Earnings Call Transcript - STEL Q4 2022

Operator, Operator

Good day and thank you for standing by. Welcome to the Stellar Bancorp Inc. Fourth Quarter 2022 Earnings 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 to Courtney Theriot, Chief Accounting Officer of Stellar Bank. Please go ahead.

Courtney Theriot, Chief Accounting Officer

Good morning and thank you to all who have joined our call today. We would like to welcome you to our earnings call for the fourth quarter of 2022. This morning’s earnings call will be led by Stellar’s 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 Executive 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 act. 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 maybe 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 now turn the call over to our CEO, Bob Franklin.

Robert Franklin, CEO

Thank you, Courtney, and good morning. Welcome to Stellar Bank Corp’s fourth quarter earnings call and our first ever combined organization. I will begin by thanking our dedicated staff that is working tirelessly to make Stellar Bank an outstanding organization. This is an all bank team effort and our team is responding to the challenge. We are divided by two operating systems, but we are fully engaged in supporting a successful system integration in February of 2023. Completion of this conversion is an important step in solidifying the combination of our two banks. The fourth quarter provides us with a first look at both our balance sheet adjusted for purchase accounting with market valuations and our income statement, which will provide insight into the expenses associated with our merger along with day 2 provisions. The fourth quarter is one dominated by purchase accounting adjustments, and merger-related expenses. Our goal today is to help guide the reader of our financials to a core franchise and reveal the core earnings power created by our combination. We have also been proactive in our decision making, given the current interest rate environment and the economic environment. Throughout the fourth quarter, we looked to make business decisions that best fit our current focus on liquidity, capital and credit. First of all, we took care to make proper reserves as we transition into a more challenging economic environment. Secondly, we sold some of our more challenge credits, which would have been longer term workouts with uncertain outcomes, opting for certainty, which decreased our classified credits allowed us to realize greater values than our indicated marks. Having to mark to market the CBTX securities portfolio for the transaction, we own the securities today at market value. We felt that it was an opportune time to sell some of those securities and bolster our liquidity. Later, Paul and the team will provide more detail to aid in understanding the changes to our financials. Regulatory approval was a key factor in the timing of our closing; between the announcement and final approval, the interest rate environment changed significantly due to the Federal Reserve increasing interest rates at a very rapid pace. Therefore, the purchase marks affected by interest rates have been a moving target. Today, a majority of that work is done. And we have had a chance to review the results. We have never been more bullish on the long term success of this financial combination. Our ability to deliver for our constituencies, our shareholders, our customers, our employees, and our communities in which we operate has never been better. However, in the near term, we cannot ignore the actions of the Federal Reserve which are taking to slow our economy and contain inflation. We know from lessons learned in previous cycles to be cautious. The end of this interest rate cycle remains unclear, but we will be vigilant as to the effects on our customers and our operating economic environment. We will stay disciplined in managing our capital, our liquidity and the credit in our bank as we continue to build Stellar Bank. Our franchise resides in one of the most robust economies of the country. Our long-term future is bright, and we will stay determined to increase shareholder value. Our belief is that Stellar Bank is well positioned to deliver on that promise. I will now turn the call over to Paul Egge.

Paul Egge, CFO

Thanks, Rob. Good morning, everybody. We are very pleased to be reporting our first quarter as a combined company as our merger went effective on the first day of October. For accounting and financial reporting purposes, all of our filings contain comparative information relative to Legacy ABTX financial results with historical shares and per share numbers adjusted for the reverse merger. But given the transformative nature of the merger to create Stellar, I will focus my commentary on the year now of Stellar. Thinking about what we believe are the most salient takeaways from our combined financial condition at the end of 2022, our Q4 operating performance and what it all means for our outlook. Then I'll turn the call back to Bob and he'll open it up for questions. Before diving in, I'll note that while I won't be directly referencing the accompanying investor presentation, there's a good amount of detail included in that presentation regarding merger accounting adjustments, non-GAAP items, and other information. So I will start with our financial condition, which reflects the impact from purchase accounting and the strategies we executed in the fourth quarter. We ended the year with $10.9 billion in assets after accounting for the merger and results of operations for the quarter. As we previewed on our third quarter call, the fair value purchase accounting adjustments were meaningful given where the yield curve was at the effective time of the merger. The impact of losses in the securities portfolio to equity were already accounted for in AOCI, amounting to $69.8 million after tax. But the impact of bringing the CBTX loan portfolio over at fair value was even more significant as the fair value mark in the loan portfolio totaled $156.4 million and was mostly interest rate related. The combination of these items led to more goodwill resulting from the merger, incrementally impacting capital in tangible book value per share. Going forward, we will effectively earn that loan mark back through significant purchase accounting increasing the loan yield over the life of the acquired loans. The next most significant merger accounting adjustment was the $138.1 million core deposit intangible created in the merger. This amounted to approximately 3.97% of core deposits, which is relatively high and reflective of the nature of the yield curve at that time and the high-quality composition of the CBTX deposit franchise. The resulting CDI will be amortized on an accelerated basis over 10 years using a sum of years' digits method. This expense represents a partial offset to the beneficial dynamic of purchase accounting increasing revenue from the loan mark. The last significant merger-related item I'll note is the Day 2 provision of loan losses for non-PCD loans under CECL, which totaled $28.2 million, along with a $5 million Day 2 provision for unfunded commitments on loans running through the income statement. We also booked over $7.5 million in allowance for credit losses on PCD loans, which did not run through the income statement. We ended the quarter with $7.75 billion in loans, which after adjusting for the previously mentioned merger-related fair value mark on loan reflects an increase in loans over the quarter of around $200 million. This represents what we feel is an appropriate deceleration of loan growth from prior quarters given current market dynamics. During the quarter, we saw deposits decrease $116.9 million from a combined $9.38 billion to $9.27 billion at the end of 2022. $100.7 million of this decrease came by way of interest-bearing deposits. Even though we saw an incremental increase in noninterest-bearing deposits totaling $16 million, we feel great about our deposit composition with 45.6% of our deposits being transactional, noninterest-bearing deposits. The cost of our interest-bearing deposits has continued to increase reflective of current industry markets and a fiercely competitive deposit market. So we feel very good about how we've been able to manage these dynamics, relatively speaking. Strategically, we’re really pleased with our balance sheet positioning going into 2023, particularly considering our loan deposit ratio of 83.7%, solid capital levels and strong quarterly earnings power to support a healthy go-forward capital bill. Our fourth quarter results were noisy. Our bottom line is $2.1 million in net income translating to $0.04 in EPS. These headline numbers were impacted significantly by merger-related and non-recurring items, which obscure the continuation of many positive operating trends both ABTX and CBTX brought into the Stellar combination. First, net interest income and net interest margin were extremely strong thanks in part to purchase accounting increasing the loan yields. But even after adjusting for this, we're very proud of our revenue profile, notwithstanding market dynamics driving costs of funds upward. Headline NIM was 4.71% and after excluding for scanning accretion, adjusted net interest margin was 4.38%. Purchase accounting accretion recognized was $8.2 million in the quarter. The future recognition of purchase accounting accretion will be driven by scheduled and non-scheduled paydown behavior in the acquired portfolio. Our current expectations for 2023 would be to recognize between $26 million and $30 million of purchase accounting accretion income into yield. This will be partially driven by our expectation that fewer lower-yielding loans will pay down early in the current interest rate environment. Walking down the income statement, it's hard not to notice that outside provision for loan losses in the quarter totaling $44.8 million. But it's important to note that after excluding the PCD provision of $28.2 million on non-PCD loans and $5 million for unfunded commitments, our quarterly provisioning amounted to $11.6 million, reflective of our more conservative view on credit given an increasing economic uncertainty, loan growth and changes in specific reserves. The total allowance for credit losses ended the year at $93.2 million, or 1.2% of loans. Before moving on, I should note that we did have a higher than usual net charge-off number during the quarter, totaling $5.7 million, of which $4.6 million related to the proactive sale of $35.4 million in loans. Most of these loans came over with meaningful marks such that the actual sale netted a gain despite the charge-off. This is a good segue into our non-interest income, which was also bolstered by these gains and other gains totaling $4 million. $1.9 million related to the loan sale we just mentioned, about $1 million came from the sale of branch assets and the remainder came from a strategic sale in October of more than $350 million of acquired securities to support our liquidity profile. Moving on to non-interest expense. This is elevated in the quarter due to the recognition of $11.5 million in merger-related expenses and the introduction of merger CDI amortization into our expense base, which totaled $6.3 million for the quarter. During 2023, scheduled CDI amortization expense from the merger will total $24.5 million in addition to the $2.3 million in scheduled CDI amortization from prior deals. Holding aside the M&A expense noise, we feel very good about our core operating expenses in the fourth quarter, a result of both legacy ABTX and CBTX doing an exceptional job holding the line on non-interest expenses in an otherwise very inflationary environment. From an overall performance standpoint, when you exclude merger-related expenses and non-recurring gains, purchase accounting accretion, and that CDI amortization, we feel very good about our adjusted pretax, pre-provision earnings power in the fourth quarter at Stellar at $53 million. This represents 1.92% of average assets. We believe this strong core operating earnings power will drive rapid capital builds. And once the non-recurring merger noise subsides, the remaining merger-related accounting items will be additive to our core operating earnings power since we expect merger-related purchase accounting accretion to exceed the amortization of CDI trades in the merger. In summary, we feel pretty good about our combined positioning on earnings, liquidity, capital, and credit, which we know will prepare us for a wide range of economic scenarios. As we look into 2023 and beyond, we are hyper-focused on maintaining the absolute and relative financial and strategic gains from our merger. We feel well-positioned to advance our business, notwithstanding the potential challenges 2023 can bring. Thank you. And I will now turn the call back over to Bob.

Robert Franklin, CEO

Thanks, Paul. And we'll be happy to answer some questions around trying to help folks get through this kind of noisy quarter. So, operator, we're ready for questions.

Operator, Operator

Our first question comes from David Feaster with Raymond James. Your line is open. Please go ahead.

David Feaster, Analyst

Hey, good morning, everybody. I just wanted to start maybe, with if you could just give us some color on the economic backdrop in Houston. Obviously, the economy's strong, but I was hoping you could kind of give us a pulse from your perspective on your client and how demand for loans is trending? And then also your appetite for credit. I mean, obviously, the economic backdrop is a bit uncertain. So where do you see good risk-adjusted returns? And ultimately, how do you think about loan growth for this year?

Ray Vitulli, President and CEO

David, I'll start on that. This is Ray. The economic backdrop in Houston is still strong. We don't have full 22 job numbers in yet, but it's expected to be somewhere around 150,000 in job growth for the year, which is a strong year. Maybe it tapered down a little bit in December, but it still looks good. Our pipeline going into the fourth quarter was known to be a little less than the prior quarter. And that really manifested itself through fewer originations in the fourth quarter, but still really strong. Think about it, we presented about a billion in the third quarter and on a combined basis and then about 850 or so in the fourth quarter. So knowing that the demand had tapered just a little bit in our pipeline, it did manifest that way in originations. I'll let Bob talk about how we've adjusted around our approach to lending, given the uncertainties in the economic environment. Overall, we still have a healthy pipeline even as we think about 2023. Loan growth in 2023 is expected to be in the low to mid-single digits.

Robert Franklin, CEO

Yes, David, I think what we're trying to adjust to is what may happen in the future, which for us is uncertainty. Nobody likes uncertainty. I think we need to be proactive. We're enhancing our credit underwriting, making sure that we do the right things. It slows things down a bit. But also in these rising interest rate environments, we see cycles where at first, these rising interest rates are somewhat ignored, customers continue to buy at low cap rates, and then they start to find it very difficult to finance their purchases at the rates that they are trying. So we start to see cycles of repricing of those assets. We are in that phase where there is a lot of uncertainty. We want to be cautious as we move through this cycle, but we still have a decent pipeline. It’s not as robust as what we had in 2022, but we had some strong loan growth in 2022. We believe the Fed is going to continue on potentially to rates around that five and a quarter number. We must be prepared for the effects of that, and we're watching what we put on our portfolio.

David Feaster, Analyst

Okay, that makes sense. Along the same line, I think, the timing of the deal was really opportune given the economic backdrop. I wanted to get an update, and we talked about the conversion and integration upcoming. Could you provide an update on the timing of the synergies? Is that timeline still on track, and have you identified any other levers to pull given the increased scale to help decelerate expense growth or any change to that overall synergy target?

Robert Franklin, CEO

No change in the synergy target. It has been invaluable in really offsetting what's been a very inflationary environment. As you know from prior calls, we've been able to hold the line and really pulled through a lot of merger cost savings up to this point. We aim to reach almost all the way there by mid-year. There are a couple of expense items that will drop off to absolutely finish things at the end of 2023, but they are relatively small compared to the overall success on cost savings. We continue to have more levers. I appreciate you hitting on the fortuitous timing of the merger, because we feel that this merger gives us a lot more financial flexibility going into uncertain times and more levers to potentially pursue additional cost savings. We are better off with combined scale to confront these uncertain times, and we will be better off when it's time to get back on offense.

Ray Vitulli, President and CEO

We are scheduled for conversion.

David Feaster, Analyst

Terrific. And this kind of $68 million, you touched on the CDI and some of those impacts, but that's just $68 million run rate is a pretty good starting base on a core basis.

Paul Egge, CFO

That's actually high. I look at core expenses now that we have the introduction of that very large CDI expense coming from the merger. Core non-merger related expenses in 2022 will probably run around $265 million for the year. You can break that into quarters as you see fit. But that's a broad target for us. Naturally, our execution will be a function of opportunities as they arise. We're not going to shy away from the right people or investments if they come along in 2023. But currently, that's our target, give or take.

David Feaster, Analyst

Was that 255 or 265?

Paul Egge, CFO

265.

David Feaster, Analyst

Got it. And then just the last one for me, I wanted to touch on the $35 million in loan sales. It sounds like we're just kind of cleaning things up given the deal and the uncertain backdrop, getting ahead of some issues, or some potential issues. Just curious if you could give us some color on that? What did you sell? Were these on the legacy or CBTX side or both? And then was there anything unique in this pool that made you cautious at this point?

Robert Franklin, CEO

Yes, David, we had what's unique about these loans is that they were essentially the post-COVID hangover. So we had about four or five credits that were really struggling post-COVID. We were having to put pretty heavy marks on those credits anyway. They were still operational, but it would have required long-term workouts with real uncertainty about what the final outcome might be. We opted for certainty around those losses. This allowed us to clear the COVID piece of that as we managed to come inside our marks.

David Feaster, Analyst

Got it. That makes sense. Thanks, everybody.

Robert Franklin, CEO

Thanks, everybody.

Operator, Operator

Thank you. And one moment for our next question. And our next question comes from the line of Brad Milsaps with Piper Sandler. Your line is open. Please go ahead.

Brad Milsaps, Analyst

Hey, good morning, guys. Thanks for all the color. I'd like to start with the coordinated interest margin. Paul, could you provide an updated sense of what you feel like your new loan or earning asset data will be going forward as well as the interest-bearing or the total deposit beta at the combined company, and how that would impact your core NIM?

Paul Egge, CFO

Certainly. We're actually really proud of where our cumulative beta is up to this point. We've seen a measure of acceleration in the cost of funds here in the fourth quarter, but many measures show we're in the low teens relating to cumulative cycle deposit betas on the overall portfolio. This is hugely benefited from our very large spring deposit base. This has been really powerful in holding down our overall deposit data and ultimately allowing time for our loan betas to move. Ray can probably comment a little more on the composition of the loan portfolio. But we're feeling good about the overall pace of things, notwithstanding the fact that we've seen the cost of deposits start to accelerate.

Ray Vitulli, President and CEO

Regarding our loan yield side, the loans came in with a weighted average rate of 6.64%, which was a nice increase from the previous quarter. Towards the end of the quarter, loans were coming in at 6.90%, so we feel really good about where the new loan originations are concerning those rates.

Brad Milsaps, Analyst

That's helpful. Ray, can you give us a new profile breakdown of fixed versus variable loans? How does that impact repricing?

Ray Vitulli, President and CEO

In the combination, we had a higher concentration of floating loans from the community. But on a combined basis, we’re around 58% fixed and 42% floating.

Brad Milsaps, Analyst

Sure. It looks like the loan beta was just under 30% in the quarter. So that's basically indicating that this should continue to improve as some of this repricing takes place.

Paul Egge, CFO

That's correct. You should expect improvement as we move forward.

Brad Milsaps, Analyst

Great. I think I heard you correctly. You have about a little over $150 million in discount on total loans to recognize over time versus about $130 million of CDI you set up. Is that the way to think about it?

Paul Egge, CFO

That's the correct way to think about the CDI. We've provided guidance on how that will be scheduled, and we've included that in the investor presentation.

Brad Milsaps, Analyst

Got it? And I know you had the loans that you sold and cleaned up this quarter. So that probably drove a little higher core provision. Many companies experience a reduction in provision post-merger due to the marks. Can you help us think about how you will be addressing your core loan loss provisioning?

Paul Egge, CFO

Currently, our allowance for credit losses is 1.2% of loans. Our view for net loan growth in the future will be dependent on the economic environment and our ongoing assessment. We believe that leaning slightly more conservative relative to prior periods is appropriate, and we will continue to monitor how we move forward.

Brad Milsaps, Analyst

Got it. And I need clarification; the $265 million expense number, does that include the CDI? And what's a good combined tax rate for the combined company?

Paul Egge, CFO

That includes CDI, but not non-M&A expenses. Our overall tax rate will largely be a function of dynamic securities portfolio, but it will be under 20%.

Brad Milsaps, Analyst

Got it? Okay. Thank you very much. I appreciate it.

Operator, Operator

Thank you. And one moment for our next question. Next question comes from the line of Matt Olney with Stephens. Your line is open. Please go ahead.

Matt Olney, Analyst

Thanks. Good morning, everybody. Just following up on the last question from Brad on expenses. Bob, what's your estimate of the remaining noncore expenses we could see for the rest of the year?

Robert Franklin, CEO

About $5 million front-loaded; it might come in less.

Matt Olney, Analyst

And then we'll head on to liquidity. I think you mentioned on the last call that you sold some securities immediately following the deal closing. Remind me of that amount of securities. What kind of cash flow are you looking for from your existing securities in the portfolio in 2023?

Paul Egge, CFO

Sure, thanks. We sold just over $350 million in securities, which represented about 59% of the CBTX portfolio that was brought over. After that sale, we're looking at annual cash flows approximating a little short of $200 million a year in the coming years, providing a significant source of liquidity in the near term.

Matt Olney, Analyst

Okay, thanks for that, Paul. And then on the capital front, looks like the CT1s around 10%. It feels like that could build quickly given the profitability here. Any updated thoughts you have on capital, any capital actions being considered right now?

Paul Egge, CFO

I'd say the first capital action is to build. We, as a byproduct of these merger accounting adjustments, have come out with lower capital than we expected, both from the merger, obviously affected by the industry environment. We feel fine with where we stand, but given the uncertainties in the economy, we’re looking forward to seeing rapid capital builds to provide more flexibility for future strategic capital strategies.

Matt Olney, Analyst

Okay, thanks for that, Paul. I would like to clarify the CDI expense from the transaction in 2023, the $24.5 million you mentioned in the presentation. Did that include or exclude the additional $2 million from prior deals?

Paul Egge, CFO

That excludes.

Matt Olney, Analyst

Excludes. Okay, that's all from me. Thanks, guys.

Paul Egge, CFO

Thanks, Matt.

Operator, Operator

Thank you. And one moment, please. And we do have a follow-up question from Will Jones with KBW. Your line is open. Please go ahead.

Will Jones, Analyst

Hey, great, thanks. Good morning, guys. Paul, I just wanted to follow up on the margin discussion. It sounds like you guys expect new deposit costs to accelerate a little bit from here, but you’re optimistic on the loan side with some repricing opportunities upcoming, indicating a potential for the margin to expand from here. Could you provide some commentary on that?

Paul Egge, CFO

Certainly, we feel there’s potential for additional upside, but our primary focus is on protecting our strong margin profile. If we can add to it incrementally, that will be a bonus. The key task in 2023 and beyond is safeguarding the progress we've made with our margin profile through this merger. It's a highly competitive industry environment, but we are optimistic about our ability to maintain our strategic advantages and leverage them.

Will Jones, Analyst

That’s super helpful. Thanks for that. Considering the balance sheet as a whole, with the selling of some loans and wind down of CBTX bonds, are you happy with where the balance sheet landed post-close? Is there any more restructuring to be done?

Paul Egge, CFO

We want to maintain flexibility in our balance sheet management going forward. We want the ability to be on the high end of our loan growth expectations, but not feel pressured to perform. This is not the market to take untoward risks in. We're managing our balance sheet strategically to ensure we're well-positioned for financial flexibility in capital, liquidity, and credit management.

Robert Franklin, CEO

Yes. I think we finally get an opportunity to shine as a core funded institution. Recognizing the value of this franchise in a time when relationship banking and core funding are being highlighted is an advantage. We aim to take advantage of that and grow our franchise moving forward. We feel well-capitalized, and nothing is off the table as we consider our options.

Will Jones, Analyst

Yes, totally understood. Thanks again, guys. Just one more if I could sneak it in. The buyback has been discussed as a tool in your strategy; is that something we could see come to fruition now that you have a handle on pro forma capital?

Paul Egge, CFO

Sure, we love having that tool available. For now, we're focused on building capital, but we value the flexibility to utilize buybacks when appropriate.

Will Jones, Analyst

Yes, understood. Thanks, guys. Appreciate the color.

Paul Egge, CFO

Thanks.

Operator, Operator

Thank you. And one moment for our next question. Next question comes from a follow-up from Matt Olney with Stephens. Your line is open. Please go ahead.

Matt Olney, Analyst

Yes, thanks for taking the follow-up. I want to jump on and ask Paul more about some of the commentary around the core margin. You mentioned you want to protect the core margin in 2023. Can you provide some insight into how you're actively managing that?

Paul Egge, CFO

We're strategically evaluating how we manage the balance sheet. Currently, we feel good about our net interest income and margin. The goal is to protect it, but if we can grow significantly, that's even better.

Matt Olney, Analyst

Okay, got it. Thanks, guys.

Operator, Operator

Thank you. And I’d like to hand the conference back over to CEO Bob Franklin for any further remarks.

Robert Franklin, CEO

Michelle, thank you, and thanks everyone for their interest in Stellar Bancorp.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect. Everyone have a great day.