ServisFirst Bancshares, Inc. Q3 FY2020 Earnings Call

Good day. And welcome to the ServisFirst Bancshares, Inc. Third Quarter Earnings Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to David Mange, Director of Investor Relations. Please go ahead, sir.

Good afternoon, and welcome to our third quarter earnings call. We will have Tom Broughton, our CEO; Bud Foshee, our CFO; and Henry Abbott, our Chief Credit Officer, covering some highlights from the quarter and then we will take your questions. I will now cover our forward-looking statements disclosure. Some of the discussion in today’s earnings call may include forward-looking statements. Actual results may differ from any projections shared today due to factors described in our most recent 10-K and 10-Q filings. Forward-looking statements speak only as of the date they are made and ServisFirst assumes no duty to update them. With that, I will turn the call over to Tom.

Thank you, David, and good afternoon. As a backdrop to our call today, I will give you an update on where we see the economy. We have seen a really nice rebound in the economy in the last several months. One helpful thing is the Southeast of the United States has never had to shut down like many areas of our country, and it has not had the social unrest problems in many areas. So it is now fully reopened. Unemployment rates on average in the Southeast are under 7%, which is much lower than most of the country, so we are fortunate in that regard. We are not seeing many issues even in affected industries, and I would attribute that partly to softer and shorter shutdowns in the economy. We did have one client that had 100% revenue loss due to COVID, and the company was restructuring in the quarter. Henry will talk a little bit more about that in a minute. Let’s talk about our loan pipeline level, which hit a low at the end of last quarter; it’s now back at record levels, up 40% over last quarter. So we are seeing a nice rebound in loan demand since mid-July. The pipeline has more small closings, largely due to our bankers' efforts in the PPP program in assisting customers of other banks, and we are starting to see those customers transition their banking over to us now from their former banks. Many projects are moving ahead where we and the client hit the pause button during the early part of the pandemic. The multifamily and industrial commercial real estate loan demand seems very robust. There are significant lags in growth of outstanding loans with the construction loans, so we have a pretty good backlog of construction loans that will ramp up over the next few quarters. The C&I line utilization is still at historically low levels. In the past quarter, we described loan demand; C&I loan demand is fairly tepid. It has improved significantly at the end of the quarter, and part of the reason we have had low line utilization continuously is, I think, due to the PPP loan proceeds and also because we have customers that still have low inventories, as their supply chains are still not rebuilt from the early days of the pandemic. Overall, we expect pretty solid loan growth over the next few quarters with construction loan advances, organic growth, and an expected line utilization increase. Let’s talk about the expenses and expense cuts; I see a lot in the industry written about how all the banks need to look for expense cuts due to tighter margins and lower loan demand. We constantly look for expense savings, which is one reason we have one of the lowest efficiency ratios in the industry. While we do have a small branch network, the pandemic has proven that we can be more efficient with it, and we see opportunities to reduce staffing in the future. We also see opportunities in cost processing for expense savings plus additional outsourcing. One thing I will say about expenses: you can cut expenses to improve profitability, but it will not help you reach prosperity. So our focus will always be on revenue growth. On the deposit side, we continue to see strong deposit inflows, which we attribute largely to our strong performance in the PPP program, again, many of these are strong owner-managed companies with limited borrowing, which will make good core deposits in the future. We are often asked about mergers, and we are open to the right acquisition opportunity. While many might make economic sense, few are a good cultural fit, and most that we see have a large legacy branch network, which would not be a good fit with ServisFirst. We are generating excess capital and will look at acquisitions on a selective basis. I will say this: I think if you make a lot of acquisitions, you will over time become a very mediocre bank, so that’s something we would like to avoid. Our Board will continue to also look at enhancing our dividend on an annual basis. I will now call on Henry Abbott to give a credit update.

Thank you, Tom. I am pleased with many aspects of how our Bank’s loan portfolio performed in the third quarter and throughout the pandemic. For the quarter, we continued to see a significant decrease in deferrals as they burned off, and those clients who were on a deferral returned to normal payments. As of September 30, we had roughly $28 million of loans that were on some form of deferral. This represents a 92% decrease from the prior quarter end, when we had $342 million in loans on deferrals. Throughout the pandemic, the overwhelming majority of deferrals granted were principal-only deferrals. At the same time those deferrals burned off, our past due loans were only $9.3 million, which is the lowest we have seen in over three years. We have not seen a significant rise in past due credits, as indicated by past dues to total loans being only 11 basis points. As it relates to deferrals and past dues, we have not seen any major swings within our COVID-impacted industries, including hotels, restaurants, and retail commercial real estate. As discussed in the past, these segments on a stand-alone basis each make up between 1.5% and 3.5% of our total loan portfolio, and the investment slide deck posted on our website provides this data in more detail. We had one performing hotel loan of roughly $2.7 million added to the watch list and one oil and gas customer with exposure of roughly $3.6 million added as well. The hotels are currently owned and are on deferral with less than 1%—only $1.5 million of our restaurant portfolio is on a deferral. We have a well-diversified portfolio from an asset class and geography perspective, and we continue to diligently monitor and take proactive actions as appropriate. Non-performing assets were $33.4 million for the quarter, which is down from the prior year-end of 2019, as well as from the first quarter of 2020. But this is an increase of roughly $5 million from the prior quarter end. I am proud to say our non-performing assets to total assets were 29 basis points at quarter-end, which is lower than the majority of our peer banks and less than our results for 2018 and 2019 when they were 41 basis points and 50 basis points respectively. While our asset quality continues to remain strong, we were proactive with one large charge-off, which elevated net charge-offs in the third quarter. Credit expenses for the quarter were roughly $11.5 million. This increased amount is specifically related to one severely COVID-impacted borrower, which represents 63% of our total credit expense for the quarter. The borrower is in a line of business within the transportation industry that has been dramatically impacted by COVID, and the revenues have essentially been reduced to zero. The borrower had a viable business prior to COVID but needs the economy to continue to reopen before they can return to full-scale operations. At this time, we feel we have taken proper steps to mark the loan and don’t anticipate any future large charge-offs of this nature on this relationship. We continue to spend a great deal of time on credit servicing activities, which should help identify elevated risk pockets and enable us to mitigate future credit expenses. Tom, I will pass back to you.

Thank you. I am calling on Bud Foshee now to give a financial update for the quarter.

Thank you, Tom. Our net interest margin for the third quarter was 3.14%. It was 3.32% in the second quarter. To exclude the average PPP loan balances of $1.05 billion and the interest income and loan fees related to PPP of $6.6 million, the margin was 3.25%. Also, if you exclude the increase in our average Fed funds sold of $610 million, the margin was 3.33%. The remaining PPP deferred fees at the end of September are $25.3 million. CD maturities for the remainder of 2020 are $127 million. The average rate on those CDs is 1.33%. We expect the majority of these CDs will reprice at 0.50% or below. Additional cuts on the CD rates occurred on October 16th. With these rate cuts and repricing, we will see an annual expense reduction of $1.1 million. The quarter-to-date cost of funds has decreased this year. It was 1.14% in the first quarter, 0.69% in the second quarter, and 0.58% in the third quarter. Rate cuts on September 11th reduced annual interest expense by $5.5 million. Additional cuts on the money market rates occurred on October 16th, and those cuts will reduce expense on an annual basis by $360,000. At quarter-end, deposit costs totaled $0.34 million, interest-bearing DDA cost was $0.32 million, and total interest-bearing deposits was $0.47. The holding company is in the process of refinancing one of the sub-debt issues that will close on October 21st. The total debt is $34.75 million, with annual savings from the refinance amounting to $348,000. We submitted 45 PPP loans to the SBA for forgiveness. The total loan amount is $42.7 million. Three of those loans have been forgiven, totaling $143,000. As a reminder, we had no accretion income related to acquisitions. Our liquidity, our Fed funds sold was $600 million when we started funding PPP loans in April, and funds were $1.55 billion at the end of September. Our non-interest income, such as credit card income, was $1.8 million for the third quarter versus $1.4 million in the second quarter. The spend amount on purchase cards increased by $4.5 million in the third quarter, business credit cards increased by $9 million, and consumer increased by $1.3 million. Our total spend for the third quarter of 2020 was $151 million versus $135 million in the third quarter of 2019. Our spending is back to pre-pandemic levels except for business credit cards. Our merchant service income year-to-date is $397,000 versus $299,000 year-to-date in 2019, and we have two options dedicated to selling that service. Our mortgage banking income was $2.5 million in the third quarter versus $2.1 million in the second quarter. We purchased a $300 million notional amount of a one-year LIBOR cap in the second quarter. The mark-to-market adjustment to the third quarter was negative $343,000 and the strike price is 0.50%. A reminder, we don’t sell any government-guaranteed loans to generate non-interest income. In terms of our non-interest expense for the year, total producers were down five; we had 134 producers at the end of September. Total employees are down nine from year-end 2019, totaling 496 employees as of September 30. We discussed expense control in our previous calls, so to clarify, total loans for non-interest expense have been adjusted for any PPP expenses. The FASB 91 deferral related to PPP loan originations and/or expenses for the first quarter totaled $27.2 million, in the second quarter $26.4 million, and in the third quarter $26.2 million. Capital: the Bank’s Tier 1 leverage ratio was 8.78% at the end of September. Regarding earnings retention: we are paying $0.175 as a quarterly dividend, but our earnings retention for the quarter was 78.2% and year-to-date was 76.2%. For taxes in the third quarter, the rate was 20.3%; for the third quarter of 2019, it was 20.2%; and year-to-date in 2020 the rate is 20.1%, compared to 20.2% for year-to-date 2019. That concludes my commentary, and I will turn it back over to Tom.

Thank you, Bud, and thank both of you for the reports. As you can see, we had really solid financial performance in the quarter and also very strong performance from a credit quality standpoint, where there were a lot of questions early in the pandemic about loan deferrals, which we have addressed. We won’t have to talk about loan deferrals again. So we will be happy to answer any questions you might have starting right now. Thank you.

Our first question today will come from Kevin Fitzsimmons with D.A. Davidson. Please go ahead.

Hey. Good afternoon, guys. How are you?

Hey, Kevin.

Hi, Kevin.

I appreciate all the detail you all provided. Just a couple of follow-ups here, I noticed the allowance ratio. Despite the charge-off, which looks like it’s stemming from one lumpy loan in a particular industry as you described. But the allowance ratio largely was stable to even slightly down. So based on what you see here, Tom, do you think you are at peak reserve levels in terms of needing to build that reserve further, not including whatever you may do when you retroactively adopt CECL, but just thinking about the next two or three quarters—is it reasonable to think that the days of the large reserve build are behind you? Thanks.

Yeah. Well, we are above CECL today. Our CECL model would suggest our reserve should be about $3 million lower than it is currently. So we are above CECL if that answers your question. Kevin, I understand that, of course, nobody has the crystal ball. And I would also point out that the actual loan loss reserve levels are something that regulators consider. The best defense against losses is profitability. We have profitability, and that is the best defense against any future loan losses. So we don’t see any reason to believe that we need substantially higher loan loss reserves today, or we would have provided for them during the quarter. We still have a fairly large amount of PPP loan fees that we accrued, and I don’t know when the SBA will start paying the loans that we have submitted to them. Out of $45 million, only $145,000 has been paid on three loans. So I don’t know when they will start doing that or when our customers will submit their loans to us for us to send to the SBA. I hope that answers your question, Kevin.

Yeah. That’s great, Tom. I appreciate that. Maybe just shifting gears, I know Bud, you provided a lot of detail on rates coming down on the funding side and what was driving the margin compression this quarter. Could you help us from a more top-level perspective to view the likely trajectory of the margin going forward here over the next several quarters, whether you want to take that from the stated margin or whether you view it more as a core level, excluding some of the lumpy items that you described? Thanks.

Yeah. Kevin, the hardest thing to predict is liquidity. I mean, we were at $1.6 billion at the end of September; we have been hovering around that level for a while. For the margin to increase, that situation really has to change. Loan production did pick up in the third quarter, but it will have to pick up more. A lot of the PPP income is still tied up as our customers have the funds they received sitting here. So it’s hard to forecast when they are going to spend that. Plus, as Henry pointed out, our line utilization is still down. So we are waiting on that to turn around before we can provide a good answer on margin improvement.

Kevin, I can’t imagine there’s ever been a worse time for an analyst to try to run their models than right now. There are just so many variables that none of us know the answer to in terms of liquidity. When will line utilization come back? It’s just a matter of when. Our loan draws are down over $300 million since the pandemic began. We see loans flowing back in and picking up, which will certainly help with margin, but I don’t think we’ll get back to where we are used to anytime soon.

Yeah. You can say that again about the model—it’s a tough one.

Okay.

Yeah.

And then one last thing, I’ll get off—is it fair to say, if we were to assume the bulk of the forgiveness impact to the margin running in the fourth quarter, it’s now probably reasonable to push a lot of that out to the first quarter. Do you think that’s reasonable?

Yeah. This is purely a guess, but I would estimate that 25% of the remaining fees will be accrued in the fourth quarter, and 75% will come in the first quarter of next year. Of course, it seems they are not paying the large loans yet, only the very small ones. Those three loans totaling $145,000 are probably the smallest loans we submitted. There have been a couple of businesses that we’ve turned in that are larger; one of those was $8 million, and I know it hasn’t been paid. It’s an interesting situation. We are trying to ensure we do our due diligence to protect our SBA guarantee, and I read a statistic recently that fintechs only processed 15% of PPP loans, and the majority of fraud situations identified so far are within the fintech companies. This bodes well for traditional community banks that know their customers, and we take great care to verify who our customers are. That would be my guess, Kevin, and that’s purely a guess on my part.

Okay. I appreciate that. Thanks, guys. Have a good evening.

Thank you.

Thank you.

And our next question will come from Brad Milsaps with Piper Sandler. Please go ahead.

Hey. Good evening, guys.

Hi, Brad.

Hi, Brad.

Hey, Tom, you sounded pretty optimistic on loan growth. Just kind of curious if you could provide a little bit more color on the magnitude of that growth. I know you mentioned the pipeline was up maybe 40% above where it was. You talk a lot about pipelines, and I know those can be misrepresentative sometimes. But I’m just curious on what the pull-through rate looks like and where those loans are being originated in terms of new rates.

Yeah. Bud, in terms of new loan rates, I’ll let you answer that question.

Yeah. Most of the new loans are probably around 4% to 4.25%, somewhere in that range—probably close to 4%.

From the standpoint of the loan pipelines, they are not perfect predictors of future loan growth, Brad. I am always the first to say that and will repeat it. But what we see in the loan pipeline from a C&I side is a lot of smaller credits that are coming in as a result of our efforts on the PPP loan front. Many of these are new customers to the Bank, and they are smaller, but that’s fine—there are just a lot of them, and that adds up to a substantial amount of money I think over the next couple of quarters. And then our construction loan draws that we expect are in future quarters, which amount to well over $300 million of loans that have already closed. We do see a number of multifamily projects and other commercial real estate projects, and we hope to see the line utilization come back up over the next few quarters. Again, I believe that the lack of ability to acquire products for our customers to rebuild their inventories is a significant part of the issue. Their supply chains are still broken from the pandemic, and they cannot refill their inventory stock. So all of this gives me reason for optimism, Brad, regarding the future outlook.

And just on the rates, Tom, are you guys looking at the ServisFirst prime right now, considering the rates out in the market?

We are, and of course, there are banks that are outliers that we choose not to compete with. We identify ourselves as a disciplined growth company with high standards for performance, and discipline is an important part of that. So we will continue to maintain that discipline.

Great. And I wanted to follow up on your comments regarding expenses. I know that six or nine months ago you were discussing needing to tighten up on expense management. On this call, you mentioned that you can’t cut expenses your way to prosperity. But I am curious about the initiatives that you were discussing nine months ago. Are they now part of the regular run rate, or do you expect they will need to be implemented moving forward?

Well, for the second and third quarters, we are at $26 million if you strip out the PPP and the ORE—$26.4 million in the second, $26.2 million in the third quarter. We feel like that’s a good level. We have essentially cut out salary increases for this year. I know that will really come into play in 2021. So we feel we are at a good level going forward, somewhere in that range for non-interest expense.

I think, Brad, forecasting the margin is particularly difficult right now because there’s so much noise in the numbers with the PPP loan expenses and other unexpected costs like overtime pay for incentives, which we believe are deserved for a job well done. Therefore, we have a number of initiatives that have begun—they have yet to pay off in terms of core processes and expense control. You heard about the headcount reductions we’ve implemented; we believe those will bear fruit in the future as we proceed. However, we continue to hire people—some in our growth markets—so that will offset some of that.

All right. Thanks. Take it easy on us this weekend. Appreciate it.

All right. Thank you, Brad. We will need a rest after Georgia.

And our next question will come from Kevin Swanson with Hovde Group. Please go ahead.

Hi, guys.

Hi, Kevin. How are you?

Hey. NPAs were up slightly after the higher charge-offs, but obviously, they are still below levels earlier this year. Could you provide any insight on when you think NPAs might peak, and is there any specific credit that impacted the quarter?

In terms of when they might peak, I don’t want to speculate on that, but obviously we feel good about our asset quality. One large C&I credit was added that helped drive that figure for the quarter—it was just a longstanding customer that was struggling, and we felt it was appropriate to move it onto NPAs. But I feel good about where we are going to end the year in terms of NPAs; I just don’t have a crystal ball.

Kevin, we are seeing our credits bounce around a little bit. If you look back over the last 12 quarters, it’s been up or down occasionally. Most of our loan problems, I could list for you, and only one credit involved this quarter is, as far as I know, COVID-related, as we mentioned—a large write-down to right-size that company. Other than that, we have one small oil and gas supplier, which could also be seen as COVID-related. We can’t provide more clarity other than we are proactive in recognizing issues as soon as they arise. We don’t see a large backlog of problem assets. For example, the SBA made payments on 7(a) loans for six months, which just ended. We aren’t a big SBA lender, but if I were, I might be concerned about the potential issues that could arise once the customers are required to make payments on their loans. Overall, I see a lot of businesses doing exceptionally well amid the pandemic, and we only have one hotel on the watch list and none on deferral.

Thanks. That’s great. In the environment of lower rates, considering peer success in generating deposits, has the value of a relationship changed, given the difficulty in capitalizing on that?

When it comes to the core deposit relationship, it’s still very much the key aspect for any bank. Even if you ask for book value and ask about sell-side participation, you may not have strong core deposit relationships. I view ourselves as very committed to these relationships. While the premiums may not be the same today compared to a couple of years ago, our ability to grow deposits has shifted dramatically; we worried about liquidity back in February, and now we’ve seen $2 billion in deposit growth in the last 12 months.

Yeah. I agree. Thanks for that context. Lastly, prior to the pandemic, there was significant M&A potential in your area. Can you provide an update on any offensive moves? I know you mentioned being open to acquisitions, but any additional colors or insight on previous acquisitions?

We continue to hire producers. We brought on several this quarter that we are very excited about. We believe we are the best place for bankers to bring their customer base to, so we are excited about that. Obviously, we don’t see a lot of M&A activity right now; everyone seems to want to wait a few months for more clarity on the credit quality of other banks before making any moves.

Okay. Great. Thanks, guys. Stay healthy.

Thank you.

Thank you.

And our next question will come from William Wallace with Raymond James. Please go ahead.

Thanks. Good evening, guys.

Hi, William. How are you?

So, Tom, following up on your point about deferrals: you look at your deferrals, and you are at, if not near, the best of the bunch in terms of having the lowest amount of loans on deferral. I’m curious if you have spent any time trying to decipher what might differentiate ServisFirst's loan portfolio from that of your competitors?

I don’t know about others. We don’t have any companies heavily impacted by COVID; that’s about all I can say. I just know what we have.

And the hotels—do you know what the occupancy rates have been in your portfolio and what the debt service coverage looks like for your hotel loans?

Our worst hotel is the one we have on the watch list, which has a debt service coverage ratio of 0.9.

It’s below 1. If you consider the loan book...

The overall coverage is good on debt service, and it’s a 50% loan-to-value. We feel very confident about that property and its worth. We would sell our note; we wouldn’t sell that loan at a discount. We are pleased about our position and again, we don’t have a lot of highly leveraged borrowers, while in this situation. Clarence and I discussed this earlier this week. You look at a business that’s got a lot of debt and no equity—it's a formula for disaster. We don’t work with that kind of borrower.

So, you don’t have an estimate on how much of that loan was charged-off, or what similar reasoning applied there?

No. We did not write off the entire balance. The direct debt to that borrower remaining is roughly $13 million. As Tom noted, we are trying to right-size the debt to help them get through the pandemic. They are a viable business that just needs the economy to reopen before they can return to full operations.

Was that loan part of the NPA bucket in the second quarter?

That loan was not in the NPA bucket in the second quarter.

And is it in now in the third-quarter numbers?

No, it was not. We worked on it—it’s a poster child for COVID in that it faced 100% revenue loss due to the pandemic. It will come back, and we feel good about the company and the owner—we are helping them get through this challenging period.

The amount charged-off was to adjust to your estimated value of that collateral, or was it a restructure?

Yes, it involved adjustments to align it with the collateral's value at present. You can’t truly assess collateral in terms of value when no one is using it, right? It’s similar to the loan-to-value assessment earlier; those figures will likely be higher than when we first underwrote the loans considering the industry impacts.

On the hotel portfolio—excluding the one on the watch list—what about occupancy rates in the third quarter, say, from the low point in April?

We follow up with most of our borrowers and get performance reports. It depends on the specific location; I think generally, occupancy rates picked up, but it’s quite market-specific. Hotels near the beach or coast have seen increases due to summer travel, for instance—but generally, we do monitor coverage and performance closely.

Do you have any range of occupancy rates across your markets?

I can get you more specifics, but it’s generally around the 50% range or slightly below that.

Most hotel operators I speak with are doing well and remain positive. We just don’t have overly leveraged borrowers. Again, as Henry noted, when assessing collateral values, we have to consider that they’re probably far lower now than prior to the pandemic. Also, we lack convention hotels, which is fortunate because I doubt we will return to previous convention levels anytime soon. This will most certainly impact them significantly.

Going back to loan growth, did you state in your remarks that your pipeline is at record levels?

Yes, it is back at record levels.

Have you adjusted any of your underwriting requirements out of the caution regarding pandemic uncertainty, or do you think you were previously conservative enough?

We are conducting additional stress testing on potential borrowers. Our Florida banker advocated for this cautious position during the pandemic much like we did during the past recession in Florida when values were substantially impacted. We always pride ourselves on making consistent decisions regardless of the economic climate; to clarify, we are looking closely at any potential COVID-related risks in new credits.

I agree, Tom. Our focus has been on stress scenarios and considering occupancy and related metrics, but we haven’t made material changes to our criteria.

Okay. Thanks very much, guys. I appreciate it.

Thank you, Wally.

Thank you.

And this concludes our question-and-answer session, thus concluding today’s call. We would like to thank you for attending today’s presentation. You may now disconnect your lines.