Prosperity Bancshares Inc Q4 FY2023 Earnings Call

Good day, and welcome to the Prosperity Bancshares' Fourth Quarter 2023 Earnings Conference Call. 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 2023 Earnings Conference Call. This call is being broadcast live on our website and will be available for replay for the next few weeks. I'm Charlotte Rasche, Executive Vice President and 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; and Bob Dowdell, Executive Vice President. Mays Davenport, our Director of Corporate Strategy, is ill and unable to join us today. 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. 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 our 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 would like to welcome and thank everyone listening to our fourth quarter 2023 conference call. For the three months ending December 31, 2023, our net income was $95 million or $1.02 per diluted common share compared with $112 million or $1.20 per diluted common share for the three months ending September 30, 2023, and was impacted by a one-time FDIC special assessment of $19.9 million and merger-related expenses. Excluding the FDIC special assessment, net of tax and merger-related expenses, net of tax, net income was $111 million or $1.19 per diluted common share for the three months ending December 31, 2023. Our annualized return on average assets, average common equity and average tangible common equity, excluding the FDIC special assessment net of tax and merger-related expenses net of tax for the three months ended December 31, 2023 were 1.15% return on average assets, 6.29% return on average common equity and 12.3% return on average tangible common equity. Although our earnings, excluding the one-time FDIC assessment and merger-related expenses were strong, they are still lower than last year, primarily because the majority of our earning assets have not yet repriced and our interest-bearing liabilities have. This will correct over time, and we expect that our operating ratios will be more reflective of our historical returns. Loans were $21.2 billion on December 31, 2023, a decrease of $252 million or 1.2% from the $21.4 billion on September 30, 2023. Loans increased $2.3 billion or 12.4% compared with $18.8 billion on December 31, 2022. Loans excluding the warehouse purchase program loans and loans acquired in the merger of First Bancshares of Texas increased $882 million or 4.9% during 2023. We did see a slight decrease in loans in the fourth quarter. However, we grew loans organically for the year as projected. Our deposits were $27.2 billion on December 31, 2023, a decrease of $133 million or approximately 0.5% compared with $27.3 billion on September 30, 2023. Deposits decreased $1.4 billion or 4.7% compared with $28.5 billion on December 31, 2022. Our deposit outflows have mitigated since last March. However, we still have customers moving money into higher-paying instruments such as high-yielding government bonds or high-rate products offered by competitors. When we saw the increase in deposits during the previous two years, we knew that some portion of them would leave the bank, and that's what's happening now. As the Federal Reserve reduces the money it has put into the economy by reducing its debt, deposits are replacing it in buying the higher rate securities it had purchased. Prosperity has one of the best core deposit bases in the business. We have noninterest-bearing deposits of $9.8 billion, representing a strong 36% of total deposits, and certificates of deposits representing only 13% of total deposits. Further, we have not purchased any broker deposits. Our nonperforming assets totaled $72.7 million or 21 basis points of quarterly average interest-earning assets on December 31, 2023, compared with $69.5 million or 20 basis points of quarterly average interest-earning assets on September 30, 2023 and $27.5 million or 8 basis points of quarterly average interest-earning assets on December 31, 2022. The increase during 2023 was primarily due to the First Bancshares merger. Despite a relatively low nonperforming asset ratio, it is higher than our historical levels due to the recent merger. This is not unusual for us, and we expect to reduce our nonperforming asset ratio to a more normal level within a reasonable period of time. The acquired loans charged off during the fourth quarter were fully reserved for. The allowance for credit losses on loans and off-balance sheet credit exposure was $369 million on December 31, 2023 compared with $72.7 million in nonperforming assets. We look forward to our acquisition of Lone Star State Bancshares, which is pending the receipt of regulatory approvals. We are hopeful that we will receive them soon. We remain interested in mergers and acquisitions and believe our company is in a strong position to participate, especially given our capital, merger and acquisition experience and the relationships we have built over the years. Prosperity operates in two of the best economies in the U.S. Even with the recent interest rate increases, economic activity and job growth in Texas and Oklahoma remain solid. We are excited about our growth and future of our company. Prosperity has a strong capital position that provides us with flexibility in pursuing strategic opportunities such as mergers and acquisitions and the repurchase of our stock when appropriate. We expect that our net interest margin will continue to expand to our historically normal levels as our assets reprice over the next several years, increasing our earnings per share. Further, we have a strong core deposit base with 36% of our deposits in noninterest-bearing accounts. I would like to thank all of our customers, associates, directors and shareholders for helping build such a successful bank. Thanks again for your support of our company. Let me turn over our discussion to Asylbek Osmonov, our Chief Financial Officer, to discuss some of the specific financial results we achieved.

Thank you, Mr. Zalman. Good morning, everyone. Net interest income before provision for credit losses for the three months ended December 31, 2023 was $237 million compared to $239.5 million for the quarter ended September 30, 2023 and $256.1 million for the same period in 2022. The net interest margin on a tax-equivalent basis was 2.75% for the three months ended December 31, 2023 compared to 2.72% for the quarter ended September 30, 2023 and 3.05% for the same period in 2022. Excluding purchase accounting adjustments, the net interest margin for the three months ended December 31, 2023 was 2.71% compared to 2.68% for the quarter ended September 30, 2023 and 3.04% for the same period in 2022. The fourth quarter increase in net interest margin was primarily due to the decrease in borrowings of $525 million during the fourth quarter of 2023. Noninterest income was $36.6 million for the three months ended December 31, 2023 compared to $38.7 million for the quarter ended September 30, 2023 and $37.7 million for the same period in 2022. Noninterest expense for the three months ended December 31, 2023 was $152.2 million compared to $135.7 million for the quarter ended September 30, 2023 and $119.2 million for the same period in 2022. The linked quarter increase was primarily due to the one-time FDIC special assessment of $19.9 million. For the first quarter of 2024, we expect noninterest expense to be in the range of $134 million to $136 million. The efficiency ratio was 55.6% for the three months ended December 31, 2023 compared to 48.7% for the quarter ended September 30, 2023 and 40.9% for the same period in 2022. Excluding the FDIC special assessment, the efficiency ratio was 48.3% for the fourth quarter of 2023. The bond portfolio metrics at December 31, 2023 showed a weighted average life of 5 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 nonperforming assets at quarter end December 31, 2023, totaled $72,667,000 or 34 basis points of loans and other real estate compared to $69,481,000 or 32 basis points at September 30, 2023. This represents a 4.6% increase. Since December 31, 2023, $3.2 million of nonperforming assets have been removed or put under contract for sale. The December 31, 2023 nonperforming asset total was made up of $70,883,000 in loans, $76,000 in repossessed assets and $1,708,000 in other real estate. Net charge-offs for the three months ended December 31, 2023, were $19,133,000 compared to net charge-offs of $3,408,000 for the quarter ended September 30, 2023. This is a $15,725,000 increase on a linked quarter basis. There was no addition to the allowance for credit losses during the quarter ended December 31, 2023. Also, there was no addition to the allowance during the quarter ended September 30, 2023. No dollars were taken into income from the allowance during the quarters ended December 31, 2023 and September 30, 2023. The average monthly new loan production for the quarter ended December 31, 2023 was $300 million compared to $398 million for the quarter ended September 30, 2023. Loans outstanding at December 31, 2023 were approximately $21.181 billion compared to $21.33 billion at September 30, 2023. The December 31, 2023 loan total is made up of 42% fixed rate loans, 27% floating rate loans and 31% variable rate loans. I'll now turn it over to Charlotte Rasche.

Thank you, Tim. At this time, we are prepared to answer your questions. Our call operator will assist us with questions.

The first question comes from Dave Rochester with Compass Point.

Was hoping to get your outlook for the margin and NII for either 2024 or at least maybe the first quarter? And any comments on the trajectory from there through the year would be great, specifically where you see the bottom in NII. And I know your outlook is pretty positive over the next few years, but just more near-term trends would be great to hear and get your thoughts on.

If we examine our margin in the short term, we are still benefitting significantly from the repricing of our loans and assets. On the borrowing side, we've reduced our borrowing by $525 million, which is helping to enhance our margin through cash flow from investments and paying down debt. This is resulting in an increase of about 300 basis points. Combining the loan repricing and debt reduction, we anticipate margin expansion. We experienced a three basis points expansion in the fourth quarter and expect to see continued marginal expansion in the first quarter and beyond. However, looking at the long term, particularly in the second half, we anticipate greater expense impacting the margin compared to the first half, as it takes time for the assets to reprice. Our guidance from last quarter indicates that in 24 months, our net interest margin should be around 3.30 to 3.40, and our model supports this expected expansion. Overall, the outlook appears promising.

Dave, what we mentioned is that from the previous quarter, in 12 months we expect to reach 3%. If you examine the models we are using, it's important to note that they assume no changes in loans or deposits; it's a rather static model. According to this model, in 6 months we anticipate approximately 2.96%, and in 12 months, around 3.14%, with even better results in 24 months. Additionally, it's encouraging that regardless of interest rate fluctuations, our projections indicate that our net interest margin will expand to more typical levels. We are quite optimistic about that.

Great. And so are you assuming the forward curve in that analysis at all, even though you're keeping the balance sheet static?

Yes. The numbers we presented indicate that the rates remain unchanged. However, if our model considers a decrease of 100 or 200 basis points, our margin is still solid. Even with a 200 basis point drop over 24 months, our margin may be slightly lower than what we anticipate in a stable environment, but it will still be expanding within the next 12 to 24 months.

Okay. Great. And what are you guys including in that expectation? I guess it excludes balance sheet changes, but what are you thinking in terms of deposit growth for the year?

That's probably the million-dollar question, Dave. I don't know if anyone really knows. Historically, we've always grown the bank organically by 2% to 4%. The last several years have been unusual. We were experiencing a 10% annual growth rate. Recently, we reviewed our situation and examined the deposits we lost in the last few years.

Before the COVID.

What's really surprising is that despite the amount we gained, we are still about 15% ahead, which translates to a 5% organic growth rate over those years. Looking ahead, it's quite challenging because one of the primary objectives of the Federal Reserve is to slow down the economy. This is being achieved by two main methods: increasing interest rates, which reduces the number of borrowers, and withdrawing money from the system, which totaled $1 trillion over the past year. As they reduce money in the system, bank liquidity is affected unless you're investing in brokered funds. We have chosen to maintain our cost of money with core deposits instead of pursuing brokered funds. This is simply our decision, and whether it's the right or wrong choice is uncertain. However, I would estimate that the maximum gain in deposits is probably around 2%, and you might agree with that.

Yes. Historically, our deposits tend to decrease a bit in the first quarter due to tax payments. However, I believe we should be able to return to historical rates in the long term. This will depend on macroeconomic conditions and the impacts of quantitative tightening as well.

The main thing is I don't see a 5% organic growth rate this year, that's for sure.

Yes, I agree.

The next question comes from Brett Rabatin with Hovde Group.

Wanted to stick with the balance sheet and the margin. And just looking at the securities portfolio, it's about $13 billion, and I know you've got over $2 billion in cash flow annually. But if you look at the yield kind of year-over-year, it's kind of flattish at 2.07%. Does that start to move up in the next quarter or two? Or can you give us any thoughts on the securities portfolio progression from a yield perspective from here?

Yes. Since we're not buying any new securities, I think the yield will remain around 2.05%. However, it also depends on the mortgage rates. If there are significant increases or decreases in mortgage rates, it could accelerate the turnover of those securities, potentially improving yield. Overall, we do not expect a significant increase or decrease in the security yield.

The only way that the yield would go up in the bond portfolio is if we elected instead of reducing debt or putting the money in the loans where we prefer putting it, we would buy back securities. In that case, then it would go up.

Exactly.

Otherwise, it's probably going to stay stagnant for the most part or flat.

Okay. And then on the funding side, can you give us a refresher on how much you guys have in index deposits? And then just thinking about the usual seasonality for municipal deposits? How much you guys having that and how you see the next quarter or two playing out from that perspective?

From the overall funding, we have about $3.7 billion in borrowing, which is around 5%. We’re using cash flow from our investment portfolio to pay this down. In terms of time deposits, 13% of our deposits are in this category. We introduced a special program that pays 5%, allowing our customers to earn a rate instead of just dealing with competition. These are short-term deposits, specifically 7-month CDs, so we can quickly reprice them if rates decrease. Currently, we have about $3.5 billion in CDs, with $3.1 billion maturing within the next 12 months. Out of that, I believe about $1.8 billion are those special CDs, and the remainder consists of money market and noninterest-bearing deposits.

Okay. And then any thoughts on municipal deposits and how those trend from here?

Generally, municipal deposits tend to increase at the end of the year. However, when we compare this year's municipal deposits to last year, we see a decrease of about $500 million. This is likely because they are moving their funds into higher tax pools or similar options. As a result, we did not receive as much in public funds this quarter at year-end as we did in the previous year, which was anticipated.

Yes. And on the public funds note, I would say, I think we are down to almost to their operating accounts because all the excess they could earn, they probably moved out to tax pools. So we're kind of maintaining their operating accounts.

Maybe a little bit higher right now, people are still paying tax dollars. But again, most of the money that we do is their operating accounts, it's not their investment funds.

I mean big picture, correct.

Okay. That's helpful. If I could sneak in one last one, just around the Lone Star transaction. Any update there? I know that the Justice Department, it's reviewing that one, so it's taking longer, but have you guys heard anything or any update on from a timeline perspective when that might close?

We were really hoping to be able to say something at this meeting. Unfortunately, we're not. But we're still very hopeful that we're going to get the deal done. And hopefully, we'll hear about it soon.

Yes. And you mentioned Justice Department, we're out of the Justice Department.

Right. Rather than Justice Department... They've cleared us.

Great. Thanks for all the color.

Still at the FDIC, and they take off most of Christmas for December, so...

The next question comes from Michael Rose with Raymond James.

I wanted to start on some of the proposals that are out there as it relates to interchange and overdraft. And I know these won't hit until later this year or next year for that matter. But have you guys looked at those? And what could the potential impact be for Prosperity?

You've touched on something that really concerns me, Michael. If this proposal goes through, I believe it's likely to happen in the latter part of 2025. I hope perhaps a new administration can intervene because I really think it's misguided to consider reducing overdraft charges to $0, $3, or $17. It promotes behavior that should not be encouraged. Think about it like telling your children that something is wrong, but then rewarding them for continuing that behavior. On the other side, when someone writes a check to buy goods from a merchant or retailer, that merchant is not receiving their money. They end up losing money in the transaction because the bank often covers that overdraft, and we may not be doing that in the future. So the bottom line is that I hope Rohit Chopra will reconsider this deal. I hope we can have a conversation with him. Additionally, if banks are to continue operating, they need service charge income. The regulatory burden is extremely high right now. Therefore, banks might need to alter their service charge structures, as we currently offer free checking accounts to attract customers with lower deposits. In the future, if this deal goes through, banks may have to impose a minimum balance requirement of $2,000 or $3,000 along with a service charge, which would lead to the elimination of many lower-end checking accounts that regulators and the Federal Reserve want to encourage for these customers. I don't think it's entirely finished yet, but if it happens, it would certainly have a significant effect on us. The impact would depend on whether they allow charging $17 or just $3. If it's $17, being able to charge that or $15 could generate around $10 million or $11 million before tax. If it's $3, it might be closer to $16 or $17 before tax, something in that range. On the other hand, we would need to identify other areas to increase service charges to offset and make up for that loss. While we might not fully cover the entire amount, we would need to implement additional charges in different areas.

Got it. Okay.

I gave you too much information, Michael?

No, that's great. And sorry to hit a hot button topic. Maybe just as a follow-up, you guys announced a new share repurchase program the other day, and you guys haven't been very active, but capital levels are really high. I don't think you're expecting a ton in terms of balance sheet or loan growth this year. Any sort of thoughts around increased usage of the buyback as we move through the year, assuming credit remains relatively benign?

I mean I don't think that we would have ever issued a repurchase agreement if it wasn't our intention to use it. I think we did use it last year. I think how many shares did we purchase last year?

About 1.2 million shares.

1.2 million shares were purchased last year. While it's not a significant amount, we proceeded cautiously. Last year was challenging, particularly starting in March with the issues at Silicon Valley Bank and Signature Bank. Additionally, there has been ongoing scrutiny regarding bond portfolios and potential losses. We considered these factors, and regulators were also concerned. As a result, we approached things more conservatively. Currently, we feel more reassured. Our preference is always to increase dividends, but if we don't fully utilize our resources for that and don't secure a merger or acquisition deal, we would likely consider buying back stock if it is undervalued.

And I think it's important to emphasize that the potential for M&A right now is very significant. May or may not happen, but it's out there.

What's going on? Yes, go ahead, David. I'm sorry.

We believe that in the past, making a strong M&A deal could yield greater financial benefits compared to simply buying back stock. However, this is not always the case, so we will need to evaluate each deal individually as they arise.

Got it. Is there a minimum threshold on CET1 that you wouldn't want to go below? Or is there like kind of like a medium-term or longer-term level of CET1 that you think is appropriate for the bank, just given the relatively lower risk profile of it?

I'm more focused on the leverage ratio. Essentially, you take your goodwill, divide it by your assets, and that gives you your leverage ratio. I believe we're currently around 10%. In the past, having 5% or 6% was considered solid. I think regulators prefer us to be in the double digits, which we are, and I believe they appreciate that. If we pursue a deal, I would prefer not to drop below 8% on the leverage ratio. That's just my instinct at the moment.

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.