STEL - NASDAQ

Good day, and thank you for standing by. Welcome to the Stellar Bancorp Inc. Third 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. [Operator Instructions] Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your first speaker today to Courtney Theriot, EVP and Chief Accounting Officer of Stellar Bank. Please go ahead.

Thank you, operator and thank you to all who have joined our call today. Good morning. I am Courtney Theriot the Chief Accounting Officer of Stellar Bank and I would like to welcome you to the Stellar Bancorp Inc. earnings call for the third quarter of 2022. This morning’s earnings call will be led by Bob Franklin, the CEO of the company. Also in attendance will be Steve Retzloff, Executive Chairman of the company; Ray Vitulli, President of the company and CEO of Stellar Bank; Paul Egge, Senior Executive Vice President and CFO of the company and Stellar Bank and Joe West, Senior Executive Vice President and Chief Executive Credit Officer of Stellar 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.

Thank you, Courtney, and good morning, to everyone. First and foremost, I’d like to welcome the entire ABTX and CBTX teams to the Stellar family. It took a little longer than we initially planned, but we are so pleased to have completed our merger so that we can finally be one organization. I’d like to personally thank Steve Retzloff and Ray Vitulli for their constant support and partnership as we work together to unite these two great organizations to support our vision. I also want to thank the great teams of both organizations that have performed admirably as we have awaited this transition. We are beginning our journey as Stellar Bancorp, but until we complete our core system integration in the first quarter of 2023, we will continue to conduct business as Allegiance Bank and Community Bank of Texas, a division of Allegiance Bank. That said, we cannot wait to open our doors as Stellar Bank. We will release our brand to the market over the next few months as we get closer to conversion to allow our customer banks to begin to become familiar with our brand. Our first priority is making sure that all of our stakeholders are comfortable with the merger. We are mindful of maintaining our great team, our incredible customer base and assuring our community partners that we will be there to provide a great same grace support that both banks are known for in the market. We believe there is great power in the combined franchise. Stellar Bank is well positioned as we take our place in the top tier of banks in our market. We will also be uniquely positioned as the largest locally owned locally headquartered bank in our market. We are and will remain a true community bank taking local deposits and lending those deposits back into our local communities. Today we are reporting our last quarter as standalone CBTX and ABTX. Our goal is to give you some context around the two banks’ third quarters before merger close and to begin to show the earning power gained by combining these two organizations together. I will focus my remaining commentary on the current operating environment and our strategic priorities. It has been repeated many times, down 5%. The Federal Reserve is making very clear their intentions to curb inflation by any means necessary creating a unique and unprecedented market backdrop. So while we appreciate the benefits of higher rates, we must also be sensitive to the impacts on our customers and our markets in general. We will focus on capital and liquidity and stay disciplined on credit given the uncertainty of the economy in 2023. We have an experienced lending staff and a strong credit culture. We have a uniquely, relationship-driven deposit base and a staff that stays close to those customers. We reside in one of the best markets in the United States to do business and a long term future for our franchise is great. We will continue our determination to make sure that we have a successful combination of these two franchises. I will now turn the call over to our CFO, Paul Egge.

Thanks, Bob, and good morning, everybody. We sit in a unique position today reporting as Stellar Bancorp, the third quarter results of our two predecessor companies on a standalone basis since our merger went effective October 1. So we’ll spare you a detailed discussion of our third quarter separately and instead provide a high level discussion of our results focusing on what it means for our combined company, then I’ll turn the call back to Bob and he’ll open it up for questions. First, the third quarter operating results for Allegiance and CBTX featured different versions of the same themes. First, strong year-to-date loan growth in a current rising interest rate environment drove higher net interest margins and net interest income making for a very strong revenue profile. Second, both companies recognize a meaningful level of M&A expenses during the quarter, impacting our bottom-line and securing the earnings power of products we’ve made so far this year. After adjusting for M&A expenses though, both Allegiance and CBTX entered the merger at record levels of bottom-line and pretax pre-provision earnings power. Holding aside the M&A expense noise, both legacy ABTX and CBTX have done an exceptional job holding the line on non-interest expenses in an otherwise inflationary environment without hindering growth since announcing the merger. This represents the meaningful pull-forward of pro forma operating leverage and concepts. Now turning our focus to the balance sheet, both Allegiance and CBTX saw a continuation of strong loan growth combined with incremental decreases in interest-bearing deposit balances putting us at a blended loan to deposit ratio of about 82% at the end of the third quarter, which is a level we are comfortable with. Up to this point, we have stayed relatively disciplined on deposit rates. We did see some outflows from more rate-sensitive deposit categories in the third quarter and year-to-date as a result. In the third quarter we started to be more responsive to the current rate environment and we expect to see additional rate impacts on our funding base due to competitive pressures. A very bright spot has been our strong base of non-interest bearing deposits, which has so far held steady during the quarter on a combined basis and has grown year-to-date. Last, our noisy impact of unrealized losses in our [Indiscernible] and through AOCI its impact on tangible common equity and tangible book value per share. The impact was meaningful for both companies but it’s certainly not an outlier relative to the industry. In the legacy leasing portfolio, we view this impact as transitory since we don’t plan on selling the underlying securities. The legacy CBTX portfolio is a great segue to how we are proactive to manage Stellar’s liquidity profile. After closing the merger, we sold just under two-thirds of the legacy CBTX security portfolio or approximately $350 million of securities in aggregate to bolster liquidity. Since Allegiance is the accounting acquirer in the merger, the CBTX balance sheet including securities portfolio is coming over at fair value. So we are able to reposition the balance sheet with immaterial impact swelling to Stellar’s income statement in the fourth quarter. A portion of this cash was used to pay off the FHLB borrowings that were on Allegiance’s balance sheet at the end of the third quarter and the rest is sitting in financial support, a bolstered degree in profile. After these transactions, Stellar’s wholesale funding usage as a percentage of funding is lower than when we announced this merger and we feel much better positioned as we look to the future. Wit merger effectiveness on October 1, the work on fair value marked from the CBTX balance sheet is still underway. While most merger assumptions remain materially correct in the aggregate, we’ve seen interest rates change significantly since we initially announced our merger and marks on interest rates of assets will be significantly different. As a result, the previously expected level of excess capital will be lower due to anticipated interest rate marks that we are very comfortable with our pro forma capital position, particularly in the context of our strength in core earnings profile and the rapid capital build it will drive. Note also that our robust core earnings will also benefit from significant accretion income that will result from the first accounting marks, much of which will be non-credit related. We feel great about, when appropriate, we will seek to update disclosure on our first accounting adjustment to get analysts and investors better clarity on these items. We feel great about our combined positioning on earnings, liquidity, capital and credit, which we feel prepares us for any range of economic scenarios. As a result, we find the financial and strategic rational behind the merger to create Stellar to be even more meaningful now than when we announced it last year. I will now turn the call back over to Bob.

Thank you, Paul. In summary, we are set to build a great future for Stellar Bancorp that will benefit our stakeholders. The current operating environment has served us well so far in 2022, but as we look forward, we will continue to monitor the Fed and its effects on the economy. We will then curb to match their goals while we continue to build strength in our markets. In 2023, we are dedicated to executing a successful and smooth integration and we will focus on the quality of our business composition as we harness what will be a very strong core earnings profile. We believe that the industry is in a period of transitioning from the liquidity event provided during the pandemic to what of a more normal operating environment. This causes us to be cautious about the next year, but also optimistic about our long-term future. We are excited about the future of Stellar Bancorp and Stellar Bank. With that, I will turn the call over to the operator to open the line for questions.

[Operator Instructions] And our first question comes from the line of David Feaster from Raymond James. Please go ahead.

Hey, good morning, everybody.

Good morning, David.

Good morning, David.

Congrats on the deal. Excited to see what the future holds for Stellar. But maybe just starting on the growth outlook, just kind of reading between the lines, Bob, a bit on your commentary, it sounds like you might be taking a bit more of a cautious approach just given the backdrop, which I think is prudent. But just curious how you think about the net growth of the pro forma company. Obviously, both companies got really strong growth prospects in the economic backdrop and your footprint one of the best in the country. But just curious your appetite for growth here and the pro forma trajectory and if you plan to decelerate growth, how would you do that? Is it through tightening standards? Higher pricing or just curious what you are seeing?

Well, David, you did a good job of kind of laying that out for, and sort of all the above, I think we’ve had some robust growth especially for our franchise and Allegiance also over the last year. I think what we are trying to signal the pulse is that, to continue to grow and at those types of levels is probably not going to be available to us in 2023. However, we can still grow the franchise. Our markets are still pretty good here and we are going to continue to take advantage of the things that we have available to us. We get to start with a pretty clean balance sheet. We’ve got 82% loan to deposit ratio. We are going to work hard on maintaining our liquidity position and also give us the ability to go out and make loans when maybe some others are going to struggle with that. So, we think the market is going to give us some opportunities to continue to grow the franchise. They always signal there is that we are going to concentrate on quality and it may not be quite as robust as what we have seen in 2022.

Okay. That makes sense. And I know the deal is taking longer than we all wanted to close, but just curious whether there were any ways in the longer time to close has been beneficial for you all. And maybe whether it makes the integration smoother or as you’ve – you think about synergy forecasts, have you been able to particularly find additional revenue synergies or have you already started to realize some of those? And just any other – as you’ve gotten under the hood, any other potential benefit to the deal that you see today that maybe you didn’t anticipate at the beginning?

Hey, David, it’s Ray. So, yeah, I think we were really trying to get the deal closed earlier, but the delays did as you said give us a little breather and more time to do kind of what if you think about two kind of like if you think about two kind of milestones in deals legal close and what has to happen in day one and then where you have to be for system conversion. So, it did give us a little bit extra time to get all that in place and we are really pleased with that day one how we opened after legal close to have everything that needed – that was needed for day one. We were there and we are on track for system conversion in the first quarter. As far as synergies, that spirit of day one, we had our mortgage operations between the two banks ready to get at day one. So, as we talked about before Allegiance, while we had a portfolio of projects with we really do not have a robust mortgage offering and community does. So that’s been in place and there is a pipeline for that and we are really excited about how that’s coming through early in the – as a combined bank.

I’d say, nobody likes to be waiting so long for a deal to close, but you got to credit the teams of both companies to be able to keep their eye on the ball with respect to delivering such great growth year-to-date and it really is special. I will say hitting on the cost front, we are extremely proud of what we’ve been able to pull through and how we’ve been able to manage in an inflationary environment. We kept things quite tight knowing that there is reinforcement when we put these two companies together and ultimately share duties and operate as one organization. So, you never want to have too much time, but I would say that it hasn’t hurt being that we’ve been able – we did not skip a beat on loan growth, that’s anything we did great and then separately we were able to manage through this inflationary environment holding line on cost extremely well.

We’ve been close in June, when the marks would have probably been less on the rate marks, but other than that everything is good.

That’s great. And then, just last one from me, maybe touching on the capital priorities, I mean, we got the buyback in place. Obviously, it’s pretty attractive from a valuation perspective when we think about the combined earnings power of this business. Just curious how you think about the buyback and capital priorities from here?

Sure thing, David. We were purposefully high level, but the one detail that we did not hit on was the fact that, in the third quarter both companies were relatively active in their share repurchase programs, altogether repurchasing about $25 million in the aggregate of shares during the quarter. We’re really pleased of the progress we were able to make ahead of the deal. But being that, the purchase accounting adjustments is going to heat into our excess capital position more than we expected. We are going to take little bit of a wait and see approach particularly going into this current environment. But we feel extremely well positioned and we think being mindful of our capital, particularly right now it’s going to open up a lot of doors down the line.

Perfect. Thanks everybody.

Thanks.

Okay, good.

Thank you. And I show – we have a next question from the line of Matt Olney from Stephens Inc. Please go ahead.

Hey, thanks. Good morning, guys. I’d like to also congratulate you guys for closing the transaction. It’s an exciting time now.

Thanks, Matt.

Thanks, Matt.

On expenses, I think I heard you say the core conversion in the first quarter. Anymore details behind that and I guess, what quarter do you expect to get a full quarter of overloaded cost savings? And I guess, just more broadly, I think you talked about original cost savings from the deal of around $35.5 million. I think you also made the comment that some of those costs have may have been pulled forward a little bit over the last few months with the delay. So just any commentary about how much of these cost savings have been realized through the third quarter and how much is still going to come? Thanks.

The – Olney, it’s going back to this long waiting period we had to consummate this merger. It has brought the opportunity to pull some cost savings forward. But with the – with our core conversion being pushed into 2023, it’s also had the effect of effectively stretching some of those cost saved out. So we are going to – we are having seen longer tails, I guess, you could say as it relates to the realization of cost savings. So, there may be some dangling chards into the back half of 2023 but we are going to be 80% to 90% of the way there. I believe around half way through 2023. There is certain costs that will roll off the balance sheet at the end of – roll off the income statement, I should say that’s scheduled to roll off in the end of 2023, but that’s very much on the tail end of things. The bulk is going to be coming through once we get past that conversion and we’ll be entering the back half of 2023 appreciably there with a little bit of drag. But we feel great about what we are delivering from the standpoint of cost saving, yes. When you look at our respective cost base stripping out M&A expenses, you’ll see that we’ve held the line extremely well. Actually, combined headcount is down about 70 individuals from announcement quarter or the third quarter of 2021 to the third quarter of 2022, which is part of that pull forward is why we are extremely excited to be together because we have been running things tight. So, it’s meaningful. The amount that has pulled through especially when you think about a world that’s facing nearly 10% inflation.

Okay. Thanks for that, Paul. And I guess, I am trying not to overstate the remaining cost savings in my forecast. Any – I mean, that the 70 lower FTEs since announcement is helpful, but any other numbers I can think about as far as what portion has been recognized so far?

I would direct you to just do some math around our combined expense base in the third quarter of 2021 and our year-to-date taking out things like OTC related expenses and any merger-related expenses and then roll forward a comparison of those core expenses year-to-date and in particular for the third quarter of 2022 and then put an inflation factor on there and compare the number. You’ll see that that would queue a very nice story with respect to what we’ve been able to accomplish up to this point.

Okay. That’s helpful, Paul. And then, also on deposits, I think deposit balances were down at both banks in the third quarter and we are obviously seeing this at most if not all your Texas peers. Anymore color on what you guys are seeing with respect to deposit balances in Houston and then, looking at the fourth quarter, I think it’s typically a stronger quarter for deposit balances, especially at the end of period that could even outstrip loan growth. What are the thoughts about deposit growth more near term? Thanks.

Yeah, as there is a lot of pressure in the marketplace and do you know – knew what – know well some of the players at our market that are being a little more aggressive around deposit interest rate. So, we’re playing a little bit of defense in that regard, but we’ve got a strong relationship-driven deposit base and those folks have been really good to us and we are going to continue to be fair to them and we have been as we raised our interest rate for them as we go through these interest rate increases. But we’ve let some of those higher priced deposits roll off and trying to manage the expense base and then, it leaves us plenty of room to do what we need to do to kind of protect the good strong deposit base that we have especially those demand deposits in my markets that we enjoy. So, we’ll play at the front on the higher interest rate piece of this but we’re going to maintain and continue to protect the good deposit base the both banks have.

Okay. Thanks, guys.

Thanks, Matt.

Thanks, Matt.

Thank you. And I show – we have our next question from the line of Will Jones from KBW. Please go ahead.

Yeah, hey guys. This is Will Jones, KBW. How are you guys?

Good.

Good morning.

Hey, good morning. So, I am just going to echo what Matt is saying on the deal. I know you guys are thrilled to be doing this call jointly today. Paul, I just wanted to go back to your comments, if I heard you correctly you guys had sold two-thirds of CBTX’s bond book as the deal closed. Does that mean that you guys had to realize maybe some of those losses on that book that may have occurred just with the rising rates?

It all comes in at fair value. So the purchase accounting dynamics effectively realizes and that effectively gives us the ability to sell those without a meaningful impact on the income statement. It actually doesn’t go through the income statement. So, immaterial impacts from an income statement perspective, but it does effectively from a capital standpoint recognize that in the fair value mark, which is just what happens in purchase accounting.

Got you. Got you. That’s very helpful. And then, I know, it’s still maybe too early to tell. You guys laid out an EPS number in the mid-2.60s back in as the deal moves back in November and that included some forward accounting soon and do you guys obviously right about that and then some, but if you guys are ready to lay off maybe a new EPS target today or just maybe you point us on the right direction as to where do you think the earnings power this company could go in the next year or so?

The earnings of this company is great and it’s amazing to reflect on how nearly a year ago we were announcing this merger and we had expectations for pro forma earnings that seemed like a sketch back then, but we were – the interest rate environment kind of how kicks the coverage of those estimates and with loan growth, both companies have really not took cover off the ball from an earnings power standpoint. So, we fit in a really good spot and actually, one of the reasons we showed a dynamic around the core earnings power in the front page of our earnings release which is a little bit of a unique presentation is to kind of give appeal for just that. So I’d direct you there.

Got you. Okay, okay. Super helpful. And then, maybe last thing for me, just think about the margin of the combined company, we were thinking about deposit betas through the cycle, I think that maybe ABTX ran a little bit harder than CBTX did last cycles. Could you just point us towards maybe a good blended beta that you guys are trying to manage through the course of this cycle?

We are going to do what it takes to navigate the current market but we are extremely proud of our core net interest margin profile. You put these two companies together and we will solidly have a fore handle on our net interest margin and we are going to work our best to protect that. Separate from the core net interest margin of course will be the incremental gains from the interest rate mark dynamics with respect to purchase accounting accretion. So, it will be even higher on a stated basis, but we will do our best to really separate that out for your benefit to see where that core margin is. We sit in a really nice place and it’s our duty to protect that margin profile going forward.

Awesome. Super helpful, Paul. Thanks and that’s it for me guys. Congrats again on the deal close.

Thanks.

Thank you. [Operator Instructions] And I show our next question comes from the line of Brad Milsaps from Piper Sandler.

Hi, Brad.

If you have your phone on mute, please unmute your line.

We are not hearing you Brad, if you are talking.

[Operator Instructions] I am showing no further questions in the queue at this time. I show we have a question from Mr. Milsaps from Piper Sandler. Brad Milsaps, your line is open.

Hey, am I coming through now?

Yeah.

Yeah, Brad.

I just don’t know what the issue was there. Paul, I want to follow-up on the accretion comments in the 8-K that you guys filed a few days ago, I think it notes, maybe $37 million of accretion or interest rate adjustments, is that in totality, I know that’s as of 2021 and if that is the right number, how – over what span would you expect that 37-ish million to kind of accrete through between the bond and the loan book?

We are not really in a position to comment on what it’s going to look like at 9/30. But obviously the 6/30 8-K we put out did provide an approximately for an illustration I should say for what it could look like based on the 6/30 marks. But ultimately, the way it works, particularly with the interest rate marks is a three year portfolio gets marks, pick a number by $90 million you are going to recognize that negative mark back into income over three years. So, it’s really a timing dynamic. So, we lose some net worth now. We gain it back in the future and that’s what drives it. So whatever the marks end up being, really going down to an asset-by-asset level. The accretion is recognized over the life of those marked assets. So, what was put in the 8-K was an illustration based on these 6/30 numbers and we are working hard to provide better feedback with respect to getting our work done for the purchase accounting marks at 9.30 and we look forward to updating the market when appropriate.

Okay. So you’ll get more earnings accretion and it’s my back of the envelope, I mean, it looks like tangible book would be down, I don’t know, maybe as much as 20%, maybe a little low or little less, I know you get some final marks. But is that, it might in the right ballpark there based on kind of what you are thinking as of June 30.

Well, it’d be a little less. I mean, ultimately, your – what is conservative about that 8-K was we recognized the market-driven marks that ties approximately to the fair value marks on the loans as well as the AOCI on securities at 6/30. What was understated in the 8-K which is a function of the fact that the work haven’t been done yet, actually we use the old number for the core deposit in tangible. That which kind of drives the conservatism, that was in the 8-K because the core deposit intangible in the current interest rate environment is actually going to be meaningfully higher than it was in our initial estimations. It’s just at 6/30 we had not updated that now since the announcement of the merger. That analysis being done now and that’s going to be a significantly positive mark to counteract what are otherwise negative interest rate marks. But the way I kind of see it is, we see the securities AOCI getting tangible book value over the quarters since we announced the transaction. The only thing that is kind of unseen that is interest rate based into the negative would be that loan fair value.

Brad, I’ll just add. Be cautioned around using specific numbers, I think what we are trying to show directionally what this looks like and obviously the 9/30 marks are going to be different than the 6/30 marks and it depends on – it’s a point in time. So, just understand you got – unfortunately because of the way this thing came down, we got so many different timing pieces to put that, is that now necessarily flow exactly to go with it.

Right, right. No, I now understand there is a lot of moving parts. And then, maybe just back to Matt’s question around expenses, Paul, wanted to make sure I am thinking about it correctly, in your mind the way to think about it would be go back to the third quarter of 2021, which would be sort of the quarter prior to the merger’s announcement, annualize – add together and annualize expenses for both companies add a inflation factor for 2022 maybe add an inflation factor for 2023 and then deduct out the cost savings and that might be – you are pretty close to where expenses would be in 2023. Obviously, you’ve got some timing around the conversion et cetera, but that – is that kind of how you are thinking about it as you are trying to paint a picture for us?

I wasn’t meaning to provide guidance, but I was trying to provide for you all was just a kind of a feel for how successful we’ve been holding the line on expenses and how you can kind of put it in perspective relative to inflation, the inflationary environment. We have effectively held our expense runrate even on a core basis. Actually I hear less, which is a Herculean task in what has been a really inflationary environment. Now it’s come from the pull through of certain headcount reductions, partially it’s a byproduct of how long the pendency of this merger was. But that has helped us affect – be more affected than I think most organizations in battling the effects of inflation. We’ve got less people. We are doing more work. We are still willing and able to invest in our business. There is still more cost savings to come, but conceptually there has been a pull through, and that’s the way I think about it.

Okay. Alright. Great. Thank you.

Thank you.

Thank you. I show no further questions in the queue. That concludes our Q&A Session. At this time, I’d like to turn the call back over to Bob for closing remarks.

Well, we appreciate being able to have our first call around Stellar Bancorp and appreciate everybody’s attendance today and thank you.