Bank OZK Q3 FY2021 Earnings Call

Thank you for standing by and welcome to the Bank OZK Third Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. As a reminder, today's program is being recorded. I would now like to introduce your host for today's program, Tim Hicks, Chief Credit and Administrative Officer. Please go ahead, sir.

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 focus on 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; Brannon Hamblen, President; Greg McKinney, Chief Financial Officer; and Cindy Wolfe, Chief Banking Officer. We will now open up the lines for your questions. Let me ask our operator Jonathan to remind our listeners how to queue in for questions.

Our first question comes from the line of Ken Zerbe from Morgan Stanley. Your question, please.

Good morning, everyone. Starting off in terms of interest-bearing deposit costs, you guys have done a great job of bringing those down over time. I was just kind of curious what the pace is of further interest-bearing deposit cost reductions from here. So if you get another 13 basis points in the fourth quarter, I mean is that even possible? Thanks.

Ken, I think the pace of that is going to slow. Obviously, we've had some really good improvements in it. We do have, as outlined in our document, several more quarters of CDs with reasonable volumes at somewhat higher rates. But the big gains have been achieved. I think there are more gains to come. The more important aspect of that whole story is the work that Cindy, Carmen McClennon, Ottie Kerley, and the other people on our retail and deposit teams are doing to grow non-interest-bearing longer-term core accounts. The benefit of that should be seen when we get into a rising rate environment—our deposit betas should, if we execute their strategies, be much less in a rising rate environment than what we experienced in the last rising rate cycle. So we're working hard in the short run to get further improvement and in the long run to improve the quality of that deposit base so it performs better in the next cycle. So that's our view on it, at least.

Okay. No, that's helpful. Thank you. And then just as a follow-up question. In terms of provision expense, a lot of banks that reported this quarter definitely made a lot of progress in getting closer to their CECL day one ACL ratios. I know you guys seem to be slowing the pace of reserve release at least this particular quarter. Are you seeing anything in the portfolio that would justify a sustainably higher reserve ratio than your CECL day one reserves on a go-forward basis?

No, I'm not seeing anything, and I'll let Tim and Brannon also comment on that. But our point of view on this is conservative. There is a lot of uncertainty in the economy. There is a lot of uncertainty in the fiscal and monetary policy landscape and supply chain issues, and there are many shifts happening in Washington trying to create policy and change social structures in our country. The risk of unintended consequences from Washington is always something to consider. When you have many people trying to do as much as is currently being done in Washington, it creates a lot of risk for unintended consequences. For example, there is a big push for an infrastructure program. You look at the supply chain disruptions in materials and the labor market disruptions in labor availability, which are resulting in incremental cost increases for our projects. Yet, the massive push for infrastructure in Washington can only aggravate that already challenging situation. So we want to see some of these cards play out. We're taking a fairly conservative view on future economic conditions until we see more developments that provide greater confidence that unintended consequences don’t tip us back into an adverse direction.

Our next question comes from the line of Brock Vandervliet from UBS. Your question, please.

Just following up on Ken's question about the deposits, particularly time. I can appreciate if you don't want to share the goal with us but do you have a goal for the percentage of time deposits, even if it's an internal one, that you think you can get to? It looks like that category has dropped $3 billion or so, a nice remix. I'm wondering where you think that could go, if you have any insights?

Brock, we don't have a specific goal on that. Our goal is to do everything that we realistically and reasonably can to continuously remix and improve the mix of that. Part of our ability to remix that is lowering the price of CDs at a lower rate while letting a lot of those CDs run off, particularly the higher cost or brokered public fund CDs. We've had a lot of loan repayments and very little or even somewhat negative loan growth in recent quarters. So as we get into a much more positive growth environment—which we hope to do—we’ll probably need to augment our growth in core accounts with some growth in CDs. I don't think it's a constant downward trajectory on the CD book, but we hope that while achieving good balance sheet growth, we’re also adding a lot of core deposits. We aim to mix that in a way that keeps our deposit betas at a relatively tolerable level when we enter a rising rate environment, assuming that occurs. We’re working hard on this every day, but we don't have a specific mix, and we realize the CD book will likely grow to some degree when we enter an environment with strong loan growth, which we hope will occur.

Yes. And just as a follow-up on the—you've done a lot in terms of refocusing the branches on gathering core deposits. Is that template fully in place at this point? And is it now just about execution, or are there more changes pending there?

I'll let Cindy Wolfe take that question if you don't mind. Cindy?

Sure. I'm happy to do that. Thank you for the question. The template is broadly in place, so now we're in a refinement mode. The biggest pieces of the playbook are in place, and we're seeing some nice results from that. As George said, we don't have a goal, and of course, the story is that it tends to be the CDs right now. The things we put in place in the retail bank aren't quick fixes or short-term initiatives; they're really foundational efforts meant to position us for the long term. So we'll continue to refine those, but the biggest pieces are already in place, including a lot of the new talent we've recruited. We're happy about the early signs of success we've seen in the mix and the effect it's having on both the mix and service charges, and we expect that trend to continue.

Our next question comes from the line of Timur Braziler from Wells Fargo. Your question, please.

Maybe starting on RESG, the pace of paydown activity seems to have abated a little bit in the third quarter. There is a comment in the management letter that some of that was pushed out into the fourth quarter. Can you quantify how much of that was pushed out into the fourth quarter? I know you're still expecting payoff activity to top 2019 levels, but if it were to match, it would still result in a linked quarter reduction in the fourth quarter. Can you quantify by how much you expect payoff activity to top 2019 levels, now that we're a little further into the year?

I'm going to let Brannon Hamblen take that question, but I will tell you, Timur, we're not going to be able to give you an exact number because these are big, chunky loans in our RESG portfolio, and them moving around a month or two is nothing unusual, making it hard to precisely predict if a payoff is going to occur in December or if it will slip to January or February. There’s a lot of movement, but Tim, Brannon can provide some good color on that. So, Brannon?

Sure, Tim, thanks for the question and good morning. George's answer is accurate. As we've guided from quarter to quarter, the loans are quite chunky and the market is pretty active right now. That's good news for our origination side, but there are a lot of people trying to get many transactions closed after a quieter year in 2020. It's not unusual for loans to move around, and I could even if I told you what I thought in Q4, because of the size of some of the loans that are paying off, it really could matter around what the final result is. As I've said before and will just point you again to our vintage chart, it points to the origination trends, which will guide you well on repayment trends. As we move into the 2018 and '19 vintage, those loans will be coming due, and as we've guided, that will likely affect our Q4 numbers in 2021. I believe it will be a record year. I don't think we'll have enough pushback that we won't achieve it. There’s nothing unusual about this timing push; it's just the timing of many market transactions that need to be accomplished.

Okay. I appreciate that color. And maybe on the other side of the equation, on the production side, impressive quarter. I’m just wondering if there was any pull forward on that production and if any was pushed into the fourth quarter that got pulled into the third quarter and then from your comments that the market is active right now, is that kind of a reasonable production rate here at least for the near-term, kind of $2 billion-plus?

I alluded to the fact that the heavy transaction volume out there is affecting repayment and origination timing. Our guys have done a phenomenal job in this market, really getting new business with new customers and expanding product types that we like in markets that we prefer. We've got a healthy portfolio. I think you asked whether anything was pulled forward from Q4 into Q3. I don't see a lot of that happening. It's generally taking longer to close transactions, affecting both payoffs and originations, and we have a healthy pipeline. I would tell you that I won't predict too far into the future, but I think we have a very good shot to meet or beat what we did in originations in Q3. Looking forward, we're seeing good volume and good loans that fit our criteria, so that's the guidance I would provide.

Okay. Thank you. And then maybe one more if I can just look at the securities book this quarter and pairing that with the comments on adding a veteran investment portfolio officer to your bench. What is the outlook for securities? Is that indicative of getting back some of the lost balances from the third quarter and the fourth quarter, especially when we would be coming up a little bit? How should we think about the bond book and where you'd like to see that as a portion of total assets?

That's a great question, Tim, and I'll take that. We had almost no purchases—just one $50 million purchase in the bond book in the quarter just ended, and that number may not be exactly right, but there were minimal purchases in this quarter. The portfolio is short, and even the mortgage backs in it are pretty short duration with a lot of cash flow. The bond book did shrink in the quarter, but that was fine with us given the less than compelling reinvestment opportunities. Certainly, you've seen a little bit of lift in rates recently, getting us closer to an area where we could do some reinvestment. We are very pleased to have added another veteran team member to our investment team this quarter. This person has a lot of experience; I’ve known him for 30 years. I think that gives us more horsepower to get into some investment niches, where we can unlock real value that requires additional research and understanding to appreciate the value and quality of some investments. We will see that portfolio shrink or increase depending on market conditions ahead, but it seems like we are getting toward a situation where we may see portfolio growth in Q4 or possibly Q1 and Q2 of next year, with new purchases on a more positive trend than we saw in the last quarter.

Our next question comes from the line of Michael Rose from Raymond James. Your question, please.

Thanks for taking my questions. I just wanted to touch on expenses, which are up a little bit. You cited wage inflation, and obviously, you're hiring in some areas. As we think about next year, can you frame kind of the investment options that are out there, both in terms of talent and anything else, and could you estimate what expense growth would look like given some of those initiatives? That would be great. Thanks.

Yes. I can, Michael, and then certainly add color. We have completed our annual process of reviewing the entire composition of our personnel. We have evaluated what we need to be effective for our business, to support growth, operate effectively, and provide the needed service to our customers. Clearly, the nationwide worker shortage is having significant impacts on pretty much every company, including us. We expect to see increases in our salary and benefits line items as we move into 2022. We've commented that we think our Q3 run rate is somewhat indicative of what we would expect in future quarters, right at or slightly above $110 million. This seems like a pretty solid baseline as we approach 2022. Everyone is trying to fill positions needed to effectively serve customers and run the business. The timing for filling those positions may impact salary costs and when that will reflect in the P&L, but I think our Q3 run rate is a fair indicator as we move into at least the first part of next year, and even the fourth quarter of this year.

And Michael, I'll provide a little more detail. We started our annual salary budget process on July 19 and just completed it earlier this week. I've personally spent time with various department heads to review every employee in this process, setting pay rates for next year. In light of the worker shortage, we reviewed many rates and adjusted many effective compensation amounts sooner than previously. You'll see some of those wage increases in Q3, with a larger chunk in Q4. As our management comments mentioned, we had atypical items adding around $3 million to our non-interest expense line in Q3. This includes about $2 million from branch closing costs and approximately $800,000 related to the early redemption of higher interest rate subordinated notes paid off on July 1. We believe that plus the already recognized salaries in Q3 likely gives us the room we need to absorb wage increases in Q4 as fillings and any related adjustments happen. Greg mentioned that the $110 million in non-interest expense looks like a good run rate for the next couple of quarters.

That's very helpful, guys. And just as a follow-up, it looks like you’ve used a little more than 12% of the buyback. Stocks are still here at about 1.5 times tangible. Just help us frame how we should think about utilizing that as we move forward. Given it seems loan growth is picking up.

I'll offer one comment on that and then turn it over to Tim, who manages that program for us. It’s the first buyback we’ve done, and when it was approved last quarter, we took a fairly conservative approach because it's our first time. Tim, you can discuss our thoughts on where this goes.

Yes, thanks Michael. We do plan to be more active this quarter. It will depend on our stock price as we progress; we will have the program active for the entire quarter rather than just a portion. As George mentioned, we were cautious on how to approach this, ensuring we were aware of all operation parameters. Predicting an exact number for Q4 is tough due to how our stock price might react, but we do expect to be active.

Our next question comes from the line of Catherine Mealor from KBW. Your question, please.

Good morning. I wanted to follow up on a question about the origination volume, which is a really encouraging level, and I think we'll see the same level or something close to that next quarter. As we think about the timing for those originations and funding, how do you think about some of the headwinds in today’s environment with liquidity and supply chain? Brannon, you mentioned longer times to close loans. Is the timeframe from origination to funding wider than it has been in the past?

Catherine, thank you for the question. On the whole, as we sit here today, we're not seeing a material impact. There are many factors that affect timing concerning our loans, such as the project's status when we close, initial funding amounts against conservative land loan values, and how many of those loans we do. Some markets tend to have more of these than others, along with product mix variances. I would say much of the delay in closing loans is due to a real sharpening of the pencil regarding project costs and tied contracts. There are various equity sources in the market today, especially for larger loans, where they want to ensure numbers are tightened given recent historical variability. This affects the timing for slower closings, but it also provides more certainty around contracts. I cannot say yet whether supply chain issues will have a material effect, but as George stated earlier, there are discussions on this front, and it’s something we’re monitoring. Bottom line—it's hard to say right now if there's a material impact; we have not seen much so far.

Catherine, I would add that the delays we've observed so far on new loans are mainly pre-closing and not post-closing. People are working hard to secure costs before they close, given the variability in costs experienced over the last year or two. This makes it harder to close things. Once they're closed, they seem to maintain their original path, unless confronted with unexpected supply chain disruptions.

Our next question comes from the line of Matt Olney from Stephens. Your question, please.

Good morning. I want to ask more about loan yields. I think last quarter we talked about higher levels of miscellaneous fees even outside of PPP by way of extension fees and then interest fees that were heavier than normal. I'm curious about these levels in the third quarter versus more normalized levels?

When you have something that fluctuates, Matt, it’s difficult to define normal. However, I would say that the unusual fees, exclusive of PPP that we document in our remarks, such as prepayment penalties, minimum interest, and short-term extension fees in Q3 were more typical of what we would consider normal than the elevated levels we saw in Q1 and Q2. This amount will continue to fluctuate, and there wasn't a particularly elevated level, other than the PPP impact, which contributed about six basis points in Q3 and the first nine months of the year to our net interest and loan yields.

Okay. Great. That's helpful. And then I want to ask about interest rates and the bank's sensitivity to rates. The market is now assuming Fed tightening late next year, and you provide good disclosures around loan floors, which seem to be moderating. What else should we anticipate over the next year to better prepare the bank for higher interest rates?

We constantly review this, and as the portfolio seasons at current interest rates, the loan floors impede our ability to raise rates. Loans originated three years ago in a higher rate environment have higher floors, so rates must rise significantly before those loans increase. I appreciate your attention to our graphs; you've noted a steady trend toward the percentage of loans that will down-adjust before reaching higher rate levels. As older loans payoff and newer loans replace them, those newer loans will adjust more quickly as rates rise. Thus, with each passing quarter in this current environment, we become more sensitive to rising rates. We're working hard to reduce what we call the Dead Zone in loans—the gap between where the formula rate would be today ignoring the floor, and the actual loan rate, which remains stagnant until hitting that floor. We continuously strive to minimize the Dead Zone in maturing loans without sacrificing yield. With each quarter that we experience a combination of renewals and payoffs, the scenario becomes more favorable. In preparation for a rising rate environment, we are not only focusing on loans, but also on enhancing the quality of our deposit base and beginning to extend the duration into the deposit base on the CD side.

Our next question comes from the line of Stephen Scouten from Piper Sandler. Your question, please.

Thanks for taking the call. I wanted to circle back, and maybe this is more of a Brannon question or George, your comments would be nice too. But on the RESG, can you give some color on the product mix regarding the types of projects you're seeing? Is it more condos, offices? Is it mixed? Are there any project types that you are more wary of? I know some banks have been hesitant on office, but it looks like you guys made some office investments this quarter. So more color on the mix would be great.

Brannon, go ahead.

Sure, Stephen. Thanks for the question. In Q3, we continued to originate a lot in multifamily, which was probably at the top of the list. As we’ve been indicating, we're seeing more mixed-use projects come to market and we have a strong pipeline there. Multifamily still leads by dollar volume, but mixed-use and office were also significant components in Q3. From a market perspective, we’ve seen activity in the South and Southeast, but also in the Northeast, Midwest, and West. The team is finding good opportunities. Regarding what we're cautious about, we always look for the right sponsorship on the right deals. Many deals are coming to market, and we must be prudent in selecting deals that fit our guidelines. The team's done an excellent job of finding new quality sponsors, and we’re seeing those partnerships yielding results. Those projects can take a long time to piece together, so while they may seem new now, our team is often tracking them for years. Some of them are starting to come to life now, reflecting contemporary demographic trends. There are definitely new projects that are being formed based on migration trends we witnessed this year. For instance, Texas obviously offers a bit more space for new developments than Manhattan, which is a more constrained environment.

That makes a lot of sense. And then I guess one last quick question from me is that deposit service charges were robust in the quarter and have been trending positively for a while. Is that just indicative of the progress you’ve made with your deposit mix and account growth? Or is there anything unusual to note there?

There really isn't anything unusual. It reflects a shift in our quality and quantity of core deposits. While there’s typical movement in NSF and OD fees, those aren’t key to our core service charge strategy, but they tend to follow spending trends. So spending will fluctuate with COVID variants impacting economic activity, contributing to part of the increase. Underneath, we see fundamental positive changes in the sustainable growth of the service charge income moving forward. I appreciate the question.

Our next question comes from the line of Brian Martin from Janney Montgomery. Your question, please.

Good morning. Just one follow-up to the last question on new production. Can you, Brannon, how much of that can be attributed to the new initiatives implemented by the new lending teams you've mentioned? It's one thing to see this quarter and with the equipment finance, obviously, not part of it, but I'm curious about ABL and others. What gives you confidence in the sustainability of production?

Brannon, let me respond to that and then I'll let Brannon add additional context. We've not seen growth yet from either our ABL team or our new leasing team, which just launched. These teams seem to be making progress, and we hope to see some closings in those areas in Q4 or Q1 or ideally both. Our indirect team, which wasn't mentioned, continues to work on this new business model, but that environment has turned very competitive, slowing our ramp-up. We're still experiencing net negative growth in that indirect portfolio, but I spent time speaking with those guys over the past week or so, and we're making minor changes we believe will drive growth next year. Our community bank, when excluding net originations and pay downs of PPP, has been positive for the entire year so far. While the Corporate & Business Specialties Group had positive momentum in Q3, RESG is looking at solid pipelines if we can close all these deals. We're optimistic about our ability to continue generating loan growth across multiple fronts in 2022, even if Q4 presents some pay-down challenges, but we're hopeful for decent growth in 2022.

I agree with George. I was referring to RESG before, but the guys in these other groups are starting to see some traction too. I’m hopeful we’ll have an ABL origination and our CBSG Group's numbers included some reduction in the SNC portfolio in the quarter too. So, we’ve got some good things coming next year.

No, that's helpful and just last one or two follow-ups. From a high-level standpoint, Tim, I don't know, just on the growth in organic loan volumes, I mean, I know M&A is still something you've discussed as a potential focus. Has that changed since last quarter, or do you have any updated views on that?

No changes. We're still very interested in doing M&A. It's hard to predict when we could do a deal. We’re looking at opportunities and plan to be financially disciplined, wanting to ensure it meets our financial hurdles. We’re interested in examining M&A opportunities and will remain active in this pursuit. Our robust capital levels enable us to pursue organic growth, add business lines, and explore M&A opportunities.

Okay, last one was just on the margin. If there is—it sounds like last quarter when we talked it was kind of peaking out and I’m just wondering if there’s any change in your outlook there? Also, when do you anticipate stabilizing your non-purchased loan volumes? I know you’ve addressed some of the pressure out there earlier.

Yes, we are achieving good results in enhancing our core spread, which has been consistent for about five quarters now, alongside quarterly trends in our net interest margin. Currently, we are originating loans at rates that are notably lower than many loans on our books that are maturing today. This indicates some future downward pressure on loan yields. We will do our best to mitigate this through further improvements in deposit costs, which becomes difficult as those deposits decrease. The investment book is somewhat unpredictable in how it might affect all these dynamics. So there are multiple factors at play. We may be at or near the top in the current environment regarding NIM and core spread. While we can bring more improvement in the short run, the restrictions from loans originated today will start to corner a lower loan yield pattern next year.

Thank you. This completes the question-and-answer session of today's program. I'd like to hand the program back to you, George Gleason, Chairman and CEO for any further remarks.

Thank you for your time and attention today. We appreciate you being on the call and look forward to being with you again in about 90 days. Have a great quarter. Thank you. Goodbye.

Thank you, ladies and gentlemen, for your participation in today's conference. This concludes the program. You may now disconnect. Good day.