Prosperity Bancshares Inc Q4 FY2022 Earnings Call

Good morning. Welcome to the Prosperity Bancshares, Inc. Fourth Quarter 2022 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Charlotte Rasche. Please go ahead.

Thank you. Good morning, ladies and gentlemen, and welcome to Prosperity Bancshares fourth quarter 2022 earnings conference call. This call is being broadcast live over the Internet at prosperitybankusa.com and will be available for replay for the next several weeks. I'm Charlotte Rasche, General Counsel of Prosperity Bancshares, and here with me today is David Zalman, Senior Chairman and Chief Executive Officer; H. E. Tim Timanus Jr, Chairman; Asylbek Osmonov, Chief Financial Officer; Eddie Safady, Vice-Chairman; Kevin Hanigan, President and Chief Operating Officer; Randy Hester, Chief Lending Officer; Merle Karnes, Chief Credit Officer; Mays Davenport, Director of Corporate Strategy and Bob Dowdell, Executive Vice-President. David Zalman will lead off with a review of the highlights for the recent quarter. He will be followed by Asylbek Osmonov, who will review some of our recent financial statistics and Tim Timanus, who will discuss our lending activities, including asset quality. Finally, we will open the call for questions. During the call interested parties may participate live by following the instructions that will be provided by our call moderator MJ. Before we begin, let me make the usual disclaimers. Certain of the matters discussed in this presentation may constitute forward-looking statements for purposes of the federal securities laws, and as such, may involve known and unknown risks, uncertainties and other factors which may cause the actual results or performance of Prosperity Bancshares to be materially different from future results or performance expressed or implied by such forward-looking statements. Additional information concerning factors that could cause actual results to be materially different than those in the forward-looking statements can be found in Prosperity Bancshares' filings with the Securities and Exchange Commission, including Forms 10-Q and 10-K and other reports and statements we have filed with the SEC. All forward-looking statements are expressly qualified in their entirety by these cautionary statements. Now, let me turn the call over to David Zalman.

Thank you, Charlotte. I appreciate everyone who is joining our fourth quarter 2022 conference call. For the three months ending December 31, 2022, our annualized return on average assets was 1.47%, and our annualized return on average tangible common equity was 16.2%. Prosperity's efficiency ratio for this period was 40.8%. Our net income for the same three months was $137.9 million, up from $126 million during the same period in 2021, marking an increase of 8.7%. The net income per diluted common share was $1.51, up from $1.38 in 2021, representing a growth of 9.4%. For the year ended December 31, 2022, our net income was $524 million compared to $519 million in 2021, showing an increase of $5 million or 1%. The net income per diluted common share for the year was $5.73 compared to $5.60 in 2021, an increase of 2.3%. Our loans, excluding Warehouse Purchase Program and PPP loans, reached $18 billion at December 31, 2022, an increase from $16.7 billion at December 31, 2021, reflecting an increase of $1.4 billion or 8.5%. Our linked-quarter loans, also excluding the Warehouse Purchase Program and PPP loans, rose by $518 million or 3%, which is 11.8% annualized from $17.6 billion at September 30, 2022. Our deposits at December 31, 2022, totaled $28.5 billion, down $2.2 billion or 7.3% compared to $30.8 billion at December 31, 2021, primarily due to a decline in public fund deposits. Additionally, linked-quarter deposits decreased by $766 million or 2.6% from $29.3 billion at September 30, 2022. While our period-end and average non-interest bearing deposits showed slight increases, we noted that most of the decrease in total deposits was in the public fund category. Our asset quality saw non-performing assets total $27 million or 8 basis points of quarterly average interest-earning assets at December 31, 2022, compared to $28 million or 9 basis points at December 31, 2021. The allowance for credit losses on loans and off-balance sheet credit exposure was $311 million at December 31, 2022, down from $316 million at December 31, 2021, and $312 million at September 30, 2022. We are enthusiastic about our pending merger with First Bancshares of Texas and Lone Star State Bancshares. The combined entities are set to add approximately $3 billion in assets and enhance our market share in West Texas, particularly in Lubbock, Midland, and Odessa, while also granting access to new markets in Wichita Falls, Amarillo, and various areas in Central Texas. These transactions are awaiting regulatory and shareholder approvals and are anticipated to close in the first half of 2023, though delays may arise. During the fourth quarter of 2022, we continued to observe growth in loans, which we expect to carry on into 2023. This growth is fueled by ongoing demand for loans and relatively slower repayment rates compared to periods of lower interest rates. Consumer spending remains robust, especially in tourism, dining, and hospitality. Although real estate sales and pricing have been impacted by rising rates, we anticipate that inventory levels and population growth will mitigate the effects in Texas and Oklahoma. We believe the economies in these states will surpass others in the coming years, as both companies and individuals continue to relocate here due to lower taxes and a favorable business environment. We foresee an increased need for infrastructure and housing, as well as spending avenues for consumers, all of which will require bank financing for growth. While some banks have seen immediate improvement in their net interest margins due to higher rates, we expect Prosperity’s margins to rise steadily over the coming years as our bond portfolio, which yielded 1.96% in the fourth quarter of 2022, adjusts to higher yields, assuming rates stabilize near current levels. Overall, we are looking forward to the growth and future of our company. I want to express my gratitude to our customers, associates, directors, and shareholders for contributing to the success of our bank. I appreciate your continued support. Now, I would like to hand over the discussion to Asylbek Osmonov, our Chief Financial Officer, to go over some of our specific financial results. Asylbek?

Thank you, Mr. Zalman. Good morning, everyone. Net interest income before provision for credit losses for the three months ended December 31, 2022 was $256.1 million compared with $244.8 million for the same period in 2021, an increase of $11.4 million or 4.6%. This was due to an increase in loan and security interest income of $28.9 million and $25.7 million, respectively, partially offset by an increase in interest expense of $43.6 million. Comparing the quarter ended December 31, 2022 to the same period in 2021, the net interest income increased $11.4 million despite having $7.9 million less in PPP loan fee income and $4.5 million less in fair value loan income. The net interest margin on a tax equivalent basis was 3.05% for the three months ended December 31, 2022 compared to 2.97% for the same period in 2021 and 3.11% for the quarter ended September 30, 2022. Excluding purchase accounting adjustments, the net interest margin for the quarter ended December 31, 2022 was 3.04% compared to 2.91% for the same period in 2021 and 3.1% for the quarter ended September 30, 2022. Noninterest income was $37.7 million for the three months ended December 31, 2022 compared to $35.8 million for the same period in 2021 and $34.7 million for the quarter ended September 30, 2022. Noninterest expense for the three months ended December 31, 2022 was $119.2 million compared to $119.5 million for the same period in 2021 and $122.2 million for the quarter ended September 30, 2022. For the first quarter 2023, the new FDIC assessment rate is expected to increase expenses by approximately $2 million. As a result, we expect noninterest expense for the first quarter 2023 to be in the range of $122 million to $124 million. This excludes any potential impact from one-time merger-related costs for our pending acquisition, which are expected to close in the first half of 2023. The efficiency ratio was 40.9% for the three months ended December 31, 2022 compared to 42.8% for the same period in 2021 and 41.4% for the three months ended September 30, 2022. The bond portfolio metrics at December 31, 2022 showed a weighted average life of 5.3 years and projected annual cash flows of approximately $2.2 billion. And with that, let me turn over the presentation to Tim Timanus for some details on loans and asset quality. Timanus?

Thank you, Asylbek. Our non-performing assets at quarter end, December 31, 2022 totaled $27,494,000 or 15 basis points of loans and other real estate, compared to $19,878,000 or 11 basis points at September 30, 2022. This represents approximately a 38% increase in non-performing assets. The December 31, 2022 non-performing asset total was comprised of $25,531,000 in loans, $0 in repossessed assets and $1,963,000 in other real estate. Of the $27,494,000 in non-performing assets, only $767,000 are energy credits. Since December 31, 2022, $6,114,000 in non-performing assets have been removed. This represents 22% of the non-performing assets at December 31. Net charge-offs for the three months ended December 31, 2022, were $603,000 compared to $1,780,000 for the quarter ended September 30, 2022. No dollars were added to the allowance for credit losses during the quarter ended December 31, 2022, nor were any taken into income from the allowance. The average monthly new loan production for the quarter ended December 31, 2022 was $613 million. Loans outstanding at December 31, 2022 were approximately $18.840 billion, compared to $18.506 billion at September 30, 2022. The December 31, 2022 loan total is made up of 42% fixed rate loans, 30% floating rate and 28% variable rate. I will now turn it over to Charlotte Rasche.

Thank you, Tim. At this time, we are prepared to answer your questions. MJ, can you please assist us with questions?

Yes, of course. We will now begin the question-and-answer session. Today's first question comes from Brady Gailey with KBW. Please go ahead. Brady, your line is open.

Sorry. I was muted. Good morning, guys.

Good morning.

Good morning.

The margin took a slight step back in the fourth quarter. I understand that over the long term, as the bond book is repriced higher, it will be very beneficial to the margin. When do you think the margin can begin to experience significant improvement from the higher pricing of the bond book?

Hey, Brady, this is Asylbek. I'll address that and we might have more to discuss later. Our overall situation remains unchanged; it's centered on our balance sheet composition. Long term, I agree it looks very favorable for us due to the current higher interest rates. We currently hold about $14 billion in bonds with yields under 2%. Regarding our loan portfolio, as Mr. Timanus mentioned, we have 42% in fixed rates and around 28% in variable rates, which will be repriced over time as well. This is a positive aspect for us. From our bond portfolio, we generate about $2.2 billion in cash flow annually, and we have experienced significant loan growth in recent quarters. If we allocate that cash flow to high-yielding loans, which are currently at 6% to 7%, it will greatly benefit us in the long run. Additionally, our IRR model indicates that over the next 12 to 24 months, we anticipate an expanding net interest margin, consistent with our performance during the last rate cycle. This provides more insight into the long-term outlook. However, in the short term, particularly in the first quarter, I expect our net interest margin to be somewhat flat due to ongoing repricing of deposits. The main variable here is how deposits will be repriced, especially given the current competitive landscape. Despite that, we are optimistic about our long-term margin, which should improve over time.

Brady, I'd like to share some insights. Our models indicate substantial increases in our net interest margins over the next six to twelve months, which is encouraging. In fact, the projections for 24 months are quite impressive. These estimations are based on current interest rates, and as rates rise, our model anticipates a 25 basis points increase in February and another 25 basis points in March. For every 100 basis points increase, we estimate a 65 basis points adjustment for money market accounts. However, if we encounter deposit pressures that require us to raise rates quicker or more than expected, it could affect the net interest margin. Overall, we still have considerable room for improvement in a normalized rate environment, and the timeline for this remains uncertain. While other banks may have realized their net interest margin gains already, ours is still forthcoming; it is just a matter of timing.

The yield on the bond book is 1.96%. When you purchase new bonds today or if you consider the bond purchases made in the fourth quarter, what was the new yield on those?

We no longer need to purchase bonds as our loan portfolio has been expanding. We're focusing all our efforts on loans. In the short term, I don't anticipate significant bond purchases, instead, we will continue to grow our loan portfolio, which has increased by $500 million in the last quarter. The outlook for the first quarter is also positive. Even though there are discussions about a recession in some regions, we are still observing strength in our loan portfolio. Based on current borrowing levels and our strategy with loans, I believe we will allocate most of our resources towards loans while reducing our borrowings from the Federal Home Loan Bank.

I think what the 15-year mortgage backs now are about 4.5%. Is that right?

Probably so. Yes.

It is clearly our preference to invest those dollars in loans rather than in securities at this level. We have had some success with that recently, so that is the plan.

And on the loan growth, I think you guys kind of longer-term guide to a mid-single digit level loan growth, but as I look at the last three quarters, annualized, you are growing like north of 10%, so how do you think about loan growth for 2023?

Yes, part of the loan growth is due to slower paydowns across the portfolio, especially in the structured real estate portfolio, which is now under $400 million. The payoffs are really slowing down in that area. The first month of the year has shown strong loan growth, consistent with our performance in the past few quarters and possibly even a bit better. For the year, I would estimate growth to be in the mid-single digits to the high single digits, depending on single-family mortgage origination pricing. If the pricing is lower, it may be more beneficial for us to package those loans and sell them for a gain, which would result in more profit from the gain rather than the loan growth. Thus, if rates align with that scenario, we could see results leaning more towards the mid-single-digit range. But if we choose to portfolio the loans, we might experience high single-digit growth. No matter the approach, we're expected to increase our profits, and we will be strategic and mindful in deciding whether to hold or sell the loans based on current rates.

Okay, that makes sense. Thanks, Kevin.

The next question comes from Michael Rose with Raymond James. Please go ahead.

Hey, Kevin. Regarding loan growth, could you provide an update on the warehouse? It seems that the volumes were a bit lower than what you mentioned in October, which isn’t surprising considering the MBA's forecast. Do you have any insights on the near-term expectations for warehouse volumes? I would anticipate some additional downward pressure followed by potential stabilization, but I’d really appreciate your thoughts on this. Thanks.

Yes. And I saw your note this morning, you had me scrambling for our transcript, because I thought I guided right to the number we had. But I'll call you later on that once I confirm. It has trickled down in January. It always does. Michael, we're averaging so far for the quarter exactly $590 million. So it's off from the last quarter average of $729 million, I think, something like that. So I expect this would be kind of the low points for the quarter, and we may rally from here a little bit, but again, depending upon where the 10-year moves, but it seems to be settling in. I'm going to say we're going to average for the quarter somewhere between $550 million and $600 million.

Perfect. And then maybe just for David Zalman. Obviously, the two deals announced recently, I know there's a lot of other banks out there, a lot of dislocations. Just any change and update on kind of your thought process around M&A at this point? And would you potentially look to maybe do additional deals here in the next couple of quarters, even if you're still integrating the two that you've already announced? Thanks.

I believe that mergers and acquisitions are part of our strategy. For the last 20 to 30 years, we've aimed for about an 8% organic growth rate on loans and around 4% on deposits, with the remaining double-digit growth typically coming from M&A. So, the answer is yes. If you ask whether the activity is as intense as last year, there are still opportunities, and we’re receiving inquiries. However, the environment is more subdued. A challenge we face is the accumulated other comprehensive income on most banks’ books right now, which we will need to navigate in some of these transactions. Previously, larger deals allowed us to address this with some flexibility, while smaller deals often had their value adjusted accordingly. There’ll need to be discussions and adjustments regarding the AOCI. Nevertheless, M&A will always be a constant; market conditions change regularly. There’s a lot happening, and I believe we will continue to be active in this area.

Okay. And maybe finally for me, just on the buyback announcement, you haven't repurchased shares here recently. Is that just more of a kind of a tool in case there's dislocations? Or would you actually expect to maybe potentially be a little bit opportunistic here? Thanks.

Historically, we've utilized it for market dislocation. Whenever prices get somewhat unreasonable, particularly below 70, we have re-entered the market. In the past, this approach has been primarily for situations of dislocation.

The next question comes from Dave Rochester with Compass Point. Please go ahead.

Hey, good morning, guys.

Good morning.

I appreciated all the color on the margin earlier. I was just wondering if you could talk about where your incremental loan production yields are, what you're seeing today. I know the curve has been all over the place. But given where we are today, what are you guys seeing?

Basically on the low end, 6.5% on the high end 8% and they're fluctuating within that range.

Got it. So you got a decent amount of upside there from your average yield on the quarter alone over the next few years?

We averaged 5% for the quarter, if I remember it correctly. So there is quite a bit of upside available. That's correct.

Yes. Sounds good. And then just a quick one on expenses. I appreciate the 1Q outlook. But I know you guys have your merit increases in 2Q, I think, midway through. So if you have any visibility into how much of a step-up you guys are expecting from that in 2Q and maybe into 3Q, we get the full quarter impact by 3Q, that would be great.

I will address that. Historically, we have implemented merit increases of about 3% to 4%. In terms of dollar amounts, I expect this to align with last year's increase. Therefore, we are looking at an additional expense of around $2 million to $3 million. Specifically, I estimate that it will contribute approximately $2 million in additional expenses beginning in the second quarter.

Okay. Great. And maybe one last one on deposits. I was wondering how much in the way of public deposits you guys have left after the decline in 4Q. And then are you guys still thinking about core deposit growth of roughly 2% that you were talking about before? Has that changed at all? And then last one, how are you thinking about deposit betas for the cycle at this point? Thanks.

May take some of the…

Yes. We finished the year with approximately $3.3 billion in public funds, which remains our current level. We have a solid relationship with all of our public fund clients, and the text pool and other rate payers are currently at rates above 4%. We believe it is advantageous to allow some of those funds to be used at those rates rather than absorbing the costs ourselves. This does not reflect a lack of good relations with our public funds; we still manage their operating accounts and daily transactions, and we do not anticipate any changes to that. We have several bids approaching this year, which can be challenging since some banks tend to be overly aggressive while others are more reasonable. We address each situation individually. Overall, we have a positive outlook regarding public funds at this time.

I think regarding the 2% increase, it's difficult for me to say we would achieve that growth. Given the high interest rates that some other banks are offering, we haven't pursued those rates. Normally, I would suggest that we could expect an organic growth of 2% to 4%. However, I'm unable to make that assertion at this moment. We still want to observe how deposits stabilize for our sales going forward.

Yeah. And probably Asylbek is the best guy to answer on. I think you asked about beta as well through the cycle. I think I know where it is but Asylbek on top of that one.

If you examine the cycle prior to the December rate increases, the Fed's rate hike of 3.75 resulted in our beta for interest-bearing deposits being around 20 basis points. In comparison, total deposits saw a rise of about 12 basis points during that time, although figures are currently lower than what we anticipated in our IRR report. We understand that betas generally start off slow and gradually increase, but we have yet to reach the levels we experienced in 2015 or 2016 with prior rate increases. While we remain optimistic about our position, we acknowledge there is competition for deposits, which may exert some pressure on us.

It's not just about deposits with our competitors. I can't recall the last time we've experienced a lack of deposit growth, perhaps 10, 15, or even 20 years ago. People are exploring other options, like purchasing a 4.2% treasury for two years. This makes it difficult for us to provide a clearer perspective since we lack historical data to model this situation. We're monitoring the situation and making necessary adjustments daily. This isn't a scenario we've faced in banking for a long time, especially considering the significant influx of monetary support we've seen in the past few years. We're trying to determine where things will settle and stabilize.

Okay. Great. Thanks, guys. I appreciate the color.

The next question comes from Peter Winter with D.A. Davidson. Please go ahead.

Thanks, good afternoon. Credit, obviously, the hallmark for you guys. When I look at that reserve coverage, it's 10 times the nonperforming loans. So the question is, can you guys still keep a zero provision expense this year even with a mild recession?

Yes, I can provide some insight. As we mentioned before, we have a base scenario along with recessionary scenarios. Based on the combination of these two scenarios, the current allowance levels are deemed appropriate. Moving forward, we will continue to run the models to assess the economic situation at that time and determine the necessary allowance.

Yes, when we first implemented the model, we included a COVID variant, which had a significant impact. Later, we considered oil prices, and currently, with discussions around a potential recession this year, it provides us the opportunity to maintain a higher reserve by utilizing those variables.

Yes. I think it's highly dependent on how high rates get and that remains to be seen. And if for some reason, population growth should slow down or even go the other direction in Texas and Oklahoma, that would have an impact on it. We don't foresee that, but things happen in life that you don't foresee. So I think the answer to your question is, certainly, at this point in time, we wouldn't anticipate right away an increase in the reserve. But as the year plays out, we just have to watch some of those things that I just mentioned.

Yes. Last thing I'd add and I think Tim covered it in his prepared remarks was that we did move up, NPA has moved up to $27 million from $19 million or $20 million. Most of that was just some loans that didn't get renewed at year-end that have subsequently been renewed. So that number is back down to where it had been. So in terms of stress, we haven't seen any yet. That doesn't mean we can walk out of this meeting and get a phone call that somebody stumbled, but we're watching it, and we feel good about where we sit.

That's correct. A wildcard is always the price of oil and gas. And right now, it's good, it's stable. But it never stays the same. If we've learned anything, we've learned that. So next year, we still think it would probably be stable, but we'll just have to see where it goes.

Okay. And then just second question, just I realize regulators operate kind of in a black box. But when you first announced the two acquisitions, the thought was you're going to close it in the first quarter, now you're saying in the first half of the year. When does that impact the synergies from the deal, the accretion to the deal maybe pushes out a little bit? And two, are the regulators saying anything that causing change a little bit in terms of the timing of closing the deals?

I'm attributing that statement to our general counsel. From closing the first quarter to the first half, we wanted to be cautious regarding the deal given the current regulatory environment. I believe we are still aiming for a first quarter closing, but she suggested mentioning the first half due to the circumstances we are facing.

I think it's important to emphasize, we don't have any answer yet from the regulators. So until we do, we can't schedule a closing.

The next question comes from Manan Gosalia with Morgan Stanley. Please go ahead.

Hey, good afternoon.

Good afternoon.

Good afternoon.

I had a question on NIM and just given the positive dynamics that you have on the security side, how should we think about the potential downside in NIM if the Fed begins cutting rates in the back half of this year? Should that actually be maybe a little bit of a benefit in the near term if deposit competition alleviate and your securities keep repricing higher?

I think overall, big picture, I mean, even if the Fed would decrease the rate, and we don't know, we're just speculating if they would and how much. We still are in the bond portfolio, we're sitting less than 2%. So even they decrease. I mean, there's still a lot of upside for us and also on the loan. So even if there is a foreseeable future, you see the decrease, I think we still have upside. And definitely, you're right, I think from the cost perspective on deposit costs definitely helped a decreased rate environment.

I think it probably helps on mergers and acquisitions too, it will change the valuation of the loss in the portfolio and the AOCI probably. But for the most part, the yields that we have in the bond portfolio today really reflect a time and period that we've not seen before in banking where interest rates were at zero. So in any type of normalization of rates we stand to benefit on a repricing too.

Got it. And then maybe to round out the discussion on the funding side, can you help us with how we should think about FHLB and CDs as a source of funding? So to the extent that deposit pressure accelerates from here, how much room do you have to bring your loan-to-deposit ratios up versus the 66% or so that it's at right now?

So first of all, we have the capability to borrow $15 billion if we want overnight just because of our pledging that we have with the Federal Home Loan Bank. But for the most part, and you can jump in, Asylbek, if you want, but we have a certain amount of bonds that just roll off every year, which is about $2 billion, close to $2 billion. So instead of buying securities like we have in the past, we would take that money and either put them into the loans that we discussed the growth in loans and also reduce the debt. Also, the banks that are joining us will probably take a certain portion of their liquidity instead of reinvesting it and probably pay down the Federal Home Loan Bank too. So it will probably be a combination of money that we get from paydowns in our own portfolio and also the banks that join us, really don't necessarily have a big portfolio, but the other one, I would have to look and see, but we're looking at doing that and probably using that money just to pay down the Federal Home Loan Bank probably.

Got it. So it feels like you wouldn't be leaning into CDs at all?

I believe that over time, people will start moving money into CDs if interest rates remain elevated. However, historically, we haven't been the type of bank that actively promotes CDs or high interest rates. While that may change in the future, it is not our current approach. We have never chased after these deposits because we have always maintained a significant amount of liquidity, and we continue to have a strong liquidity position when considering our borrowing capabilities and core deposits.

Great. I appreciate it. Thank you.

The next question comes from Matt Olney with Stephens. Please go ahead.

Hey, thanks. Good morning, everybody.

Hey, Matt.

Good morning.

Good morning.

I want to drill down on deposit pricing. And I think last quarter you mentioned that early in 4Q, you increased some of the posted rates across the network. And obviously, we saw that in the 4Q results and some of the deposit pricing pressure. Asylbek, you mentioned incremental deposit pricing pressure in 1Q. Any notable changes in the deposit posted rates over the last few weeks or months?

Yes, at the end of December, we saw a slight increase in our deposits. However, if you examine the results from the third and fourth quarters, our beta on interest-bearing deposits for the fourth quarter was around 30 basis points. Currently, we may consider raising rates on deposits a bit, but we do not have a specific amount for that increase at this time.

If you recall from our previous meeting, I mentioned that we anticipated rising interest rates, and at that time, our money market rate was quite low, around 50 basis points. I indicated that we should prepare for a decrease in our net interest margin by about five or six basis points, which occurred since we raised our money market account rate to 2.25%. Additionally, we provided a CD product for 22 months at a 3.5% rate. If interest rates increase further, we expect a quarter of a point hike in February and another quarter of a point in March. Our model suggests that we might see an increase of about 65 basis points overall. This could lead to an additional increase of around 30 basis points. If there is a significant change, such as heightened competition resulting in funds leaving the bank, we may need to adjust our rates further. However, I believe our core strategy remains unchanged. We prioritize long-term growth rather than short-term fluctuations. Our net interest margin remains positive, and our recent rate hikes were implemented to better serve our core customers. If necessary, we would do so again, but I don't foresee any changes affecting our long-term net interest margin outlook.

Yes, Matt, this is Kevin. I'd just add with the cash flows coming off the bond book and our loan-to-deposit ratio sub 70%, we've got a little room to let that loan-to-deposit ratio drift up and protect margin at least in the short run.

Yes, okay.

I think it even improve your margin, just if you can keep up your loans, too, just I'm not even saying 10%, you pick up 2% or 3% on a couple of billion dollars’ worth of loans, you really improve your margin dramatically.

I was encouraged that, on average, your noninterest-bearing deposits were relatively stable in the fourth quarter compared to the third quarter. Many of your competitors are facing significant pressure in this area. Can you provide some insight into your depositors and how they might differ from some of your other public bank peers in Texas?

We are observing some of our depositors shifting their funds. A significant amount of money entered the banks due to government stimulus, and many individuals had previously invested elsewhere without earning much. For instance, I recently attended a trust committee meeting where I noticed that a customer could add $15 million to their account with us, but they decided to transfer it to our trust department because we were offering a higher interest rate than a competitor like Goldman Sachs. This trend is occurring even as we see stability in some areas.

Greater percentage of retail deposits, more granularity drives some of that for us compared to some of our Texas peers anyhow, but maybe more commercial deposits. It's these small towns where we have really big market shares and granular portfolios where we're getting pressure or people that ask us to come off of our rate sheets tends to be from professionally managed money, bigger companies that's got $50 million, $60 million, $70 million in the bank that's got a CFO that's keeping track of things and…

And we can count those on our hands.

Right. There's only a handful of those, and they're willing to work with us. It's kind of, we don't have to go all the way to the market. That's usually a conversation between either Eddie and David, Tim and myself. But hey, let's take these guys to 2.50 or 2.75 if our rates are 2.25. And thus far anyhow that kept most of the money with us.

Yes, I think what you've just said is completely accurate. When I mentioned that we have a strong relationship with our public fund customers, I feel that applies to all of our deposit customers as well. They usually don't withdraw their funds to seek higher rates elsewhere without contacting us first to discuss it. While there are times we need to raise our rates, we generally don't have to go beyond a certain point, and that has been the trend so far. I believe there is some upward pressure on deposit rates, but it's manageable and remains relatively stable due to the relationships we maintain with our customers.

Yes, I said this on the last call, too, in this rate environment, from a guy who ran a 95%, 98% loan-to-deposit ratio bank ex the warehouse. So with the warehouse, it was running 110%. I'm glad to be sitting in this room.

Okay. I appreciate all the color, guys. And then just one more on loan growth. It looks like the drivers of that 4Q loan growth was from construction and single-family. Kevin, you addressed a single-family portfolio kind of driven by yields as far as kind of the factor in 2023. What about construction? Is that going to be the primary driver of the loan growth in 2023?

I think we're going to see it in construction, which is funding up projects that we've approved. We've got a big, very large unfunded and funding up construction book of really good customers, underwritten for rates being materially higher than they are now, and we feel pretty good about that portfolio. And I think we're going to continue to see some success this year on the C&I side.

Yes, some of our markets currently have strong unfunded loan commitments. Our Houston market had probably over $700 million, and Central Texas had... how much, Eddie did you…

About $300 million or $400 million.

So if those hold up our book, it looks pretty good. But again, anything can change. We just don't want to tell you something that's going to be this glorious because if you do go into a recession or something like that, that can all change. Overall, I think the guidance that Kevin gave a while ago is a really good guidance to stick with really.

Okay. Thanks, guys.

The next question comes from Jon Arfstrom with RBC Capital Markets. Please go ahead.

Hi. Good morning everyone.

Hi, Jon.

I'm probably not going to ask about deposit pricing, but how optimistic are you about the long-term margin? You mentioned putting on loans at 6% to 8%. Securities yields are certainly higher, and you're saying that you're not overly concerned about deposit pricing. What could this margin look like in 12 or 24 months with that kind of increase in earning asset yield?

I would share the details from the model in front of me, but I might face some backlash if I did. What I can take away from it is that it's not a matter of whether the net interest margin will see a significant increase, but rather when that will occur. Assuming we don't have to raise rates significantly from our current position, we could expect noticeable increases in six, 12, and even 24 months. However, if we face unexpected competition or if we experience a large outflow of deposits that forces us to act quickly, that could affect the timing of the net interest margin's rise. Overall, the outlook is very positive; it’s primarily about managing the situation effectively.

Yes. Timing-wise, I think the sooner the Fed goes into pause mode, the sooner this happened.

There is currently an inversion factor that is quite significant. When you look at the 10-year span at 3.5 and the two-year treasuries at 4.2, it highlights this inversion. I don't want to be evasive regarding your question, Jon; we're working our way through it. I've often referred to it as parking the Queen Mary, and we have done that multiple times. Right now, we are likely in that process of figuring out how to navigate parking the Queen Mary.

It connects to my next question, but I agree that a pause would be beneficial for you. This reminds me of the Queen Mary and the parking lot, specifically thinking about Sugar Land. You mentioned the conditions concerning M&A targets. What are your observations in that regard? Are we facing issues similar to SMB challenges? Is it that severe yet, or do you foresee larger opportunities in the long run? How significant is this issue, and what insights are you gathering from potential sellers? What is the prevailing message?

I think the real challenge on AOCI is if you're talking about a real large merger partner. The smaller ones you can deal with and really in some of the smaller ones, that we've done, we mark-to-market, what it is. So the seller actually takes the hit on the loss. I think it's really the bigger ones that we're really looking at. And it's just one of those sayings I’d say.

It's hard to do the deal as it's picking up and they have that issue.

It's challenging to meet the previous demands, particularly for larger deals, as marking to market can negatively impact your tangible capital ratio. We're not inclined to compromise significantly on that front. In the future, there will likely need to be some negotiation between the seller and buyer for larger transactions.

Yes, the earn back part is very capable. However, the goodwill remains indefinitely. In larger deals, it can lead to a significant goodwill amount that is not easily written off.

I mean from an earnings standpoint, when you look at one of these deals when you model it out, the earnings are just if you mark everything to market are just phenomenal. I mean because the bond portfolio may be like us instead of waiting two and three years to get all that money back, you're marking it to market right there. And so the earnings for the first two or three years just look phenomenal on a deal like that. But the problem is really on the tangible capital issue, I think.

Okay. All right. Thanks for the time. I appreciate it.

The next question comes from Bill Carcache with Wolfe Research. Please go ahead.

Thanks. Good morning, everyone.

Good Morning.

I wanted to follow up on your comments around why your noninterest-bearing deposit mix has held up materially better than many other banks. I appreciate all the color that you gave. I wanted to ask if you could also discuss how much of a role earnings credit adjustments play in your relationship with some of your commercial customers? And has that been entering into the discussions more?

I'll start off by saying that we've been increasing the earnings credit again, including a 10 basis point rise this morning. The granularity in our customer base is key to understanding the noninterest-bearing accounts. We don’t have a small percentage of customers controlling most of the bank; instead, we have a diverse range of businesses and small enterprises throughout the state, from metro areas to small communities. This diversity contributes to the granularity, and no single person dominates the bank. Our customer base is also comprised of immigrants from various backgrounds, which adds to this granularity.

Yes. And on the ECR, while we get rate requests for off-sheet rate requests, Frequently, the ECR doesn't come up all that frequent, and it's that professionally managed larger corporation that's got a bunch of money with us, which we can count on a couple of hands where those CFOs are thumping on us for ECR. But we haven't had to move nearly as much as you would think.

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

Thank you. Thank you, ladies and gentlemen, for taking the time to participate in our call today. We appreciate your support of our company, and we will continue to work on building shareholder value.

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