CapStar Financial Holdings, Inc. (NASDAQ:CSTR) Q4 2022 Earnings Call Transcript

CapStar Financial Holdings, Inc. (NASDAQ:CSTR) Q4 2022 Earnings Call Transcript January 20, 2023

Operator: Good morning, everyone, and welcome to CapStar Financial Holdings Fourth Quarter 2022 Earnings Conference Call. Hosting the call today from CapStar are Tim Schools, President and Chief Executive Officer; Mike Fowler, Chief Financial Officer; Chris Tietz, Chief Credit Policy Officer, Executive VP of Specialty Bank. Please note that today’s call is being recorded. Replay of the call and the earnings release and presentation materials will be available on the Investor Relations page of the company’s website at capstarbank.com. During the presentation, we may make comments, which constitute forward-looking statements within the meaning of the federal security laws. All forward-looking statements are subject to risks and uncertainties and other factors that may cause the actual results and performance or achievements of CapStar to differ materially from those expressed or implied by such forward-looking statements.

Listeners are cautioned not to place undue reliance on forward-looking statements. A more detailed description of these and other risks, uncertainties and factors are contained in CapStar’s filing with the Securities and Exchange Commission except as otherwise required by applicable law. CapStar disclaims any obligation to update or revise any forward-looking statements made during this presentation. We would also refer you to Page 2 of the presentation slides for disclaimers regarding forward-looking statements, non-GAAP financial measures and other information. With that I will now turn the presentation over to Tim Schools, CapStar’s President and Chief Executive Officer.

Tim Schools: Okay, thank you, sir. Good morning, and thank you for participating on our call. We appreciate your interest in CapStar. We’re pleased with our results for 2022 and the quarter. We reported earnings per share of $1.77 and our return-on-equity of 10.7%, strong loan growth NIM expansion disciplined expense control and low-credit costs each contributed. In line with our capital allocation efforts we also returned a record $17.9 million to shareholders through dividends and share repurchases. What is significant is within the annual numbers we had $2.7 million of loss related to mortgage and the wire loss, and TriNet was breakeven. We’re in a complex operating environment, but our mortgage and TriNet divisions are outstanding businesses that have strong earnings power in the right markets.

As we mentioned last quarter, we had two operational losses of which one for 732,000 was fully recovered this quarter. We remain optimistic that we will have a recovery also related to the wire later this year. As an aside, I will mention the FBI, the TBI and the Cleveland Tennessee Police Department have identified the fraudster and have put out a national indictment which is unusual as they typically are limited to 500 miles. The TBI also intends to add the individual to the Tennessee top 10 most wanted list. In contacting our core FIS, this individual’s online credentials showed up across their operating system attempting to penetrate other banks. He also attempted to defraud another Tennessee Bank a few weeks after us. Assuredly, he is part of a larger network and he is trying to impact a number of banks.

In the third quarter, we reported $0.47 per share and a return on equity of a 11.8%. As noted, our earnings included the recovery of 732,000 related to one of the operational errors. It is subject to appeal but our Counsel feels it is more likely than not that the opinion will remain favorable to CapStar. The appeal process could continue through year-end. Loan growth for the quarter remained strong at 11.1% average and 8.6% in the period linked-quarter annualized when you exclude the TriNet balances that we moved this summer and our holding in loans held for investment. Our markets remain strong although lending has begun to slow due to the impact of higher rates. As a bank, we are being cautious with the uncertain economic and funding outlook having pulled back on CRE last summer tightening some underwriting criteria and maintaining our discipline on loan spreads.

We have a strong loan engine an advantageous markets that continue to be in a conservative nature. Our credit metrics remained strong which Chris Tietz will cover later. We have three past dues we are addressing, two of which have been problem loans for a while. We are performing active portfolio management with higher rates to identify customers early who might become a problem now or in a slowing economy. As we communicated last summer depositors became very aggressive in the second quarter of 2022 and that continues today. One of the biggest competitors to date has been the U.S. Treasury and Treasuries were individuals have pulled money from banks into treasuries. We are working hard to offer competitive rates and products to maintain and attract new depositors while not cannibalizing the portfolio.

It is as challenging as I have seen it. More recently, banks have stepped up to wholesale prices on their deposits and you face a situation that you either have to match or lose the relationship. We hope this will slow as the Fed slows but margin pressure will likely continue in the near-term through the first half of 2023. Until then deposit rates will continue to rise, we will work hard to get as much offset as we can on the loan side. Some of the specific actions we’re taking related to deposits include, we are monitoring competitor bank rates in our markets and their specials. To-date it appears our betas are in line or a little lower than our local competition. We are proactively discussing each customer request that comes to the table.

We’re requiring the primary deposit relationship on all new loans. We are calling on all relationships where a deposit was not obtained historically. We’re calling on all customers for accounts that they might have elsewhere. Lastly, we’ve changed our incentive plan to require a certain level of funding percentage to loans for each banker in market. Our highest paying category has always been deposits and specifically DDA. This will also ensure our great staff our outstanding bankers and not just outstanding lenders, encouraging them to call on deposit only customers as much or more as borrowers. As it relates to fees, mortgage volumes remain at historical lows nationally. We have a tremendous mortgage company and team and are monitoring local and national markets.

We reduced staff in the third quarter and have an opportunity to evaluate that further. Again, we have a strong division and do not want to be shortsighted but it is something we are discussing. TriNet was paused in third quarter 2022 due to the unusual rate environment. We will be testing a limited pool in the first half of 2023 with a different rate structure and risk protocols. We do not have a tolerance for further losses. So volumes might be lower, but we want to ensure we have a gain on sale. We’re very excited about our new SBA expansion. From my experience, SBA is something you should really be committed to or not do it. CapStar has had a limited investment to-date and demonstrated some success overtime. In fourth quarter 2022, we were approached by a top 10 team that elected to join us.

Overtime, we are planning that they can generate $2 million plus of quarterly gain on sale. There are three other revenue components that Chris will discuss later but that is the most visible component. In the past, we’ve cited $16.5 million as our non-mortgage expense noninterest expense range. Recently, we’ve been running under that and this team adds another approximate 800,000 a quarter of noninterest expense to include commissions that would go with their revenues. Lastly, we’ve worked hard to put CapStar’s capital to use in a productive manner. By entering new markets and growing loans, increasing our dividend and buying back stock. We renewed our buyback this week albeit at a lower level of $10 million. We feel that is prudent with the uncertainties with the economy at the moment and we’ll continue to evaluate as the year progresses.

Now I will turn it over to Mike for more details on the margin and other items.

Mike Fowler: All right. Thank you, Tim and good morning everyone. So on Page 5 a few quick comments on financial results for the quarter. We reported net income of $10.3 million, $0.47 a share. As Tim noted Q4 results do include a 700,000 recovery related to one of the two third quarter operational losses. Total revenue was $31.2 million in Q4. That is up $2.4 million versus Q3. So recall that Q3 did include $2.1 million of realized and unrealized losses related to selling or transferring to held investment the remaining TriNet loans, which were in held for sale. Expenses were $16.3 million for the quarter. They were down $1.3 million versus the prior quarter. But again, as Tim noted, recall that the prior quarter did include $2.2 million of operational losses, partly offset by an $800,000 voluntary executive bonus reversal.

On Page 6, I’d just point out a few metrics. So we did report pretax pre-provision as a percent of assets of 1.86%. We reported return on assets of 1.31% and reported return on tangible equity of 13.6%. And we will go through Chris will review the credit metrics obviously later in the presentation. On Page 7 in terms of net interest income and net interest margin after rising materially in the second quarter and the third quarter where we benefited modestly from Fed hikes and remixing the asset shifting excess cash into loans as Tim noted, the fourth quarter net interest margin 344 was down 6 basis points versus the third quarter primarily due to two factors on the deposit side. One was a mix shift into higher cost categories and one of customer funds, which we’ll talk about on the next slide.

And number two is additional deposit pressure from increases in customers seeking alternatives but also from an increased an increasingly competitive local deposit market. And I would say some of that is from local competitors locally based competitors within our footprint. I’ve been surprised somewhat to see more aggressive pricing both on promotions and on an exception basis from a much larger regional players and from some very large national players, haven’t seen that until recently. Overall, our deposit beta increased to about 40% in Q4. And as Tim alluded to we have seen NIM pressure later in the quarter. And that does suggest likely near term NIM pressure in the next one to two quarters. On Page 8 in terms of deposits, total deposits were roughly flat.

I would say in terms of deposit pricing, we have seen our betas and as Tim said, we actively monitor competitor pricing through S&P. We monitor standard rates, we monitor promotional rates and we monitor exception rates through what we’re hearing from our bankers. And we certainly as we’ve seen in prior cycles and as we expected we have seen betas increase the deeper, the Fed has gone into their Fed hiking cycle. In terms of balances, we did see customer balances decline this quarter by $156 million. We saw about $60 million in our correspondent banking division, as our correspondent bank clients are deploying our excess liquidity but we also saw $97 million in other bank customer balances decline. We offset that this quarter with $160 million in broker deposits.

And from a price from a cost standpoint as you can see on the chart our deposit costs rose 58 basis points to an average of 1.2%. If we look at Page 9, in terms of loan growth and loan yields, we continue to have solid loan growth. The bar chart on the left is our reported loan balances. The first forward the Tim referred to in terms of our held-for-investment loan growth that is excluding the TriNet transfer from its removing TriNet loans that we have had in held-for-investment. Normally, those are in held for sale. So we did remove the TriNet impact from the 11.1 average growth and the 8.6%, end-of-period, without excluding those, you can do the math the period-end is a little bit under 4% without adjusting for TriNet. We continue to see strong loan production.

It is down a bit from last quarter I believe that we’re continuing to see solid loan production $150 million in Q4. And the pipeline remains strong across our markets, commercial pipeline $450 million. As we’ve said on the last call and I know we’re hearing more of this in the industry, we are being more disciplined and somewhat limiting our loan growth maintaining disciplined pricing which I would say we’ve seen more challenges on the deposit side from a pricing standpoint, we’ve seen I would say the summary expects the flip side of that on the loan side middle of last year when the Fed was hiking 75 basis points, every meeting ratio going up sharply along the curve, as we mentioned on earlier calls we were remaining disciplined, but seeing more competitive pricing that hadn’t caught up to where market rates have gone.

I think with the Fed slowing and the yield curve flattening and inverting, we’re seeing competitive pricing more in line with where the markets are I think giving us more comfort and ability to achieve our targeted spread on the loan side. Our loan yield did increase this quarter 41 basis points and we did achieve in terms of originations for the quarter match-funded spread against wholesale funding against home loan funding 2.39% as of the time of funding. On Page 10 related to non-interest income mortgage revenue as you know has been down sharply from a year ago, with the increase in mortgage rates. We do believe at this point mortgage revenue reflects limited volume in-line with national trends. Margins however, have started to rebound and are returning to what we view as more normal levels.

As Tim mentioned, TriNet which we had announced previously, we had paused and third quarter that remained paused through the fourth quarter. But as Tim said, we are now testing a limited pool in the first quarter, as he said, we have no appetite for additional losses, and these are originated to sell, we’re cautiously optimistic that our testing will be successful and will lead to potentially further expansion of that business, but SBA lending revenue, as Tim said, very excited about that. Chris will talk about that more in a few minutes. You certainly see the results the recent SBA expansion in terms of fourth quarter revenue, where fourth quarter SBA lending revenue is up a little bit under a $1.5 million up about 900,000 from last quarter.

Turning to Page 11, and non-interest expenses adjusting for — well again we reported $16.6 million that includes the recovery that Tim had mentioned of 700,000 operational loss from Q3. That is down from $17.9 million last quarter. But recall as Tim mentioned, last quarter did include $2.2 million of operational losses and partially offset by 800,000 voluntary executive bonus reversal. A good part of the increase in adjusted expenses versus last quarter is the additional SBA or costs related to the additional SBA hires, which again are very excited about and I will turn over to Chris to discuss now.

Chris Tietz: Great, thank you, Mike. Turning to Page 12, we are excited to announce additions to our SBA team under the leadership of its newly appointed Director, Marc Gilson. Marc is assembling a team of seasoned professionals that I have been impressed with in every interaction. This team generally comes from high production SBA lenders with volumes writing them in the top-tier of national lenders. Their primary target is the origination of SBA 7A loans generally with a 75% government guarantee where we will intend to sell the guaranteed portion for a fee. As shown in the chart on Page 12, while we are pleased with the historical trend in growth in the SBA Group, we felt that it had potential for more. Please note that of the $2.5 million in SBA net fees for 2022 over half of this was earned in the fourth quarter.

While net interest income will change with variable-rate pricing we believe that the fourth quarter provides good insight into near term expectations for fee growth. Last quarter, we provided guidance to you of $750 to $1 million in fees for the fourth quarter. With the addition of this new team, we were able to exceed that guidance at $1.4 million for the quarter. Having said that, we believe that the near-term average will be in the $1 million to $1.5 million range per quarter on a growth trajectory to $2 million per quarter as the team settles in and gains cadence and efficiency in their process. In addition, we continue to recruit new business development officers coming from efficient well-run lenders demonstrating long term credit loss experience below the SBA averages.

Execution is the key in this arena to be sure we maintain the SBA guarantee. We believe that we must have strong investment in revenue production, robust underwriting and approval support and a strong and seasoned servicing team. With this in mind we believe our strategy is sound, with the goal of staffing our team with seasoned SBA lenders but we are also adding the oversight of an SBA specific post-closing loan review by an external accounting firm to mitigate execution risk and to hold us accountable to strong expectations. Now turning to risk management. On Page 14, we are pleased with continued improvement in our overall level of criticized and classified loans having achieved a 50% reduction for the year from 2.64% of loans at December 31, 2021, to 1.31% of loans at December 31, 2022, and that reflects a 27% reduction for the fourth quarter.

Of note, approximately 60% of the criticized and classified loans outstanding at year end 2021, we paid-off or upgraded in the course of 2022. We are encouraged by this improvement in overall asset quality. There are some data points relating to the level of impaired and doubtful loans and past dues that warrants some additional insight. First, let me remind you of the evolution of problem loans, often they start exhibiting red flags with us either through identification of borrower operating results, giving us pause for concern or delinquency or a combination of both. Upon identification of concern such borrowers will generally be rated special mention and may migrate up or down from there overtime. Once a loan migrates to substandard, as I’ve indicated in prior quarters calls it often takes 18 to 24 months to resolve the situation.

Approximately 38 of the 41 basis points in impaired loans are in three borrowing relationships in active workout status. These loans are impaired and have been subjected to impairment review with approximately $700,000 in specific reserves applied to the account to account for potential loss. These three impaired relationships also account for 41 of the 50 basis points in past dues. Despite the negative migration in that small number of credits, we remain encouraged with overall asset quality for the following reasons. The improving trend in special mention and substandard loans is a favorable leading indicator for future asset quality in the near-term. With each of these two categories, at 25 basis points and 65 basis points respectively, they represent historically low levels, which buffers us against the impact of potential deterioration in uncertain economic times.

Adjusting for these three relationships in active workout past dues would be an exceptionally good 9 basis points continuing a favorable trend from prior quarters. So let me step into the three relationships I’ve mentioned. The total of these three relationships is approximately $8.9 million. All of this $8.9 million approximately $5 million is a single relationship where the primary collateral is real estate. This relationship came to us through an acquired institution. The remaining two loans totaled $4.9 million and our SBA guaranteed transactions originated in 2020 with $3 million of SBA guarantees retained on our balance sheet, mitigating us against risk of loss. Subjecting these three loans to impairment reserve or review, we have accounted for $700,000 of potential loss in a specific reserve accounted for in our provision of $1.5 million for the fourth quarter.

Turning to Page 15 with the impairment of the loans previously discussed, our provision expense of $1.5 million takes us to 113 basis points at 12.31 including fair value marks. As you know, like others, we adopted CECL on January 1. Our general guidance is that the impact of the conversion to us is in line with other banks as to the expectation for direction of change in the allowance for credit losses under CECL in coming periods we would expect it to be driven by macroeconomic conditions with modifiers based on the direction of risk in our own portfolio assessment from period-to-period. With that, I’ll turn it back to Tim.

Tim Schools: Okay, thank you. Thank you, Chris. I’m really proud of our team and look forward to 2023. Since the onset of the pandemic the environment continues to bring new challenges and we continue to work hard to address each one and improve the bank along the way. That concludes our presentation and we are happy to answer any questions. We appreciate your support.

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Q&A Session

Operator: And our first question comes from Brett Rabatin from Hovde Group. Your line is now open.

Brett Rabatin: Hi, good morning guys. Appreciate taking the question. Wanted to start-off with the margin and just your expectations for the first half of the year. And if you had the December margin that would be helpful. And then just maybe thinking about the spread of 2.39%, that seems a little lighter than what I think you would have been the case you be comfortable with previously. Just want to make sure I understood if that was primarily on the lending side that you’re not being able to accelerate the yields as fast or if that’s just deposits or such so more expensive. Thanks.

Tim Schools: So, I’ll start on the loan spread first and I’ll let Mike talk about the margin. And good question. Thank you for the question. You can sort of just do it on a napkin or an excel. But if you take a 200 basis points spread, right, and then you got to multiply, just take $1 million and multiply it by 2% you’re assuming that is your spread minus your FTP cost. If you’re going to assign some level of credit expense, some level of operating expense and then taxes today at 20%, to me you really want to get a 200 basis point spread. I mean there’s times where other banks I remember when I was in Memphis there was competitors that would do large churches over there at 110 basis point spread. If you think about that, if you’re going to have operating expenses, commissions, expenses and taxes you’re not going to get a 125 ROA.

So it’s just been a rough rule of thumb for me, Brett, in my career that on the commercial side, I try and get my teams to do a minimum of 200, sometimes we don’t. Last if you go back to the fall of 2021, I think that fourth quarter our commercial spreads were 250 basis points from my memory in that range. As we enter the spring of 2022, you might remember me mentioning that we have extreme discipline and probably too much. And we wanted to hold tight at that and as rates went up, banks did not move their market rates to match the underlying rise and FHLB sort of base rates. So the rates we put on the spreads, we put on the first half of last year I think from memory, we’re in the 170 range. And so, I’m actually pleased that this quarter was 239 again I think that would be great in a normal operating environment, so I’m glad to see that we need to keep trying to get as much as we can.

I saw someone put out a note on home bank in Arkansas, I don’t follow them that their new production was at 7.1%. And they talked about how they were trying to make up some of it on the loan side, we need to do that as well and our deposit strategies, but I am pleased with the 239. Now I will turn it over to Mike to talk about the margin and I think that December is a good question.