S&T Bancorp Inc Q3 FY2023 Earnings Call

Welcome to the S&T Bancorp Third Quarter 2023 Conference Call. After management’s remarks, there will be a question-and-answer session. Now, I’d like to turn the call over to the Chief Financial Officer, Mark Kochvar. Please go ahead.

Great. Thank you. Good afternoon, everyone. Thank you for participating in today’s earnings call. Before beginning the presentation, I want to take time to refer you to our statement about forward-looking statements and risk factors. This statement provides the cautionary language required by the Securities and Exchange Commission for forward-looking statements that may be included in this presentation. A copy of the third quarter 2023 earnings release as well as this earnings supplement slide deck can be obtained by clicking on the materials button in the lower right section of your screen. This will open up a panel on the right where you can download these items. You can also obtain a copy of these materials by visiting our Investor Relations website at stbancorp.com. With me today are Chris McComish, S&T’s CEO; and Dave Antolik, S&T’s President. I’d now like to turn the call over to Chris.

Mark, thank you. Good afternoon, everyone, and welcome to our call. I appreciate all the analysts joining us today. We look forward to your questions. I also want to thank our shareholders and employees who are listening. The commitment and engagement of our employees drive these results, and we’re proud to share them with you. Before discussing the numbers, I want to emphasize how pleased I am with the progress we're making to advance S&T based on our commitment to our people forward purpose. This purpose is guided by our values, which define who we are as a company, and is driven by our key performance indicators: growth in our deposit franchise, solid credit quality, leading core profitability, and our focus on enhancing employee engagement and talent. This work helps us deliver differentiated service to our customers and the communities we serve, as evidenced by the efforts of our team and the results we will discuss today. For the third quarter, we reported earnings of $0.87 per share, totaling over $33 million in net income. This was driven by our fourth consecutive quarter of net interest income in the high-$80 million range. We are pleased with our top quartile net interest margin of 4.09%, despite a slight decline from the previous quarter. Our pre-provision net revenue is also top quartile at 1.99%, and our return metrics are strong. Coupled with our capital levels, this positions us well for the future. Our net charge-offs for the quarter were 20 basis points, and our efficiency ratio remained steady at 52.68%, which is slightly up from the second quarter but still within our expectations. Looking ahead, before I pass it to Dave to discuss our loan side, you can see that our deposit mix stabilized this quarter. Customer deposits were relatively flat, with some shifting from demand deposit accounts and savings into CDs. We experienced $80 million in customer CD growth, with approximately $30 million from new deposits and $50 million from internal shifts. We continue to actively enhance customer relationships, expanding deposit opportunities and balancing growth, margin, and cost while focusing on our relationships. Now, I’ll turn it over to Dave to discuss the loan aspect of our balance sheet, and I look forward to your questions shortly.

Well, thank you Chris. And continuing this review of our balance sheet, we did see increased loan growth in Q3 of $196 million or almost 11% annualized. This growth was driven by increases in both our residential mortgage and commercial real estate categories. Regarding our residential mortgage activities, we continue to see solid demand for construction and purchase-related products and anticipate this demand and the pace of this growth to continue in the coming quarters. We are closely monitoring the pricing of these products and believe that keeping this activity on our balance sheet provides for the most favorable economic benefit for S&T. Our commercial real estate balances grew during the quarter, primarily as a result of new production in our multifamily, storage, retail, and industrial segments. As a reminder, a few quarters back, we provided details on our office portfolio. We continue to remain comfortable with our exposure to the office segment. And as a reminder, that segment represents approximately 7% of our total loans. We have not seen changes in that segment since that disclosure and balances remain flat quarter-over-quarter. It’s also worth mentioning that our healthcare-related exposure remains flat quarter-over-quarter, and we believe that we remain comfortable with that exposure as well. In our C&I book, we did not see significant changes in any of the core metrics that we measure, including things like utilization and collateral advance rates. We have seen reduced payoff levels in both our residential mortgage and commercial real estate books primarily related to increased interest rates. And based on our current pipeline and these reduced payoff levels, we anticipate total loan growth in the mid-single-digit range for the coming quarters. Turning to asset quality, non-performing assets declined by $1.6 million to $16.4 million when compared to Q2. Net charge-offs for the quarter were $3.7 million or 20 basis points of total loans. And primarily as a result of loan growth that I described earlier and the qualitative factors in our model, our ACL grew by $2.4 million during the quarter and remained at 1.44% of total loans. And I’ll turn it over to Mark to dig in a little deeper.

Great. Thanks Dave. Before rates started moving higher back in the fourth quarter of ‘21, our net interest income was $68.4 million, and the net interest margin was 3.12%. While there has been and will continue to be some pressure on funding costs, our asset-sensitive balance sheet has provided significant revenue improvements over the past seven quarters. In the third quarter of 2023, the net interest margin is 97 basis points higher, and we’re generating almost 28% or $19 million of additional revenue per quarter compared to the beginning of the cycle. The third quarter net interest margin rate of 4.09% is down 13 basis points from the second quarter as earning asset yield improvement of 13 basis points did not keep pace with the 35 basis points increase in costing liabilities. The cost of total deposits, including DDA increased by 24 basis points to 1.38%, bringing the cycle-to-date beta to 25%. Our deposit mix remains much improved compared to the end of the last rate cycle in 2019 when we had just 24% of deposits in DDA compared to almost 32% today. Customers continue to seek higher rates, but the pace has moderated. DDA declines were $54 million in the third quarter, that’s far less than the $138 million decline in the second quarter and the lowest decline since this rate cycle began. We expect the funding cost pressure to continue with the net interest margin compression of approximately 10 to 12 basis points in the fourth quarter and into the first quarter of ‘24. Assuming no Fed changes, we expect compression to moderate and the net interest margin to stabilize by mid-year ‘24. Non-interest income decreased by $2 million in the third quarter compared to the second. Most of the variance is in the other category. This primarily related to a $1.6 million of changes in valuation adjustments. A little over half of this is due to the transition from LIBOR to SOFR and its impact on our back-to-back customer swap program. While the remainder of the valuation adjustment is related to changes in the value of a deferred benefit plan, that is offset in expenses and is P&L neutral. In addition to that, we had a gain on OREO of $600,000 in the second quarter and no activity in the third quarter. Remaining fee category line items were fairly consistent quarter-over-quarter. Our quarterly fee outlook is in the $13 million to $14 million range. Expenses continue to be well controlled with an efficiency ratio of 52.68%. Increasing expenses came primarily in salaries and benefits and were in line with our expectations. In the second quarter, we lowered our incentive accruals as full-year expectations have changed, and this quarter we’re back on a more normal pace. Our quarterly expense expectations remain in the $52 million to $53 million per quarter range. And as we look ahead to 2024, we expect that the pace of expense growth will reduce back to lower-single-digits. The TCE ratio declined 11 basis points this quarter due to loan growth and higher AOCI. TCE remains quite strong and has been stable over the last year due to good earnings and a relatively small securities portfolio. As a reminder, all of our securities are classified as available for sale. Our capital positions us well for the environment and to take advantage of organic or inorganic growth opportunities. Our remaining share repurchase authorization of just under $10 million, we did not execute any buybacks in the third quarter. We’ll cautiously look for opportunities to deploy the remaining authorization depending on economic conditions, our financial performance and outlook, along with the price of the stock. Thanks very much. At this time, I’d like to turn the call back over to the operator to provide instructions for asking questions.

Your first question comes from the line of Daniel Tamayo of Raymond James.

Good afternoon, guys. Maybe just starting on the margin. I appreciate the guidance that you gave. Just curious kind of where you entered the quarter, if you could talk about kind of margin or loan yields or deposit costs that you had at the end of the third quarter.

Again, it’s trending down slightly. So, we exited the quarter a couple of basis points below the full quarter number.

Okay. I would like to discuss credit trends. Can you share your thoughts on how things are developing in that area? Additionally, do you have details on shared national credits, leverage loans, or participations that are currently on your books?

Yes. I mean, generally speaking, you saw the increase in the ACL and some of what’s reflected in that is the qualitative factors that enter into that calculation. So we are anticipating that there may be some headwinds in terms of macroeconomic conditions that will impact our customers.

And it relates to shared national credit, we basically have very little exposure at all.

Okay. Great. And then lastly, just a cleanup question. Do you have the actual MSR valuation adjustment in the third quarter?

We didn’t have any impairment or anything like that. Is that what you’re referring to?

Sorry. You had the valuation adjustment, the $1.6 million change. I was just curious what the actual number was?

That wasn’t MSR related. That was related to the back-to-back swap program. We have like a slight difference between the two rates between the customer rate and the rate with counterparties. So, that adjustment was around $900,000 of that $1.6 million. The rest of that was defined benefit trust that’s in the stock market. So, it has both an asset and liability component, and those get offset between fees and expenses, but it creates variances when the stock market value changes.

Okay. So the amount that we should view as kind of volatile or non-core is the $0.9 million. The $1.6 million is just the change from the second quarter. Is that right?

The change quarter-over-quarter is $1.6 million. Depending on how you interpret this defined benefit plan, it can be viewed positively at times and negatively at others, making it difficult to quantify. Additionally, there was an OREO gain in the second quarter that contributed to this change.

Yes, I got the OREO gain, that makes sense. All right. I appreciate that, guys.

Your next question comes from the line of Matthew Breese of Stephens.

First of all, I wanted to touch on deposits. So, one of the surprising, in a very good way, things about this interest rate cycle for you all is how noninterest-bearing deposits have kind of really held up a lot better than your peers. And it feels like at this point, there’s probably a pretty good line of sight at where the bottom is. I did want to get a sense for where you all are projecting that 'bottom' and whether or not you think you can kind of hold noninterest-bearing deposits north of 30% as we get into 2024?

I think you’re right. We are very pleased with that. We’ve put a lot of effort into our treasury management activities and have been developing programs specifically for the small business segment. We believe that there will be some support from that. So even though we may lose some deposits, we are actively working to build new relationships and add more. In terms of our internal modeling, we experiment with various scenarios. However, we expect to remain well above where we were in the last cycle, and we anticipate staying at least around the 30% mark as the bottom.

Matt, it’s Chris. To expand on what Mark mentioned, we've been focusing on several programs and initiatives related to the health of our deposit franchise. This effort began before the recent rate increase cycles because we understand its importance for defining customer relationships. In previous quarters, we’ve highlighted our talented team dedicated to treasury management. Additionally, we have improved our product offerings and delivery methods, including establishing customer relationship teams that focus on proactively managing and nurturing these relationships. We have strong customer loyalty and high engagement, as noted by independent measures. This enables us to have proactive conversations in a trustworthy manner to strengthen the critical aspects of our customer relationships, particularly the day-to-day operating accounts of businesses. This focus is a significant priority for us, and while it's challenging to attribute specific outcomes to specific initiatives, we understand its vital importance, and that’s where we are directing our resources.

Understood. And maybe along these lines, where do you expect the total cost of deposits to peak in this interest rate cycle, or do you have an estimate for the terminal deposit beta?

Well, as guidance, we look at how the last cycle panned out. We think we’ll do a little bit better than that just because we have a much better mix. So, last cycle, we were around 35%. We’re at 25% now. So, my best guess is about the middle there, so closer to 30%, when it’s all said and done.

Okay. And then, I know you had mentioned a near-term outlook for the NIM, it sounds like down 10, 12 basis points for the fourth quarter and the first quarter and then stabilization in the middle of 2024. Should that be kind of in the 3.80%, 3.75% range? Is that a fair estimate of where the NIM should stabilize?

Yes.

You’re good. You’re still on.

I noted the last question regarding the balance sheet, which stands at $9.5 billion. There's the $10 billion threshold we've talked about before, and I wanted to clarify, first, what the impact of Durbin is, and second, when you expect to realistically cross that $10 billion threshold.

We view the Durbin threshold to be around $6 million to $7 million. This quarter, we earned over $30 million, which is part of our financial planning as we prepare for growth. We recognize the $10 billion threshold and have significantly improved our compliance and risk management capabilities to support this growth. We believe that organically, we will celebrate reaching this goal, which we anticipate may happen within the next two calendar years, depending on our growth.

Once you reach a point where net interest margin stabilizes, do you anticipate that it will fluctuate slightly, with a few basis points up or down, or is there still some lingering pressure, or could it possibly increase a bit? What are your initial thoughts on that stage? There are certainly many factors at play, but I’d like to hear your insights.

Yes, you're correct. There are many factors at play. Historically, we've been more focused on rates decreasing rather than increasing, particularly given the current higher rates. We have established $0.5 billion in received fixed swaps that will unwind over a two-year period starting in 2025. As these positions roll off, they should alleviate some pressure on our margin. At that point, we'll need to reassess whether to renew these positions and consider the implications based on the curve's shape. We expect to encounter some favorable developments beyond 2024 and into 2025 that will assist us as well. However, it’s indeed complex, with numerous variables affecting the situation from now until a few years ahead.

I appreciate that. On the deposit side, you talk about those initiatives, and you’ve added talent, you’ve added new technology, new products. Do you have a quantifiable deposit pipeline? Just kind of give me some way to frame the deposit growth opportunity to year-end or possibly near term in general?

Yes. Measuring the pipeline in terms of dollar amounts is challenging because changes in the portfolio depend on factors outside of our control and customer account balances. Currently, we are assessing the pipeline more through the number of activities and their intensity. For example, with treasury management products, we know how many customers we've improved our relationships with, the number of products involved, and the associated revenue. It's difficult to directly translate this into specific dollar amounts for balances. Therefore, we are focusing on activity levels and opportunities as a measure of growth. We have also introduced tools to better understand deposit flows. For instance, from the $80 million customer CD growth, there was a $30 million shift within our balance sheet and $30 million in new deposits. We are analyzing three aspects of the deposit portfolio: the reduction in current relationships, increases in existing accounts, and new customers. It's challenging to set growth targets considering the industry is experiencing a decline of about 6% year-over-year, so we must be realistic about the market size we are targeting.

We are focused on identifying and shaping the opportunity within our customer base. We recognize there is untapped potential in our existing relationships, particularly in enhancing our primary deposit accounts. To achieve this, we have created tools, calling lists, and products aimed at strengthening our connections with customers who engage with us but do not yet consider us their primary bank. This is where we are directing our efforts.

As I look across those initiatives, which ones do you feel are performing well? Are you satisfied with all of them, or do you think some are doing better than others?

Some of them did not all start simultaneously. For instance, an initiative we implemented earlier this year aimed to enhance and improve the efficiency of our bankers in branches and our business bankers to develop treasury management capabilities for what we recognize as business banking and small business customers. This has led to a significant number of new opportunities, which were previously untapped. Our goal was to simplify the process for our teams to seize these opportunities and gain expertise. Consequently, we added talent and improved the flow of information between our teams, allowing us to onboard customers more efficiently. We are very pleased with the progress made so far. Recently, we announced the launch of an integrated payables product for our largest commercial banking customers, which aligns us more closely with our largest competing banks from a treasury management perspective. Currently, we are engaging in discussions with customers that will pave the way for future business. Some of these initiatives are being introduced gradually over time.

That color is great. Is there a near-term loan-to-deposit target that this can help move you towards given they are 103% now? Maybe that’s a different way to approach it.

Yes. We aim to reduce that over time. Currently, we don’t have specific deadlines because we want the focus to be on quality improvement. However, as we progress, we see a chance to enhance our margins by substituting some of our borrowings and wholesale funding with deposit growth. This transition has the potential to improve margins by increasing deposits and reducing our reliance on wholesale borrowings. We believe there is significant value in pursuing this, but we do not yet have specific loan-to-deposit targets with defined time frames.

Your next question comes from the line of Daniel Cardenas of Janney Montgomery Scott.

Just quickly, can you give me some color as to how much of your securities portfolio is scheduled to mature or reprice in Q4 and are expectations to put that to work in the loan portfolio, or are you going to reinvest them in securities?

We have a relatively small securities portfolio, and we aim to maintain its size to ensure a comfortable level of on-balance sheet liquidity. Typically, we see between $25 million to $35 million rolling off from cash flow and maturities each quarter. Our intention is to reinvest that into the securities book to keep the balance roughly where it is currently.

All right. Great. Thanks. And then maybe if you could give me some additional color on the credit quality side. How does your watch list look, what are the trends this quarter? And what your level of classified assets look like compared to last quarter?

Yes. I mean as you can see, starting with the NPLs, we saw a reduction. The level of C&C and watch rate credits has remained relatively stable. And that’s what we see ultimately in the ACL remaining stable as a percentage of loans quarter-over-quarter. Any changes in terms of the risk rating stack would be reflected in the ultimately in the ACL.

In terms of the $30 million of new deposits acquired this past quarter, what was the average rate required to secure those new deposits?

Well, that $30 million was specifically for CDs. Our rates to secure those probably range between the mid-4s to low-5s.

Okay. And where does that put you guys in terms of your competitors, kind of middle of the pack, higher end of the pack?

Let’s say maybe probably just above middle, overall. I mean, we have an active exception pricing program. So, we view that as a way to help build and enhance the relationship that we have with customers. So the rate on the sheet may not be exactly the rate that the customer gets, depending on what the relationship is and what the opportunity is.

And then what was your AOCI level at the end of the quarter?

It increased by about $15 million to around $100 million.

Okay. My other questions have been asked. I’ll step back.

Your next question comes from the line of Michael Perito of KBW.

A lot has been discussed, but I would like to clarify a couple more things. First, I’m sure you are starting to think about next year and the budget for 2024. I’m curious, while you may not be willing to provide specific details, if you have any high-level insights regarding expenses and the rate of investment. It seems that NIM pressure will continue into the early part of next year. Does this affect your timeline or the scheduling of planned investments? As we consider the rate of expense growth in 2024, any high-level commentary you can provide would be helpful for us.

Yes, I’ll address a couple of those points. On the expense side, we experienced higher expense growth this year, primarily driven by the labor market which was very competitive, particularly earlier in the year. We've seen some improvement since then and have also added more staff, resulting in a higher staff level going forward. Therefore, we expect expense growth to be more in the 3% range compared to 6% this year. We anticipate a significant reduction in this area. However, I don't believe it will greatly affect our timelines. We have key priorities and initiatives that we consider very important, and those will continue to progress as planned.

Yes, we are facing contracting margins. However, we enter this situation as a very efficient company with strong PPNR. We believe this provides us with opportunities as we move forward, alongside our capital levels and the strength of our balance sheet. Additionally, there is considerable disruption in the marketplace, allowing us to engage with bankers and teams of bankers. We plan to be opportunistic as we approach 2024 and build for a future where our operating model and capabilities are appealing to both customers and employees. We will continue to seek strategic opportunities to grow the business, which will depend on having the right number of people.

Got it. That’s helpful. Mark, I have a question for you. The current rate cycle is quite unusual due to its rapid changes over a short period. Right now, it seems that the consensus is focusing on a higher for longer environment, but that could change, right? I'm curious about your initial thoughts on how a rate cut might impact margins. It seems like there could be a static analysis, but the realistic analysis feels different given how quickly rates have increased compared to historical trends. Have you considered this, and can you provide any insights?

Yes. We think about that all the time. I guess, I mean just a few comments I’ll make is that, as I said, kind of our baseline, just given where we’re at is that we are going to have some margin compression. That kind of uses the Fed doesn’t do much from here, at least through ‘24, so kind of the higher for longer. But with that, that is a better scenario for us than a rate down on the front-end scenario. Even though we have hedged out some of our exposure to the front of the curve because we are still our asset-sensitive bank, not all of that goes away. So, we’re still better off with a higher rate environment on the front end than we were if they were to cut 100 or 200 basis points, we would have more difficulty on the margin side, keeping pace with that. So higher for longer, even though it represents compression or a challenge for us on a baseline is still better than a Fed down scenario.

I would like to turn the call over to Chief Executive Officer, Chris McComish for closing remarks.

Okay. Well, thank you. We really appreciate the engagement of the analyst community and the questions. And again, there’s a lot to feel proud of in the quarter. We look forward to finishing the year strong and moving on to a productive 2024. So, thanks to everybody for joining us this afternoon. Have a good rest of the week.

This concludes today’s conference call. You may now disconnect.