Independent Bank's (IBTX) CEO David Brooks on Q4 2015 Results - Earnings Call Transcript

| About: Independent Bank (IBTX)

Independent Bank Group, Inc. (NASDAQ:IBTX)

Q4 2015 Earnings Conference Call

January 28, 2016 08:30 AM ET

Executives

Torry Berntsen - President and Chief Operating Officer

David Brooks - Chairman of the Board and CEO

Michelle Hickox - Executive Vice President and Chief Financial Officer

Analysts

Brady Gailey - KBW

Brad Milsaps - Sandler ONeil

Brett Robinson - Piper Jaffray

Steven Moss - Evercore ISI

Kevin Fitzsimmons - Hovde Group

Michael Young - SunTrust

John Moran - Macquarie Capital

Matt Olney - Stephens

Operator

Good day, ladies and gentlemen, and welcome to the Independent Bank Fourth Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions]

I’d like to [turn] this conference call to Torry Berntsen. You may begin.

Torry Berntsen

Thank you and good morning. Welcome to the Independent Bank Group conference call to discuss financial results for the fourth quarter 2015. I’d like to thank you for joining us this morning. I’ll go over a few housekeeping items and then hand it over to David Brooks, our Chairman and CEO to lead the presentation.

We issued our earnings release last night and a copy is posted on our website. We will be going over much of the release on the call. If you have any trouble accessing it, please call Robb Temple 214-544-4777 and we will e-mail or fax you a copy.

Some of the remarks made today will constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. We intend such statements to be covered by the Safe Harbor provisions for forward-looking statements contained in the act. Please see page 4 of the text in the release for additional information about the risks associated with these statements.

Please also note that if we give guidance about future results, that guidance will be only a statement of management’s beliefs at the time the statement is made. Predictions that we make may not continue to reflect management’s belief and we do not publicly update guidance.

In this call we will discuss a number of financial measures considered to be non-GAAP under the SEC’s rules. Reconciliations of these financial measures to the most directly comparable financial measures calculated and presented in accordance with GAAP are included in our release. At the conclusion of our remarks, we will open the telephone lines for questions. At that time, we will provide instructions for submitting your questions.

With those reminders out of the way, I’d like to outline the agenda for the call. David will open with his thoughts regarding the fourth quarter results; Michelle Hickox, our CFO, will lead you through the quarter’s operating results and some balance sheet highlights. David will then close the presentation and open the phone lines for questions.

I’ll now turn it over to David.

David Brooks

Thanks, Torry. Good morning everyone, and welcome to Independent Bank’s fourth quarter and year-end 2015 earnings conference call. We are pleased with the results for the quarter as we continue to execute our strategies in the midst of rapidly changing market conditions.

Here are few of the highlights. Core earnings were strong and continues to grow. They increased sequentially and on a year-over-year basis fueled by organic and acquisition loan growth. Quarterly core earnings of $11.4 million are the best reported by our company to date.

For the year, net income available to common shareholders was $38.5 million compared to $28.8 million in 2014, an increase of 33.8%. Our organic loan growth accelerated during the quarter to 21% on an annualized basis. Growth that is focused in the commercial real estate and non-energy C&I portfolios. In spite of the significant decrease in our energy portfolio in 2015, organic loan growth was a healthy 16.1% for the year. This growth occurred across all of our markets.

The Grand Bank acquisition closed November 1, which was approximately three months after the announcement date. The integration of their branches and employees is going well and the systems conversion is on track and will be completed in a couple of weeks.

Total assets increased to $5.1 billion at year-end, an increase of $1 billion over year-end 2014. This represents material growth from total assets of $1.8 billion as of our IPO on April of 2013. Our conservative credit culture remains important especially in today's volatile market conditions and we remain focused on asset quality.

Nonperforming assets represented 0.36% of total assets at year-end, consistent or flat with the year ago. The credit team continues to closely supervise the underwriting, monitor asset quality and maintain effective credit administration. Our team is very focused on our energy and Houston portfolios.

As of year-end our energy production portfolio was $182.5 million less than 5% of total loans. This represents a decrease of 13% from the third quarter. Our criticized and classified amount at year-end was $67.7 million or 1.7% of total loans, a consistent percentage with the previous quarter.

The oil field related services portfolio was $22.4 million or 0.6% of total loans at year-end. None of these loans are criticized or classified. Michelle will give further detail on the energy portfolio in her comments.

Our Houston portfolio continues to perform well. The total portfolio is $1.1 billion and represents 28% of our overall loan portfolio at year-end. CRE represents 66% of the Houston portfolio and average loan size is approximately $326,000. 46% of this Houston CRE portfolio is owner occupied and office buildings represent only 6.3% of the Houston portfolio. At year-end nonperforming Houston assets were only 0.17% of the Houston portfolio. Overall we believe that our 2015 performance in the face of challenging economic conditions demonstrates that the company’s fundamentals remain strong, and with that I would like to ask Michelle to go over more details on our 2015 fourth quarter operating results. Michelle?

Michelle Hickox

Thank you, David, and good morning, everyone. As noted in the earnings release, our fourth quarter core net income was $11.4 million, or $0.63 per diluted share compared to $10.9 million, or $0.64 per diluted share for the fourth quarter of 2014, and $8.9 million, or $0.52 per diluted share for the quarter ended September 30, 2015.

Net interest income increased during the fourth quarter to $42.2 million compared to $38.2 million for the fourth quarter of 2014 and $38.1 million for the third quarter of 2015. The increase in net interest income reflects increased average loan balances resulting from organic growth and loans acquired in the Grand Bank acquisition.

Our net interest margin was 3.96% for the fourth quarter, compared to 4.28% for the prior year quarter, and compared to 4.08% for the third quarter. The decrease is primarily related to the Grand Bank balance sheet mix that we inherited as part of the transaction. The reduction in the margin was not as dramatic as we had previously estimated because we have been able to deploy the liquidity they had into loans quicker than anticipated. Our core net interest margin, which does not include accretion was 3.91% compared to 4.07% in the third quarter.

Total noninterest income increased 293,000 compared to the fourth quarter last year, and increased 455,000 from the prior quarter. The increase from the fourth quarter last year is primarily attributable to increased service charges on deposit accounts, gains on the sale of real estate and enhanced wealth management and correspondent fees, offset by decreasing gains on securities sold.

The increase from the linked quarter relates to a decreased loss in the sale of premises and equipment, and enhanced wealth management and correspondent fees, offset by a reduced mortgage income and a decrease in the gain on sale of loans.

Total noninterest expense increased $3.6 million from the fourth quarter last year, and $2.7 million from the prior quarter. The increase in each period is primarily related to increases in salaries and benefits, occupancy, data processing, FDIC assessments and acquisition related cost, all associated with the Grand Bank transaction and integration. Expenses have also increased due to our growth, including higher compensation accrual and also as a result of higher legal fees on some existing litigations.

The provision for loan loss expense was $2 million for the quarter, an increase of $219,000 from the fourth quarter of 2014 and a decrease of $2 million from the third quarter of 2015. The provision reflects loan growth as well as a moderate increase in general reserves for the energy portfolio in recognition of the continued decline in commodity prices. As you recall, we took a significant provision last quarter much of which was directly related to the energy portfolio.

As it relates to loans, for the fourth quarter organic loans held for investment grew 5.3% from September 30, 2015 or 21% on an annualized basis. Additionally, we added $273 million in loans through the Grand Bank acquisition. The composition of the overall loan portfolio remains comparable to previous quarters.

As David mentioned, Energy E&P outstandings at the end of the fourth quarter were $182.5 million comprised of 25 borrowers. This represented 4.6% of the entire loan portfolio. We participate [Indiscernible] by other banks. In 2016, close to 50% of the portfolio is hedged at an average price of $54 per barrel.

We currently have two nonperforming energy credits totaling $7.1 million and one performing classified credit totaling $17.1 million. Aggregate criticized and classified energy credits totaled $67.7 million, which is up from $56.4 million at the end of the third quarter. Energy related reserves now make up 4.1% of the energy production portfolio. Oil field service related balances represented an additional $23.4 million or 0.6% of total loans outstanding at December 31, 2015. The service loans were acquired in our Houston acquisitions and represent 26 borrowers with whom the acquired banks had long-standing relationships.

With respect to overall asset quality, total nonperforming assets represented 0.36% of total assets at December 31, 2015, the same as December 31, 2014, and compared to 0.34% at September 30, 2015. The slight increase compared to the linked quarter is due to the addition of a $2.9 million energy loan that was placed on non-accrual status in the fourth quarter.

With respect to funding, total deposits were $4.03 billion at December 31, 2015, compared to $3.25 billion at December 31, 2014, and $3.53 billion at September 30, 2015. $524 million of the increase was a result of the Grand Bank acquisition. We believe that Grand’s lower cost of funds will benefit us going forward.

The average cost of interest-bearing deposits was 0.45% for the quarter, the same as for the fourth quarter last year, and was compared to 0.48% for the third quarter of 2015. Our year-to-date rate on total deposits decreased to 0.34%. 26.6% of our deposits are noninterest bearing, up from 25.2% at the end of 2014. Total borrowings increased by $65.1 million from the fourth quarter of last year, and increased by $36.8 million from the prior quarter. This reflects changes in the balances of short-term FHLB advances.

The company and the bank are both well capitalized at year-end. Earlier this month we redeemed the SBLF Preferred Stock that was assumed in the Bank of Houston transaction in 2014. The redemption was funded through a dividend paid from the bank. Both entities remain well capitalized after the redemption.

That concludes my outline of the highlights of our financial statements. I’ll turn it back over to David.

David Brooks

Thanks, Michelle. We continue to believe in our fundamental business, the strength of our asset quality and our ability to execute our growth strategies. We continue to monitor our energy portfolio at all levels of the organization. We remain in very active discussions with our borrowers, which is the strength of the composition and structure of our portfolio. Given the current energy environment and the impact it has had M&A activity in Texas, I am sure that no one is surprised, has slowed. I continue to have dialogue with banks located in the identified markets where we plan to grow.

Over time as the energy and capital markets improve, these conversations should prove helpful as we continue to build out our footprint. We have continued to create long-term shareholder value. Both our tangible book value and earnings per share increased significantly during the year, and we increased the quarterly dividend. We remain committed to enhancing shareholder value, and every major decision is made with that commitment in mind.

In conclusion, we know that there are challenges ahead, but we believe that our solid financial position, strong credit quality and commitment to our proven business model will continue to yield positive results. We also believe Texas is stronger, has greater diversity and is more resilient than in the past energy downturns. We look forward to a solid 2016.

With that, we’ll open the call to questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Brady Gailey with KBW. Your line is open.

Brady Gailey

Hi guys. It is Brady. Good morning.

David Brooks

Good morning Brady. How are you?

Brady Gailey

Good. So your 16% loan growth in ’15 and you finished the year at a rate above that, how do you all think about loan growth as we head into 2016?

David Brooks

We are still cautious Brady around that. We did have a really good second half of the year. We do have good pipelines going forward. But we still have some headwind, in terms of energy pay downs. You have seen our energy book declining. We project that to continue – we actually had an accelerated rate in the first quarter. So that said, we are cautious around growth rate.

I think we said in our third quarter call that low double-digits, low teens, kind of number is what we expect for or what we are thinking about for 2016. And we haven't changed that based upon our loan growth last year just – it seems to always be lumpy, and we had a really slow first quarter and a really big fourth quarter, and we think it will be lumpy again this year given we don't when the pay downs come on energy as we get resolution with some of these credits. So I think low double-digits is still a good guess for us for 2016.

Brady Gailey

All right. And then it is interesting if you look at some of your peer banks through this earnings season, Bank of Oklahoma increased their energy portfolio. LegacyTexas increased their energy portfolio, you are kind of headed in a different direction, but it decreased, what is driving the shrinkage in energy and then is there any way to guesstimate how much energy could shrink in 2016?

David Brooks

Great question Brady. We just have seen the shrinkage as a result of resolution of credits. Our borrowers going to capital markets and either refinancing, in some cases with some subordinated or secondary type debt, where they are selling assets in a lot of cases, either partial sales or complete sales of their portfolios and retiring debt. So that is what is driving the pay downs.

We could see it come down another 20% to 30% we think this year in balance. So we finished the quarter at $182.5 million in E&P production loans, we wouldn't be surprised to see that come down to that 140, 150 level this year, when we bottom out. But again as we said going into 2015, we said that it would be – we thought we will decline for a while and then see opportunity in the second half of the year when prices stabilize to do more financing.

We have seen some opportunities to grow the portfolio or to book new loans in the second half of the year. We have been more focused on resolutions and so we do intend to be active in the market. We are looking for good opportunities but we just haven't seen credits that we were willing to take a position in in the fourth quarter.

Brady Gailey

All right and then finally, how top heavy are you in your energy book, you mentioned that three SNCs that are agented by others, but how large are your largest energy borrowers?

David Brooks

That is a good question. I think their positions are four largest are in the $12 million to $18 million range, broadly average $15 million a piece. So I would say, our SNCs I believe or the four snicks totaled $66 million, something in that range give or take a million or two there Brady. I don't have an exact number in front of me, but it is mid upper 60s for the total of those four SNCs. We do expect one of those to be repaid in the first part of the year, first quarter, second-quarter of the year through asset sales, the other SNCs we are just working on and resolving. We don't have any imminent payoffs on the other three SNCs, but beyond that, then when you go outside of those four SNCs Brady, our average probably goes down in that 5 to 10 range for the remaining credits on the E&P side, and a lot of those are – we are the sold lender. We have guarantees and in some cases we have other collateral, real estate collateral, things like that in addition to the reserves that are pledged behind those loans.

So that is something that is different about our portfolio when you compare us Brady to our peer banks. Our absolute exposure is down to on the E&P side below $200 million from a peak of close to $250 million, and when you look at the amount, the percentage of our credits that are SNCs and the percentage of our total book that are made up of SNCs it is less I think than a lot of the other banks that you are talking about.

And again we are not proclaiming that as a positive or negative. We just said this is what we are if you will at this point and we do think that gives us some additional control, but it also makes our portfolio look different Brady, and then we don't have a huge fall redetermination and a huge spring redetermination. We certainly – our SNCs obviously are on that schedule, but the rest of our credits are more on rolling redeterminations and our price deck adjust very frequently and we are redetermining.

So we don't feel like we are facing a big bullet if you will in the spring of this big redetermination and if prices stay in this low 30s range that is going to be a – make a whole bunch of our credit slide over into substandard. We have continued to see some migration. We saw our classifieds go down in the fourth quarter, but our OAEM special mentioned credits kicked up a little bit as we did some borrowing base redeterminations and some of them were deficient to our policy, and if I can say broadly about energy, we feel good about where we are. Our team is working hard resolving credits. We are seeing pay downs as a result.

We still don't – we are at a little over 4% reserved against our energy book. We made that if you recall in the third quarter as we took an outsized provision in the third quarter in anticipation of these lower prices and what they might – the effect they might have in the fourth quarter and we think that was appropriate and we feel well reserved at the end of the year.

I have listened to a number of the other calls. In one of the, I think questions and all of us are trying to get to it is what if oil prices stay in the upper 20s to low 30s for this entire year. I think that is an unrealistic scenario. But I understand it is something we are all thinking about and it is certainly our credit folks are aware of that scenario and I still don’t believe – all that to lead to my broad statement, I still don't believe that lower for longer means that we or the other banks broadly in this space are going to have huge credit losses, because there are still assets, there are still cash flow. You do your redeterminations and what happens is they fall out of compliance, right, with our policy and thereby, they have still got cash flow but those cash flows don’t pay back the debt in the half Y for whatever that asset pool. And so you have extended pay outs and you've got loans at over 65% advanced against the collateral value. And so, therefore you're out of compliance. That means you got to make it a mention or a substandard loan. You got to look and see what is the potential loss exposure and reserve against that.

At the end of the day, unless you think oil's going to stay at $28 or $30 for the next five years, I just don’t, we don’t see big losses coming down the pipe. But we could see as everyone continues to say, more migration of these credits to being more special mention, more classified as they fall out of boring base, but all that gets rectified in a hurry, if and when oil prices go back up. We're not banking on that but we're certainly aware and don’t believe that oil prices stay at $28 $30 for the next five years, five or so.

Brady, just one point on that, you asked about he what levels were, remember they're 25 borrowers in the portfolio. So, I'll give you 25 and the outstanding is are 182.5, so that'll give you some kind of parameters to look at as well.

Brady Gailey

Great. Thanks for the color, guys.

David Brooks

Thanks, Brady.

Operator

Our next question comes from Brad Milsaps with Sandler ONeil.

David Brooks

Good morning, Brad.

Brad Milsaps

Hey, good morning, guys. Hey, David, I appreciate your guidance on loan growth for this year. I was just curious looking at the GAAP capital ratio down below 7% now and some of the regulatory ratios getting pushed. Are you limited any categories particularly kind of C&D or CRE in terms of what you do willing to grow there, given I guess C&D was over a 100% of some of your regulatory capital, not be your risk based capital number. Just kind of curious on the individual categories, if you have any limitations there.

David Brooks

No. We obviously monitor that closely, Brad, but that's our kind of bread and butter has been CRE as a community growth community bank over the year. So, a lot of the things we do end up being real-estate secured and we talk and happy to get into more details behind that. But it's broad, it's diversified, it's a lot of owner occupied. So, we're not overly concerned about this CRE level.

The construction side, we've been a strong line business for us. Over the years, it's been our interim construction lending. We stayed away broadly from development loans, meaning lots on the ground and spec land for future lots and things like that. Those have not been big lines of business for us. And we've also avoided, so maybe a limitation Brad, that we think about is given where we are, capitalize, given where we are CRE, we would continue to feel strongly that we don’t want to be a participant in big national type real-estate construction projects or large office buildings, large multi-family complexes. We haven’t done that historically anyway, but given our capital ratio's we certainly wouldn’t be a big player in those types of credits today going forward.

So, we then continue to conduct our business as we have. We manage the risk and given that we've been a large real-estate lender, Brad, for the entirety of our existence, the regulators have been in year after year and looked at our monitoring systems looked at the way we manage that credit and that risk and they've looked at our losses in each of the downturns, and they've been minimal compared to our peers. So, we'll stand on our track record on real-estate.

Brad Milsaps

Now, that's helpful. And then secondly, I know you had too much of Grand Bank. Just curious, Michelle, how quickly or if how quickly you're able to reposition it that the balance sheet, I know they did a lot of it before it came over, just curious kind of from a run rate perspective on expenses and then some of the revenue line items, is it kind of where you want it to be and at what point did it get there during the quarter. Just trying to get a sense of what it can contribute, of a full quarter basis in the first quarter?

Michelle Hickox

Yes. Actually, if you remember, we were really projecting it would take us about six months to use our liquidity, rebalance the balance sheet. Our loan growth was so strong in the fourth quarter, we've had actually happened a little quicker than what we thought it was going to. Maybe noticed our name was much better than what I thought it would be considering that we brought them in two months earlier than we originally thought we would, at least in the fourth quarter. We will get more of the cost size in the first quarter from the Grand acquisition. The operational conversion is set for February 12.

So, we'll be able to get some more cost out once that happens. There is a few employees that are staying through that date. And just other costs from having to run to systems that we'll be able to eliminate. I think if you look at our core expenses in the release, I would expect they're going to be down a little bit from that. The run rate will be. I think some of the questions we have are related to professional fees. I expect that to be lower. We had some unusual expenses in the fourth quarter, but those maybe elevated historically.

There are some things in fourth quarter, like I think somebody had a comment about advertising expense. That's always lumpy, we usually front load that. So, I would expect that number will be a little higher in the first quarter. Fourth quarter, we typically don’t have as many expenses. So, hopefully that's helpful.

Brad Milsaps

Very much, brilliant. Just final question. If [indiscernible] is right up there, $27 million dollar reserve. About seven of it is assigned to the energy books. So, that will be about 20 for the rest of the portfolio. Can you just remind us what marks you have, what that reserve will look like, if you looked at it on a, I guess, a legacy loan basis or non-acquired loan basis?

David Brooks

Yes. We still, with the current marks, post the Grand acquisition, Brad, we're at 1.01% overall to the overall portfolio. So, an additional $10 million to $12 million of marks out there in addition to the reserve that you're seeing. So, that puts us what close to 40 million against the reserve on a $4 billion book. So, we're just a hair over 1%, which is consistent for what we're been in the past. If you take a look at what's in the loan loss provision plus the marks against the acquired loans, we've been in that one to 1-10 range consistently. And that's where we still are.

Brad Milsaps

Perfect. Thank you, guys.

David Brooks

Thanks. And one other thing I would say Brad, to your question on efficiency, and I think it was Michelle said it but with it's going to take the first quarter here to get the cost. Where we. So, the first quarter that you should see a cost run rate that's pretty indicative as the second quarter of this year going forward and certainly Michelle can provide more detail to the analysts regarding what we think that pro forma looks like in the second quarter going forward.

Brad Milsaps

Actually, a lot of that goes away when you have the conversion on the expenses, because you don’t need two people to run similar things from both institutions.

David Brooks

Okay.

Operator

Our next question comes from Brett Robinson with Piper Jaffray.

David Brooks

Good morning, Brett.

Brett Robinson

Hi, good morning. David, I wanted to just ask at first on the loan growth which you had in 4Q. Could you give us some idea of origination rates you were seeing in the fourth quarter? And then you talked some about what you weren’t doing in commercial real-estate, as you guys thinking about 2016. What are you doing, are you going to see more C&R relative to CRE. It sounds like maybe and then what as you pulled back from many thing in Houston and maybe some Houston comments on what's your real-estate.

David Brooks

Sure. So, we saw good origination across the footprint, Brett, in the fourth quarter. And it really was nothing unusual, it’s the same core business we've been doing for last 25 years. It's a lot of owner occupied real estate, banking professionals, medical office buildings, investments for wealth families that are investing their family office money and the real estate projects that generate income. And that was across the footprint although often endeavors are certainly growing faster than Houston at this point, but I think when we look to the originations for the year it was around 20% growth in the Dallas and Austin markets and then about 12% growth in Houston. And then, we’ve got some areas that are not as growth further north of Dallas and somewhere Central Texas locations are not as high growth. But, in our higher growth markets of Dallas, Austin and Houston for the full year of 2015 we saw of about 20, 20 and 12 approximately, so that’s how the spread was across the footprint in originations and again lot of smaller credits sustain our sweet spot of that $3 million to $10 million where most of the originations were.

As far as Houston goes, we’ve been quite pleased with the portfolio there, I think we put in our releases we got, our portfolio at the end of the year was approximately $1.1 billion of which approximately 65% was CRE that CRE broken down broadly across many categories and approximately 50% or 46% owner occupied. Importantly there I think when you look at our portfolio in Houston, CRE portfolio in particular to note that our multifamily exposure is approximately $25 million or about 2% of our Houston portfolio and our office building component is about $70 million or 6% of the Houston portfolio. So, when you put those two together 89% of that total portfolio is in office and multifamily which are the categories most people are most concerned about and with a lot of particular focus on some of the larger projects that are just coming to market or have recently come to market and tried to fill the buildings or the apartments and thereby you’re putting a lot of pressure on rates. We’re just not a participant in those credits and so, when you look at our portfolio it tends to be much smaller, very granular, your average loan size in Houston of $326,000 and if you look at the average CRE may be quite a little better, average CRE loan is $850,000 in Houston.

So that portfolio is well seasoned, it was just, we continue to grow their with the same customer base that we acquired and we merged with Bank of Houston and Houston Community Bank. We’ve got a terrific team of lenders on the ground down there that have warm and deep relationship, we’ve got season veterans of 30 plus years leading the charge down there, but we’ve got a terrific group of younger women and men on the ground there, cultivating relationships every day, we’re just not participating in large syndicated credits there, we’re building relationships one at a time down there. And frankly Houston has slowed down and there is continuing concern and we’re very much monitoring the situation there.

We’re actually encouraged to grow 12% in 2015 in the face of what a lot of people think is Houston falling into the Gulf of Mexico, it is not true in our experience at this point, doesn’t mean we’re not continuing. And certainly the lower oil prices based in Houston and Southern Texas area, so we’re watching, paying close attention, but we’ve almost, I think we put in our classified credits in Houston were 0.17%, I mean that’s better than if you look at the rest of the company across the state and I’ve heard our Chief Risk Officer say that that portfolio was very clean going in and has held up better than most the portfolios that we’ve acquired in acquired banks over the years. So it’s doing terrific, we’ve got the right people, we’ve retained the folks that joined us in those acquisitions have stayed on and worked hard and taken up the Independent Bank flag and done a good job with it. So, we’re happy with where we’re in Houston, but we’re like everyone else on the energy portfolio, on the Houston portfolio, we’re watching and we’re slicing it seven different ways and studying it every day and every week to look through weaknesses or risk factors that so far we’re not seeing.

Brett Robinson

Okay, I appreciate the color on that. And then, just thinking about the funding base, do you guys have any, loan to deposit ratio obviously is still kind of close to 100%, but I guess I am just curious as you think about maybe slower growth this year than 2015, is it possible to change may be the mix of funding base sum and how do you guys think about the loan to deposit ratio here and your outlook on deposits?

David Brooks

Yes, we have been working hard to build a treasury management team for the last two years. We believe we are finally going into 2016 completely staffed with seasoned professionals and veterans from various of the other regional Texas banks have joined up and we put a very strong focus on that every loan we book there is a discussion around how the deposit look with that customer, how can we get a larger share, larger wallet share with that customer. That said it's a tough battle when you are booking loans at 20% a year, 16% a year it's been a challenge. We’ve mitigated that somewhat over the years by acquiring deposit rich franchises such as the grand acquisition that was 50% loan to deposit and blended them in.

As Michelle said, we have because of the accelerated loan growth in the fourth quarter we loaned up a lot of those funds already and kind of went, we went from 98% to 90% or 92% back up to 98% in the quarter, so a lot of I guess volatility in our own loan to deposit ratio there. But long-term we have got to do a better job at that Brett, we have invested in the people, we put the attention on it from my office and all the executive team here across the organization. At the end of the day, as you point out if our loan growth slows a bit to the low double-digits range then that will give us a chance to catch our breath on that but ultimately we have got to continue to find merger partners as well that are deposit rich with good sticky low cost deposits and continue to blend that as a part of our growth strategy. But, for the foreseeable future Brett, we are going to be a high loan deposit bank so –

Brett Robinson

Thanks for the color.

David Brooks

You bet.

Operator

Our next question comes from Steven Moss with Evercore ISI.

Steven Moss

Good morning guys.

David Brooks

Hey good morning Steve.

Steven Moss

I was wondering certainly about the Houston exposure if you could give us loan to value ratios and debt source coverage for that portfolio?

David Brooks

For the entire portfolio?

Steven Moss

For the commercial real estate?

David Brooks

Yes, for the commercial real estate, I don't think we have run the metrics or if we have let me say it this way, I haven't seen the metrics on a portfolio across the entire portfolio looking at a portfolio wide debt service coverage and all that. I will tell you that those deals typically are 1.5% to 2.5% debt service coverage on those smaller credits that we have got down there, the core of the book. I think our loan to values tend to be in the 65% range on those credits, typically a lot of them as I mentioned earlier are seasoned credits and they are to guarantees, they are to family offices, they are to small businesses, they are to doctor practices, doctor groups that have been in practice for 10, 20 plus years. So, we just don't, I am not sure if that answers your question specifically Steve and I know you are trying to get to what is the risk of the sensitivity, but I can just tell you broadly and certainly we can get you some statics back of our internal to the extent we have portfolio wide numbers on that. But given how small and how granular that portfolio is, I am not sure that that really even if I could tell you it's 1.8x coverage that doesn't mean that we don't, we wouldn't have two or three that are 1.1 and then – so I am not sure that that –

Steven Moss

That’s helpful for overall color.

David Brooks

I am glad Steve.

Steven Moss

And then, the other thing I was wondering about is what percentage of your energy loan have subordinated debt relative to your position?

David Brooks

I am sorry, ask that again. Steve?

Steven Moss

What percentage of energy loans have subordinated debt?

David Brooks

Very, probably two of our 25 credits have subordinated debt behind us.

Steven Moss

Okay. But those people larger credits or the –

David Brooks

Correct, yes larger credits and one in particular that we expect substandard that we are expecting to be paid off on this quarter has sub-debt behind it.

Steven Moss

Okay.

David Brooks

That would be one of the two.

Steven Moss

Okay. And then, with regard to the acquired oil field service loans, wondering if you can quantify what the discount is on that portfolio?

David Brooks

The mark, credit mark?

Steven Moss

Yes.

David Brooks

It was really low gearing towards when you take out, I believe there are 26 credits in that

Torry Berntsen

26 in that credit, 22.4 portfolio.

David Brooks

Yes, so $22 million portfolio with 26 credits in there, 26 relationships Steve and so they’re all generally, really some of those credits you would look at and think that's really more of a traditional C&I, machine shop in the heart of Houston, but because they had a significant part of the revenue coming from the oil field, we classify them as a oil field service credit. But in reality it's a third generation machine shop with not that much leverage they have all paid down debt where need be, and so we really that's obviously a portfolio. It’s got a lot of attention, it’s got a tremendous amount of attention on the going inside because that's not a business we are in. And so, as we often do when we are looking at a bank that's in a line of business it's not in our core, we tend to look twice at those and reserve double what they really need and in this case, we did not see the need to put extra reserves against it. And so, I don't recall what the total reserve for that, for the total mark against the Houston portfolio was around 1% and I would expect that book would have been about the same, Steve.

Steven Moss

Okay that's helpful. Thank you very much.

David Brooks

Thank you.

Operator

Our next question comes from Kevin Fitzsimmons with Hovde Group.

David Brooks

Good morning Kevin.

Kevin Fitzsimmons

Hey good morning David and everyone. First question I have is, it's probably for Michelle was and I apologize if you went over this already. I was just wondering, I thought I heard you say that the margin held in a little better than you all had thought, but just looking forward if you can give us a little sense for how you expect the margin to go from here either on a reported, I know on a reported basis a little tough with accretion income, but maybe on a core basis?

Michelle Hickox

Yes, I think our accretion income is going to be probably lumpy like it has been historically, but generally it's 2 to 3 basis points difference on a quarterly basis. And based on our projections, we think our margin will probably be stable this year from where it was in the fourth quarter. And really where I said, I expected it, it was higher than I expected it to be with because we were able to bring grand in with two months left in the quarter and with their balance sheet mix, I really thought that the margin would drop probably 10 basis points more than what it did. So the ability for us to move their liquidity into loans as quickly as we did really helped our margin in the fourth quarter.

Kevin Fitzsimmons

Okay. Great that's stable outlook versus fourth quarter that’s on the core margin, correct?

Michelle Hickox

Right, yes.

Kevin Fitzsimmons

Okay. And one quick follow-up, David this is for you and I know this is probably tough one to answer. But just looking out over the next few years on one hand I have to imagine you sensed an opportunity, there is probably banks that are pulling back that are retreating from energy altogether and so there is an opportunity to further penetrate and expand some relationships. On the other hand I have to imagine that a bank coming out of this experience that we are still in, the energy cycle there may be low sensitivity about what do we want to expand our concentration into energy given that we are going to go through these things every once in a while. So how do you balance that and how is your outlook on that? Thanks.

David Brooks

That’s a great question Kevin, I think everybody is looking here going well this has been more difficult than we expected obviously here 18 months ago with lower for longer. That said, we are committed to be in the business. We are building a first rate that you need to be in, you need to do it well. We have seen here during this downturn, continue the importance of conservative underwriting and assuming bad things when you underwrite a credit to make sure you are prepared before it happens. So we are going to be looking for opportunities and as soon as there are some stability in these prices and people get confident of these, we have got a number of our borrowers that are well capitalized and sitting on cash and anxious to do something and so we think we will see opportunities. We think we will see that portfolio grow, but as I mentioned earlier I suspect we will see that E&P to the portfolio decline in the 140, 150 range before we begin to see some upward mobility. We hope that's in the second half of the year, we haven't planned for that and that's not in our numbers if it were to happen we have only figured in headwind at this point. But energy is a business that we have been in, we got in about three, four years ago now and that we built our portfolio in what people thought was the raciest of times the portfolio, our portfolio was holding up quite well and so we feel good about our broad underwriting.

We will work through the problems and issues like all of our colleagues are doing across the state and across the Southwest and we are committed to be in the business for the long haul and I think at the peak we are about 8% of our portfolio and energy, we are down to below 5% on the, 4.5% on the E&P piece of the portfolio, so it's reduced dramatically and we didn't expect it to reduce that dramatically, but we also didn't expect oil prices to go to 26 and change either. So, we are adapting on the ground, we have got a terrific team and I will say to people who produce those loans and who have the relationships that hung in there with us and are helping us work through them and they are at the table and working with the customers and the customers have been terrific so.

Kevin Fitzsimmons

Great, thank you.

David Brooks

Thanks much Kevin, appreciate it.

Operator

Our next question comes from Michael Young with SunTrust.

David Brooks

Good morning Michael.

Michael Young

Good morning. David, I am curious on the M&A side just given the lower capital levels right now and the oil or energy price volatility in the market, how long do you think it will be before you guys can be active on that front?

David Brooks

Well, I think it's hard to know obviously, if we knew exactly when oil prices were going up and bank stock prices seemed to be marching in lock step these days with energy prices I would know the answer to that. But I think it's probably instructive Michael that when we announced our last transaction, last summer with Grand Bank our price was between $43 and $44 and that deal was accretive and met all of our bars and terrific deposit base and great locations and great officers and directors etcetera. So, I think we would need to see some increase and stability in oil prices and we need to see bank stocks follow that in order for us to be active in the market although it's interesting the lower and longer these prices go for oil, I think it does cause a lot of other banks, privately held banks across the state to think about hey if we were thinking we wanted to find a merger partner in the next few years, what does that look like and what our price expectations. And I do hear more and more people talking about hey we just want to make sure we find the right partner who has got the right strategic vision and conservative credit culture. And so, we will see that may change some of those metrics that's why I hesitate to give you a hard number of saying hey if our stock gets to X we are in the game, but we continue to have discussions, we continue to build and try to nurture relationships we have had for long time and we feel like that when the opportunity resent itself we will be as well-positioned as anyone Michael to operate in.

Michael Young

Okay, great. And then as a follow-up, just given the work you have done I guess on the energy side to bring that portfolio down and maybe the confidence you have in Houston, is there any interest in sort of doubling down on that would you look at the bank that has energy or Houston exposure, are you trying to stay away from that at this point?

David Brooks

We look at every opportunity but that would be a pretty high bar for us to double down on energy or Houston at this point. And again, not that is not at all to say we are not ecstatic with the partners we have made in Houston and the book of business we have and our lender there and our teams there, but if you are asking me if we would be, want to buy another $1 billion or $2 billion of Houston assets today that would be a high bar for us.

Michael Young

Okay, great. And if I can sneak one last in. Just on the deposit side I know you have a lot of municipal sort of funding accounts that have been core for long time, but I am curious sort of your outlook for those in a potentially rising rate environment, how often are those sort of re-priced or you are seeing any additional competition for those deposits at this point?

David Brooks

Yes, they tend to re-price, re-bid every couple of years. We have had, in most cases we have got longstanding relationship to those portfolios. That said they are public funds and their boards and the school boards and city councils and etcetera have a fiduciary responsibility to the taxpayer which we understand to maximize the return on their available funds. So they have other vehicles, state pools, money market type funds that pricing has been very stable at about 50 basis points on those funds to-date, but that's something when we do our asset liability model, we make provisions for that. So when we say asset liability model is basically balanced slightly asset sensitive, but basically balanced. We’ve put into our model because we do have this book of municipal deposits and we know that they can be more price sensitive than some of other deposits, we have that modeled into our model.

Michael Young

Okay, great. Congrats on the good quarter.

David Brooks

Hey thanks Michael.

Operator

Our next question comes from John Moran with Macquarie Capital.

David Brooks

Good morning John.

John Moran

Hey morning guys how is it going?

David Brooks

Great.

John Moran

Couple of quick follow-ups and then one sort of ticky-tack modeling question. The line utilization on the overall production book and then could you just remind us how many of those are in MCR and how that process is going?

David Brooks

Great. So about 60% of the credits we have are on MCRs at this point John and the line availability you might imagine with prices coming down and the price decks hitting the deck so to speak would be, that has used most of the availability, so we have, our existing E&P borrowers have very little unused availability at this point. So we do not expect any advances or increases in our portfolio coming from that source.

John Moran

Got it and then the MCR process itself, everything has been orderly continues to be it sounds like that?

David Brooks

Very much so and a lot of times once a borrower goes on MCR that means, the basic business model in that business as you know John is to have a proven field, be drilling wells, increasing proven and producing oil flow and gas flow that's creating cash flow. You go to the bank, you increase your line, you grow more wells, and usually when you get into an environment like this and the MCRs are put in place to reduce those credits and to bring these loans back into conformers with the borrowing base with policy of 65% say, loan to value that usually is a tipping point if you will for a borrower to go okay why can't in this environment execute my strategy of continuing to drill wells. And so, a lot of times it causes them to think well I need to recapitalize because I want to keep drilling or I need to sell-off some non-core fields and use that money to go drill some more wells.

So my point in that John is that lot of times once you set up MCRs then we will see a sale of assets that either reduces the debt or that they use to go drill some more wells, get some more production and then the next borrowing base determination, prices may not have gone up but they have got more proven producing wells that increase the borrowing base in terms of the amount of barrels they are producing and even at lower price mitigates a little bit against the borrowing base problem that they might have. So I will add to say yes, the borrowing base or the MCR process is going well, it’s accomplished exactly what we are trying to do, but in some cases it's probably contributed to this decline in our real book because once you put someone in MCR they go well, maybe I need to just sell my assets or whatever and so you see some pay downs from that.

John Moran

Understood that's definitely helpful. And then, I wanted to circle back on the services book that 22.5 million around numbers and services, it sounds like David you said some of – alright a good chunk of that maybe is now what we, in sort of the analyst community would consider like real pure services near or maybe like one step remove from the drill bit, but rather a manufacturing business that has significant portion of revenue tied in some way to energy, could you key that out for us a little bit and sort of say how much is, what we would define as like traditional services versus manufacturing?

David Brooks

Yes, so traditional services if you think of that John as what’s going out at the well head, the drilling and salt water disposal and the camp sites and all those things that we have almost none of that. What we have is what’s grown out of the Bank of Houston was banking wealthy families, wealthy families often times over the years have had investments in companies that are more manufacturing and transportation related and secured by those types of assets. And again, I am not saying that means it’s insulated from pressures certainly they have seen their cash flows go down and they have had reduced the debts or plead additional collateral or whatever the case maybe. But we found those borrowers as I mentioned earlier those really look – that book looks a lot more like a traditional C&I book then what you think of when you think of oilfield service. And in terms of stuff going on out in the field, we have almost none of it in that portfolio and again most of those are small credits, average size in that portfolio $850,000 per credit and they have been on the books multi-generational, well capitalized owners and families with other resources other than what’s on the balance sheet of that company.

And they have been willing to bring those to bare to keep those credits performing past rated and cash flowing and so we just, as I mentioned earlier John there is no portfolio in the bank that's got more attention before we purchase it. And since we purchase it then that portfolio has and again that's not a prediction of future, future performance that we couldn't have a classified loan in that book, but it means that right now what we have seen and what we have on the ground has all been extremely positive, much better than if you were to told us John that we are going to see this kind of oil price environment for this long and said, do you think you have some classified criticized credits in that book, we were to say certainly and but so far so good.

John Moran

Understood that is definitely helpful. The last kind of follow-up is, you guys mentioned the multi-family exposure in Houston and then the good detail on CRE owner occupied and in terms. You have construction development land there, I imagine it's probably pretty small, but…

David Brooks

Yes. Very little construction development and land at this point. About, Torry, would you, I think you've looked at some numbers before the call this morning. Would you?

Torry Berntsen

Yes. Roughly, if you looked at land and land development of the overall portfolio, it's roughly around 7% of that of the billion one.

John Moran

Okay, yes. So, 7% of the Houston exposure. Okay.

David Brooks

Correct, yes.

John Moran

All right. And then last --.

Torry Berntsen

This side is the billion one.

David Brooks

Right.

John Moran

Okay. And then last one from me. Just, I guess, a follow-up for Michelle. How much could we see drop out of the [indiscernible] run rate in 2Q, once you guys kind of flip the switch here. And then what kind of operating leverage would that imply?

Michelle Hickox

I don’t know that I can give you firm numbers on that at this point. I do expect that our expenses will go down in Q2. But I hesitate to give you firm numbers right now. We do expect our efficiency ratio. It's bent up at the end of 2015, but we expect that that's going to go back down to mid-50s, possibly even below that by the end of this year.

David Brooks

Yes. I think on a run rate, mid-50s kind of efficiency ratio that's and then hopefully as Michelle said "As the year goes along, we'll get below that, significantly." But is that fair Michelle?

Michelle Hickox

Yes.

David Brooks

Mid-50s in the second quarter?

Michelle Hickox

Right, yes. I think that's fair. And some of that, whether be creating efficiencies are going to come from generating revenue. So, just --.

John Moran

Yes. I understand, of course, yes, there's two point for that equation. Hey, thanks very much for taking the question, guys.

David Brooks

Thanks, John.

Michelle Hickox

Thank you.

Operator

Our next question comes from Matt Olney with Stephens.

David Brooks

Good morning, Matt.

Matt Olney

Hey, good morning, guys. How are you?

David Brooks

Very well, thanks.

Matt Olney

All my questions have been addressed. But I appreciate the great detail and congrats in the quarter.

David Brooks

Hey, thanks much, Matt. Hope you have a great day.

Michelle Hickox

Thank you, Matt.

Operator

Our next question is a follow-up question from Brett Robinson with Piper Jaffray.

Brett Robinson

My follow-ups been addressed, thank you.

David Brooks

Hi, Brett. Okay, thanks, Brett.

Michelle Hickox

Bye.

Operator

And I'm not showing any further questions at this time.

Torry Berntsen

If that's it for the questions, then that's going to conclude our fourth quarter 2015 earnings call. Hey, look, we appreciate everybody dialing in and appreciate your interest in Independent Bank Group. And look forward to seeing you out on the road here this first quarter. Thanks.

Operator

Ladies and gentlemen, so that concludes today's presentation. You may now disconnect and have a wonderful day.

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