice quality. Our internal team remains dedicated to this principle, and we're expanding our capabilities to better achieve growth while upholding product quality. We do business with groups familiar with our strict requirements, benefiting from that ongoing relationship. Regarding the Union Square project in New York: I can confirm that we sold the loan recently, allowing us to pocket interest during the time we held it. Our transactions reflect low leverage points allowing flexibility in how we manage our investments.

I want to add some context here. For those unaware, the loan received attention as the sponsoring entity is public, which made the communication surrounding it part of their official filings. While we weren't satisfied with the project's progress, we granted more time, increasing the interest rate in exchange while selling the loan to another party ultimately representing a reclaim of our capital. This transaction was advantageous for all parties involved and provided stakeholders the timeframe they needed to get back on track. Our strategy here allows for higher leverage while providing options for scheduled repayment to protect our investment.

Thank you for the insights. I appreciate the depth of your color on these issues.

Thank you. And I am showing no further questions on the phone lines. I would like to turn the conference back over to George Gleason for any closing remarks.

Thank you all for joining the call today and for the insightful questions. We appreciate your interest in our company. I look forward to speaking with you again in about 90 days. Thank you. That concludes our call.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone have a wonderful day.