First Commonwealth Financial Corporation (FCF) Q2 2012 Earnings Report, Transcript and Summary

Good day and welcome to the First Commonwealth Financial Second Quarter 2012 Earnings conference call and webcast. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mr. Richard Stimel, Communications Manager. Mr. Stimel, the floor is yours, sir.

Thank you. As a reminder a copy of today’s earnings release can be accessed by logging on to fcbanking.com and selecting the Investor Relations link at the top of the page and then selecting news on the left side of the page. We have also included a slide presentation on our Investor Relations page with supplemental financial information that we will reference throughout today’s call. With me in the room today are Mike Price, President and CEO of First Commonwealth Financial Corporation; Bob Rout, Executive Vice President and Chief Financial Officer; and Bob Emmerich, Executive Vice President and Chief Credit Officer. After a brief comments from management, we will open the call to your questions. For that portion of the call, we will be joined by Mark Lopushansky, our Chief Treasury Officer. Before we begin, I would like to caution listeners that this conference call will contain forward-looking statements about First Commonwealth, its business, strategies and prospects. Please refer to our forward-looking statements disclaimer on Page 2 of the slide presentation for a description of risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. And now I would like to turn the call over to Mike Price.

Thanks, Rich and thank you all for joining us on the call this afternoon. The second quarter was another solid quarter for our organization with net income of $12.3 million or $0.12 per share. Our fundamentals are sound and improving and we are seeing the effects of good loan growth, appropriate pricing discipline and strong household acquisition. Through the first 6 months of the year, we generated $103 million of loan growth with branch and indirect auto lending driving the portfolio. Encouragingly, we also saw momentum in small-business lending in the second quarter. On the corporate side, good traction in large corporate lending and middle market has helped to counterbalance continued run-offs in our commercial real estate portfolio. Much of this run-off was anticipated as we expected some of the larger loans to move to the permanent market. But overall, our corporate bank is on track through June where it’s best new money production in more than 3 years. And I might add that, that production is equally yoked between commercial real estate, middle market and corporate finance, those functions through 6 months. At the same time, we’ve become increasingly effective at gathering core deposits with demand deposits and transaction account balances up 12% through the first 2 quarters, this low-cost deposit growth has helped drive net interest income. With household, we’ve also seen strong growth in both retail and small business with particularly notable gains in our Pittsburgh market. Our market-wide retail household growth hit a new high in the second quarter and our new middle market relationships continue to propel household growth in our corporate banks. As we shift to credit, our efforts around the credit quality have translated into decidedly lower provision expenses. Bob Rout will touch on this and Bob Emmerich will dig into the details. But in general, we continue to the see the right trends in NPLs, OREO classified assets and charge-offs. We’ve built a good foundation and I think it will benefit us for years to come. Although there are a lot of positive takeaways for the quarter, it will be critical for us to maintain the momentum we have as our net interest margin continues to feel pressure. We’ve seen the margin slips in the second quarter of 2011, and this low interest rate environment will continue to challenge investment and loan yields. The antidote for what could become a protracted low interest rate environment is really the fundamentals, growing loans, improving our asset mix, growing our non-interest bearing deposits, maintaining our pricing discipline, picking up the pace on our efficiency efforts, improving cross sells and making sure we don’t overreach with an acquisition, the basic community banking fundamentals. And obviously, capital plays a central role. We announced in late June a $50 million stock buyback program through the end of the year, also in April of this year, we increased the quarterly dividend from $0.03 per share to $0.05 per share. These actions were another one of our strategic focuses to thoughtfully manage capital by ensuring stability and benefitting shareholders as credit heals and earnings return. So far the program has bought back 470,000 shares. So we are pleased with our general performance after 2 quarters and we feel like we are very competitive in our core businesses of retail banking, corporate banking and wealth. On that note, I will turn it over to Bob Rout for a review of the financial highlights for the quarter. Bob?

Thank you, Mike and good afternoon everyone. As Mike just mentioned, we continue to make very good progress trending our financial performance to higher levels. Earnings per share for the quarter were $0.12 with a little upward [indiscernible] and $0.42 year-to-date. Both of these numbers comparing very favorably to the comparable 2011 figures of $0.07 and $0.12 per share respectively. The primary factor in that improved performance is credit related. In the fourth quarter of 2011, Mike focused the organization toward clearly putting legacy credit issues behind us. That focus is now benefiting the organization on a number of different levels. Bob Emmerich will be following me with a more detailed discussion of asset quality. But just from a 10,000 foot level, credit related costs including provision expense, OREO write-downs and inflection costs are down about $50 million on a year-over-year basis for the 6 months ending June 30. That does not include the $2.9 million of recoveries on 3 troubled loans that were classified as held for sale in the fourth quarter of 2011 and subsequently sold in 2012. $1 million of delinquent interest inflected when a troubled loan paid off in the first quarter of this year and about $1 million of rental income from an OREO office building that eventually got sold. Those effects could be seen in the non-interest income category of our income statement. Net interest income is down slightly between the periods despite some 14 basis point declines in the net interest margin. We, like most other spread-dependent banks, are feeling spread compression in this unusual interest rate environment. We have been able to mitigate a lot of those effects by growing DDA and other transactional comp balances, which are up a $102 million or 12% year-over-year growing earning asset balances by $216 million in the last 12 months. The interest rate risk and liquidity positioning of our balance sheet has allowed some additional short-term borrowings rather than chasing rate sensitive CDs for funding and cleaning up some non-performing loans has been helpful to net interest income as well. This difficult interest rate scenario does not look like it’s going to abate any time soon, if you believe the Federal Reserve and other economic prognosticators. That provides an even greater sense of urgency towards our efficiency efforts to decrease non-interest expense. The good news in non-interest expense is the reduction in credit related cost as troubled loans get down to more normalized level. And we have lots of opportunities related to process and IT enhancement, that just take time to address. Our salaries and benefits were up $600,000 on a linked quarter basis. That is related to severance for an exiting executive and increased incentive payouts for our retail folks that are doing a bang up job so far this year. We always get questions about the effective tax rate. For those of you that like to do modeling, ours was 26% to 27% at June 30, 2012. So with that, I will turn over the discussion to Bob Emmerich for some additional color on credit.

Thank you, Bob. In the second quarter, First Commonwealth experienced good credit results with favorable outcomes for net charge-offs and provision expense and continued improvement in asset quality. Let me start with the progress we made in reducing problem assets. Non-performing loans decreased to $85 million down from $90 million at 3/31. Other real estate owned decreased to $19 million down from $21 million the prior quarter. Classified assets decreased to $170 million down from $178 million in the prior quarter and that is down $308 million at June 30, 2011. We ended the quarter with non-performing loans at 2% of total loans and non-performing assets of 1.75% of total assets. You will recall that at the end of the year, the bank moved 3 loans into held for sale with a carrying value of $13.4 million. One of those loans was sold and closed in the first quarter. The second loan, that was carried at $4.1 million was sold in the first quarter and closed at the beginning of the second quarter with a gain of $1.2 million. The third loan that was being carried at $3.9 million was sold and closed in the second quarter at approximately the value that it was being carried at. The bank currently has no loans in the held for sale category and we do not foresee any further loan sales in the near future. However, we would always consider loan sales as an option for resolution of our problem assets. In the second quarter, the bank returned to accrual status, the $9.4 million balance on a loan to a technology services provider that we have previously disclosed. This loan was downgraded last year at the Shared National Credit Review and placed on non-accrual at June 30 of last year. The company’s operations have improved such that it was profitable in 2011 and in the first quarter of this year. The company’s credit facility matured at June 30 and the borrower was given a temporary extension as it is currently in the process of refinancing its bank debt. Those improvements in non-performing loans were partially offset by new additions, the 5 most significant are the following: A $4.9 million loan to a non-profit institution in Western Pennsylvania. This loan is secured by real estate and has no reserve allocation. A $2.5 million loan to a manufacturer of medical equipment. This loan is secured by all the company’s assets and has a reserve of $1 million. A $1.3 million loan on a residential lot development for which the bank has negotiated a short payoff. A charge-off of $150,000 was taken in the quarter to write the loan down to the negotiated payoff amount. A $2.8 million loan to a water treatment plant. This loan is fully reserved for. A $3.7 million loan to a gas well servicing operation. This loan is secured by all the company assets and there is no reserve allocation. This loan has been left on accrual status but was classified as a TDR due to the terms of a forbearance agreement that was negotiated. These latter 2 loans, loan to the water treatment plant and the loan to the well servicing operation, are part of a $21 million relationship with the shallow well gas operator, whose business has been impacted by the sharp drop in natural gas prices and the falloff in shallow well drilling due to the success of the Marcellus deep well drilling. In addition to these 2 loans, First Commonwealth has extended loans to a related exploration and production company secured by the well interest and loans to the principal, secured by real estate. Regarding OREO, the bank was successful in selling one larger OREO property during the quarter, a medical office building that was carried on the books debt, $1.3 million and sold for $1.1 million. Charge-offs for the quarter were $3.4 million versus the provision expense of $4.3 million. The loan loss reserve at June 30 was up $1 million to $61.7 million or 1.48% of total loans compared to $60.7 million or 1.47% at March 31. The specific reserves on impaired loans were $11.7 million or 14.6% of the impaired balances. The general reserves on non-impaired loans were $49.9 million or 1.22% of non-impaired loans. This ratio has stayed pretty consistent for the last 3 quarters, it was 1.19% at March 31 and 1.21% at year-end. We have normally reported on the level of credit commitments that exceed $15 million. At June 30, the commitments over $15 million were $366 million or 52% of risk-based capital down from 411 million or 59.7% at 3/31. I will now turn the call back to Mike Price.

Thank you, Bob. With that, we would like to answer any questions you might have.

[Operator Instructions] The first question we have comes from Mike Shafir of Stern, Agee.

I just have a couple of questions, kind of thinking about the margin moving forward. This quarter, specifically the securities and loan yields were down pretty significantly. So, as we think about reinvestment yields and it looks like you guys have a pretty vanilla securities portfolio. What can you kind of do to try to offset some of this? I know the time deposits are still relatively high but looking at the long-term debt and such, just wondering if you have anything coming due that could offset some of the asset yield compression that we’re probably going to see.

Yes, Mike, but it’ll be limited. There is just not a whole lot out there in the investment arena right now unless you are willing to compromise your risk profile. We are not willing to do that, we’ll probably write it out until things change here. As far as the investment yields or the loan yields go, we are not seeing nearly as much compression there as we are seeing in the investment portfolios. Certainly, our C&I lending and our corporate finance areas are still maintaining relatively good spreads at variable rates. And there is some room on the liability side but not a lot. You’re right about this, term deposits that’s going to help us going forward and changing up the mix of that funding base.

On securities portfolio, how much cash is that throwing off on a quarterly basis?

We just looked at it the full year, there is probably – you know what, I’ll have someone give you an exact number here, as we are moving along. I don’t want to just guess this number.

Sure. Just the reinvestment yields that you guys are putting that money back to work at, is it still, I mean is it around 1.5%?

I don’t think - I think that’s generous. When you look at 15-year mortgage-backed securities at probably 140 with a premium and probably the 10-year agency stuff, hovering around 1%, if you want something with 3 years, you are about 50 basis points. So we will continue to focus on the loan growth area as opposed to doing any type of major expansion within that investment portfolio.

Should we see that portfolio shrink or kind of maintain at the current relative level from a securities to assets ratio standpoint?

I think you would see at least over the next quarter to stand where it’s at, maybe shrinking down just a bit.

The next question comes from Bob Ramsey of FBR.

Just a kind of follow up on Mike’s questions. You did highlight this continued margin pressure. When you sort of strip out the delinquent interest recovery last quarter, I think you guys were down about 6 basis points this quarter. Is that a good ballpark for where you’re going to be in the next couple of quarters?

This is Bob Rout, I’ll take a shot at that one. You’re right on your calculation, it’s about 6 basis points drop. We don’t see anything in the future interest rate scenario that is going to cause that to increase at this point.

Okay. Or decrease? I mean is that probably where we are at least in the immediate term?

Absolutely. We are having spread compression and we expect that to continue for the next quarter or 2

Okay, that’s fair. I was hoping you could talk a little bit more about the repurchase agreement that you guys announced this quarter. I know you all gave an update with where you were as of the end of the quarter. Have you bought back any more shares subsequently and could you maybe give a little more detail on the trading agreement? I think you all said you entered the same time.

No, we won’t be comfortable releasing any more than what we did in the press release this quarter and also when we did our announcement. We are into a 10b5-1 program that goes through the end of August and we will reassess that program at that point and see if there is a pricing change need or a brokerage change need. But now we are not comfortable giving you any other information out at this point. It is just too much intelligence to people out there who buy and sell our stock.

The next question we have comes from Collyn Gilbert of Stifel, Nicolaus.

Just a question and if you covered it, I apologize. But the drop that you guys saw was a huge drop this quarter in the collections expense. Is that more just a function of what was going on in some of the credit movement or doing you think that’s kind of the line, a level where you guys can carry it going forward?

I think we can carry it going forward and it was really a function of getting through some OREO and some OREO related expenses.

And then, tied to that too, just as we think about the reserves, where do you think kind of a fair reserve level should settle out here in the next 6 to 12 months or so?

Collyn, it’s Bob Rout. We are comfortable where it’s at now given the credit quality. It’s all going to be a function of growth and changes we’re seeing in the credit quality of the portfolio, and right now, we are looking for continued improvements. I don’t think you will see it swing that much as it’s going to be pretty much tied into credit losses at this point and portfolio growth. We are not expecting major swings in the credit quality at this point.

Okay. Just back to loan growth, it sounds like the momentum can kind of pick up here. Can you quantify that a little bit in terms of what you’re expecting? I mean I think we’re kind of looking at mid-single digit loan growth for you guys for this year and next. Does that seem within reason or how should we think about all in the loan growth that you can put on from here?

I think if you look at through 6 months, that pace is very reasonable. I mean some upside might be small businesses just kicking in, in the last quarter and that was sluggish in the fourth and the first quarter of this past year. But we are on a good trajectory in retail. And I think about this as business lines and I apologize, Collyn, because I know that doesn’t always dovetail with your reporting. But in retail, I mean we are in a good trajectory with our branch indirect lending. And as we switch to the corporate side, I know you follow this closely, we have the corporate finance and large corporate and syndication, that’s been on a good trajectory but we also have middle market and commercial real estate kind of kicking in equally with production, now they have had more run-off. So I think if that run-off dissipates, there could be a little upside. So all in, you kind of mix that in, I think where we have been is a good trajectory and there might be a little upside.

The next question we have comes from Damon DelMonte of KBW.

I was wondering, Bob, maybe you could talk a little bit about your outlook for the provision. We’ve had a couple of good - couple of quarters have been better than what we have seen in the last year or 2. Are you getting more comfortable with the credit quality such that we can go back to more normalized level of provisioning?

This is Bob Rout. That sort of ties in with Collyn’s question. We would expect the provision expense to approximate our future charge-offs with the adjustments, of course, for any loan growth that we put on. The credit quality of the portfolio, we have seen last 2 quarters here stabilize, and we have cleaned up the last couple of troubled loans, there are still a few more in there to take care of, but we are real pleased with the direction at this point.

Okay. And then I think a couple of times you guys had mentioned about trying to capitalize on efficiency opportunities. Do you have any type of efficiency goals in mind as far as a percentage?

Well, we think that in order to be a high performing, the banks need to get their efficiency ratio down into that low 50 range. That’s obviously not doable here in the near short term for us and most other banks, and then we also have the additional pressure of continued compression within the margin over the next couple of quarters. But I think I told this group just from a raw non-interest expense number that our target is to try to get that run rate down to $40 million a quarter. We are making progress on that number. Once you strip out some of the non-recurring issues, that improvement is what Mike likes to define as incremental, just a whole lot of ideas and process changes coming from throughout the organization, which we have fairly well engaged. But in order to get us where we need to be, there needs to be a couple of more transformative issues and we have 2 or 3 of those on our strategic planning discussion page and we will be going through that process here over the next couple of months and hopefully, come up with a couple of those.

The next question we have comes from Julie Margetich of Janney Montgomery Scott.

Bob, you have already covered this, I was just wondering if you could give any color on your loan growth projection going forward for your business, for the near term, and especially for the long-term, and what about - in terms of organic growth?

Just shared that, I think through 6 months roughly $107 million on the base we had at about $4 billion we are fairly comfortable with. And I think there might be some upside in small business, middle market, and a couple of other segments in commercial real estate, where we’ve had a little run-off. And we feel good about the teams we have assembled. And our production we have had secondary market take out anticipated most of the commercial real estate but we’ve seen it take out a little bit more than we thought. And so there could be a little upside in those numbers.

[Operator Instructions] We have a follow-up from Mike Shafir of Stern, Agee.

I think you guys just actually addressed this. But I just want to confirm, I know last quarter you guys spoke to getting to an expense run rate at $40 million to $41 million and clearly you are making pretty good headway to that. Are we thinking that we could get to that by the end of this year or is that more of a kind of a gradual goal as things kind of fall into place?

Mike, it’s Bob Rout. I’d like to get there by the end of the year, that’s certainly our - what we’re shooting for.

Okay, then with that, should we outside of kind of the expense that’s been associated with credit that’s run into your non-interest expense lines, could we see further declines in net occupancy and salary and benefits as well as we go through the remainder of the year?

That’s certainly our goal. Mike, just one other thing, to follow up to your question about the investment portfolio. Over the next 12 months, we are expecting $276 million of runoff in that portfolio, maturities and paydowns, and of course, that represents about 23% of the portfolio.

It appears that we have no further questions at this time.

We appreciate your interest in First Commonwealth and please know that Bob Rout, myself and Bob Emmerich, if there’s something you need to follow up with us, we are a phone call away. Thank you very much.

We thank you, sir and the rest of the management for your time. The conference call has now concluded. We thank you all for attending today’s presentation. At this time you may disconnect your lines. Thank you and have a good day.