Great Western Bancorp (GWB) Q3 2019 Earnings Call Transcript

Great Western Bancorp (GWB)
Q3 2019 Earnings Call
Jul 25, 2019, 8:30 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning, and welcome to Great Western Bancorp, Inc. third-quarter fiscal year 2019 earnings conference call. [Operator instructions] Joining the call this morning are Ken Karels, chairman and chief executive officer; Doug Bass, president and chief operating officer; Peter Chapman, chief financial officer; Karlyn Knieriem, chief risk officer; and Michael Gough, chief credit officer. Before getting started, Great Western will like to remind you that today's presentation may contain forward-looking statements that are subject to certain risks and uncertainties that should cause the company's actual future results to materially differ from those discussed.

Please refer to the forward-looking statement disclosures contained in the presentation on the company's website, as well as our periodic SEC filings for a full discussion of the company's risk factors. Additionally, today, certain non-GAAP financial measures will be discussed on the conference call. References to non-GAAP measures are only provided to assist you in understanding Great Western's results and performance trends and should not be relied upon as a financial measure of actual results. Reconciliations for such non-GAAP measures are appropriately referenced and included within the presentation.

Please note, this event is being recorded. I would now like to turn the conference over to the Great Western Bancorp's chairman and chief executive officer, Ken Karels. Ken, please proceed.

Ken Karels -- Chairman and Chief Executive Officer

OK. Good morning, and thank you for joining the call. While we were disappointed with the asset quality matrix this quarter, we feel there are still a number of positives to point out. With the elevated credit charges, we remained profitable for the quarter with net income of $26.8 million.

Our returns remained very strong with a return on average tangible common equity of 14.5% for this fiscal year. Expense control was very good, with our efficiency ratio at 47.2% for the quarter and 46.3% fiscal year to date. We continue to remain strongly capitalized with capital levels remaining in line with prior quarter, and the net interest margin performed better than previous guidance. Now for more insight on our June-quarter financial results, I'd like to turn the call over to our chief financial officer, Peter Chapman.

Pete?

Peter Chapman -- Chief Financial Officer

Thank you, Ken, and good morning, everybody. Looking to revenue, interest income was $140 million for the quarter, which reflected an increase of $4.3 million or 3.2%. Our net interest margin and our adjusted net interest margin were 3.7% and 3.71%, respectively for the quarter, with the adjusted net interest margin down 5 basis points quarter over quarter. Of the decrease, 7 basis points was driven by the additional $250 million on balance sheet liquidity that we discussed last quarter, partly offset by 2 basis point increases in the investment portfolio and loan yields respectively.

Also, it's going to see increases in deposit costs slowing, with these contributing to a 2 basis point reduction in NIM, which is down on prior quarters. Noninterest income decreased by $7.5 million for the quarter to $10.8 million. The main driver of the decrease was an unfavorable movement of $5.2 million related to credit-related charges on loans held at fair value and an adverse variance of $2.1 million in swap fee income due to lower sales volumes during the quarter and an increase in CVA and DVA. Outside of these items, service charges, wealth management and mortgage banking income all increased modestly during the quarter.

Noninterest expenses were $56 million for the quarter, a decline of $0.6 million. Salaries and benefits declined by $0.6 million, but within this amount, core salaries increased by $0.5 million, and this was offset by $1.6 million in lower healthcare costs for the quarter. Data processing and communication expenses increased by $0.3 million, mainly due to project cost on a new system rollout. Occupancy expenses declined by $0.5 million due to seasonal spend -- lower seasonal spend and an upfront credit of $0.2 million on a new facility.

For more now on loan and deposit growth, I'll turn over to our president and chief operating officer, Doug Bass. Doug?

Doug Bass -- President and Chief Operating Officer

Thanks, Pete, and good morning, everyone. At the June 2019 quarter end, loans were $9.9 billion, which is up $116 million or 1.2% compared to prior quarter. This brings fiscal year-to-date growth to 5% or $471 million. It was good to see growth during the quarter as construction conditions improved and seasonal draws commenced.

We remain confident in mid-single-digit growth for the full year and with good pipelines, likely offset by continual softness in ag balances as we work through some of these problem credits. Growth for the quarter was comprised of $142 million increase in nonowner-occupied commercial real estate segment, with no real concentrations in specific sectors or geography. The growth occurred across Nebraska, Colorado, Arizona, and Iowa. On a combined basis, owner-occupied commercial real estate and commercial nonreal estate balances grew $35 million, which reflected good progress on growing this segment of the portfolio, which was not impacted by large irregular paydowns during the quarter.

The North Scottsdale office, which opened in December 2018, has now reached $35 million in loan balances, most of which is in the C&I sector. Our Yuma, Arizona loan production office has been opened less than one year and has reached $18 million in loan balances. We just converted our loan production office in Cedar Rapids, Iowa to a full service branch, where year-to-date loan growth has been 39%. Agricultural balances decreased $72 million during the quarter, with the decrease attributable to some dairy relationships in Arizona, reducing debt via asset sales and lower balances in Iowa due to the refinancing of some term debt to other lenders.

We have also seen lower draws on operating lines in the protein sectors in the Midwest as the hog industry is seeing good profitability. Deposits contracted during the quarter by $232 million or 2.2%. The main source of decline in balances was a $143 million reduction in brokered CD balances as the Federal Home Loan Bank has been more cost-effective during the quarter. In addition, there were seasonal outflows of $50 million and $37 million in consumer and public fund areas of the portfolio, which is consistent with timing in prior years.

With a focus on C&I business, we have seen an increase in noninterest-bearing balances for the quarter, bringing fiscal year-to-date growth to $94 million or 5.1%. During the quarter, we also saw the increase in the cost of deposits start to slow as we have reduced promotional deposit rates in the latter part of the quarter. We've also begun to reduce money market rates, as well. We anticipate further reductions in deposit rates with a potential upcoming move by the Federal Reserve.

Let's turn the call over now to our chief credit officer, Michael Gough, who will take us through asset quality developments. Michael?

Michael Gough -- Chief Credit Officer

Thanks, Doug. I'll first touch on our dairy portfolio, which we have discussed numerous times in prior-quarter earnings calls. During the June quarter, we typically received most of our accountant reviewed or audited year-end financials. Due to lower milk prices during the fourth quarter of 2018, fiscal '18 results were weaker than expected, providing some borrowers to have debt service cash flow below loan covenant requirements.

While we are of the view we have strong collateral and do not believe there are maturing provisions to come from this portfolio, we have downgraded some borrowers to substandard. Of the $217 million increase in substandard loans in the June quarter, the dairy portfolio accounts for approximately 71% and 79% year to date. We will continue to monitor these borrowers closely, and we have seen more positive cash flows from borrowers in calendar 2019, as milk prices have improved since the start of the year. For the remaining increase, beef cattle operations accounted for the majority, with the movement in these coming from a small number of operations that we have been monitoring for a number of quarters, which we will now move through the workout process.

Charge-offs were $17.5 million for the quarter. Of this, $8 million was attributable to one C&I and one cattle relationship where we believe customer fraud was involved. But the remaining charge-off amounts $6 million related to cattle and $3 million related to grain relationships that have been troubled and under close monitoring for a number of periods that we are moving to resolution. For our ag-related watch and substandard balances, as well as charge-offs, you will see that we have provided more breakout across the portfolio on Slide 8 of the earnings release deck.

This shows that while substandard balances have risen this quarter due to dairy, other parts of the portfolio are stable or improved across most metrics. Apart from the charge-offs taken on the beef portfolio this quarter to put these behind us. When we look at overall credit-related charges for the quarter, these are elevated due to the downgrades and charge-offs I have just discussed. The required provision for loan losses was $26 million to ensure that we have the appropriate levels of general and specific provisions.

Credit-related adjustments on loans and derivatives held at fair value were $5.5 million for the quarter. With respect to key asset quality ratios, net charge-offs points for the fiscal year to date through to the 30th of June 2019. Our allowance for loan and lease losses as a percentage of total loans is 77 basis points at June 30, '19, an increase of 7 basis points from the prior quarter, and our comprehensive credit coverage, which includes credit-related fair value adjustments on our long-term portfolio and purchase accounting marks also increased to 1.02%. With that, let's turn the call back to Ken for some closing remarks.

Ken Karels -- Chairman and Chief Executive Officer

Thank you, Michael. While we were disappointed with the asset quality movements this quarter, we are pleased with our loan growth and asset quality throughout the portfolio outside the dairy. We are also pleased that we've been able to manage the cost of our funding and continue to manage our expense base. We will now open up the call for questions.

Questions & Answers:

Operator

[Operator instructions] Our first question comes from Jon Arfstrom of RBC Capital Markets. Jon, please proceed.

Jon Arfstrom -- RBC Capital Markets -- Analyst

Yeah, Thank you. Good morning, guys.

Ken Karels -- Chairman and Chief Executive Officer

Good morning.

Jon Arfstrom -- RBC Capital Markets -- Analyst

Obviously, we'll start with credit. And I guess, Michael, some of the comments you made about dairy mending a bit and not seeing any other signs of weakness, is the basic message here, this is a rearview mirror, looking for things that may have happened late last year, and you're not seeing any new problems emerge? Or is that the wrong way to think about this?

Michael Gough -- Chief Credit Officer

Very good question. I actually think that's the right way to look at it. As we noted in the presentation, in our key markets where we have dairy, but the milk prices have already shown improvement this year. And we certainly don't expect to see a repeat of this quarter in that sector of our loan book.

Jon Arfstrom -- RBC Capital Markets -- Analyst

OK. Basic provision message is that we can see the provision come back down to where it was historically and this likelihood of the substandard balances ending up in NPAs or charge-offs. At this point, the way you see this fairly low?

Michael Gough -- Chief Credit Officer

I would think in the coming quarters, we're going to see provisioning and downgrades get back to the prior fourth-quarter average, not including the quarter ended June 30th.

Jon Arfstrom -- RBC Capital Markets -- Analyst

OK. And then, I guess, the other bigger-picture question then is, I kind of asked it before, but any other signs of weakness in any other parts of the portfolio, ag-related or non-ag-related? These things seem pretty specific to what you're doing. But just bigger picture, are you seeing any other weakness?

Michael Gough -- Chief Credit Officer

Right now, the answer would be no. It's really been dairy and the cattle sectors, where we've seen the issues that we have discussed already this morning. But there are plenty of other sectors that we always pay attention to that can be moved by the overall economy. But nothing near to that stream right now is what I'd say.

Jon Arfstrom -- RBC Capital Markets -- Analyst

OK. All right.

Michael Gough -- Chief Credit Officer

Thanks.

Jon Arfstrom -- RBC Capital Markets -- Analyst

Yeah, thank you.

Operator

Our next question comes from Jeff Rulis of D.A. Davidson. Jeff, please proceed.

Jeff Rulis -- D.A. Davidson -- Analyst

Thanks, good morning.

Ken Karels -- Chairman and Chief Executive Officer

Hi, Jeff.

Jeff Rulis -- D.A. Davidson -- Analyst

I guess I'd just tackle kind of the margin front. I didn't hear you guys talk about kind of expectations there. I think there was some thought on rate cut. So I just wanted to kind of see with your outlook on margin, also kind of if you could outline just the underlying assumptions on what you take on the level of rate cuts that we'll get kind of yield-curve type use, that would be great.

Thanks.

Ken Karels -- Chairman and Chief Executive Officer

Jeff, certainly, we're not trying to forecast the yield curve. So I won't really go into that other than book margin is probably a point or two better than this quarter than what we guided to last quarter. I think the team has done a really good job of working down some higher-cost deposits. And as Doug said, if there is a cut next week, we've got a pretty good plan in place to move deposit costs down again.

So I don't want to get too much into to give you guidance on margin there, but certainly, we think we've been good at it this quarter. And we think we've got some work to do that can help us next quarter also.

Jeff Rulis -- D.A. Davidson -- Analyst

So I guess, all things being equal, your margin guidance, in reality, was -- I guess, the results were a bit better than that. If we just increase by that level of kind of the new base this quarter and then expectations thereafter. I mean the only thing that changed is, perhaps, between last quarter and now is the rate cut probability. So I guess could you just engage a little bit more with how maybe the view beyond just the next quarter has changed on margin? Or maybe you're saying that, that has not?

Ken Karels -- Chairman and Chief Executive Officer

Not as such. I think you're looking at it exactly the right way, Jeff. So it started from a little higher base, continued to work through as we guided last quarter. Now we're in a down rate environment.

It has got to get to a point where loan and spread start to expand and hopefully, that can help us there, as well, but we haven't seen that as yet. But you're thinking about it the right way.

Jeff Rulis -- D.A. Davidson -- Analyst

[Inaudible] Thanks.

Ken Karels -- Chairman and Chief Executive Officer

Thanks very much. Do we have any other questions?

Operator

[Operator instructions] Our next question comes from Ebrahim Poonawala of Bank of America Securities. Ebrahim, please proceed.

Ebrahim Poonawala -- Bank of America Merrill Lynch -- Analyst

Good morning, guys.

Ken Karels -- Chairman and Chief Executive Officer

Good morning.

Ebrahim Poonawala -- Bank of America Merrill Lynch -- Analyst

I'm sorry if I missed this, but would appreciate if you can just talk to, in terms of the loss content on these loans when they go substandard or delinquent. Just if we can address how to think about potential losses when the loan goes bad in the cattle and the dairy portfolios and the collateral that you have and how we could think about the loan-to-value on these loans? That will be extremely helpful.

Doug Bass -- President and Chief Operating Officer

Yeah, Ebrahim, Doug here. Relative to provisioning expense last quarter, it was -- with the increase in substandard credit categories of dairy, as we had mentioned and called out, there was very minimal provision expense. Again, that relates back to an overall leverage component that is overall lower in the ag sector and reflective of that in the dairy, as well.

Ebrahim Poonawala -- Bank of America Merrill Lynch -- Analyst

So does this mean that the increase in criticized should not translate into material losses or provisioning as we go forward? Is that the fair takeaway?

Doug Bass -- President and Chief Operating Officer

Yes. And I think a couple of fronts on that -- again based on the collateral base, the overall leverage of the operations being, again, lower than commercial lending categories. And then secondly, as Michael mentioned, when we look at the trajectory and year to date '19 results of milk prices and futures prices, we see positive activities, positive cash flows and profitability in '19 and continuing that way in the near term.

Ebrahim Poonawala -- Bank of America Merrill Lynch -- Analyst

And would you say we are close to sort of peaking out in terms of -- because I think last quarter, you mentioned you went through 97% of the grain portfolio. You've gone through the dairy, cattle portfolio now got -- received the financials. So are you -- should we assume that, given where things are, you fully caught up with the loan book, and we should see substandard criticized loans, if anything, flatten out or decline from here?

Doug Bass -- President and Chief Operating Officer

Yes, we've received all 2018 information, and in some sectors, interim results giving -- given protein prices, grain prices, commodity prices, growing conditions, trajectory of commodity values. Yes.

Ebrahim Poonawala -- Bank of America Merrill Lynch -- Analyst

Got it. And just last question on that is how much of this becomes a headwind to loan growth as we think about potential for some of these to run off? Like if you could provide any -- quantify that in terms of -- is there $100 million, $200 million of these loans that you would like to get off the balance sheet over time?

Doug Bass -- President and Chief Operating Officer

The answer would be, yes. And we have had, as we called out in this quarter, it was down a little over $70 million on the ag front. Yet we had 1.2% growth overall. And I think given pipelines in commercial sectors, both C&I and across commercial real estate and across all geographic functions, we continue to be able to support declines in the ag sector with increases in other areas.

So yes, it will be a headwind, but with other segments doing well, we still believe mid-single digit as a year-to-date result is reasonable.

Ebrahim Poonawala -- Bank of America Merrill Lynch -- Analyst

That's helpful. And one last. Pete, in terms of the -- your comments on margin. I think your previous guidance was 2 basis points to 3 basis points down per quarter.

Do you think that's kind of the right way to think about it, even with the Fed rate cuts? Am I hearing you correctly?

Peter Chapman -- Chief Financial Officer

Yes. Look, I think we'd still see a little bit of pressure on the new term, Ebrahim. But as I said, we're trying to work through those deposit costs. So we did a little bit better this quarter than we forecast last quarter.

And we'll just keep trying to work on as much as we can.

Ebrahim Poonawala -- Bank of America Merrill Lynch -- Analyst

Wonderful. Thanks for taking my questions.

Peter Chapman -- Chief Financial Officer

Thanks, Ebrahim.

Doug Bass -- President and Chief Operating Officer

Thanks, Ebrahim.

Operator

Our next question comes from Damon DelMonte of KBW. Damon, please proceed.

Damon DelMonte -- KBW -- Analyst

Hey, good morning, guys. Quick question on the -- on composition of the loan portfolio. What percentage is floating versus fixed?

Peter Chapman -- Chief Financial Officer

If you go to our slide, David, on the -- in our investor pack that gives it to you. So it's the same one that we've had historically. That 40% use is generally floating. And then we've got some that's adjustable over and above that.

Damon DelMonte -- KBW -- Analyst

OK. I can -- I'll track that down. That's fine. OK.

And then just quickly on expenses. Obviously, a nice decline quarter over quarter. I think you guys attributed part of that to lower healthcare costs. How should we think about the expense run rate going forward?

Peter Chapman -- Chief Financial Officer

Look, I think it'd still be with previous guidance, Damon. We've now came in a little lower that healthcare cut, that healthcare one. And we had lower claims, and we had a health-care claim reserve just update its assumptions this quarter, which I wouldn't expect to happen in the next quarter. It's sort of a once-a-year type event.

So look, I would still expect them to be little higher and in line with previous guidance, but not a huge step change other than that.

Damon DelMonte -- KBW -- Analyst

OK, great. I will step out. Thank you.

Operator

Our next question comes from Tim O'Brien of Sandler O'Neill and Partners. Tim, please proceed.

Tim O'Brien -- Sandler O'Neill + Partners, L.P. -- Analyst

Thank you. Just to follow on Damon's questions about floating and fixed. Are you guys -- do you have active floors on your floating rate or adjustable rate loans. Some of those -- are you incorporating those into new covenants on new production? What's the -- how are you using those to -- if at all, to -- in preparation for rate cuts?

Doug Bass -- President and Chief Operating Officer

Yes. Tim, this is Doug Bass. Yes, to your question. We have rate floors typically in all variable, whether prime or LIBOR based.

We also would insert floors on resets of loans that adjust to current treasury.

Tim O'Brien -- Sandler O'Neill + Partners, L.P. -- Analyst

And are some of those active floors right now, or the rates need to come down to activate them?

Doug Bass -- President and Chief Operating Officer

No. I would say, today on the variable side, that rates will need to come down to activate on some of the term resets with the treasury curve. Some of those may have been impacted.

Tim O'Brien -- Sandler O'Neill + Partners, L.P. -- Analyst

All right. Thanks  a lot.

Operator

Our next question comes from Janet Lee of J.P. Morgan. Janet, please proceed.

Janet Lee -- J.P. Morgan -- Analyst

Hi, good morning.

Doug Bass -- President and Chief Operating Officer

Good morning, Janet.

Janet Lee -- J.P. Morgan -- Analyst

So could you just give us little more color on these credit issues? Like how many borrowers were involved for each credit issue you identified each in like beef, cattle, dairy, and C&I and maybe size of loan reserves for each and whether these are truly one-offs? Or a little bit more systemic?

Peter Chapman -- Chief Financial Officer

Yeah. We don't usually give that information out specifically by borrowers that type the size on it. I think we generally talk that most of the increase is on the dairy piece of it. I think as Doug pointed out before, we are pretty well secured with all these credits, so very little specific reserve needed in these credits on it, but then we'll get into specific size.

Credit wise, size, they maybe varied from $5 million to $40 million roughly, is the largest and of the charge-offs for the quarter, Janet, on the beef, cattle side of things we're talking less than a handful amount on that. So I wouldn't say systemic across the portfolio.

Janet Lee -- J.P. Morgan -- Analyst

OK. And on the NIM front, it's good to see the deposit costs only rose three bps this quarter. So is it fair to say that June quarter marked the peak and we should start seeing a decline on a quarter-over-quarter basis going forward?

Peter Chapman -- Chief Financial Officer

Yes. We'd hope so. If the Fed decrease here next week, Janet, we've got a strategy in place that Doug said that we'll roll out pretty quickly after that. So -- and we'd hope that will assist in that.

Janet Lee -- J.P. Morgan -- Analyst

OK. And just last one. I know you're not giving specific guidance on NIM, but just directionally for every 25 bps rate cut by the Fed, like, how much would that impact your NIM?

Peter Chapman -- Chief Financial Officer

Well, that depends on loan spreads, Janet. So I won't go into sort of specific guidance on that. We'll just have to see how loan spreads play out there and how much people are -- people want to try to protect there. I think we did a good job this last quarter of just managing that in managing interest rates costs down or interest deposit costs down.

Our beta was higher as rates went up. I think we were ahead of the curve within a lot of other banks and leasing rates anticipating more increases. That gives us some flexibility in deposit rates to pull some leverage there to maintain margin.

Janet Lee -- J.P. Morgan -- Analyst

All right. That's it for me. Thanks for taking my questions.

Peter Chapman -- Chief Financial Officer

Thanks very much.

Operator

Next question comes from Nathan Race of Piper Jaffray. Nathan, please proceed.

Nathan Race -- Piper Jaffray -- Analyst

Hey, guys. Good morning.

Peter Chapman -- Chief Financial Officer

Good morning.

Nathan Race -- Piper Jaffray -- Analyst

Just going back to that last question. Pete, I was wondering if you could just help us kind of think about the trajectory of core loan yields for the September quarter. If I look back at the loan yield expansion following Fed rate hikes, there was maybe an average of 7 basis points, 8 basis points? Is it just as simple as maybe just taking the inverse of that and thinking about the core loan yield trajectory here in fiscal 4Q?

Peter Chapman -- Chief Financial Officer

That's probably a little high. Probably, it's about -- probably about five or six on that one, but you're thinking about it in the right way. Yes.

Nathan Race -- Piper Jaffray -- Analyst

OK, great. And then if I could just ask a question on credit quality. I'm just curious just given that a handful of these issues in the quarter were related to fraud. Just curious if anything has changed from a monitoring or credit review process in the wake of these issues?

Michael Gough -- Chief Credit Officer

This is Michael. I'll take the first crack at that question, and it's a very good one. The short answer is, yes. We think we've done some things internally already to bolster our processes, and we're looking at some other enhancements, as well, especially because of the fraud.

Nathan Race -- Piper Jaffray -- Analyst

OK. I appreciate you guys taking the questions.

Michael Gough -- Chief Credit Officer

Thank you.

Operator

[Operator signoff]

Duration: 30 minutes

Call participants:

Ken Karels -- Chairman and Chief Executive Officer

Peter Chapman -- Chief Financial Officer

Doug Bass -- President and Chief Operating Officer

Michael Gough -- Chief Credit Officer

Jon Arfstrom -- RBC Capital Markets -- Analyst

Jeff Rulis -- D.A. Davidson -- Analyst

Ebrahim Poonawala -- Bank of America Merrill Lynch -- Analyst

Damon DelMonte -- KBW -- Analyst

Tim O'Brien -- Sandler O'Neill + Partners, L.P. -- Analyst

Janet Lee -- J.P. Morgan -- Analyst

Nathan Race -- Piper Jaffray -- Analyst

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