Greetings, and welcome to the Independent Bank Group Second Quarter 2020 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Paul Langdale, Senior Vice President, Corporate Development for Independent Bank Group. Thank you. You may begin..

Good morning, everyone. I am Paul Langdale, Senior Vice President and Director of Corporate Development for Independent Bank Group, and I would like to welcome you to Independent Bank Group's Second Quarter 2020 Earnings Call. We appreciate you joining us.

The related earnings press release and a slide presentation can be accessed on our website at ibtx.com. I would like to remind you that remarks made today may include forward-looking statements. Those statements are subject to risks and uncertainties that could cause actual and expected results to differ.

We intend such statements to be covered by safe harbor provisions for forward-looking statements. Please see Page 7 of the text in the release or Page 2 of the slide presentation for our safe harbor statement. All comments made during today's call are subject to that statement.

Please note that if we give guidance about future results, that guidance is a statement of management's beliefs at the time the statement is made, and we assume no obligation to publicly update guidance. In this call, we will discuss a number of financial measures to be considered non-GAAP under the SEC's rules.

Reconciliations of these financial measures to the most directly comparable GAAP financial measures are included in our release. I'm joined this morning by David Brooks, our Chairman, CEO and President; Dan Brooks, our Vice Chairman and Chief Risk Officer; and Michelle Hickox, Executive Vice President and CFO.

At the end of their remarks, David will open the call to questions. With that, I'll turn it over to David..

Thanks, Paul. Good morning, everyone, and thank you for joining us on today's call. Since the COVID-19 pandemic emerged in March, our teams have worked tirelessly to mitigate risk and manage through unprecedented uncertainty while adapting our operations to the new normal.

I'm especially proud of how teams from across our company came together during the quarter to process over 6,200 PPP loans totaling over $823 million for our customers, providing a crucial lifeline to many small businesses in our communities.

We took a very large loan loss provision this quarter to prudently prepare for the economic volatility in the days that lie ahead. Despite this outsized provision, we were able to report adjusted earnings per share of $1.14, which reflects an adjusted return on average assets of 1.2% and adjusted return on tangible equity of 14.86%.

This solid financial performance in the face of the unprecedented challenges in our local, state and national economies reflect our conservative credit culture and commitment to ongoing operational efficiency.

While we believe building our loan loss provision amid the current uncertainty is prudent, we were pleased to see how well our loan portfolio held up during this quarter. As Dan will discuss, asset quality metrics remain strong. We also continue to build capital with our key ratios showing increases from the previous quarter.

With that overview, I'll turn the call over to Michelle for more detail on the operating results for the quarter..

Thank you, David. Good morning, everyone. Please note that Slide 5 of the presentation includes selected financial data for the quarter.

Our second quarter adjusted net income was $49.1 million or $1.14 per diluted share compared with $52.9 million or $1.22 per diluted share for the second quarter last year and $43.4 million or $1.01 per diluted share for the linked quarter.

Net interest income was $128.4 million in the second quarter, down from $129.6 million in the second quarter last year and up from $123.2 million in the linked quarter. A decrease in asset yields from the first quarter primarily due to accretion, low PPP yields and Fed fund decreases was offset by a significant drop in funding costs in Q2.

Year-over-year, net interest income was impacted by a $9.1 million decrease in purchase accounting accretion, but this decrease was mostly offset by a reduction in funding costs. The adjusted NIM, excluding all loan accretion, was 3.32% for the second quarter compared with 3.60% in the second quarter last year and 3.48% in the linked quarter.

The decrease in the adjusted NIM was driven by multiple factors, including low yields on PPP loans and a substantial increase in the bank's liquidity position during the second quarter. We estimate that the increased liquidity negatively impacted the adjusted NIM by 20 basis points as compared to the first quarter 2020.

Total noninterest income increased $10.9 million from the linked quarter to $25.4 million in Q2. The increase was driven primarily by an $8 million increase in mortgage banking revenue and the recovery of a $3.5 million reserve on an acquired SBA loan.

These increases were partially offset by a decline in volume-based service charge income due to the COVID-19 pandemic and a decline in investment management income. Total noninterest expense totaled $83 million for the second quarter 2020.

There were several nonrecurring items, including $15.6 million of acquisition costs for the terminated Texas Capital MOE, $1.5 million of expenses due to the COVID-19 pandemic and a $738,000 ORE impairment.

In addition, salaries and benefits of $34.4 million were lower than normal due to an increase in deferred costs of $9.4 million over Q1 related to PPP loan origination and the significant increase in modifications.

This decrease was offset by $2.8 million of severance and accelerated RSA expense for strategic restructuring after the merger termination as well as nonrecurring salary and bonuses of $2.4 million related to PPP and COVID-19. Slide 20 shows our deposit mix and costs.

Total deposits were $13.3 billion as of June 30, 2020, an increase of $1.4 billion or 47.9% annualized from the linked quarter. We estimate approximately $580 million of this increase is related to PPP borrowers that continue to hold the deposits in their commercial accounts as of June 30.

Total borrowings were $1.1 billion at June 30, 2020, and includes $500 million of short-term FHLB advances that have matured since June 30 as well as an additional $150 million of FHLB advances expected to roll off prior to the end of the third quarter.

These short-term advances were obtained early second quarter in anticipation of the PPP fundings as well as to ensure adequate liquidity during the pandemic. We will continue to monitor liquidity and can utilize the PPP LF if we need additional funding in Q3. Capital ratios are presented on Slide 22 and reflect that we continue to build capital.

The common equity Tier 1 capital ratio increased by 23 basis points to 10.17%, and the total capital ratio increased by 39 basis points to 12.44% as of quarter end. That concludes my comments this morning, so I will turn it over to Dan to discuss the loan portfolio..

Thanks, Michelle. Overall loans held for investment, not including mortgage warehouse purchase loans, were $11.7 billion at June 30, 2020, compared to $11.0 billion at March 31, 2020. Loan growth of $669.4 million for the quarter includes PPP loans of $823.3 million.

Loans excluding PPP loans were down $61.6 million year-to-date due primarily to the economic dislocation resulting from the coronavirus pandemic. Mortgage warehouse purchase loans averaged $665.8 million for the quarter, up from $547.3 million from the quarter ended March 31, 2020.

Our mortgage warehouse continues to see sustained demand from the persistent low mortgage rate environment. Slide 9 shows the composition of our loan portfolio, and Slide 11 shows the composition of our commercial real estate portfolio. As of June 30, 2020, commercial real estate makes up 45.9% of loans.

Our CRE book is well diversified in types of collateral with the largest segments in retail and office, which includes office warehouse. Across our entire CRE portfolio, our average loan size is $1.2 million, and our largest loan size is $20.9 million. 29.7% of our CRE portfolio is owner-occupied.

Slide 12 further breaks down the retail CRE portfolio by property type. Our retail portfolio is an extremely granular book with an average loan size of $1.7 million. Before the COVID-19 pandemic began, the weighted average debt service coverage ratio in our retail portfolio was 1.68x, and the weighted average loan-to-value was 54%.

While this portfolio has seen a large number of deferral requests dating from the early days of the pandemic, subsequent developments have been favorable to landlords and our conversations with borrowers indicate that rent collections across our markets have been better than anticipated.

About 1/3 of our retail book received a deferral, and about 1/3 of those loans have since returned to payment.

We anticipate more retail loans to return to full payment in the third quarter, and we have a high degree of confidence that our conservative underwriting coupled with the overall granularity of the retail CRE portfolio places the bank in a favorable position to navigate any impacts to this asset class.

Additional detail regarding our hotel and motel exposure can be found on Slide 14. The hotel book is largely secured by properties in our markets and is conservatively underwritten with a pre-COVID weighted average LTV of 57% and a pre-COVID weighted average DSCR of 1.78x.

The hotel and motel asset class has been one of the most acutely impacted during the pandemic. And while occupancy rates have lifted from the lows seen during March and April, we expect that this segment will continue to lag behind other segments of the portfolio. Slide 13 contains some additional detail on office CRE.

The office CRE product type is just as granular as our other CRE lines with an average loan size of $1.0 million. Of note, 35% of office CRE loans are secured by office warehouse properties. Slide 15 contains details regarding our energy book.

Given the recent rebound in commodity prices and the results of recent stress testing, we are confident that this book will continue to exhibit resilience. Slide 16 provides detail on COVID-19 loan modifications.

Consistent with our approach to relationship banking, we readily provided temporary payment relief to our affected customers while actively gathering information and evaluating developments. The vast majority of deferrals were granted for a period of 90 days.

And since March, the cumulative total percentage of loans that have received some sort of payment relief is 9% of the bank's total loans. We have been pleased that many borrowers who received full payment deferrals began to voluntarily resume making payments as the economy reopened.

56% of the loans that have been granted deferrals have started to make payments again. Note that deferrals sharply peaked in April. As of early July, approximately 6% of our loans remain in deferral or have not yet made a payment and we anticipate this number to decrease as payments resume following the expiration of the first deferral period.

Overall, our credit quality metrics continue to remain strong with total nonperforming assets decreasing to $28.4 million or 0.17% of total assets at June 30, 2020, down 3 basis points from the linked quarter. Net charge-offs remained flat at 0.05% annualized for the first quarter of 2020.

As noted in our first quarter call, we elected to defer the adoption of CECL as provided under the CARES Act, and our allowance and second quarter 2020 provision were calculated using our incurred loss model. Provision for loan loss expense was $23.1 million for the second quarter, an increase of $14.7 million over the linked quarter.

This represents a qualitative factor to prudently recognize the economic environment and uncertainty related to the COVID-19 pandemic.

The provision expense also included a $1.1 million charge-off on a commercial loan and a $4.1 million increase to a specific reserve placed on an energy credit that had previously been placed on nonaccrual and discussed in prior quarters. These are all my comments I have related to the loan portfolio this morning.

So with that, I'll turn it back over to David..

Thanks, Dan. Following the announcement of the termination of the Texas Capital merger, we began a strategic realignment initiative with regard to our overall organizational design and infrastructure. We intend to focus on this process over the remainder of the year to position the company for continued high performance and future growth.

Our company's footprint encompasses 4 of the country's strongest markets across Colorado and Texas. I've consistently said that having great customers in great markets has helped us deliver strong returns to shareholders, and I believe that our great markets will help us in the pursuit of continued strong performance through this challenging period.

In addition, our lenders are continuing to build relationships that will deliver even stronger results as the economy improves.

I am grateful for the tremendous result and dedication of everyone here at Independent Financial, and I'm confident our teams will continue to serve as a great source of strength to our customers and our communities in the months and years ahead. Thank you for taking the time to join us today. We'll now open the line to questions. Operator..

[Operator Instructions] Our first question comes from the line of Brad Milsaps with Piper Sandler..

Maybe I'll start with on the expense side of things. Michelle, a lot of moving parts this quarter.

I don't know if I got all of them, but it seems like maybe on a net basis, your expenses were somewhere around $70 million to $71 million, kind of depending on what you wanted to include or exclude? Just kind of curious kind of how you're thinking about the expense run rate in the back half of the year, opportunities that you may have seen as a result of pandemic, where you can get some savings kind of against additional areas where you may have to do some investing?.

Yes. Thanks, Brad. Your, I think your numbers are exactly right.

I have that, did we, had we not had sort of the noise primarily related to deferred costs mostly on PPP loans, some due to all the modifications that we did this quarter, our salary run rate would have been about a little over $39 million for the quarter had we not had that plus some additional onetime expenses that offset that related to severance and then PPP bonuses and some premium COVID pay that we had this quarter, which would put our noninterest expense run rate at right about $71 million for the quarter if it was normalized.

And I still think that $71 million to $72 million run rate ongoing for now is a good number..

Great. And, I appreciate that.

And then just on PPP lending, do you happen to have the average amount of PPP loans you had in the quarter? And then what the amount of the level of interest income that you recognized in the second quarter as well?.

I don't know the exact average. I think it was a little less than $700 million for the full quarter, Brad, and the total income recognized was about $4.5 million if you include fees and interest..

Great. And maybe just final question for Dave or Dan. As you kind of think about provisioning kind of the things that drove it this quarter, understanding that you guys haven't adopted CECL yet.

But if we have economic stability, however you want to define that, from here continue to improve, would you expect that you would see incremental reserve building from here? Do you think you're getting close to a peak? Or do you expect to have kind of more significant building as you kind of move through the back half?.

Brad, this is Dan. Yes, in the second quarter, we added some Q factors primarily related to CRE to recognize the current environment we're in.

And to answer your question specifically, if the current economic conditions hold or slightly improve, then we certainly would expect the future reserves to be less than what we took in the second quarter noting that the second quarter was really the recognition of those additional risk factors..

And as we've, Brad, as we've noted previously, our, we expect our day 1 CECL adjustment when we do adopt to be about $80 million. If you put that in with where we ended up ex PPP, we're at about 1.47%, which is far higher than we've ever had before. And we think we're fully reserved at the moment, as Dan said, given the circumstances.

And then, obviously, future economic data will determine quarter-to-quarter how it goes.

But I might also mention that in checking with Michelle and Dan and the committee that sets, looks at the whole provisioning and also at the CECL model that's running also beside the incurred loss model, the, at 6 30, we think that the incurred loss model and the CECL model year-to-date are materially the same.

So other than $80 million, we wouldn't expect a big adjustment when we adopt CECL is another way to say that..

Our next question comes from Brady Gailey with KBW..

So David, can you just expand a little bit on this strategic realignment, I think is what you call it, after the TCBI merger didn't happen? Is that done? Is it ongoing? And what should we expect there? I mean, sometimes you hear something like that, and you think that it's potentially some expense savings on the horizon.

Maybe just expand a little bit on exactly what you're focused on there and what we can expect?.

Yes. Brady, thanks. The, as you know, we have Michael Hobbs, who is our Chief Banking Officer and he's coming down from Colorado where he was President of Guaranty Bank when we acquired it. And Michael, I asked Michael to take a really hard look. He was intricately involved.

As you know, we had announced in the merger he was going to be an executive officer overseeing all the traditional community banking and several other aspects of the revenue along with [Jon Sarvadi] in the new go-forward company. Well, so he has been intricately involved in those discussions around all this integration.

And so he really had a look at what we were doing and a deep dive at what Texas Capital was doing.

And then obviously, he's got his experience in Colorado that he brings with him as well and some of the successes they had up there as we've talked about before in both retail and in middle market C&I, where they had a terrific amount of success really under Michael's leadership, hiring teams, putting teams together in those areas.

So the strategic realignment was our decision to exit the origination of equipment finance and equipment loans, both leases and loans as of line of business and also to pullback a little bit on SBA as it regards business development in SBA as a separate line of business. So we're still going to be very active in SBA.

We feel good about, and our experience on that is what allowed us to have very good early success in the PPP program. So we think we're very good in SBA overall, but we are now viewing it more as a support line to all of our community banking across Colorado and Texas as opposed to a separate line of business generating that makes sense.

So that's kind of the realignment is to move away a little bit, or move away completely from equipment finance and a little bit from SBA. And then to move more directly, as we've talked about before, Brady, into a retail strategy that's been very successful in Colorado. We're now going to roll that out across Texas.

We've made 2 key strategic hires we'll be announcing here in the next week or so in that business to roll that out across Texas. And then also to implement the middle market C&I business.

So to your point, yes, we are down, call it, $3 million or so in run rate salaries on the revenue side, but we're going to turn around and reinvest a chunk of that into the retail strategy and into the middle market strategy as well as, as Michelle has spoken about, our infrastructure investments and initiatives as well.

So that's why, as you mentioned, I think, to Brad's question earlier about our run rate expenses, even though, yes, we're down a little bit right now, we expect it to be steady, consistent in that $71 million, $72 million that Michelle mentioned earlier..

Okay. Great. Next, I wanted to ask about loan growth. And if you look at it ex PPP and excluding mortgage warehouse, it was down linked quarter.

Any thoughts on loan growth in the back half of the year and into next year?.

Yes. We, second quarter was, obviously, we think, an anomaly to have a decline in our loans held for investment really for the first time we can remember. That said, the economy was shut down.

And another thing we saw was some investment groups and families exiting some assets, particularly real estate assets, given the continued low cap rates and given the economic uncertainty. So we had a lot of headwind on payoffs in the quarter.

And given the economy is shut down while we are continuing to have a lot of discussions and looking at opportunities, we just didn't get enough deals to the finish line in the second quarter to offset the pay downs that we had. So that's what happened. As far as the go-forward, I think it's going to, the pipeline is really strong right now.

We feel good about how things are developing here in the third quarter. And looking at a lot of really nice opportunities, it seems like some investors are now coming off the sidelines and saying, okay, I'm going to start looking for the opportunities now of any disruption or dislocation.

It's just hard to call exactly, I guess, maybe 2%, 3% growth is what we would expect in the back half of this year, Brady, and then, obviously, pending economic activity, it should be significantly stronger than that in '21, assuming we get back to a more normal kind of environment..

And then finally for me, maybe just an outlook on the margin. Cost of deposits came down pretty nice this quarter, but it feels like it could go a little lower. And then I know liquidity has a big impact on the NIM.

But any thoughts on either spread income or the NIM for the back half of the year?.

Yes. I still think, I estimate the liquidity impacted our NIM by 20 basis points. We just, our balance sheet was large. We had, we're holding a lot of money in interest-bearing deposits. And the yield on those is not that great, as you know. We've already, our balance sheet has already shrunk by about $500 million since the end of the quarter.

We've let a couple of FHLB advances go that we didn't need. So I don't think that we will have maybe half of the liquidity that we had on our books this quarter. So just that the NIM will increase. But if you just look at the underlying loan and deposit yields and costs, we still have some opportunity on deposits. We're continuing to see those go down.

Our treasurer is still working really hard with our relationship managers to move exception rates down. She's done a really good job at that.

As we've talked about before, we still have some promotional CD products, 13-month CDs that are maturing over the next 3 months that there's probably a 2% delta in what those were paying versus what they'll be renewing at. So we'll still get some benefit.

I think the question is loan yields as, at what point are we able to get better pricing on loans at, I think, is pretty competitive right now. But sort of given where we are, I think our, if you just look at underlying loans and deposits, I think our NIM is, I call for it still to remain stable through the rest of this year..

It was actually, Michelle, I believe we discussed the core NIM as we think about ex liquidity, ex PPP was probably up 3 or 4 basis points this quarter..

That's right..

So that's consistent with your previous indication that we think it will be flattish going forward. I think that was supported in the second quarter.

Is that fair?.

That's right..

Our next question comes from Michael Rose with Raymond James..

I wanted to start on criticized and classified. I'm trying to understand kind of the reserve build this quarter. How much was those Q factors? And then maybe how much was some risk rating migration? I think criticized was classified, it was about $219 million last quarter.

Any update there? And then any update on the 30, 89 past due bucket?.

Yes. I think the criticized is classified. You didn't see a material change in those from the previous quarter, Michael. I think it's still early. As we look at that, we're evaluating each credit as we're touching them these days to determine further grading as it is necessary.

And past dues, as you can see, materially better than what we have seen there. I think there are, the portfolio continues to perform well. So we would expect at this point that there will be some migration as I think everyone would expect as the pandemic continues, but we don't see that as being an outsized change at this point..

Okay. That's helpful. And then maybe just a clarification for Michelle. I just want to make sure that I understand the expense commentary correctly. So that would exclude the $10.3 million roughly of expenses that you deferred related to PPP.

So the way I understand it is you'll recognize those expenses as the fees are recognized when the loans are forgiven or they come up for maturity in 2 years? Is that the way to think about it?.

That's right. That's right..

Okay. So then if we assume that, I guess, what is your assumption for at this point based on what you can see from the PPP loans in terms of forgiveness? And then I assume that you'd expect a larger proportion of the fees in the fourth quarter..

Yes. I think at this point, just given what's happening, I don't believe that we're going to get a lot of forgiveness, maybe any, this quarter. I think most of that's going to get pushed to fourth quarter, maybe even first quarter now.

Our run rate on fees that we're recognizing on PPP is about 1.3 million a month, Michael, if that's helpful, assuming no payoff..

And then can we just get a little color, I'm sorry if I missed this, on the deposit growth this quarter ex the PPP impact. It was really strong. I mean was there any sort of concentration there? Was there a couple of large borrowers? Just any color you might have would be helpful..

We look at that. There's really not a significant concentration. We do have our title companies. Those tend to be lumpy. Our noninterest-bearing deposits grew significantly even ex PPP. And looking at our deposit base, it was just $2 million to $5 million chunk sort of across our commercial depositors.

And our specialty treasury group did have, I think about $100 million that came in, but that's not really that unusual for them. And so it was really just sort of across our deposit base is where our deposits came from..

Our sense of it, Michael, was that the sentiment of our customer base was liquidity is important in times of uncertainty. So a lot of, we just felt like a lot of our customers were keeping extraordinary amount of balances in their accounts, given the uncertainty in the world.

And we don't know how to think about that, although it was really extraordinary. The growth rate of our noninterest-bearing DDA in the quarter was greater than we've ever seen before. So we'll see how that holds up.

But we do, we are encouraged about our continuing, something we've talked in the the last 2 years, our ability to generate core low-cost deposits across our branch network continues to be a strength of the company..

But also safe to assume that maybe some of that reverse is, assuming the environment gets less bad as we move forward?.

Sure. Yes, I think that's fair..

Our next question comes from Matt Olney with Stephens..

I want to start with retail CRE. And Dan, I believe you mentioned in prepared remarks that recent rent collections have been better than expected.

Can you add any more color to the statement?.

Yes. I think we've talked about this some in the past, Matt. Very strong performance pre-COVID in this book. And going into it, I think many of the deferrals as a measure of perhaps, the way this portfolio is, would perform. Many of those deferrals were defensive, it appears now.

When they came to us and asked for a 90-day deferral, we looked at it and asked what was going on. And based on that, we readily granted those to the customers that needed them. In retrospect, as we've continued to gather a lot of detailed information from many of those borrowers, the rent collections were much better than expected.

And I'd say they range probably average in 70% to 80% range, but we certainly had some that collected 100% of their rents. And certainly, some of that would have been less. But I think on average, 70% to 80% would be a good number to think about. Overall, I think that book performed well and better than perhaps our borrowers thought it would..

Okay. That's great. I appreciate that. And then, I guess, in that same book, Dan, I think you disclosed debt service coverage ratios and LTVs, and overall it looks great. Looks like the overall leverage levels are pretty low.

Have you looked at any updated appraisals in recent months since the pandemic started? And if so, any takeaways from the more recent appraisals..

I would say we've not gone in and done new appraisals on any of the existing book on new credits that we would evaluate and that we continue to be aware of. Those appraisals have not seen a material decline in the last couple of months.

So we've not seen a big shift in values, which is the question everyone wants to know, right, is are we seeing a deterioration in value? We've not seen that at this point..

Great. That's great news. And then shifting over to Michelle. Michelle, you mentioned some FHLB funding that's rolling off right now. What was the average cost of that, that rolled off? And I assume you'll be replacing this with more retail deposits.

What's the incremental deposit costs you're seeing today? Just trying to see what the trade-off of is going to be?.

The FHLB, those short-term advances, we were paying 35 basis points on those, Matt. And today, our overall cost of funds is right at 50 basis points..

The 50 bps, that's the incremental cost for the new deposit?.

No. I mean it depends. Like I mentioned earlier, our promotional CDs that we have out there, those that were paying 250, those are renewing at 35 basis points. We have money market index funds, some that pay up to 75 or 85 basis points depending on the customer.

Most likely though, we'll, we can still utilize the PPP LF if we need funding for the PPP loans until those pay off, and that's at 35 bps. So I don't really, one, right now, we don't need the liquidity. And I don't really anticipate an additional incremental cost related to that..

Really, the trade, Michelle, if I'm thinking about it right, would be, we've got excess liquidity we don't need. So you're rolling out, if you take a hypothetical $100 million, you'd rollout $100 million of repay that advance at 35 bps, and that would come out of the balances we're holding at other financial institutions, which are yielding....

It depends. 25 to 35 basis points..

Yes. So it really should have no real impact on our spread at all..

[Operator Instructions] Our next question comes from Michael Young with SunTrust. [Operator Instructions] As we have no additional questions at this time, I'd like to pass the floor back over to management for any additional or closing comments..

Thank you very much. I appreciate the help today with the call. We appreciate your participation, and thank you for your interest in Independent Bank Group. Hope everyone has a great day. Bye..

Ladies and gentlemen, this does conclude today's teleconference. We thank you for your participation, and you may disconnect your lines at this time..