Texas Capital Bancshares, Inc. (NASDAQ:TCBI) Q2 2023 Earnings Call Transcript
Texas Capital Bancshares, Inc. (NASDAQ:TCBI) Q2 2023 Earnings Call Transcript July 20, 2023
Texas Capital Bancshares, Inc. beats earnings expectations. Reported EPS is $1.33, expectations were $0.95.
Operator: Hello and welcome to today's conference call titled Texas Capital Bancshares Q2 2023 Earnings Call. My name is Ellen and I'll be coordinating the call for today. [Operator Instructions] I will now hand over to Jocelyn Kukulka to begin. Jocelyn, please ahead when you are ready.
Jocelyn Kukulka: Good morning, and thank you for joining us for TCBI's second quarter 2023 earnings conference call. I'm Jocelyn Kukulka, Head of Investor Relations. Before we begin, please be aware that this call will include forward-looking statements that are based on our current expectations of future results or events. Forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from these statements. Our forward-looking statements are as of the date of this call, and we do not assume any obligation to update or revise them. Statements made on this call should be considered together with the cautionary statements and other information contained in today's earnings release, our most recent annual report on Form 10-K and subsequent filings with the SEC.
We will refer to slides during today's presentation, which can be found along with the press release in the Investor Relations section of our website. Our speakers for the call today are Rob Holmes, President and CEO; and Matt Scurlock, CFO. At the conclusion of our prepared remarks, our operator will open up a Q&A session. And now, I'll turn the call over to Rob for opening remarks.
Rob Holmes: Thank you for joining us today. The firm's sustained progress against our well-documented strategy was evident again this quarter as the people, products, services and infrastructure implemented over the past 2.5 years, delivered another quarter marked by notable improvements in financial performance. I am proud of the foundation we have built and acknowledge the early successes of our strategy are due entirely to the material efforts of the employees across the firm, and the trust placed in us by our clients who believe in what and to how we are building. We are resolute in our mission to realize the unique opportunity to create something differentiated for our clients and steadfast in our commitment to building something of lasting value.
The financial resiliency of this firm continues to be a strategic advantage. A goal since our arrival was to build a firm characterized by the strength of its balance sheet and the breadth of its platform, a firm "that is resilient through market and interest rate cycles." Maintaining sector-leading capital and liquidity continues to enable our bankers to focus on growing the firm by both serving the broader needs of existing clients in confidently engaging identified prospects with an increasingly mature and compelling offering. The pace of client acquisition over the first two years of the transformation was marked largely by aggressive balance sheet reallocation to focus our capital on defined industry end market segments, where we believe the clients will benefit from the material investments made in our treasury solutions, private wealth and investment banking offerings.
Our view was that as the capabilities and culture evolve, we would become more relevant to our clients, and in turn, begin to generate structurally higher returns on that allocated capital. Both this quarter's financial results and client behaviors suggest sustained progress towards this objective. We continue to add operating accounts at a pace consistent with our long-term plan. Gross payment revenues increased for the second straight quarter and were up 12% year-over-year, as our multiyear focus and material investments in proprietary applications like our commercial onboarding solution Initio are enabling us to win the operating business indicative of becoming our client's primary bank, a designation that not only improves long-term earnings capacity but also advances the already strong quality and associated resiliency of a transforming deposit base.
Over 90% of our commercial client onboardings now occur digitally. And during the second quarter, new business client onboarding increased over 30% compared to the prior quarter. Given the current rate environment, clients with deposits greater than necessary for daily operating needs are utilizing other cash management options on our platform, including interest-bearing deposits or in some instances, short-term liquid investments like treasuries. We are and will remain materially more focused on ensuring client needs can be met with our offerings than on our own near-term financial outcomes. The full rebuild of the private wealth business that I have detailed in prior calls is nearing completion, resulting in a front, middle and back-office structure built for both superior client experience, and significant scale.
The pace of year-over-year client acquisition was 13% this quarter and remained an indication of both future earnings potential and further connectivity across our services. Clients are increasingly benefiting from our still-emerging investment banking capabilities. Investment banking and trading income had a third consecutive record quarter with revenue up $8.7 million or 47% quarter-over-quarter to $27.5 million, with contributions from all components of our newly built platform. We continue to achieve milestones in our product and services road maps and will focus future investments in an offering capable of delivering at least the 10% of total revenue targeted by 2025. Since its launch in December 2021, our investment banking business has built an impressive array of capabilities to help clients solve a broad set of needs.
Our capital solutions offering enables our clients to manage their interest rate risk via strategies of varying complexities and sophistication, such as swaps, collars, corridors and FX hedging. Our capital markets group has been actively assessing and executing alternative financing strategies for clients, including securitizations, high yield, follow-on, initial public offering in our first convertible bond trade occurring this quarter. Additional trades in the last six quarters have included TBA trades, specified MBS pool trades, corporate bond trades, corporate loan trades and equity trades. Sales and trading has now completed over $35 billion in notional flat trades since the first trade last May. Our M&A advisory team has assisted clients in realizing the long-term strategic objectives through its first buy-side advisory mandate and the closing of its first sell-side engagement.
Finally, our newly created ETF and funds management team successfully launched the Texas Capital Texas Equity ETF, now trading under the ticker TXS on the NYSE. At Texas Capital, we recognize that Texas' diverse, business-friendly climate and vibrant economy are critical to our growth in success. I am excited to announce that last week, we launched the aforementioned Texas Capital Texas Equity Index, exchange traded fund as the first investment offering created by Texas Capital's newly founded ETF and Funds Management business. With this launch, we entered one of the fastest-growing spaces in the asset management industry, further progressing against our objective to be the flagship financial services firm in the State of Texas and marking a significant expansion of our asset management capabilities.
The substantial and transformative investments made over the last two years to deliver a higher quality operating model, supporting a defined set of scalable businesses is resulting in the intended outcomes. The entire platform contributed to our now fourth consecutive quarter of positive operating leverage as year-over-year quarterly PPNR grew 43% in Q2. Noninterest income as a percentage of total revenue increased to 16.6% this quarter. It stands at 15.1% year-to-date, already in line with the bottom end of our full year 2025 goal to generate 15% to 20% of total revenue from fee income sources. Importantly, these diverse and complementary revenue streams were all built in the last two years. It will take time to deliver both at the magnitude and with the consistency we expect.
That said, we are pleased with our progress to date, and have proven that each of our areas of focus will be key contributors to earnings going forward. Before concluding, a foundational tenet of the financial resiliency we have established and consistently communicated and will preserve its continued focus on tangible book value which finished the quarter up 7% year-over-year, ending at $57.93 per share, a near all-time high for our firm. As you have heard me say in the past, while fully committed to improving financial performance over time, maximizing near-term returns is not the primary goal. We are instead focused on responsibly scaling high-value businesses through increased client adoption, improved client journeys in realized operational efficiencies.
Doing so will enable both higher quality earnings and a lower cost of capital which results in attractive through-cycle shareholder returns. Thank you for your continued interest in and support of our firm. I'll turn it over to Matt to discuss the quarter's results.
Matt Scurlock: Thanks, Rob. Good morning. Strong balance sheet positioning built over the last two years continues to be exemplified by top-tier capital and liquidity levels. At quarter end, on-hand cash liquidity totaled $2.8 billion or 10% of total assets compared to 5% median in our peer group. On insured deposits as a percentage of total deposits further decreased this quarter to 40%, and deposit coverage ratios remained extremely strong, both in absolute and relative terms with cash plus contingent funding to uninsured deposits of 165%. Capital levels remain at or near the top of the industry. CET1 finished the quarter at 12.2% and tangible common equity to tangible assets finished the quarter at 9.6%, which ranks first relative to first quarter results for all large U.S. banks.
Photo by Cytonn Photography on Unsplash
Notable progress in our fee-generating businesses continued again this quarter. As year-to-date noninterest income to total revenue was over 15%, in line with our long-term target of 15% to 20%. This was in part driven by quarterly investment banking and trading income of $27.5 million, which increased nearly 150% from the second quarter of last year and is up 47% linked quarter. Notably, this is our third consecutive record quarter since launching the investment making business last year. Treasury product fees increased 1% quarter-over-quarter. The pull-through to earnings from sustained momentum in our cash management and payment businesses as at this point in the rate cycle being offset by increased deposit compensation. We are less focused on quarterly fluctuations in revenue from this offering than we are in ensuring we are adding primary banking relationships consistent with our long-term plan.
Wealth management income increased 8% quarter-over-quarter, as assets under management grew 6%, resulting from market changes, net new inflows and some additional rotation from existing commercial and private wealth clients and to manage liquidity options. Managed liquidity now represents approximately 25% of AUM, up from less than 5% a year ago. Taken together, fee income from our areas of focus increased by approximately $16 million or 70% year-over-year, representing the early stages of client adoption across the set of capabilities, unique in our markets and custom built for our clients' evolving needs. Total revenue increased $5 million linked quarter, as the $3.3 million decline in net interest income was more than offset by improving noninterest revenue.
As expected, despite seasonally strong warehouse loan growth, net interest income was pressured by industry-wide increases in overall deposit costs. Total revenue increased $46.2 million or 20% compared to Q2 2022, with year-over-year results benefiting from a 76% increase in noninterest income, coupled with disciplined balance sheet repositioning into higher earning assets. Total noninterest expenses declined 6.4% linked quarter, as structural efficiencies associated with our go-forward operating model began to flow through the income statement. Taken together, quarterly PPNR increased 43% year-over-year to $96.4 million, the high point since we began this transformation in Q1 of 2021. Net income to common was $64.3 million for the quarter, up $34.5 million year-over-year, while earnings per share increased $0.74.
This is the highest level in two years, adjusted for our divestiture. Preparation for an evitable normalization and asset quality began in 2022, as we steadily built the reserve necessary to both address known legacy concerns and align balance sheet metrics with our foundational objective of financial resilience. We recognized $8.3 million in net charge-offs during the quarter, reducing nonaccrual loans to 28 basis points of total assets. This quarter's provision expense of $7 million accounts for the modest increase in criticized loans, as well as quarterly loan growth predominantly related to mortgage finance, which garners proportionately lower reserve rates. Quarterly performance metrics continued their steady progression towards target financial outcomes with quarterly return on assets, and return on tangible common equity of 0.95% and 9.17%, respectively, both more than double levels observed in the second quarter of last year.
Our balance sheet metrics remain strong, with the end-of-period profile reflective of continued execution on our set of core objectives. Gross LHI balances increased by $1.3 billion or 6% linked quarter, driven by predictable seasonality in the mortgage finance business and modest increases in commercial real estate, which is experiencing lower levels of prepayment activity. Deposit balances increased 5% or $1.1 billion in the quarter. Consistent with previous guidance, the deposit and loan growth were likely to more closely mirror each other in the near term after significant loan growth in Q1. As a result, the period-end loan-to-deposit ratio remained flat linked quarter at 91%, and down from 95% in the second quarter of last year. Cash balances moderated to 10% of total assets as outstanding FHLB borrowings declined by $750 million, and are now below our historically observed levels representing one component of our ample contingent liquidity.
As we detailed on the January earnings call, we have rebuilt nearly every process and procedure across the firm. As a result, in the second quarter, changes were made to certain estimates used in the Company's CECL model. The most significant of which are more granular estimate of historical loss rates to incorporate probability of default, loss severities and allocations of expected losses to outstanding loan balances and off-balance sheet financial instruments. These changes resulted in adjustments to the Company's portfolio segments, including introduction of the consumer category. And in a reallocation of the allowance for credit losses between loan portfolio segments and the allowance balances allocated to off-balance sheet financial instruments.
The changes made to estimates used in the Company's CECL model results in a higher allocation of losses to off-balance sheet financial instruments as is reflected in the $24 million decline in the ACL loans. On a combined basis, however, total ACL inclusive of off-balance sheet reserves remained relatively flat as compared to the prior quarter. Finally, the increase in interest rates resulted in an AOCI decline of $65 million, which is nearly offset by net income to common and result in tangible book value share of $57.93. Total LHI, excluding mortgage finance increased $213 million or 1.43% for the quarter and is now up $1 billion or 6.8% for the year. After expanding 8% in Q1, commercial loan growth moderated this quarter, declining $126 million or 1%, as both clients and the industry reset expectations for capital costs and its impact on credit demand.
Commercial loan growth over the past four quarters has added $1.4 billion of client balances consistent with our strategy, an increase of $0.15 when adjusted for divested loans. This capital previously attributed to loan-only relationships and the insurance brand finance business continues to be recycled into a client base that benefits from a broadening platform of available product solutions delivered within an enhanced client journey. Overall, request for capital extensions continue to come primarily from new and expanded relationships, as utilization rates were constant quarter-over-quarter at 51%. Our balance sheet committee trends indicate that while volume has declined from the year ago period. The proportion of new activity that includes more than just the out has increased substantially over the last two years to over 95% for the first six months of the year.
This is further evidence of our ability to bring increasingly comprehensive solutions to our clients in any economic environment, entirety of their corporate life cycle. Period-end real estate balances increased $358 million or 7% in the quarter. We continue to experience the expected but still material slowdown in payoff rates off recent record highs. Our clients' new origination volume also slowed in recent quarters but remains focused on multifamily, reflecting both our deep experience in the space and observed performance through credit and interest rate cycles. Only 12% of the real estate portfolio had a maturity date in 2023, while over 58% of the portfolio matures in '25 or later. Our exposure to at-risk asset classes is limited with office exposure of $460 million, approximately 9% of the total commercial real estate portfolio.
The office book has solid underwriting with a current average LTV of 57% and 89% recourse, as well as strong market characteristics is over 75% is Class A properties and over 71% is located in Texas. Average mortgage finance loans increased $1.1 billion or 33% in the quarter, as the seasonality associated with spring home buying partially offset rate-driven pressures that continue to drive down estimates of next 12- to 24-month activity. Year-over-year, the industry has contracted from $3.4 trillion to $1.6 trillion in trailing 12-month originations. Overall, market and volume estimates from professional forecasters suggest total market originations to decrease modestly in the third quarter, with full year expectations still showing a decline of more than 30% in origination volume.
Consistent with historical performance, we would expect to maintain our outperformance margin of about 25% as we remain confident in our ability to successfully serve this industry. In line with expectations communicated last quarter, total ending period deposits increased 5% quarter-over-quarter, with changes in the underlying mix reflective of both a continued funding transition and a tightening rate environment, coupled with market-driven trends and predictable seasonality. Total noninterest-bearing deposits remained stable quarter-over-quarter, with the proportion of total deposits decreasing modestly to 40% from 42% at year-end. The underlying composition, however, does continue to shift. As expected, mortgage finance noninterest-bearing deposits increased $884 million or 20% quarter-over-quarter, alongside higher loan balances as we remain focused on holistic relationships with top-tier clients in the industry.
Average mortgage finance deposits were 120% of average mortgage financial loans at the high end of our guidance of between 100% and 120% due to the impacts of decreased mortgage originations. Other noninterest-bearing deposits declined $955 million or 19%, in part due to previously described trends whereby select clients shifted excess operating account balances to interest-bearing deposits, including insured cash sweep or to other cash management options on our platform. While the pace of rotation is slowing, we do expect a portion of our total deposits comprised of noninterest-bearing excluding mortgage finance, to continue to decline in the near term. These behaviors, coupled with continued realization of additional interest-bearing deposits through business channels aligned with our strategy, resulted in a 10% linked quarter increase in total interest-bearing deposits.
The pace of our proactive repositioning away from index deposit sources has slowed as balances are now aligned to clients consistent with our strategy and at 6% of total deposits well inside our published 2025 threshold of 15%. Including the $195 million reduction experienced this quarter these balances are now down over $8.5 billion since year-end 2020. During the quarter, we did begin prefunding a portion of the $499 million of brokerage CDs maturing during the third quarter. We maintain ample broker capacity and while always evaluating future liquidity composition consistent with established balance sheet management priorities, we do anticipate that brokerage CDs will remain relatively flat during the third quarter. Our expectation remains that we will be able to grow client deposits by a continued elevated marginal cost, given the material change in market conditions experienced over the last four months.
As expected, our earnings at risk decreased this quarter to 2.6% or $26 million and a plus 100 basis point shock scenario, and minus 3.8% or $39 million and a down 100 basis point shock scenario, as a result of both increased funding costs and proactive measures taken earlier in the year to achieve a more neutral posture at this stage of the rate cycle. There were no new security purchases in the quarter, as we continue to believe holding levels equivalent to 15% of total assets, an efficient and prudent portion of our liquidity asset composition at this time. The core component of our naturally asset-sensitive profile remains the large portion of our earning asset mix that reprices with changes in short-term rates. 93% of the total LHI portfolio, excluding MFLs is variable rate, with 91% of these loans tied to either prime or one-month index.
Net interest margin decreased by 4 basis points this quarter and net interest income declined $3.3 million, predominantly as a function of a decline in interest-earning assets and higher quarter-over-quarter deposit costs, partially offset by increased average loan balances and improved loan yields. Our multi-quarter business model transformation and associated platform build is directly intended to lessen our dependence on these inevitable fluctuations in rate-driven earnings. Sustained execution on noninterest income initiatives will enable revenue stability even should near-term net interest income expansion moderate. Further, the systemic realignment of our expense base with strategic priorities is beginning to deliver the expected associated with a rebuilt and more scalable operating model.
We expect to see continued contraction in quarterly noninterest expense over the remainder of the year, which when coupled with revenue stability resulting from strong execution on behalf of our clients will enable core earnings expansion despite the market backdrop. Criticized loans increased $58.2 million or 10% in the quarter to $619.3 million or 2.9% of total LHI, as increases in special mention real estate loans offset a $22 million reduction in criticized commercial loan credits. The composition of criticized loans continues to be weighted toward commercial clients reliant specifically on consumer discretionary income plus a handful of well structured commercial real estate loans supported by strong Texas-based sponsors. We've previously communicated that we anticipated manageable real estate migration beginning in the middle of this year.
And based on our economic outlook, believe our client selection and underwriting guidelines provide adequate protection against realized loss. Detailed credit reviews, a credit risk practice implemented during the pandemic continued to occur quarterly, whereby the line of business leads and their credit partners conduct a series of reviews on a name-by-name basis. Additionally, during the second quarter, executive management hosted enhanced credit review sessions in middle market and corporate, resulting in a review of over 50% of the commitments in these verticals. Since late March, specific reviews have also been conducted on asset classes or industries, including office, multifamily, homebuilder, contractors, beverage distributors and Software as a Service.
The results of these reviews are represented in the migration trends, both inflows and outflows, and special mention and substandard loans this quarter. We have previously commented on the portion of legacy loans still on the balance sheet in consistent with current client selection and our underwriting principles that will be resolved through maturities, workouts or select charge-offs. During the quarter, we recognized net charge-offs of $8.2 million against this identity portfolio and have now reduced total exposures by over 55% to approximately $100 million of book balances since early 2022. These actions, coupled with negligible new inflows into the category, supported a $12.9 million reduction in nonperforming assets during the quarter and an improvement in our ACL coverage to 3.5 times.
Total allowance for credit loss, including off-balance sheet reserves was relatively flat on a linked-quarter basis at $282 million or 1.32% of total LHI at quarter end, up over $35 million or 29 basis points year-over-year in anticipation of a more challenging economic environment. Total regulatory capital remains exceptionally strong relative to the peer group and in our internally assessed risk profile. During the quarter, $75 million of the original $275 million mortgage warehouse related credit-linked notes were partially paid down. As mortgage industry volumes and related credit protection eligible balances have declined significantly since the note was issued in early 2021. This reduction in note balance was neutral to CET1. And at current interest rate levels, saved the firm $0.02 of interest expense in the second quarter or $7.9 million on an annualized basis.
We remain focused on managing the hard-earned capital base in a disciplined and analytical manner focused on driving long-term shareholder value. Our guidance accounts for the market-based forward rate curve, which now assumes Fed fund reaches 5.5% this quarter and remains there through year-end. Changes in anticipated system-wide funding costs and slower net interest income expansion was specifically cited in our revenue guidance update last quarter. Our outlook for low double-digit percent full year revenue growth remains unchanged. As evidenced by this quarter's results, the significant investments made over the last two years are yielding expected operating and financial efficiencies that will continue contributing to profitability in the second half of the year.
Our noninterest expense guidance also remains unchanged, and we believe the current consensus expense estimates are achievable. Together, these expectations should result in the maintenance of operating leverage, as defined as year-over-year quarterly PPNR growth. Finally, we are committed to maintaining our strong liquidity and capital positions, and our intent remains to hold greater than 20% of our total assets in cash and securities and to exit the year with a CET1 ratio of at least 12%. I'll hand the call back over to Rob for closing remarks.
Rob Holmes: Thank you, Matt. Operator, we're available for any questions.
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