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Spirit of Texas Bancshares (NASDAQ:STXB)
Q2 2020 Earnings Call
Jul 21, 2020, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Greetings, and welcome to the Spirit of Texas Bancshares record second-quarter earnings conference call. [Operator instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Jerry Golemon, executive vice president and chief operating officer.

Thank you. Mr. Golemon, you may begin.

Jerry Golemon -- Executive Vice President and Chief Operating Officer

Thank you, operator, and good morning, everyone. We appreciate you joining us for the Spirit of Texas Bancshares conference call and webcast to review our 2020 second-quarter results. With me today is Mr. Dean Bass, chairman and chief executive officer; Mr.

David McGuire, president and chief lending officer; and Ms. Allison Johnson, interim chief financial officer. Following my opening remarks, we will provide a high-level review and commentary on the financial details of the second quarter before opening the call for Q&A. I'd now like to cover a few housekeeping items.

There will be a replay of today's call, and it will be available by webcast on our website at www.sotb.com. There will also be a telephonic replay available until July 28, 2020, and more information on how to access these replay features was included in yesterday's release. Please note that the information reported on this call speaks only as of today, July 21, 2020, and therefore, you are advised that time-sensitive information may no longer be accurate as of the time of any replay listening or transcript reading. In addition, the comments made by management during the conference call may contain certain forward-looking statements within the meaning of the United States federal securities laws.

These forward-looking statements reflect the current views of management. However, various risks, uncertainties, and contingencies could cause actual results, performance or achievements to differ materially from those expressed in the statements made by management. The listener or reader is encouraged to read the company's annual report, Form 10-K filed with the SEC for the year ended December 31, 2019, to understand certain of those risks, uncertainties, and contingencies. The comments today will also include certain non-GAAP financial measures.

Additional details and reconciliations to the most directly comparable GAAP financial measures are included in yesterday's earnings release, which can be found on the Spirit of Texas website. Now, I'd like to turn the call over to our chairman and CEO, Mr. Dean Bass. Dean?

Dean Bass -- Chairman and Chief Executive Officer

Thank you, Jerry, and good morning, everyone. David and I started the company more than a decade ago, excited at the opportunity to serve various communities throughout Texas, while also earning a solid return on investment for those who believed in our vision. Over the next 10 years, we focused on growth by adding quality assets, managing risk, and partnering with the best and the brightest bankers in Texas. Being a banker, though, involves not only growing in the good times but making tough decisions in the economic downturns.

Every downturn is different and presents both unique challenges and opportunities for the future. During the cycle of stress, we are focused on the solution for recovery. Our bank wholeheartedly supported the government programs intended to save our communities. We are very fortunate that our commitment to the communities we serve and deploying our talented staff has provided a strong return on investment and led to our best quarter since inception.

We are pleased to announce net income of $7.7 million for the second quarter and dilutive earnings per share of $0.44. Our second-quarter performance was bolstered by the payroll protection program. We were able to successfully leverage years of experience with small business lending to help those in need by quickly and effectively deploying our entire bank staff to meet the demand of our small businesses across Texas. Our lenders, many of our support staff, worked tirelessly throughout the process.

As a result, during the second quarter of 2020, we were able to help small businesses obtain $428 million in funding while generating $15.3 million of origination fees, which will be earned over the life of these loans. While the fight against global pandemic is far from over, we are very pleased that the majority of Texas is now open for business and Texas consumers are doing a great job of supporting local business. We remain committed to our employees, customers and have implemented enhanced safety protocols throughout the organization. Now I'd like to turn the call over to Mr.

David McGuire, our president and chief lending officer, to discuss the loan portfolio and asset quality. David?

David McGuire -- President and Chief Lending Officer

Thank you, Dean. We are truly in unprecedented times. Like many businesses throughout Texas, the past three months for us has been an exercise in assessing damage, planning for an uncertain future, and ensuring that all decisions we make are in the best interest of our shareholders. We are extremely fortunate that we entered this environment with superior credit quality, a strong capital position, and the most talented lending and credit administration staff in Texas.

It is now time to leverage these expert resources and to capitalize on current macroeconomic opportunities. Throughout most of the second quarter, many of our borrowers' businesses were closed, and approximately 25% have requested some form of relief. We granted a period of relief for 90 days to those in need and are extremely pleased that the vast majority of those struggling businesses have regained some level of footing as Texas reopened and welcome back consumers. We fully expect that more than 90% of these borrowers will resume scheduled payments as many already have and the request for additional relief has been minimal.

We continue to monitor segment significantly impacted by COVID-19 and have worked diligently over the quarter to reduce risk in these segments, which include retail strip centers, hospitality, restaurants, and direct and indirect oil exposure. Retail strip centers at June 30, 2020 consisted of $120.4 million or 5% of the loan portfolio. Of these retail strip centers, 75% are nonowner occupied and the remaining 25% are owner-occupied. Hospitality exposure at June 30, 2020 consisted of $91.4 million or 3.8% of the loan portfolio.

Of these hospitality loans, 84% are term loans and the remaining 16% are construction loans. At June 30, 2020, the loan portfolio consisted of $30.5 million of restaurant exposure or 1.3%. Of these restaurant loans, approximately half are quick-service restaurants, and the other half are full-service restaurants. Total oil exposure in the loan portfolio at the end of the quarter was $74.7 million or 3.1% of total loans outstanding.

Direct energy exposure was 1.8% of the total loans outstanding and 1.2% was indirect energy exposure. Loan growth during the second quarter was primarily due to us successfully funding $428 million of PPP loan originations. Excluding PPP loans, organic loans increased $43.1 million or 14.4% annualized, which included $13.3 million of participations purchased. We saw a lack of demand during the second quarter, which was expected given the current environment.

However, we are pleased that many of the quality relationships we had in the pipeline at December 31, 2019, have simply delayed plans as opposed to canceling them outright. We fully expect that by the end of the year, with the presidential election behind us and, hopefully, a vaccine near, demand for loans will return as borrowers embrace a more certain economic environment. The yield on loans in the second quarter of 2020 was 5.14%, which decreased 80 basis points from Q1 2020. The reduction in yield was expected since a large portion of our variable-rate loans repriced quarterly and repriced on April 1, 2020 at levels indicated by recent declines in index rates.

As of June 30, 2020, the majority of our variable-rate loans have reached their floors, and we do not expect further deterioration in loan yield going forward. We are pleased to report no significant weaknesses in asset quality quarter over quarter, with nonperforming loans to outstanding loans declining to 31 basis points at the end of Q2 2020 compared to 38 basis points at the end of Q1 2020. The provision for loan losses for the second quarter was $2.8 million, which increased the allowance to 9.9 million or 41 basis points of our loans outstanding. At quarter-end, the coverage ratio on the organic portfolio was 77 basis points, excluding PPP loans.

Annualized net charge-offs were 10 basis points for the second quarter of 2020. As the full picture of the length and severity of this pandemic comes into view over the next few quarters, we believe we are well-positioned, well-staffed, and fully committed to ensuring a full and robust recovery. With that, I'll turn the call back over to Jerry Golemon to provide a review of the funding side of the company. Jerry?

Jerry Golemon -- Executive Vice President and Chief Operating Officer

Thank you, David. Total deposits at the end of Q2 were $2.4 billion, an increase of $338 million or 16.3% from Q1 2020 and an increase of 53.8% over Q2 2019. Of the $338 million sequential increase from Q1, approximately $108 million were PPP-related deposits. Noninterest-bearing deposits increased $258.6 million or 53.1% from Q1, again, with PPP deposits accounting for $108 million of the increase.

Significantly, exclusive of PPP-related deposits, noninterest-bearing deposits now make up 27.7% of total deposits, up from 23.4% at the end of Q1 2020. This improved shift in deposit mix, along with aggressive repricing of deposits, resulted in a 0.67% cost of deposits, a decrease of 26 basis points from Q1 2020. The bank has no broker deposits. The reported loan-to-deposit ratio at the end of Q2 is 100.5%.

Excluding PPP activities, the loan-to-deposit ratio drops to 86.6%. Borrowings increased by $79.8 million during the second quarter to $193.1 million due to our utilization of the Feds PPP liquidity facility for partial funding of the PPP loans. Borrowings totaled 6.5% of assets at the end of Q2. The company has significant sources of available liquidity, including $40 million in a holding company line of credit, Fed funds lines totaling $108 million, and Federal Home Loan Bank availability of $519.5 million.

I'd now like to turn the call over to our Interim chief financial officer, Allison Johnson, to provide a financial overview of the second quarter. Allison?

Allison Johnson -- Interim Chief Financial Officer

Thanks, Jerry, and good morning, everyone. We provided detailed financial tables in yesterday's earnings release. On a consolidated basis, net income for the three months ended June 30, 2020 was $7.7 million, with fully diluted EPS of $0.44 compared to earnings of $5.8 million and fully diluted EPS of $0.41 in the second quarter of 2020. While this is a great quarter given our success with the payroll protection program, we have used the past three months to review our capital plan, liquidity position, and core expense run rate.

The current environment demands that we remain prepared to resume robust operations if the economic recovery is V-shaped while having sound contingency plans if the recent spike in COVID-19 cases slows the pace of the recovery. We are committed to acting in the best interest of all shareholders by not reacting too drastically, but quickly enough to capitalize on future opportunities that may arise. Our tax-equivalent margin in the second quarter of 2020 was 4% compared to first-quarter 2020 tax-equivalent margin of 4.4%, representing a 40-basis point decrease. The decline from the first quarter of 2020 is primarily due to rate resets on interest-earning assets as a result of the decreases in the interest rate set by the federal open market committee during the first quarter of 2020.

And the addition of PPP loans, which yield 1% on a stated basis and 3.4% when accounting for the effects of deferred costs and fees on an effective yield basis. Excluding the impact of PPP loans, tax-equivalent net interest margin was 4.21%. As of June 30, 2020, our loan yield declined 80 basis points to 5.14% from Q1 2020. Excluding the impact of PPP loans, as of June 30, 2020, our yield on loans was 5.54%, a decrease of 40 basis points from Q1 2020.

The impact of the first-quarter index rate declines was fully phased into our loan yield during the quarter as the majority of our variable-rate loans reset on April 1, 2020. We do not anticipate further deterioration in loan yields despite market rates given that the majority of our loans are currently at their floors. The provision for loan losses for the second quarter was 2.8 million, which increased the allowance to 9.9 million or 41 basis points of our loans outstanding or 50 basis points, excluding the 100% government-guaranteed PPP loans. The majority of the provision expense for the quarter related to increase in qualitative reserves in response to the current economic environment as opposed to a deterioration in credit quality or an increase in impaired loan balances.

The coverage ratio on the organic portfolio was 77 basis points on the 1.3 billion in organic loans outstanding, excluding PPP loans at quarter-end. Additionally, we have 6.7 million unamortized discount on the acquired loan portfolio at June 30, 2020. As an emerging growth company, we have delayed the adoption of CECL until 2023. Under our current incurred loss model, our reserves are based upon an estimate of loss events, which have occurred as opposed to forecasting future loss events.

Over the next quarter, as periods of deferment expire and we receive updated financials from borrowers, which will include the period of businesses were not in operation. We anticipate risk rate movement in the third and fourth quarters, elevated impaired loan balances, and an elevated provision expense and corresponding increase in coverage ratios. We are committed to working through problem loans quickly and mitigating losses wherever possible. At June 30, 2020, we believe we are adequately reserved at 9.9 million based upon the knowledge we have of the current economic environment and our borrowers' financial condition.

Noninterest income totaled 2.6 million for the second quarter of 2020 compared to 2.7 million for the first quarter of 2020. U.S. small business administration loan servicing fees increased 246,000 quarter over quarter as a result of favorable servicing asset valuation. As many of the valuation assumptions are currently at their floors and ceilings, we do not anticipate much volatility in the servicing assets for the next two quarters.

Additionally, during the second quarter of 2020, mortgage referral fees increased $155,000 as mortgage activity increased as a result of lower interest rates during the quarter. We would expect based on strong housing starts and permit data for this trend to continue as first-time homebuyers take advantage of historically low rates and current homeowners take this opportunity to refinance. Gain on sale loans and interest rate swap income declined 138,000 and 369,000, respectively, in response to general declines in lending activity during the quarter. Noninterest expense totaled 16.1 million in the second quarter of 2020, a decrease of 23.2% from 21 million in the first quarter of 2020.

The primary reasons for this decline in noninterest expense was the deferral of 4.9 million of salary expense recorded in conjunction with the PPP loan originations. These loan costs will amortize on a straight-line basis over the life of the loans. At June 30, 2020, approximately 500,000 of these deferred costs had already amortized into the loan yield along with 1.5 million of deferred fee revenue. Yesterday morning, there was a press release announcing the sale of one of our branch locations.

This is one of the many initiatives we have strategically put in place to prove our commitment to diligently managing expenses this year. Additionally, we'll begin realizing some of the cost savings from the Citizens acquisition at the end of July after conversion. We currently enjoy a strong capital position at both the bank and the company on a consolidated basis. It is vital that we preserve capital over the next two quarters so that we are well-positioned to work through any troubled assets while maintaining the ability to look for deals and continue our growth trajectory.

As of June 30, 2020, the bank had a tier 1 leverage ratio of 9.6%, and the company on a consolidated basis has a tier 1 leverage ratio of 9.49%. The majority of PPP loans were funded through deposits and partially through PPP liquidity facility, which is neutral to capital. During the quarter, with the encouragement from our board of directors, we amended and extended our stock buyback plan. With our current stock still trading below tangible book value per share this quarter, we felt this was an opportunity to repurchase 640,000 shares of undervalued stock.

We remain committed to repurchasing undervalued stock as long as the internal rate of return from the purchased shares exceeds the return earned on other investment opportunities and the capital is not needed elsewhere. I'd now like to turn the call back over to Mr. Bass for wrap-up. Dean?

Dean Bass -- Chairman and Chief Executive Officer

Thank you, Allison. More than a decade ago, we chose to name Spirit of Texas Bank because the spirit of this great state is not intangible. It is something that our customers and our employees feel every day. While we join the rest of the country that is in recovery, I know that the Texas economy will rebound faster, stronger, and better because of this spirit.

And I'm proud that our bank has committed to forging a path to a strong, profitable, and lasting recovery. Our motto has always been Texans helping Texans, and our employees are committed to those words. And in so doing, we believe we will emerge from this period stronger and with the ability to significantly enhance shareholder value. This concludes our prepared remarks.

I'd like to ask the operator to open up the line for any questions. Operator?

Questions & Answers:


Operator

Thank you. [Operator instructions] Our first question comes from the line of Brad Milsaps with Piper Sandler. Please proceed with your question.

Brad Milsaps -- Piper Sandler -- Analyst

Hey, good morning.

Allison Johnson -- Interim Chief Financial Officer

Good morning.

Brad Milsaps -- Piper Sandler -- Analyst

Let's see, Allison, maybe I want to start with just a little more color around PPP for the quarter. Do you happen to have the average balance of PPP loans for the second quarter?

Allison Johnson -- Interim Chief Financial Officer

Sure, Brad. The average balance is about 325,000.

Brad Milsaps -- Piper Sandler -- Analyst

325 million?

Allison Johnson -- Interim Chief Financial Officer

325 million.

Brad Milsaps -- Piper Sandler -- Analyst

OK. And if I understand the accounting correctly, you guys generated gross fees of $15.3 million. It looks like in the release, you say you recognized about $1 million of those in the quarter plus the $4.9 million related to FAS 91. So that means -- would that mean you've got about $9.4 million left to recognize in the bottom line? Is that the correct way to think about it?

Allison Johnson -- Interim Chief Financial Officer

No. We've got about 12 million remaining after the quarter.

Brad Milsaps -- Piper Sandler -- Analyst

OK. OK. Got it. All right.

OK. And just around your comments around the reserve. It sounds like you guys are going to plan to build that in the back half of the year. Obviously, that's dependent upon kind of what happens with classified, criticized assets as some of the deferrals come off.

Can you talk about, maybe at this point, kind of what you think in terms of order of magnitude as it relates to kind of what you feel like you can build the reserve to in the back half?

Allison Johnson -- Interim Chief Financial Officer

Sure. Yeah. Let me elaborate on that and provide some color. So as you know, we're under the incurred loss model, so our reserve levels are calculated to adhere to accounting guidance.

We don't set target coverage ratios and then bend our model to support those levels. I know the expectation and the preference would be that we set aside some of this PPP income and increase our provision. But the accounting just doesn't support that at this time. And as David can elaborate on, we've always prioritized quality over chasing loan growth.

This puts us in a stronger position to deal with the current environment. And we believe based on the facts we have today that reserve levels are appropriate. With that being said, there's still a great deal of uncertainty in the economy right now. So we've budgeted between 2 million and 3 million per quarter in estimated provision expense over the next two quarters, and we feel like that's conservative and sufficient given what we know right now.

Brad Milsaps -- Piper Sandler -- Analyst

Great. And that's helpful. Dean or David, have you guys noticed any differences in kind of how your legacy book has performed versus maybe some of the loans that you've acquired over the last couple of years with some of your acquisitions?

David McGuire -- President and Chief Lending Officer

Actually, no. And the first thing we do during due diligence is to see that the underwriting matches up with what we're used to dealing with on a daily basis with the legacy bank and it's performing very well on the acquired side. And our legacy portfolio right now is just as good as we've seen it.

Dean Bass -- Chairman and Chief Executive Officer

This is Dean. Let me add something. The banks that did join us were highly regarded rated and had excellent performance in their own right before they joined us, and we've seen nothing but continued from that point. And if you actually look back at their past dues, it's even improved because they've initiated some of the procedures we put in place.

And so we're very pleased both with the staff and management team and the loans associated, plus it gives us diversity outside of the metro markets. Those banks are away from the focus of the COVID virus and gives us great ability to continue their legacy in those markets.

Brad Milsaps -- Piper Sandler -- Analyst

Great. Thank you, guys.

Operator

Thank you. Our next question comes from the line of Matt Olney with Stephens. Please proceed with your question

Adam Freyaldenhoven -- Stephens Inc. -- Analyst

This is Adam Freyaldenhoven on from Matt. I wanted to start with the PPP loans, specifically on the $12 million remaining to recognize. What are your expectations on when that will come in?

Allison Johnson -- Interim Chief Financial Officer

We currently have budgeted that 25% of those will get forgiven in Q4 and then the remaining over 2021. And David, you can add a little bit more color on that, if you'd like, as far as expectations.

David McGuire -- President and Chief Lending Officer

Yes. It's still in development as far as -- there's still some legislation out there that we're recommending our customers hold off on it [Inaudible] asking for forgiveness at this point. [Inaudible] get their forgiveness. And so like Allison said, we'll start seeing some of that forgiveness probably starting in August, but the majority of it most likely will be in latter quarter of the year, the fourth quarter into the first quarter.

Adam Freyaldenhoven -- Stephens Inc. -- Analyst

OK. That's helpful. And then the other government program, the Main Street Lending Program, will this be material for any of your customers?

David McGuire -- President and Chief Lending Officer

We think so, actually. We studied it and decided that it would be good for our customer base. Right now, it's about half and half between existing customers and potential new customers to the bank. As far as exact numbers, I'd hate to say at this point, but it's looking like it's going to be a lot of volume for us toward the end of the third quarter and if they extend the program into the fourth quarter.

Adam Freyaldenhoven -- Stephens Inc. -- Analyst

OK. That's helpful. And then I just wanted to circle back to just kind of loans. In the press release, you noted there were 13 million in participations purchased.

Can you provide any more color? I know last quarter you sold some of the participation, and you're purchasing this quarter.

David McGuire -- President and Chief Lending Officer

Well, our liquidity improved during the quarter, so we need to deploy that. And those were actually repurchased participation sold.

Adam Freyaldenhoven -- Stephens Inc. -- Analyst

OK. Any industry or anything like that you could provide on what was purchased during the quarter?

David McGuire -- President and Chief Lending Officer

I'm sorry. Can you repeat that?

Adam Freyaldenhoven -- Stephens Inc. -- Analyst

Industry or anything specific you can provide about the purchase participation this quarter.

David McGuire -- President and Chief Lending Officer

They're just existing relationships that we had -- there are larger loan relationships that we extend to couple of friendly banks in the state, and we bought them back.

Dean Bass -- Chairman and Chief Executive Officer

This is Dean. It was all around liquidity, as David said, and those are the same ones that we liked before. And remember, it was a different world back in the first of March. And so we were in preparation to try to determine what battle and when it might be fought.

And so since then, life continues to change each week, each day, each week, each month. So that we brought back home the same ones we like that we sold that we thought we needed to provide through the quarter-end, some liquidity to make sure we knew what we were facing going up through today. So that's why we decided to buy those back.

Adam Freyaldenhoven -- Stephens Inc. -- Analyst

That's helpful. And then last question for me. It looks like restaurant exposure came down 20 million to 30 million from 1Q. Is there any more details behind this?

Allison Johnson -- Interim Chief Financial Officer

Yeah. We actually had quite a few payoffs in the restaurant portfolio this quarter, as well as we did a scrub of our collateral codes and identified one that was incorrectly identified in Q1, so we've actually moved that out of the population. So those are the two drivers there.

Adam Freyaldenhoven -- Stephens Inc. -- Analyst

Thank you, guys.

Allison Johnson -- Interim Chief Financial Officer

Thank you.

Operator

Thank you. There are no further questions at this time. I'd like to turn the call back over to Mr. Bass for any closing remarks.

Dean Bass -- Chairman and Chief Executive Officer

Thank you very much. I appreciate it. From the Spirit executive team, I'd like to thank everyone for joining us today, and thank you to everyone that helped us put this together and their contribution. The battle of both the COVID and starting these companies back has been a difficult matter and continues to be a lot of hands-on work, and compliments to David and our team on the front lines making that happen.

The essential part of what we do every day is also dealing with COVID around us. So they've done an excellent job with committing themselves, working with their family and themselves to make this successful. So thank you to everyone. Thank you for being on the call.

Operator

[Operator signoff]

Duration: 33 minutes

Call participants:

Jerry Golemon -- Executive Vice President and Chief Operating Officer

Dean Bass -- Chairman and Chief Executive Officer

David McGuire -- President and Chief Lending Officer

Allison Johnson -- Interim Chief Financial Officer

Brad Milsaps -- Piper Sandler -- Analyst

Adam Freyaldenhoven -- Stephens Inc. -- Analyst

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