United Community Banks Inc Q3 FY2022 Earnings Call

Good morning, and welcome to United Community Banks Third Quarter 2022 Earnings Call. Hosting the call today are Chairman and Chief Executive Officer, Lynn Harton; Chief Financial Officer, Jefferson Harralson; President and Chief Banking Officer, Rich Bradshaw; and Chief Risk Officer, Rob Edwards. United's presentation today includes references to operating earnings, pretax, pre-credit earnings and other non-GAAP financial information. For these non-GAAP financial measures, United has provided a reconciliation to the corresponding GAAP financial measure in the Financial Highlights section of the earnings release, as well as at the end of the investor presentation. Both are included on the website at ucbi.com. Copies of the second quarter's earnings release and investor presentation were filed last night on Form 8-K with the SEC, and a replay of this call will be available in the Investor Relations section of the company's website at ucbi.com. Please be aware that during this call, forward-looking statements may be made by representatives of United. Any forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those expressed in the statements. At this time, I will turn the call over to Lynn Harton.

Good morning, and thank you for joining our call today. While I have concerns about the pace of the Fed tightening and the impact of a potential overshoot, our southeastern economies are performing well, and we had a very strong quarter that demonstrated momentum in several key areas of our business. First, our net interest revenue grew at an annualized rate of 47%, driven by loan growth at the upper end of our target range and a 38 basis point expansion in our margin. While we did see deposit outflows and we expect the pace of deposit rate increases to accelerate, the strength of our core deposits will continue to give us an advantage in this environment. Our loan to deposit ratio remains low at 73%, providing us ample liquidity to fund growth at a reasonable cost. Our operating return on assets improved to 1.34%. Our return on tangible common equity increased to 15.6%. Our pretax, pre-provision return on assets reached 1.97%, and our efficiency ratio reached an all-time low for us at 48%. Credit continues to perform well with very low net charge-offs and only nominal increases in both non-performing assets and special mention credits. We are not seeing significant signs of consumer or business stress. While inflationary pressures are impacting both consumers and businesses, both groups exited the pandemic in stronger than normal financial shape, enabling them to continue to perform well to date. Employment activity continues to be strong in our markets with labor shortages continuing to be common for many of our business customers. We are seeing slowdowns in our mortgage market, as well as slower turnover in our builder finance business as home sales slow, both of which would be expected given higher mortgage rates. We increased our loan loss reserve this quarter as Moody's economic forecast weakened due to their anticipation of higher unemployment and reduced residential sales and home improvement activity in the future. Loan growth was at the higher end of our target range, with commercial increasing by $100 million, led by equipment finance at $70 million, and residential mortgage grew by $152 million as more of our closed loans were adjustable-rate, which we hold on balance sheet rather than sell. Our commercial growth was negatively impacted by runoff in Tennessee. This was not unexpected and we believe we're making great progress in implementing a growth plan in that outstanding market. We continue to look forward toward closing our acquisition of Progress Bank. Progress has outstanding bankers with strong momentum and will be a great addition to our franchise. We've been working closely with them as we anticipate becoming one team early in 2023. And now, Jefferson will share more details on the quarter.

Thank you, Lynn, and good morning to everyone. I'm going to start my comments on page eight and go into some details on deposits. We are proud of our core deposit franchise, and we think it will serve us well as rates move higher. 40% of our deposits are demand deposits, which grew by $48 million in the quarter. That said, total deposits shrunk by 2.5% or $552 million this quarter, about half of that decrease was in public funds deposits, which are typically seasonally weak in the third quarter. That said, we are also in a higher rate environment where customers have a lot of attractive options outside the banking industry, which is creating headwinds for our deposit growth and the industry. Still, our transaction deposits were up $406 million or 4% year over year, excluding acquisitions. Our cost of deposits was up 11 basis points in the quarter and helped drive our margin expansion that I will talk about on a later page. On page nine, we talk about our diversified loan portfolio. We grew loans at a 9% annualized pace. Lynn mentioned the drivers of the loan growth in his opening, so I'll move on to page 10. On page ten, we highlight that we believe we are in a very good position when it comes to balance sheet strength and flexibility. The combination of loan growth and deposit shrinkage this quarter took our loan to deposit ratio to 73%, up from 70% last quarter, again, giving us a lot of flexibility to fund future loan growth. Our tangible common equity ratio improved in the quarter to 7.7%, despite higher unrealized bond losses, due to good profitability and a smaller balance sheet. More on capital on page 11. Our ratios improved and are above peers. Our tangible book per share decreased by $0.16 in the quarter, as the higher unrealized bond losses drove $0.68 of headwind in the quarter. Moving to page 12, we discuss our net interest margin. As Lynn mentioned, we had 38 basis points of margin expansion in the quarter, 33 basis points of which came from the impact of higher rates and seven came from the positive mix change in the form of lower cash on the balance sheet and the higher loan to deposit ratio I mentioned earlier. Page 13, we talk about fee income. It was down from last quarter. Our mortgage business was a driver of the decrease, with rates rising and rate lock volumes declining 24% in response. The mortgage line had a $2.4 million MSR gain that will most likely not repeat in Q4, and the other income line had a $650,000 BOLI gain that is also unlikely to repeat in the fourth quarter. Moving on to some of the other fee income categories, we also had $1.5 million in gains on SBA loans and just under $700,000 in Navitas loan sale gains in the quarter. Moving to page 14 and expenses. Operating expenses were improved by $2.6 million in the quarter. The lion's share of the improvement was due to lower mortgage commissions, and we got the final cost savings from the Reliant acquisition. With the help of higher rates and the expense improvement, our efficiency ratio came in just under 48%. Moving to credit on page 15. We had strong credit results in the quarter with 3 basis points of net charge-offs and continued low levels of problem loans. On page 16, we show our waterfall chart on the allowance for credit losses. While net charge-offs were $1.1 million, we provided $15.4 million into reserve and have built our reserve for three consecutive quarters. Part of that reserve increase is due to our solid loan growth, but Lynn mentioned the main drivers in his remarks, which was anticipated higher unemployment and reduced future investment in residential real estate at year end. With that, I'll pass it back to Lynn.

Thank you, Jefferson. I want to express my gratitude to the United team for their outstanding performance, which you should all take pride in. I also want to welcome George Bell to our Board of Directors. George and I first met in the BV&T training program when we began our careers in the early '80s. He has over 35 years of experience in information technology, primarily in large financial institutions, focusing on customer information management. George possesses significant expertise in using technology to enhance products and services, improve customer experience, and boost organizational productivity. Welcome to United, George. It’s an honor to have you on the team. I would now like to open the line for questions and start the question-and-answer session. Up first is Kevin Fitzsimmons with D.A. Davidson. Please go ahead.

Hey, good morning, everyone. Just very impressive margin expansion. So just trying to dig a little deeper in terms of looking out at the next quarter or two with the anticipated further hikes from the Fed. Jefferson, wondering if you can have handy what for the month of September, the margin, the loan yield, and cost of deposits might be just to help guide us on that trajectory for each of those? Thanks.

Yes. Thanks, Kevin. Thanks for the question. How I'm thinking about the margin next quarter, I want to start with the cost of deposits and the deposit beta there is that it was only 8% last quarter. I think from the rate changes that we've already made, you're at 10% for the fourth quarter. And then I think with rate hikes that are expected, I expect us to raise deposits on that too. So I'm using an 18% cost of deposits, or 18% deposit beta in my model. On the entire margin, I think you are seeing, with that increased deposit betas, a little less asset sensitive as we go forward, but I think with our expectations for some mix change to help us, I expect that our loan beta should stay relatively stable as rates continue to rise. And also to bring it all together, I'm expecting about 20 basis points of margin enhancement next quarter.

Okay. Thank you. And just one quick follow-up. So on the comments that it's been three consecutive quarters of building the reserve, given the uncertainty and the headwinds out there, should we expect that reserve growth based on what you can see now? Thanks.

Thank you, Kevin. It's Rob. There are really three factors at play here. This quarter, the change in the economic forecast was significant, but loan growth and asset quality will also impact the future. I don’t believe that loan losses will remain at 3 basis points indefinitely; it seems likely they will revert to more typical levels, which will influence provisioning and the allowance going forward. The Moody's economic forecast is harder to predict.

Okay. Thanks very much.

Our next question will come from Brad Milsaps with Piper Sandler. Please go ahead.

Hey, good morning, guys.

Good morning, Brad.

Hey, Jefferson, you talked about some mix change in the fourth quarter and maybe beyond. Can you talk a little bit about the bond portfolio and sort of how you balance the aspect of that rate continuing to move higher since 25% of it is variable? It would almost seem like the yield on the bond book going forward would move up maybe more than what it would cost you to go out rate deposits. Just kind of wanted to hear your thinking on maybe shrinking versus keeping the bond book the same and how that plays into your margin and balance sheet guidance?

Thanks for the question. I believe our securities portfolio has likely reached its peak, and you can expect it to decrease in size for the fourth quarter and into next year. It generates approximately $60 million to $90 million in cash flow each quarter, with slightly higher amounts in the near term, followed by a gradual decline into next year. I plan to use this cash flow to support loan growth in 2023. Therefore, if you're forecasting the securities portfolio, I would suggest modeling it to become smaller over time. On the funding side, the environment is challenging. While deposits are stabilizing somewhat, there is a possibility they could decline again next quarter due to significant competition from short-term money market funds and similar investment options. I wouldn’t be surprised to see a decrease in deposits, although it may not be as steep as in the third quarter. The fourth quarter typically sees stronger public fund activity, which could provide some relief. Regardless, my short to medium-term strategy is to leverage the runoff of our securities portfolio to fund much of our loan growth, which should help shift the mix and improve margins next year.

And maybe just one quick follow-up to that. As you use those cash flows, does most of that come out of the fixed piece, or do you expect the variable piece to kind of stay static in terms of its dollars of the bond book?

I think that mix will remain relatively the same.

Okay, okay. And then my second question, Jefferson. You guys have done a great job managing expenses, benefited from cost savings from deals, lower mortgage commissions this quarter. And I know you put in some new merit increases mid-year in addition to what you did earlier. Just kind of curious how you're thinking about expenses going into next year. Obviously, a lot of inflationary pressure out there, but just wanted to get your thoughts around your ability to continue to control costs.

I'll start on that and see if anyone else wants to add. We implemented a mid-year salary increase for employees earning under $75,000, which affects our current financial figures. You might notice a slight rise in the fourth quarter due to this early adjustment in the third quarter. As we plan for next year, we will incorporate some operating leverage into our budgets. It's been a challenging year due to inflation, and we are actively managing costs as vendors and others push for price increases. This has created some upward pressure on expenses. However, we expect to save $3 million per quarter from Progress, which will provide some relief in 2023. I am initially estimating mid-single-digit expense growth for the upcoming year, but we are currently working through the budgeting process.

Excuse me. This is Rich. With regards to mortgage, we continue to rationalize our headcount with the change in volumes, so we've taken that down accordingly.

Great. Thank you. I'll hop back in queue. Appreciate the color.

Our next question will come from Michael Rose with Raymond James. Please go ahead.

Good morning. Thank you for taking my questions. I wanted to discuss the SBA and Navitas businesses. I understand that spreads on SBA have been under pressure, and it seems like you are focusing more on those. Could you provide an outlook for the future? Additionally, regarding Navitas, while yields remain consistent as you mentioned, it appears that credit may be starting to normalize. Can you give an update on what you anticipate for cumulative losses throughout the cycle in that business and how your underwriting practices have changed to mitigate loss risks compared to the last cycle? Thank you.

Okay. I think there's two, maybe three questions in there. And do you want to start that, Rich?

Yes. It's okay. That's all good. On the SBA side, premiums are down a little bit. So that fourth quarter is traditionally a stronger quarter for us, so we are expecting to be up on fee income this quarter. And then just a quick note, we have out of 20,000 PPP loans, we have 12 left that we're administering. So we're pretty happy about that.

I would say strategically on the SBA side, some quarters over the last couple of years, we have held back and kept some of those loans in portfolio. I think our strategy is depending on the pricing out there, is most likely changing to what we're going to sell, what we originate. So with the fourth quarter being a seasonally strong quarter and with the new strategy of not holding loans back, I would expect that SBA loan sale gain line to be about $0.5 million or maybe a little more higher in the fourth quarter. Yes, we have been selling loans consistently over each quarter. I remember on last quarter's call I was mentioning that we may not sell them every quarter with rates moving higher and that being a fixed-rate business. I could see that if the gain on sale there is not attractive, there could be a quarter in here where we don't sell Navitas loans. So what I would say is, the most likely expectation is another small Navitas loan sale and more normal higher SBA loan sales. But again, there could be a quarter in here where we don't sell these loans if we don't like the pricing.

And it's the same thing on SBA. There's kind of an over-under when we hold and sell based on what the sale dollar amount would be. Now, the normalized Navitas credit loss part of that question, let me pass it over to Rob.

In the first quarter of this year, we experienced 9 basis points of losses, and as we anticipated, they have risen to 35 basis points this quarter. Historically, our losses were even higher; back in 2020, we saw them reach 78 basis points. While I don't believe we'll return to that level, I do think we will see some normalization. The quality of our portfolio is better now than it was in 2020, as we've improved the profiles of the customers we engage with throughout the approval process. I suspect our losses will increase, but we haven’t yet observed a significant difference between 30 and 35 basis points. I'm closely monitoring early-stage delinquencies, which were at 1% before the pandemic, and currently, we are far from that figure, showing little change in that area.

Okay. Very helpful.

Credit changes, but the portfolio has been upscaled. So all things equal, it's a lower-risk portfolio we believe compared to when we bought it in 2018.

Makes sense. Maybe just a follow-up. I'm sorry if I missed this, but any update on the Progress deal and getting approval there? And then if you can just remind us, Jefferson, you've obviously had a couple of deals, this one pending here recently. As we go into next year, what is the pool of accretable yield that you'll have to realize over the next couple of years? And do you have an initial expectation for next year for scheduled accretion? Thanks.

Yes. So, this is Lynn. And on the Progress deal, we continue to work with the FDIC and Fed toward approval and are optimistic toward getting that done so that we could close in the early part of next year, but we're just continuing on the process with them.

Yes. I don't have the exact number of accretion with me. Let's talk afterwards; I'll give you the accretion numbers. The pool of accretion numbers coming through.

Perfect. Thanks for taking my questions.

Our next question will come from Catherine Mealor with KBW. Please go ahead.

Thanks. Good morning. I wanted to ask about credit. We noticed a higher provision this quarter, mainly due to improved growth and macro changes. Given the current situation, what is your outlook on the possibility of additional reserve builds in the coming quarters, considering the potential shifts in macro factors and your current reserve levels?

It's an interesting question. I think both Lynn and Jefferson highlighted two key drivers: one being the change in unemployment, which significantly influences all of our models. How we envision the future of unemployment will impact that aspect. The other driver is new home sales. This quarter, particularly in our residential portfolio, our models were affected by new home sales and home improvement spending. We are already observing market declines in new home sales compared to last year, especially in September. This decline is already occurring. Therefore, if these trends continue, it will be less likely that we will predict additional declines. However, if we see further tightening and more negative perceptions regarding unemployment, then we may anticipate a reserve build.

It's really sensitive to this Moody's model based on whether the weather is improving or deteriorating. This makes it challenging to provide the answer you might be seeking. The model is subject to change and can sometimes differ from consensus, which complicates the situation further. Therefore, it's a difficult question to address.

The loan growth has been very strong, and we believe that after incorporating Reliant, you will see even stronger growth due to the strength of the national market. However, the economy is somewhat weaker today compared to when the Reliant deal was initially made. Could you provide some overarching comments on what loan growth might look like as we head into next year?

Thank you for the question, Catherine. It has changed a bit for next year. We're still confident in our strong market position, which is encouraging. Although our pipelines remain robust, factors such as labor supply chains and interest rates will affect us next year. We experienced high single-digit growth this year, but we expect it to decrease slightly to mid-single digits next year.

Great. Everything else has been answered. Thanks so much.

Thank you.

Our next question will come from David Bishop with Hovde Group. Please go ahead.

Yes, good morning, and thanks for taking my question. I think Lynn or Jefferson in the preamble, you noted there were some headwinds in the Nashville market, like maybe on the loan front. Just curious, are you seeing any rationality in the market on the loan to deposit side and maybe when you expect to resume growth in that market? Thanks.

Hi, this is Rich. Yes, Tennessee was down. Part of that was related to our credit appetite. We had a significant amount primarily consisting of two subprime auto loans and a land loan. We have identified most of what did not align with our credit standards, with just a bit more to address in Q4. We feel optimistic about our direction and the team's efforts. Additionally, I'm happy to share that we're seeing strong momentum in hiring in Nashville, which we feel good about. This market is quite robust, and we are positive about its outlook moving forward.

And I might just overlay that. It's pretty typical when we buy a bank to see loan strength for a quarter or two or maybe even sometimes three as we're overlaying our box. There's a conversion, there's some distraction sometimes. But either way, we feel really good about the team, we feel really good about the market, and we feel this vary within our expectations of what we're seeing.

I understand. Thank you for that information. I have a follow-up question, Jefferson, regarding mortgage banking. I realize this area can be quite unpredictable in terms of revenue. You mentioned there were some issues. Could you clarify that again? Also, do you have an insight on how this might stabilize as we move into 2023? Thank you.

Yes, I'll start with the noise, and Rich can talk about the business a little bit. So the accounting noise in the quarter was the MSR gain, which was $2.4 million. I don't expect that to repeat. So I'd take that out the start, and Rich can talk about the pipelines and volumes and expectations for locks in Q4.

Yes, we do expect Q4 to be down about 20% from Q3, and probably a little bit more mix move to arms as well. And we're expecting the margins to be down just a little bit as well.

Got it. Appreciate the color.

Our next question will come from Christopher Marinac with Janney. Please go ahead.

Hey, thanks. Good morning. Jefferson, I wanted to ask about the increased use of the held to maturity securities. And I'm wondering if that taps some of the excess deposits that you already have on the balance sheet, and does that become a factor in how you think about funding the next several quarters?

Thanks, Chris. That’s a great question as we consider next year and plan out the balance sheet. I mentioned the cash flow I expect to come from both the held to maturity and available for sale portfolios. We’re not planning to sell the 40% or about $3 billion of held to maturity securities. However, the cash flow will support many of our loans. If we also don’t plan on selling available for sale securities, we can borrow against both the available for sale and held to maturity securities. I think the inventory could decrease from $2.5 billion to anywhere between $5 billion to $4 billion, which would represent a more typical loan to deposit ratio for us. The amount of held to maturity securities aligns well with the size of the portfolio we anticipate maintaining. Therefore, the combination of allowing the portfolio to reduce and the ability to borrow against both categories is not significantly impacting our strategy for liquidity or the portfolio size.

Got it. That's very helpful. Thanks. And perhaps a question for Rich or whoever, are there any new pools of deposits that you can tap or that perhaps you are tapping, or just what could be a greater generation? I'm just curious if there's incentives for teams of people that can focus more on deposits than was necessary the past year?

That's a great question. I'll begin with it and maybe others will want to add their thoughts. I wouldn't say there are new pools of deposits right off the bat, but I believe that we, like most banks, are shifting our approach to deposit growth. We're relying more on rates, and you'll notice that changing. Previously, our bankers tended to use rates defensively to retain customers, but I can see us launching campaigns in the future. I foresee an increase in compensation linked to deposit growth and a shift in our focus from having excess deposits to a desire to expand our deposit base. Therefore, you can expect to see a change in our organizational energy towards growing deposits.

And a real focus on our core customers. That's really where we want the emphasis, and more so than public funds. It's really protecting the core customers, and that's where our state presidents are putting a lot of energy in our teams.

Great. Thanks again for the background. It's super helpful. I appreciate it.

Thank you, Chris.

And this concludes our question-and-answer session. I'd like to turn the conference back over to Lynn Harton for any closing remarks.

Thank you all for joining the call. We discussed the economic environment, and it's difficult to predict what lies ahead. The Federal Reserve's tightening suggests a possible recession, but the resilience of consumers and businesses, along with a strong employment market, suggests any downturn may be mild. It's important to focus on the company's built-in protections. Considering our current pre-tax, pre-provision return on assets, our liquidity, core deposits, capital strength, and credit culture, I feel optimistic about what 2023 holds. I appreciate everyone being on the line and feel free to reach out if you have any questions. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.