Greetings, and welcome to South Plains Financial third quarter earnings conference call. At this time, all participants are in listen only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Steven Crockett, Chief Financial Officer. Thank you, sir. You may begin.
Thank you, operator, and good morning, everyone. We appreciate your participation in our third quarter 2019 earnings conference call. With me here today are Curtis Griffith, our Chairman and Chief Executive Officer, and Cory Newsom, our President. As a reminder, a telephonic replay of this call will be available through 11:59 P.M. Eastern Time on October 31st, 2019. Before we begin, let me remind everyone that this call may contain certain statements that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These include remarks about our future expectations, beliefs, estimates, plans, and prospects. Such statements are subject to a variety of risks, uncertainties, and other factors that could cause actual results to differ materially from those indicated or implied by such statements.
Such risks and other factors are set forth in our prospectus filed with the Securities and Exchange Commission, dated May ninth, 2019. We urge listeners and readers of our earnings release to review the Risk Factors section of that prospectus and the Risk Factors section of other documents South Plains Financial files with the SEC from time to time. Listeners and readers of our earnings release are cautioned not to place undue reliance on forward-looking statements contained in this earnings call or in our earnings release. We do not undertake any duty to update such forward-looking statements except as required by law. Additionally, during today's call, we may discuss certain non-GAAP measures which we believe are useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP.
A reconciliation of these non-GAAP measures to the most comparable GAAP measures can be found in our earnings release. At this point, I'll turn the call over to Curtis.
Thank you, Steve, and good morning. On today's call, I will briefly review the highlights of our third quarter and then provide an update on our pending acquisition of West Texas State Bank. Cory will discuss the success that we have achieved improving our profitability and returns as we scale our infrastructure and remain disciplined on expenses. Steve will then conclude with a more detailed review of our third quarter financial results. To start, I'm very pleased with our results as they clearly demonstrate the successful execution of our strategy to grow the bank while also improving our returns as we pursue our long-term goal of achieving returns in line with or better than our peers.
For the third quarter, we reported net income of $8.3 million, or $0.45 per diluted common share, as compared to net income of $6.1 million, or $0.37 per diluted common share in the second quarter of 2019. Net interest income increased to $26.6 million for the third quarter of 2019 as compared to $24.8 million for the second quarter. While overall loan growth has been soft, we benefited from our normal cyclical ag fundings this quarter, combined with improved cost of funds. As a result, our net interest margin increased 19 basis points from the second quarter to 4.07%. Our cost of funds improved 10 basis points to 98 basis points compared to the second quarter as we experienced a positive mix shift to non-interest-bearing deposits in the third quarter, as well as a decline in interest rates paid during the quarter.
As Cory will touch on in more detail, a key focus of our strategy is to leverage the significant investments that we have made in our infrastructure while also reducing our expense base in order to deliver peer average or better returns, which we believe will create real value for our shareholders. Today, our infrastructure can handle significant asset growth, which will allow us to further scale the bank without adding incremental people or investments. Additionally, this investment will also allow us to pursue strategic M&A, like our pending acquisition of West Texas State Bank, or WTSB, which we detailed on our second quarter earnings call. As a reminder, WTSB is headquartered in Odessa, Texas, and operates six bank branches located across five West Texas communities that will be rebranded to City Bank upon closing of our acquisition.
At quarter end, WTSB had $430 million in assets, $375 million in deposits, and $200 million in loans, all of which are consistent with their second quarter financials. I am pleased to report that we have received all necessary regulatory approvals and expect to close the acquisition on October 31st. Ahead of our expected closing, we've been working closely with the WTSB management team on our integration plan and are very pleased with the mutual spirit of collaboration. We continue to believe that our resulting balance sheet will be a competitive advantage and open City Bank to new business opportunities. We also anticipate cross-selling opportunities with WTSB customers for our mortgage, wealth management, and trust products.
In meeting with their branch employees, we believe there is a real need for mortgage lending in WTSB's more rural markets, and we believe our mortgage banking teams will be able to hit the ground running very quickly post-close. We also believe that there will be strong demand for our wealth management and trust products in WTSB's markets and are optimistic that we will be able to generate revenue synergies in addition to the cost synergies that we have previously outlined. In regards to our expectations for cost synergies, we continue to expect that we will reduce WTSB's non-interest expense by 30% by 2021, approximately 75% of which we expect to achieve next year. We continue to expect 20% earnings accretion over four quarters beginning in 2020, with a tangible book value per share earn back of less than four years. I'd now like to turn the call over to Cory.
Thank you, Curtis, and good morning, everyone. As Curtis discussed, we are very pleased with our progress working with the WTSB management team as we prepare to close the acquisition and begin integrating their operations into City Bank. A key advantage that we have relative to our community bank peers is the significant investment that we've made in our systems and infrastructure, which position the bank for growth and expansion. In fact, we believe these investments will allow us to scale our business without commensurate additional expenses and will help the bank deliver peer average or better ROAs and ROEs. As we continue to grow the bank, both organically and through accretive acquisitions, we will remain disciplined on expenses as we continue to optimize our cost structure to further improve our profitability.
An example of this can be seen in our third quarter results, which benefited from a redesign of our benefit plans to be more in line with our peers, as well as continued operational efficiency gains, which have allowed us to reduce our headcount. Taken together, we were able to reduce personnel expense by approximately $650,000 in the third quarter of 2019, which marks the second quarter in a row of personnel cost savings. Importantly, these actions were focused on improving our efficiency without sacrificing customer satisfaction. Additionally, we have implemented technology solutions to help us handle loan growth more efficiently and without adding incremental costs for people, as Curtis mentioned.
Though we did experience one-time costs associated with our IPO and acquisition of WTSB, we see our core quarterly run rate for expenses in the low $29 million range for the fourth quarter versus $30 million run rate that we've been operating at thus far in 2019. Our success is also beginning to show itself in our financials as we improved our efficiency ratio by 123 basis points year-over-year for the third quarter. Our return on average assets increased by 44 basis points year-over-year to 1.18% annualized. Our return on average equity increased by more than 200 basis points year-over-year to 11.1% annualized in the 2019 third quarter. While we are pleased with our results, we recognize that this is a journey, and know that we have more to accomplish.
Turning to loan growth, the environment has remained challenging, but we will not sacrifice credit quality for growth. In the third quarter, we grew loans by 5.6% annualized or by $27 million for the second quarter. This growth was primarily the result of seasonal agricultural production loans net fundings of $19 million. Overall, we've experienced an increase in loan prepayments and payoffs, which have been a headwind to loan growth. That said, I'm encouraged by our loan production as we have generated over $500 million in new loans year to date. For the full year, we expect loan growth to be broadly flat year-over-year before accelerating in 2020 to more normal levels.
Turning to fee income, which is a priority for our team, we generated $14.1 million of non-interest income in the 2019 third quarter, which compares favorably to the $13.7 million that we generated in the second quarter. The increase was primarily the result of strength of our mortgage banking business, given the sharp decline in interest rates so far this year. Overall, our fee income is primarily driven by our mortgage operations, debit card, and other bank service charge income and income from our insurance, trust, and investment service business. Our fee income provides shareholders with a recurring and diversified earnings stream as it represented 35% of total revenue for the third quarter.
Looking forward, we are excited by the opportunities that we see to further expand our fee income through potential cross-selling of our products into the more rural communities in which WTSB operates, as well as expanding our crop insurance business. As a reminder, our crop insurance business is a good business for us as it generates healthy fee income without presenting the bank with underwriting risk. I would now like to turn the call over to Steve.
Thank you, Cory. This morning, I will briefly review the remainder of our third quarter 2019 results, as Curtis and Cory have touched on many aspects of our results, before turning the line back over to Curtis for concluding remarks. In the third quarter of 2019, deposits were essentially flat at $2.29 billion as compared to the 2019 second quarter. That said, we experienced a positive mix shift as non-interest-bearing deposits increased by $43 million, while interest-bearing deposits decreased by $39 million. We ended the third quarter of 2019 with total non-interest-bearing deposits of $556 million, or 24.3% of total deposits, compared to $513 million, or 22.5% of total deposits at the end of the second quarter of 2019. This mix shift contributed favorably to the 10 basis point decline in our cost of funds.
Though Cory touched on our loan growth in the quarter, I would reiterate that we pride ourselves on our disciplined credit culture and will not sacrifice our underwriting standards to drive loan production. As a result of this, our Non-Performing Assets to total assets ratio declined six basis points during the third quarter of 2019, down to 31 basis points at the end of the quarter. I would also note that we recorded $420,000 of provision for loan loss expense in the quarter, which reflects our annualized net charge-off rate of eight basis points, coupled with below-trend loan growth.
As loan growth re-accelerates through next year, I would expect our provision expense to rise to more normal levels. The yield on average earning assets was 5.16% for the third quarter, an increase of 19 basis points as compared to the same period in 2018, and was driven by an increase in our yield on total loans of 34 basis points to 5.91%. To conclude, we remain well-capitalized to support our growth with Tier 1 capital to average assets of 12.17% at the end of the third quarter 2019, compared to 10.09% in the third quarter of 2018. Our priority for capital remains focused on strategic M&A designed to increase the franchise value of South Plains, like our pending acquisition of WTSB, as well as continued organic growth. Our second priority is to return capital to shareholders through a consistent dividend.
Last week, we announced that our board of directors had approved our second consecutive quarterly dividend of $0.03 per share. Looking forward, we will continue to maintain a thoughtful and balanced capital allocation strategy designed to maximize value for all stakeholders. I will now turn the call back to Curtis for concluding remarks.
Thank you, Steve. To conclude, I'm very excited with the progress that we've achieved executing on our strategic plan to grow the franchise value of City Bank, which is focused on organic growth, strategic acquisitions, and achieving the benefits of scaling our infrastructure, which can handle significant asset growth. Our third quarter financial results demonstrate the success that we are achieving as we markedly improve the return profile of the bank, and we have made strong progress working to close our acquisition of WTSB, which will provide both cost and revenue synergies as we look next year. I would like to thank all of our employees for their hard work, for they are the key to our success. With that, I'd like to ask the operator to open up the line for any questions. Operator?
Thank you. At this time, we will conduct a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment while we poll for our first question. Our first question comes from the line of Woody Lay with KBW. Please proceed with your question.
Morning, guys.
Morning.
Good morning.
The NIM growth was really impressive this quarter. I know some of that was related to the decrease in deposit costs, and I'm guessing some of it was related to the increase in the ag loans. Just curious, as those ag loans run off with seasonality, do you expect the NIM to give up some of the gains it had this quarter?
Yes. We definitely did see an increase, as we normally do in the third quarter in our ag fundings. We do expect the NIM to drop back just a little bit. Ag loans will pay down in the fourth quarter. We did see a few things in the NIM, not totally out of the norm from what we see during different quarters. We had a servicing fee that came in for a couple basis points. We also had a recovery of some non-accrued interest on an ag loan that paid off. We did have five or six basis points increase in the NIM for a couple of those items. Again, we typically have some different servicing fees and some other of those type fees that come in throughout the quarter.
This is Curtis. While it is true we will see some pay downs in the ag portfolio, we actually get the bulk of those in January, so we'll still have fairly significant balances outstanding in the ag portfolio through the fourth quarter.
Got it. That's helpful color. Looking at the ag portfolio as a whole, it was nice to see NPAs dip down. I was just curious about the health of the portfolio and if you're seeing anything out in the market that gives you a little bit worry on the credit front.
I think we're still in relatively good shape. Clearly, across the country, ag loans are at a point that can certainly give some banks problems. We have scrubbed ours fairly thoroughly. We did have a couple of Non-Performers that were really related to cattle loans, which we have very, very few of. Our row crop producers have had a challenging weather year, but the early indications are that they'll be able to pay back their loans. It's just not going to be a very profitable year for them, and we'll look again, as we always do, next spring at our underwriting standards and whether we can go with everybody again. Currently, we actually feel pretty good about where we stand on our ag loans.
This is Cory, I want to add just a little bit of color to that. One of the things that we're seeing on the ag side with the different payments and stuff that the farmers are seeing, we're seeing those balances carry over just a little bit longer throughout the year so that we don't have as much pay down. We are getting the benefit of that we haven't had four or five years ago, but the last three or four years, it just takes a little bit longer for them to get all their money in throughout the year. The thing, as far as the asset quality, as we measure our internal classifications within the bank, we find ourselves at a 10-year low for classifications in the way that we measure. We really think asset quality is in really good shape.
That's great to hear. Last from me, strong quarter in non-interest bearing deposit growth. I was just curious if part of this was related to the seasonal influx of ag loans or if this was just a reflection on y'all's focus on growing that bucket.
Yeah. This is Steve. We do focus on trying to grow that, and we've had success. I will point out, though, that about half of that increase we had during the quarter was related to one customer, and it's something that could shift into an interest bearing at some point. While we're proud to be where we're at, and we always strive to increase, that's not something that we'll necessarily be able to sustain that type of growth each quarter.
This is Curtis again. We have really worked hard on our treasury management team and the products and getting those working with our commercial lenders, and we are beginning to see payoffs in that, where we're getting some substantial corporate deposits from some customers that previously we just weren't seeing. Quite a few of those are non-interest bearing. That's where we're trying to go.
This is Cory, and I'll just add one last comment about that. From the technology side of it, we've recently rolled out our business commercial app, and that has been extremely well received from the treasury, and gives the treasury management side a lot of legroom to keep moving forward with that.
That's great color. All right. Congrats on the great quarter, guys.
Thank you.
Thank you.
Thanks.
Our next question comes from Brad Milsaps with Sandler O'Neill. Please proceed with your question.
Hey, good morning, guys.
Morning, Brad.
Morning, Brad.
Morning.
Good. Appreciate you taking my questions. Appreciate the additional info on the asset yield side of the margin. Kind of curious on the deposit side, the funding side, you guys did a great job of lowering cost this quarter. Kind of curious, how aggressive you plan to be if the Fed cuts again in October and again, maybe in December. I'm just kind of curious how much more room you think you have to pull deposit costs down as you think about the margin going forward.
This is Cory, and I will tell you that, we're going to have to look very strong at it. We've got some things from the interest bearing that are sitting about as low as they can go, but there's some other areas that we do think there's some cutting and some room in the rough pricing that we had that we can have some reduction. The other thing we keep looking at is we know we've got, with the merger of West Texas State Bank coming in, it's going to help us with our liquidity, and we're going to have the opportunity to be a little bit more aggressive than we might have been in the past when we looked at some of these cuts. They've got very low cost of funds, but they also run roughly a 50% loan deposit ratio.
We know we're going to have liquidity. We do a better job of managing the overall cost.
Yep. Brad, this is Steve. One thing I would add to that, and I think it's in the press release itself, we did selectively target a few areas of some of our larger customers, just that had excess balances in some of the public funds or some broker deposits of some accounts that maybe we were not needing as much liquidity at the time, especially with the West Texas coming up. We were able to lower some of those balances. You see some of that occurred in the third quarter. There's a little bit more of that on the brokerage side that you'll see coming in the fourth quarter. That's an additional help to the lowering of the cost.
I guess the main thing out of that is most of that movement was by design and not by default.
Great. That's helpful. Steve, I noticed the bond book was on a period end basis, maybe about $100 million, plus or minus, kind of bigger than the average. I know you'll need some cash for the West Texas deal, but might you see you grow the bond book larger than where it kind of currently finished at the end of the quarter? Or do you think you did most of your pre-investing there?
We've still got a little bit of investing we're doing right now. We did have quite a bit of liquidity at the end of the second quarter and even early to mid third quarter. We decided, especially with the West Texas acquisition coming online, with the liquidity that is there, that we wanted to go ahead and start investing those funds today, especially because their portfolio is very short term right now. We wanted to go ahead and get that, but don't look for that to have that type of increase going forward.
Great. That's helpful. Just maybe a moment on fees. You guys had a nice quarter there. Was maybe a little surprised that mortgage wasn't up a little bit more than it actually was. I know you've made a lot of changes with the mortgage company. I know you guys are really focused on purchase as opposed to refi, kind of curious if you had any additional color there on the mortgage business. Secondly, typically, in your crop insurance business, you get a good seasonal lift in the back half of the year. Just curious, with everything going on with ag, if you still feel good about that as you get into the back half. I noticed the third quarter was down, maybe just a touch from the second. Just any additional color on insurance revenues and fees in general.
Yeah. Overall, we're seeing positive things on the crop side. From what I understand, we're still on track to be able to be consistent with where we were last year on the tail end revenues, as you mentioned. We did have a little bit of that come in last year in the third quarter. We should capture all of that in the fourth quarter this year.
This is Cory. I'll give you a little color on the mortgage. Currently, we're about up 22% year-over-year for production. Our Q3 was up 16% over Q2. Back in reference to some of the refi, for 77% of the volume in 2019 is purchased versus 83%, which shows you that there is some refi business that we're able to pick up and actually getting some benefit from. I think you're just going to see that a little bit like a snowball continuing to grow over the next several quarters.
I might add a little bit on color on the crop insurance. While as you indicate, there are challenges out there in the ag sector, but for virtually all producers, purchase of federal crop insurance really isn't a discretionary choice. I know we do it here, and in most instances, whoever's financing those farmers will require the purchase of that crop insurance. That's just not a revenue stream that varies very much.
Got it. Thanks, guys. I wasn't sure if you got extra bonuses depending upon performance of the federal contract.
There's a little benefit, but since we don't take any underwriting risks, we kind of don't pick up that upside either.
Yeah, that's basically a choice. We could have a format in which we basically shared some upside, but you might share some downside. We've chosen not to go that way.
Got it. That's helpful. Just final question, I was writing quickly. I think, Cory, you mentioned that you thought expenses would go back into kind of the low $29 million range. I think I picked up there was about $300 thousand to $400 thousand in sort of costs related to the IPO as well as the West Texas deal. Is that about the right number there?
Yes.
Okay. Then the rest of the savings would just come from just you guys continuing to kind of wring out costs from the system as you did this quarter.
Yeah, I think that's fair. We continue to try to find ways to streamline and improve what we're doing. We'll pick up some benefit. It's going to take a little while to get all the benefits for West Texas State Bank in there because we're going to have to get those computer conversions and everything done and just get some of the professional fees and other non-interest expenses back in line where they should be and benefit from what we've already built as a system as a whole.
That's great. Really good quarter, guys. Thank you.
Thanks.
Thank you.
Thank you. At this time, I would like to turn the call back over to management for closing comments.
This is Curtis Griffith. We thank everybody for being on the call. I appreciate your interest in South Plains Financial. We're excited to see the trends that we believed we could achieve beginning to start. It's a long road ahead of us. We're very excited to proceed with our first major acquisition and are excited about what that will bring to the table for us, both in asset footings and in quality of talent. That's going to help us really make a good presence down in the Permian Basin, and we'll see where things go from there. We will continue to be looking over the next 12 months for other acquisition targets. We don't have anything online at this time, but certainly we will continue to be in a mode of growth through both great organic growth and solid acquisitions.
This does conclude today's teleconference. You may disconnect your lines at this time, and have a great day.