Columbia Banking System, Inc. (COLB) Q3 2017 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to Columbia Banking System's Third Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session, instruction will be given at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to your host, Mr. Hadley Robbins, President and Chief Executive Officer of Columbia Banking System.

Thank you, Paige. Good afternoon, everyone, and thank you for joining us on today's call as we review our third quarter 2017 results, which we released before the market opened this morning. The release is available on our website, columbiabank.com. I'm pleased to inform you that we have received shareholder and all regulatory approvals for the merger of Pacific Continental Bank into Columbia. Subject to customer and closing conditions, the transaction is expected to be completed on November 1. We look forward to the upcoming close of our merger with Pacific Continental. Our conversion date is set for March 12. And our teams at both banks have been working diligently to prepare a smooth transition for clients and employees. As a combined organization, we will continue to provide the customer-focused approach to banking and has been the hallmark of both brands. As we approach the 25th anniversary of our company, it's important to acknowledge that, as in the past, our future remains about placing the customer at the center of all we do. We will continue to grow the bank by concentrating on building long-lasting relationships with our customers, making the necessary investments in technology in order to provide the contemporary products and services and continue on our ongoing efforts to increase operating efficiency. We will also look into continuing to expand the franchise by combining with acquisition partners that have good cultural and economic fit. This was another solid quarter for us. We achieved record net income for the period of $41 million, which includes the $9 million after-tax gain on the sale of our Merchant Card Services portfolio. During the quarter, our bankers were successful on generating loan production at $255 million, which contributed a net growth in loans of $89 million. Credit quality remained stable, and nonperforming loans continued at low levels. Deposits also increased $269 million during the quarter. And our operating net interest margin expanded 6 basis points to 4.15%. On the call with me today are Clint Stein, our Chief Financial Officer and recently announced Chief Operating Officer. Clint will provide details about our earnings performance. And Andy McDonald, our Chief Credit Officer, will review our loan activity and credit quality information. I will conclude by providing a quick update on business conditions. Following our prepared comments, we'll be happy to answer your questions. It's also important to note and remind you that we'll be making forward-looking statements today, which are subject to economic and other factors. For the full discussion of the risks and uncertainties associated with the forward-looking statements, please refer to our securities filings and, in particular, our 2016 Form 10-K. At this point, I'd like to turn the call over to Clint to talk about our financial performance.

Good afternoon, everyone. As Hadley mentioned, earlier today, we reported record third quarter earnings of $40.8 million or $0.70 per diluted common share, which is $0.23 higher than the same quarter of last year. There were a handful of items that impacted our reported earnings for the quarter. The net of tax amount of these items and their associated impact to EPS were a gain on sale of the Merchant Card Services portfolio increased our reported earnings by $9.1 million, adding over $0.15 to EPS. BOLI proceeds related to 2 former employees increased our reported earnings $1 million, adding nearly $0.02 to EPS. The recapture in provision for loan losses increased reported earnings by $421,000, adding just under $0.01 to EPS. And acquisition-related expenses reduced our reported earnings by $761,000 and decreased EPS by just over $0.01. The net of these items increased EPS for the quarter by roughly $0.17. Pretax acquisition-related expenses of $1.2 million in the quarter were in the following line items: occupancy, $593,000; advertising, $184,000; legal and professional, $157,000; data processing, $66,000; and other expenses, $168,000. Our reported net interest income of $88.9 million was an increase of $2.8 million from the prior quarter. The linked quarter improvement was primarily driven by increased loan interest income of $3.1 million that resulted from the combination of higher loan yields and balances. This was partially offset by decreased investment interest income of $748,000. Non-interest income of $37.1 million in the current quarter was an increase from the prior quarter of $12.9 million. Excluding the $14 million gain on the sale of our Merchant Card Services portfolio, non-interest income decreased by $1.1 million from the prior quarter. The prior quarter included $2.3 million in merchant processing revenues, but are no longer being generated. Prior to outsourcing, merchant activities generated about $8.5 million in non-interest income and $5.5 million in non-interest expense on an annual basis. For our pretax contribution of roughly $3 million, we received $438,000 of merchant services-related card revenue this quarter, as we launched our new program and eliminated virtually all of the associated expense. Going forward, we expect to generate a pretax contribution during the first year of about $2 million, as we ramp up the capacity of a new platform. Reported non-interest expense was $67.5 million for the current quarter. It's a decline of $1.3 million from the prior quarter. However, the prior quarter included a $2.4 million charge resulting from the early termination of our loss share agreements with the FDIC as well as $1.1 million in merchant processing expense that is now zero. When compared to the linked quarter, there were notable increases in compensation and benefits and B&O taxes, which were up $1.6 million and $752,000, respectively. Compensation was higher due to increased incentive plan expenses and an extra pay cycle in the current quarter. B&O taxes returned to normal levels as the prior quarter's expense reflected a refund of $655,000. After removing the effects of OREO activities and acquisition-related expense, our non-interest expense run rate for the third quarter was $66.1 million. Using the same basis, as well as removing the effect of the FDIC loss share termination on the prior quarter, this is a $660,000 linked-quarter increase and resulting expense ratio remaining unchanged from the prior quarter at 2.73%. This ratio continues to remain within the range that we have discussed on prior earnings calls. As such, we still believe, for modeling purposes, an expense ratio in the mid-2.7% range is reasonable. We will update you on our target for this ratio next quarter, as we begin to integrate Pacific Continental. Total deposits at quarter end were $8.3 billion, an increase of $269 million, or 3.3% from the second quarter. Core deposits increased $278 million to $8 billion during the quarter, while the cost of deposits remained unchanged at 5 basis points. The quarterly average tax adjusted coupon rate for the new loan production increased to 4.59%, exceeding the portfolio rate of 4.53%. There was a higher-than-normal level of LIBOR-based origination this quarter. The production as of 38% fixed, 36% LIBOR-based, 18% prime and 8% variable. Bankers continue to remain active in sourcing new opportunities, and pipeline volumes are holding fairly steady, but they are roughly 15% lower when compared to this time last year. In addition, we anticipate seasonally lower levels of line utilization, as we move toward the winter months and our agricultural borrowers began paying down their operating lines. Now I'll turn the call over to Andy to review our loan activity and credit performance.

Thanks, Clint. As noted earlier, loans increased $89 million or 1.4% during the third quarter. Items of note. First, line utilization declined modestly during the quarter to 48.2% versus 49.2% last quarter. And combined, the prepayment and pay-off activity was $16 million higher in the third quarter as compared to the second quarter. New production for the third quarter was predominantly centered in the C&I and commercial real estate and construction loan portfolios. Term loans accounted for roughly $160 million of the total new production, while new lines represented about $95 million. The mix of new production remained granular in terms of size. 20% of new production was over $5 million. 27% was in the range of $1 million to $5 million. And 53% was under $1 million. In terms of geography, 56% of new production was generated in Washington, 33% in Oregon and 11% in Idaho and elsewhere. C&I loans ended the quarter at $2.7 billion, up about $31 million from the previous quarter, or 1.1%. New production and net advances were lower in the previous quarter -- excuse me, new production and net advances, which were lower in the previous -- than the previous quarter, and prepayments were slightly higher. Industry segments with the highest net loan growth in the third quarter include ag, forestry and fish, which was up $24 million, again, representing the seasonal nature of the portfolio. The dental book continued to expand and grew an additional $10 million. Then we also saw growth in professional services and transportation as well. Our finance company portfolio contracted roughly $15 million during the quarter, as mortgage activity reflected the seasonal nature of home sales in our part of the country. Commercial real estate loans ended the quarter at $2.8 billion, up $38 million. And growth was centered in retail, warehouses and in the health care sector. Commercial and construction loans ended the quarter at around $214 million, up approximately $18 million from the prior quarter. Growth was principally driven by draws under existing multifamily and warehouse construction projects, to which we've had on the books now for several quarters. On the credit side, the company had a provision recovery for the allowance for loan lease losses of $648,000 as compared to a provision of $3.2 million in the prior quarter. This included a provision release of $675,000 for the discounted portfolio and the release of $473,000 for the purchase credit impaired portfolio. This was offset partially by a provision of $500,000 for the originating portfolio. Relatively stable credit metrics in all of the portfolios allowed the releases, along with our extremely low net charge-off activities. As of September 30, 2017, our allowance to total loans was slightly lower at 1.1% as compared to 1.14% last quarter and 1.13% as of December 31, 2017. For the quarter, nonperforming assets increased $3.1 million, and the increase was centered in commercial real estate portfolio of about $1.9 million. And Consumer portfolio was about a $1 million increase there. As a result, nonperforming assets to total assets increased to 45 basis points, up from 42 basis points last quarter. In summary, as I mentioned before, was a stable quarter. Past dues came in around 19 basis points. NPAs were essentially unchanged. And our annualized net charge-offs continue to be at extremely low levels of only 4 basis points for the quarter. So the portfolio continued to perform nicely. I will now turn the call back to Hadley.

Thanks, Andy. For the next 12 months, we continue to believe the Northwest will grow faster than the national economy. However, growth is likely to pull back slightly, as the region's labor supply tightens, tighter labor supplies, in part, due to a limited housing availability and higher housing costs. This is especially pronounced in major Northwest metropolitan markets. Seattle and Portland experienced the highest year-over-year increase in home prices, among the 20 cities reported in the Case-Shiller composite index. There was labor supply tightening. Upward pressure on wage rates typically follow. Farmers and contractors, in particular, have found it progressively more difficult to find workers and many are paying high wages for the workers they hire. Business owners we surveyed during the third quarter were positive about their ability to navigate the current business conditions and remain cautiously optimistic about the future. Some owners are becoming more willing to consider committing resources or taking on additional debt to fund expansion plans. However, we continue to look for more certainty regarding Trump administration policy changes, especially tax reform. In closing, our quarterly dividend of $0.22 per common share will be paid on November 14 to shareholders of record as of the close of business on October 31. This dividend constitutes a payout ratio of 31% for the quarter and a dividend yield of 2.09% based on the closing price of our stock on October 26. This concludes our prepared comments this afternoon. As a reminder, Clint and Andy are with me to answer your questions. And now, Paige will open the call for questions.

[Operator Instructions] Joan, do we have any questions on the phone?

Yes, Paige. We have a question coming from the line of Jeff Rulis [D.A. Davidson] Go ahead with your question. You line is now open.

Thank you. Good afternoon.

Hey, Jeff.

The comment on the deposit growth, pretty impressive in the quarter, I guess, versus any comments on what led to the search and deposits in the quarter?

We typically have a surge at this point, in our year. If you go back over the last couple of years, you'll see that it builds in the third quarter. And it's a continuation, I think, of that trend. It's also related to the development of our C&I business and bringing on new customers. So I think the combination of those 2 things account for most of it.

And then given the lack of change in the funding costs, I guess, any comments on just the pricing environment seems as if there's - you're not seeing much pressure?

At this point in time, we're not seeing pressure, although, we're carefully watching. The market will offer changes and deposit pricing changes. So we all know that it's expected and we're prepared with a strategy to address it when it occurs.

And one for Andy on the provision. Just - you've got almost a $4 million swing sequentially and I know there's - there's different pieces to that makeup. But any kind of broad comments on what you'd expect going forward?

Yes, I think that this quarter, the stars aligned for us pretty well. I would not characterize the third quarter provision as something that would be sustainable going forward.

So reverting to, perhaps, first half of year levels?

I think that would be a better metric to use, yes.

Okay. And maybe last one on the -- just the integration of Pacific Continental being somewhat delayed. Anything that you'd say is substantially or material in terms of what - how that impacts you, I guess, through the integration or even comment on the Pacific Continental employing [indiscernible] that if you anticipate any impact there? Thanks.

Well, I think the delay is -- certainly has been a point of frustration, both for all involved on our side as well as Pacific Continental. But I think the teams have done a wonderful job of adjusting to the lengthened time frame. And I think had it in to the close and the subsequent conversion that we've got a team that's engaged and wants to move forward and in a way that we create a very smooth transition for everyone. So we actually feel pretty good about it. Jeff, I don't know if there's been any impacts on your model or not as a result of it. But I think that as we plan the merger to unfold, we continue to expect it to unfold relative to the model that we have.

I'll just add that I think the biggest point is now we have the certainty of the dates. We know we're going to close next week. The conversion is scheduled for late in the first quarter, I believe, it's a mid-March. And so people can start planning their lives. And I think that will help with the impact that it's had on the Pacific Continental employees who just didn't have the certainty around the timing. With respect to our merger model, we're still comfortable with everything that we have in there, the timing of the realization of cost saves. And I believe, when we were targeting a mid-2017 close, we were expecting to have about 85% realization in 2018 numbers. Now that we're closing here in the fourth quarter, we're going to get about 70% of the 34% cost saves or the roughly $19 million that we modeled. We'll realize about 70% of those in 2018. And then we'll realize 100% in 2019. So it doesn't really -- the timing doesn't change our expected earnings accretion or anything like that. So still feeling pretty good about that. And we're just looking forward to next week and closing it and starting to work towards the path of bringing these two things together.

Great. Thank you.

Thanks, Jeff.

Your next question comes from the line of Jon Arfstrom [RBC Capital Markets] Go ahead with your question. Your line is now open.

Hey, thank you. Good afternoon, guys.

Good afternoon.

Nice quarter. Just want to confirm that. So you still feel the 8% for 2018 and 10% for 2019 are good. They're good accretion targets.

Yes, I think so. I think that it's just that a little bit of timing of it. I guess, if I think about maybe an extra 5, 6 weeks from close to when we'll actually do the conversion that - than what we had expected when we were modeling it. So there's 5 to 6 weeks of delay of realizing a lot of the cost saves because those occur once we get the core systems converted over. But it still feels like, from accretion standpoint, we're still tracking towards the model.

Okay, okay. Great. Bigger picture on the loan growth outlook. I know you've talked about pipelines being down a little bit, but still solid. If you guys set aside ag and what typically happens seasonally, what would you say about the rest of the pipeline? Is it holding in there?

I think it's holding in there. The pipeline is - it was exceptionally strong at - during the mid-part of 2016. When we look at our quarterly production during the second and third quarter of last year, they were record production for that point in the year by a wide margin. So I think what we've seen is it's normalized. It's - but it is - that normalization is lower than where we were a year ago. It's less than $50 million is the change. But I also think that we could grow loans at a faster rate, but we're sticking to our disciplines around diversification, some areas we have as much as we want, while still retaining enough capacity to take care of our existing relationships. And in other places, we're just seeing some irrational pricing occurs. We saw some stuff at LIBOR plus 1. So those are things that we'll walk away from and it has an impact on the production side. Bottom line, loan growth is also skewed by what we get in terms of prepayments, and that's hard to forecast.

Yes. Okay. This is actually my last question. Andy, for you. You mentioned prepayments a couple of times. And would you say they're elevated? Were they elevated at all this quarter? You had a good production quarter, but you mentioned it a couple of times. Is it typical and maybe a little elevated?

Well, it was a little bit higher. We had about $155 million in prepayment activity in the second quarter. And it came in around $170 million, $171 million in the current quarter. So I mean, that's not a huge difference. But that $16 million is influential when you're looking at the total growth numbers. And then we also have a little bit of seasonal activity now also on the finance company portfolio. Home sales activity peaked in June. And by the time you get to September, they're down anywhere from 15% to 20%. Given the year - this year, they're down about 19%. So from a focal date standpoint, which is what we're looking at here June versus September, that also had an additional $50 million impact in terms of the contraction in that portfolio.

Okay. That helps. And good luck with the merger close.

Thanks, Jon.

Your next question comes from the line of Jackie Bohlen [KBW] Go ahead with your question. Your line is now open.

Hi. Good afternoon, everyone.

Hello.

Andy, you gave a lot of great coverage on last quarters call in -- with regards to some of the commodity pricings and just what you were seeing within that portfolio. Can you provide an update on how you're thinking about that right now?

Yes. We're actually seeing things, for the most part, stabilizing to improving. So again, cattle, which was one of the areas I talked about, continues to hold in there pretty well. We've actually seen a rebound for potatoes and onion. If you recall, potatoes was the real issue that we have last quarter. So we're still seeing some pretty good results there. The fruit is okay -- we think will be okay from that perspective in terms of the apples and cherries and blueberries. So we remain cautiously optimistic. But you have to remember, and this is what I say, cautiously, is that - or some - a lot of these products, which now have been harvested, really, will be sold over the next 6 months. And so we really don't know what the impact of other markets in terms of -- as those come into harvest, what -- how that can impact commodity prices and then overall consumption. But at this juncture, we're optimistic on the ag book.

Okay. And did any of that optimism and rebound play into the quarter's provision expense?

It did. We were able to reverse about $3 million of impairments by obtaining additional collateral on ag credits.

Okay. So they -- it had a meaningful impact on the quarter's provisioning?

Correct. Because with the reversal of the $3 million impairment, we were able to use that, for example, to help fund the loan growth and any other weakness that may have arise elsewhere in the portfolio.

Okay. That's very helpful. And then just lastly still on credit. Recently, your net recoveries have done a really nice job of tracking alongside the net charge-offs that just have -- a lot of gross charge-offs keeping that charge-off low. How much do you think is left in that recoveries and if that phenomenon will continue going forward?

The recoveries that we have been enjoying are not from legacy recession credits. So they're -- they are charge-off's and activities that occurred in the last 3 years. So it's been phenomenal. I mean, 4 basis points on an annualized basis. Hard to imagine if you can sustain that. But we've been under that 10 basis point range now for a while. I think it has a bit to run. So assets some real surprise. I would anticipate the activity to remain consistent with what we've seen over the prior several quarters.

Okay, great. Thank you very much.

Thank you, Jackie.

Your next question comes from the line of Matthew Clark [Piper Jaffray] Go ahead with your question. Your line is now open.

Hey, good afternoon.

Hi, Matt.

On the C&I loan growth in the quarter, you talked about utilization being down, which is unusual in the third quarter. As you drill down, look at the numbers and type of activity, is there any reason to believe why you shouldn't be able to restore kind that double-digit annualized growth in kind of second, third quarter that's supposed to be seasonally stronger? As -- thinking about maybe next year, I'm just curious if there's anything unusual this quarter.

Matt, this is Andy. I mean, to echo Clint's comment, I guess, if we want to be more aggressive on the credit side, we could enjoy stronger loan growth. But we are trying to remain disciplined. We are at an interesting point in the cycle. It's run its course. Underwriting in the C&I space is probably some of the most aggressive that we've seen, certainly, during this recovery cycle. So I think that we are getting what we want, and it's healthy. I'm not sure that it would be healthy if we were growing loans at double digits.

So I guess, thinking about the utilization piece of it, can you say what happened there?

I think the utilization has somewhat to do with what occurred in the finance company portfolio in that we provided increased commitments to really fuel what was record sales in the second quarter, especially in the King County market. That really came back down. Those commitments were not reduced. And I also think - when you look across the broad C&I category to some of the remarks that Hadley was saying, business owners are optimistic, but labor tends to be a problem throughout our footprint. So growth is being constrained. And so the cash flow is being reinvested by reducing debt as opposed to expanding balance sheet growth.

Okay. And then maybe for Clint on the core margin. Nice lift this quarter. Sounds like production more tied to prime LIBOR variable in the latest quarter and given more coupons are relative to the portfolio being little bit above, your sense of that core margin can continue to drift higher here and then maybe with the December hike, you get a little follow through with '18. Is that the way you're thinking about it? And not -- and then PCBK, I think it's fairly neutral, but just any comments there, too, to the margin.

I think that all the factors that left me optimistic about the margin and the resiliency of the margin last quarter are still present. We're seeing loans that have been supported by their floors continue to lift off the floors. This last quarter, we had just under $150 million of loans that lifted off their floors. And I mentioned that the average coupon on the new production continues to exceed the portfolio rate. One of the things that, I think, probably cost us a basis point or so on the margin this last quarter was we had higher balances in overnight funds. We expected that those will return to near 0, which is our long-term target for managing our overnight funds. And that will help the margin a little bit in the fourth quarter. December rate hike, that will certainly give us a tailwind for the first quarter of next year, as we've seen year where the rate hikes have come in last month of the quarter. It's really that following quarter where we see the impact come through. So absent some dramatic shift in the asset mix, I think that the margin continues to be positioned to take advantage of increasing an rate cycle. Pacific Continental, when we get to the end of the quarter, that, obviously will have an impact. It's about $1.8 billion of loans we'll bring on. So I guess, the -- it will play all of that into how that impacts the repricing through our existing portfolio, we can talk about if that changes my optimism for the margin next quarter.

Okay. And then on the Merchant Card Services revenue that you mentioned you had in the quarter, I think $438,000, obviously growing from there. But what was the related expense embedded in the non-interest expense run rate? And -- just want to make sure that we're growing that as well.

So under the new program, we had, as I mentioned and you stated, we had the $438,000 of card revenue. There really isn't under our old in-house model with a fully functioning department. I don't know. I think there were 23 or 24 FTEs committed to that endeavour. The annual non-interest expense associated with generating our net revenues was about $5.5 million. With this new program, we have one employee, one FTE that, essentially, is the relationship manager to the vendor. And so that cost is pretty modest relative to the $5.5 million that we've had, say, over the last year in 2016. So the net contribution on an annual basis, has been trending, has been around $3 million. We think that we're going to be about $2 million initially with this in terms of annual contribution from this new platform.

Got it. Okay, thank you.

There are no further questions from the phone lines at this time. Please continue.

Looks like there's no web questions, either. So if you guys want to wrap it up.

Okay. Thank you, everyone. We'll conclude the call.

Thank you.