Earnings Call Transcript - SMBK Q3 2022

Operator, Operator

We acquired this Chattanooga based insurance agency during the quarter and are very excited to merge it into our existing platform. This agency has a great business line focused on the trucking and transportation insurance business. As many of you know, we have some great ties into that industry, particularly with Miller's background and experience, and we're very excited to create some synergies to grow this speed generating business line. Before I turn it over, just a couple of other notes. Both new markets and legacy markets are all performing very well. We just opened our Birmingham, Alabama office and our Brentwood Franklin office in the national MSA is slated to open in Q4. Our team from Fountain Equipment Finance is having an outstanding year. We have almost doubled the size of that balance sheet since acquiring this equipment finance group a couple of years ago and we have some great momentum there. We have a number of things going very well in their company, so let me go ahead and turn it over to Rhett to walk through the balance sheet and credit, and Ron will then provide some additional details on the income and expense side Rhett.

Rhett Jordan, Chief Financial Officer

Thank you, Billy. As Billy mentioned earlier, solid loan growth continued through the third quarter with period-over-period net organic loans and leases growing at a 15% annualized pace, excluding PPP loans. As you can see on Slide 6, loan and lease balances outstanding grew over $105 million for the quarter putting the portfolio total just over $3 billion. Quarterly production was very evenly spread across our footprint markets. Well diversified toward our target portfolio segments and evenly split between fixed and variable rate products. Deposits were flat quarter over quarter with net balances of just over $4 billion and average deposit costs from 45 basis points. The combination of these factors resulted in a 72% loan to deposit ratio. The loan portfolio mix has continued to be very stable as shown on Slide 7. While most economic outlooks and market guidance continue to indicate a higher probability of recession driven by inflationary pressure and corresponding interest rate increases over the next several quarters, our market areas continue to show some solid economic results and our business clients are continuing to relay positive outlooks to our lending teams for their near-term guidance. Interest rates on loan production and renewals are beginning to see some gradual increases, as Billy mentioned earlier, with market-based rates continuing to move upward due to fed funds direction and corresponding term rates responding accordingly. Given that near-term directional expectation, we're still cautiously optimistic for continued growth opportunities in the loan portfolio over the next couple of quarters. As the next slide indicates, our portfolio credit quality continues to be extremely strong as it has been all year, but given challenging economic outlooks, we've taken some additional steps over the last few months to refresh our lending teams on those key conservative underwriting factors that have allowed us to maintain these extremely strong portfolio performance results for such an extended timeframe. Our breadth of interest rate stress analysis, strong cash equity requirements, and limited exposure growth to industry segments with weaker economic outlooks have always been core essential components of our lending approach, and they're essential in this challenging time to protect our historically top tier credit quality performance. As I noted previously looking at Slide 8, it shows the third quarter reflecting continued strong and stable performance across our core asset quality metrics. Non-performing assets to total assets, past due loans to total loans, and classified loans to total loans are all improved quarter-over-quarter. Our CRE ratios were stable to prior quarter end as well with total CRE holding at 303% of capital. We did have a slight 9% increase in the CRE construction ratio that ended the quarter right at the regulatory guidance target due predominantly to continued funding on active construction projects. As noted in prior calls, we've historically managed our CRE portfolio in the upper end of the ratio guidance and continued to feel very comfortable doing so given the credit profiles of our CRE book and our historically conservative underwriting in that space. Our loan pipeline continues to be solid and evenly distributed across all our market areas with a significant portion of these opportunities being non-CRE in nature. Overall, our 2022 year-to-date loan production and credit quality have been strong results and we are still cautiously optimistic in our outlook as we close out the year. Now I'll turn it over to Ron to walk you through our allowance positioning.

Ron Gorczynski, Chief Credit Officer

Thanks, Rhett, and good morning, everyone. Let's move forward to Slide 9, our loan loss reserve. As Rhett covered much of our credit stats, I would like to add that during the quarter, we recorded a $974,000 provision related to strong loan growth with minimal credit-related provisioning. At quarter end, our allowance for originated loans and leases was at 75 basis points and our total reserves for total loans and leases was at 1.2%. On to Slide 10, we utilized over $100 million of excess cash to fund our new loan production. As previously mentioned, our loan to deposit ratio increased to 72% and our overall liquidity position, which includes cash and securities, represented approximately 28% of total assets giving us much flexibility to fund future loan growth. Our third quarter net margin was 3.29%, a 21 basis point quarter-over-quarter expansion, despite having a reduction of $580,000 related to PPP and acquired loan accretion. During the period, our interest earning asset yield increased by 40 basis points outpacing the 28 basis point increase in our funding costs. While rising rates put pressure on our margin, we still experienced approximately 12 basis points of compression as a result of our strong liquidity position. For the quarter, our yield on our loan portfolio, less loan increasing in PPP fees, increased 28 basis points to 4.55% with the September loan portfolio yield of 4.66%. Our interest-bearing deposit costs for the quarter increased 29 basis points to 0.62% with September deposit costs of 0.76%. Noteworthy this quarter was a significant increase in deposit competition across our footprint, which also contributed to our deposit beta acceleration. As of September 30, our deposit beta was roughly 15% since March, and we estimate our deposit beta to be around 25% for the fourth quarter. As mentioned during our last earnings call, we'll be judicious in our approach to raising deposit pricing; however, not at the expense of losing good relationships. For the fourth quarter, we are forecasting our margin to be in the 3.40% range included in our margin forecast is estimated loan accretion of four basis points or approximately $320,000. Further, our operating revenue increased $2.7 million for an annualized quarter-over-quarter increase of over 26% in spite of the revenue headwinds related to reduced acquired loan, PPP fee, and mortgage banking income, which in aggregate totaled $481,000 compared to $5.6 million for the same prior year period. We're extremely proud of our smart bank associates to not only offset these differences but grow our quarterly revenue to a company record of approximately $43 million. On Slide 11, you'll find some of our interest rate sensitivity information. With the sharp rise in interest rates and the deployment of some of our cash liquidity during the quarter, our balance sheet has shifted from a modestly asset-sensitive to slightly asset-sensitive position. We expect further increases in short-term rates to have a positive impact on our net interest margin and net income, but will be more muted as we approach a more neutral asset sensitivity position. Currently, we have $1.2 billion available rate loans with $668 million resetting almost immediately. The remaining floating rate loans would reset over a specified time period with $77 million resetting rateically over 2023.

Billy Carroll, Chief Executive Officer

Thank you, Ron. As you can hear, we're really starting to hit a nice stride in this company. Ron had mentioned some of our guidance and we continue to feel that we're positioned very well, even with some possible slowing due to rate increases. We can continue to grow by capitalizing on the investments we've made recently in new markets, new business lines, and technology. I feel our loan growth outlook is still solid. Our Q4 pipeline is good. And I do feel even though I think loan growth will ease a little moving forward, we should still be able to grow at a nice pace. We grew at a 15% pace this quarter, and we're probably looking at somewhere in the higher single digits, maybe a little better than that over the next couple of quarters. We are continuing conversations to add talent to our team, adding several people in recent weeks, and we're in discussions with several others. So the hiring momentum that we picked up last year, we see that continuing as we look ahead into the coming quarters. We also want to just say a quick thank you as we close out to date to our SMB, our whole SMBK team. Many of those folks listen to these calls. We always talk about the numbers on these calls, and I don't want to overlook the phenomenal culture that we are building. I do think we will continue to differentiate with that culture in our markets, and it's our team members that make that happen. So thank you. It continues to be a great time to be involved in this company and we will stop there and open it up for questions.

Feddie Strickland, Analyst

Yeah, this is Feddie. Can you hear me?

Billy Carroll, Chief Executive Officer

Yes, go ahead. Thank you.

Feddie Strickland, Analyst

Okay. I wasn't sure if they cued me up or not. How are you guys doing this morning?

Billy Carroll, Chief Executive Officer

We're good. Thank you.

Feddie Strickland, Analyst

Was just curious. We talked a little bit about the opportunities in Nashville. I know you guys have an LBO there. I was just wondering if you could speak to how much opportunity you think you have in Nashville and whether there's any plans to expand your presence in that market.

Billy Carroll, Chief Executive Officer

Yes. Feddie, it is. As I said, we're opening our Brentwood Franklin office here this quarter. Excited about what we've seen with the team that we have on the ground that we added this last year, really just to start to see some momentum going. We do. We think there's obviously one of the best markets in the country. I don't think there's any doubt about that. Obviously, competitive as all good markets are. But we do feel like, again, kind of going back to my commentary on culture, we have demonstrated our ability to add some really good revenue producers to our company over the last little bit. We think we can do that. Again, we wanted this year to really digest what we took on at the end of last year, first part of this year. As we are doing that now, we're really starting to look a little harder. Excited about the opportunities to expand that market and think that's something that we can do over the next year.

Miller Welborn, Chief Operating Officer

So we played around with it for the last couple of years in Murphysboro, and that's been an incredibly strong market for us. Great people there, and we think we can lean in on it a little bit further.

Feddie Strickland, Analyst

Got it. That makes sense. I think I already know the answer to this, but I’ll ask it anyway. As we look towards future growth, that’s primarily going to come from building out market share in existing markets, right? You're not really looking at expanding beyond your current footprint right now.

Billy Carroll, Chief Executive Officer

That's correct, Feddie. We're not looking to go to any other markets outside of the kind of the regions that we're in. You always look for opportunities, but really, there's nothing strategically that we're looking at now kind of outside the zones where we are. We think there are a ton of opportunities in the Nashville, Birmingham, and other markets in these great new Alabama MSAs that we entered as well last year. So that's probably where Focus 1A is going to be, but we're always opportunistic if something comes up.

Miller Welborn, Chief Operating Officer

Yes. We always look upstream and downstream. I will say, it's interesting. We've talked a little bit about this potential AOCI impact on these banks that are $1 billion and lower. I do think that's a potential negative impact to capital on some of these guys, been deploying that liquidity into those securities portfolios. And if that comes to bear, hopefully not, but if it could be some negative impact and some certainly some M&A opportunity.

Feddie Strickland, Analyst

Got you. And just one last question from me before I step back in the queue. Based on your guidance, it seems margins should improve in the fourth quarter. Do you think there could be some additional margin growth early in 2023 if we see a couple of rate hikes? It appears that was what Ron was hinting at earlier.

Billy Carroll, Chief Executive Officer

Yes, let me provide some additional insights before Ron adds his thoughts. Feddie, I believe there has been a bit of a discrepancy between some of the analyst projections and our numbers. Our loan yields are progressing well. Initially, with the first couple of rate hikes, we still had loans that were in the pipeline at slightly below market rates at the time, which affected our book. As a result, our loan yields lagged for a few months, but we are beginning to see them catch up. As Ron mentioned, as our variable rate loans reset in different quarters, we anticipate continued positive momentum in loan yields over the next period. This is a crucial aspect for us, and it's certainly something to pay attention to.

Ron Gorczynski, Chief Credit Officer

Yes. And to further that, as long as we can, deposit competition, as we alluded to, has been pretty significant. As long as we keep our deposit beta down in that higher 20% range, yes, we definitely will have a margin expansion going into 2023.

Miller Welborn, Chief Operating Officer

So we're seeing them queue up. So I think we have next...

Ron Gorczynski, Chief Credit Officer

Kevin Fitzsimmons.

Miller Welborn, Chief Operating Officer

Kevin, are you on the phone?

Ron Gorczynski, Chief Credit Officer

Kevin is on the line. I'll open his line now.

Kevin Fitzsimmons, Analyst

Deposit levels are clearly changing for banks, and we have noticed a decline in deposit levels, some of which is intentional. Can you provide your perspective on the loan-to-deposit ratio over the next few quarters? It appears you still have considerable flexibility with it currently at 72%. How do you envision this changing over the next four to five quarters? Do you expect to maintain deposit levels as you did this quarter, or should we anticipate a further decline in deposits moving forward?

Billy Carroll, Chief Executive Officer

I'll begin, and others can join in as needed. I believe you'll notice a slight increase in the deposit ratio due to our liquidity flexibility. We intend to remain proactive in our markets, maintaining our core business. However, if necessary, we may allow some non-core deposits to decrease, as it could be beneficial from a margin perspective. Therefore, I expect that number to gradually rise in the coming period, which aligns with our strategy. Ron and I have discussed the data, and it's impressive how the new teams we've brought on over the past year have significantly boosted our deposits. While our loan growth has been solid, the performance of our deposits has surpassed our expectations, and I foresee this trend continuing. Our emphasis on enhancing our treasury program, particularly in attracting more deposit-based businesses, especially checking accounts, is crucial for us. Thus, our deposit generation efforts will remain a priority, even as we may allow some higher-rate deposits to decline. Overall, I'm anticipating a relatively stable projection for deposits, while we aim to manage rate increases effectively. Ron and Nick, do you have any insights or additional comments?

Ron Gorczynski, Chief Credit Officer

Yes, we will gradually increase, but as Billy mentioned, when we reexamined the lift-outs, we recognized they were effective in gathering deposits, and they performed well in the third quarter for us, demonstrating their ability to collect deposits.

Billy Carroll, Chief Executive Officer

And good deposits.

Ron Gorczynski, Chief Credit Officer

We anticipate a slight decline in our deposits of about 1% to 3%. I'm not entirely certain that will happen, but it is what we have modeled. Nonetheless, the loan-to-deposit ratio will gradually increase as we move forward.

Kevin Fitzsimmons, Analyst

Okay. And maybe this is more kind of a top-level question. I believe in the last quarter or two, Billy, you've talked about that you guys have been very active in adding talent. And so obviously, that has expenses attached to it immediately, and then the revenues come later, and that the near-term priority is really going to be about demonstrating improved profitability. And so it had the kind of implication that you guys, while always being opportunistic, you were not in so much the investing mode but the delivering bottom line profitability mode. Where do you say you are on that front today?

Billy Carroll, Chief Executive Officer

Kevin, I'd say we're probably in the middle innings on that. I think we have. I mean you look at the results. I mean, we've demonstrated. I mean if you look at the revenue growth, look at the EPS growth, efficiency ratio continuing to tick down. Again, our focus is more again kind of another baseball analogy since we're in the middle of the playoffs. We're singles and doubles and just continuing to grind this thing higher. So I love where we're sitting. I do think we're in kind of middle innings. I think there's upside to the investments that we've made. But we're also going to continue to invest in talent if those opportunities pop up. So that's kind of my take. I don't know if you guys have any other comments. Ron, anything from you?

Ron Gorczynski, Chief Credit Officer

Yes. One thing that's happened over the last several quarters is that we truly have core revenue. We've lost our PPP fee. The accretion has dwindled down. We're really a core revenue shop at this point and the growth, and it's been pretty amazing for us. So yes, I think it's more good things to come as we go forward.

Billy Carroll, Chief Executive Officer

Yes, Kevin, you made an excellent point that our audience should be aware of. When we examine our numbers, we've consistently found ways to achieve a good return, though some of that has come from various income sources that aren't central to our business. We're now establishing a robust core operation. That's why I'm excited about our direction. I believe we can continue to gradually improve our metrics from this point onward, and I see significant potential for growth.

Operator, Operator

We take our next question from Catherine Mealor of KBW.

Catherine Mealor, Analyst

I have a follow-up question regarding the margin. When you mentioned the 25% beta for the fourth quarter, are you referring to the quarterly beta? And is that based on total deposits rather than just interest-bearing deposits?

Ron Gorczynski, Chief Credit Officer

The nonmaturity deposits will not account for total deposits. I believe the overall beta will reach 25% by the end, while our model suggests it will be closer to 30% for the quarter. However, starting from the beginning of March, we should fall within that 24% to 25% range.

Catherine Mealor, Analyst

Got it. On a more cumulative basis?

Ron Gorczynski, Chief Credit Officer

Yes, yes.

Catherine Mealor, Analyst

Okay. That makes sense. Okay. Cool. I just want to make sure that we were aligned in that guidance. Okay. That's great. And then on the loan yields, too, you said your loan yields were 4.66% at the end of September. I mean, to get to this kind for 3.40% number for the margin, I kind of see an acceleration in your loan yields as early as this quarter, more so than kind of a next year thing. Is that a fair assessment?

Ron Gorczynski, Chief Credit Officer

Yes. For the 3.40% margin, we believe our loan yields should be around 4.90%. Yes, we are aligned.

Catherine Mealor, Analyst

Okay. That makes sense. Okay. Great. Let me sure I'm thinking about that right. And then as you think about expense growth for next year, how are you kind of thinking about the pace in which we'll see expenses grow, maybe kind of relative to the revenue and potential positive operating leverage that we'll see as we move into next year?

Ron Gorczynski, Chief Credit Officer

At this point, we haven't finalized our forecasts for next year, and there are many variables to consider. We expect to see mid-single-digit expense growth and likely upper single-digit growth in net interest income. However, we are not providing specific guidance on those figures as we are still analyzing the details.

Catherine Mealor, Analyst

Great. It's still an environment where you think you can grow total revenue at a faster pace than you can grow expenses.

Ron Gorczynski, Chief Credit Officer

Oh, yes. Oh, definitely, yes.

Operator, Operator

Our next question is from Stephen Scouten of Piper Sandler.

Stephen Scouten, Analyst

I just wanted to dig in on Catherine's last question there a little further. If you talk about positive operating leverage in '23, is that possibly you think even after rate hikes are finished, say, we get to 2Q, '23 and beyond, you still think you can deliver positive operating leverage even without the help of higher rates?

Billy Carroll, Chief Executive Officer

I agree, Stephen. A lot of it will depend on growth. As Ron mentioned, we have been analyzing our models and the key question is how growth interacts with an environment where the Fed's terminal rate may be 5% or higher. Given the current rates and forecasts, we believe there is potential for growth even when rates stabilize. We need to ensure growth, which is why we are focusing on diversifying our fee lines that are less sensitive to interest rates. If we experience any slowdown in our top line, we can also manage our expenses accordingly. We're preparing for some additional hires and expanding our team next year to boost revenue production. Even in a situation where we expect the Fed's rates to stabilize, we can still find opportunities for leverage.

Stephen Scouten, Analyst

Okay. That's helpful. And then you guys gave great color on the deposit betas there. How should we think about like a loan beta, if you will, relative to the 22% variable rate loan book? And just kind of how we should think about the upside there other than the 4.90% number, Ron, you gave?

Ron Gorczynski, Chief Credit Officer

Yes. Going forward, loan betas seem to be a little bit more trickier to figure out than deposit betas. I think we're running the betas around 19% to 20%. So I would say that's to date. I think it would probably I would probably keep that. I don't know if it's going to accelerate more. But again, we are getting higher rates, so maybe I backtrack, and we probably should see a little bit higher beta as our new production pipeline, which we're getting now what we're seeing now in the 6 handles, we'll accelerate that. So I would probably go to mid-20s with that.

Stephen Scouten, Analyst

Okay. Great. And then just last thing for me. Kind of how you're thinking about the loan locks observed moving forward, potential recessionary scenarios, CECL kind of what that could do to your reserve and where you think it could be most sensitive to? Is that going to be like an unemployment factor or where the sensitivity would be to reserve levels moving forward?

Ron Gorczynski, Chief Credit Officer

Great question. We are currently using the incurred loss model but will be adopting CECL on January 1. So far, we have completed our third parallel run, and our CECL model has been validated, making us ready to implement it on that date. We expect the initial day to have an immaterial event. We are maintaining a lot of fair value marks that will assist in building the allowance for credit losses. Given the uncertainty of the future, we anticipate a possible 30% increase in provisioning under the CECL model as we move into 2023. However, this is not official guidance, just an update on our current thoughts. There are many factors in play as we move forward, and it’s difficult to predict exact numbers since things are changing regularly. We're estimating that the increase in provisioning should be around the 30% area due to new loan growth.

Stephen Scouten, Analyst

And Billy, as far as I'm concerned, the baseball playoffs ended about 1.5 weeks ago, so I'm not sure about that rate.

Billy Carroll, Chief Executive Officer

I know. That part of it.

Ron Gorczynski, Chief Credit Officer

We agree, too.

Operator, Operator

We have no further questions in the queue. So I'll hand it back to Miller.

Miller Welborn, Chief Operating Officer

Thank you very much. Again, thanks to each of you for joining us today, as always. If you have any additional questions, reach out to us directly. We appreciate your interest in the bank and thanks for joining us today. Have a great day.

Operator, Operator

This concludes today's conference call, ladies and gentlemen. Thank you for joining us. You may now disconnect your lines.