Bank7 - Q3 2023

Transcript

Operator (participant)

Welcome to the Bank7 Corp.'s third quarter earnings call. Before we get started, I'd like to highlight the legal information and disclaimer on page 25 of the investor presentation. For those who do not have access to the presentation, management is going to discuss certain topics that contain forward-looking information, which is based on management's belief, as well as assumptions made by and information currently available to management. Although management believes that the expectations reflected in such forward-looking statements are reasonable, they can give no assurance that such expectations will prove to be correct. Such statements are subject to certain risks, uncertainties, and assumptions, including, among other things, the direct and indirect effect of economic conditions on interest rates, credit quality, loan demand, liquidity, and monetary and supervisory policies of banking regulators.

Should one or more of these risks materialize or should underlying assumptions prove incorrect, actual results may vary materially from those expected. Also, please note that this conference contains references to non-GAAP financial measures. You can find reconciliation of these non-GAAP financial measures to GAAP financial measures in our 8-K that was filed this morning by the company. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press Star, then one on a touch-tone phone. To withdraw your question, please press Star, then two. Please note, this event is being recorded.

Representing the company on today's call, we have Brad Haines, Chairman, Tom Travis, President and Chief Executive Officer, J.T. Phillips, Chief Operating Officer, Jason Estes, Chief Credit Officer, Kelly Harris, Chief Financial Officer. With that, I'll turn the call over to Tom Travis.

Thomas L. Travis (President and CEO)

Thank you. Good morning, and thank you for joining us today. We recently celebrated our five-year anniversary of our IPO, and we're happy with our results over the last five years and how we've had consistently strong earnings and compounded our shareholder value. We've done that far better than just about any other financial institution. Our equity compounding and total shareholder returns are in pretty rare air, and I'm sure in the top few percent of all banks. You can see these dynamics on page 6 of our deck, as it shows the doubling of both of our EPS and tangible book value metrics. You can also see our total return when including dividend payments. Essentially, since the IPO, we've doubled our equity and our earnings, and on top of that, provided competitive dividend yields while doing so.

Our recent quarter was strong, clearly negatively affected by a one-off large credit event. We'll touch on that shortly. In the meantime, we report record PPE, continued disciplined expense management, NIM strength, stable liquidity, properly matched balance sheet, and we also note the absence of a meaningful AOCI adjustment. With the exception of the one adverse credit, our asset quality strength is consistent with our history. We take comfort knowing that our fundamentals carry the day. Before we move into a Q&A, let's spend some time on that one large, one-off credit. First, this is clearly a one-off situation. As the rest of the portfolio is very strong, we do not see any weakness.

In fact, excluding that one credit, our past due loans and adverse credit grades are even better than the prior quarters, and those quarters were strong as well.

Our team has been together for decades, and we've never experienced anything like what we are faced with on this one credit. I'll tell you on a personal level, it's an extreme letdown for sure. The credit in question is in litigation. The underlying borrower is in bankruptcy, so we have the need to be cautious with our comments. In addition to the specific reserve we took in Q3, shortly after closing the books, we became aware of a few significant new bankruptcy-related claims, and we became also aware that the borrower and their consultants will take a significant amount of additional time to wrap it up, all of which costs money, and so it required us, in good faith, to include a subsequent event note. In Q4, we will make an additional ACL increase or we'll take an actual write-down.

The amount will exceed the $3 million reserve we made in Q3. The range of possibilities is wide, and while it's difficult to provide specifics due to the bankruptcy process, the outside larger possible amount could soak up much of the Q4 earnings. We would still expect, even if that were to happen, to report a strong return on equity year. Based on information available today, even using the large possible loss amount, our ROE would still be somewhere in the industry average and a little bit better. So really, in a perverse way, it illustrates the strength of our core earnings to be able to take a meaningful hit and still perform where the industry performs.

Regarding the one troubled credit, again, we're involved in litigation, but I want to make it really clear that this situation is not caused by errors in underwriting or collateral perfection or collateral valuation. Rather, it is a case of, we believe, severe management failures, which were then compounded by outside consulting and legal fees that are being paid from the cash collected from the sale of our collateral. It is unfortunate to be in a position where the sale of our collateral will generate almost twice as much as what the senior secured lender is owed, yet that won't be sufficient enough to avoid a loss. The bottom line is, the bankruptcy process is slow, it's very expensive, and it's very lucrative for consultants and attorneys.

And so, without further commenting on that one situation, we're moving forward. We have a very strong company.

Our fundamentals are very good, and we expect to do what we've always done, and that is to continue compounding equity in a very meaningful way. We're really excited about our company in spite of the one event. With that being said, we're here to answer any questions we can. Thank you.

Operator (participant)

Okay. We will now begin the Q&A session. To ask a question, you may press Star, then one on your touch-tone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star, then two. Our first question comes from Thomas Wendler with Stephens. Please go ahead.

Thomas Wendler (Associate)

Hey, good morning, everyone.

Thomas L. Travis (President and CEO)

Morning.

Operator (participant)

Good morning.

Thomas Wendler (Associate)

I just wanted to touch one time on the credit that was moved to nonaccrual. Can you give us an idea of when you're expecting resolution on this credit?

Thomas L. Travis (President and CEO)

We think that... We looked at information this week. The probability is going to be the Q2 of next year. The bankruptcy process is maddeningly slow, and the final asset sale is going to occur here in a couple of weeks, and yet it's still going to take that long to wrap it up.

Thomas Wendler (Associate)

Okay, thank you for that. And then just kind of thinking about some of your other larger relationships, can you give us an idea of the size of some of your larger relationships and then kind of your internal policies around those relationships?

Jason Estes (President and Chief Credit Officer)

Sure. You know, I would say the number of relationships that exceed $25 million, where you have, like, a single repayment source—I would use an example. We have one group, you know, that owes us about $35 million collectively. They operate in the QSR space, so quick-serve restaurants operating over 100 different locations. When I say one repayment source, the vast majority of those, you know, are a single brand, but they're scattered throughout different metros across the country. I'm going to call that a single repayment source, so just bear with me there on that. There's really five relationships that have a single repayment source, where our balances exceed $25 million.

And so in that, you know, you've got, as I mentioned, you know, QSR, we've got a broadband group. And of the five, the bankrupt entity is the only one that doesn't have strong personal guarantees backing the credit, you know. And so those relationships obviously get a lot of scrutiny because of the size of the credits. This one, you know, is the outlier as far as personal secondary support. You know, the other, I'd say there was five. The one is the credit we've been discussing. The second one, you know, you've got QSR. Third, real estate with secondary support. Fourth, you know, that's a company that operates a broadband operation, also has significant secondary support from an individual.

And then you've got another entity that is a manufacturing company and well-secured, also has secondary support.

Thomas Wendler (Associate)

That was great color. Thank you. Thanks for answering my question, guys.

Operator (participant)

Our next question comes from Nathan Race with Piper Sandler. Please go ahead.

Nathan Race (Managing Director, Senior Research Analyst)

Yep, great. Hi, guys. Good morning. Thanks for taking the questions.

Thomas L. Travis (President and CEO)

Hey.

Nathan Race (Managing Director, Senior Research Analyst)

I'm sorry to go back to the large loan that moved to nonaccrual in the quarter, but can you just remind us all in terms of the size of your exposure there, kind of what specific reserves you expect to take, additionally on this credit, in addition to what was allocated in the Q3? I think the release alluded to some subsequent impairments in 4Q. And I know it's kind of a dynamic process at this point, and it could be prolonged in terms of the resolution to early next year, but any thoughts on just kind of the ultimate loss that you expect to take on this credit relative to the size of it?

Jason Estes (President and Chief Credit Officer)

So, Nate, the loan amount. So, think of it as in two different tranches. You've got the pre-petition debt, and then you've got the debt financing. And so we have partner banks, and of the pre-petition debt, our share was just under $27 million as of September 30. And then the remaining portion that gets you to the $40.5 million, which is, you know, just over $13.8 or 13.9 million, that's our share of the DIP loans.

Nathan Race (Managing Director, Senior Research Analyst)

Okay. And then again, I understand it's a fluid process, but, you know, based on what you know today and, you know, what liquidity remains on the assets and the company, any sense for kind of the overall loss, given default on this credit as this process plays out?

Thomas L. Travis (President and CEO)

Yeah, the subsequent events were additional large claims that are going to be fought over. And, I would just say, Nate, as I said in those comments, that we're expected to, you know, based on what we see today, it's possible they could soak up the Q4 earnings. And we just look at it as that's where it is, and a lot of that has to do with the extended time that it's taking, because every month that goes by, the court allows some of the money that's in the court to be used to cover wind-down expenses and the consultants and the attorneys and so on and so forth.

We're prepared for, as I said, in reference to, if we don't have any earnings in the Q4, you know, that's what we see as the outer bound today. That's where we arrived at. If that were to happen to the company, I think, Kelly, that would put our year income somewhere in that $27 million range, which is what we made last year.

Jason Estes (President and Chief Credit Officer)

Correct.

Thomas L. Travis (President and CEO)

Right?

Kelly Harris (EVP and CFO)

That's correct.

Thomas L. Travis (President and CEO)

And so, so if one were to assume that outer bound and we didn't make money in the Q4, then you'd be looking at a return on equity somewhere in the 13%-15% range. And that's kind of the way we're looking at it, Nate.

Nathan Race (Managing Director, Senior Research Analyst)

Okay, understood. And just to clarify, you know, on that outer bound expectation level, I mean, that would imply, I mean, you guys had about $14.5 million in pre-tax, pre-provision earnings this quarter. Is that kind of the potential additional impairment we're thinking?

Thomas L. Travis (President and CEO)

I think so.

Nathan Race (Managing Director, Senior Research Analyst)

Okay, great. I appreciate all that color. And maybe just kind of thinking about the margin outlook going forward, you know, it seems like there was a little bit greater pressure than maybe we were looking for this quarter. So perhaps, Kelly, kind of any thoughts on, kind of how you see the core margin, ex-fees, trending over the next few quarters, if the Fed remains on pause? And kind of in perhaps for Jason, what does that contemplate in terms of kind of loan growth expectations, as well as core deposit growth over the next couple of quarters as well?

Kelly Harris (EVP and CFO)

Yeah, Nate, this is Kelly. Our NIM has held up extremely well the past few quarters, even with the deposit pressures. But I do see NIM - I think we alluded to that 4.50% range in Q2 and Q3, and I think that's maybe a more normalized NIM going forward. That said, I mean, we still feel very comfortable operating in that range.

Jason Estes (President and Chief Credit Officer)

Yeah, and I think on the loan growth, Nate, you saw – and we do this, you know, periodically, you'll get quarters where, you know, the growth maybe exceeds expectations and quarter, where maybe it's a little bit less. So, you know, I think this Q4, I would expect us to end up more in line with the guidance we've been given all year, which is, you know, the loan book, we expected it to grow in the mid-single digits this year, and I think that's where we're going to end up. So basically, what I'm describing is we kind of expect a little bit of contraction in the Q4, just based on known, you know, exits or refinance, that are pending.

Nathan Race (Managing Director, Senior Research Analyst)

Understood. And then just in terms of kind of deposit growth expectations, you know, over the years, you guys have done a great job in terms of matching core deposit growth to loans, as Tom described earlier in his comments. Just curious to kind of get an update on kind of the pipeline for client wins on the deposit gathering side of things.

Jason Estes (President and Chief Credit Officer)

I think it's more of the same, you know, where there's typically a credit need and a chance for a transaction, that's where we can typically, you know, target deposits and have a higher success rate, you know? And so I think if you look at just our normal loan portfolio churn, I would think it'll be, you know, in line with those loans or maybe just trailing a little bit based on all the deposit gathering pressure that's out there, you know, with all of our competitors. So it's a tough fight. We do a pretty good job of it every day of winning those wars, but, you know, I still think it's going to be, you know, a challenge in the deposit environment we're in.

Thomas L. Travis (President and CEO)

And we could have grown deposits faster this year, if we would have increased our money market and CD rates, but we didn't have the need to do it. And so we've been more disciplined and more measured, and we benefit from not having to go out and pay those rates. So that has an effect on the growth of the deposits as well.

Nathan Race (Managing Director, Senior Research Analyst)

Got it. Understood. And if I could just ask on expenses. I know it's probably early in the budget process for next year, but perhaps, Kelly, any thoughts on just kind of the overall expense growth trajectory that we should expect for 2024? It looks like you guys are on pace for, you know, 5%-6% growth this year in expenses. Any thoughts on how we should think about the 2024 growth rate?

Kelly Harris (EVP and CFO)

Yeah, I think that's probably a good projection for 2024. I know Q4 historically has been a little bit heavier expense load than the prior three quarters. So we anticipate, you know, non-interest expense to trend up in Q4. That said, I think we've done a really good job. You know, if you look at our historical range with non-interest expense to really control that. But I think a 5% increase for 2024 is probably a good, a good projection.

Thomas L. Travis (President and CEO)

It may be a little bit more than that late in the year. We're gonna build some new branches that are gonna replace existing facilities in a couple of locations, which will add to our depreciation expense, but that probably won't kick in till the end of next year. So that's really probably more of a 2025 issue.

Nathan Race (Managing Director, Senior Research Analyst)

Got you. And, and I think you guys alluded to this earlier, just going back to credit quality, but outside of the one loan that we've discussed, just in terms of overall criticized, classified trends in the quarter, any thoughts there across the broader portfolio?

Kelly Harris (EVP and CFO)

Just gradual improvement over the last couple of quarters. I mean, past dues look good, as Tom mentioned, and adversely graded credit trends looks good outside of the one credit.

Thomas L. Travis (President and CEO)

Yeah, that's why we put in the deck. You'll notice on that one page, I don't know what page it is, but we look, we illustrated our historical low NCO number. And I'm just gonna sound like a broken record, but this, this outlier credit issue is just, it's. I've been doing this since 1981, guys, and I know that makes me old, but it also, I can just tell you that I've never experienced ever anything like this. And our team is just, this is just, if you're in the business long enough and, you know, we had plenty of collateral and plenty of this and plenty of that, and it's just probably the everything's lining up against us and, you know, we've torn it apart, looked back at our-

This is not some credit that was done with big policy exceptions and things like that. It's just one of those things. And so I, I would say that, we're very comfortable with our company, and we're very comfortable with our NCOs and our NPAs, and we have every expectation that, that we're gonna just continue to do what we've always done for decades. And, it just, unfortunately, is our turn in the box. And, but, you know, don't think for a minute that we've got some new lender that's rogue or some new process or we just pivoted. It's just one of those things that I guess everybody, as I said, everybody gets one in their lifetime, so hopefully, that's this is ours.

Nathan Race (Managing Director, Senior Research Analyst)

Yep. No, it truly sounds like an idiosyncratic event this quarter. I appreciate you guys taking the questions and all the color.

Operator (participant)

This concludes our Q&A session. I would like to turn the conference back over to Tom Travis for any closing remarks.

Thomas L. Travis (President and CEO)

Well, thanks again. Obviously, we're - it's a bummer for us, you know, for this one large credit, but we're gonna focus on the really good, positive fundamentals of our company. As I said, it's a - I guess, it's a perverse illustration that we could experience this Scud missile that lands on us and causes a big hit, and yet we're still gonna be returning what we think is gonna be at least equal to the, to the industry and perhaps even better. And then, you know, we haven't, we haven't taken our eye off the ball. So the company fundamentals are strong. We're gonna continue to compound much better than other people and, you know, make a good return for the shareholders, and, and that's what, that's what we're here to do. So we appreciate everyone, and thank you.

Operator (participant)

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