Prosperity Bancshares, Inc. (PB) Q3 2017 Earnings Report, Transcript and Summary

Good morning, and welcome to the Prosperity Bancshares Third Quarter 2017 Earnings Conference Call. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Charlotte Rasche. Please go ahead.

Thank you. Good morning, ladies and gentlemen, and welcome to Prosperity Bancshares Third Quarter 2017 Earnings Conference Call. This call is being broadcast live over the Internet at www.prosperitybankusa.com and will be available for replay at the same location for the next few weeks. I'm Charlotte Rasche, Executive Vice President and General Counsel of Prosperity Bancshares. And here with me today is David Zalman, Chairman and Chief Executive Officer; H.E. Tim Timanus Jr., Vice Chairman; David Hollaway, Chief Financial Officer; Eddie Safady, President; Randy Hester, Chief Lending Officer; Mike Epps, EVP for Financial Operations and Administration; Merle Karnes, Chief Credit Officer; and Bob Benter, Executive Vice President. David Zalman will lead off with a review of the highlights for the recent quarter. He will be followed by David Hollaway, who will review some of our recent financial statistics, and Tim Timanus, who will discuss our lending activities, including asset quality. Finally, we will open the call for questions. During the call, interested parties may participate live by following the instructions that will be provided by our call moderator, Brandon. Before we begin, let me make the usual disclaimers. Certain of the matters discussed in this presentation may constitute forward-looking statements for purposes of the federal securities laws, and as such, may involve known and unknown risks, uncertainties and other factors, which may cause the actual results, performance or achievements of Prosperity Bancshares to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Additional information concerning factors that could cause actual results to be materially different than those in the forward-looking statements can be found in Prosperity Bancshares filings with the Securities and Exchange Commission, including Forms 10-Q and 10-K, and other reports and statements we have filed with the SEC. All forward-looking statements are expressly qualified in their entirety by these cautionary statements. Now let me turn the call over to David Zalman.

Thank you, Charlotte. I'd like to welcome and thank everyone for listening to our third quarter 2017 conference call. First, I'm excited to announce that the Board of Directors has increased the dividend for the third quarter to $0.36 from $0.34, which represents a 5.9% increase. The increase in dividends reflects the confidence we have and the continued growth and prosperity of our company. For the third quarter of 2017, we had impressive annualized returns on average tangible common equity of 14.83% and returns on average assets of 1.22%. Our net earnings were $67,908,000 for the third quarter of 2017. Our earnings this quarter were slightly impacted by Hurricane Harvey. Hurricane Harvey made landfall near Rockport, Texas on Friday, August 25, and continued to impact the Houston and Belmont areas through much of the following week. Our lenders have visited with every loan relationship we have in the affected areas in excess of $1 million. The vast majority of our customers impacted have flood insurance and/or business interruption insurance. We did, however, make a $3 million provision for credit losses this quarter, given the increased risk on loan performance and the possibility of some diverse economic impact from the storm. Our fee income was also slightly impacted in the third quarter as we waived certain ATM, overdraft and late payment fees for customers in the affected areas. Our diluted earnings per share were $0.98 for the third quarter of 2017 compared to $0.99 for the same period in 2016. Our loans at September 30, 2017, were $9,911,000,000, an increase of $363 million or 3.8% compared with $9,548,000,000 at September 30, 2016. During the first 2 quarters of 2017, we experienced approximately 5% annualized organic loan growth. However, given the distraction of the hurricane and recovery process, organic loan growth for the third quarter was approximately 1.9% annualized. For the first 3 quarters of 2017, annualized organic loan growth was approximately 4%. Our nonperforming assets at September 30, 2017, were $45,823,000 or 24 basis points of quarterly average earning assets compared to $60 million or 32 basis points of quarterly average earning assets at September 30, 2016. This represents a 24% reduction in nonperforming assets year-over-year. Our nonperforming assets as of June 30, 2017, were $47,618,000. Deposits at September 30, 2017, were $16,907,000,000, a decrease of $13.9 million or 1/10 or 1% compared with $16,921,000,000 at September 30, 2016. Linked-quarter deposits decreased $163 million or 1% from $17,071,000,000 at June 30, 2017. On a positive note, our noninterest-bearing deposits increased 6% to $5,465,000,000 at September 30, 2017, compared to $5,159,000,000 at September 30, 2016. Our core deposits, excluding public funds, continue to see growth of 2% this year. As mentioned in prior earnings calls, our deposits are the lowest for the year, in the second and third quarters, due to a seasonal decrease in deposit balances of the over 400 municipalities we do business with, as well as a decrease in the balances of our barn-and-ranch customers who are using their money to finish out their crops. We have historically experienced an increase in deposits in the fourth quarter of each year. With regard to acquisitions, as we've indicated in prior quarters, we continue to have active conversations with other bankers regarding potential acquisition opportunities. We remain ready to enter into a deal when it is right for all parties and is appropriately accretive to our existing shareholders. A little color on the economy. Since the storm, because many displaced homeowners in Houston have elected to rent, if only temporary, occupancy rates have risen substantially and the multi-family overhang appears to have been eliminated. The Federal Reserve Bank of Dallas expects short-term job loss in the Gulf Coast region of Texas in the range of 55,000 to 75,000 jobs. However, they believe these losses will be temporary. In closing, we are pleased - our results for - we are pleased with our results for the third quarter considering the challenges in some of our areas. The Dallas Fed Reserve expects that the fourth quarter will show a rebound in economic activity that should more than offset the decline in the third quarter. They also expect Texas' job growth, of approximately 2.6% in 2017, the strongest rate in 3 years. We are excited about the opportunities we have in front of us and look forward to the fourth quarter. I want to end my comments by thanking all of our associates, directors and other individuals who contributed to a relief fund for our associates who were impacted by the hurricane. Over $229,000 was collected and distributed to 126 of our fellow associates to help alleviate some of their hardships. Your generosity has been inspiring and very meaningful to the associates who received the funds. I would also like to thank our whole team once again for a job well done. Thanks again for your support of our company. Let me turn to over our discussion to David Hollaway, our Chief Financial Officer, to discuss some of the specific financial results we achieved. David?

Thank you, David. Net interest income before provision for credit losses for the 3 months ended September 30, 2017, was $156.1 million compared with $154.1 million for the same period in 2016. Total loan fair value discount accretion was $7.9 million for the quarter ended September 30, 2017, compared to $7.6 million for the same period in 2016. The net interest margin on a tax-equivalent basis was 3.22% for the quarter ended September 30, 2017, compared to 3.29% for the same period in 2016 and 3.14% for the quarter ended June 30, 2017. Excluding purchase accounting adjustments, the net interest margin on a tax-equivalent basis for the quarter ended September 30, 2017, was 3.07% compared to 3.06% for the quarter ended June 30, 2017. Noninterest income was $28.8 million for the 3 months ended September 30, 2017, compared with $29.7 million for the same period in 2016, and noninterest expense for the 3 months ended September 30, 2017, were $77.5 million compared with $79.5 million for the same period in 2016. The efficiency ratio was 41.9% for the 3 months ended September 30, 2017, compared to 43.3% for the same period last year and 42.3% for the 3 months ended June 30, 2017. The bond portfolio metrics at 9/30 showed a weighted average life of 4.0 years, an effective duration of 3.7 years and projected annual cash flows of approximately $1.6 billion. The net premium amortization on the bond portfolio was $10.1 million for the third quarter of '17 compared to $9.4 million for the second quarter of 2017. And with that, let me turn over the presentation to Tim Timanus for some detail on loans and asset quality. Tim?

Thank you, David. Nonperforming assets at quarter-end September 30, 2017, totaled $45,823,000 or 46 basis points of loans and other real estate compared to $47,618,000 or 48 basis points at June 30, 2017. This is a 3.77% decrease from June 30, 2017. The September 30, 2017, nonperforming asset total was made up of $31,201,000 in loans, $110,000 in repossessed assets and $14,512,000 in other real estate. Of the $45,823,000 in nonperforming assets, $17,195,000 or 37.5% are energy credits. This is broken down between $12,105,000 in exploration and production credits and $5,090,000 in service company credits. Since September 30, 2016, $170,000 in other real estate has been sold and $4,735,000 in loans have been removed from the nonperforming asset list. This represents a decrease in nonperforming assets of $4,905,000 or 10.7%. Net charge-offs for the 3 months ended September 30, 2017, were $3,871,000 compared to net charge-offs of $3,062,000 for the 3 months ended June 30, 2017. $6,900,000 was added to the allowance for credit losses during the quarter ended September 30, 2017 compared to $2,750,000 for the quarter ended June 30, 2017. The average monthly new loan production for the quarter ended September 30, 2017, was $241 million compared to $309 million for the quarter ended June 30, 2017. This is a 22% decrease. Loans outstanding at September 30, 2017, were $9,911,000,000 compared $9,864,000,000 at June 30, 2017, representing 1.9% annualized growth. The September 30, 2017, loan total is made up of 40% fixed growth loans, 36% floating rate and 24% variable rate. I'll now turn it over to Charlotte Rasche.

Thank you, Tim. At this time, we are prepared to answer your questions. Brandon, can you please assist us with questions?

[Operator Instructions]. Our first question comes from Brady Gailey with KBW.

Well, if I look at realized loan growth was a little slower, but average earning assets actually shrank a little bit linked-quarter, and looks like most of that was in the bond portfolio that fell, I think, around $300 million on average. Is there any color on why the shrinkage there and how we should think about the size of the bond book going forward?

Yes, I think - this is Dave Hollaway. I think just in the prior quarter, we had bought ahead a little bit, just a timing of cash flows. And this past quarter, it's just more normalized. If you noticed, borrowings went down along with the securities. So nothing real, no plan there. [indiscernible] is just a timing thing, with rates going up on securities and deposits going in. We may see that go up if the loan growth doesn't set up all the cash flow.

I think that's right, Dave. I mean, usually when Treasury - the Treasury is, actually, in that part of the last quarter, was actually going down. So when rates were not going up, we generally are not as heavy borrowing as we do when rates are going up like they are now.

All right. But longer term, I mean, should we think about the growth of the bond portfolio being a similar growth rate as the loan book? Or do you think that bond balances will be kind of more flattish going forward?

Again, it's not a moving part. So it - I would say, it'd be flattish. But if we put the math together, think of it this way, if our deposits begin to flow in, in the fourth quarter, we'll probably see good deposit growth. And if we don't lend that cash flow out, it would be invested in securities. So that could show as average balance is going up a little bit. But for looking over the long haul, I think loan growth would mean that you would think that the average securities portfolio should be kind of flattish, that's what we would say.

Our focus, Brady, is to put more of our deposits into loans and less into the bonds. And the only thing that would probably increase the bonds would be in - as we always do in the fourth quarter, get big increase in deposits or more borrowings from the Federal Home Loan Bank. But giving everything else being static, deposits and Federal Loan Bank money, our intent is to put more money into the loan portfolio.

Okay. And then finally for me on M&A. David, I heard your comments about you're having active conversations, your TCE whatever, 9% for you guys, which I know is a big number versus where you'd all like to run that. Your currency is trading at 2.4x tangible, which is a little less than [indiscernible], and valuations for sellers in Texas in the markets that you're looking are probably pretty full right now. So to me, it seems like M&A is probably a little less likely for you guys now than it has been historically. Do you think that's the right way to think about it?

No, I completely disagree with you. I think basically, we're on sale right now, but we continue to have discussions with banks, larger banks and smaller banks at the same time. A lot of it all depends on the accretion set we can do - that we can get into potential merger acquisition. But by no means, no means will I take that off of the table.

Our next question comes from Ebrahim Poonawala with Bank of America Merrill Lynch.

David, I was wondering if you can sort of comment on how much feel deception was there when you think about loan growth this quarter. And as we think about fourth quarter into next year, is the rebound going to look similar to the growth rate we had in the first quarter of about 4% to 5% annualized?

Well, let me say this, that really certain markets that we had, Ebrahim, for example, the Houston market, the Dallas market and the Austin market, those markets were growing in the first couple of quarters that's probably 10% or better. Our weaker markets were markets in South Texas, West Texas and Oklahoma. So we can get - if we can see improvement in the markets that were not performing as well, we can get a better - we can get better growth than the 5% or 6%. If those markets don't pick up and again a lot of those was tied to oil and gas and ranching and farming prices, so our goal is to do at least do what we did this year or more. But our goal is to even do better. And for the fourth quarter, for us to catch up, I just did a little bit of math where when you add the 3 quarters we have together right now because we only do 1.9% in the third quarter. We're only at 4% year-to-date. But again, for us to get to the 5% or better, we only have to achieve about another $180 million in loans, which sounds like a lot, but if we divide $180 million by 245 locations, that's $772,000 apiece. So it looks very achievable. Now having said that, I would remind that this morning that we have a lot of paydowns. So each one of those locations on an average, we'll have a, maybe a couple hundred thousand dollars in paydown, but again, still what we're asking for is not unrealistic at all. And again, a lot of it depends on the economy, but if you read the reports especially that we borrow a lot from the Federal Reserve Bank of Dallas, they expect our economy to really pick up, increase and make up for what we did in the third quarter, and we're on board for that.

Understood. And are you seeing any improvement in the slower markets that you mentioned, which have been sort of dampened by ag or oil and gas?

Yes. We're starting to see, especially in the West Texas market, where deposits have gone down for the last couple of years with oil and gas being down. A lot of our customers were using their money to make payments on loans. We're starting to see those customers now. Their deposits starting to build back up. And South Texas area especially in the Corpus Christi area, there's a big plant that's playing from Saudi Aramco and Exxon in the billions of dollars, so that should help the South Texas market to a certain degree. And again, I think more probably - probably, the Oklahoma market is probably a little bit more dependent on oil and gas, but overall, there should be some opportunity.

Understood. And did you call out - I'm sorry if I missed it, how much of the provisioning this quarter was impacted by the hurricane - related provisioning?

We put extra a $3 million into provisioning. Again, we didn't have anything specific. But again, we didn't feel it would be prudent not to put something in there in the event we did miss something from the hurricane.

$3 million current. And I guess, just moving to David on expenses, you've talked about $70 million to $80 million as a good sort of manageable quarterly run rate previously. Is that still good? Or is that number moving a little bit lower as you think about next few quarters?

No, I think that range still holds, even in the short term.

Our next question comes from Dave Rochester with Deutsche Bank.

Back on capital. It was brought up earlier, the TCE ratio is over 9%. I understand if you want to do a deal, you're thinking that - a possibility of the next year it sounds like. But if it doesn't happen, that capital ratio still grows, all capital ratios still grow. So at what point do you guys draw the line and say, "All right, we've got 10% TCE. We've got to kick this buyback back in." How do you think about that?

Well, if you noticed this quarter, we increased our dividend by almost 6%. So that's part of it. I think that our bank in the past has really wanted to use our money for growth. In the past, we've not used our money to purchase back our stock. We used the money for growth. And I think that, that's probably still the position that we will take, that basically, we're going to grow the deal. We will - things might not have happened in the last couple of years, but we've had 40-something transactions. And when the time is right, we'll have a deal, and we will use it. But again, we still feel the money should be used for growing the company. So we'll see either growth in using the money and the capital for acquiring banks or else increasing dividends.

Okay. And then just back on the securities discussion from earlier. I know in the past you guys have pre-bought when rates have moved up. Have you been buying all this quarter? And what do you see in for securities purchase rates right now?

Again, I - Dave, you want to jump in here in a minute. But really, the 10-year is really [indiscernible] kind of the benchmark from what we buy. We buy the mortgage-backed securities, the 10- to 15-year mortgage-backed securities with an average life of 5 years. So the 10-year treasury impacts that market more than anything. And we're really seeing the 10-year treasury. I haven't looked at it this morning as much yet, but yesterday and a couple of days before, it's been going up 2% a day. So I think you will see us more in the market now buying more as these rates continue to go up. Dave, I haven't seen what we can buy in the securities since the [indiscernible] is going up. I guess, it's - have you seen that?

Yes. In this last quarter - in this past quarter, we didn't do much purchasing, but the few that we did because of rates moving up, we're in that 2.30% yield, which is significantly higher than it was.

And I would say over the last couple of days, the 10-year going up 2%, you're probably going to be more closer to the 2.40%, 2.50% yield probably today.

So if that plays out and the deposits comes flooding in and we can't lend it all out, then we also can reinvest at a much higher rate than what our portfolio is yielding today.

Okay, great. And then, as you're thinking about future rate hikes, whenever they may hit, how do you think the NIM reacts? Do you still think you might get a little of a move up on the NIM or more stability there?

I think we do get a little bit of a bump. And again, our bank is a little different. Again, when you look at - remember, where our loan-deposit ratio has not near 100% like most banks. But we absolutely will benefit as they begin to raise rates. It's just the cash flow comes back, so it takes a little longer but absolutely, as we look at on our margin, kind of stable, and improves as we put more loans on the books, but with an interest rate hike, helps that along a little bit more.

Our real net interest margin really goes up in the second and third year. We're not - we don't get the net interest margin gains that some of the others do in the first year. It takes us a little bit longer to get there. But having said that, interest rates going up helps our bottom line tremendously over a period of time.

Okay. And just one last one on deposits. Are the - we did see a lot of seasonal strengths in the fourth quarter. But are you seeing any tick-up at all in inflows that you would attribute to recovery efforts in Houston?

If I'd say anything where I might have been wrong so far, I would have said that our deposits would have start picking up already with insurance checks. And we haven't seen - there's been some, but we haven't seen the insurance checks as meaningful as I thought they would have been so far.

Our next question comes from Matt Olney with Stephens.

I just want to go back to the M&A discussion. And can you just remind us of how small of an acquisition you would consider. And then in terms of tangible book value, I'm curious what kind of tolerance you'd have for day 1 dilution of tangible book value.

Let me answer the second part of the question first. I mean, historically, we haven't gone for tangible book value dilution. So in the past still, we haven't done that. So the first part of your question, say it again.

How small?

How small. I would say that we're looking in ranges between $2 billion right now and $10 billion. Having said that, a year-or-so ago, we bought a $600-million bank here in Houston, Tradition Bank, and we bought it because it was a bank that has been there for a long time. Its order had good core deposit, it's something that we really cherish a lot. And so it was around our other locations and so it fit in very good. I would say that we would look at smaller locations in markets that we're at already. And if those - we can enhance our position in the market. So for the most part, I wouldn't take anything off of the table. Again, we did a $600 million deal, but for the most part, we would like to do bigger deals, of course.

Okay. That's helpful, David. But going back to the other part of the question. I appreciate you have not done deals that are dilutive to tangible book value in the past. But given your relative currency today, is that still something that you're sticking towards? Or would you consider some dilution on an acquisition?

For us, the bigger aspect of a - the bigger aspect for us in an acquisition is really accretion. A lot of it depends on accretion. We're probably more focused on accretion than we are anything else. Having said that, as larger deals come in and you can improve your market share or it makes you stronger somewhere where you're not. All of those things have to be into consideration. I think I know where you're coming from. I think you're looking at a lot of the banks that you've covered and a lot of other banks cover and they're trading at such a high multiple. And when you look at their multiple compared to our multiple, it looks like a harder deal to do. And I think that's what you're referring to. But for the most part, if we do a bigger deal, the bank that we would have to come in couldn't be a whole lot of premium at a larger bank. Because again, we still - are still focused on accretion, and they would have to buy off on the fact that the combination of our companies would be better as a whole than as one. They would have to see that, and those are discussions that we talk about continuously.

Our next question comes from Peter Winter with Wedbush Securities.

So the core margin, you guys finally hit the inflection point. Is it an inflection point? So in other words, if rates don't increase from here, do you think you could hold the core margin stable going forward?

Yes, I mean - I guess, you can look at it as an inflection point, but when you look at - just look at the moving pieces and why this really helps us get a couple of things going on here. One, if we continue to increase our loan book at those yields that's much better than what you get on securities. And then the second piece of the equation is, just as we were mentioning a little while ago, amortization on the portfolio, it picked up a little bit this quarter, but not significant. But the bigger piece of that is if we're - if the rates have gone up and we have to reinvest in the bond portfolio, that too, has become a positive, because you're getting in at 2.30%, 2.40%, pick whatever number, that's much better than what the yield is on the portfolio. So you've got those 2 positive dynamics going, which is - which, I guess, you can call an inflection point and could begin to move our margin up, just absent any kind of interest rate changes.

Dave, I agree with everything you're saying around that, but I think the net interest margin is stable or growing up with the exception, we have to remember this time the net margin improved because of the additional accretion that we got this core, but...

The piece of core.

If you're on core, yes, I'm fine with that. Yes, absolutely.

And just with regards to the purchase accounting accretion, it was elevated this quarter, what is a run rate we should think of going forward?

Yes, I mean, that was 7.9% or whatever it was this quarter, obviously, that is not a good run rate. But we would - intend to say as we look at those numbers, let's try to use approximately $4 million going forward.

Yes. I think that this time, if we just - we had a very, very large loan that ended up being paid off, it was a loan that we had on the books. It was a long, longer-term payout, it was a very long, and this company got bought out and the loan got paid off and that's why you saw the increased accretion this time. It wasn't something that was expected.

Our next question comes from Gary Tenner with D.A. Davidson.

You guys gave the monthly loan production for the quarter, and I appreciate that compared to the prior quarter, can you give us an idea of where it was, say for July and August, for the hurricane?

Yes. For example, during the first quarter of the year, that average was $279 million. Then in the second quarter, it increased quite a bit to $309 million. And then, of course, dropped back to this $241 million that I mentioned in this, quarter. This quarter was a little bit harder to figure out I guess, because September clearly had been affected by the hurricane, it's hard to put an absolute dollar number to that, but volume did fall off because of the hurricane, and sometimes the summer doldrums are realized in the loan volume, and that was the case in July. July was a weak month. It bounced back in August. August was a decent month. And then, it did not fall quite as much in September as I thought it might have. So a little hard to figure out, but I think clearly, there was some impact from the hurricane, and I don't know how to explain July other than the fact that sometimes in the middle of the summer, it's just weak. I mean, people are on vacation and doing things other than borrowing money. So that's probably the best answer.

If I could jump in and say July probably is weaker sometimes because people are on vacation. But again, Gary, we had 3 weeks where our loan committee usually starts at 10:30 in the morning and we finish at 6:00 in the evening. And during this hurricane, we had three weeks where we're already gone by lunch. So people just couldn't get to the banks. So it's probably a combination of some weakness in July, but a lot to the hurricane.

I think that's right. And you have to ask yourself a question what does that mean going forward? We're optimistic about what it means going forward. If you look at the fundamentals in Houston, for example, they look pretty good right now. So while the economy was certainly impacted by the storm, the storm created a lot of future economic activity going forward. And as David mentioned in his comments, at this point in time, has made the single-family market a little hard to figure out, but the apartment market, the multi-family has improved quite a bit. And we think that's going to hold for a while. And just as an example, within the last few weeks, we approved a $78 million loan that we obviously think is a good loan. And we've been told that the customer is going to go with us. So that's just an example of some sizable activity that's still ongoing out there. So we're fairly optimistic about the loan value going forward.

It was more in the Dallas market.

It was. It was, yes.

[Operator Instructions]. Our next question comes from John Rodis with FIG Partners.

I guess most of my questions have been asked and answered, but maybe one question just on the tax rate. What sort of the tax rate we should use, David, going forward?

We should be sitting in that, I would say going forward, if you want to do a 32.5% to 33%, somewhere in there, that's probably a good projection.

Shouldn't it be 20%?

When they change the rules, we'd be at 20%, but that's something out there.

I think it's 20% if the Astros win the World Series, right?

Yes, there you go, yes.

50%, 50%, yes, when they win.

Maybe just one other question too, David. On the - on fee income, the other line item was up a little bit this quarter, but I guess, it was down last quarter from the first quarter, anything unusual in other fee income?

Yes, yes. In the other, it's a little elevated. I would use last quarter as probably closer to normalized run. This quarter, we had a few unusual small things that I gave it up a little bit. So I wouldn't use that. It looks like $300,000 or $400,000 extra this quarter.

This concludes our question-and-answer session. I would like to turn the conference back over to Charlotte Rasche for any closing remarks.

Thank you, Brandon. Thank you, ladies and gentlemen, for taking the time to participate in our call today. We appreciate the support that we get for our company, and we will continue to work on building shareholder value.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.