Earnings Call: Q2 2019

Jul 30, 2019

Good morning, and welcome to the South State Corporation Quarterly Earnings Conference Call. Today's call is being recorded and all participants will be in listen only mode for the first part of the call. Later, we will open the line for questions with the research analyst community. I will now turn the call over to Jim Mabry, South State Corporation Executive Vice President in charge of Investor Relations and M and A. Thank you for calling in today to the South State Corporation earnings conference call. Before beginning, I want to remind listeners that the discussion contains forward looking statements regarding our financial condition and results. Please refer to Slide number 2 for cautions regarding forward looking statements and discussion regarding the use of non GAAP measures. I would now like to introduce Robert Hill, our Chief Executive Officer, who will begin the call. Good morning. I'll begin this call with summary comments about the Q2, observations on our overall performance. John Pollock will review the quarter in more detail and we will then conclude the call with questions from the research analyst community. Our focus continues to be on building long term shareholder value and this quarter marked continued progress towards that goal. Adjusted net income was $49,400,000 or $1.40 per diluted share and represents a 1.28% return on average assets and a 15.79% return on tangible equity. Net income totaled $41,500,000 for the 2nd quarter or $1.17 per diluted share. This represents a 1.08% return on assets and a 13.38% return on tangible equity. In December of last year, we met with investors to provide further insights into our progress and the road ahead. As part of the conversation, we articulated longer term financial performance targets. While we did not put a timetable on the achievement of those targets, our performance in the 1st 6 months of 2019 have us off to a good start. Among the highlights of the quarter was considerable improvements in adjusted operating leverage. We showed meaningful growth in revenues and demonstrated good expense control. Interest income growth was fueled by an increase in average loan balances and fee income was up in all lines of business. Ultimately, it is the ability to grow customer relationships that is critical to the creation of shareholder value and our company continues to perform very well in area. The strength and integrity of our balance sheet is core to the success of South State. Capital levels remain strong, asset quality metrics continue to be impressive, and funding remains a key competitive advantage. The quality of our funding mix continues to improve with solid growth in non interest bearing deposits. Despite remaining active in share repurchases, our tangible book value grew $0.70 in the quarter to $37.85 per share and capital levels remain strong. The Board of Directors has declared a cash dividend of $0.43 This is an increase of $0.03 from last quarter and represents a 22.9% increase in our dividend from a year ago. I will now turn the call over to John Pollock for more detail on the financial performance for the quarter. Thank you, Robert. My comments this morning will focus on our margin, non interest income and expense and capital management. We showed significant improvement in adjusted operating leverage this quarter with nice increases in both net interest income and non interest income while limiting expense growth. On Slide number 5, you can see the $3,900,000 improvement in net interest income. The margin declined 10 basis points as much of the growth in interest earning assets was in short term investments and the investment portfolio. As shown on slide number 6, the growth in average loans was 4.9% linked quarter, which had a very positive impact on net interest income. Net interest income in the margin also benefited from $162,000,000 increase in average non interest bearing checking accounts this quarter. Our cost of funds increased to 71 basis points, up 4 basis points linked quarter as rates on deposit accounts were unchanged except for increases in certificates of deposit. Slide number 7 shows the impact of accretion this quarter, which is down to 6.1% of total interest income as the balance of this portfolio continues to decline. You can see those balances and the discount remaining on the portfolio on slide number 8. We had very strong improvement in non interest income this quarter, as shown on Slide number 9, led by a $2,900,000 increase in mortgage banking income. Fees on deposit accounts and wealth management were up $900,000 $400,000 respectively. Our Capital Markets Group also had a very nice quarter with $900,000 in income due to the increase in back to back swap activity. Slide number 10 shows our linked quarter expense detail. Adjusted non interest expense, which excludes branch consolidation and pension plan termination costs, was up $700,000 linked quarter, primarily in professional fees and marketing. We had good expense management this quarter, holding the adjusted expense growth 2.8% annualized, achieving the cost save initiatives that were previously announced, dollars 13,000,000 in pre tax on an annualized basis played a large part in the results. We achieved about $1,500,000 in incremental cost saves this quarter, remain on track to achieve 75% of the saves in 2019. As a result of the $8,300,000 in revenue growth and limiting expense growth, our adjusted efficiency ratio improved from 60 point 5 percent in the Q1 to 59.8 percent this quarter shown on Slide number 11. Tangible book value improved to $37.85 as shown on slide number 12, over 9% growth from a year ago despite being active in the share repurchases during most of this period. We give you an update on our share repurchase activity on Slide number 13. During the Q2, we retired 641,200 shares and to date this quarter, we have retired an additional 594,000 400 shares. We currently have 1,264,400 shares available for repurchase under the existing plan. From a capital management standpoint, the repurchase activity combined with some asset growth has our tangible common equity to tangible assets ratio at 9%. The dividend declared by our Board this quarter represents 35% of GAAP earnings and 30% of adjusted earnings. These capital management efforts and operating leverage improvement this quarter result in a 15.8% adjusted return on tangible common equity. I will now turn the call over to Robert for some summary comments. We are optimistic about the balance of 2019 and continue to make progress on improvements in systems and processes to make us more efficient and prepared for future growth. Our markets are exhibiting strong underlying economic activity. South State is well positioned with a solid balance sheet and a great team to build upon the results of the 1st 6 months of 2019. This concludes our prepared remarks and I would like to ask the operator to open the call for questions. We will now open the line for questions. The first question comes from Stephen Scouten with Sandler O'Neill. Please go ahead. Good morning, guys. How are you doing? Good morning, Stephen. So I'm curious if you could talk a little bit more about the leverage strategy you're undertaking with some more of these borrowings. I think it's maybe $700,000,000 over the past two quarters. Just kind of wondering where you are in that process, if that's something we should expect to continue and kind of I guess what's the driving force behind that in terms of expected balance sheet growth and otherwise that's leading this to be the right path for you? Stephen, this is John. I'll start on that. I think as we talked last quarter, we thought it was a really good opportunity to put a little bit of leverage on the balance sheet. I think companies our size, when you look at them, they have a little bit more leverage than we did. So, we're kind of trying to look for an entry point. And we felt with where the yield curve was, it was a really good time to go in and you can see the blended cost on that 700 $1,000,000 with dividend. You'll see it's close to 2%. So I'd say, first of all, we feel like that's kind of a permanent increase in the balance sheet. You can see it in our average earning asset growth. It's up 19% linked quarter. So, we feel really good about that. You can see we did some work in the investment portfolio. We put on a little over $215,000,000 of just kind of the traditional things that we buy in the investment portfolio. And Stephen, that yielded us right at 3%. So, feel good about some of the deployment. Obviously, we still have a lot of cash to fund our loan growth. And I think in the future, the good news is we still have more optionality around that. I think where we are right now, we're going to get this deployed, but we're going to continue to really look at that option in the future. Okay, great. And then if I'm thinking about expenses, you guys noted some of the remaining, I think it was $6,400,000 in annualized savings to come out in 3Q and 4Q from the efforts you've already been undertaking. Is that something where you would believe that we could actually see the expense run rate move down quarter over quarter? Or will that be spend on new hires or other continued investments? Stephen, this is John again. Let me talk about expenses for a minute. So I think I'd go back to our long term goals. And kind of what we said at Investor Day is we were trying to stay in that 0% to 3% range. So we did it 1 quarter. That doesn't mean we'll do it every quarter. But I think when you kind of dig into the expenses, can kind of see what we're doing. So if you look at our kind of our professional and marketing line on those professional fees. We're spending money. We announced our partnership with Ncino. You've heard us talk about our digital roadmap some. So I think as we said, we're investing there. I think the good news is the investment there doesn't mean that's a permanent increase in the expense as we get some of these implemented. But I think our view on the expense side, Stephen, is where we do best over a long period of time is try to stay in that 0% to 3% range. Okay. So no change there? Correct. Okay, great. And then just last one little question for me is just on new loan yields. I think you said they're around 4.7% last quarter. Where were those coming on this quarter and how do you think about those with the potential Fed cut in the coming quarters? They came down a tad this quarter. I think our view of the Fed cut is it does give us an opportunity to maybe get a little bit more balanced, Stephen. I think, as you know, we have a pretty heavy residential loan book, and obviously those rates were kind of stuck as rates went up. And I think our view is it gives us an opportunity to get more floaters on our balance sheet as we build the commercial bank. Today, when you look at our floaters, we have right under $5,000,000,000 but over half of that is really hybrid arms. So, we've got about $2,400,000,000 in floaters. You can see our capital markets income for the quarter, we're really starting to hit on all strides in our capital markets group. And so that was really nice to see. I think as rates come down, it does give us an opportunity really to focus there. On the flip side, on the mortgage side, I think one of the things that we all need to kind of see now in the new world as rates are coming down is you're just going to see more refinances on the mortgage side. So when you kind of look at our loan book, now 30 year fixed rate mortgages are below 4 percent. Obviously, equity line balances are tied to the prime rate. So you're going to see some churn there. But of course, Stephen, that's going to lead to more fee income and you can really see our mortgage area really begin to click on all cylinders from a fee side. Yes, for sure. Okay, very helpful. Thanks guys. I appreciate it and congrats on a great quarter. Thanks. The next question comes from Jennifer Demba with SunTrust. Please go ahead. Thank you. Good morning. Good morning. Question on your net interest margin outlook over the near term with rate cuts likely coming here in the second half of the year. Yes, Jennifer, this is John. I think, clearly, managing the margin today has been difficult for all of us. We got to the end of the year. Everybody thought there was going to be a lot of rate increases. And here we go kind of the other way. So I think our outlook, if you kind of dig into our cost of funds, I think that's a good place to start. Outside of the CD book, we really saw stability on the deposit rate side this quarter. So, I think that was really good news. And we saw a little bit increase in the CD book. So, I'd say I think, first of all, it does feel like rates are beginning to come down. We don't guess a lot on rates. We try to have always try to manage maybe a little bit more towards neutral. I kind of go back in my comments with Steve and we feel like we can get a little bit more balance between fixed and floating in this environment. And then ultimately on the margin for us, it gets back to the noninterest DDA growth. And you can see linked quarter, we had significant noninterest DDA growth. So, Jennifer, we got to stay very focused on that, as rates come down. Our treasury area, I'll give you one example. Our treasury area is really starting to hit on all cylinders. They completed their conversion of all the systems in April. And in fact, they've got over $100,000,000 in new deposits that they've generated this year. So clearly, rates are going to come down. Got to stay real focused on the funding. I think you all know us, we're going to be very measured on our funding costs. We've got checking accounts that have been with us 4050 years. So, we'll be measured as they come down, but it's good to see some stability at least on the deposit side. So, you're expecting some modest margin compression with these rate cuts, but you'll keep focusing on the funding? I think you'll see some, but I also think on the flip side of that, you're going to see you're going to see more fee income. So take mortgage is you're just going to see more on the fee income side. And so what we've always said on mortgage is when rates are coming down, you need to produce more fee income. When rates are at a very low point, you don't want to grow that book a fair amount. So I think some of the offset in that margin, not that it's totally correlated, but you can see it in our fee income this quarter, especially on the mortgage side and then the nice capital markets quarter we had. Okay. A separate question, what's your interest in further M and A at this point? This is Robert. I guess, strategically, maybe let me just start with where I see the company just overall and then how that plays into kind of where we go strategically is, I think a few things. First is, where we are from a soundness perspective is pretty extraordinary. Our balance sheet, very solid deposit base, as John mentioned, very granular. We're on pace to grow probably 12,000 new customers this year. Treasury is really kicking in. Capital stack is really it's almost all common. We've got a lot of optionality there. And credit, I mean, so from a credit perspective, really, we're in a net recovery position for the year on an $11,000,000,000 book. So we're just overall feel really good about strategically the soundness piece of the company, which is our number one focus. And then the last 2 years, as we explained in December, the Investor Meeting, the building blocks were just being put in place. And you look at commercial, treasury, capital markets, digital transformation, on and on, tremendous headway getting the right platform in place. And then the expense management, we made investments in technology, but we've also improved our productivity. So we found ways to pay for those investments. And that is feeling like that's on a really good path. So, then it kind of goes to what's the future hold. And I think 1st and foremost for us is the forward momentum of the company feels really good. And I think you see a lot of it in our numbers this quarter. Obviously, net loan growth is not what we want. But if you look at our pipelines, the quality of the customers that we're bringing in, the momentum that we have, the talents of our teams, the productivity levels, that all feels really good in really every area of the company. And a year ago, that was still kind of spotty. So my point in saying that is the foundation now is in a really much better place than it's been in a long time, and we feel great about our organic path. But as you know, I mean, we're always open to create value for our shareholders, and we want to build a great bank. So if there are opportunities to do that, we would certainly consider that just as we always have. But our primary focus is clearly on making sure we've got a strong foundation that's in place to really pursue whatever options are the best. And that hadn't really changed from where we've been in the past. I think what has changed is our foundation is just stronger than it has been in quite a while. Okay. Thank you. The next question comes from Tyler Stafford with Stephens. Please go ahead. Hey, good morning and thanks for taking the question. I want to start on fee income. Obviously, you guys had nice fee results this quarter. Can you talk about your mortgage production and gain on sale margin this quarter? What that was relative to last quarter as well? And then just curious if there was a fair value MSR impact this quarter as well? Stephen, this is John. From a margin perspective, it held in there pretty well. We don't disclose exactly what our margin is on fees, but held in there very well. One of the unique things was really the movement of the kind of the 10 year in mortgage rates. And so mortgage rates kind of hit a bottom and treasuries kept on going, right? So that really kind of helped, I'd say, on gain on sale when you look at it. From the MSR side, the last couple of quarters, Tyler, it's been a battle. Last quarter didn't really make a whole lot of money on a MSR. This quarter, we generate about $2,000,000 in fees out of our MSR asset on a quarterly basis. We got about half of that. And so I think on the mortgage side, we're seeing stability in the MSR. We added 5% in growth to that asset. So it's starting to build. We're getting more income streams. So if we could just get a little stability in the rates, I feel really good about where we are on the MSR asset. But clearly, mortgage rates go below 4%. Does the bottom kind of hold there to the 10 year? I think that's question nobody really knows. Now on the flip side, if you just kind of go over to the production is, as I mentioned earlier in the call, our view in mortgage is we like to use our balance sheet, but we also like to generate secondary market business. So you're going to see, as Robert talked about our growth, there's just going to be more pressure to grow the mortgage portfolio on balance sheet. It's going to create more fees in the secondary market. So, we feel really good about the momentum on the fee side. But ultimately, this is how you want your mortgage book to work. As rates go down, you want to get that churn and have those hybrid arms, as we talked about earlier, either refinance into the second get refinanced in the secondary market or they'll go and pick a new arm product. Okay. Thanks, John. I appreciate that. Just following up on Jenny's earlier question, just if we do get a cut tomorrow, just curious if you could size up just a range for us to think about in terms of margin pressure with the July cut, if we do get one? Well, I wouldn't know exactly how much it would be, but typically, if you look at our betas when rates come down, they average 15% to 25% of the cut. So, it kind of depend on the bucket. But clearly, there should be some pressure you would think on the funding side as it comes down. But I also think on the loan side, as Robert mentioned, our pipelines are really good. We went out and did this leverage strategy. We got more our view is that ought to help there. And then, obviously, I think as you think about the pressure, you also got to consider what as we mentioned earlier, what's going to happen on the fee side. Sure, sure. Okay, thanks. Just looking at, I guess, profitability and just ROA, the leverage strategy is obviously helping Southside achieve that longer term 16% to 18% RoTC. I'm just curious if there's a corresponding ROA target that we should think about? Nothing that we put out there, but I get it. Clearly, we want a higher ROA. I think our view was over time, we kind of talked earlier about kind of permanently taking the balance sheet size up some. And so, we grew those average earning assets 19% linked quarter, and we did those transactions. So, I think our view is over time, I would much rather, instead of putting over $200,000,000 in the investment portfolio, but we did get 3% yields on that, you're going to see that shift into the loan growth. I think that's going to help us a lot. Okay. And then just lastly for me, John, the earnings release talked about how the share buyback positively impacted EPS by $0.01 this quarter. And then later, the release stated the tangible book value was impacted by $0.66 due to the buyback. So I'm just wondering what the TBV earn back is on your repurchase and just how you think about kind of book value dilution and earn back associated with repurchases? Thanks and I'll hop out. Well, I think if you're thinking traditionally on tangible book value earn back from an M and A perspective, it's clearly a longer timeframe. But hey, these are assets I know, assets that we put on the books, assets that we've marked. We're very bullish on what we've been able to do from a share purchase side of what it does for the shareholders. So, clearly, a little bit longer period of time than on the M and A, but you're investing in something that you know very, very well. The next question comes from Christopher Marinac with Janney Montgomery Scott. Please go ahead. Thanks. Good morning. I wanted to look at the change in staffing the FTE numbers year over year. Is that change possibly similar either in percentage terms or just absolute numbers in the next year or is the bulk of that shift already behind you? Chris, this is John. We're continuing to look at staffing levels, how we run our lines of business. That's just a constant thing that we do. To say that the FTE reduction would be the same next year, I don't know that. We are beginning to approach our budget season for next year. So we'll begin to look at where we want to invest. Is there a way to make things more efficient? So, it will be something we will continue to look at. Chris, just to kind of add on, this is Robert, is we will obviously continue to add as we always have is just continue to add revenue producers. We added 8 in Q1, I believe, 10 in Q2. That's just kind of a normal process, the same as John is talking about on kind of the productivity and efficiency side is on the revenue side. That's been a pretty consistent number for us the last few quarters. That's great. Thanks for that explanation. I appreciate it. And then when we step back and look at the change in kind of valuation on the acquired book and how that's sort of progressed as you had revaluations most quarters, what does that tell us on sort of the broader credit picture either in general in your footprint or in your portfolio specifically? It just seems that you've had a lot of success on how that has looked for you, but I'm curious what it tells you about the health and your footprint? Well, I think the soundness portion and the credit culture in our company is kind of where it all starts. And we were talking the other day about net loan growth not being quite where we wanted to be, but productivity being good and at what point in the cycle are you. And really, in the downturn, financial crisis, recession, times like now where you've just got some churn in the book and a little slower net loan growth or really robust times, our credit philosophy doesn't really change. So, it's kind of time tested, it's cycle tested, and we kind of stick to it. So I think ultimately what it says is we have a really good credit culture. I think it's what we're very selective, we underwrite well, we pick quality customers. I think on top of that, but we're in both rural markets and we're in growth markets. And both right now are tending to perform extraordinarily well. We're seeing businesses that are well capitalized that aren't overleveraged. You've certainly seen some one offs in terms of credit in the industry over the last quarter or 2, but we've not witnessed any of that in our markets. Unemployment rates are low. Businesses seem to be very profitable. The amount of risk in the market seems to be manageable. And our loan portfolio I think is reflected reflection of that. Great. That's helpful. And I presume that you'll continue to have potential revaluations in future quarters. It just take it 1 quarter at a time. Is that the right way to think about it? Chris, this is John. Obviously, we got 2 more quarters before CECL, right? So, yes, I would think you'd see that really over the next couple of quarters. Then revaluation really changes, right? As we get into the CECL world, it really begins to change. And so, for us, as I think about CECL, we've gone out and looked at our kind of 10 year loss history with a few caveats. And so, from a quantitative perspective, if you look over the past 10 years, it's only about a little over 60 basis points on the whole loan portfolio. Obviously, we got to layer a qualitative piece on top of that, to kind of get to the total reserve. But when you think about the moving pieces, Chris, of revaluation, how it comes back in the income statement, is you kind of look at where we are today. And there's really 2 pieces in our income statement. First of all, you'll notice in the acquired loan accretion on the credit impaired side is we had a nice really nice accretion this quarter. And about $1,000,000 of that came from a loan that's had a big, big mark on it. Well, guess what? That part wouldn't come through the accretion. It would come through really a reserve release and come back through kind of come back through the reserve. The other piece that's in there is when you look at our acquired non credit impaired charge offs, we had 25 basis points. So it was about $1,500,000 in charge offs. And as you know, traditionally what we've done, we've basically paid for those charge offs in the acquired non credited book as we go through each quarter. Well, now that $1,500,000 it would have pushed up against the reserve and really wouldn't have come through the income statement. So you throw those pieces in there. And then finally, we're breaking up our loan pools on the acquired credit impaired bucket. You're going to see more accretion come through our income statement. And the reason I say that is when you're in pools, I think, as you know, the increase in this stretched out over the weighted average life of those pools. We actually have loans back from our CBT transaction 10 years ago in the pools. Well as those pay out, then that excess accretion is going to come in. So, a couple of more quarters of where we are, then I think you're going to see a lot of changes as we get into 2020. Got you. Sounds great, John. Thank you for the additional color here. I really appreciate it. The next question comes from Nancy Bush with NAB Research. Please go ahead. Good morning, gentlemen. How are you? Good morning. You mentioned the $900,000 in revenues that you got from the Capital Markets business and I think you referenced swap activity as being the reason behind this. And I'm assuming that this is primarily the platform that you acquired with Park Sterling. When I ask a question about capital markets a couple of quarters ago, there seemed to be some ambivalence about further build out of this platform. And I'm wondering if you can just update us and if whether the results that you've received this quarter have changed your mind about how much you want to go or how further you want to go with that business? Yes. Nancy, this is Robert. I'd say if that was the perception that just it's just the wrong perception. We've been excited about really capital markets and treasury were part of Sterling that we were very committed to from the beginning. Now how you execute on it, how you integrate it over a bigger platform, those were certainly things that we had to kind of work through that took some time. But you're starting to see the fruits of that those efforts over the last year. So we're fully committed to the business. We need it for our customers, number 1, I think, 1st and foremost, but we like the business as we It helps our interest rate risk management. It helps us It helps our interest rate risk management. It helps us compete in the marketplace. There's just a number of reasons we like it. We really like our team. Randy Reuther, who leads our Capital Markets Group is very talented. He's helped us really solidify a lot of commercial relationships across our footprint. But we've just really started. The pipeline there is robust and as is our commercial pipeline overall. So, I feel like that line of business is just starting to mature inside our company, but still has a lot of progress, but fully committed, same as capital markets I mean, excuse me, same as treasury. John mentioned the traction there, but $100,000,000 in new deposits so far this year, 200 new relationships is so the things we've invested in over the last couple of years, this quarter we're starting to see really some of the results of that. I would just ask as an add on to that. I mean, there's been a lot of talk on Q2 conference calls about the turmoil that's taking place in the banking environment in the Southeast and particularly in the Charlotte area and whether you're able to add people to the Capital Markets businesses or indeed maybe to go into some new areas of Capital Markets as a result of some of this turmoil? I think that there are 2 several areas that we're looking. We added 10 people in Q1 really across all business lines, commercial, private, middle market, consumer, mortgage investment. I think capital markets is clearly an opportunity for growth, both in terms of people and also customers. But you look at what we're doing overall, too, on the digital transformation, and this kind of speaks to some of the turmoil in the market and the changes in the market. But the digital transformation in our company, in Q1, 7% of our deposits came through our digital channels, in Q2, 11%. So, we're I think our commercial footprint and commercial platform is much more robust than it was 18 months ago, as is our consumer, and both are getting good traction. Okay. Thank you. Gentlemen, it appears there are no further questions in the queue. Thanks everyone for your time today. We will be participating in the Stephens Bank Forum in Little Rock, Arkansas beginning on September 23rd. We look forward to reporting to you again soon. The conference is now concluded. 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