Earnings Call Transcript - SBFG Q3 2022

Operator, Operator

Good morning, and welcome to the SB Financial third quarter 2022 conference call and webcast. I’d like to inform you that this conference call is being recorded, and all participants are in listen-only mode. We will begin with remarks by management, then open the conference to the investment community for questions and answers. I’ll now turn the conference over to Sarah Mekus with SB Financial. Please go ahead, Sarah.

Sarah Mekus, Investor Relations

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; and Tony Cosentino, Chief Financial Officer. This call may contain forward-looking statements regarding SB Financial’s performance, anticipated plans, operational results, and objectives. Forward-looking statements are based on management’s expectations and are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied on our call today. We have identified a number of different factors within the forward-looking statements at the end of our earnings release, which you are encouraged to review. SB Financial undertakes no obligation to update any forward-looking statements except as required by law after the date of this call. In addition to the financial results presented in accordance with GAAP, this call will also contain certain non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release. I will now turn the call over to Mr. Klein.

Mark Klein, Chairman, President and CEO

Thank you, Sarah, and good morning, everyone. Thanks for joining Tony Cosentino with me for our third quarter 2022 conference call and webcast. At a high level, highlights for the quarter include net income of $3.3 million, down $761,000 or 19% off from the prior year quarter, but would be up 9% when you exclude the PPP program and small OMSR recapture. On a year-to-date basis, net income was $9 million, with diluted EPS of $1.27, down from $2.08 EPS last year, or a decline of $0.81 per share. Excluding the effects of mortgage lending in both this year and last, EPS would have been up $0.14 per share year-over-year. Return on average assets was 1.03% and return on equity was nearly 11%. Net interest income of $10.4 million was up 8.7% from a linked quarter, and 4.1% from the prior year. Loan growth and interest rate increases have offset our higher funding costs. Loan balances from the linked quarter rose $30 million. When we adjust for PPP balances, loans were up $81.5 million, an ordinary increase of 10% compared to the prior year. Annualized, our loan growth for the first nine months of the year was a healthy 16.6%. Deposits grew from the linked quarter by $14.1 million, but were down nearly $26 million from the prior year. Expenses were down from both the linked quarter by 3.9% and the prior year by 7.7%. Mortgage origination volume for the quarter was nearly $69 million, and for the trailing 12 months, they’ve now originated $388 million, despite the effects of the headwinds of this rapidly rising rate environment. The mortgage business line contributed $6.1 million in total revenue for the first nine months of this year, compared to $16.4 million in the same period last year, a reduction of 63%. Asset quality metrics remain strong, with non-performing assets at just 40 basis points. And net loan losses for the year now stand at a net recovery of $19,000. We continue to attribute our success to our continued commitment to our five key strategic initiatives that we've talked about for a number of quarters. That's continuing to diversify our revenue, balancing net interest income with fee-based business lines, focusing on growth, offering more products and services, expanding our market reach, and of course, excellence in our operations through better deployment of technology. Our focus on asset quality remains paramount. First, revenue diversity. This quarter, mortgage volume and loan sale gains were down from the prior year by 55% in volume to nearly $69 million, and 78% in gains to $876,000. The impact of higher rates is evident in the mix of volume for the quarter, with refinance making up just 11%, and purchases and construction comprising 89%. This contrasts with the third quarter of last year when the split between refinance and purchase volume was approximately 52% and 48%, respectively, indicating a significant shift. The relationships we've built with realtors over the past decade are paying dividends as we pivot to the purchase market. Non-interest income decreased to $4 million from the prior year quarter of $6.6 million. The current quarter includes a mortgage servicing recapture of $65,000 compared to a recapture of $248,000 in the third quarter of last year. Non-interest income to total revenue for the year still remains strong at 33%, but well below our traditional level of near 40%. Our wealth management team continued to provide stable and consistent revenue in the quarter of $930,000 and continues on pace to deliver annual revenue of $4 million. Despite our wealth assets under management now down $80 million year-to-date, we have still performed better than the NASDAQ Index and in line with the S&P 500 Index. Our baseline decline was 15.4%, while the S&P 500 Index decreased by 15.3%, and the NASDAQ Index fell nearly 29%. Second initiative, more scale. Loan growth in the quarter was strong, with an increase of $30 million from the linked quarter and $81 million net of PPP from the prior year quarter. All of our regional markets have solid pipelines, and we continue to actively prospect and reach out to our current clients and prospects. With this quarterly growth noted, we have now grown in five of our last six quarters, increasing over $100 million from $815 million in balances to over $925 million or 13.4%. We intend to continue to drive organic growth as we enter the commercial arena in one of our newer markets in Indianapolis, Indiana. We feel confident that this market will complement our higher-touch, relationship-based model, similar to our growth markets like Columbus, Fort Wayne, and Findlay. The growth in our deposit portfolio this quarter reflects the hard work our bankers have done in reaching out proactively to clients. We continue to face strong competition for funding in each of our markets, both from banks and non-banks, but we intend to remain relevant in this retail-driven space as we seek lower-cost funding to grow our loan book. Our loan-to-deposit ratio was up again this quarter to 85%, as we get closer to our historical levels, which would be somewhere in the 90s. The increase of 1.6 percentage points was a result of the increased deposits and loans I've just mentioned. Thirdly, our strategy to develop deeper relationships and more services within those households has been successful. Our success with the PPP program enabled us to capture over 200 new relationships and expand upon 920 existing ones, each driving more engagement. Our SBA strategy post-pandemic has also accelerated. This quarter, our SBA business line contributed $125,000 in revenue as we begin to see more demand for 7(a) enhancements. We are optimistic about SBA originations this year and beyond and aim to reach the top quartile of nationwide producers of SBA loans. Although our transition from the PPP program to the 7(a) program is slower than we expected, we have originated over $6 million this year-to-date in total volume. After the quarter, our pipeline stands at $15 million and is as strong as we've ever seen since the onset of the pandemic. All business lines benefited this quarter from collaborating and making proactive referrals to one another. Our bankers have now made over 1,100 referrals to other teammates, resulting in nearly 600 closure goals for an additional $57 million in new business. To ensure our culture remains collaborative, we recently hired a corporate sales champion to expand key sales initiatives and drive best practices. Our operational excellence is another critical focus. Our mortgage business line has enabled us to drive non-interest income to peer-leading metrics, averaging 40% of total revenue over the last seven years. Despite facing challenges in the origination of residential saleable products and lower gains on sales, we have been able to supplement our non-interest income with net interest margin on portfolio products, albeit with some mild duration risk. However, as the market normalizes, we believe we are well-positioned to capitalize on potentially the next wave of refinancing opportunities, should they emerge. We are expanding our pay-for-performance variable-based pay MLO stack to aim for an average production near $460 million annually. While individual MLO production has decreased from an average of approximately $30 million to $15 million today, we are continuously identifying more producers to hit the $500 million target, increasing from 22 producers at the end of 2021 to 25 last quarter and now to 27 today. Our retail staff continues to complement our first mortgage producers by offering consumer second mortgages and home equity lines to enhance scale. Regarding expenses, year-over-year levels have declined compared to both the prior year and linked quarter, primarily due to lower mortgage loan volume and related expenses. By focusing on processing capacity and cross-selling opportunities among the 9,000 households we serve through our new CRM platform, we see a clearer path to greater organic balance sheet growth. Retail office walk-in activity continues to moderate as we commit more to a digital delivery channel. We are consolidating our daily digital and telephonic client transactions into our new contact center. With better clarity on service level commitments, we expect to improve both client satisfaction and organic growth potential. Our asset quality remains strong amid economic uncertainties. We have not seen any deterioration in our customers' financial positions so far this year. We have not set aside any provisions yet this year, despite over $100 million in loan growth, and remain comfortable with our current reserve levels. Our coverage of non-performing loans stands at 313% at the end of the quarter. Our robust underwriting process should continue to pay dividends as we pivot with the credit cycle. Now, Tony will give us a little more detail on our quarterly performance. Tony?

Tony Cosentino, Chief Financial Officer

Thanks, Mark, and good morning, everyone. For the quarter, we reported GAAP net income of $3.3 million, and $9 million for the first nine months. Some highlights for the quarter include total operating revenue up 1.5% on a linked quarter, but down 13.2% from the third quarter of 2021, as headwinds in the mortgage business have been offset by loan growth and improved margins. Loan sales delivered gains of $1 million for mortgages to small businesses. For the nine months, total loan sale gains were $4.2 million. Margin revenue was up $837,000, or 8.7%, from the linked quarter. When we adjust for PPP, loan interest income was higher by $1.3 million from the prior year, or 14.7%. In addition, if we adjust operating revenue by removing the impact of PPP and the entire mortgage business line, we see positive revenue growth of 19.2% and 16.1% from the linked and prior year quarter, respectively. Looking at the third quarter income statement, margin yields were impacted minimally by the PPP initiative, which is down to just one remaining credit. However, year-over-year comparisons are still significant, contributing just $114,000 to margin in the first nine months of 2022 compared to $3.3 million for the prior year's similar period. Adjusting average loan yields for both periods would show a 21-basis point improvement from the prior year, and up 36 basis points from the linked quarter. The improved loan yields and mixed shift from cash and securities drove a similar improvement in earning asset yields. As our loan growth has been in the low double digits, we have needed to fund this growth with retail deposit offerings at the margin, alongside selective wholesale funding options. While we plan to allow our investment portfolio to decline over time with scheduled amortizations, our expected loan growth will necessitate higher deposits and borrowing for funding. In the third quarter, our deposit cost of funds came in at 31 basis points, and the cost of interest-bearing liabilities at 58 basis points. This compares to 21 and 39 basis points, respectively, for the linked quarter. From the linked quarter, the beta on our earning asset yields was 32 basis points, and the interest-bearing liability beta was 13. Clearly, competition for funding has intensified, and we're expecting deposit and overall funding costs to continue to rise in the coming quarter. Our net interest margin stood at 3.46%, expanding 30 basis points from the linked quarter, and was up 25 basis points from the prior year, showing an increase of 55 basis points when PPP is excluded. The significant margin improvement from the linked quarter was driven by a positive change in the asset-side balance sheet mix, as interest-bearing cash shifted towards loans while deposit levels declined. Year-over-year comparisons for total non-interest income, which was down to 39%, were impacted by expected declines in mortgage revenue. If we look at the quarter and exclude the mortgage gain on sale, our non-interest income was up over 26% from the prior year, driven by better customer service fees, higher servicing income, and improved swap activity. Our fee income to average assets remains strong at 1.2% for the quarter, and 1.5% for the first nine months of 2022, although down from both the prior year and historical average, we are still above the 75th percentile of our 65-bank peer group. As Mark indicated earlier, revenue diversity is one of our strengths, and a key initiative with not only mortgage business but also wealth management, swaps, and net service fee income. As discussed last quarter, residential gain on sale yield continued to stabilize, coming in at 2.24% for the quarter, and 2.32% for the year, with a sale percentage of originated loans at just 57% and 62% for the year, representing a significant decrease from our traditional 85% sale percentage. The market value of our mortgage servicing rights improved slightly this quarter, with a calculated fair value of 114 basis points, increasing three basis points from the linked quarter and 30 basis points from the prior year. Our servicing rights balance is now $13.5 million with a small temporary impairment of $262,000. Expenses for the quarter totaled $10.4 million, down for both the linked quarter and the prior year, as our volume of business declined. Expense levels aligned with revenue reduction, with a 13.2% decline from the prior year, nearly double our expense line at 7.7%. However, in comparison to the linked quarter, revenue growth was 1.5%, while expenses declined by 3.9%. We expect revenue growth to improve quarter-over-quarter with better margins, while expenses may increase or slightly decline from the current $10.4 million level. Loan outstandings at September 30th stood at $925 million or 71% of total assets, which compares to 63% the previous year. The third quarter saw a significant mix shift within our earning assets, as cash and securities decreased by over $24 million from the linked quarter, while loans grew by $30 million and deposits increased by $14 million. Our loan-to-deposit ratio ended the quarter significantly higher than the previous year. Historically, we have limited our investment portfolio to allow for higher loan growth, and we moved from less than 10% of our assets in bonds in December 2019 to the current 19%. We are being mindful of maintaining a shorter duration and focusing on cash flow instead of yield, which has exposed us to higher market value deterioration. However, we believe we are comfortable with the portfolio and our average duration of just over five years should provide ample cash flow to fund expected loan growth. Following our capital position, we finished the quarter with $114.6 million, down 29.7% or 20.6% from the prior year, while our equity to asset ratio remains at 8.8%. When we exclude the OCCI temporary valuation adjustment of $33.4 million, our equity grew 2.1% from the prior year and would be 11.4% on an equity asset basis, even after $6 million in stock buybacks and $3.3 million in dividends. We continued to repurchase shares this quarter, with a total of 77,326 shares bought back. Year-to-date, we have repurchased over 300,000 shares or 4.4% of total shares outstanding. We plan to continue our buybacks at current prices funded by organic net income. Lastly, all of our asset quality metrics remain steady and positive, with charge-offs well controlled for both the quarter and year-to-date. Total delinquency levels are at just 31 basis points, down from both the linked quarter and the prior year. Currently, our level of allowance to total loans stands at 1.49%, which is better than the major exchange rate of one to 100 billion by 30 spheres. I will now turn the call back over to Mark.

Mark Klein, Chairman, President and CEO

Thank you, Tony. I want to conclude, as we've done in prior quarters, acknowledging the dividend announcement we made last week of $0.1250 per share, which represents a 27% payout ratio and a dividend yield of 2.94%. Through nine months, our loan growth and higher rates have helped to offset the expected decline we have seen in the residential mortgage arena. Additionally, we continue to feel positive about our markets, the pipelines we've generated, the product lineup we have, and the prospects for continued balance sheet growth. Consumer households are strong, with lower cost leverage resulting in lower overall debt to income ratios and robust disposable income fueled by a 3.5% unemployment rate. We continue to see positive economic growth absent much stronger Fed resistance should inflation persist. Now, I'll turn the call back over to Sarah for any questions.

Sarah Mekus, Investor Relations

Thank you, and we're now ready for our first question.

Operator, Operator

The first question comes from Brian Martin with Janney Montgomery. Please go ahead.

Brian Martin, Analyst

Hey, good morning, guys. I have a couple of high-level questions. Just on the mortgage side, could either Mark or Tony provide the outlook here? I know you talked about some dynamics and the MLOs you are looking to bring on. Considering the shift with rates, what is your general outlook for volume over the next couple of quarters, the gain on sale margins, and sale percentages? Any commentary you can provide?

Mark Klein, Chairman, President and CEO

Yes, just a couple of comments, Brian. We remain bullish on the mortgage side. We are optimistic about the 9,000 households we serve. We probably have 1.5 to maybe 1.6 services per household. So, we are excited about utilizing Salesforce to deepen those relationships. However, as both Tony and I have indicated, the market at 7% is substantially higher than where we were. We are doing some of the 5.5 to 6.25 mortgage portfolio products, which keeps it on our books, positioning us for potential refinancing. As I have noted previously, the number of producers is crucial. We've hired two high-level producers in the Indianapolis market to support our efforts there. Targeting $500 million is our goal, though we are selling substantially less in the secondary market due to product characteristics. Nevertheless, we are optimistic about our direction. The decrease in average producer production from $30 million to $15 million leads us to project closer to 30 producers.

Tony Cosentino, Chief Financial Officer

So, Brian, we've managed to obtain about $260 million in originations through the first nine months. We expect to end the year somewhere between $300 million to $320 million, depending on Q4 outcomes. I would say our 2.25 sale yield is likely to remain stable in Q4, possibly slightly increasing in 2023. We're looking to grow our origination total next year by 6% to 10% depending on market conditions, actively picking up where competition has diminished, resulting in a larger share of a sector projected to remain flat or slightly decline. Refinancing will likely remain around 10% to 15% of total volume through the end of 2023 unless there's a change in rates.

Brian Martin, Analyst

Okay. And what about your sale percentage? Are you still comfortable with your current approach of continuing to hold loans on the books for now?

Tony Cosentino, Chief Financial Officer

Yes, that's the question we're still pondering. We continue to engage high-quality clients. The ARM product has gained appeal due to the shock of a 7% Freddie Mac fixed rate. Rates might decrease a bit, leading to normalization in client attitudes. However, I don't believe we will reach an 85% to 90% sale percentage again. We're likely headed toward the 70% to 75% range, which feels more sustainable long-term compared to the current 60% range.

Brian Martin, Analyst

That sounds perfect. It looks like you have hiring plans in 2023, especially on the mortgage front. You've recently welcomed a couple of new team members, but do you see opportunities to bring on additional personnel?

Mark Klein, Chairman, President and CEO

In light of what we've seen with Quicken and others leveraging the refinance market, we are pleased to see the relationships we’ve established with realtors benefiting us as we shift into this purchase market. We plan to pursue excellent producers in positive markets, and we intend to get back to our average production levels. Operationally, we will continue to manage expenses and potential FTEs carefully.

Brian Martin, Analyst

Great, that's helpful. On the loan growth outlook, it's been very impressive, as you've indicated. With the rising rates, do you anticipate any changes to your pipeline? Are you still experiencing activity that suggests a robust outlook ahead?

Mark Klein, Chairman, President and CEO

Some of our strategies involved taking on duration risk lately, which has kept people engaged in deals despite lower cap rates. This aspect seems stable, and as I mentioned, our bankers are actively making calls. Plus, hiring a corporate sales champion will bring more focus on each of our salespeople and business lines to enhance our digital platform and CRM strategy. By transforming our 9,000 households from 1.6 services per household, we aim to improve organically. We remain optimistic about Indianapolis and the commercial market. While economic conditions fluctuate, we see good opportunities. Our diverse markets are a strong asset overall.

Brian Martin, Analyst

It sounds like you're positive about growth in 2023, even if it might not reflect the same pace as achieved this year?

Mark Klein, Chairman, President and CEO

That's correct. The Fed's actions will be data-dependent, and if the pace moderates going into 2023, it should reflect positively. The economic pattern, including car sales, remains uncertain, but at 3.5% unemployment, we must address labor shortages. As the economy recovers, we expect to find clients willing to leverage funds, despite some associated duration risks.

Brian Martin, Analyst

Thanks for that. A final query for Tony regarding margin expansion. What should we expect over the next quarters? If the Fed pauses, can we anticipate some fluctuation in margins as deposit betas catch up?

Tony Cosentino, Chief Financial Officer

Yes, that’s a reasonable expectation. Loan betas have outpaced others in the quarter. We'll likely align to one in Q4 if the Fed raises rates today and more ahead. Our margin expansion primarily remains contingent on loan growth expectations. In Q4, loans could remain stable or shift slightly upwards. Though we target $100 million year-on-year, approximately half on residential mortgage. Looking ahead, we predict that residential mortgages will taper to represent 25% to 30% of our growth.

Brian Martin, Analyst

Understood. Most improvements stem from assets repricing and shifts in funding, focused on cash flows from the securities portfolio?

Tony Cosentino, Chief Financial Officer

Yes. Anticipating $10 million to $12 million cash flow from the bond portfolio in Q4, we'll not reinvest but use those funds to support loan growth. We feel confident our deposit side can remain stable or increase, potentially impacting margin positively while funding our growth strategies.

Brian Martin, Analyst

Excellent, thanks! One last point: your expenses were positively trending this quarter. Given efficiency efforts and mortgage output reductions, how do you foresee next year's inflationary effects on expenses?

Mark Klein, Chairman, President and CEO

Brian, there's been a noticeable shift in narrative regarding personnel. We’ve filled open slots but are cautious in deciding if replacements are warranted, as that represents our largest expense. We're committed to driving efficiency. Our efficiency ratio requires improvement. Our strategy focuses on elevating scale while enhancing commercial loans through treasury management services, crucial for expanding margins. Overall, we remain optimistic about our standing.

Brian Martin, Analyst

Understood, and regarding provisioning, you’ve noted no provisions this year amid ongoing credit strength—are reserving levels stable, or might we see adjustments?

Mark Klein, Chairman, President and CEO

Indeed, we are optimistic about our underwriting. The results have been strong. Much depends on the Fed and the economic response to recent actions. In 2023, we may need to make some adjustments to our reserve levels, though we've maintained progress, and I'm pleased we allocated $5.5 million in accumulated reserves from the PPP in the past few years. We may add to reserves next year given our growth trajectory.

Brian Martin, Analyst

Understood. Lastly, regarding your outlook on SBA activities, it seems more optimistic than before. Should we expect enhanced revenue growth in that sector next year, in light of current trends?

Mark Klein, Chairman, President and CEO

Yes, we have accomplished significant progress. As noted earlier, six to seven years ago, our goal was to be within the top 100 in the US for SBA performance. We achieved about $50 million in five years, followed by $112 million through the PPP initiative, and we’re moving back to 7(a). We are enthusiastic about the 7(a) program, currently reporting $6 million this year, aiming to regain our competitive position among nationwide production of SBA loans. We've secured the right talent in vital markets. The current economic climate, where we prefer equity replaces with debt, also allows us favorable positioning for yields. We are targeting to reach $15 million to $20 million next year, leveraging the diverse opportunities we now have.

Brian Martin, Analyst

Thank you for your insights, great quarter, and thanks for responding.

Operator, Operator

Thank you. At this time, we have no further questions. We'll turn the call back over to Mr. Mark Klein for closing remarks. Please go ahead.

Mark Klein, Chairman, President and CEO

Thank you for joining us. We look forward to connecting with you all again in January for our fourth quarter of 2022 results. Have a great day and take care.

Operator, Operator

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