Sb Financial Group, Inc. (SBFG) Q3 2023 Earnings Call Transcript

Good morning, and welcome to the SB Financial Third Quarter 2023 Conference Call and Webcast. I would like to inform you that this conference call is being recorded and that all participants are in a listen-only mode. We will begin with remarks by management and then open the conference up to the investment community for questions and answers. I will now turn the conference over to Sara Mekus with SB Financial. Please go ahead, Sara.

Thank you, and good morning, everyone. I'd like to remind you that this conference call is being broadcast live over the Internet and will be archived and available on our website at ir.yourstatebank.com. Joining me today are Mark Klein, Chairman, President and CEO; Tony Cosentino, Chief Financial Officer; and Steve Walz, Chief Lending Officer. Today's presentation may contain forward-looking information. Cautionary statements about this information, as well as reconciliations of non-GAAP financial measures, are included in today's earnings release materials, as well as our SEC filings. These materials are available on our website, and we encourage participants to refer to them for a complete discussion of risk factors and forward-looking statements. These statements speak only as of the date made, and SB Financial undertakes no obligation to update them. I'll now turn the call over to Mr. Klein.

Thank you, Sarah, and good morning, everyone. Welcome to our third-quarter conference call and webcast. Highlights for the quarter include net income of $2.7 million, down from both the linked and prior quarters, as funding costs and lower mortgage volume have impacted profitability. Pretax pre-provision return on average assets was 96 basis points, with return on tangible common equity of 10.8%. Total interest income of $14.8 million was up $3 million, or 25.8% from the prior year and up $390,000, or 10.8% annualized from the linked quarter. Loan balances were higher from the linked quarter by just $4.2 million but have now risen nearly $64 million or 7% over the prior year quarter. Our expansion markets in Fort Wayne and Columbus were the catalyst, growing 29% and 15%, respectively. Deposits were higher by $14.1 million or 5.2% annualized compared to the linked quarter and remained steady from the prior quarter, albeit with higher funding costs that rose from 46 basis points to 176 basis points. The loan-to-deposit ratio of 91.1% marks our second consecutive quarter above 91% and is higher by nearly 6 basis points from the prior year. Operational liquidity stood at nearly $500 million, which is 35% of total assets and sufficient to meet all our growth needs. Notably, we have not needed at any time to access the Federal Reserve term funding program. Expenses were slightly higher than the run rate this quarter, which Tony will touch on shortly, as we had some nonrecurring items that impacted results. Mortgage origination volumes are lower than both the linked and prior year quarters but did show a very high level of sold volume at 88%. Capital levels remain strong, with Tier 1 leverage of 11%, common equity Tier 1 of 13.6%, and total capital over total risk-based capital of 14.8%. Customer deposits for the company that are below the FDIC insured threshold were nearly 84% of total deposits. Excluding any collateralized deposits, that level increased to 89%. Asset quality metrics remained strong, with delinquency levels at 33 basis points and year-to-date net charge-offs of only 1 basis point. We continue to concentrate on our five key initiatives: revenue diversity, more scale in our current households, more scope and operational excellence, and asset quality. To discuss revenue diversity, the mortgage business line has been under significant pressure this year from not only higher rates but also the lack of inventory in most of our markets. This quarter reflected not only the new lower level of activity but also the ongoing side of our pipeline. The expectation is that the $15 million to $20 million per month volume will continue for the majority of the next six months. We have, as previously indicated, been actively moving away from residential portfolio growth by making changes to pricing with a focus on shorter-duration products. It was encouraging that we sold 88% of our production in the quarter, with yields on those sales in line with the last four quarters. Despite headwinds that all banks have encountered this year, our quarterly noninterest income has remained fairly stable. Our $4.2 million this quarter was up slightly from the prior quarter but down slightly from the linked quarter. We have settled into a 30% level of fee income to total revenue, which, while down from our very high historical levels in the high 30s to low 40s, still places us well into the top quartile of our peer group. As we look at year-to-date results, the negative impact from the mortgage business line, with $1.2 million of servicing right impairment and an additional $900,000 due to lower gain on sale, has overshadowed our other fee-based business lines. We remain committed to our title insurance business despite headwinds from the residential sector and are pleased with the progress we have made this year in making Peak Title the number one choice for our clients in our markets. For this year, our State Bank commercial team has delivered over 145,000 of revenue, accounting for 11% of Peak’s total revenue for the year, which is over double the commercial revenue from the prior year. This commercial contribution is nearly on par with our internal residential level of contribution for the year. We continue to emphasize the quality and capacity of our peak business line to all clients. As I indicated in our second quarter webcast, our goal remains to generate 50% of Peak's revenue, all else remaining constant. This quarter, State Bank delivered 34% of Peak's revenue and now claims 30% of their revenue year-to-date. We spent the majority of the quarter integrating our new wealth management leader, mitigating the loss of a prior wealth adviser, remaining connected with our current wealth management clients, and developing new contacts as well. However, revenue growth has been challenged by downward pressure in the equity markets and our need to identify more wealth advisers. Regardless, this business line continues to deliver a stable $3.7 million to $4 million in annual revenue and provides a competitive advantage over our community bank peers. It remains a great complement to our private banking and commercial customer bases, ensuring that we provide our clients with a comprehensive solution to all their financial needs. Secondly, regarding more scale, loan growth rose slightly from our last quarter, as I previously stated. Consecutive quarter-over-quarter growth dating back seven quarters has been a notable achievement in our overall balance sheet growth. We understand that growth will become more difficult as we anticipate a further slowing economy. With this scenario, we will work harder to deliver the same or better results. By doubling our calling efforts to clients, as well as strong prospects tied to our competitors, a number of whom have stepped away from lending, we expect that when the economy does turn, we'll be better positioned to achieve pre-pandemic levels of loan growth. Growing deposits from the linked quarter was a key achievement, as we have worked extremely hard this past year to maintain our deposit levels on par with the prior year. We have given our bankers the flexibility to deepen every deposit conversation with clients to ensure we are keeping and growing those valued relationships. Obviously, maintaining that deposit level has come with a reduction in our net interest margin, with our year-to-date deposit cost of funds up 101 basis points from the prior year. Keeping that rise less than the increase in our earning asset yields, which have risen 119 basis points, feels like an accomplishment in this rather challenging environment. Third, regarding more scope, we closed just under $1 million in SBA loans this quarter, and thus far for 2023, we have originated $7.4 million. That production, which we anticipate will approximate $10 million for the year, is certainly less than our capacity and well below the goals we have set for this very profitable sector. With increased prime lending rates, we intend to adjust our traditional pricing model to drive portfolio balances and revenue higher. Fortunately, we can often attract the entire deposit relationship with each new SBA credit. Additionally, our strong credit culture and the added safety net of government guarantees stabilize asset quality and revenue. We expect to build on our fourth-quarter successes to lay the groundwork for a stronger 2024 in the SBA arena. As discussed in prior quarters, our investment in technology to help us better identify and target clients for business expansion continues. We are in the midst of our Salesforce integration project and are confident that both our corporate sales champion and consultant sales approach with each client will bring us closer to a more extensive banking process while maintaining a community bank feel. As a result, we have accelerated training for our staff with a focus on retaining 100% of our current clients and delivering a robust community bank brand for all prospects alike. Operational excellence is our fourth key initiative. Operating expenses were up just slightly in the linked quarter, as we had some check fraud and other nonrecurring items. However, a large portion of our expense base is well tied to the number of units produced in our SBA and mortgage business lines. As those volumes have declined, associated compensation levels have also decreased. We have taken steps to reduce fixed costs in both areas by reducing support staff and shifting responsibilities to departments with excess capacity. From the prior year, total FTE is down 17% or 6%, reflecting those impacts. Beginning in the fourth quarter, we will identify initiatives to further improve our efficiency ratio. We expect that our fourth-quarter expense level will reflect a more efficient run rate near the $10 million per quarter range. Lastly, to deliver more value to our commercial client base, we recently launched a comprehensive calling strategy across our entire footprint to deliver and potentially implement positive pay risk mitigation software to protect our 1,700 client accounts from fraud, as well as constrain our operational risk. In terms of asset quality, charge-offs remained low this quarter, just $5,000. Year-to-date, we have had just $88,000, which equates to only 1 basis point of total loans. We have to go back 13 quarters to identify a period with net charge-offs exceeding $65,000. Additionally, our reserve coverage of nonperforming loans at 474% gives us great comfort moving forward, indicating our asset quality is strong, stable, and prepared to confront any potential weaknesses in the economy. For all our underwriting and dynamic loan administration, these are the common threads here. We had a slight uptick in delinquencies from the linked quarter, which were all in the under 60-day category. The clients involved have now become current, and we expect that when we report our 2023 results, they'll be back in the mid-20 basis points range. We do not anticipate any material level of delinquencies in the near term in the portfolio outside of identified nonperforming credits. Now I'll turn it over to Tony Cosentino, our CFO, for more details on the quarter.

Thanks, Mark, and good morning, everyone. For the quarter, we had GAAP net income of $2.7 million, with EPS of $0.39 per share. It is notable that our pretax pre-provision earnings adjusted for the MSR recapture for the nine-month period are up $550,000, or nearly 6%, from the prior year nine-month period. Highlights of the income statement this quarter include that total margin income has declined for the quarter from both the linked and prior years despite robust growth in interest income, exceeding 25% as significant accumulation of funding costs pressured total margin. The margin ended the quarter down 7 basis points from the June quarter and was down 37% from the prior year. However, we have seen some stabilization in our margin with declines in the past three quarters of 25, 20, and now 7 basis points. We anticipate that the fourth quarter will likely be the low point in our margin, with expectations of some slow improvement in 2024. In addition to the shift in the mix of assets away from securities to loans, increases in asset pricing have driven earning asset yields higher in every quarter this year, with yields up 89 basis points compared to the third quarter of 2022. Loan yields have increased by the same level, with new volume and contractual repricing consistent with market movements in the rate curve. This quarter, our margin betas have followed the pattern of the last two quarters, with funding betas exceeding repricing betas on our earning assets. Specifically, the deposit and total cost of funding betas were at 88% and 87%, respectively. These are approximately 1.5 times higher than the loan and earning asset betas, which are 60% and 58%. Since the Federal Reserve began the rate-increasing cycle, the betas for both sides of the balance sheet are nearly neutral, with earning asset beta at 31% and cost of funds beta at 28%. Our level of fee income to average assets remained even with both the linked and prior year quarter at 1.2%. As Mark pointed out, it has stabilized at the 30% level relative to total revenue. We track our coverage of noninterest expenses to assets by noninterest income to assets every quarter. In an ideal world, driving that coverage to zero would be ideal, but we understand that it is extremely difficult. This quarter, we had a negative 1.9% as part of a trend improving in this metric for this calendar year, as we have adjusted operating expenses to reflect lower levels of fee income, especially in the mortgage business line. This quarter did show positives in residential mortgages, especially our level of sold loans, and our gain on sale percentage of 2.2% is in line with the linked and prior year quarters. Our ability to hedge the pipeline, coupled with our historically high pull-through mortgage rate of nearly 90%, has allowed us to command good loan sale yields despite the tough secondary market. We do, however, expect the next six months in the mortgage business to be difficult, with total origination levels around $100 million. This would mark our lowest origination level in several years but reflects the near 8% rate mortgage market. As rates potentially stabilize into 2024, our consistency in the market should allow us to return quickly to higher origination levels. Despite the slight uptick in total expenses this quarter, our trend to drive annual operating expenses below the $41 million level remains on track. We have reduced operating costs on consultants and are adjusting operating hours in our retail locations, contributing to the expense reduction that Mark just mentioned. Compensation and benefits as a percentage of total expenses was 52.4% this quarter, down from 56.4% in the third quarter of 2022. With compensation per employee rising 2.9% annually, reflecting lower commission levels and our efforts to manage employment costs effectively. Now, as we turn to the balance sheet, the total size of our balance sheet experienced a slight decline from the linked quarter due to marginal loan growth, with cash and securities levels declining. Securities as a percentage of total assets continued to reduce in the quarter, now just 16% of total assets compared to 17% and 18.7% for the linked and prior year quarters. Regular amortization and some small paydowns in the investment portfolio brought the balance down to near the $200 million level. Encouragingly, this quarter deposit growth enabled us to pay down more high-priced repos and FHLB borrowings by over $26 million, or 25%, compared to the linked quarter. We maintained a stable valuation of our mortgage servicing rights, which stood at 118 basis points. The servicing rights balance increased to $13.9 million, with the servicing portfolio now at $1.37 billion, slightly up from the prior year. We continue to have very strong capital levels, as Mark highlighted. Our common equity Tier 1 ratio stands at 13.6%, and even with adjustments for AOCI, the level remains robust at 10%. Tangible book value per share is slightly higher compared to the prior year. When adjusted for the CI impairment, our tangible book value per share would be $18.92, which is up 3.5% from year-end 2022. Our share buyback continued this quarter, although volume was down compared to our historical buyback run rate per quarter. Specifically, we purchased 44,000 shares at an average price of $14.02, or less than 85% of book, slightly higher than our tangible book value. Our allowance was stable in the quarter, reflective of both minimal provisions and charge-offs. Due to the small increase in loan balances, our reserve to loans remained flat compared to the linked quarter at a healthy 1.6%. Compared to the prior year, we have increased our reserve percentage by 11 basis points. Our criticized and classified loans were stable compared to the linked quarter and now stand at $9.7 million, down $3.1 million or 24.2% from the prior year. I'll now turn the call back over to Mark for closing comments.

Thank you, Tony. We continued our consistent pattern of raising our common dividend with our announcement this week of a $0.135 per share common shareholder dividend. For the year, we've now declared cash dividends of $0.52 per share, or nearly $3.6 million. The total dividend payout ratio for this year will be approximately 30% with a current dividend yield around 4.2%. We continue to buy back our shares to return earned capital to our owners. Navigating 11 rate hikes since early 2022, including four 25 basis point hikes this year, has significantly impacted our rate-sensitive business lines, including mortgage and SBA. We have adjusted resources as appropriate, and we'll continue to do so moving into the fourth quarter. Our budgeting process for 2024 reveals markets and products we feel will have strength and how our operation will emerge with greater emphasis on margin expansion, stabilization, balance sheet growth and mix change, and noninterest expense containment to preserve and grow EPS. Now I'll turn the call back over to Sarah Mekus for questions.

Thank you, Mark. We're now ready for our first question.

We will now begin the question-and-answer session. Our first question comes from Brian Martin of Janney Montgomery.

Hi. Good morning, guys.

Good morning, Brian.

I just thought maybe you could talk a little bit about the loan pipeline. Just kind of how you're seeing those given current market conditions and then just how your markets are performing.

Good morning, Brian. This is Steve. We see 2023 as a bit of a year of acceptance for borrowers as they've gotten used to the new rate reality. Some things we thought we would see come to the fore earlier this year have been delayed. That said, we do have some optimism for the fourth quarter, as some of those projects have come online. Anecdotally, we’re hearing from lenders that we’re getting more calls. The pipeline seems to be accelerating again as borrowers adjust to the new rate environment, and we're also seeing an economy that seems to be stabilizing, which encourages them to proceed with projects.

Okay. And as far as just your outlook, whether it be fourth quarter or the next several quarters, what type of growth rate appears to be the near-term target based on what you might see?

Brian, we're likely to end this year around the 6% range when complete. As we look forward, that's probably the low end of the range we're targeting for 2024. A lot hinges on the commercial side because, as you know, we have stepped back from residential portfolio growth. SBA has shown some strength here in the fourth quarter and we're getting more inquiries. I'm hopeful that number reaches 7% to 8% as we exit this year, roughly around a $70 million total for the year.

I appreciate that. Thank you. Can you provide insights on the mortgage production, particularly for the upcoming quarters? Based on current trends, how do you project it will shake out in terms of volume?

For Q4, I expect origination to be around $50 million. Our pipeline seems to hover around the $18 million to $20 million level, though December seems to be dropping off a bit. So I suggest a $50 million range for Q4. I anticipate that level will continue into Q1, based on forward rate curves and current indications. I expect sales will be around 85% to 90%. We are not seeing high levels of portfolio activity, with clients focused on fixed-rate Freddie Mac saleable products.

Just a follow-up comment, Brian. We expect volumes to rise again, potentially in the latter half of 2024, as we might see improvement in the rate environment and the rate curve. We've also reduced some expenses in the back end of that process and positioned ourselves with the same number of MLOs from Columbus to Indianapolis to lower Michigan to achieve that $500 million without additional costs. So we are ready to advance when the market adjusts correctly, yet we'll be cautious with variables such as higher and lower inventory.

That's helpful. Switching to margin, Tony, you mentioned that it might reach a bottom in Q4 and potentially stabilize or improve next year. What are your thoughts on the benefits for asset repricing? How much do you anticipate loans will reprice and what trends do you see that might offer stability or expansion in the coming year?

It's a tough question. The variability this year about how fast funding costs have risen relative to earning assets has slowed. We anticipate getting closer to a 1:1 ratio in Q4 between deposit costs and asset side pricing. I’m hopeful that our disciplined approach allows repricing to flow through effectively. What is essential is how clients respond as their loans approach repricing dates.

Could you share what yields you are currently getting from new production and what repricing occurs in the next months? Perhaps over the next 12 months to get an idea of how the loan book will perform?

The margin we are currently seeing is about $225 million to $250 million over the relevant index. We aim to hold that as loans reprice while others step back. We believe that combined with our level of service, we should be able to retain those loans.

Got it. And regarding total repricing, how much do you have scheduled for the short and long term?

Traditionally, around 15% to 20% of our entire portfolio reprices on an annual basis, with most priced within a three to five year duration. This coming year, I expect a slight increase from that percentage due to the majority of our recent loans being relatively short-term.

Great, and lastly, regarding credit quality, it sounds like things remain strong on your end. Are there any stress indicators you’re observing within certain areas of the portfolio?

No, Brian, we are very satisfied with our portfolio's performance. We did a deep dive into our CRE portfolio focused on investment real estate, and we were pleased with the validation of leases and cash flows' resilience against increased rates. We feel confident about our current portfolio.

Thank you for the insights. That's all my questions.

Thanks, Brian.

Thank you, Brian.

Since there are no further questions, I would like to turn the call back to Mr. Mark Klein.

Once again, thanks for joining us this morning. We certainly look forward to speaking with you in January to provide our fourth quarter and full 2023 year-end results. Goodbye.

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