Stellar Bancorp, Inc.

Greetings and welcome to the Stellar Bancorp third quarter earnings release conference call. At this time, all participants are in listen-only mode. A brief question and answer session will follow after the formal presentation. If you would like to ask a question at that time, please press star followed by number one on your telephone keypad. Thank you. I will now turn the call over to Courtney Theriault Chief Accounting Officer, you may now begin.

Thank you, operators, and thank you to all who have joined our call today. Good morning. Our team would like to welcome you to our earnings call for the third quarter of 2024. This morning's earnings call will be led by our CEO, Bob Franklin, and CFO, Paul Ege. Also in attendance today are Steve Redfloss, 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 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 statement, except as may be 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.stellerbankcorpinc.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 will now turn the call over to our CEO, Bob Franklin.

Yeah, thank you, Courtney. And welcome to the Stellar Bancorp third quarter earnings call. I begin by thanking our team for the great work they're doing every day to build our brand and to continue to provide the great service our bank is known for in our markets. As we pass our second anniversary of Stellar Bancorp, we are proud of our progress toward building a strong infrastructure needed to cross the $10 billion mark, and our focus on capital, liquidity, and credit. We have de-risked our balance sheet by significantly increasing our liquidity, reducing our CRE concentrations, and building capital. We believe that we have provided the bank maximum optionality and are well positioned for the future. Soon we will have the stress of the presidential election behind us, and it appears that interest rates are attempting to normalize. Combined with the strong markets we serve, the runway for 2025 appears to be good. We will be approaching the market with a more balanced lending philosophy, and we will continue to build strong relationships to support both sides of the balance sheet. Our capital base is strong and allows us optionality. Top of mind will always be safety and organic growth, With respect to M&A, we will continue our efforts to look at well-balanced franchises that will help us grow our bank with an emphasis on funding profiles. We will also weigh our opportunities to buy back our stock, increase our dividends, or pay down subordinated debt in an effort to return excess capital to shareholders. The markets we serve are some of the best in the country, and we are well positioned to succeed in these markets in the coming years. I'll now turn over the call to Paul Ege, our CFO, for more detail on the quarter.

Thanks, Bob, and good morning, everybody. We are pleased to report third quarter net income of $33.9 million, or 63 cents per diluted share, which represents an annualized ROAA of 1.27%, and an annualized ROATCE of 13.63%. This compares with second quarter earnings of $29.8 million, or 56 cents per diluted share, which signified a ROAA of 1.13% and a return on average tangible common equity of 12.82%. A key driver of our performance in the third quarter was an approximate $6 million reversal of provision for credit losses on loans primarily due to a decrease in the specific allowance related to individually evaluated loans, thanks to significantly lower non-performing loans and, to a lesser extent, lower loan balances. While net charge-offs were elevated in the third quarter, totaling $3.9 million, more than 88% of the charge-offs had been previously specifically reserved for. Setting aside the provision reversal, We feel very good about our quarter-over-quarter progress in our core pre-tax, pre-provision earnings power, largely due to improvement in our net interest margin, excluding purchase accounting adjustments. We are very pleased with our ability to protect our earnings power over this rate cycle while de-risking the balance sheet, bringing our CRE and CND rate concentrations solidly within regulatory guidance, and lowering our loan deposit ratio from approximately 92% a year ago to about 86% at the most recent quarter end. Not to mention, all while managing the increased expense associated with crossing the $10 billion asset threshold. Net interest income for the quarter was $101.5 million, representing a slight increase from the $101.4 million booked in the second quarter of 2024. This translated into a net interest margin of 4.19% in the third quarter, relative to 4.24% in the second quarter of 2024. Purchase accounting accretion in the third quarter was $6.8 million relative to $10.1 million in the prior quarter. Excluding this purchase accounting accretion, net interest income increased in the quarter about $3.4 million to $94.8 million from $91.4 million in the prior quarter. and net interest margin was 3.91%, up from 3.82% in the prior quarter. Key drivers to the margin performance in the third quarter included stability in our non-interest bearing deposit portfolio, representing about 38% of our deposit base, a three basis point improvement in our cost of funds, driven by a five basis point improvement in our cost of interest bearing liabilities, higher securities yield, and higher loan yields after excluding purchase accounting accretion, offsetting those lower loan balances. Walking further down the income statement, we booked the aforementioned $6 million reversal of provision for credit losses on loans in the third quarter. In combination with the net charge-offs during the quarter, this brings our allowance for credit losses on loans to $84.5 million, or 1.12% of loans. from $94.8 million or 1.23% of loans at the end of the second quarter. That said, since NPLs decreased nearly 37% from $50.9 million to $32.1 million during the third quarter, we ended the quarter with an allowance coverage ratio to non-performing loans of 262.9% from 186.2% at the end of the second quarter. Moving on to non-interest income, we earned $6.3 million for the quarter versus $5.4 million in the second quarter. I'll note that the current quarter benefited from $1.3 million of SEIC income and a small gain on asset sales. Last, non-interest expense for the quarter was $71.1 million, down slightly from the $71.2 million in non-interest expense from the second quarter. Excluding some non-recurring items such as severance and certain other items, non-interest expense was roughly in line with our expectations. Our strong bottom line results have driven a continuation of our track record of growing our regulatory capital ratios since the merger. Total risk-based capital was 15.91% at the end of the third quarter relative to 14.02% at the end of 2023 and 12.39% at the end of 2022. This progress has been consistent across all regulatory capital ratios and is reflective of our tangible book value growth since closing the merger, thanks to a relatively strong earnings profile, notwithstanding accelerated amortization of CDI expense. Since our first quarter end post-merger at the end of 2022, we have grown tangible book value per share by 37.5% from $14.02 per share to $19.28 per share after dividends, representing a compound annual growth rate of 20%. We continue to like our prospects for strong internal capital generation and the optionality it creates, which we feel is very valuable in the current operating environment. During the third quarter, we started to repurchase shares for the first time since the merger, buying back 108,000 shares at an average price of $26.10 under our repurchase program. While on the topic of capital, we also intend to redeem the $40 million of bank-level subdebt that we have on our books in December. So given cumulative industry pressures and our position at just over $10 billion in assets, We feel very good about our balance sheet and earnings power relative to the industry, our positioning for future organic and inorganic growth opportunities, and the potential for meaningful operating leverage when we add more scale to the Stellar Bank platform. Texas, and more specifically our markets within Texas, continue to exhibit strength relative to the rest of the country. We feel the combination of the economic strength and resilience of our core markets And our home field advantage as the largest locally focused banks in the market we serve will sustain growth and success into 2025 and beyond. Thank you, and I will now turn the call back over to Bob.

Yeah, thanks, Paul. Operator, I think we're ready for questions, please.

Thank you. We are now opening the floor for question and answer session. If you'd like to ask a question, please press star 1 on your telephone keypad. Our first question comes from David Feaster from Raymond James. Your line is now open.

Hey, good morning, everybody. Morning, David. I wanted to start on the loan side and dig into some of the dynamics that you're seeing there. Obviously, loans decline more than expected, but I wanted to get a sense of the drivers of that. How much that's less appetite for growth and strategic declines in CRE or more of a function of, of weaker demand and continued payoffs and paydowns. Just kind of curious what you saw in the quarter, the pulse of your clients, and just how you think about growth near term as we head into 2025.

David, I think you touched on all of it. Particular to the third quarter, we originated about a little in excess of $300 million for the quarter, which was $50 million more than the second quarter. So we were pleased with that number. Um, it didn't fund up to a level, um, you know, uh, pro rata as the previous quarter. So we have, we'll probably get a little lift there in future quarters from that. And then our payoffs, um, actually were a little bit, a little bit less. So we had payoffs of 230 million in the quarter. Um, and then what we call it, I think, you know, our waterfall, but what we call our carried, which is our, um, advances compared to our payments, um, that because of our posture around, um, construction development. For the last few quarters, we're starting to see that to be actually a negative to loan growth. So now our payments are exceeding our advances because of that posture around C&B. I think our track record now in that $300 million, we feel good about that and think that we're really positioned for when we see some increased demand and the economy lessens. Our team, we have a track record of being able to originate more than that to get some get some growth and we're ready for that.

Yeah, David, I think from our standpoint, when we put the two banks together, we look very much like two community banks coming together. And I think there was a reason for us to reformulate our loan portfolio into something that looked more like a larger bank. And the market actually gave us that opportunity to do that. I think we've sort of repositioned ourselves And we've hired some really nice C&I people to help us sort of balance out what that portfolio looks like going forward. But we feel really good about what our position is today about making loans. That's great.

And then maybe on the other side of the coin, too, I mean, it's been pretty impressive what you've done on the funding cost side. And it seems like the benefit of some of those hires are coming to fruition. But I'm just curious, what are you seeing on the deposit front? You were able to reduce deposit costs even ahead of Fed cuts. I'm just curious, how's reception been from clients thus far as you start reducing rates? How do you think about the deposit outlook just in general as rates start coming down and your ability to reprice those lower?

On the customer, how we feel around the customer sentiment, third quarter was the largest of the last three quarters as far as dollar amount of opened accounts. Real pleased with that. Came on at a lower rate than the previous quarter, so that's good, too. And, you know, the NIV mix of those new accounts support where we have on the whole as far as our NIV balance. So all those are encouraging.

Yeah, and we really feel good about how our deposit costs have played out through this cycle. We've been able to exhibit a high level of discipline. And what you saw in the third quarter was reflective of that, definitely reflective of letting wholesale funds roll off incrementally and then otherwise just good core execution that we think has possession potential to bear fruit in the future, but it takes time.

Okay. And then, you know, I just wanted to get us into the margin trajectory as we look forward, you know, inclusive of Fed cuts. I mean, the core NIM was, you know, expansion was better than we had expected. And it's, again, great to see the decline in deposit costs ahead of the cuts. But obviously, there's a lot of moving parts, right? You got the sub-debt redemption, too, that's going to help. But just wanted to get a sense of the margin trajectory as we look forward, assuming more cuts are on the horizon.

Certainly. We feel pretty good about where our margin sits. There are a lot of moving parts. So we know that we're going to be able to defend it very well. It's all going to be about execution. Now, late in the quarter is when we'll redeem that sub-debt, which obviously will be a positive. But early in this quarter, we had a sub-debt issuance that went variable. So you really hit the nail on the head as it relates to there being a lot of moving parts But we're very comfortable about where we sit, and especially we feel like if and when we get rate cuts, we'll take what the market gives us in terms of that front-end exposure of deposits, taking away a little bit of that pressure on costs. And, of course, we tend to invest all across the curve, and we think that has long-term benefits. It's hard to give great guidance as to where it's going to be in the next three months, in the next six months with all the moving parts, but actually we feel we're in a great position to defend it. And depending on how loan growth and other factors play out, perhaps even improve it.

Okay. That's helpful. Thank you.

Your next question comes from Matt Olney from Stephens. Your line is now open.

Hey, good morning. Thanks for taking the question, guys. I want to go back to the loan growth discussion, and it sounds like there's still some uncertainty maybe in the near term in the fourth quarter. Just looking for more color on the borrower sentiment and kind of what borrowers are saying. And then as we think about 2025, you know, I'm curious if we think we can get back to that mid-single-digit pace that we've talked about previously and are more more normal kind of macro economy? Is that a reasonable goal, especially as you kind of layer in some of these new CNI producers as they gain more traction? Thanks.

Yeah, Matt, I think that is what we're focused on. But, you know, I think that we're still want to see the smoke clear on the election and really more around this inflation rate and where rates are going to go. Our markets are still pretty good. I wouldn't say that loan demand is huge. It's good. It's still, you know, Houston still provides, and our markets, other markets also still provide good places for us to make loans. But, you know, our goal would be to get back to that mid-single digit, and that's what we're shooting for next year if we're given the proper market to do it in. So that's kind of what our thoughts are.

Okay. Appreciate that, Bob. And then I guess switching gears on the expense side, I know there were some non-core items this year. I think we've been targeting about $280 million for the full year, but it looks like we're trending a little bit above that. Just any updated thoughts on expense levels from here?

Certainly. That $70 million quarterly run rate is what we target. And unfortunately, There tends to be noise, and we had some noise in seasonality in all our quarters year-to-date, generally trending more at that $71 million run rate. We are working as hard as we can to position the bank well from an infrastructure standpoint and really hold the line on that expense growth. So yes, we've had some items that have had us running about $1 million above of our $70 million target, but we're still doing our best to hold the line, and we see fourth-quarter expenses, we're going to be targeting that same level and managing it along those lines.

Okay. Okay. That's great, Paul. Thanks for the color. Thanks for that.

Your next question comes from Andrew Gorjica from Piper Sandler. Your line is now open.

Hey, good morning, everyone. Good morning. I just had a couple questions, one on the purchase accounting accretion, just looking for what you guys expect that to be going forward, kind of more in 2025. It should be waning.

In the fourth quarter, we expect around $7 million, and we'll see it kind of trail off now. Recognition of purchase accounting accretion income has been hard to predict with paydowns and the waxing and waning of that. So I'd expect a run rate that starts to decay from that $7 million that we expect in the fourth quarter. We still have a remaining loan discount of $81 million, and that will be extinguished over time. And I think you can assume that it will continue to decay and also be subject to some lumpiness.

Okay. Sounds good. Thank you for the details. That's helpful. And then just the other one I had really quick, you guys mentioned earlier, as far as M&A goes, looking at some targets that maybe have a better funding profile. Just was curious if you had any other commentary around M&A, if conversations are picking up, and if we get an administration change here in November, if that affects anything going forward.

I don't know if the administration change really changes it very much, but we're certainly hanging around the hoop on a lot of different fronts around M&A, and it's really finding the right partner for us. We do think there's a need for us to kind of get away from this between $10 and $11 billion to help us with some of the expense level that we have, but we want to make sure we do the right thing when we do it and find the right partner. we're having a lot of conversations with a lot of different banks, whether they're private or public, and that's kind of how we're approaching the deal. We have several folks that we really like out there that are doing a good job, but we'll see where that takes us. You can't really necessarily judge timing on that. A lot of it has to do with when somebody wants to come to market.

Got it. Thank you. Thanks for taking the questions and congrats on the quarter. Thank you.

If you'd like to ask a question, please press star 1 on your telephone keypad. That's star 1 on your telephone keypad. Our next question comes from Matt Olney from Stephens. Your line is now open.

Hey, guys. Thanks for taking the follow-up. Just want to hit on the securities portfolio. another big quarter of growth there. Just curious on, I guess, a few things. One, just remind us, are you targeting any certain size of that portfolio, or is that just a temporary kind of placeholder in the absence of loan growth? And then two, just update thoughts on duration. Are you considering any kind of duration at this point?

Certainly. Well, a big push early on was to get ourselves to a minimum of 15% of our balance sheet. And we consider even increasing that because we believe in the value of a good strong balance sheet and good liquidity profile. We have a great cash flowing securities portfolio. We, in the next 24 months, projected to bring in 30% of that back in cash flows. Our current adjusted duration, effective duration is about three and a half years. And we have about $300 million in principal cash flows that we expect just in the next 12 months. So we definitely value the norm, look forward to and will value the normalization of the yield curve and the ability to choose our spot as it relates to duration to optimize our earnings profile, notwithstanding having a higher proportion of securities on our balance sheet.

Okay. Okay. Thanks for that, Paul. And then I guess on the credit side, a little higher charge-offs, but non-accrual loans move lower. Any more color on the credits you addressed this quarter? I know there was some deterioration earlier this year with a few, I think there were a few smaller C&I credits that you PISA non-accrual status. Were these the credits addressed in the third quarter? Just looking for any color there.

Yeah, Matt. We did have some increase in NPLs throughout the balance of the year and what happened in the third quarter was that we had some favorable things happen where we were working toward some resolution on those and that all kind of came into focus and occurred in Q3. We had payoffs as well as significant paydowns in that group.

Okay. And I guess anything beyond that as you look at classified list, watch list, any other notable migrations to call out in recent months?

Not so much. We've seen some increase in our loans that we have risk graded special mention. as we've taken a really hard look at loans in the portfolio, and so we have a little bit of an increase in the special mention loans compared to previous times. But I think what you'll see is that we're working hard on a resolution of problem credits, and so we're also keeping a really clear eye toward the cash flows that support the credits, and so if we see some diminution in cash flow, we'll we'll grade the loan appropriately.

Okay. Thanks, guys. Appreciate your help. Thanks, Matt.

Your next question comes from Katherine Miller from KBW. Your line is now open.

Thanks. Good morning, everyone.

Good morning, Katherine.

I want just to follow up on the margin and see if you could just give us a little bit more commentary on your expectations for I know you've said previously that you've got about 20% truly floating, 40% variable, 40% fixed. And so, just if you could kind of talk us through those three buckets and the repricing opportunity just to kind of give us a sense to where you think loan yields are going. Thanks.

Well, let me kind of correct a little bit. We're about 55% fixed. and about 45% variable, and that variable is what's split amongst kind of pure floating and otherwise. But you still have... Say that again?

What's the truly floating again?

The truly floating is, I think, about 20% of that variable number. Pardon me, 20% of the total to 40% or 50% of the variable number.

20% of the total number.

Yeah.

Got it. Okay, that's what we had. Okay, great.

But what you see is the fixed rate loans are about 5.59%, which still represents a northward repricing opportunity. And the variable rate loans are sitting spot at 7.07%. And Ray can give a little bit of guidance on how the loans that were originating are coming onto the books. But we feel like our spot levels have at least some room for improvement as the fixed rate loans pay down or pay off and reprice higher. And Ray, why don't you share some details?

Yeah, Catherine. So on the $300 million of new loans that we originated, weighted average rate was $758 on those loans. And in the quarter, we also renewed another $750 million of loans. that renewed at 847. So between the 750 and the 300, call it a billion in the quarter that received the market rate.

Okay, great. And then mostly of that 20% floating, is that mostly tied to SOFR?

Prime and SOFR. Prime and SOFR.

That combined, okay. Okay, great. Okay, so still significant upward repricing opportunity that feels like. And then on the funding side, you mentioned that you still had a large amount of new deposit accounts come in this quarter. Do you have the kind of average pricing of what that looks like?

Yeah, that all in, that came on at 297, which was about a little bit more than 40 basis point improvement from the prior quarter of our new onboarded deposit accounts.

Okay, great. So then all in the NIMS, Even with fed cuts, it feels like you can keep that core NIM fairly stable, just given the kind of balance between those two things. And maybe even up a little bit, Paul, you were saying.

We want to set expectations appropriately. We feel really good about our ability to defend NIM and that there's potential for upside. There's a lot of moving parts, but we've got great confidence in our ability to maintain really strong NIMs.

Got it. Okay. Great. That additional caller is helpful. Thank you very much.

Thanks, Catherine.

Thank you. I'd now like to hand back over to Bob Franklin for further remarks.

Thank you very much for attending and your interest in Stellar Bank Corp. With that, we'll conclude our call. Thank you.

Thank you for attending today's call. You may now disconnect. Have a wonderful day.