Good morning, everyone, and welcome to the SB Financial's Second Quarter 2023 Conference Call and Webcast. I would like to inform you that this conference call is being recorded and that all participants are currently in a listen-only mode.

We will begin with remarks by management and then open the conference up to the investment community for questions and answers. I would now like to turn the floor over to Sarah Mekus with SB Financial. Ma'am, please go ahead..

Thank you, and good morning, everyone. I would like to remind you that this conference call is being broadcast live over the Internet, and will be archived and available on our website at ir.yourstatebank.com. Joining me today are Mark Klein, Chairman, President and CEO; Tony Cosentino, Chief Financial Officer; and Steve Walz, Chief Lending Officer.

Today's presentation may contain forward-looking information. Cautionary statements about this information as well as reconciliations of non-GAAP financial measures are included in today's earnings release materials as well as our SEC filings and other investor materials.

These materials are available on our website and we encourage participants to refer to them for a complete discussion of risk factors and forward-looking statements. These statements speak only as of the date made and SB Financial undertakes no obligation to update them. I will now turn the call over to Mr. Klein..

Columbus, Ohio; and Indianapolis, Indiana. Our lower cost funding continues to be provided by our legacy markets, while loan demand is projected to provide greater asset lift, particularly from these growth markets.

The overarching goal here is to gain market share and expand relationships with clients that can provide not only lending opportunities, but also the expansion of our deposit-gathering initiatives through our treasury management department.

Our new corporate sales champion we referenced in prior quarters is singularly focused on expanding the number of services in each of our single-service households. As we discussed in prior quarters, his focus remains on organic initiatives to drive scale on both sides of the balance sheet.

Given our expansion in the mortgage business line over the last decade in a number of markets where we are clearly under branched, a number of these clients have a limited relationship beyond the initial mortgage product.

With our expanded ability to service these clients digitally, we intend to continue to drive more scope by adding additional products and services to each household. In fact, to date, we have logged a service per household now of 2.90.

Our goal is to add one more service per household in our 36,000 households to drive the depth of our relationship nearer to four, all else being equal. The need for us to provide seamless and digital experience for our clients remains a key objective.

We have begun the process of testing a more robust online account opening process, and we continue to make strides to improve our internal CRM usage and utilize the nCino platform to drive efficiency in our lending processes. Clearly, there remains more work to be done to fully realize the potential of our technology gains.

Operating expenses have been on a general downward trend over the last 18 months due to not only our lower volume-driven commission levels that have led to a pullback in revenue, but also our targeted reduction in resources in those business lines.

Our total headcount is down over 5% compared to the prior year even with the additions we identified for our client contact center we launched this year and five new MLOs. As a result of our focus on cost containment, we have delivered positive operating leverage for both Q1 and Q2.

We expect to continue this positive trend as the balance sheet expands, asset mix normalizes and expenses moderate. Our client contact center was introduced in Q1 and is now, as I mentioned, assisting with client care. In fact, this group is now fielding approximately 12,000 calls per month.

More success on referrals and cross-sells is in the queue as we begin to more effectively embrace the capabilities of our sales force platform. Fifth and final, asset quality. Asset quality continues to reflect strong credit underwriting. Charge-offs were down from the linked quarter to just 22,000.

And for the year, our annualized charge-off rate is just 2 basis points. Thus far, the resilience of our clients has been as anticipated as they appear to have managed their exposure to higher interest rates quite well.

Tony will discuss the favorable position that we continue to see with our allowance level that now includes coverage of our non-performing loans above 500%.

This industry-leading metric is a direct reflection of our commitment to not only prudent lending practices, but also the measures we took during the pandemic to build our reserve in order to provide greater earnings stability post-COVID.

Delinquencies ended the quarter at $2.4 million or just 24 basis points with our less than 90-day delinquencies ending the quarter at just 10 basis points. With client credit bureau scores higher and household debt as a percentage of disposable income lower, all signs point toward continued positive trends in our loan portfolio.

At this time, I'd like to ask Tony to give us a little more detail on the quarter.

Tony?.

Thanks, Mark, and good morning again, everyone. Again, for the quarter, we had GAAP net income of $3.1 million with EPS of $0.44 per share, which is up 10%. Excluding the servicing recapture from the prior year, core diluted EPS are up 22% as compared to the similar core earnings achieved in the second quarter of 2022.

Total operating revenue was up from the linked quarter, but down just slightly as compared to the prior year. And when we exclude the servicing rights recapture from both years, operating revenue would be up 3.3%. Margin revenue was up 2.5% compared to the prior year and for the full-year is up 11.5%.

The efficiency of our balance sheet continued to improve in the quarter as our loan-to-deposit ratio rose to 91.9% and total loans to assets increasing to now 73.4%. Now let's take a look at the second quarter income statement.

On margin for the quarter, net interest margin came in at 3.16%, which is flat as compared to the prior year due to the shift in our earning asset mix and the net negative beta of earning asset yields versus funding.

Compared to the linked quarter, the impact of much higher funding costs, as Mark mentioned, could not be overcome by our loan growth and the improvement in those earning asset yields. Cash and securities as a percentage of total assets continued their reduction in the quarter, but they are now just 19.2% of total assets.

This compares to 19.9% and 23.4% for the linked and prior year quarters. The shift in mix has benefited interest income as evidenced by the improvement in our earning asset yields. For the quarter, we had an earning asset yield of 4.61%, up 12 basis points from the linked quarter and up 116 basis points from the prior year.

Interest income as a result of balance sheet growth and that yield improvement was $14.4 million, up $582,000 or 4.2% for the linked quarter and up $3.9 million or nearly 38% from the prior year. As we experienced last quarter, funding betas have exceeded earning asset betas from both the linked quarter and the prior year.

Deposit costs rose to 1.29% in the quarter, up 35 basis points from the linked and up 109 basis points compared to the prior year. We forecast that these negative betas will continue for the remainder of 2023 based upon the current rate forecast and that we will begin to see stabilization entering 2024.

Fee income as a percentage of average assets improved from the linked quarter to a level of 1.3%. The positives that we have discussed in residential lending were supplemented by better SBA sales volume. As Mark mentioned, we feel that the SBA product is well positioned for the current economic environment.

Additionally, we continue to see stable results in our other fee income categories as compared to both the linked and prior year quarters.

While GAAP operating revenue is down for the year, when we adjust for the servicing rights recapture, total operating revenue growth on a core basis is actually a positive 2.6% and when we add it to our operating expense reduction is a $1.3 million cumulative pretax change compared to the prior year.

Mortgage gain-on-sale yields came in right on the expectations for the quarter at 2.2%, which is still below historical levels, but we anticipate this to be the floor on yields in 2023 and into 2024. Sales volume improved this quarter nearly 75%, and our pipelines are running in the high 70s of saleable product.

We continue to forecast 2023 origination levels to be slightly below our break-even level of approximately $350 million, but we will continue to review resource allocation to preserve profitability.

Market value on our mortgage servicing rights stabilized in the quarter with a calculated fair value of 123 basis points, up 12 basis points from the prior year. That servicing rights balance increased compared to the linked quarter at $13.7 million, and remaining temporary impairment was flat at just $137,000.

As has been our focus in 2023, total operating expenses were down from the linked quarter by $434,000. And when we look at year-to-date expenses, we are down $549,000 or 2.5%. This compares to our operating revenue decline for the year of 1.3%. Now let me take a quick look at the balance sheet.

Total assets of $1.34 billion were flat to the linked quarter and were up $47.5 million or 3.7% compared to the prior year. We were able to fund the growth in loans by the scheduled amortization of our investment portfolio.

And we expect that investment portfolio to continue to decline with that amortization and some prepayments over the next 18 month when we would stabilize the size of the portfolio at that new level.

On the funding side, the deposit decline from the linked quarter was replaced by higher borrowings from the Federal Home Loan Bank, albeit at a marginally higher cost. Deposits compared to the prior year were flat, which required a loan growth of 10% to be funded by the investment portfolio runoff and those higher FHLB borrowings.

Our investment portfolio is now down by over 14% compared to the prior year. However, since overall rates are generally flat to a bit higher, prepayments have – as a source of funding have been constrained.

Tangible common equity, including the AOCI impairment, declined slightly in the quarter to 7.13%, while tangible book value was stable at $13.81 per share, which includes AOCI. And when we exclude the temporary impairment, tangible common equity rises to 9.63%.

Regulatory capital continues to be strong with common equity Tier 1 and total risk-based capital reported at 13.2% and 14.4%, respectively, at the end of the quarter.

We continued an aggressive buyback of our shares in the quarter with 91,000 shares repurchased at an average price of $13.67, which is well below the adjusted tangible book value of our shares in the quarter that I just mentioned of $18.65. Our loan loss allowance improved in the quarter and ended at 1.6% of total loans.

Due to the improvement in the economic factors and a reduction in our level of unfunded commitments, our total provision expense for the quarter was just $145,000 net. We were, however, able to add $375,000 to the allowance. And coupled with our low level of charge-offs, the allowance level improved by two basis points compared to the linked quarter.

And again, this quarter, we had positive momentum in our classified loans. Our criticized and classified loans now stand at just $8.9 million and are down 5.8% compared to the linked quarter and are down $3.3 million or 27% from the prior year.

And quickly, before I turn the call back to Mark, just a quick summary of our year-to-date earnings per share, which while flat to 2022 on a GAAP basis would be up $0.12 or 18% when we exclude the impact of the temporary servicing rights recapture from both years. Mark, I'll turn the call back over to you..

Thanks, Tony. Once again, I want to conclude by acknowledging the dividend announcement that we made this week of $0.13 per share, which equates to approximately 3.8% dividend yield and a 30% payout ratio.

We continue to believe that our strong dividend and continued buyback strategy will drive tangible book value improvement and maximize returns to our shareholders.

Optimistically, we continue to expect higher performance, one that includes prudent organic balance sheet growth, asset mix corrections, as Tony had mentioned, expense control and a return by us to a more traditional ratio of non-interest income to total revenue at or near that traditional 40% mark, albeit on a marginally slowing economic front.

Now I'll turn it back over to Sarah for questions.

Sarah?.

Thank you. We're now ready for our first question..

Ladies and gentlemen at this time, we will begin the question-and-answer session. [Operator Instructions] Our first question today comes from Brian Martin from Janney. Please go ahead with your question..

Hey, good morning everyone..

Good morning, Brian..

Hi, Brian..

Hey. Just maybe a couple of things I just going to touch on. It sounds like the loan outlook or growth sounds like the pipeline is pretty healthy and maybe some people pulling back in the market. Just kind of want to confirm just kind of how you guys are thinking about loan growth.

Just I mean, hearing that's positive, a lot of people with rates being up seem like there's some activity slowing a bit. So just trying to understand the loan growth. And then just, Tony, you talked about funding the loan growth. Just trying to understand, in the past, you've been kind of relying on some of those securities portfolio runoff.

You had some borrowings increase this quarter. Just want to understand if the loan growth you do have, how you're thinking about funding it here in the near term..

Yes. Hey Brian. Just a quick comment. Steve Walz is here, our Chief Lending Officer. But from my seat, as you heard, we're making tons of calls. And we all agreed when we made the presentation of the 2023 budget to our Board that it's going to take twice as much work to get half as far.

And I think our commitment to outwork the competition is somewhat evident in that $60 million pipeline. But Steve Walz is here, and he can kind of give us a little more color on where that's coming from, Steve, and what you see in the next two, three months..

Sure. Thanks, Mark. Good morning, Brian. Yes, we saw definitely some acceleration of our pipeline from the first half. Some of the looks we saw in the first half, a lot of – some investment CRE that given our commitment to asset quality didn't appeal to us. We are seeing some improvement not only in the volume of our pipeline but in the credit quality.

And I think, Brian, some of that is due – well, a few factors. Certainly recent economic indicators show some increasing confidence from borrowers, consumers as well as businesses that take care of them. So we're seeing more broad activity, but I think also, as Mark mentioned earlier, some of the competition is pulling back.

I think they have probably liquidity concerns that aren't quite the concern they are for us and allow us to perhaps pick up some new clients in the marketplace. So we're seeing some opportunities from competitors as well driving that.

And as Mark mentioned, we saw some softness in our rural ag markets due to the strong earnings of our farm community, which is great for asset quality but hasn't resulted in as much borrowing from them. So that's kind of the picture..

And then a couple I think on that, Brian, you asked about funding. I think that still continues to be a challenge. And I do think, as Mark said, we're being a little bit more selective on what we're looking at. But I think we're willing to take a piece or two off of our margin that we've been accustomed to in the past for good quality credits.

Because we know most of our funding is now coming kind of at that 4.25% to 5% range on the margin. We've done okay on relationships. We certainly could do better at any time, but that's certainly kind of the bottom line. I think you're still able to generate a fair amount of funding dollars, call it, 100 basis points below the wholesale market.

If you want to do that, the risk, obviously, is your current book of business and how you manage that, which thus far, we feel like we've done a pretty good job..

Okay. So not much in the way of securities. I guess the growth you do have in the back half of the year, there's not much opportunity to fund it from the bond book at this point or even in the next year.

So we should think about it being more growth in the balance sheet going forward?.

Yes. I think we're going to have kind of our normal $2 million to $3 million of amortization of the portfolio, some slight prepayments as we get to some rate notches and some maturities. But it's going to be, like we said, $30 million to $40 million that the portfolio is going to decline, but that's about it, not any kind of rapid prepayments..

Yes. Okay. That's perfect. And then maybe just a couple of others, just on – high level on the mortgage. I know you talked about, Tony, the gain – the margins sound like they're at a bottom here, a trough and are either stable or up from here. That seems fair. And the sale volume seems pretty – definitely improved.

Just as far as origination volume, how are you guys thinking about that? Just holistically over the next couple of quarters or just 18 months, just how you think, see things playing out there?.

Well, I think we've done $114 million through the first half of the year, call it, 32%. I would think we're comfortable that we're probably in a $70 million to $80 million third quarter. I have a – I guess I'd lean more to the upside on that at this point of what we're seeing. And then we'll see how Q4 lands.

So that kind of lands us somewhere between 2.50% to 2.85% for the full-year, which I think is still, as we've talked about, below that kind of 3.50% kind of Mendoza Line for us. But I think that lends towards a nice 2024..

And Brian, just to comment, we – as I mentioned, we continue to be very bullish on this new in Indianapolis market that we've descended upon. We now have five producers there. Last month, they were at the top of the list on production. Still like some limited PCG kind of mortgages kind of thing, but we're very bullish on that market.

And as we've discussed before, we think it can be all of what Columbus has been in the past. But we have five high-level producers that get the concept, and we kind of like to classify them as self-propelled lawnmowers. They want to do as much as volume as we want to do.

So we're bullish on that, and we think that's going to certainly help us going forward, to get back to where we used to be, which is somewhere around a $500 million – north of $500 million mark..

Yes. Okay. That's helpful. And maybe just jump into the margin for a moment.

Just as far as how you're seeing things play out here with the rate increase yesterday and then just the growth outlook going forward and just the funding cost, how should we think about the margin over the next couple of quarters? I mean, does it begin to trough? And then with the rate environment potentially being down next year, just trying to understand the dynamics near term and then how we should think about the balance sheet being positioned with potentially seeing rates drop..

Yes. I think that you're spot on there. And what we've seen is, I think the market has stabilized, if you can call it stabilization. I'd call it that 4.5% to 5.25% range that's where marginal retail funding is. And I think most community banks can kind of survive there.

We're seeing loan pricing in the high-6s to low-7s, and that seems to be okay with our clients. I think our 3.16% margin is going to stay roughly in that range, I would think. I think we'll start to get some slight improvement as we get into 2024. We were very aggressive on being short-term on our funding, so we're going to have a lot roll-off.

And if we do get rate declines and if the market cooperates, I think we'll start to take some funding costs off the table as we enter, call it, 2Q of 2024..

Being a little more liability-sensitive..

Yes. Yes..

Yes. But so really, this quarter, it could be a trough, Tony, as far as where the margin is and it's flat to up from here? Is that kind of what you're saying, you think there's a little bit more pressure near term and then....

Yes. I do think Q3 will have some – still have some downward pressure just because as you've seen probably in all your banks that the rapid acceleration of funding costs is just – it's just not really stopping.

And there's a lot of competition out there, which I tell there's – which tells me on the funding side, there's real liquidity strain, which is why, as Mark talked about, we've seen some of our competitors pull back on the asset side because they just can't find the funding..

Got you. Okay. That's helpful. And maybe just the last one. Just on the – the expenses have been really strong management-wise.

Just understanding what – how that looks for the back half of the year, just kind of the run rate we're at today, absent the swings in mortgage volume, up or down, I guess, what – is this a pretty good level? Are there more things and more initiatives you guys are undertaking? Or is this a pretty good level?.

Yes. I think the $10.3 million to $10.5 million, as we've talked about, is kind of what we consider to be our core level of expense range. I do think there's probably some bias to the downside from that just because we continue to be, I think, very cognizant on the front line.

We've had pretty detailed instructive lessons with our teams about let's understand what we're doing and what we're getting to. We're on the back half of kind of our technological investments that we put in place. I don't think that's going to be a headwind going forward. So it is going to be a bit of a volume game.

I think we've rationalized some head count resources, as we've talked about. We've consolidated some positions. We've done some other things. We've got management all in place that we think. So I don't – I really don't think other than producers, that's going to be our only kind of FTE increases going forward.

So long answer to what I think is this is kind of our core level with a slight bias downward going forward, absent volume constraints..

Got you. No, that's helpful. And one other thing you mentioned, the SBA business. I guess it sounds as though you expect the momentum there given the current market conditions to continue to be pretty healthy.

Is that – I don't know how the – I think you talked about the pipeline, maybe I missed it but just understanding, is that similar – whatever the level of kind of earnings this quarter was.

Is that kind of how to think about that going forward? Or is that – anything ramping up from here? Or is it pretty consistent?.

Well, I think, Brian, it's kind of consistent, but it's also very bullish. As I mentioned, we think that SBA program as a preferred lender really fits quite well into finding some of the deals we're finding, which would be generally a replacement of equity with debt for companies changing ownership because of aging management and so forth.

It's playing really well into that arena of the SBA. And we not only get good yielding residual portfolio. We sell off the parts that we want. We keep some of it for net interest margin in comparison. And obviously, getting that C&I deposit account is really important, which they're willing to do.

So very bullish on that in a market where the economy may be slowing a bit. And I think we've found what we've generally liked. We're trying to score a few more of them so that we can be more nimble with the process.

But we expect that $15 million to $20 million in 2023 is kind of our bogey, and it gets us back to where we pretty much landed before COVID..

And I would just supplement there, Brian. Traditionally, we've seen SBA, call it, as a percentage of that commercial loan pipeline to be in the kind of mid- to high single digits. That number is, call it, 20% to 25% now. So that $60 million, you've got a fairly strong pipeline out there.

And again, those are a little bit more risky because they take a little bit longer, but that's why you try to have a big pipeline in there to get that to the bottom line..

And Tony, some of it is on client need..

Yes..

But Brian, half of it is on more appointed calling in those 1,900 calls, where we're doing more calling on the C&I kind of thing, like we talked about over a year ago. But it's easier said than done because they're harder to find, they're more work, and they're a little – more elusive. But it's making some difference on the SBA platform..

Right. And on that 60 – on that piece of the SBA portion, some of it's going to go – I guess, if that's part of – that's a good chunk of the pipeline. A good piece of that, if it gets done, gets sold and you keep a limited piece of it.

So the $60 million pipeline per se is somewhat diluted by some of that going sale market and coming on balance sheet but getting the benefit both sides on the fee income side and the piece you put on the balance sheet getting the revenue.

Is that how you think about it?.

We'd like to have our cake and eat it too. We'd love to be able to get the gain as well as the balanced growth. But you're exactly right. Some of that is going to be SBA, but we're selectively deciding how they're priced, what is the market value if we sell versus the breakeven on the net interest margin. So we're constantly deciding per deal.

What do we do with it? Do we put it on our books and keep the gain longer term or do we sell it and take it upfront? And I know, Tony, we're kind of evaluating each one as we speak. And that's probably a nice balance of each in there..

Yes, yes..

Okay, perfect. I appreciate all. Thank you guys for taking the questions and the update and nice quarters. Thank you..

Thanks Brian..

Talk to you later..

Thanks Brian..

[Operator Instructions] While we're waiting for additional questions, I'd like to remind you that today's call will be accessible on our website at ir.yourstatebank.com. [Operator Instructions] And ladies and gentlemen, I'm showing no questions at this time. I'd like to turn the floor back over to Mark Klein for any closing comments..

Thank you, sir. Once again, thanks for joining us. I look forward to bringing you up to date on our third quarter in October. Goodbye..

Ladies and gentlemen, with that, we'll conclude today's conference call. We do thank you for joining. You may now disconnect your lines..