Stellar Bancorp, Inc. (NASDAQ:STEL) Q4 2022 Earnings Call Transcript

Stellar Bancorp, Inc. (NASDAQ:STEL) Q4 2022 Earnings Call Transcript January 27, 2023

Operator: Good day and thank you for standing by. Welcome to the Stellar Bancorp Inc. Fourth Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question and answer session. Please be advised today’s conference is being recorded. I would now like to hand the conference over to your speaker today to Courtney Theriot, Chief Accounting Officer of Stellar Bank. Please go ahead.

Courtney Theriot: Good morning and thank you to all who have joined our call today. We would like to welcome you to our earnings call for the fourth quarter of 2022. This morning’s earnings call will be led by Stellar’s CEO Bob Franklin and CFO Paul Egge. Also in attendance today are Steve Retzloff, Executive Chairman of the company; Ray Vitulli, President of the company and CEO of the Bank and Joe West, Senior Executive Vice President and Chief Executive Credit Officer of the Bank. Before we begin, I need to remind everyone that some of the remarks made today constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as amended. We intend all such statements to be covered by the Safe Harbor provisions for forward-looking statements contained in the act.

Also note that if we give guidance about future results, that guidance is only a reflection of management’s beliefs at the time the statement is made and such beliefs are subject to change. We disclaim any obligation to publicly update any forward-looking statements, except as maybe required by law. Please see the last page of the text in this morning’s earnings release, which is available on our website at ir.stellarbancorpinc.com for additional information about the risk factors associated with forward-looking statements. At the conclusion of our remarks, we will open the line and allow time for questions. I now turn the call over to our CEO, Bob Franklin.

Robert Franklin: Thank you, Courtney, and good morning. Welcome to Stellar Bank Corp’s fourth quarter earnings call and our first ever combined organization. I will begin by thanking our dedicated staff that is working tirelessly to make Stellar Bank an outstanding organization. This is an all bank team effort and our team is responding to the challenge. We are divided by two operating systems, but we are fully engaged in supporting a successful system integration in February of 2023. Completion of this conversion is an important step in solidifying the combination of our two banks. The fourth quarter provides us with a first look at both our balance sheet adjusted for purchase accounting with market valuations and our income statement, which will provide insight into the expenses associated with our merger along with day 2 provisions.

The fourth quarter is one dominated by purchase accounting adjustments, and merger related expenses. Our goal today is to help guide the reader of our financials to a core franchise and reveal the core earnings power created by our combination. We have also been proactive in our decision making, given the current interest rate environment and the economic environment. Throughout the fourth quarter, we look to make business decisions that best fit our current focus on liquidity, capital and credit. First of all, we took care to make proper reserves as we turn into a more challenging economic environment. Secondly, we sold some of our challenge credits, or more challenge credits, which would have been longer term workouts with uncertain outcomes, opting for certainty, which decreased our classified credits allowed and allowed us to realize great values greater than our indicated marks.

And having to mark to market the CBTX securities portfolio for the transaction, net we own the securities today at market value. We felt that an opportune time to sell some of those securities and bolster our liquidity. Later, Paul and the team will provide more detail to aid and understanding the changes to our financials. Regulatory approval was a key factor in the timing of our closing between announcement and final approval, the interest rate environment changed significantly by the Federal Reserve increasing interest rates at a very rapid pace. Therefore, the purchase marks that were affected by interest rates have been a moving target. Today, a majority of that work is done. And we have had a chance to review the results. We have never been more bullish on the long term success of this financial combination.

Our ability to deliver for our constituencies, our shareholders, our customers, our employees, and our communities in which we operate has never been better. However, in the near term, we cannot ignore the actions of the Federal Reserve is taking to slow our economy and contain inflation. We know from lessons learned in previous cycles to be cautious. The end of this interest rate cycle remains unclear, but we will be vigilant as to the effects on our customers and our operating economic environment. We will stay disciplined and managing our capital, our liquidity and the credit in our bank as we continue to build Stellar Bank. Our franchise resides in one of the most robust economies of the country. Our long-term future is bright, and we will stay determined to increase shareholder value.

Our belief is that Stellar Bank is well positioned to deliver on that promise. I will now turn the call over to Paul Egge

Paul Egge: Thanks Rob. Good morning, everybody. We are very pleased to be reporting our first quarter as a combined company as our merger went effective on the first day of October. For accounting and financial reporting purposes, all of our filings contain comparative information relative to Legacy ABTX financial results with historical shares and per share numbers adjusted for the reverse merger. But given the transformative nature of the merger to create Stellar, I will focus my commentary on the year now of Stellar. Thinking to what we believe are the most salient takeaways from our combined financial condition at the end of 2022, our Q4 operating performance and what it all means for our outlook. Then I’ll turn the call back to Bob and he’ll open it up for questions.

Before diving in, I’ll note that while I won’t be directly referencing the accompanying investor presentation, there’s a good amount of detail included in the presentation regarding merger accounting adjustments, non-GAAP items, and other information. So I’ll start with our financial condition, which reflects the impact from purchase accounting and the strategies we executed in the fourth quarter. We ended the year with $10.9 billion in assets after accounting for the merger and results of operations for the quarter. As we previewed on our third quarter call, the fair value purchase accounting adjustments were meaningful given where the yield curve was at the effective time of the merger. The impact of losses in the securities portfolio to equity were already accounted for in AOCI, amounting to $69.8 million after tax.

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But the impact of bringing the CBTX loan portfolio over at fair value was even more significant as the fair value mark in the loan portfolio totaled $156.4 million and was mostly interest rate related. The combination of these items led to more goodwill resulting from the merger, incrementally impacting capital in tangible book value per share. Going forward will effectively earn that loan mark back through pretty significant purchase counting increasing the loan yield over the life of the acquired land. The next most significant merger accounting adjustment was the $138.1 million core deposit intangible created in the merger. This totaled of approximately 3.97% of core deposits, which is relatively high and reflective of the nature of the yield curve at 930 and the high quality composition of the CBTX deposit franchise.

The resulting CDI will be amortized on an accelerated basis over 10 years using some of year’s digits method. And this expense represents a partial offset to the beneficial dynamic of purchase accounting increasing revenue from the loan mart. The last significant merger related item I’ll note is the Day 2 provision of loan losses for non-PCD loans under CECL, which totaled $28.2 million, along with a $5 million Day 2 provision for unfunded commitments on loans running through the income statement. We also bought over $7.5 million in allowance for credit losses on PCD lands, which did not run through the income statement. — I progress during the quarter, we ended the quarter with $7.75 billion in loans, which after adjusting for the previously mentioned merger related fair value marked on loan reflects an increase in loans over the quarter of around $200 million.

This represents what we feel like is an appropriate deceleration of loan growth from prior quarters given current market dynamics. During the quarter, we saw deposits decrease $116.9 million in the quarter from a combined $9.38 billion at $9 30 to $9.27 billion at the end of 2022. $100.7 million of this decrease came by way of interest bearing deposits. Even though we saw an incremental increase in noninterest-bearing deposits totaling $16 million, we feel great about our deposit composition with 45.6% of our deposits being transactional, noninterest-bearing deposits. The cost of our interest bearing deposits has continued to increase reflective of current industry markets and a fiercely competitive deposit market. So we feel very good about how we’ve been able to manage these dynamics, relatively speaking.

Strategically we’re really pleased with our balance sheet positioning going into 2023, particularly considering our loan deposit ratio of 83.7% solid capital levels and a strong quarter earnings power to support a healthy go-forward capital bill. Failing the earnings, our fourth quarter results were noisy. Our bottom line is $2.1 million in net income translating to $0.04 in EPS. These headline numbers were impacted significantly by merger related and non-recurring items, which obscure the continuation of many positive operating trends both ABTX and CBTX brought into the Stellar combination. First, net interest income and net interest margin were extremely strong. Thanks in part, to purchase counting increasing the loan yields. But even after adjusting for this, we’re very proud of our revenue profile, notwithstanding market dynamics driving cost of funds upward.

Headline NIM was 4.71% and after excluding for scanning accretion, adjusted net interest margin was 4.38%. Purchase counting accretion with $8.2 million in the quarter. The future recognition of purchase accounting accretion will be driven by scheduled and non-scheduled paydown behavior in the acquired portfolio. Our current expectations are for 2023 would be to recognize between $26 million and $30 million of purchase accounting accretion income into yield. This will be partially driven by our expectation that fewer lower yielding loans will pay down early in the current interest rate environment. Walking down the income statement, it’s hard not to notice that outside provision for loan losses in the quarter totaling $44.8 million. We hit on this in the merger accounting discussion.

But it’s important to note that after excluding that pay to PCD provision of $28.2 million on non-PCD loans, and $5 million on provision for unfunded commitments, our quarterly provisioning amounted to $11.6 million, reflective of our more conservative view on credit given an increasing economic uncertainty, loan growth and changes in specific reserves. The total allowance for credit losses ended the year at $93.2 million, or 1.2% of loans. Before moving on, I should note that we did have a higher than usual net charge-off number during the quarter, totaling $5.7 million, of which $4.6 million related to the proactive sale of $35.4 million in month. These most of these loans came over with meaningful marks such that the actual sale netted again, despite the charge-off.

This is a good segway into our non-interest income, which was also bolstered by these gains and other gains totaling $4 million. $1.9 million related to the loan sale we just mentioned, about $1 million came from the sale branch assets. And the remainder came from that strategic sale in October of more than $350 million and acquired securities to support our liquidity profile. And we — Bob mentioned this and we discussed this on our prior earnings call. Moving on to non-interest expense. This is elevated in the quarter due to the recognition of $11.5 million in merger related expenses in the introduction of merger CDI amortization into our expense base, which totaled $6.3 million for the quarter. During 2023 scheduled CDI amortization expense from the merger will total $24.5 million in addition to the $2.3 million in scheduled CDI amortization from prior deals.

Holding aside the M&A expense noise in the introduction of CDI amortization expense, we feel very good about our core operating expenses in the fourth quarter, a result of both negative ABTX and CBTX doing an exceptional job holding the line on non-interest expenses in an otherwise very inflationary environment. And we’re proud of being able to do this without hindering growth since the merger analysis. From an overall performance standpoint, when you after excluding merger related expenses, and non-recurring, the non-recurring gains, purchase accounting accretion and that CDI amortization, we feel very good about where we set the bar for our adjusted pretax, pre-provision earnings power in the fourth quarter at Stellar — at $53 million. This represents 1.92% of average assets.

We believe this strong core operating earnings power will drive rapid capital builds. And once the non-recurring merger noise subsides, the remaining merger related accounting items will be additive to our core operating earnings power, since we expect merger related purchase accounting accretion to exceed the amortization of CDI trades in the merger. In summary, we feel pretty good about our combined positioning on earnings, liquidity, capital and credit, which we know will prepare us for a wide range of economic scenarios. As we look into 2023 and beyond, we are hyper focused on maintaining the absolute and relative financial and strategic gains from our merger. We feel well positioned to advance and advance our business, notwithstanding the potential challenges 2023 can bring.

Thank you. And I will now turn the call back over to Bob.

Robert Franklin: Thanks, Paul. And we’ll be happy to answer some questions around trying to help folks get through this kind of noisy quarter. So, operator, we’re ready for questions.

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Q&A Session

Operator: And our first question comes from the line of David Feaster with Raymond James. Your line is open. Please go ahead.

David Feaster: Hey, good morning, everybody. I just wanted to just start maybe, with if you could just give us some color on the economic backdrop in Houston. Obviously, the economy’s strong, but I was hoping you could kind of give us a pulse from your perspective on your client, how demand for loans is trending? And then also your appetite for credit. I mean, obviously, the economic backdrop is a bit uncertain. So where are you seeing? Where are you still seeing good risk adjusted returns? And ultimately, how do you think about loan growth for this year?

Ray Vitulli: David, I’ll start on that. This is Ray. On the — the economic background in Houston is still strong. We had — don’t have full 22 job numbers in yet. But that’s expected to be somewhere around 150,000 and job growth for the year, which is a strong year. And, maybe tapered down a little bit in December. But there’s still, that looks good. Our pipeline going into the fourth quarter, we knew was a little was less than the prior quarter. And that really manifested itself through less originations in the fourth quarter, but still really strong. Think about it, we presented about a billion in the third quarter and on a combined basis. And then about 850 or so in the fourth quarter. So kind of that knowing that the demand had tapered just a little bit in our pipeline, it did manifest that way and originations.

I think I’ll let Bob talk about kind of how we’ve, that’s kind of the message around our approach to lending, given the uncertainties in the economic environment. But, but overall, we still have a healthy pipeline, even as we think about 2023. And think about our loan growth in 23, even all of that probably still in the low to mid-single digits, but turn it over to Bob.

Robert Franklin: Yes, David, I think what we’re trying to adjust to as well, what may happen in the future, which is for us is uncertainty, nobody likes uncertainty. I think we need to be in front of this stuff. So we’re, we’re enhancing our credit underwriting, making sure that we get to do the right things. And it slows things down a bit. But also in these rising interest rate environments, we see these cycles where at first, these rise — the rising interest rates are sort of ignored, customers continue to buy at low cap rates, and then they start to find it’s very difficult to get things finance, at the rates that they are trying to buy the assets. So you start to see cycles of really repricing of those assets. So then we get to the point where people are hesitant, because now there’s a lot of talk about when the rate is going to come back down again.

So you give people I’m going to hold off on my project until maybe rates come down, I don’t want to borrow at 8%. So there’s a lot of we’re in that phase where there’s a lot of uncertainty. And so we want to be cautious around that as we move through the cycle, but we still have a decent pipeline. It’s not as robust as what we had and in 2022, but we have some pretty substantial loan growth in 2022. So we think we do believe the Fed, we think the Fed is going to continue on to possibly have rates around that five and a quarter number. And so we have to be prepared for the effects of that. So we’re watching our portfolio and watching what we put on.