SB Financial Group - Q3 2023

Transcript

Operator (participant)

Good morning, and welcome to the SB Financial third quarter 2023 conference call and webcast. I would like to inform you that this conference call is being recorded and that all participants are in a listen-only mode. We will begin with remarks by management and then open the conference up to the investment community for questions and answers. I will now turn the conference over to Sarah Mekus with SB Financial. Please go ahead, Sarah.

Sarah Mekus (Investor Relations)

Thank you, and good morning, everyone. I'd like to remind you that this conference call is being broadcast live over the internet and will be archived and available on our website at ir.yourstatebank.com. Joining me today are Mark Klein, Chairman, President, and CEO, Tony Cosentino, Chief Financial Officer, and Steve Walz, Chief Lending Officer. Today's presentation may contain forward-looking information. Cautionary statements about this information, as well as reconciliation of non-GAAP financial measures, are included in today's earnings release materials, as well as our SEC filings. These materials are available on our website, and we encourage participants to refer to them for a complete discussion of risk factors and forward-looking statements. These statements speak only as of the date made, and SB Financial undertakes no obligation to update them. I'll now turn the call over to Mr. Klein.

Mark Klein (Chairman, President, and CEO)

Thank you, Sarah, and good morning, everyone. Welcome to our third quarter conference call and webcast. Highlights for the quarter include net income of $2.7 million, down from both the linked and prior quarters as funding costs and lower mortgage volume have impacted profitability. Pre-tax, pre-provision return on average assets of 96 basis points, with return on tangible common equity of 10.8%. Total interest income of $14.8 million was up $3 million, or 25.8% from the prior year, and up $390,000, or 10.8% annualized from the linked quarter. Loan balances were higher from the linked quarter by just $4.2 million, but have now risen nearly $64 million or 7% over the prior year quarter.

Our expansion markets in Fort Wayne and Columbus were the catalyst, growing 29% and 15%, respectively. Deposits were higher by $14.1 million, or 5.2% annualized compared to the linked quarter and remained steady to the prior quarter, albeit with higher funding costs that rose from 46 basis points to 176 basis points. Loan-to-deposit ratio of 91.1%, our second consecutive quarter above 91% and higher by nearly 6 basis points from the prior year. Operational liquidity of nearly $500 million, that is 35% of total assets, and sufficient to meet all of our growth needs, and noticeably, we have not needed at any time to access the Federal Reserve Term Funding Program.

Expenses were slightly higher than the run rate this quarter that Tony will touch on shortly, as we had some non-recurring items that impacted results. Mortgage origination volume, while lower than the linked and prior year quarters, did show a very high and a more traditional level of sold volume at 88%. Capital levels remain strong, with Tier 1 leverage of 11%, common equity Tier 1 of 13.6, and total capital or total risk-based capital of 14.8%. Customer deposits for the company that are below the FDIC insured threshold were nearly 84% of total deposits, and when we exclude any collateralized deposits, that level increased to 89%. Finally, asset quality metrics remain strong, with delinquency levels at 33 basis points and year-to-date net charge-offs of only 1 basis point. We continue to concentrate on our five key initiatives.

That's revenue diversity. It's all about net interest income and fee-based revenue, more scale in our current households, more scope, and operational excellence and asset quality. First, revenue diversity. The mortgage business line has been under significant pressure this year from not only higher rates, but also the lack of inventory in most of our markets. This quarter was reflective of not only the new lower level of activity, but also the ongoing size of our pipeline. The expectation is that the $15 million-$20 million per month level of volume will continue for the majority of the next six months. We have, as previously indicated, been actively moving away from residential portfolio growth by changes to pricing with an emphasis on shorter duration products.

It was encouraging that we sold 88% of our production in the quarter, and the yields on those sales were in line with what we achieved in the last four quarters. Despite the headwinds that all banks have encountered this year, including us, quarterly non-interest income has remained fairly stable. Our $4.2 million this quarter was up slightly to the prior quarter, prior year, but down slightly from the linked quarter. We have settled into a 30% level of fee income to total revenue, which while down from our very high historical levels of high 30s%-low 40s%, would still place us well into the top quartile of our peer group.

As we look at our year-to-date results, the negative impact from the mortgage business line with $1.2 million of servicing right impairment and an additional $900,000 due to lower gain on sale, has clearly overshadowed a decent year in our other fee-based business lines. As such, we remain committed to our title insurance business, and despite the obvious headwinds from the residential sector, we are pleased with the progress we have made this year in making Peak Title the number one choice for our clients and our markets. For the current year, our State Bank commercial team has delivered over $145,000 of revenue, or 11% of Peak's total revenue for the year, which is over double the commercial revenue from the prior year.

This commercial contribution is nearly as high as our internal residential level of contribution for the year. We continue to emphasize the quality and capacity of our Peak business line to all of our clients. As I indicated in our second quarter webcast, our goal continued to be to generate 50% of Peak's revenue, all else remaining constant. This quarter, State Bank delivered 34% of Peak's revenue and now claims 30% of their revenue year-to-date. We spent the majority of the quarter integrating our new wealth management leader, mitigating the loss of a prior wealth advisor, remaining connected with our current wealth management clients, and developing new contacts as well. However, revenue growth has been challenged by the downward pressure in the equity markets and our need to identify more wealth advisors.

Regardless, this business line continues to deliver a stable $3.7 million-$4 million in annual revenue and continues to provide us a competitive advantage over our community bank peers. It remains a great complement to our private banking and commercial customer bases and helps ensure that we are providing our clients a comprehensive solution to all their financial needs. Secondly, more scale. Loan growth from our linked quarter rose slightly, as I previously stated. Consecutive quarter-over-quarter growth dating back seven quarters has been a noticeable achievement in our overall balance sheet growth. We understand that growth will become more difficult as we look out to a potentially further slowing in the economy. Faced with that scenario, our response will be to work twice as hard to deliver the same or better results.

By doubling our calling efforts to our clients, as well as our prospects that are tied to our competitors, a number of whom have stepped away from lending, we expect that when the economy does turn, we'll be better positioned to achieve pre-pandemic levels of loan growth. Growing deposits from the linked quarter was a key achievement, as we have worked extremely hard this past year to maintain our deposit levels on par with the prior year. We have given our bankers the flexibility to elevate every deposit conversation with clients to ensure we are keeping and growing those valued relationships. Obviously, maintaining that deposit level has come at a reduction of our net interest margin, with our year-to-date deposit cost of funds up 101 basis points from the prior year.

Keeping that rise less than the increase in our earning asset yields that have risen 119 basis points, does feel like an accomplishment in this rather challenging environment. Third, more scope. We closed just under $1 million in SBA loans this quarter, and thus far for 2023, we have originated $7.4 million. That production, which we anticipate will approximate $10 million for this year, is certainly less than our capacity and well below the goals we have set for this very profitable sector. With the increases in prime lending rate, we intend to adjust our traditional pricing model to drive portfolio balances and revenue higher. Fortunately, we are often able to attract the entire deposit relationship with each new SBA credit.

Also, when coupled with our strong credit culture and the added safety net of the government guarantee, asset quality elevates and revenue stabilizes. We expect to expand our fourth quarter successes and provide the emphasis to a stronger 2024 in the SBA arena. As we have discussed in prior quarters, our investment in technology to help us better identify and target clients for business expansion continues. We are in the midst of our Salesforce integration project, and we are confident that both our corporate sales champion and consulted sales approach with each client will bring us closer to a bigger bank process, but with a community bank feel. As a result, we have accelerated sales training for each of our staff members with a focus to retain 100% of our current clients and deliver a strong community bank brand for all prospects alike.

Operational excellence are our fourth key thing. Operating expenses were up just slightly in the linked quarter as we had some check fraud and other portfolio non-recurring items. However, a large portion of our expense base is variable and tied to the number of units produced in our SBA and mortgage business lines. As those volumes have declined, the associated compensation levels have also declined. We've also taken steps to reduce the fixed costs of both of these areas by reducing support staff and shifting responsibilities to departments with excess capacity. In fact, from the prior year, total FTE is down 17, or 6%, reflecting those impacts. Beginning in the fourth quarter, we will identify initiatives to further improve our efficiency ratio. That said, we expect that our fourth quarter expense level will reflect a more efficient run rate near the $10 million per quarter range.

And finally, to deliver more value to our commercial client base, we recently launched a comprehensive calling strategy across our entire footprint to deliver and potentially implement positive pay risk mitigation software to protect our 1,700 client accounts from fraud, as well as constrain our operational risk. Finally, asset quality. Charge-offs were again low this quarter at just $5,000, and for the year, we've had just $88,000, which equates to just 1 basis point of total loans. In fact, we have to go back 13 quarters to identify a period with net charge-offs exceeding just $65,000. In addition, our reserve coverage of non-performing loans at 474% gives us great comfort moving forward, that our asset quality is strong, stable, and prepared to confront any additional weaknesses in the economy. Quality underwriting and dynamic loan administration are clearly the common threads here.

We had a slight uptick in delinquencies from the linked quarter, which were all in the under 60-day category. The clients involved in the increase are now current, and we would expect that when we report our 2023 year-end delinquencies, they'll be back in the mid-20 basis point range. We also do not anticipate having any material level of delinquencies in the near term in the portfolio outside of identified non-performing credits. And Tony Cosentino, our CFO, will give you a few more details on the quarter. Tony?

Tony Cosentino (Executive VP and CFO)

Thanks, Mark. Good morning, everyone. Again, for the quarter, we had GAAP net income of $2.7 million, with EPS of $0.39 a share. It is notable that our pre-tax, pre-provision earnings, adjusted for the OMSR recapture for the nine-month period, are up $550,000 or nearly 6% from the prior year nine-month period. Highlights of the income statement this quarter. Total margin income has declined for the quarter from both the linked and prior years, despite very strong growth in interest income in excess of 25%, as a significant accumulation of funding costs impacted total margin. Margin ended the quarter down 7 basis points from the June quarter and was down 37 from the prior year. However, we have seen some stabilization in our margin, with declines in the past three quarters of 25, 20, and now 7 basis points.

We anticipate that the fourth quarter will likely be the low point in our margin, with the expectation that in 2024, we will start to see some slow improvement. In addition to the shift in the mix of assets away from securities to loans, increases in asset pricing have driven earning asset yields higher in every quarter this year, and they are higher by 89 basis points when compared to the third quarter of 2022. Loan yields have increased by the same level as new volume and contractual repricing have stayed consistent to market movements in the rate curve. This quarter, our margin betas have followed the pattern of the last two quarters, and that our funding betas are exceeding the repricing betas on our earning assets. Specifically, the deposit and total cost of funding betas were 88 and 87, respectively.

These are approximately 1.5x higher than the loan and earning asset betas, which are 60 and 58. Since the Federal Reserve began the rate increasing cycle, the betas for both sides of the balance sheet are nearly neutral, with the earning asset beta at 31 and the cost of funds beta at 28. Our level of fee income to average assets remained even to both the linked and prior year quarter at 1.2%, and as Mark pointed out, has stabilized at the 30% level relative to total revenue. We track our coverage of non-interest expense to assets by non-interest income to assets every quarter. In a perfect world, driving that coverage to zero is ideal, but we understand extremely difficult.

This quarter, at -1.9, is part of an improving trend in this metric for this calendar year, as we have adjusted operating expense to reflect lower levels of fee income, especially in the mortgage business line. Although, this quarter did show some positives in residential mortgage, especially our level of sold loans, and that our gain on sale percentage of 2.2% is in line with the linked and prior year quarters. Our ability to hedge the pipeline, coupled with our historically high pull-through rate mortgage clients of nearly 90%, has allowed us to command very good loan sale yields despite the tough secondary market. We do, however, expect the next six months in the mortgage business to be difficult, with total origination levels of roughly $100 million.

This would mark our lowest origination level in a number of years, but it's reflective of the near 8% rate mortgage market. As rates potentially stabilize into 2024, our consistency in the market should allow us to quickly return to higher origination levels. Despite the slight uptick in total expense this quarter, our trend line to drive annual operating expense below the $41 million level remains on track. We have reduced operating costs on consultants and are adjusting operating hours in our retail locations, which will contribute to the expense reduction that Mark just mentioned. Compensation and benefits as a percentage of total expense was 52.4% this quarter, down from 56.4% in the third quarter of 2022, with compensation per employee rising 2.9% annually, reflecting lower commission levels and our concerted efforts to manage employment costs effectively.

Now, let's return to the balance sheet. The total size of our balance sheet experienced a slight decline from the linked quarter due to marginal loan growth, with our levels of cash and securities declining. Securities as a percentage of total assets continued the reduction in the quarter, as they are now just 16% of total assets. This compares to 17% and 18.7% for the linked and prior year quarters. Regular amortization and some small paydowns in the investment portfolio brought the balance down to near the $200 million levels. Encouragingly, this quarter, the deposit growth enabled us to pay down more high-priced repos and FHLB borrowings by over $26 million, or 25% compared to the linked quarter. We did maintain a stable valuation of our Mortgage Servicing Rights, which stood at 118 basis points.

The servicing rights balance increased to $13.9 million, with the servicing portfolio now at $1.37 billion, up just slightly to the prior year. We continue to have very strong capital levels, as Mark has highlighted. Our common equity tier one ratio stands at 13.6%, and even with adjusting for AOCI, the level remains robust at 10%. Tangible book value per share is higher, slightly compared to the prior year, and when we adjust for the AOCI impairment, our tangible book value per share would be $18.92 per share, which is up 3.5% from the year-end 2022. Our share buyback continued in the quarter, although volume was down compared to our historical buyback run rate per quarter.

Specifically, this quarter, we purchased 44,000 shares at an average price of $14.02, for less than 85% of book, and just slightly higher than our tangible book value. As we stated, our loan loss allowance was stable in the quarter, reflective of both minimal provision and charge-offs. Due to the small increase in loan balances, our reserve to loans remained flat to the linked quarter at a healthy 1.6%. Compared to the prior year, we have increased our reserve percentage by 11 basis points. Our criticized and classified loans were relatively stable compared to the linked quarter, and now stand at $9.7 million, a decrease of $3.1 million, or 24.2% from the prior year. I'll now turn the call back over to Mark for closing comments.

Mark Klein (Chairman, President, and CEO)

Thank you, Tony. We continued our consistent pattern of raising our common dividend with our announcement this week of a $0.135 per share common shareholder dividend, and for the year, we've now declared cash dividends of $0.52 per share, or nearly $3.6 million. Total dividend payoff ratio for this year will be approximately 30%, with a current dividend yield of around the 4.2%. We continue to buy back our shares to return earned capital to our owners. Dealing with 11 rate hikes since early 2022, including four 25 basis point hikes this year, have impacted our rate-sensitive business lines of mortgage and SBA significantly. We have worked to adjust resources where appropriate, and will continue to do so moving into the fourth quarter.

Our budgeting process for 2024 is revealing in what markets and products we feel will have strength, and how our operation will emerge with greater emphasis on margin expansion and stabilization, balance sheet growth and mix change, and non-interest expense containment to preserve and grow EPS. I'll turn the call back over to Sarah Mekus for questions. Sarah?

Sarah Mekus (Investor Relations)

Thank you, Mark. We're now ready for our first question.

Operator (participant)

We will now begin the question and answer session. If you would like to ask a question, please press Star, then one on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the key. To withdraw your question, please press Star, then two. Once again, that was Star, then one to ask a question, and at this time, we will pause momentarily to assemble the roster. Our first question comes from Brian Martin of Janney Montgomery. Please go ahead.

Brian Martin (Director and Senior Equity Research Analyst)

Hey, good morning, guys.

Mark Klein (Chairman, President, and CEO)

Morning, Brian.

Tony Cosentino (Executive VP and CFO)

Hi, Brian.

Brian Martin (Director and Senior Equity Research Analyst)

Hey, just thought maybe you could talk a little bit about the kind of the loan pipelines, just kind of how you're seeing those, just given kind of the current market conditions, and then, you know, kind of just how your markets are performing so.

Steve Walz (Chief Lending Officer)

Yeah, good morning, Brian. This is Steve. We come to see 2023 as a bit of a year of acceptance for borrowers as they've gotten used to the new rate reality. So some things we thought we would see come to the fore earlier in this year have been delayed. That said, we do have some optimism for the fourth quarter as some of those projects have come online. Anecdotally, we're hearing from lenders that we're getting more calls from folks. So pipeline seems to be accelerating again as folks adjust to the new reality on the rate side, but also seeing an economy that seems to be stabilizing and still showing some resilience has encouraged them to proceed with projects that before they had had some trepidation about.

Brian Martin (Director and Senior Equity Research Analyst)

... Okay. And as far as just kind of your outlook, whether it be fourth quarter or just kind of the next several quarters, I mean, what type of growth rate, you know, I guess appears, you know, I guess kind of a near-term bogey as far as what you might be able to see?

Tony Cosentino (Executive VP and CFO)

You know, Brian, we're going to end this year probably, you know, 6-ish type % when we, when we fully finish. I think as we've looked at expectations, we're. That's probably the low end of the range that we're looking at in 2024. You know, a lot depends on really the commercial side, because as you know, we've stepped back from the residential as much on portfolio. SBA has seemed to show some strength a little bit here in the fourth quarter, and we've seen some more looks. So I'm hopeful that, you know, that number gets to call it the 7%-8% range as we get out, which would be kind of a $70-ish million type total number for the year. And we'll see a lot more as we finish Q4.

I think as Steve said, that's going to be pretty instructive in terms of what clients are looking at.

Brian Martin (Director and Senior Equity Research Analyst)

Sure. Okay. No, I appreciate it. Thanks. And then how about just, I think you touched a little bit on the mortgage production, maybe being a little bit lower here over the next couple of quarters. Just, you know, big picture, you know, I guess as we think about, you know, full year 2024, you know, I guess, can you give any thoughts or just, you know, how you're thinking about, you know, where that may shake out as far as what you're based on kind of extrapolating current trends, what you're seeing today? Both on-

Tony Cosentino (Executive VP and CFO)

Yeah, uh-

Brian Martin (Director and Senior Equity Research Analyst)

Both on both volume, I guess, and kind of, you know, your—like you had the benefit this quarter, Tony, of, you know, more, more production. So just kind of what you're thinking on both fronts?

Tony Cosentino (Executive VP and CFO)

Right. Right. So, you know, I think, you know, Q4 is probably going to be a, you know, a $50 million type range of origination. I think we're seeing a little bit, you know, our pipeline seems to be in that $18 million-$20 million level. You know, December looks to be dropping off a bit from that, so call that $50 million for Q4. I would think that's probably still going to be the level as we look at Q1, based upon, you know, the forward rate curves and the things that we're looking at. I do think, you know, our level of sales are going to be at a minimum, 85%-90%. We're not seeing the level of portfolio either by the client or anywhere else.

I mean, I think the clients that are doing mortgage and are interested are focused on fixed, fixed rate Freddie Mac saleable product. And we've had certainly a back off in our PCG market, which had been incredibly successful for us in, you know, 2021 and into 2022. That certainly has seemed to come off the table quite a bit.

Mark Klein (Chairman, President, and CEO)

Yeah, just a follow-up comment, Brian. You know, we, we do clearly expect that volume to rise again, maybe in the latter part of 2024, that maybe we'll see some improvement in the rate environment and the rate curve. But we clearly have cut some expenses in that back end of that process, and positioned ourselves with same number of MLOs we've had from Columbus to Indianapolis to lower Michigan, to do that $500 million with no additional cost. So we're prepared to move ahead when the market right sizes, so to speak, but it's still going to be constrained with potential higher rates and lower inventory. But we're prepared, and since they're a variable rate on compensation, we're willing to kind of stand pat.

Brian Martin (Director and Senior Equity Research Analyst)

Gotcha. No, that's helpful. And how about just flipping over to the margin for a minute? I think, Tony, you said, or kind of indicated that it might, you know, reach a bottom here in 4Q, and, you maybe see some stabilization or improvement next year. I guess it sounds like the funding cost pressure is beginning to abate. Just kind of wondering how you're thinking about, you know, the, the benefits on the opposite side with asset repricing. Maybe just how much in the way of loans reprice and kind of, you know, what trends you're seeing there to kind of, you know, give you some stability and or, you know, I guess, expansion next year.

Tony Cosentino (Executive VP and CFO)

Yeah, I mean, it, you know, it's the as we all talk about for all of us, it's the million-dollar question. I mean, certainly the variability this year between how fast funding costs have risen relative to the asset side has slowed down. You know, we were two times that early in the year, we were, you know, 1.5x. We'll get closer to kind of a one-to-one, I think, in Q4 of deposit and funding costs rising relative to the earning asset side. I'm hopeful that, you know, our discipline will allow the majority of the repricing that we have to flow through.

You know, I think it's going to be a big factor in terms of what calls all those clients are getting as their loans are coming up to reprice, and what that's going to do on a relative basis. But certainly, if you look at just the numbers of our portfolio and how it's repricing, it should maneuver its way to be at or slightly above what I anticipate funding costs to be as we move forward. So that's why I'm a bit hopeful for that to improve, you know, call it into 2024.

Brian Martin (Director and Senior Equity Research Analyst)

Got you. And just the new production, what yields, you know, I guess, are you kind of getting new production at? And just, do you have any sense for, or I can follow up, just on what repricing occurs maybe over the next 12 months, or if you have a six months, I guess, what as you think about that loan book?

Mark Klein (Chairman, President, and CEO)

Sure, Brian, you know, the margin we're seeing now is that 225-250 over the relevant index. You know, and we're certainly looking to hold that as-

Steve Walz (Chief Lending Officer)

... loans repriced, there are no banks have stepped back that we think, combined with our level of service, we should be able to retain those, those loans.

Brian Martin (Director and Senior Equity Research Analyst)

Gotcha. Okay, and then just the total repricing, I guess, how much repricing do you have kind of here in the short term or in the longer term?

Tony Cosentino (Executive VP and CFO)

We're probably going to have, you know, we're traditionally about 15%-20% on an annualized basis of the entire portfolio. You know, the majority of our portfolio reprices in that three to five-year rate curve duration. So, you know, every year, we're probably in that 15%-20% of total repricing. I think it'll be a little bit better than that number, percentage-wise in 2024, just because the majority of the things we put on were relatively short term over the past, you know, three years. You know, that's kind of where the client has been in anticipation of rates coming down.

Brian Martin (Director and Senior Equity Research Analyst)

Gotcha. Okay. And then last one for me was just on credit. Just sounds like things are, you know, still remaining very strong. I mean, anything that, you know, I guess you're seeing as you come through this quarter, it sounds like the trends in criticized and classified were pretty stable. So, you know, leading indicators, or at least how they criticize are continuing to remain strong. Just anything that you're more mindful of, or you're seeing any stress in certain areas of the portfolio?

Steve Walz (Chief Lending Officer)

No, Brian, we've been very satisfied with the performance of our portfolio. We did a deep dive into our CRE portfolio, particularly the investment real estate, things that were coming up for repricing, and we were very happy with what we saw as far as leases that were in place, as well as the ability of those cash flows to withstand the pressure of an increased rate. We feel pretty good about where the portfolio is right now.

Brian Martin (Director and Senior Equity Research Analyst)

Okay. I think that's all my questions. So thank you for taking the questions, guys. I appreciate it.

Tony Cosentino (Executive VP and CFO)

Yep. Thanks, Brian.

Steve Walz (Chief Lending Officer)

Thanks, Brian.

Operator (participant)

Once again, if you would like to ask a question, please press Star, then One. If there are no further questions, I would now like to turn the call back to Mr. Mark Klein.

Mark Klein (Chairman, President, and CEO)

Once again, thanks for joining us this morning. We certainly look forward to speaking with you in January to give you our fourth quarter and the full 2023 year results. Goodbye.

Operator (participant)

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