Southside Bancshares Inc Q2 FY2020 Earnings Call

Good day, ladies and gentlemen. Welcome to the Southside Bancshares Incorporated Second Quarter 2020 Earnings Call. At this time, all participants are in a listen-only mode. I would now like to turn the call over to Suni Davis, Chief Risk Officer. The floor is yours.

Thank you, Suni. Good morning, everyone, and welcome to Southside Bancshares' Second Quarter 2020 Earnings Call. A transcript of today's call will be posted on southside.com under Investor Relations. During today's call and other disclosures and presentations, I will remind you that any forward-looking statements are subject to risks and uncertainties. Factors that could materially change our current forward-looking assumptions are described in our earnings release and our Form 10-K. Joining me today are Lee Gibson, President and CEO, and Julie Shamburger, CFO. First, Lee will share his comments on the quarter including the COVID-19 pandemic. Then Julie will give an overview of our financial results. I will now turn the call over to Lee.

Good morning. And welcome to Southside Bancshares' second quarter earnings call. I'm going to provide an overview of the quarterly results and how we are dealing with the pandemic and managing the bank in this current economic environment. Starting with our second quarter results, we reported net income of $21.6 million, earnings per share of $0.65 and an annualized return on average tangible equity of 15.24%. The provision for credit loss expense during the quarter was $5.2 million. During the quarter, the allowance for loan losses increased $6.2 million to $59.9 million, increasing the allowances as a percentage of total loans net of PPP loans 20 basis points to 1.69%. Non-performing assets as a percent of total assets linked quarter remained unchanged at 0.24% and the tax equivalent net interest margin decreased one basis point to 3.02% due to the PPP loans booked during the second quarter. Consistent loan underwriting standards and strong asset quality have long been a cornerstone of Southside's business model. Since the pandemic began in earnest, we've further intensified our focus on asset quality by significantly increasing the frequency and level of monitoring the loan portfolio. In addition to our normal procedures, we are reviewing more detailed reports by industry and we are conducting numerous Zoom meetings deep dives with respected loan officers by industry within the loan portfolio on an individual loan basis. Overall, we are encouraged by what we've learned and observed relative to asset quality. We've recently completed a deep dive to discuss which modified loans customers have indicated they will resume making full normal scheduled payments once the initial 90-day modification period ends. Our modified loan total as of yesterday was approximately $326 million. This total has been trending downward and we anticipate that trend should continue during the third quarter as many of the modified loans are expected to resume their normal payments. Julie will provide a more detailed review of modified loans by industry during her presentation. The balance sheet moves remained during the first quarter, purchasing highly rated largely Texas Municipal Securities along with certain funding decisions performed as expected during the second quarter. All of the second quarter loan growth resulted from PPP loans booked during the quarter and all of the $331 million increase in deposits occurred in our noninterest-bearing deposit categories. While potential loan growth during remains uncertain, we're encouraged by our pipeline and the opportunity to grow quality loans in future quarters. In June, we decided to freeze all future benefit accruals in our defined benefit retirement plan for remaining active employees. This required a remeasurement of the retirement liability at June 30th, 2020. This resulted in the recording of a curtailment expense of $163,000. In addition, due primarily to the decrease in the discount rate to 2.78% at June 30th, from 3.41% at December 31st, 2019, there was a decrease to accumulated other comprehensive income included in shareholders' equity of approximately $6 million. Due to the remeasurement, we anticipate retirement expense during the last half of 2020 will increase $450,000. During 2021, we anticipate overall retirement expense will decrease approximately $2 million when compared to 2020. As we continue operating the bank during this pandemic, our primary focus and concern remains the safety of our team members and customers. Again, I want to thank all the Southside team members for their outstanding attitudes and continued dedication to Southside and our customers during this challenging time. Despite the impact of COVID-19, the underpinnings of the Texas markets we serve appear sound and should recover once this economic downturn caused by COVID-19 subsides. As a result, utilizing the strength of our balance sheet, liquidity, and capital position we believe we are well positioned to successfully navigate these challenging times and grow our Texas franchise. I will now turn the call over to Julie.

Thank you, Lee. Good morning, everyone, and welcome to our call this morning. We reported net income of $21.6 million for the second quarter, an increase of $17.6 million or 445.3% on a linked quarter basis and an increase of $2.9 million or 15.8% compared to the same period in 2019. For the quarter ended June 30th, 2020, our diluted earnings per share were $0.65, an increase of $0.53 on a linked quarter basis and an increase of $0.10 compared to the same period in 2019. During the second quarter, we originated loans to qualified small businesses through the Payroll Protection Program or PPP under the provisions of the CARES Act. As of June 30th, our loan portfolio included approximately $308 million in PPP loans to approximately 2,100 borrowers. We expect to recognize approximately $2 million in PPP loan-related fees as a yield adjustment over the terms of these loans. During the second quarter, we recorded approximately $1 million of these fees in interest income. As a result of our participation in the Paycheck Protection Program, we reported an increase in loans of $251.6 million or 7% during the second quarter. However, excluding the PPP loans included in our commercial loan portfolio at June 30th, we experienced a decrease on a linked quarter basis of $56.8 million or 1.6%. The decrease occurred primarily in our construction loans, one to four-family residential portfolios and the commercial portfolio excluding those PPP loans, partially offset by an increase in the commercial real estate loan portfolio. For the six months into June 30th, 2020, PPP loans excluded, our loan portfolio decreased $24 million or 0.7%. As Lee mentioned in his remarks, due to the uncertainty that remains around the full economic impact of COVID-19, loan growth is uncertain for 2020. Our allowance for loan loss increased $6.2 million or 11.6% on a linked quarter basis, primarily driven by the economic uncertainties surrounding COVID-19. Our non-performing assets were $17.6 million, an increase of $197,000 or 1.1% linked quarter. The non-performing assets to total assets remain unchanged at 0.24% linked quarter and two basis points lower when compared to 0.26% at year end. Beginning in March and through most of the second quarter, we assisted our borrowers that were experiencing financial hardship due to COVID-19-related challenges with payment deferrals. Generally these deferrals were up to three months. As of July 20th, we have deferrals totaling approximately $326 million. The largest categories of deferrals include commercial retail centers of approximately $127.3 million; oil and gas, $57.1 million; hotels, $43.1 million; one to four residential, $41.6 million; and food service and restaurants, $3.7 million. At June 30th, 2020, our loans with oil and gas industry exposure were $118.5 million or 3.08% of total loans. Our securities portfolio decreased $147.6 million or 5% for the quarter ended June 30th, 2020. We recognized approximately $2.7 million in net securities gains on the sale of AFS Securities during the second quarter. At June 30th, 2020, we had a net unrealized gain in the securities portfolio of $137.9 million. At June 30th, the duration of the portfolio was 4.7 years, an increase from 4.4 years at the end of 2019. And our mix of loans and securities shifted slightly to 56% loans excluding PPP loans and 44% securities compared to a mix of 55% loans and 45% securities at March 31st, 2020. Our net interest margin decreased by one basis point to 3.02 from 3.03 for the quarter ended March 31st, 2020. The margin continued to benefit from lower deposit and funding costs, which largely offset negative impacts on lower rates on interest-earning assets. We had a six basis point increase in the interest spread linked quarter to 2.82 as a result of the lower deposit and funding costs. Net interest income increased by $2.6 million driven by lower interest expense directly related to the decrease in interest rates on interest-bearing liabilities. We recorded $352,000 in loan accretion this quarter, a decrease of $85,000 or 19.5% from the prior quarter. Also, as mentioned earlier, we recorded approximately $1 million in fees related to the PPP program and interest income this quarter. For the three months ended June 30th, 2020, noninterest income excluding the net gain on the sale of AFS Securities decreased $426,000 or 4.3% for the linked quarter due to the decrease in deposit services and trust fees, partially offset by the gain on sale of loans. During April and May, we experienced decreases in overdraft income due to stimulus checks and reduced consumer spending. However, in June, we did see an increase when compared to May. Our noninterest expense decreased $664,000 or 2.2% for the linked quarter due to a decrease in salaries and employee benefits, partially offset by an increase in net occupancy expense. The decrease in salaries and employee benefits occurred primarily as a result of lower health claims expense during the second quarter. For the third quarter of 2020, we are estimating noninterest expense of approximately $31 million. We are pleased to report our efficiency ratio decreased to 18.29% compared to 51.91% on a linked quarter basis primarily due to the increase in net interest income. Income tax expense increased $2.3 million or 486.4% linked quarter driven by the increase in pretax income. Our effective tax rate increased to 11.5% from 10.8% in the first quarter of 2020. Last quarter's effective tax rate was positively impacted by a discrete tax benefit recorded at $52,000 or 1.2%, which had a significant impact more than normal due to the lower pretax income reported in the first quarter. At this time, we are estimating an effective tax rate of 11.6% for the remainder of the year. Thank you for joining us today. This concludes our comments and we will open it up for questions.

Your first question comes from the line of Michael Young from SunTrust. Your line is open.

Hey, good morning. I was wondering if we could maybe follow up on the categories, Julie, that you provide a little additional detail on with the forbearance. Could you guys maybe just talk a little bit about what your thoughts are going forward on the specific categories in terms of how much do you expect to add an additional maybe 90 days of forbearance? And how much do you expect to return back to kind of just normal paying as agreed?

We recently held a meeting to discuss this, and we were pleased to see that a significant number of our customers are not expected to request a second 90-day modification. The hotel industry appears to be the primary area seeing more requests for modifications, as it has been one of the hardest hit sectors. Approximately one-third of our hotel portfolios involve a single loan that has a strong loan-to-value ratio, is in a great location, and carries a reputable brand. The properties currently have solid cash flow to support them; however, their occupancy rates have declined, which explains their request for modification at this time. Beyond that, it's somewhat unpredictable who may seek a second modification, but we do expect a large proportion will not. Currently, we believe this number is decreasing and should continue to decline through the third quarter.

In light of that and what's currently factored into the loan loss reserve model, do you expect the reserve to revert to more normal levels going forward and be able to maintain that, even with the increase in cases in Texas and elsewhere?

The primary factor influencing the CECL model is the economic forecast, and it is challenging to predict what that forecast will be at the end of September. If the forecast improves, we may see a return to more normalized reserves. However, if it does not improve, we might have to add to the reserves. Currently, after conducting thorough analyses, we feel confident about our reserve level at this time, but it's all contingent on the economic model, with the forecast being the most critical aspect. In Texas, business activity has increased significantly; aside from bars and restaurants operating at limited capacity, overall commerce is active, and people are adapting to the COVID environment. Traffic levels have risen substantially compared to a month and a half ago, making it hard to provide a definitive answer. I apologize for that.

No. That's okay. I know it's a challenging question, but was interested to get at least your thoughts. And then I guess maybe lastly just kind of trying to think about capital going forward as it pertains to maybe the dividend, special dividend and/or any share repurchase in the future. I mean this is more of a medium-term thought process, but what are you guys thinking in terms of when you would look to return to maybe either share buyback or continue a special dividend on a go-forward basis. So there are certain things you're kind of watching for.

The main thing we're monitoring is the new reserve requirements in relation to the CECL model. If we continue to experience quarters like this, we believe things will normalize regarding share repurchase. At this moment, we do not foresee any impact on the dividend, and we feel confident about our capital position. We just need to ensure that we generate enough earnings to sustain these actions and facilitate stock repurchases when the time comes. However, if you examine our balance sheet and factor in the risk-based capital, I would much prefer our capital position compared to those with significantly larger capital percentages.

Your next question comes from the line of Brad Milsaps from Piper Sandler. Your line is open.

Hey. Good morning, guys. Julie, I was curious if you had the average amount of PPP loans during the quarter? Just the average balance.

Yes. The average balance for the quarter was around $240 million.

Okay, and I think I heard you say that you recognized a $1 million in fee. Is that's just the fee portion, correct?

Yes. All and we recorded about a $1.6 million for the quarter on the PPP loans and about $1 million and that was the net fees.

Okay, you mentioned there is about $2 million left to recognize, which seems a bit lower than what was estimated. Is some of that reflected in operating expenses as we account for it, or did I misunderstand the $2 million amount?

Yes, and what I had intended to say was that we have said last quarter we expect to get $10 million from these loans and we did that and we are accreting it over the yield. And we only accreted $1 million. We still have around $9 million.

Okay, $9 million left. Okay.

Yes. So I got that.

No problems, is there really no impact on the expense line?

No. I mean we paid some over time, but it was minimal compared certainly to the $1 million in fees.

Got it. Got it. Okay. All right. I appreciate that. And then Lee, you made obviously a lot of moves in the bond book in the first quarter. How are you thinking about that going forward? Would you be more likely to use liquidity to maybe pay down borrowings or let some CDs run off, just kind of get a sense that's kind of how you're thinking about the balance sheet, the rate environment as it pertains to the margin and just kind of what you're thinking there in this very low-interest rate environment.

Currently, there isn't much activity in securities. We occasionally add a small amount, but overall, I don't expect the securities portfolio to grow unless we experience another liquidity crisis in the bond market like we did in March. Regarding funding, we're not offering higher rates, and if certificates of deposit mature and funds can be found elsewhere, we will let them go. We are continuing to reduce our overall funding costs. We're seeing a good number of mortgage prepayments now, but reinvesting that at an acceptable margin is challenging. I'm not suggesting that the balance sheet will shrink significantly, but it may gradually decrease unless circumstances change. We plan to pay off the higher funding costs and move forward.

Great. That's helpful. I think your average CD cost in the quarter was around 163 basis points. What are your renewal rates at this point in time? And do you have some larger pieces that will be coming off the books later in the year?

I don't believe we're paying anything above 35 basis points, and many of the CDs are performing well below 25 basis points right now. In the brokered market, our total cost is 15 basis points, but the interest income to the end user is just five basis points. Therefore, we anticipate significantly reducing that CD, particularly since many of the public fund CDs often relate to this situation.

So kind of all that but against that backdrop does that kind of obviously loan growth will be up but that's a bit of an unknown but do you think you can hold the NIM relatively stable kind of given those things you talked about?

I think so. They will see some impact from the PPP loans in the third quarter. However, I believe it will remain relatively stable because the assets have mostly been repriced down, and we still have additional short-term liabilities that we are planning to reprice. It's uncommon for people to go beyond a year on CDs, so we should continue to see this stability for the next six to eight months.

Got it and final question just to follow up on Michael's question regarding some of those categories that you did list out there. Would it kind of be an order in terms of your area biggest concern? Would you start with CRE retail and then sort of work your way down inside in terms of the area that you're watching or most worried about or to be one specific sector within that the portfolio that you're most concerned with at this point?

Retail represents the largest dollar amount from what we're seeing. Many of those that were modified in terms of retail are planning on resuming their normalized payments after their initial modification. I think I go back to probably the area if I were going to be concerned about an area would be the hotel loans simply because of the uncertainty surrounding occupancy and when business travel is going to pick up and things of that nature.

You have one more question from the queue from Wood Lay from KBW. Your line is open.

Hey. Good morning, guys. It seems like you're a little bit more optimistic towards the loan pipeline. I think it's better than you might have thought it was going to be at this point. Do you think grown ones in the back half the year in the lowest single-digit range could be achievable if you exclude any impact on PPP balances?

It's possible. We're currently evaluating a solid pipeline of loans in industries that have not been significantly affected by COVID-19. It really depends; some may not be finalized this year, while others could close early next year. There's a degree of uncertainty right now because many of our prime borrowers paused for the first few months to assess the situation and determine which sectors were affected and which were not. Some are beginning to take action in the unaffected areas, and a few sectors have even seen benefits from COVID, as you may know. So it's possible. We are currently describing our uncertainty about loan growth with that term. It's possible.

That's helpful color. And then last for me, I know, pre-COVID you were planning to open an LPO in Houston along with hiring some additional lenders for that market. Do you still intend to go forward with this point in 2020 or is it sort of been put on hold for the time being?

We have hired three lenders in the Houston area who are currently active. They participated in the PPP process with us and secured several strong PPP loans. We are exploring different loan opportunities for them in that region. However, we decided to pause hiring additional lenders in that market until we can assess the impact on various parts of the Texas economy, particularly different local markets. We are definitely committed to Houston and plan to remain there. Once the situation starts to improve, we will actively seek more lenders in that area.

We have a question from Mr. Michael Young from SunTrust. Your line is open.

Hey. Thanks for the follow up. I'm just wanted to ask, I don't know if you have the number but could you help us understand the geographic breakup of the loan portfolio today? Maybe how much is in Tyler, Texas or other more rural areas versus how much is in Dallas, Fort Worth or Austin?

Yes, hold one second. And for all those loan portfolio we have close to $1.4 billion in the DFW market. And then about $900 million in the East Texas market. And then around $700 million to $750 million in the Austin market. Those are the three largest categories.

Okay. Perfect and yes I guess just big picture have you noticed differentiation and performance or risk factors from maybe different markets maybe the East Texas market being relatively less impacted than the metro areas or is that not necessarily true?

No, I don't think we've seen a concentration of problems in one specific market. It's really been more by industry in our hotel portfolio. We have 11 hotels spread across various markets, and while one hotel is next to a heavily occupied government facility, the others have experienced similar downturns in occupancy rates but are all seeing gradual increases. So, I wouldn't say we've identified a specific market that has been hit harder than others.

Okay and maybe just one last one just given that you're highlighting kind of the hotel portfolio. Any other kind of risk mitigant for that portfolio maybe the loan to values of the properties themselves, pre-COVID or any other sort of mitigating factors that we should be thinking about as we think about loss rates whether there's already high loan-loss reserve et cetera?

We are not major lenders in the hotel sector, so we approach this area with caution. We seek to partner with reputable brands and top operators, and we require a substantial amount of equity in these transactions because we prefer not to manage hotels ourselves. Our underwriting standards are already conservative, and when we evaluate hotel investments, we apply an even more cautious mindset compared to other asset classes.

There are no more questions from the queue, presenters. You may continue.

All right. Thank you. Southside in an excellent second quarter highlighted by continued sound asset quality, solid core deposit growth, and stable net interest margin; a 20 basis point increase in the allowance for loan losses to total loans, net of PPP loans to 1.69% and an 18.2% increase in earnings per share. Thank you for joining us today. And we look forward to reporting third quarter results in October. This concludes our comments.

This concludes today's conference call. Thank you everyone for joining. You may now disconnect. Have a great day. Goodbye.