Bank OZK Q2 FY2023 Earnings Call

Good day and thank you for standing by. Welcome to Bank OZK's Second Quarter 2023 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. Operator provided instructions. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Jay Staley, Director of Investor Relations and Corporate Development. Please go ahead, Jay.

Good morning. I am Jay Staley, Director of Investor Relations and Corporate Development 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; Brannon Hamblen, President; Tim Hicks, Chief Financial Officer; and Cindy Wolfe, Chief Operating Officer. We will now open up the lines for your questions. Let me now ask our operator Norma to remind our listeners how to queue in for questions.

Thank you. Operator provided instructions. And our first question comes from the line of Stephen Scouten with Piper Sandler. Your line is now open.

Hey, good morning, everyone. Thanks for the time. Maybe if we could start around loan growth. It's been phenomenal the last few quarters and the commentary seems to be that origination trends are improving; repayments are still a little more muted. It seems like we could continue to see this path to growth. I'm curious if you could comment on that. And then any thoughts around pushback from folks that might not want to see growth in today's environment and why you still feel good about adding that growth on these loans you booked largely last year.

Thank you, Stephen. We are cautiously optimistic about our continued growth prospects and view that as a very positive opportunity. We're being very conservative on credit quality. We're very focused on that. We've got a long tradition and track record of that. We believe in this more challenging environment and, by being conservative, we're putting on really great quality new assets and getting paid well for them. So we view it as an opportunistic time for growth. We're achieving better diversification in our portfolio. Real Estate Specialties Group is still the largest loan-generating unit in our company and Brannon Hamblen is closest to that activity. RESG is leading the growth. I'll let Brannon take the rest of that question.

Sure, George. Stephen, thanks for the question. I'll tag on what George said about our confidence in the quality of the credits we're adding. We're in the market every day through cycles and we consistently push leverage down and pricing up as the market gives us opportunity to do that, and the markets we're in today have allowed that. If you look at our more recent closings as uncertainty increased, our new closing loan-to-values and loan-to-costs have been lower than our portfolio average and pricing spreads are strong quarter-to-quarter. We feel great about the quality of what's going on. There are still a lot of deals coming to market. Some sponsors have stepped back, but our teams have outstanding market penetration on origination and excellent servicing on the asset management side. We continue to get a lot of repeat business from strong sponsors with great projects, and many projects have significant sponsor equity at lower loan-to-costs. Competition from other banks has reduced in some cases, giving us opportunities we might not otherwise have. We're putting great quality, low-leverage, well-priced credits on the book and will continue to do that.

That's great color. I appreciate the commentary about improving quality. If we assume growth is likely and think you'll have nice growth trends into the back half of this year and next year, I appreciate the commentary around the NIM and that it will face pressure on the funding side. I know the commentary that NII growth was uncertain. It feels like NII would still need to be pressured higher given the amount of growth you're seeing, or am I underweighting the continued funding pressures and how you need to fund up this ramping growth? How can I think about that?

Great question, Stephen. There's a tradeoff between growth and margin that will determine whether we can continue to grow net interest income. We're working to make that happen. From April of last year when the Fed started raising rates, our variable-rate loans moved quickly while deposit cost lagged. For many quarters we said deposit costs would begin to catch up with increases in loan yields as the Fed neared the end of their tightening, and we saw that this last quarter when our NIM gave back some of the expansion we saw earlier. There's a catch-up and we're having to be pretty aggressive on deposit costs because of the tremendous growth opportunities. To achieve the deposit growth we're getting, we're having to be moderately aggressive on rates and we can afford to do that. We have among the best net interest margins in our peer group and we're getting strong loan yields, so we can afford to be competitive on deposits. That will put a little pressure on NIM. We've said the challenge is to keep net interest income growing. We'll have less NIM but more average earning assets because of growth. If we get really good growth and mitigate the NIM impact well, we should have slightly positive NII growth. If we get less growth or don't mitigate the NIM pressure as well, we could be flat or slightly down on NII. It's a horse race.

Got it. Based on the track record I'm betting on NII growth. I appreciate the commentary.

All right. Thanks.

Thank you, Stephen. One moment for our next question. Our next question comes from the line of Matt Olney with Stephens. Your line is now open.

Great. Thanks. Good morning. I want to ask some questions around credit. It sounds like there were two loans that were downgraded this quarter as a result of some of those new appraisal values that you disclosed. I assume you've approached these borrowers to ask for additional equity since you've gotten those appraisals back. If so, any color on these conversations with the borrowers?

Both borrowers are working constructively with us. Both were already engaged in processes of bringing new capital for those transactions, so we're monitoring that closely. We are pretty confident in both borrowers' ability to get something done that will be useful to them and to us. These sponsors have shown real commitment to these assets and we expect that to continue.

Okay. I appreciate the color.

Brannon, do you have any color you want to add on those two deals?

I would echo George. They were pre-engaged in those recapitalization activities and making tangible progress. We've done a lot of business with the sponsors on both projects and feel good about the direction. We'd hope to reflect that in the numbers next quarter.

Matt, I would point out the equity on the land deal has posted a substantial reserve account to continue to carry this asset while they're working on the recap.

Yes, Matt, on the land deal that's 95% and they have $11 million in cash reserves there. That's additional support for that credit. It's not included in the LTV but it's additional support for carry. This sponsor is a prolific developer with a national footprint and a great reputation for successful projects. We have financed a number of their projects and have confidence in their commitment. On the other case, the hotel, dollars have been coming in historically. That sponsor put in additional capital during COVID and we've done extensions. In this case for the hotel, the loan is at 101%, but they have historically funded operating shortfalls and debt service, so there is ongoing capital infusion in that project. Those are not hope cards but historic performance that gives us good expectations of the outcomes.

I would add the hotel is a nice smaller asset performing at or above the comp set. It's in a Midwestern market that has been slower to come back from the pandemic and changes in travel patterns, but it's a quality asset and the sponsor's proven commitment gives us cautious optimism about the path forward.

Okay. Appreciate the detail. You've been disclosing these updated appraisals with RESG for a while now and typically the LTVs have more limited movement post-appraisal. These two are outliers. Anything unique about these transactions or properties that drove a more significant value deterioration than other ones we have seen, not just this quarter but in past years as well?

Land appraisals tend to have a lot of variability in their valuation conclusions. For example, a land appraisal might have a $300 million terminal value, and a new appraisal still reflects a $300 million terminal value. But land prices are based on discounted net present value. If the discount rate goes up significantly—say the Fed moved rates and the discount rate increases— and the holding period gets extended from three to eight years, there can be a massive contraction in present value even though the terminal value is unchanged. We've seen land values fluctuate for those reasons. Most of the land we finance is a bridge to near-term vertical development; we do very few long-term land holds. Often these are 12-month land loans with short extensions. So land value volatility can be driven by changes in discount rates and holding periods. Also note we had 15 or 16 assets reappraised last quarter and 22 paid off and new loans originated. So between new loans and payoffs and reappraisals, we get fresh values on a substantial portion of the portfolio each quarter. We probably have fresh values on something approaching 10% of the portfolio every quarter, so valuations stay pretty up to date.

Okay. Thanks, guys.

Thank you, Matt. One moment for our next question. Our next question comes from the line of Manan Gosalia with Morgan Stanley. Your line is now open.

Hey, good morning. I wanted to follow up on that last comment. If about 10% of the portfolio comes up for reappraisal every quarter, is it fair to say about 40% of the portfolio has been reappraised over the last 12 months?

Manan, either been reappraised or had new appraisals because of new loans originated, so that's a rough estimate and a fair approximation. We had 22 loans pay off in the quarter just ended and originated a similar number, so new loans have new appraisals and old loans come up for reappraisal on extension, renewal, or if we see signs of concern. If we think there's likely movement in value or performance, we get a reappraisal.

I would add that sometimes good things are happening at projects and we consider an upsize or extension; any time we do, we get a new appraisal as well. So there are positive activity reasons for appraisals to occur.

Understood. A big-picture question on downgrades and repeat business: you clearly get a lot of repeat business and great sponsor relationships. Can you walk us through other deals where you've had success in bringing in equity? What typically is required—concessions on spreads, re-upping the loan, or anything else in that negotiation?

We had several loans last quarter that were up for renewal and the sponsors brought substantial equity. In many cases we did not give concessions and in some cases we improved our economics and terms, and we received paydowns. Brannon can give details.

Yes. In the recent quarter we had several situations with extensions and material paydowns: $20 million paydown on a multifamily project in Philadelphia, $10 million on a multifamily in Oakland, another Oakland project that curtailed the loan and didn't need the full amount, a Midwest hotel with a $5 million paydown, and others including a $4 million paydown on a mixed-use project. Often terms improve in addition to getting paydowns.

Yes. As we get appraisals that indicate higher loan-to-values, in one loan we got the appraisal early and expect several million dollars of paydown in connection with an extension. We're granting extensions in many cases and typically improving the economics while keeping risk in check with curtailments and better terms.

Got it. As I think about the yield on loans—the 8.4% to 8.5% level you have now—if the Fed does one more rate hike, how should we think about those yields? Should that peak around 8.75% or are there additional repricing effects from renegotiations and the lagging repricing of the remaining fixed loans?

If the Fed continues to raise rates, that will translate to loan yields. The vast majority of our loans are variable rate—Tim has the exact number.

Yes, 79% of our loans are variable rate.

Most of those adjust monthly, so a 25 basis point movement in the Fed funds target rate—if it translates through to SOFR and Prime—will give roughly 18 to 20 basis points of impact to loan yields. In some cases we are also getting better economics on renegotiations but that affects only a small number of loans and won't move the needle materially—just a few basis points in aggregate.

Got it. Thank you.

Thank you, Manan. One moment for our next question. Our next question comes from the line of Catherine Mealor with KBW. Your line is now open.

Thanks. Good morning. A couple of follow-ups on the credit discussion. First, which market was the hotel loan in? You mentioned Midwest. And which market is the land loan in? Second, on those projects did we see any increase in specific reserves related to these two downgrades?

The land loan is in Chicago. We increased reserves for loans that were moved to special mention and to substandard; the reserves went up on those loans in connection with the change in risk rating.

I appreciate the commentary about the pace at which you get new appraisals. It seems you're mostly getting them at maturity, extension, or if you see degradation. Can you help us think through that, particularly in the land portfolio—how much of that book has an updated appraisal and is there a risk we could see additional appraisals that increase LTVs significantly?

Yes. We typically get appraisals on new loans, at maturities, on extensions, or if an issue arises that makes us want a recalibration. That keeps valuation work current. The land loan distribution is one of our smaller segments, and most land loans are bridges to vertical construction with short terms, often 12 months plus short extensions. We do very few land-hold loans; an example earlier this year was a California land track that shifted to a land hold because cost blew out, which is fairly unusual. Other than a few land-hold situations, the land portfolio is well margined and should perform well. There may be occasional bumps but I am not worried about material impact on asset quality.

To circle back, because of what George said, the majority of the land portfolio likely has valuations a year old or less because of short terms. So the timing of appraisals stays tight on land and it's our lowest loan-to-value property type.

Great. On that Chicago project, what prompted the new appraisal—degradation or maturity?

It was in connection with an extension and loan maturity.

Okay. Thanks. On growth outlook, you mentioned origination volumes closer to 2021 levels, about $8 billion. If so, that implies origination volumes over $2 billion for the next couple of quarters. Is that right?

Yes. We said we expect volumes to be in a range roughly like 2020 to 2021, about $6.5 billion to $8 billion. The thrust of our comment is we now think we're coming in at the high end and possibly a bit over that range by year-end based on pipelines. So we may be at or somewhat above the $7.94 billion level of 2021.

So that implies a pretty big acceleration in the back half of the year. Also, it felt like you said repayments should increase some in the back half—does that still hold?

Repayments are coming more slowly now. We had indicated a five-year average and current prepayments are slightly below the low side of that. We expect more prepayments to slide into next year due to lag. Many sponsors have been slow-playing projects but as the Fed appears closer to the end of tightening, sponsors are getting clearer on economics and some are moving forward. This is not broad-based, but in some markets and with some sponsors there's more clarity. At the same time, competition has reduced, particularly among banks, so we may capture a bigger share than we expected 90 days ago.

Thank you, Catherine. One moment for our next question. The next question comes from the line of Timur Braziler with Wells Fargo. Your line is now open.

Hi. Good morning. On the funding side, do you think the rates where you have them now are sufficient to provide funding and get the deposits you need? Or is there still some acceleration in adjusting your offering to get adequate funding going forward?

We've been at the same rate levels the last few weeks and inflow volumes seem to be holding up well. Tomorrow there may be tweaks or Fed action could cause movement, but where we are today, we feel good.

Okay. As you look at funding near-term loan growth—deposit growth was quite strong this quarter, cash balances increased, and you have bonds coming due over the next 12 months—how should we think about funding loan growth over the next two to three quarters? Will you focus on deposit growth or are there other levers to fund near-term loan growth?

We have a very strong focus on deposit growth. Cindy and our retail team—branch leadership and our branch staff—did an incredibly good job growing deposits. We had a big deposit growth quarter and expect that to continue. If loans grow $1 billion in a quarter, we expect deposits to grow a little more than loan growth. We've largely grown organically through locally generated deposits and haven't materially increased reliance on broker deposits as a percentage of total deposits. We have flexibility to increase broker deposits if needed, but we prefer organic local deposit growth through our branches and have had good success.

If we fast-forward into the back end of 2024 with the RESG funding schedule and if the Fed starts cutting in that period, will deposit costs fall commensurately or is there a lag on the way down given deposit production and competition?

Deposit costs lagged on the way up and will lag on the way down. Many of our CDs have 4- to 13-month terms, so deposit costs will tend to lag when rates fall. The trick is negotiating loan floors that mitigate a ramp-down in loan rates when the Fed cuts. It's a negotiating challenge; sponsors are increasingly thinking about futures with lower rates. We've had good success mitigating decline in loan yields with floors and other structures to protect margin.

Got it. Lastly, on credit: can you provide the allowance currently allocated to the land book? If sponsor activity like buying and developing during a downturn accelerates, does that increase the allowance allocated to the loan book or the land book?

Timur, I don't have the allocation to the land book number in front of me. This is a good opportunity to discuss our overall ACL. We added a chart showing the build in our ACL over the last four quarters, with the dollar amount growing by $127 million while cumulative net charge-offs were only $23 million in the same period. The percentage has gone up as well. That reflects substantial loan growth and our cautious outlook and uncertainties. We feel we're in a good position from an ACL perspective, but I don't have the specific land allocation here.

On whether a recession would require further ACL increases, that depends on severity and duration and how it affects different parts of our portfolio. We've been cautious in our approach. Our scenario weighting has been predominantly toward downside scenarios—the Moody's alternative adverse scenario and the stagflation scenario—so we've been modeling for a recession. That explains the provisions we've had over and above growth even as charge-offs have been benign. We aim to be well positioned from an ACL perspective given cautious scenario selection.

Great. Thanks for that.

Thank you, Timur. One moment for our next question. The next question will come from the line of Michael Rose with Raymond James. Your line is now open.

Hey, good morning, everyone. I wanted to start with a non-credit question. You discussed adding people to benefit growth in coming quarters. What areas are you looking to add and would that hiring extend into next year to support strong growth?

Thank you, Michael. One of our long traditions is being well capitalized, having ample liquidity, and a strong management team to capitalize on opportunities in economic turbulence. Competitors shrinking or laying off people creates opportunities to add talent across business lines. We're looking at probably 10 or so people we'd like to add across three or four lines of business. Talent is critical going forward. We are focused on recruiting and retaining high-quality talent. The U.S. workforce, demographics, and pandemic-driven mindset changes make recruiting and retention more challenging. If we can add 10, 20, 30, 50 high-quality people over the next year from competitors, that's a huge opportunity. We're keenly focused on capitalizing on that.

Maybe a follow-up on repayments: you talk about slower loan repayments in the current environment. The permanent market for these loans has been more limited. You have a lot of unfunded commitments that will fund in strong growth. Do you see this as an issue for capital, since keeping loans longer could pressure capital levels? How do these dynamics play out over the next year or two?

Anyone saying permanent markets are closed is exaggerating. We had 22 loans pay off and go permanent last quarter. Markets are not closed. Some sponsors choose not to refinance into permanent loans at current rates; they may extend with us another 6 to 12 months. We view keeping assets on our books longer at our leverage and rates as an opportunity. Permanent loans that take us out are often substantially larger loans—150% to 225% of our loan amount—so we're happy to keep assets on our books at our terms. We view this as an opportunity, not a downside.

Thank you, Michael. One moment for our next question. The next question will come from the line of Brian Martin with Janney Montgomery Scott. Your line is now open.

Hey, good morning, guys. A couple of follow-ups: on the reserve build, you went from roughly an 85 basis point level to 95 over the last four quarters. Are you at a point where you don't need to continue building the reserve given your outlook, or should we expect more build given your cautious outlook and loan growth?

Brian, there are too many factors to predict the ACL build at this point. It will depend on quarter-end growth and the macro environment at that time. If uncertainties improve, you would expect a lower provision. If uncertainties remain the same or worsen, provisions may stay similar or go higher. It's dependent on those factors.

Got you. On expense outlook, you mentioned hiring. Expense growth this year is at a lofty level given hires. Should expense growth rate come down next year relative to this year even with additional hiring? High level, how should we think about expense growth into 2024 given opportunities to add talent?

You saw our comment of mid- to high-teens percentage increase for 2023 versus 2022. This year we had a new FDIC assessment that came into effect in 2023 and we may have a special assessment this year; our guidance did not contemplate any special assessments. We also have elevated advertising and marketing that we expect to continue this year and likely next year. Headcount rose about 10% year-over-year and we've had strong compensation increases to retain talent. I could see the percentage increase in expenses decreasing next year compared to 2023, but it's too early to give firm guidance. We wouldn't expect mid- to high-teens to be a run rate for an extended period unless compelling opportunities arise to add headcount.

To add to Tim's points, our growth rate next year will be a significant factor. If the balance sheet grows 10% versus 15% or 20%, that determines the level of headcount needed. We are likely to add some branches; we're at 240 retail banking offices and have capacity in those branches for growth, but we will add some branch infrastructure later this year and into next year to support three- to five-year growth. That will increase operating costs modestly but will be offset by growth and is a strategic necessity.

Got it. On deposit cost, Cindy, what was the spot rate at the end of the quarter? And margin?

June cost of interest-bearing deposits was 3.11%.

We don't disclose a spot margin number. Those internal monthly numbers can bounce around and we don't typically disclose them, but Cindy gave you the June deposit cost.

Just trying to think about margin trough timing. Given the lag on deposit repricing, if the Fed pauses after the next meeting, is it reasonable to think margin might trough in late Q4 or early Q1, assuming Fed holds or doesn't cut until later?

There are many variables. With CDs running up to 13 months, you're looking at several quarters of lag on the deposit side. How long rates remain at peak matters. If the Fed raises one or two more times and then stays there for a year, we can set many loan floors at market levels to protect margin as rates fall. If the Fed peaks and then soon starts cutting, it's harder to set floors. We prefer a scenario where the Fed pauses or holds near peak longer, which helps us protect margin and get loan floors set. We run many interest-rate models with different assumptions, so where the trough is depends on which scenario you pick.

Thank you, Brian. One moment for our next question. Our next question comes from the line of Brody Preston with UBS. Your line is now open.

Hey, good morning everyone. I wanted to circle back to capital. You bought back a decent amount of stock this quarter. The difference between $33 and $43 is quite a bit on the stock price. CET1 is 10.8% now versus 13.3% last quarter. Is it safe to assume if you continued buybacks at those levels you should preserve capital for balance-sheet growth and not bake in much more buyback into estimates? Or might you continue repurchases?

Brody, we provided the average price we paid in the quarter and for the six months. There were compelling value opportunities at those prices and we still have authorization remaining. At these levels we will focus on organic growth and preserving capital for that, but if additional compelling values arise in our stock price, we won't hesitate to repurchase more shares.

Thanks. On land and discount rates: given the discount rates moved up and appraisals changed, is there a relationship between discount rates and reserves? If discount rates fall next year and values improve, would LTVs fall and you need less reserves?

There is correlation between interest rates and discount rates, but it's not perfect. If discount rates fall materially and terminal values hold, that should translate into better appraised values and lower LTVs. Loan-to-value is one of many factors in our risk-rating models. Higher LTVs tend to increase risk ratings, and lower LTVs, all else equal, reduce risk ratings. Those risk ratings feed into expected loss and probability of default calculations, which affect reserves.

Got it. For the land loan that moved from about 40% LTV to 95% LTV in Chicago, was that because the terminal value was unchanged but the NPV inputs changed—holding period and discount rate—rather than the end value changing?

My earlier example was hypothetical. I don't know the terminal value specifics of that particular loan. But generally, longer holding periods and higher discount rates have a greater effect than small terminal value changes on the present value and therefore on LTVs. Brannon may have additional color.

Yes, Brody, these tracks of land are in different markets with very different dynamics. The lower part of the chart you referenced is likely a tract in Southern Florida, where development dynamics and expectations are different than Chicago. So you will see different valuation outcomes across markets.

That makes sense. Is it fair to say land loans may be more at risk of LTV changes because no vertical development has occurred yet?

Yes, land loans are more variable in appraised value because they are often before vertical development.

On sponsor behavior: do you have a sense of success rate over time getting sponsors to commit more equity if needed, given strong sponsor relationships, or do they sometimes walk away or commit less because of economics?

We have a good track record of sponsors supporting their loans. Several loans this quarter had reappraisals and sponsors either contributed equity or curtailed loan amounts. The weighted average RESG portfolio LTV was roughly 53% of appraisal and loan-to-cost 43%, so there's substantial sponsor equity to protect. Also, on a weighted average basis, loan-to-value was unchanged between March 31 and June 30 despite some appraisals up and some down, payoffs, and new originations, which speaks to the portfolio quality and lower leverage of new business.

Related topic: you include a hard target net charge-off rate in incentive compensation. The other bank I cover that does differentiated lending also includes this. Are you aligning shareholders and management on credit performance, and why do you think other banks don't include NCO targets in comp plans?

In our annual short-term incentive plan for senior executives, three components are financial: EPS, efficiency ratio, and net interest margin. Asset quality components include net charge-offs and non-performing assets. Our long-term incentives are tied to relative ROA, ROE, and total shareholder return. We feel our incentive plans are aligned with shareholders. Asset quality has long been a key focus and we incentivize the team to maintain industry-leading levels.

To add, asset quality is a primary goal for our lending teams. Profitability and margin are next, and growth is tertiary. We've maintained this culture for years. We have been willing to let our balance sheet grow less in some periods to preserve asset quality. When valuations are stressed and competition retreats, we can obtain lower leverage and better margins—producing excellent risk-adjusted returns. We're somewhat countercyclical, and that has helped sustain long-term profitability.

One last question: on workout processes, what differentiates your approach to working out loans that helps you produce lower losses—early identification, sponsor strength, structuring, documentation, or asset management?

A major part of our success is structure, documentation, underwriting, and asset management. Structuring up front to address potential weak points before they arise is critical. Our documentation and closing processes enforce those protections. Our asset management team monitors credits closely—often one asset manager per roughly 14 loans—many with real estate-focused MBAs. They track leases, sales contracts, third-party reports, and other metrics daily and often see issues early. Getting ahead of problems and fixing them before they grow preserves asset quality. Our integrated process from origination to underwriting to closing to asset management is a key differentiator.

Got it. Thank you very much for the detail. I appreciate it.

Thank you, Brody. I'm currently showing no further questions at this time. I'd like to hand the conference to Mr. George Gleason for closing remarks.

Thank you for joining our call today. We're very proud of our quarterly results. We feel really good about them and I'm excited to talk to you again in 90 days. Thank you. Have a great day. That concludes our call.

This concludes the conference call. Thank you for your participation. You may now disconnect. Everyone have a wonderful day.