STEL - NASDAQ

Good morning. My name is Crista, and I'll be your conference operator today. At this times, I would like to welcome everyone to the Stellar Bancorp Fourth Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] I would now like to turn the conference over to your speaker today, Courtney Theriot, Chief Accounting Officer. Courtney, you may begin your conference.

Thank you, operator, 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 fourth quarter of 2023. This morning's earnings call will be led by our 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 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 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 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.stellar.bank 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.

Thank you, Courtney, and good morning, and welcome to the Stellar Bancorp fourth quarter earnings call. As we conclude 2023, I will begin by thanking the outstanding team at Stellar Bank. Their hard work and dedication allowed us to bring two banks together while dealing with the external pressures of current economic circumstances. Every day, we make strides in developing the Stellar way. Our team is working hard to ingrain our values across our organization, and our culture becomes more clear each day. We are pleased with our results for 2023, given all of the industry stresses while we focused on capital, liquidity and credit. Our discipline around these tenants allowed us to build capital to stabilize our valuable deposit franchise, maintain strong net interest margin while maintaining good credit metrics and finished the year with a nice return on shareholders' equity for our shareholders. Our mantra is 2024 -- for 2024 is optimized. The heavy lifting is behind us. We must seek to optimize process, expense, people and future. We will keep our focus on capital, liquidity and credit as we expect a less robust economy in '24 as the Federal Reserve continues to tame inflation. However, we operate in some of the best markets in the country, and we will be -- we are well positioned to take advantage of the opportunities we expect to be presented to us over the year. We believe that these efforts and market dynamics will provide for a rewarding value creation for our shareholders. I will now turn the call over to Paul Egge, our CFO, for more details on the quarter and the year.

Thanks, Bob, and good morning, everybody. After a year marked by industry disruption, we are very pleased to close out a strong and transformational 2023 for Stellar Bancorp. Our net income for the year was up $130.5 million, representing diluted earnings per share of $2.45, an ROAA of 1.21% and return on tangible common equity of 15.75%. As Bob noted, our focus entering into 2023 was on capital, liquidity and credit. And we feel we have performed well on all of these fronts, all while protecting earnings power, notwithstanding significant industry turbulence and competitive pressure during the year. On capital, in particular, we were very successful growing our regulatory capital ratios in 2023. We increased our total risk-based capital ratio to 14.02% at year-end from a starting point of 12.39% at year-end 2022 and showed similar improvement across all of our regulatory capital ratios. Driving this capital build was our growth in tangible book value, which grew 21.4% over the year to $17.02 per share at the end of 2023 from $14.02 per share at the end of 2022. During the year, we also maintained a very strong funding profile marked by 40% non-interest-bearing deposits, along with a disciplined strategy with respect to our interest-bearing funding. As a result, we've been able to manage pretty well through a competitive high interest rate environment to maintain healthy margins and core earnings balance. All the while, we've been able to maintain a strong credit profile. Turning our focus to the fourth quarter. We earned $27.3 million or $0.51 per diluted share, making for an ROAA of 1.02% and a return on tangible common equity of 12.61%. This was despite a higher expense flow during the quarter due primarily to nonrecurring items that I'll detail shortly. Fourth quarter earnings were incrementally lower than the $30.9 million or $0.58 per diluted share earned in the third quarter due mostly to higher non-interest expenses more than offsetting higher non-interest income and lower provision. Notable among non-interest items during the quarter was a nearly $2.4 million in other non-interest income from FDIC investments. And on the expense side, we recognized a $2.4 million expense relating to the FDIC special assessment, $1.9 million of severance expense and elevated professional fees during the quarter, relating mostly to initiatives associated with crossing the $10 billion asset thresholds. During the fourth quarter, we saw our net interest margin tick up a few basis points from the third quarter. Net interest margin was 4.40% during the fourth quarter, up from 4.37% in the third quarter. And excluding purchase accounting accretion, NIM was 3.91% in the fourth quarter relative to 3.87% in the prior quarter. We have been very pleased with the relative stability in our net interest margin during the back half of 2023, as the continued repricing of our assets has kept pace to offset an upward trend in funding growth, which has showed some signs of leveling off in the fourth quarter. We feel pretty good about stabilization in our margin trends and outlook, which continues to compare favorably relative to the industry, and we also feel good about our ability to protect our relatively strong profitability profile in this challenging environment. With respect to purchase accounting items, we ended the year with $106.8 million in loan discount remaining and a core deposit intangible asset of $116.7 million. Strong earnings, notwithstanding accelerated amortization of CDI expense, has been a really strong driver to our internal capital generation in 2023, and we like our prospects for continued internal capital generation in 2024 as well. In summary, we believe Stellar is well positioned to perform in 2024. Our capital, funding and liquidity position puts us in a good spot to maintain favorable margins and earnings power. On credit, we feel appropriately reserved given current economic unknown, and we otherwise take comfort in our credit underwriting discipline and perhaps most importantly, the fact that we operate in some of the strongest markets in Texas and the country. Thank you. And I will now turn the call back over to Bob.

Thank you, Paul. And operator, we'll be happy to take questions.

[Operator Instructions] Your first question comes from the line of David Feaster from Raymond James. Please go ahead. Your line is open.

Hi. Good morning, everybody.

Good morning, Dave.

Maybe just starting on the rate sensitivity side. You've obviously got a great core deposit franchise. We've seen core margin expansion throughout this rising rate cycle. But today, you actually screen closer to rate neutral, maybe modestly liability sensitive. Just given the increased prospects of rate cuts, I'm curious how you think about the impacts of potential cuts on the margin and how quickly you'd expect to be able to reprice deposits lower if we do get cuts this year.

We take comfort in really a neutral interest rate risk profile. In our mantra -- another mantra for 2024 is to be ready for anything. And that's true on the interest rate sensitivity. We are very neutral. And to the extent we see rate down, there is a measure of sensitivity to the front end of the curve, particularly money markets and really short CD funding. So we see our ability to reprice there as -- to be pretty strong. But once again, we're not trying to make a bet on rates with our interest rate position, and we feel well positioned for really any rate outcome in 2024.

Okay. That's helpful. And maybe just touching on the loan declines. Actually, maybe for another, how do you think about your ability to reprice deposits and the sensitivity of those clients? I mean, again, we were pretty slow to increase deposit rates. Do you think we'll be able to -- just kind of given the liquidity challenges in the market. I'm just curious how you think about repricing some of those deposits, including the competitive landscape.

I think where you get the most ability to reprice is going to be in your exception universe as well as your -- naturally, the wholesale funding that stayed pretty short, you can reprice.

Yeah, David. I would just add to that, the -- Paul mentioned that are probably our largest opportunity is in that money market where on our sheet rates, we took a very measured approach. So that might be -- we really weren't very aggressive on the up. So on the down, it'd probably be similar. But we did as we handled the exception pricing, that would be where we would target first. The time deposits that we put on during this time were short term, and then of course, we enjoy a 40% plus NIB. So I think, as Paul mentioned, it will be in that money market bucket.

David, I'd just add, as you think about our approach to the deposit side, when the market changed and people were really aggressive about trying to fund our balance sheet, we felt like we didn't want to get into that competition. It was above what we wanted to pay, and we wanted to retreat back to something that made sense for us and still maintain our great deposit franchise. Now as deposit rates start to level out, we can be as competitive as anyone on the deposit front. And we feel like we've got the ability to do what we need to do on a reprice basis to compete in the market. So we just want -- we want rates to level out or give us some kind of idea that we're not going to be paying outsized prices for these things.

Okay. That's helpful. And maybe just touching on the loan side and the declines in the quarter. I'm just curious, how much of that is strategic and tightening and pushing higher pricing to kind of slow growth versus weaker market demand and just uncertainty in the economy from the client perspective? And just your appetite for growth today, where you're seeing opportunities and kind of where pricing is holding up.

David, I think it's a combination of both that you mentioned, both our underwriting approach as well as some demand pressure and that -- as our customers are trying to get used to this rate environment. And so we're seeing it on both fronts. We have a number of quarters in a row where our construction and development originations have declined, and that has been strategic, while our C&I has remained pretty constant. So as a percentage, C&Is increased a little bit. In the fourth quarter, we did drop a little bit compared to the third quarter in total originations, but feel real good about where those came on as rates. Still with an 8 handle on our new loans, and we renewed another $600 million kind of also with an eight handle. So we're pretty pleased with that as well.

Okay. Terrific. That's great. Last one for me. Maybe just touching on the expense side. Core expenses ticked up a bit. A lot of moving parts in the quarter. I'm just curious, how do you think about a good core expense level? And then just the run rate through this year, I mean how do you think about managing expenses just in light of some of the revenue challenges that we've talked about? Curious how you think about that.

We guided 2024 expected expense on a core basis of around $280 million. There's a lot of drivers that we're going to be focused on optimization, as Bob said, to see the extent to which we may be able to do a little better. But ultimately, we feel like to achieve what we want to achieve into -- pursue the initiatives we want to pursue in 2024 to position us best, that's the spend level in the plan. Now the first quarter tends to be -- had some seasonality to it that's going to drive -- going to be a little higher than if you were to divide that by four. But that's where we're targeting.

Terrific. Thank you, everybody.

Thanks, Dave.

Your next question comes from the line of Matthew Olney from Stephens. Please go ahead. Your line is open.

Hey. Great. Thanks. Good morning, everybody.

Good morning, Matt.

I'll start on the professional fees. I think Paul mentioned professional fees was elevated due to some -- these initiatives of crossing $10 billion of assets. Any more color on these initiatives? And then how do you see that line item trending in 2024?

It was more of a timing dynamic. If you saw the third quarter, it was relatively with a dip from the second quarter. And a lot of work has been done here in the fourth quarter to kind of achieve the goals we wanted to achieve by the end of the year as it relates to all things in the new standards of being over $10 billion in assets. When we look forward, we think about a run rate of professional fees that would be certainly lower than the fourth quarter. I'd probably say more like $2.5 million, but that has some timing variation on a quarterly basis, similar to what we saw in our trend when you look at that line from the second quarter to the third quarter and the fourth quarter.

Okay. And I assume that's all embedded in that '24 guidance you mentioned, Paul, of the $280 million.

Exactly.

Okay. That's helpful. And then, I guess, switching over to the loan yields. If I take out the accretion levels, I'm getting a pretty nice uptick in the core loan yields. Any color on the drivers there? And then just remind us on the fixed rate loan repricing dynamics of the bank. Remind us what you expect to reprice higher during the year. And I heard Ray mentioned some of these newer yields are still at the 8% level. Just remind us on kind of on the reprice dynamic, what they're coming from in some cases. Thanks.

Matt, on the renewed loans, we've been -- we have a run rate of around $600 million a quarter of renewed loans. And so for the fourth quarter, those came on at -- renewed at $8.51 million coming off of $7.79 million. So I think going forward, it will -- they'll probably get closer, obviously, but probably coming off of something in the 7s and then renewing it to something in the 8s is what we would expect. And then again on the new, the new was $250 million in new loans that came on at 8%. So I hope that helps you with your -- what you're expecting in the fix rate repricing. I mean obviously, there's fixed and floating in that $600 million that I'm referring to. So that I don't have handy, the -- what the fixed rate portion of that is.

Yeah. That's helpful. I guess you mentioned the floating portion. And I think in our models, we're all assuming various things behind what the Fed does this year. Remind us of what's floating at the bank and the Fed were to cut at some point this year, just a dollar amount of loans that would reprice downward pretty quickly from the yield side.

Yeah. Around -- a little over 40% is variable, but truly floating. You'd be talking about a little over 20%. So that's what we'll move more immediately relative to Fed SOFR in particular.

Yes, direct one.

Yes.

Okay. Perfect. And then on the deposit side, you hit on some levers you can pull there if rates were to move lower. What about on the non-interest-bearing side? A little bit of give up in the fourth quarter, but still one of the kind of highest levels amongst the peers. Any more color or thoughts on where you see the balances kind of stabilizing and what timeline?

We see -- I would ask you to look at the average for the quarter. Point in time at 12/31, it looked like it would appear that we went from kind of 42% or 41.5% to right at 40% on that NIB ratio. But if you take it more on an average basis or if you were to say a point in time today, we have enjoyed around 41 or so percent of NIM deposits. And so far, we're really, really pleased with the resilience of that holding up. A little bit of what occurred at 12/31 in particular was a large growth in the interest-bearing demand. And that -- when that piece grows, you obviously kind of drown out the NIB. And NIB actually point-to-point was slightly down. So we're really pleased with the resilience of our non-interest-bearing portfolio of customers, and we look forward to maintaining really strong proportion of NIB going forward.

Okay, guys. I appreciate all the commentary, and congrats on the quarter.

Thanks, Matt.

Thanks, Matt.

[Operator Instructions] Your next question comes from the line of John Rodis from Janney Montgomery Scott. Please go ahead. Your line is open.

Hey. Good morning, guys.

Good morning, John.

Good morning.

Just looking -- switching gears, looking at fee income, what was the SBIC impact in the quarter?

$2.4 million. We recognized $2.4 million of revenue on that SBIC gain.

And how should we -- I mean, that's not really our -- I know you have it sometimes, but how should we think about that going forward?

Yeah. Since we can't set our watch to how we recognize gains there, we are very conservative as it relates to how we think about that source of revenue. So I would look at our non-interest expense base ex $2.4 million and think about that as our pace in 2024.

Okay. And then...

But we are always working -- we are always working on initiatives to build that. And Ray notes -- Ray has -- can speak to that.

Paul, just one other question on fee income. The card fees were down, I don't know, about $400,000 from the third quarter. Anything going on there? How should we think about that number going forward?

Interchange, fees.

That's our Durbin impact. So just working hard as a team to have more penetration in our cards to try to overcome that. And we've seen good -- really good story on our new account onboarding. And so I just hope to grow through that and overcome those -- that decrease we've had from Durbin.

Okay. But the hit was started in the third quarter, so it was down and then it was down even some more in the fourth quarter. So okay.

Yeah.

But nothing unusual or outside of Durbin in that line item?

No.

No.

So we have been -- we have observed that the impact of Durbin was a little bit higher than we initially estimated.

Okay. And then just one other question, guys, I guess -- and I know this is a little bit harder. But just on the provisioning, maybe how should we think about provision level going forward?

Well, I mean it's formula-driven, guys. So we're based on what happens with our loan portfolio, good or bad. And what the increases in that portfolio are will drive loan provision. It's hard to project that almost as hard as interest rate.

Are...

We do expect credit. We are -- we have a conservative stance on credit, especially given economic unknowns. So we're -- the way we've planned is for a more normalized level of charge-offs in the industry in 2024, and that obviously plays into results.

Paul, what -- when you say normal, what do you think is more normal?

I would say normal to elevated. I mean for us, both legacy companies have been able to maintain, for the most part, single-digit net charge-off numbers. But when you think about industry and what's a prudent expectation to set when there is an expectation of a credit cycle finally hitting the industry, you have to assume something in the high teens, low 20s in net charge-offs just to provide a little bit of a baseline. And we feel really good about our ability on a relative basis because of where we operate to do better than whatever the industry nationwide metrics end up being.

Okay. Thanks for the thoughts and Paul, just one other question. The tax rate is around 20%, still a good number?

Yes.

Thank you, guys.

Thanks, John.

Thanks, John.

Your next question comes from the line of Matthew Olney from Stephens. Please go ahead. Your line is open.

Yeah, guys. Thanks for the follow-up. Just want to go back to the core margin. We saw the stabilization in the fourth quarter, I think, if you take out the accretion levels. I think a quarter ago, you were a little hesitant to call for the bottom. But assuming the Fed holds off on any moves for a few quarters, any color on kind of what's the confidence level that the core NIM has, in fact, bottomed here in the fourth quarter?

No. It's a real uncertain backdrop. You're going to have a hard time teasing out a bottom out of us. But we feel really good about how positioned we are to defend our margin and defend our net interest income. And we'll let the results speak for themselves.

Okay. And then on the capital front, I think, Paul, maybe it was your prepared remarks on the call. Lots of good capital build, not just in the fourth quarter but also throughout the year. Any updated thoughts around deployment this year? Could this be a year of you leaning the stock buybacks? Or do you think the environment for something more significant is something you want to focus on and maybe buybacks take a backseat this year?

Well, Matt, I think we've spent a lot of time making sure that we build capital levels back to where everyone feels a lot more comfortable and give us optionality on the things that we want to do. And so we want to have as many options available to us as possible, and capital provides that. It will be interesting to see how the year plays out. I know there's a lot of expectation of rates coming down. I don't know if that's going to be the case or not. I think the economy still seems to be clipping along okay, although there's a little -- we're probably going to have some slowdown at some point during the year. But -- and so I think until we get a little more certainty around where interest rates are and what the economy is going to do, we're going to continue on the same path that we've been on. But all this is in -- is leading into making sure that we have optionality. And if we have the opportunity, whether it's buybacks, M&A, whatever the deployment might be of that capital dividend, we want all of those options available to us and we'll try to choose the right one for the shareholders.

Okay. Thanks for that, Bob. And let me ask it this way. The capital level is built really nicely in '23. It looks like they're going to build considerably in '24, absent any kind of other actions. Would that be acceptable, you think, for capital level to continue to build? Or at what point do you feel more urgency to deploy capital? I'm trying to figure out if this is something where we're getting close to that or give the uncertainty we could let capital levels built here for a while before we feel any urgency to deploy it.

That's a great question, Matt. I enjoy the joust. If we think about where we might be from an economy standpoint, if life comes true and we get five interest rate cuts this year or whatever somebody might project, to me, that means unemployment is going up, economy is slowing down, maybe credit starts to move in a certain way. I don't know. I don't think there's much certainty around it. Interest rates stay the way they are. Maybe a couple of small cuts gives us a better -- and I think we'll have more clarity as we move into the second and third quarter. But we're not against buybacks. We actually like buybacks. But we want to make sure that we have a good solid capital base to operate on that no one is questioning our ability to do what we want to do. And we want to keep our options open. And we will -- we certainly understand what we can do with that capital, and we're going to do the best thing for the shareholders.

Okay, guys. Appreciate all the commentary, and see you guys in a few weeks.

Thanks.

Thanks, Matt.

We have no further questions in our queue at this time. I will now turn the call over to Bob Franklin, Chief Executive Officer, for closing remarks.

Thank you, everyone, for their interest today. We look forward to 2024 and continuing to build Stellar Bank in a great way. Thank you very much.