Earnings Call Transcript - STEL Q3 2023

Operator, Operator

Good day, and thank you for standing by. Welcome to the Stellar Bancorp Inc. Reports Third 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 that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Courtney Theriot, Chief Accounting Officer.

Courtney Theriot, Chief Accounting Officer

Thank you, operator, and thank you to all who have joined our call today. Good morning. Our team would like to welcome you to our earnings call for the third 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 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 at ir.stellarbancorpinc.com 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.

Bob Franklin, CEO

Thank you, Courtney, and good morning, and welcome to the Stellar Bancorp third quarter earnings call. I will begin my comments by thanking our fine team at Stellar Bank for their great work and extra effort to strengthen Stellar Bank's infrastructure. Our combination just over a year ago is now in its second phase of refinement following our core conversion, developing one culture, and better defining our staffing needs, refining our expenses to scale to an $11 billion organization, and aligning our efforts to make Stellar Bank the bank of choice in our markets. Though the industry continues to experience pressure on the deposit side, due mainly to interest rates, we have seen our base move towards stabilization. Rates have also put pressure on our net interest margin, but the negative effects are beginning to minimize, and though we would not call it a bottom, with the uncertainties that still exist in the market, we feel we are close. Our credit metrics remain good and our markets remain strong, but we must be cautious as the effects of rapidly rising interest rates work through the economy. We did charge off one loan in the quarter, which was the result of a continued deterioration of a previously identified credit noted in the fourth quarter of 2022. The issues experienced in this credit are specific to the borrower and do not appear to be a trend within our loan book. We continue to believe that our underwriting and our markets remain solid. We are determined to concentrate on building capital, liquidity and staying focused on good underwriting. We are also making sure that we monitor our existing portfolio for any negative trends that may form in the future. We are pleased with our balance sheet positioning as we move to the fourth quarter of the year. Our goal is to put our institution in a position of having all options available to it as we move into 2024. Achieving this goal will create value for our shareholders, our employees, our customers, and our communities. I'll now turn the call over to Paul Egge, our CFO.

Paul Egge, CFO

Thanks, Bob, and good morning, everybody. We are very pleased to report strong operating performance in the third quarter. Our net income was $30.9 million, representing diluted earnings per share of $0.58, an annualized ROA of 1.14%, and a return on tangible common equity of 14.5%. This was incrementally lower than the $35.2 million, or diluted EPS of $0.66 per share earned in the second quarter due mostly to increases in funding costs more than offsetting increases in interest income, higher noninterest expense, and lower noninterest income. Notable among the noninterest items is our control of core noninterest expense after excluding merger expenses and for noninterest income, the decreased revenue effect from the Durbin Amendment on our debit card and ATM card line item and reduction in NSF fees. During the third quarter, core net interest margin, which excludes purchase accounting adjustments, contracted by 10 basis points versus the second quarter and was 3.87% in the third quarter. That said, we are pleased to have experienced relative stability in our core net interest margin since May on a monthly basis. Since May, after experiencing meaningful funding dislocation in March and April, our funding costs have continued to trend upward, but at a more measured pace and the repricing of our assets has been able to keep pace enough to maintain stable monthly core net interest margins as we entered and exited the third quarter. While we do not like to see a decrease in our NIM or pre-tax provision profitability, we feel pretty good about the stabilization in our margin trends and earnings power, which continues to compare favorably relative to the industry. We also feel good about our ability to protect our relative profitability profile in this challenging environment. With respect to purchase accounting items, we had $119 million in loan discount remaining and a core deposit intangible of $122.9 million at the end of the quarter. Strong earnings notwithstanding accelerated amortization of CDI expense has really helped us to internally generate capital at a nice pace, reflected in having shown well over 100 basis point increases in all of our regulatory capital ratios over the last third quarters. In summary, we believe Stellar is well positioned to manage through the current operating environment and thrive. Our funding composition and liquidity position puts us in a great spot to maintain favorable margins and earnings power. Finally, on credit, we feel appropriately reserved given the current economic unknowns and we otherwise take comfort in our credit underwriting discipline from lending in one of the strongest markets in the country. Thank you. And I will now turn the call back over to Bob.

Bob Franklin, CEO

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

Operator, Operator

Thank you. Our first question comes from Eric Spector with Raymond James. You may proceed.

Eric Spector, Analyst

Hey, good morning everybody. This is Eric dialing in for David Feaster. Congrats on a good quarter. Just wanted to touch on maybe some of the trends on the core funding side. Obviously, you've seen some migration, but just curious, some of the underlying trends you're seeing, maybe how new core deposit pricing is trending for core products as well as CDs, and just kind of how you think about deposit balances going forward?

Ray Vitulli, President & CEO of the Bank

I'll do it. Hey, Eric, this is Ray. So, on those deposit trends, we felt good about the third quarter when we look at the dollar amount of new deposits that exceeded closure; that really held nicely. It's actually held nicely over three quarters in a row. And then, if you look at our carried deposits, which is what's existing prior to the new closures, those outflows, there still were some outflows, but they really decelerated at a nice pace to where we almost got to core, but there is still a core outflow net for the total but it's significantly decreased from the previous two quarters.

Bob Franklin, CEO

While there were some shrinkage, we kept the composition relatively similar. So, when you think about our funding base, we succeeded in having stability in our noninterest-bearing deposits ratio, and everything else, including our wholesale funding dependency, really mirrored where we were at the second quarter.

Eric Spector, Analyst

Got it. I appreciate the color. Just kind of following up on that, just curious how you think about the balance sheet, and just the margin trajectory assuming a higher for longer environment? Just kind of any color on the bank's performance or broader economic issues that you think could arise in a higher for longer environment? Just kind of how new loan yields are trending, color on loan repricing dynamics, and how the loan yields are versus roll-off rates? Any color on that end would be great.

Bob Franklin, CEO

Certainly. I mean, the best takeaway we have that we feel good about coming out of September and really the last five months is a relative measure of stability in our net interest margin. So notwithstanding the fact that the cost of funding continued to trend upwards, it's very much been in equilibrium in lockstep with the rate of change in our assets. So, we feel good about the stability there. We think the more time we're higher for longer, it will give more time for our asset book to reprice. Over the longer term, we see a net benefit there, but we're very, very cautious around how we manage the uncertainties of this unprecedented interest rate environment. So right now, we feel pretty pleased, but we're just cautious about outlook and feel good about where we sit.

Ray Vitulli, President & CEO of the Bank

Hey, Eric, I can give you some numbers, some color on the new loans. So, new loans for the quarter originated $340 million, that was at 8.12%, we picked up 50 basis points from the prior quarter on that. And then, we renewed over $600 million of loans in the quarter at 8.71%, and that was a picked up of 65 basis points from the previous quarter.

Eric Spector, Analyst

Got it. That's really helpful color. And then, just wanted to touch on the securities book. You have the advantage of having a truly liquid portfolio. I guess if we continue to see deposit outflows, how do you think about security sales versus borrowings versus CDs and other types of non-core funding? Where are you comfortable with that loan to deposit ratio shaking out? Maybe if you could just remind us what cash flows from your securities portfolio are that will be helpful.

Bob Franklin, CEO

In the fourth quarter, we anticipate over $100 million in cash flows from our securities portfolio. Looking 15 months ahead, this could amount to around $300 million in cash flows. We regularly discuss how to manage the balance sheet and utilize that cash. We are satisfied with our current loan-to-deposit ratio and intend to take advantage of repricing opportunities. Right now, we are inclined to reinvest those cash flows, but this strategy provides us with significant flexibility moving forward, allowing us to adapt based on the evolution of our broader funding base.

Eric Spector, Analyst

Got it. That's helpful color. Thanks again for taking the questions, and I'll step back.

Bob Franklin, CEO

Thanks, Eric.

Operator, Operator

Thank you. One moment for questions. Our next question comes from Will Jones with KBW. You may proceed.

Will Jones, Analyst

Hey, great. Good morning, guys.

Bob Franklin, CEO

Good morning, Will.

Will Jones, Analyst

So I just wanted to start on loan growth, I know we've kind of been talking about this low to mid single-digit range for the full year. And if you look at the first half, there was a little stronger, but we saw a little more softness this quarter. And I guess the theme maybe that we continue to see a little bit of softness as we enter the fourth quarter. So, round trip, we may wind up still in that mid to low single-digit range for the year. I guess, A, is that kind of how you're thinking about the near-term and in the fourth quarter kind of growth outlook?

Bob Franklin, CEO

I’ll let Ray provide more details, but overall, loan growth is expected to be limited for the remainder of the year as we observe the market and assess our options. We have significantly increased our underwritings, which has helped clarify what can meet the criteria to be added to our books. Therefore, growth will be slower than it was earlier in the year. Ray, feel free to add your thoughts.

Ray Vitulli, President & CEO of the Bank

So, Will, a couple of things that contributed to that negative growth for the quarter. When you look at the waterfall, the posture that we started last year around managing credit and liquidity, if you look at our loan originations, those were second quarter about $550 million in new loans; this quarter, around $350 million. So that's definitely one component of probably where we're headed. The other thing is our pay-offs, where we've normally experienced something like $250 million a quarter; that continues to actually be around $275 million in the third quarter. So, a combination of lower originations plus not a return to the pay-off levels, but at least a slight increase in the payout, which I think is probably healthy, contributes to what Bob was talking about with muted low-single digits.

Bob Franklin, CEO

And Will, I would just add, as you think about our approach to this, and I know others have different views, we really feel strongly about our core deposit funding. So right now the competition that we're experiencing for deposits, with some pretty high rates out there, many of which don't even pertain to what core funding really is, we haven't chased that to try to increase the loan volume. We like our position from loan to deposits; we'll probably even pull it down a bit. This is a good time to really focus on strength of the balance sheet. We feel like we've been able to maintain the non-core funding to a percentage that we feel comfortable with and we’d prefer not to increase loan volume by borrowing more money at tighter margins. So, we're sort of staying within the boundaries of what we feel like is the right approach to grow the bank. We think that the true value in our organization lies in our core funding profile, and we don’t really want to disturb that.

Will Jones, Analyst

Yeah. That's helpful, Bob. I know core funding is a huge advantage to you guys. But I guess to that point, it feels like when the company was combined and put together, it was really built to be more growth-oriented. So, what do you really need to see to get more aggressive on the growth front? Do we need to see deposit costs stabilize overall? Or does there need to be a little more clarity on rates and credit? How do you think about the dynamics driving more offensive growth in that respect?

Bob Franklin, CEO

Well, we agree with you. We were built to really drive growth and pursue opportunities we wanted. Unfortunately, when we closed our deal in November of '21, the Fed was in the process of raising interest rates at the fastest pace it ever had. That had to change our trajectory; you can't just continue to push forward expecting things to align. So, we pulled back to reassess our strategy. Right now, there is not a level playing field for deposits, and deposit gains are really coming at a pretty high cost in many ways. Barring exceptions, people are running to safety. But for the rest of us, we're out here battling for deposits on a relationship basis. As long as rates continue to move and aggressive competition exists around what they're paying for deposits, we don't think that's the appropriate strategy. So, we're taking the right approach to ensure we develop relationship-type deposits and continue to look for funnel accounts. We feel like that approach has served us well over the years. On the loan side, these high interest rates will need time to manifest their effects on the economy. We haven’t seen them yet, but I believe they’re coming. We happen to be in a strong market in Houston, Texas, which remains robust from an economic standpoint. That said, we don't want to push too aggressively and hurt our balance sheet, particularly with uncertainties looming. We are still making loans and we've increased our underwriting standards to ensure comfort in the loans we do originate. We’re cautious, and we want to preserve a robust balance sheet and healthy earnings profile, which we feel we're achieving.

Will Jones, Analyst

Great. That's super helpful, Bob. Thanks for that. I just wanted to touch on credit for a bit. We obviously saw a little bit higher tick-up in charge-offs this quarter. There's a theme across the broader Southeast of maybe some idiosyncratic noise within the C&I space. Would you characterize the credit issues seen this quarter as part of that?

Bob Franklin, CEO

I wouldn't. I think it was relative to one loan from one company that frankly wasn’t managed very well, and we ended up in this position. We worked with it for a long time trying to resolve it better and unfortunately it culminated in this charge-off. It's not indicative of our portfolio. As you can see, non-performers actually decreased significantly, and we didn't backfill after we charged off the loan. So, I believe the trend is not heading in that direction. We want to make sure we don't initiate a trend in that direction, and I don't think that will be the case. However, we are cautious about what lies ahead because as we renew loans and observe how borrowers are handling increasing interest rates, it’s been enlightening. As we navigate that, a lot of opportunities are available. Our strong market position aids us in this area, and hopefully, if we achieve the soft landing everyone talks about, that would be excellent. If not, we think we are well positioned and can take advantage of developments as we move into '24.

Will Jones, Analyst

Great. So, it feels like the sentiment regarding credit at Stellar is cautious optimism. Would you agree with that characterization?

Bob Franklin, CEO

Yeah, I would. If we get clearer signals in '24, we are well positioned to return to where we would have liked to be positioned over a year ago. That being said, we have to be sure that the Fed's actions have appropriately concluded. We need to ensure that we are not encountering an economy that’s suffered due to the Fed’s success in cooling it down, impacting all of us. We’re focused on our outlook for '24, and I think we are cultivating our options carefully. We’re accruing capital, generating solid earnings, and are readjusting our expenses to secure our earnings position. We’ll see where that takes us as we transition into '24.

Will Jones, Analyst

Great. That's very helpful. Thanks for the questions, guys.

Bob Franklin, CEO

Thank you.

Operator, Operator

Thank you. One moment for questions. Our next question comes from Graham Dick with Piper Sandler. You may proceed.

Graham Dick, Analyst

Hey, guys. Good morning.

Bob Franklin, CEO

Good morning, Graham.

Graham Dick, Analyst

So, Paul, I just wanted to circle back to the NIM quickly. I heard there is stability from quarter-start to quarter-end, which is obviously great to hear. Funding pressures can be volatile, but assuming trends continue to level off as you guys have seen and no more increases in the Fed funds rate, is there any reason to think that the pressure from the funding side can start to abate as the asset side continues to reprice higher and there’s a potential handoff maybe in the back half of '24 that could lead to stabilization in the first part of the year and then perhaps even some expansion in core margin later on in the year?

Paul Egge, CFO

As long as composition stays constant, I believe there is a lot more room to go up in the asset side than on the funding side, but that is obviously a big contingency. We feel really good about our performance over the last five months and we'll work hard to defend that position. It stands to reason that the asset side has more room to grow. But we're still adopting a cautiously optimistic approach, particularly because we are still in some very competitive markets. I feel like what we've achieved to this point has been significant. We're going to continue to work on maintaining our track record of relative outperformance in our cost of funds, which is translating into meaningful outperformance in what has been a stable NIM following the turbulence we saw earlier in the year.

Graham Dick, Analyst

Yeah, absolutely understand that cautious approach there, but still good to hear that things seem to be at least trending in the right direction from what we saw at the start of the year around the industry. I also wanted to ask about your assumptions on accretion income. It has been a little bit higher than I thought it would be this quarter. I don't know if there were some early payoffs or what drove the stable accretion quarter over quarter. Any color on what you guys are looking at would be appreciated.

Paul Egge, CFO

Certainly. It has been higher than we expected and we have welcomed the accretion income. We try to analyze the business from both perspectives while being mindful of the windfall nature of some of it, as that's what's caused a higher level of accretion income; more pay downs in the portfolio than we initially expected, which we will gladly accept. Recall that all of this accretion income is interest accretion, and that's significant because ultimately, it brings forward the repricing on the entire acquired portfolio of loans. When those loans do reprice, they are repricing at market rates, which we view as powerful. Overall, while this windfall accretion has made up about 35% to 40% of what we've experienced year-to-date, we will certainly take it. We view a lot of the accretion as core when it reprices into a market-based loan, particularly at the nice rates that Ray outlined with respect to recurring loans, where we ultimately are securing rates over 8.5%, 8.7% when we repriced loans. So, we feel good about it as long as it’s repricing into those levels, but we definitely perceive the majority of it as a pull forward of market pricing.

Graham Dick, Analyst

Okay, great. And then just on that repricing front you just mentioned, Ray, is that $600 million of renewals that happened this quarter typical? Is that kind of the run rate we should expect going forwards in terms of the current loan book churn?

Ray Vitulli, President & CEO of the Bank

It's probably a little higher than the normal. Normally, you would think of our originations and renewals tracking together, and this was probably a little outsized; the first two quarters were more like $500 million of renewals, and this was $680 million. So probably something between $500 million and $680 million is a reasonable expectation. It was a little outsized.

Graham Dick, Analyst

Okay, great. That's helpful. And then I just want to turn to expenses quickly. I know you said that you've got an increased focus on expenses going forward and optimizing the expense base to align with the revenue environment in the current economy. What does that mean for your approach to expense growth in 2024 as it relates to that $265 million number you mentioned?

Paul Egge, CFO

We're aiming to manage expenses strategically and thoughtfully. There are competing dynamics at play. First, we are completing the second stage of our merger to create Stellar Bank, and we wish to be well positioned to grow when the opportunity arises. Therefore, we want to avoid under-investing, but we must also be mindful of current revenue trends to deliver for investors. This means that in 2024, we aim to keep our core expenses level from 2023 going forward and be very thoughtful about how and where we allocate expenses. This is something we consider daily, and we haven't made any sudden moves in this regard. However, budgeting season is upon us and we are hyper-focused on it.

Graham Dick, Analyst

Okay. Thanks, guys. I appreciate it.

Bob Franklin, CEO

Thank you.

Operator, Operator

Thank you. One moment for questions. Our next question comes from John Rodis with Janney. You may proceed.

John Rodis, Analyst

Hey, good morning, everybody.

Bob Franklin, CEO

Hey, John.

John Rodis, Analyst

Bob, I like your cautious view on things. I wouldn't be apologetic about that; I think that's the environment we're in. Paul, you mentioned expenses of around $265 million, and you just indicated a full year '24 target of leveling off. Reading between the lines, does that imply flat to low single-digit growth for next year? Does that make sense?

Paul Egge, CFO

I would agree; flat to low single-digit growth does make sense.

John Rodis, Analyst

Okay, makes sense. Back to yield accretion; it looks like the higher payoffs have been pulling some of the accretion forward. I think a quarter or two ago you mentioned $26 million to $28 million anticipated for the year, which would set us at around $6 million to $7 million per quarter. For modeling purposes, does that $6 million to $7 million a quarter for yield accretion over the next few quarters still seem reasonable?

Paul Egge, CFO

I think it's hard to predict these things. Initially, we were conservative assuming there wouldn't be much or any pay downs. As it turns out, we've seen many more than anticipated. Our conservative view was somewhat less warranted, but it’s still hard to predict loan repayment behavior, especially in this environment. It's been interesting to see how borrowing patterns have outpaced our expectations so far.

John Rodis, Analyst

I understand that. Back to charge-offs, can you say what industry that company was in?

Bob Franklin, CEO

John, I think we should leave it as it is. We're still in negotiation, still have some ongoing discussions with those individuals. I don’t want to call them out anyway. Being more specific is probably not to our advantage right now.

John Rodis, Analyst

I understand that. Just one follow-up on that; was it in the Houston market?

Bob Franklin, CEO

Yes.

John Rodis, Analyst

Okay. Okay, guys, thank you. It was a nice quarter. Thank you.

Bob Franklin, CEO

John, thank you.

Operator, Operator

Thank you. One moment for questions. Our next question comes from Matt Olney with Stephens. You may proceed.

Matt Olney, Analyst

Thanks. Good morning, guys. Most of my questions have been addressed, but I know the bank typically has some seasonality late in the fourth quarter and into the first quarter with respect to that deposit base. As it stands today, we'd love to hear about expectations of that seasonality? And if you expect to maintain those normal seasonal patterns?

Paul Egge, CFO

Sure. We do expect a measure of seasonality, but I will say, especially given that we're currently structured, using a higher level of wholesale funding than we would like, we see a substitution dynamic occurring. So we're probably not expecting much in terms of asset growth; more will look to allow certain seasonalities on the funding side to substitute for a measure of our usage of FHLB borrowings or broker deposits.

Matt Olney, Analyst

Okay, Paul, thanks for that. I assume those wholesale FHLB; those are all eligible to be paid down with pretty short duration, it sounds like.

Paul Egge, CFO

It's mixed, but we definitely have a certain amount that is on the short side that we are careful about managing the composition of both groups in that wholesale funding so we can hit our expectations around seasonality. To the extent it drives a bit of asset growth, we'll be able to enjoy a reasonable level of spread if we put the excess cash at the Fed.

Matt Olney, Analyst

Okay. I appreciate that. And then, on the fee side, fees were a little bit slower this quarter. I know the Durbin impact started in 3Q, but it still looks like there were perhaps some other impacts in there. The third quarter seems tough from my vantage point. Any color on fees in the third quarter and the outlook here?

Paul Egge, CFO

Sure. All I can acknowledge is that Durbin has had a more pronounced impact than we expected.

Bob Franklin, CEO

We also sort of follow the trend of not charging NSF fees any longer.

Matt Olney, Analyst

And Bob, when did you implement that? Is that at the start of the third quarter?

Bob Franklin, CEO

This last quarter, yes.

Paul Egge, CFO

Mid-August.

Matt Olney, Analyst

Okay. Perfect. And then I guess on capital, we are seeing a nice capital build. I know when the bank was put together there was an expectation of some rapid capital build, and Bob mentioned earlier the environment has changed over the last year. So, we’d like to hear your updated thoughts on capital expectations of continued build. With excess capital, what are your updated thoughts around deployment going forward?

Bob Franklin, CEO

Yeah, Matt, I think we're very comfortable with the fact that we're building capital that gives us some options. We believe it allows us to explore various ways to deploy that, whether through M&A, buybacks, or increased dividends; all these options are on the table. There's also a safety net in capital build to ensure that you can navigate tough times if they arise. So, we are keeping all options open as we head into '24 and considering what would benefit us moving forward. But we desire to continue building this organization to leverage the best use of that capital for growth.

Matt Olney, Analyst

Okay, I agree with the optionality; it's good to have in this environment. Okay, that's all from me, guys. Thanks for your help.

Bob Franklin, CEO

Thank you, Matt.

Paul Egge, CFO

Thanks, Matt.

Operator, Operator

Thank you. I'd now like to turn the call back over to Bob Franklin for any closing remarks.

Bob Franklin, CEO

Thank you for your interest in Stellar Bancorp. And with that, we are adjourned.

Operator, Operator

Thank you. This concludes today's conference call. Thank you for participating. You may now disconnect.