Good day, and thank you for standing by. Welcome to the Stellar Bancorp Inc. reports Second Quarter 2023 Results Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised today's conference is being recorded. I would now like to hand the conference over to your speaker today, Courtney Theriot, Chief Accounting Officer. Please go ahead.

Good morning. Our team would like to welcome you to our earnings call for the second quarter of 2023. This morning's earnings call will be led by our CEO, Bob Franklin; and CFO, Paul Egge. Also in attendance today are Steve Retzloff, Executive Chairman of the company; Ray Vitulli, President of the company and CEO of the bank; and Joe West, Senior Executive Vice President and Chief Credit Officer of the bank. Before we begin, I need to remind everyone that some of the remarks made today constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as amended. We intend all such statements to be covered by the safe harbor provisions for forward-looking statements contained in the end. Also note that if we give guidance about future results, that guidance is only a reflection of management's beliefs at the time the statement is made, and such beliefs are subject to change. We disclaim any obligation to publicly update any forward-looking statements, except as may be required by law. Please see the last page of the text in this morning's earnings release, which is available on our website for additional information about the risk factors associated with forward-looking statements. At the conclusion of our remarks, we will open the line and allow time for questions. I will now turn the call over to our CEO, Bob Franklin.

Thank you, Courtney, and good morning. Welcome to Stellar Bancorp's Second Quarter Earnings Call. I'll begin by thanking the great team at Stellar Bank for their continued and tireless efforts to build Stellar Bank into the premier local bank in our markets. Our team has been busy refining processes post-conversion and will continue their work as we move through the year. We will be concentrating on efficiencies through technology and expense control as we better define our needs as a combined organization. This year has had its challenges with rapidly rising interest rates, bank failures, and uncertainty in the economy. There continues to be pressure on industry margins as we see inflation in people's costs, funding, deposit costs, and competition for the dollars we held for years at low cost. However, we are seeing a slowdown in deposit runoff while also beginning to see stabilization of deposit costs. Though we cannot call a bottom for NIM compression due to uncertainty with the Fed actions, we feel that downward pressure is easing. We continue to concentrate our efforts on capital, liquidity, and credit, something we began almost a year ago. We have tightened our credit underwriting while still seeing modest loan growth. We have managed our deposit rate increases. While we saw some outmigration earlier in the year, we have seen moderation of those outflows and we have begun attracting new deposits. We have been able to maintain our target of a low 90s loan-to-deposit ratio, all in an effort to manage through the current economic uncertainties. As we move through the balance of the year, we will continue these efforts. Our goal is to ready our institution for the opportunities that will arise from the stresses of the last year. We believe that our industry will continue to consolidate, and we intend to be positioned to benefit from that consolidation. Our shareholders will benefit from our efforts and the great markets that we serve. I'll now turn the call over to Paul Egge, our CFO.

Thanks, Bob, and good morning, everybody. We are very pleased to report strong operating performance in the second quarter. Our net income was $35.2 million, representing diluted earnings per share of $0.66, an annualized ROAA of 1.31% and a return on tangible common equity of 17.05%. This was incrementally lower than the $37.1 million or diluted EPS of $0.70 earned in the first quarter, due mostly to increases in funding costs more than offsetting increased interest income. Also notable for the quarter was non-interest income normalizing to a lower level and non-interest expense decreasing, thanks largely to lower merger expenses. During the second quarter, we experienced a meaningful catch-up in our cost of funds, which was higher than our expectations and reflective of an intensely competitive deposit market post-SCB, resulting in shifts in our funding mix and more generally reflective of where we sit in the interest rate cycle. To put this in perspective, we went from a cumulative cycle-to-date beta of approximately 15% on cost of deposits at the end of the first quarter to a cumulative beta north of 24% through the end of the second quarter, bringing us closer to broader industry trends. Since we started out with a low cost of deposits and we maintain a strong base of non-interest-bearing deposits at around 43% of deposits, we are pleased with how our cost of funds compares to many of our peers, particularly those in attractive metro markets. In keeping our core funding core, we've maintained relative discipline on deposit pricing with a willingness to backfill with wholesale sources such as FHLB advances, which increased from $239 million to $370 million in the second quarter; and brokered CDs, which increased from about $203 million to $538 million in the second quarter. All this contributed to higher funding costs. Due to increased funding costs, we saw net interest margin contract from 4.80% to 4.49% in the second quarter and from 4.38% to 3.97% when you exclude purchase accounting accretion. Accordingly, our pretax pre-provision earnings power ticks down to 1.66% from 1.89% in the first quarter and on an adjusted basis to 1.56% from 1.99%. While we do not like to see a downward trend in our NIM or pretax pre-provision profitability, we still feel good about how we compare relative to the industry and our ability to protect our relative profitability profile in a challenging environment. Before turning the call back over to Bob, I'd like to make a couple of comments on our progress and positioning relative to our focus on capital, credit, and liquidity. On capital, strong year-to-date profitability fueled in part by interest-based purchase accounting accretion, more than offsetting significant non-cash accelerated intangible amortization expense from the merger, has helped us build regulatory capital at a very rapid clip. Total risk-based capital has gone from 12.39% at year-end 2022 to 13.03% at June 30. We feel very good about our prospects to continue to build capital in the near term. I should note that at the end of the quarter, we had about $131 million in loan discount remaining and a core deposit intangible asset left to amortize of $129.8 million. With respect to credit, we remain very pleased with credit performance so far in 2023. Although non-performing assets have ticked down and net charge-offs have been minimal, we took a provision of $1.9 million relative to modest loan growth of just over $182 million, putting our allowance for credit losses to total loans at 1.24%. We feel appropriately reserved given current economic unknowns, but otherwise take comfort in our credit discipline and from lending in some of the strongest markets in the country. On liquidity, our focus at the outset of 2023 on maintaining flexibility continues to prove strategic for us. We have been able to strategically access wholesale funding without overreliance, and we feel good about our ability to manage our balance sheet to maintain favorable margins and earnings power. In summary, we believe Stellar is well positioned to manage through the current operating environment and to thrive. The year-to-date has been quite eventful for the industry and even more so for Stellar due to our rebranding, systems conversion in the first quarter, and broader integration efforts. We are proud of the entire Stellar team and appreciative of everyone's efforts. The future of Stellar is indeed bright. Thank you, and I will now turn the call back over to Bob.

Thank you, Paul. And operator, we're ready for questions.

Thank you. Our first question comes from David Feaster with Raymond James. Your line is open.

Hey. Good morning, everybody.

Good morning.

Maybe let's just start on the deposit front. I appreciate the commentary about some of the trends that you're seeing and stabilization. It sounds like most of the migration that you saw happened earlier in the quarter. I'm just curious, could you help us understand maybe some of the trends that you saw? How much is true? Like was it outflows out of the bank? It doesn't sound like that's the case, but it sounds like truly more migration to higher-rate accounts. And it sounds like that, that's slowed this quarter, but not stopping. I'm just curious maybe if you could help us think of the trends on deposit balances and kind of the early read on the third quarter.

Hey, David. This is Ray. Yes, exactly. In the second quarter, we saw improvements across almost every category of the deposit waterfall. This includes opened accounts in terms of dollar amounts, closed accounts, and our carried deposits, which encompass the bulk of everything. We observed significant decreases in carried deposits during the first quarter, but it improved substantially. Although there was still a decrease in carried deposits, it wasn't nearly as severe as in the first quarter, which is encouraging. Year-to-date, we've also seen a nice increase in net new dollars, specifically in core deposits, excluding brokered money. This is positive and indicates that we've successfully navigated the conversion process and established a solid onboarding process, along with renewed energy around the Stellar brand.

I would like to explore that a bit more. Could you elaborate on the growth you are experiencing? It seems like you believe you can achieve core deposit growth in the future. Where are you finding success in generating new account growth? Is it from existing clients or are you attracting new clients to the bank? Additionally, where are you seeing new rates for average deposit costs?

We are seeing positive developments this quarter as we build relationships and capture some market share in deposits. The increase in MIB accounts has been significant, representing a healthy percentage of our total accounts, indicating potential for further growth. Our bankers are currently focusing on deposit customer acquisition, albeit with some caution regarding loans. The interest rate on new interest-bearing deposits is approximately 3.45%, which remains stable compared to the first quarter, not factoring in MIB accounts. This interest rate for new deposits opened in the quarter aligns closely with what we saw in the first quarter.

All right. That's encouraging. And then maybe touching on the loan side. Could you help us understand maybe how demand is trending across your footprint? Where are you seeing good opportunities? And then just talking about the repricing dynamic in the next maybe six months to 12 months, where add-on rates are coming, where roll-off rates are. And then just trying to think about kind of how this all plays into the NIM and maybe where a core NIM could shake out once things do start stabilizing.

I can address that. For the quarter, our new loans totaled 762 and our renewed loans were 806, with both categories being approximately $0.5 billion each. The renewed loans were initially at 806 but settled at 724. I'm pleased with how we're handling the renewed loans. We're also focused on new loans as we adjust our models related to new loan pricing. I'll ask Joe to share what we're observing.

Yeah. This is Joe. On the demand side, we've taken something of a pause on commercial real estate. We've raised the bar on our underwriting and looking for more equity, shorter amortizations, and better compensating balances from borrowers. So on the CRE side, we've seen a slowdown because of our increased underwriting requirements. We're seeing some activity on the C&I side, investing with our customers. We're talking to some people that's with some other banks and want to talk to us. So we're cautiously optimistic about a little bit of growth in the C&I side. But for new business on the commercial real estate side, it's going to be slow.

Okay. That's helpful. And I guess maybe, Paul, I don't want to put words in your mouth, but kind of here in those numbers, it feels like maybe we're getting closer to a trough in the margin or at least the pace of compression should slow materially. Is that a fair characterization?

It's a fair characterization, but I lean towards the pace of contraction slowing. What we're facing, similar to many of our peers, is a timing issue. The assets aren't repricing at the same pace as the funding base. Currently, a larger portion of our funding base is wholesale in nature, comprising about eight percent of our balance sheet. While we'd prefer that to be zero, we are aware of the current realities. Fortunately, we have a strong core deposit base and a significant amount of purchase accounting accretion, which relates to the repricing of many of our assets as of October 1. This will be meaningful for us as it brings forward the repricing happening daily, even if it's not at the pace we would like. It supports what we believe to be a more core margin, helping us navigate the existing timing differential in the near term.

Yeah. I think one of the things we're watching happen in the marketplace is that we're seeing assets start to reprice, so people can actually get deals done again. I think for a number of months, you’ve seen it very difficult for the cost of capital today for people to pencil some of these deals to make them work. So that started to change a bit. We're still in a great market. Houston, Texas is still one of the best markets, if not the best in the country. That really bodes well for us and our organization. But the math still is what it is. People are getting used to higher interest rates. In the interim, I think we see a little bit slower loan growth. But at the end of the day, we'll start to see things pick up again as we start to move through this cycle and people get used to what the borrowing costs are.

Got it. That’s helpful. Thanks everybody.

Thank you.

Our next question comes from Matt Olney with Stephens. Your line is open.

Hey. Thanks. Good morning, everybody.

Hey, Matt.

I'll start with Paul. I think you said that 8% of the balance sheet is funded by wholesale sources. And obviously, it's moved up a little bit but still pretty low overall versus some others out there. I would love to appreciate your expectations for that 8% for the back half of the year, especially with your comments about maybe some optimism getting some core deposit growth the back half of the year.

Certainly. While we are hopeful, we also recognize that a significant portion of wholesale funding is likely to remain on our balance sheet for an extended period. However, we're seeing positive signs, especially in our statistics related to new account openings and our progress in loan growth. There are various factors that will influence this wholesale funding aspect, which serves as a temporary measure. The more successful we become and the further we move away from the challenges of the first quarter, the closer we can return to our usual operations, which are strong. We are the largest locally focused bank in one of the best markets in the U.S., and our recent rebranding has yielded strong results in new account openings. Therefore, we are optimistic, but we are also realistic about the significant market forces impacting the deposit market. Ultimately, predicting this will be challenging, but we feel positive about our current position.

And Matt, I think we're also in our season. Typically, both banks have seen deposit growth begin sort of that May, June time frame and start to build through the end of the year. We're in a little bit of an unprecedented time just based on what's happened with the Fed, but it looks like we're starting to have that deposit build or at least the front end of that is starting to happen, which we feel encouraged by. We think we've got deposit pricing right now, and it appears that we're able to attract new deposits into that. So our focus and our belief is that we'll continue to build deposits through the end of the year.

Okay. Great. Appreciate the comments. And then switching over to the fees, I think Paul made a comment in the prepared remarks talking about kind of a normalization of the fee run rate. So should we expect this to be kind of the normal run rate on fees, what we saw in 2Q or any other puts and takes we should think about kind of the forecast?

Well, July 1 put us into the interchange discount, I guess you could say, as the byproduct of us crossing $10 billion. All that is true with the caveat that interchange income is something that we'll expect to see being 40% lower from the base. But of course, we're going to seek to grow so as to offset some of that, but that will be a slower road to offset.

Okay. And I think that last I heard that interchange estimate the impact was about a $2.5 million annually that we'll start to see that in the third quarter. Is that right?

Yes, it has increased slightly. I estimate that we should consider our debit card and ATM card income to be around 40% lower than before.

Okay. Got it. Okay. Thanks for that. And then I guess on the expense side, would love to hear kind of what the outlook is with all the kind of puts and takes you mentioned in prepared remarks of bringing the brands together, bringing the teams together, integration. Would love to appreciate kind of where you expect to be in the near term.

We are continuously reviewing our expense dynamics. So far, when excluding the M&A fees, we are aligned with our guidance. Given the current interest rate environment leading to softer revenue, we will be more diligent in our decision-making. We are being careful about how we allocate additional spending and considering where that funding is sourced from. We are focused on being practical regarding these matters. Overall, we are on track with our core expense run rate and are confident in our position for the year, in line with our guidance.

Yeah. And I think as you think about this, we brought two banks together to get over the $10 billion mark. We did a lot of things around people without totally knowing everything about each other. As we brought the banks together, now we have a lot more feel about people and process and the inefficiencies that we may or may not have. The expectation for us is we'll get more efficient. We do have the ability to get more efficient, unlike maybe an acquisition where you're just folding something into the tent. We have the opportunity to gain efficiencies as we move through the year. That's not just with people, but with processes and technology to lower those costs.

Okay. I appreciate the comments. And then I guess, on the M&A front in the industry, have you seen a handful of deals announced this week? I know Stellar has been heavily involved in M&A in the past. Would love to get some updated thoughts on M&A chatter in Texas as far as what you're hearing and then thoughts on M&A with respect to the Stellar Bank from here? Thanks.

Stellar Bank believes there are many opportunities emerging in the market. We are engaging in discussions with various parties to explore these possibilities. There is still a need for clarity on certain matters, particularly in relation to portfolio valuations and the implications for capital. Some transactions have already taken place as stakeholders begin to grasp the potential synergies of combined entities and the advantages for shareholders. As we proceed, I expect that people will gain a clearer perspective on whether they are willing to accept a minor reduction in expected sale values to appreciate the future benefits of enhanced efficiencies and a stronger brand. The importance of scale has increased as profit margins are tightening again. We are optimistic about the prospects ahead, although I wouldn't predict significant developments in the immediate future. We remain flexible and continue our discussions, showing interest in moving forward.

Okay, guys. Thanks for taking my questions.

Thanks, Matt.

One moment for our next question. Our next question comes from Will Jones with KBW. Your line is open.

Hey. Great. Good morning, guys.

Good morning.

So we talked a lot about funding thus far already, but we really haven't hit on the fact that you guys are still seeing really, really solid loan growth. I know you guys had tended to be a little more conservative on the outlook at the start of the year, although understandably. But now that the dust has kind of settled and the demand is still there for you guys, it's more of a mid to high-single digit growth rate. Is that right way to think about loan growth as we move into the back half of the year or is it really appropriate to think that growth slows from here?

I think you're going to see moderate loan growth. Given our current position in this cycle, especially considering potential future credit issues and the direction of interest rates, our focus is on achieving loan growth at a decent spread. We want to avoid situations where purchasing dollars today erodes our margins. Right now, that mix doesn't seem ideal. Our goal is to pursue loan growth with good margins and safe loan types. While loan growth will be moderate, we still expect to see some. This is largely influenced by the current market conditions, which encourage us to make quality loans, backed by strong guarantees, and liquidity remains accessible.

The originations over the past two quarters have been around half of what they were at their peak in the third quarter of '22. It all starts with what we originate, which is in the $500 million-plus range. Looking at the subsequent impacts, two key factors in the last two quarters have been that our payoffs haven't matched the levels we previously experienced. We're still seeing an increase in the carries, with the advancements outpacing the payments. This is driving the growth. If the loan originations had been at that level, the growth might have been slightly less, but the dynamics of advancements exceeding payments and lower payoffs have significantly contributed to the growth in the last two quarters.

Got you. That's helpful, Ray. And then is the loan-to-deposit ratio, is that really kind of your governor on loan growth? Where you can ultimately lever up the loan side of the balance sheet or is it really just to the extent you can grow deposits? How do you think about where your ability to grow loans is ultimately capped at?

I wouldn't say it's a governor on what we do. But we don't have comfort in outstripping our ability. We really focus on core funding and for us to go in and try to get to 105%, 110%, or 115% loan-to-deposit, just by doing it through excess or wholesale funds is not really the way we want to build the bank. For us, we believe the true value in these organizations is to build core funding. So it's not a governor, but that's laid around it. We like to sit when we move ourselves back to optimization at about 90%.

Great. That's helpful. And lastly for me, Paul, I know accounting can be really hard to predict, almost like it is sticking in the air, but we saw a little bit higher level of accretion this quarter. Could you just remind us where scheduled accretion is for the remainder of the year? And how you kind of think about the full year accretion number?

We have appreciated a lot of what I'll call windfall accretion up to this point. I estimate about 35% to 40% of the purchase accounting accretion we've experienced year-to-date has been ahead of schedule. We put out guidance at our purchase accounting accretion for the year. It will be somewhere like $26 million to $28 million back in January. Year-to-date has been really strong. Our initial conservatism on our expectations regarding purchase accounting adjustments was based on the concept that we thought fewer loans would prepay, and we've had more than expected. We're still not banking on there being as much prepayment. We'd like to think about it more as scheduled purchase accounting. But 35% to 40% of what we've had year-to-date is higher than our expectations.

Got it. Understood. Thanks, guys.

One moment for our next question. Our next question comes from Graham Dick with Piper Sandler. Your line is open.

Hey. Good morning, guys.

Good morning.

I heard some of the conversations around new deposit openings and how you're starting to see a better percentage of those being non-interest-bearing or at least having a non-interest bearing piece to it. I know it's very difficult to predict, and there's a lot of remix going on in the industry right now. It's a good problem to have with your all non-interest bearing deposits being considerably above 40%. I was just trying to get a sense of what you guys are seeing near term on remix out of non-interest-bearing deposits, and if you think you're close to where you might be able to start holding the line on those balances quarter-over-quarter? Any help there would be appreciated.

You're right. It's really hard to handicap, but we're buoyed by the fact that we continue to open non-interest-bearing deposits. We've seen a higher level of relative stability when you compare it to the front half of the year. Since we've never been super forward on our interest-bearing accounts, we’ve always known that sleeping has been a reality for our clients, and maybe that optimization increased year-to-date. These are operating accounts. People need these balances to manage other payables, including payroll, and things along those lines. Some organizations get to be pretty decent in size where it makes sense for them to maintain significant balances, and it's diffused among many customers. A lot of macro things are shrinking that allocation to non-interest-bearing deposits. It's hard to see where the bottom of that remix is going to be. We're really pleased with the fact that we're able to continue to open and build these accounts. We think we have the platform to be the category killer community bank in one of the best markets in the U.S. It’s about executing. In the near term, it may be a slower road and more a function of swimming against the stream of what's going on macro pressure-wise, but we're pleased about where we sit and how our prospects lie.

It is difficult to predict the situation. However, if you examine the onboarding of the new accounts, the ratio of non-interest-bearing accounts to total accounts is higher than our current non-interest-bearing accounts. We will need to see what transpires once these accounts are opened, but initially, we are successfully opening a significant number of non-interest-bearing accounts relative to the total.

Great. That's really helpful. And then I guess I just wanted to circle to capital. I know you said you wanted to continue building it in CET1s. You're well over 11% now. Any near-term capital targets you guys would point to? How do you think about capital priorities now with maybe a buyback versus M&A or organic growth? Any way you could frame that up would be helpful. Thanks.

I'd say our principal capital priority is more regarding the merger that the size of our purchase accounting adjustments brought our capital down to levels lower than we like to typically operate. We’re focused on total capital ratio. As we did in our remarks, we're really pleased with the growth. Ultimately, to position ourselves to be opportunistic on the M&A front and otherwise, our efforts will be supported by a strong capital base. We will focus on growing that. As for the priorities, the other priorities are giving dividends and share repurchases, but we think it's hard to prioritize those in the near term while we're focused on building and positioning our base for what might come next opportunistically.

As you consider the rest of the year, we're approaching our capital optimization. We want to ensure we're in a position to execute what we want to do in the future. We believe M&A is out there for us, and we want to capitalize on that. Given where things are, it takes some capital to do it. That's why we may be accumulating a little more than we might have otherwise.

I appreciate it. On the M&A front, it sounds like talks are picking up, and obviously, you guys are interested. What does the ideal target look like for you guys in terms of size, business lines, I guess, deposit mix, etc.?

Instead of being overly specific and leading to guesses about our plans, we prefer to seek out partners that can enhance our franchise, whether it's in terms of the deposit base or the marketplace. Our goal is to avoid any actions that could negatively impact our current momentum and franchise. As long as these partnerships contribute positively to our activities in our existing markets, that's what we are aiming for. There are numerous opportunities available for us to pursue, and that's essentially what we are looking for.

We'd like to get bigger, but the focus is on being better.

They way to put it. I appreciate guys. Thank you.

Thanks.

One moment for our next question. Our next question comes from John Rodis with Janney. Your line is open.

Good morning, guys.

Good morning, John.

Paul, just a quick question on the tax rate. It dipped down during the second quarter. I think last quarter, you talked about sort of 21%, give or take. What's the right number we should use going forward?

I would take the weighted average of our year-to-date, as that is more reflective of where we're sitting moving forward.

Okay. Sounds good. Thank you, guys.

Thanks, John.

And I'm not showing any further questions at this time. I'd like to turn the call back over to Bob for any closing remarks.

Great. Thank you everybody for their interest today, and that will conclude our call. Thank you.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.