SB Financial Group, Inc. (NASDAQ:SBFG) Q2 2023 Earnings Call Transcript

SB Financial Group, Inc. (NASDAQ:SBFG) Q2 2023 Earnings Call Transcript July 28, 2023

Operator: Good morning, everyone, and welcome to the SB Financial’s Second Quarter 2023 Conference Call and Webcast. I would like to inform you that this conference call is being recorded and that all participants are currently 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 would now like to turn the floor over to Sarah Mekus with SB Financial. Ma’am, please go ahead.

Sarah Mekus: Thank you, and good morning, everyone. I would 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 reconciliations of non-GAAP financial measures are included in today’s earnings release materials as well as our SEC filings and other investor materials. 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 will now turn the call over to Mr. Klein.

Mark Klein: Thank you, Sarah, and good morning, everyone. Highlights of this quarter’s results include net income of $3.1 million, up $241,000 or 8.5% from the prior year quarter, but would be up $443,000 or 16.7%, excluding the effects of the OMSR recapture for both years. Year-to-date, adjusted net income is up $738,000 or approximately 15.5%. Return on average assets of 91 basis points with return on tangible common equity, 12.4%. Net interest income of $9.8 million was up $200,000 or 2.5% from the prior year as loan growth and better asset mix have offset higher funding costs. However, compared to the linked quarter, margin income was down 4.8% as the betas on funding costs have begun to exceed those on the asset side. Loan balances were higher from the linked quarter by just $8.5 million, but have now risen over $89 million or 10% over the prior year quarter.

Deposits were down from both the linked and prior year quarters, and challenges to identify funding at or below the margin continued. Expenses were down from the linked quarter by $434,000 or 4% and down $463,000 or 4.3% from the prior year. Mortgage origination volume strengthened in the quarter, up 32% from the linked quarter. However, we are still down from the prior year. And asset quality metrics continued to trend in the positive direction on NPAs and our coverage of NPLs. As with prior webcast, we continue to concentrate on our five key initiatives: revenue diversity; more net interest income and fee-based revenue; more scale, more scope; seamless operations; and of course, asset quality. First, revenue diversity. For the quarter, our mortgage business line originated $65 million in volume, higher by $16 million or 32% from the linked quarter.

We also increased our percentage sold in the quarter to 73%, which is in line with more traditional levels and is a critical metric as we continue to manage both the size and makeup of the funding side of our balance sheet. The quest to seek out and find quality MLOs in our high-growth markets continues, and we expect that production in the coming quarters will show positive growth for both the linked quarter measurement and the prior year. Overall, non-interest income was $4.4 million, which was up from the linked quarter and down just slightly compared to the prior year, primarily due to declining residential real estate volume. However, the gain on sale nearly doubled from the linked quarter and is reflective of more competitive pricing once again in the Freddie-Fannie arena as well as our initiative to constrain portfolio volume.

That said, the residential business line fee income was down by over $1.9 million for the first six months of the year versus the same period last year. Interestingly, this decline represents 79% of our year-over-year fee income variance. Our commitment to the Title Insurance business remains strong despite the headwinds in the residential lending space. As we discussed in prior webcast, we intended to bolster our volume and revenue with a more conscious commitment to escalate title policy revenue that Peak receives from State Bank. As a result of our initiatives, State Bank has generated transaction volume for the first six months for Peak of $36.2 million and revenue for Peak of $183,000. As such, over 34% of Peak’s transactions representing 21% of the revenue was due to State Bank-sponsored activity.

Our goal is to not only diversify our sources of revenue from our other 20-plus clients, but to also escalate State Bank’s title work revenue to Peak Title to at least that 50% mark of potential activity, all else being equal. The current environment of purchase transactions presents a greater challenge as the seller typically directs the title work. Year-to-date, our title policy revenue is off 36% over the prior year period, whereas our residential lending volume is off 40%. Wealth Management continues to be a competitive advantage and a complement to our more traditional commercial banking services. Not only does it potentially provide a broader range of products and services to our now 36,000 households, but also a unique source of non-interest income and greater revenue diversity to which we aspire.

While over 50 years of providing wealth management services in our market, we have a unique ability to manage much more of our clients’ financial needs than most peer banks. We recently added new executive leadership who has a long history of advising wealth clients in the region. We believe she not only be a complement to our other six business lines, but additive to our sales initiatives to expand our current level of assets under management. Additionally, the business line is on track to provide $3.8 million in revenue for this year. Secondly, more scale. In the current rate environment, loan growth must be accompanied by substantially higher rates in order to ensure margins remain stable. To our benefit, we have witnessed a number of our competitors pulling back on lending in our markets, which we clearly have not done.

We continue to reach out to identify opportunities with new and existing clients, but we have also become much more selective in providing financing to higher-risk loan sectors and structures that we are willing to provide our customers. Until funding at the margin retreats from the current 5-plus percent mark, loan growth, we feel, will be intentional and conscious, but yet selective. Loan growth in the quarter slowed as we were up just $8.5 million from the linked quarter, but as I mentioned, $89 million or 10% from the prior year quarter. Unfortunately, our commercial lending activity has been impacted by paydowns in the agricultural sector and limited growth in the level of business activity within our current book. We continue to call aggressively in all of our markets.

For the first two quarters of the year, our commercial lenders have made over 1,900 client and prospect calls and have enabled us to log a current pipeline in excess of $60 million. As an organization, we have recommitted on our quest to garner a deeper deposit relationship with all borrowing clients, absent which pricing will be adjusted. Liquidity was fairly stable during the quarter with deposits declining slightly, which required us to replace funding with slightly more costly wholesale borrowings. Overall, the size of the company remained fairly flat. However, we forecast a slightly larger balance sheet for the remainder of 2023 in light of the paydowns in the investment portfolio and the limited borrowings to fund loan growth. Third, more scope.

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SBA lending as a preferred lender continues to be another great complement to our core business model. We began to drive a more intentional model in 2015. Since inception, we have now closed $64 million that we would have missed absent this strategy. As we discussed last quarter, timing of our SBA loan closings delayed our gain on sale to be recognized in this quarter. As such, we have now closed $7.5 million in the first half of the year and have sold $2.5 million for a gain on sale year-to-date, $242,000 while retaining $5 million on our books to drive both non-interest income as well as net interest income higher. We continue to be bullish on two of our growth markets: Columbus, Ohio; and Indianapolis, Indiana. Our lower cost funding continues to be provided by our legacy markets, while loan demand is projected to provide greater asset lift, particularly from these growth markets.

The overarching goal here is to gain market share and expand relationships with clients that can provide not only lending opportunities, but also the expansion of our deposit-gathering initiatives through our treasury management department. Our new corporate sales champion we referenced in prior quarters is singularly focused on expanding the number of services in each of our single-service households. As we discussed in prior quarters, his focus remains on organic initiatives to drive scale on both sides of the balance sheet. Given our expansion in the mortgage business line over the last decade in a number of markets where we are clearly under branched, a number of these clients have a limited relationship beyond the initial mortgage product.

With our expanded ability to service these clients digitally, we intend to continue to drive more scope by adding additional products and services to each household. In fact, to date, we have logged a service per household now of 2.90. Our goal is to add one more service per household in our 36,000 households to drive the depth of our relationship nearer to four, all else being equal. The need for us to provide seamless and digital experience for our clients remains a key objective. We have begun the process of testing a more robust online account opening process, and we continue to make strides to improve our internal CRM usage and utilize the nCino platform to drive efficiency in our lending processes. Clearly, there remains more work to be done to fully realize the potential of our technology gains.

Operating expenses have been on a general downward trend over the last 18 months due to not only our lower volume-driven commission levels that have led to a pullback in revenue, but also our targeted reduction in resources in those business lines. Our total headcount is down over 5% compared to the prior year even with the additions we identified for our client contact center we launched this year and five new MLOs. As a result of our focus on cost containment, we have delivered positive operating leverage for both Q1 and Q2. We expect to continue this positive trend as the balance sheet expands, asset mix normalizes and expenses moderate. Our client contact center was introduced in Q1 and is now, as I mentioned, assisting with client care.

In fact, this group is now fielding approximately 12,000 calls per month. More success on referrals and cross-sells is in the queue as we begin to more effectively embrace the capabilities of our sales force platform. Fifth and final, asset quality. Asset quality continues to reflect strong credit underwriting. Charge-offs were down from the linked quarter to just 22,000. And for the year, our annualized charge-off rate is just 2 basis points. Thus far, the resilience of our clients has been as anticipated as they appear to have managed their exposure to higher interest rates quite well. Tony will discuss the favorable position that we continue to see with our allowance level that now includes coverage of our non-performing loans above 500%.

This industry-leading metric is a direct reflection of our commitment to not only prudent lending practices, but also the measures we took during the pandemic to build our reserve in order to provide greater earnings stability post-COVID. Delinquencies ended the quarter at $2.4 million or just 24 basis points with our less than 90-day delinquencies ending the quarter at just 10 basis points. With client credit bureau scores higher and household debt as a percentage of disposable income lower, all signs point toward continued positive trends in our loan portfolio. At this time, I’d like to ask Tony to give us a little more detail on the quarter. Tony?

Anthony Cosentino: Thanks, Mark, and good morning again, everyone. Again, for the quarter, we had GAAP net income of $3.1 million with EPS of $0.44 per share, which is up 10%. Excluding the servicing recapture from the prior year, core diluted EPS are up 22% as compared to the similar core earnings achieved in the second quarter of 2022. Total operating revenue was up from the linked quarter, but down just slightly as compared to the prior year. And when we exclude the servicing rights recapture from both years, operating revenue would be up 3.3%. Margin revenue was up 2.5% compared to the prior year and for the full-year is up 11.5%. The efficiency of our balance sheet continued to improve in the quarter as our loan-to-deposit ratio rose to 91.9% and total loans to assets increasing to now 73.4%.

Now let’s take a look at the second quarter income statement. On margin for the quarter, net interest margin came in at 3.16%, which is flat as compared to the prior year due to the shift in our earning asset mix and the net negative beta of earning asset yields versus funding. Compared to the linked quarter, the impact of much higher funding costs, as Mark mentioned, could not be overcome by our loan growth and the improvement in those earning asset yields. Cash and securities as a percentage of total assets continued their reduction in the quarter, but they are now just 19.2% of total assets. This compares to 19.9% and 23.4% for the linked and prior year quarters. The shift in mix has benefited interest income as evidenced by the improvement in our earning asset yields.

For the quarter, we had an earning asset yield of 4.61%, up 12 basis points from the linked quarter and up 116 basis points from the prior year. Interest income as a result of balance sheet growth and that yield improvement was $14.4 million, up $582,000 or 4.2% for the linked quarter and up $3.9 million or nearly 38% from the prior year. As we experienced last quarter, funding betas have exceeded earning asset betas from both the linked quarter and the prior year. Deposit costs rose to 1.29% in the quarter, up 35 basis points from the linked and up 109 basis points compared to the prior year. We forecast that these negative betas will continue for the remainder of 2023 based upon the current rate forecast and that we will begin to see stabilization entering 2024.

Fee income as a percentage of average assets improved from the linked quarter to a level of 1.3%. The positives that we have discussed in residential lending were supplemented by better SBA sales volume. As Mark mentioned, we feel that the SBA product is well positioned for the current economic environment. Additionally, we continue to see stable results in our other fee income categories as compared to both the linked and prior year quarters. While GAAP operating revenue is down for the year, when we adjust for the servicing rights recapture, total operating revenue growth on a core basis is actually a positive 2.6% and when we add it to our operating expense reduction is a $1.3 million cumulative pretax change compared to the prior year. Mortgage gain-on-sale yields came in right on the expectations for the quarter at 2.2%, which is still below historical levels, but we anticipate this to be the floor on yields in 2023 and into 2024.

Sales volume improved this quarter nearly 75%, and our pipelines are running in the high 70s of saleable product. We continue to forecast 2023 origination levels to be slightly below our break-even level of approximately $350 million, but we will continue to review resource allocation to preserve profitability. Market value on our mortgage servicing rights stabilized in the quarter with a calculated fair value of 123 basis points, up 12 basis points from the prior year. That servicing rights balance increased compared to the linked quarter at $13.7 million, and remaining temporary impairment was flat at just $137,000. As has been our focus in 2023, total operating expenses were down from the linked quarter by $434,000. And when we look at year-to-date expenses, we are down $549,000 or 2.5%.

This compares to our operating revenue decline for the year of 1.3%. Now let me take a quick look at the balance sheet. Total assets of $1.34 billion were flat to the linked quarter and were up $47.5 million or 3.7% compared to the prior year. We were able to fund the growth in loans by the scheduled amortization of our investment portfolio. And we expect that investment portfolio to continue to decline with that amortization and some prepayments over the next 18 month when we would stabilize the size of the portfolio at that new level. On the funding side, the deposit decline from the linked quarter was replaced by higher borrowings from the Federal Home Loan Bank, albeit at a marginally higher cost. Deposits compared to the prior year were flat, which required a loan growth of 10% to be funded by the investment portfolio runoff and those higher FHLB borrowings.

Our investment portfolio is now down by over 14% compared to the prior year. However, since overall rates are generally flat to a bit higher, prepayments have – as a source of funding have been constrained. Tangible common equity, including the AOCI impairment, declined slightly in the quarter to 7.13%, while tangible book value was stable at $13.81 per share, which includes AOCI. And when we exclude the temporary impairment, tangible common equity rises to 9.63%. Regulatory capital continues to be strong with common equity Tier 1 and total risk-based capital reported at 13.2% and 14.4%, respectively, at the end of the quarter. We continued an aggressive buyback of our shares in the quarter with 91,000 shares repurchased at an average price of $13.67, which is well below the adjusted tangible book value of our shares in the quarter that I just mentioned of $18.65.

Our loan loss allowance improved in the quarter and ended at 1.6% of total loans. Due to the improvement in the economic factors and a reduction in our level of unfunded commitments, our total provision expense for the quarter was just $145,000 net. We were, however, able to add $375,000 to the allowance. And coupled with our low level of charge-offs, the allowance level improved by two basis points compared to the linked quarter. And again, this quarter, we had positive momentum in our classified loans. Our criticized and classified loans now stand at just $8.9 million and are down 5.8% compared to the linked quarter and are down $3.3 million or 27% from the prior year. And quickly, before I turn the call back to Mark, just a quick summary of our year-to-date earnings per share, which while flat to 2022 on a GAAP basis would be up $0.12 or 18% when we exclude the impact of the temporary servicing rights recapture from both years.

Mark, I’ll turn the call back over to you.

Mark Klein: Thanks, Tony. Once again, I want to conclude by acknowledging the dividend announcement that we made this week of $0.13 per share, which equates to approximately 3.8% dividend yield and a 30% payout ratio. We continue to believe that our strong dividend and continued buyback strategy will drive tangible book value improvement and maximize returns to our shareholders. Optimistically, we continue to expect higher performance, one that includes prudent organic balance sheet growth, asset mix corrections, as Tony had mentioned, expense control and a return by us to a more traditional ratio of non-interest income to total revenue at or near that traditional 40% mark, albeit on a marginally slowing economic front. Now I’ll turn it back over to Sarah for questions. Sarah?

Sarah Mekus: Thank you. We’re now ready for our first question.

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Q&A Session

Operator: Ladies and gentlemen at this time, we will begin the question-and-answer session. [Operator Instructions] Our first question today comes from Brian Martin from Janney. Please go ahead with your question.

Brian Martin: Hey, good morning everyone.

Mark Klein: Good morning, Brian.

Anthony Cosentino: Hi, Brian.

Brian Martin: Hey. Just maybe a couple of things I just going to touch on. It sounds like the loan outlook or growth sounds like the pipeline is pretty healthy and maybe some people pulling back in the market. Just kind of want to confirm just kind of how you guys are thinking about loan growth. Just I mean, hearing that’s positive, a lot of people with rates being up seem like there’s some activity slowing a bit. So just trying to understand the loan growth. And then just, Tony, you talked about funding the loan growth. Just trying to understand, in the past, you’ve been kind of relying on some of those securities portfolio runoff. You had some borrowings increase this quarter. Just want to understand if the loan growth you do have, how you’re thinking about funding it here in the near term.

Mark Klein: Yes. Hey Brian. Just a quick comment. Steve Walz is here, our Chief Lending Officer. But from my seat, as you heard, we’re making tons of calls. And we all agreed when we made the presentation of the 2023 budget to our Board that it’s going to take twice as much work to get half as far. And I think our commitment to outwork the competition is somewhat evident in that $60 million pipeline. But Steve Walz is here, and he can kind of give us a little more color on where that’s coming from, Steve, and what you see in the next two, three months.

Steven Walz: Sure. Thanks, Mark. Good morning, Brian. Yes, we saw definitely some acceleration of our pipeline from the first half. Some of the looks we saw in the first half, a lot of – some investment CRE that given our commitment to asset quality didn’t appeal to us. We are seeing some improvement not only in the volume of our pipeline but in the credit quality. And I think, Brian, some of that is due – well, a few factors. Certainly recent economic indicators show some increasing confidence from borrowers, consumers as well as businesses that take care of them. So we’re seeing more broad activity, but I think also, as Mark mentioned earlier, some of the competition is pulling back. I think they have probably liquidity concerns that aren’t quite the concern they are for us and allow us to perhaps pick up some new clients in the marketplace.

So we’re seeing some opportunities from competitors as well driving that. And as Mark mentioned, we saw some softness in our rural ag markets due to the strong earnings of our farm community, which is great for asset quality but hasn’t resulted in as much borrowing from them. So that’s kind of the picture.

Anthony Cosentino: And then a couple I think on that, Brian, you asked about funding. I think that still continues to be a challenge. And I do think, as Mark said, we’re being a little bit more selective on what we’re looking at. But I think we’re willing to take a piece or two off of our margin that we’ve been accustomed to in the past for good quality credits. Because we know most of our funding is now coming kind of at that 4.25% to 5% range on the margin. We’ve done okay on relationships. We certainly could do better at any time, but that’s certainly kind of the bottom line. I think you’re still able to generate a fair amount of funding dollars, call it, 100 basis points below the wholesale market. If you want to do that, the risk, obviously, is your current book of business and how you manage that, which thus far, we feel like we’ve done a pretty good job.