First Commonwealth Financial Corporation (FCF) Q4 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the First Commonwealth Fourth Quarter 2014 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] As a reminder, this conference may be recorded. I will now turn the call over to your host, Rich Stimel. Please go ahead.

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. We’ve also included the slide presentation on our Investor Relations page with supplemental financial information that will be referenced throughout today’s call. With me today are Mike Price, President and CEO of First Commonwealth Financial Corporation; and Jim Reske, Executive Vice President and Chief Financial Officer. After brief comments from management, we will open the call to your questions. Before we begin, I’d 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. Now, I’d like to turn the call over to Mike Price.

Hey. Thanks, Rich, and good afternoon, everyone. We appreciate you joining us on today’s call. With the release of our earnings earlier this morning, we officially wrapped up what has proven to be a successful and important year for First Commonwealth. The execution of our strategic initiatives and the progress we’ve made towards our growth objectives added up to earnings per share of $0.48 for the year, up $0.116 from last year, which is our third consecutive year of double-digit earnings per share growth. Excluding the legal settlement that we’ll discuss in a moment, earnings per share totaled $0.15 for the quarter and $0.54 for the full year. We’ve generated good loan growth over the last three quarters with the corporate banking leading the way. In particular, we’ve experienced strong commercial real estate originations. The fourth quarter saw $47 million of loan growth, and our Cleveland Business Center continues to contribute meaningfully with both approved loans and loan outstandings. Furthermore, in November and December of 2014, our mortgage loan outstandings grew for the first time in over a decade. The fact that we’ve hit the inflection point for mortgage loan outstandings will make consistent loan growth that much more likely. At the same time, credit cost in the fourth quarter decreased as the ratio of charge-offs to average loans fell to 12 basis points from 18 basis points the prior quarter. Provision expense came in at $2.6 million for the fourth quarter and $11.2 million for the full year. Beyond our day-to-day focus on the credit discipline, household growth, cross-sell activities, and customer satisfaction, 2014 also delivered many milestones for our organization. Our mortgage business launched ahead of schedule in July. Our team worked extremely hard to get people, products, and systems in place to make that happen, and we continue to add talent and new products to the business and we’ll be actively promoting and cross-selling this line of business throughout 2015. We also finalized our acquisition of a local commercial property and casualty insurance agency in the fourth quarter. This brought aboard an experienced sales and account management team that also expanded our carrier access and gives us new access to markets and infrastructure for greater scalability, and has boosted our fee income. In November, we welcomed David Buckiso to First Commonwealth as Head of our Wealth Management area. David will lead strategy and execution for our trust, investments, brokerage, and financial advisory business. And then, there’s our systems conversion, which has clearly set the foundation, proficiency, and growth efforts going forward. We realized $1.6 million in reduced technology and operating expenses in the fourth quarter, directly attributable to the conversion. Annualized savings are now approaching $7.4 million going into 2015, and we have at least a dozen complementary process improvement projects that we believe will result in additional efficiencies. The savings from our conversion has allowed us to make other investments in our business, including our mortgage build out and our insurance acquisition, and our core run rate for non-interest expense in the fourth quarter was roughly $40 million. So we’re encouraged on numerous fronts, but we also recognize there was a lot of noise in the fourth quarter that muddied the waters. Jim will speak to many of these items in detail, but I’d like to briefly address the non-interest expense, the non-interest income, and the legal settlement regarding the market rate savings IRA litigation that we have previously disclosed. First, we take the $47.4 million in non-interest expense for the quarter, and adjust for conversion-related expenses. The litigation, the wire recovery, and the donated building, and we get to about $40.1 million. We were really looking for another $1.2 million or so and that included absorbing the investment and mortgage in the insurance acquisition, which together totaled $1 million in the fourth quarter as well. Cutting to the chase, the fourth quarter shortfall of $1.2 million from our own expectation comes from elevated hospitalization expenses, higher debit card losses, and an OREO item. We continue, as I mentioned, to have other initiatives in the first half of 2015 which really portend well for expenses. Second, on the non-interest income, we were down $1.3 million on a linked quarter basis. The shortfall stand almost entirely from lower deposit service charges and swap fees. Post-conversion, our new system did not have service charge fees dialed in with the same risk tolerance as prior to conversion. Additionally, we waived an inordinately large number of fees to work with customers through the conversion. Both of these items are improving quickly. Additionally, Jim will speak to quarterly adjustment on our swap. As we have shared, our mortgage effort and a re-energized wealth initiative with new leadership also are stacked against improving our fee income. Third, the preliminary settlement we reached in January pertains to legal -- pertains to litigation that began as class action over six years ago. The claims arose from an IRA deposit product sold in the early 1980s, which the bank terminated in 2008. The court dismissed the class action claim that allowed claims by individual plaintiffs to proceed. The preliminary settlement agreement resolves the claims of 36 individual plaintiffs as well as the rest of the class. The settlement remains subject to court approval and other conditions. The expense of the settlement is reflected as a legal reserve in the fourth quarter. While we’re obviously disappointed about the impact this had on our fourth quarter earnings, we’re glad to put this issue behind us. Lastly, we also announced this morning a new $25 million buyback program that we hope to have completed in the first half of 2015. Looking forward, we’re seeing ongoing progress in our core performance, expense control efforts, and credit costs, and we’re excited to build on this in 2015. So with that, I’ll turn it over to Jim Reske for a deeper dive at the numbers. Jim?

Thanks, Mike. As Mike mentioned, 2014 was a very successful year for the company on a number of fronts -- double-digit EPS growth, solid loan growth, lower credit costs, a successful core system conversion, geographic expansion into Cleveland, launch of the new mortgage initiative, and the completion of an insurance agency acquisition. In short, it’s been quite a year. What I’d like to do now is target each element of the income statement, in turn providing some observations on the company’s performance that I hope you will find helpful. First of all, net interest income has held up as well as might be expected in the current low rate environment, $47 million for the fourth quarter as compared to $47.4 million for the prior quarter. This is driven in large part by our continued ability to grow loans. The net interest margin, however, contracted by 4 basis points in the fourth quarter to 3.23%. As a 6 basis point decline in yield, our interest earning assets was only partially offset by a decrease of 2 basis points in our cost of funds. Replacement loan yields continue to come at lower rates in the fourth quarter. This is due in part with change in the mix of commercial loan originations, reflecting a preference of our commercial customers to low-yielding adjustment [ph] loans as opposed to term loans. For the year as a whole, the net interest margin was 3.27%. Over the course of 2014, we were able to protect the margin somewhat by increasing average non-interest bearing deposits by $88.3 million, by the runoff of $97.9 million in higher cost time deposits and by a reduction of $33.4 million in long-term borrowings, which together have lowered our cost of funds over the course of 2014 by 6 basis points. Like all banks, the lower rate environment has clearly had an effect in our ability to earn interest income, so let me take a moment to describe our rate sensitivity since we’ve had a number of questions about this in the past. We remain asset-sensitive. That is, our analysis indicates that our net interest income would increase in a rising rate environment. However, we have to take note of the general frustration in the analyst community over the relative lack of comparability among banks after their disclosure of interest rate risk. Some banks, like us, use the RAMP analysis while others use Shark analysis. Therefore, starting with this year’s 10-K and going forward, we will include both a RAMP and a Shark analysis in our SEC disclosures. I don’t believe this is very common among our bank peers but we believe it’s a step forward to transparencies. And it’s worth noting that we are asset-sensitive using either method. Non-interest income of $13.9 million in the fourth quarter includes $500,000 in security gains relating to the partial recovery in a previously written bound trust-deferred security. Excluding this gain, fee income was down by $1.6 million from the linked quarter. Three items account for most of the quarter-to-quarter difference. Trust income was down about $300,000 and about half of that was due to the timing of revenue recognition on one large trust account. Service charges on deposits were down about $500,000 due mostly to the lingering effects of the system conversion. Deposit service charges are, however, relatively flat when compared to the prior year. And swapping comes down about $500,000 due almost entirely to the normal quarterly mark-to-market of our swap positions. This item shows up in the line item, other income. On a year-to-year basis, another item that’s carried in other income is a decrease in fee income of $1.1 million for the year that was associated with the investment management business that we sold in January 2014. This was more than offset by a $1.2 million gain on the sale of that business. And compared to last year, fee income from insurance and brokerage commissions was up by $478,000 in 2014. Going forward, our fee income should benefit from both our insurance agency acquisition and our investment and our mortgage initiatives. Note that when we started the mortgage initiative, we had expected to sell about 90% of our originations. But our own experience indicates that we will likely obtain between 20% and 30%. This will reduce our expected growth and gain on sale fee income slightly that’s sure to benefit the margin. Turning to non-interest expense, the most significant item of the $8.6 million legal contingency reserve that Mike described earlier. This was partially offset by a recovery on a 2012 external fraud which reduced non-interest expense by $2.1 million in the fourth quarter and by $2 million for the year. The other significant item in the fourth quarter was the donation of the buildings to a local university, resulting in a $700,000 increase in non-interest expense. The donation of this building allowed us to donate unused office space to the benefit of a valued local partner. But from a financial perspective, it will pay for itself over time through low overall operating expense including lower maintenance and property taxes. We know a number of banks are reconsidering their first [ph] to real estate in the current environment. And for us, this donation was a big first step in looking at our utilization of real estate and how we can best rationalize underperforming assets. Adjusting for these non-recurring items, plus about $100,000 of leftover conversion cost that’s in the fourth quarter, non-interest expense came in at an adjusted $40.1 million for the quarter, up from last quarter’s core expense of $39.3 million. We had previously disclosed that we expected approximately $1.6 million per quarter in lower expense following the conversion with approximately $800,000 recognized in the third quarter. So it would have been fair to expect core operating expense to come in closer to $38.5 million in the fourth quarter. However, as Mike mentioned, three items hit [ph] expense in the fourth quarter, each of which cost approximately $400,000. Our hospitalization expense was up due to timing, debit card loss was elevated and OREO expense was up due to two properties. These three items increased non-interest expense by $1.2 million in the fourth quarter. Looking past these three items, we incurred approximately $200,000 of additional expense related to investment in our insurance business from the agency acquisition and $700,000 continued investment in our mortgage business, although we consider these to be investments that will more than pay for themselves in not non-recurring items. We understand that we had a number of non-recurring items in the fourth quarter and in 2014 as a whole and that it can be difficult as an investor to cut through this noise. So we’ve laid these items out on the table starting on Page 18 of the earnings supplement that is available on our website starting today. Looking at 2014 as a whole, adjusting for the noise of the conversion, the legal reserve, the building donation and other non-recurring gains and losses that are all listed in the supplement, total operating expense of 2014 was $156.3 million. We are pleased that our operating expense is down by $3.9 million compared to last year but this figure is even more impressive when you compare it to operating expense in 2010 which was $167.7 million. That means that the company has been able to take $11.4 million out of annual operating expense in just four years. Obviously, anytime you talk in terms of non-recurring items and operating expense, these are non-GAAP concepts and a full reconciliation of GAAP figures can be found in the supplement. In other news, our effective tax rate was 28.5% at the end of the fourth quarter. We expect it to be 29.1% in 2015. And with that, we’ll take any questions you may have.

Thank you. [Operator Instructions] Our first question comes from Bob Ramsey with FBR. Your line is open.

Hey, good afternoon, guys. I appreciate you all spending a little time sort of identifying some of the unusual items in the expense space this quarter. I’m just kind of curious, as you think about 2015, do you think that you are still on a path to get to an efficiency ratio that’s in the 50s at some point in 2015?

It’ll be close, but I think we could get under the wire. In the fourth quarter, our budget is actually just right above that.

Okay. And then sort of thinking about revenues, I know you all sort of pointed out that on the deposit fees side, things are light this quarter. Some of that was fee waivers and so forth. What is the right way to think about deposit fees in the next quarter? How much of that do you think bounces back next quarter?

I think a good portion of it. I think a lot of it was waived fees from customers as it related to post-conversion issues and just working through the issues with clients. And I mentioned dialing in our risk tolerance. I’m sure you got -- you’re wondering what that means. And that really gets to just good decisioning and making sure our decisioning post-conversion with our new system is exactly the same as it was prior in things like pay, no pay decisions for checks and so forth. So we just had a little bit more tinkering than we thought we would, but I think we’d get at the same run rate relatively quickly here in the first quarter.

Okay. All right, that’s helpful. And last question, and I’ll hop back out. But wondering how you all are thinking about without any change in rates, the direction or maybe more than direction, sort of how you are thinking about the magnitude of changes in net interest margin as we go through 2015 prior to any movement at the short end of the curve?

Yes, it’s Ji, Reske. I’ll be as frank as I can about this. I mean our internal models would suggest that there isn’t a whole lot of compression from here, although I would caution that internal models did not account for the unpredictable changes in the shape of the yield curve. And so, I would say that there is some compression that could happen from this point going forward despite what those models say.

And just as it relates to the NIM, in the third quarter, we really put on a lot of higher rate commercial real estate, and then for whatever reason in the fourth quarter, we had very good production, a lot more C&I and variable rate of LIBOR. So, when you looked at the replacement yield or the actual rate, it really fell a bit in the fourth quarter, so I think a lot of it also is dependent on the mix of loans that we book in a given quarter.

And the other caution we’ve given in the past, -- that’s exactly right. And the other caution we’ve given in the past is that the part of it that’s very hard to predict is the runoffs and the payoffs. And so, if higher rate loans got paid off, if we get those, those are -- they come in and that will end up flowing net-net. So we could see some compression from this moving forward. I don’t expect it to be inordinately large, but there could be some compression.

Okay. So then thinking about when you all say could be some compression, not a lot, does that mean maybe a couple of basis points a quarter or do you think that there could be a volatility around loan mix, but then you really in the end – won’t say in the year because maybe rates move, but that you don’t really see a continued direction either way.

I’m not sure I understand exactly what you’re asking, but I don’t --

I’ll rephrase it. Sorry, I guess I’m just asking if not a lot of compression, but some from here means that you do continue to kind of trickle lower from this level or do you think it’s more a question of you bounce around a little bit but there’s not a real clear direction. It just will depend on loan origination mix and so forth.

Yes, it’s really a combination of those. And there’s definitely going to be some bouncing around within a range based on quarter-to-quarter originations and payoffs and replacement yields. If rates stay where they are -- even if rates stay where they are, there could be a little bit of compression just going forward.

Okay. All right. Thank you, guys.

Thank you, Bob.

Our next question comes from Collyn Gilbert with KBW. Your line is open.

Hi, good afternoon, guys. I guess a quick question on your comments about sort of changing strategy a little bit here on the mortgage business. How should we think about the net mortgage banking line for 2015? I had in my model which I’m assuming maybe came from a guidance you all have provided but about a 1.5 million on a quarterly run rate basis for mortgage banking. I don’t know if that’s accurate, if it’s not or if it is. Like you know, how should we think about kind of a reduction in that line item?

Sure. Hey, Collyn, it’s Jim. I can give you updated guidance on that. Yes, we previously talked about giving $6 million of fee revenue from the mortgage business after 4 million expenses dropping 2 million to the bottom line. To refine those numbers for your slightly, we’re now thinking because we’re going to retain a little bit more on mortgage production, getting about $5.7 million of fee income. And then the cost of that will be more like 3.3 million, not 4 million.

Okay.

So the net will actually pick up a little bit.

Okay, okay. Good. That’s all I have right now. Thank you.

Thanks, Collyn.

Our next question comes from John Moran with Macquarie. Your line is open.

Hey, guys.

Hey, John.

Just a follow-up on the mortgage one. The decision to kind of portfolio 25% to 30% or retain it, what’s kind of driving that? And presumably, that’s going to be 5171 kind of stuff, right?

Yes, it would be -- in general, our preference would be exactly you described, I think, which would be to sell the fixed and retain the variable. But there are other things that come into play as well. So when we built the platform originally, we did not build a platform that was a traditional mortgage banking platform, but you have to use original [indiscernible] to sell them all off. We built a platform that -- like jumbo [ph] mortgages that we might to retain in the portfolio. And so part of it was when we set up the model originally, we had just projected the kind of authorization business that we would get. And it’s coming a little bit unpredicted.

Yes, part of it, John, is simply -- I’m a little surprised by the business owners and the kinds of properties that they brought to us. And there’s been some larger loans and we expected a little chunkier, really better credit quite frankly. And that’s been a bit of silver lining [ph].

Okay.

Do we retain those mortgages that are non-performers [ph].

Got it. All right. That makes sense. Thanks. And then the other one that I had, just with energy and oil prices and everything that you realized that you guys are sitting in, a place that’s more gas kind of focused. But I’d like -- I’m just wondering if you’re seeing anything there in terms of second order flow or not on impacts or whatever. And then if I’m remembering correctly, you guys have brought in an energy lender. I’m not sure how big that business had gotten. But any kind of update that you might have on anything that you see on that front I think would be helpful for folks.

Yes, John, hey let me just take you to kind of briefly super nuts on that. As of 12-31, we had about 56 million in outstandings in oil and gas. That’s about 149 million in commitments. We have a limit or a concentration limit in that segment of about 160. If you look at the exposure, it’s about 3% of our overall exposure at the banks, so not a lot and that might surprise you. We see more in terms of the ripple effect of energy and gas as opposed to, obviously this is not a lot of loans. And we put anything into the oil and gas exposure that has 40% or more of its revenue from exploration and production companies. And so that’s a -- and then if you look at down in to the portfolio, we probably have about 47 of that 149 in exposure is in exploration, so smaller portion. But just to give you a feel for that, the bigger credits there -- public companies and large independent oil companies, they don’t borrow. They haven’t borrowed for five, six, seven years. They tend to be net depositors. And then if you really get into the supply chain, and that’s really where you see a lot more activity with tank companies and valve manufacturers and people like that. I’ll tell you right now, all of our credits are pass rated with the exception on the one service company that’s I think been on our non-performers since 2012. And so a pretty good performance so far in that portfolio. As it relates to the just more of the industry and taking a step back, natural gas prices tend to move independent of crude oil prices and they’re more weather-related in terms of the factors to drive them. But just to give you a sense, I think -- and I looked at it this morning, in 2012, gas was about $2.75 an mcf and 2013, it was $3.72 and then last year, $4.39 average price for the year. And now we’re sitting at $3. And you might say, well, gosh, can companies still make money at that level? And the answer is yes because they just got a lot more efficient on the well site and they can be profitable really at that level or even a little bit lower. And they tend to have hedging programs in place that get them out about six to eight months in the pricing. So that will give you maybe a sense. And when you look at the rig counts here in the last week and just comparing them with the same period last year, there was probably 56 rigs here first part of 2014 and it’s about 52 in this region right now. So maybe that is helpful to you.

Definitely helpful. So maybe a little bit of a slowdown, but nothing that you’re seeing really material now. And then obviously the poking hole part of this is more labor-intensive and kind of has more involved than the ongoing production. So just your -- I guess from your comments, what you’re saying is basically you’re not really seeing a material slowdown in any activity at this point that would be cause for a concern.

Not yet, but we monitor these credits closely. And the portfolio is small enough that I can really look at all the neighbors in here in one page as part of it [ph]. So it’s a lot harder to monitor maybe other segments to the portfolio quite frankly.

Sure, sure. Hey, I appreciate the detail.

Thanks.

[Operator Instruction] Our next question comes from Matthew Breese with Sterne Agee. Your line is open.

Good afternoon, guys.

Hey, Matt.

I was hoping for a little bit of color on what you think our loan growth in 2015 could look like especially in light of your change in strategy on the mortgage fund.

Yes, I just -- I think I’ve talked about kind of mid-single digits. And if you just look at our deck, I think the last year is about 4%, 4.3% or so. And one of the things you’ll notice in the mortgage category and I don’t have it right in front of me unfortunately, there’s about $1.2 billion there. But half of that is first mortgage. That ran off to about $34 million, $35 million. If you just -- the fact that that has now stabilized will just add at least a percent to our run rate. And then if we begin to grow that at all, it will add 1.5% to 2%. So in this past year, we’re growing at about 4. So maybe that’s a little bit of guidance into the mid-single digits or a little higher.

Sure.

So that’s been a little bit of the headwind. The headwind was probably $60 million to $70 million several years ago and it’s probably dissipated to about $35 million to $40 million in the last two years.

Okay. And then with that, if loan growth is starting to pick up a little bit in light of some modest margin compression, do you think net interest income can grow in ’15 versus 2014?

We do.

Okay. Any idea to -- would you frame that a little bit or is that enough?

Yes. I mean the loan growth -- even the loans that we’re putting in now, even the adjustable rate [ph] loans that are lower rates, are [ph] higher yielding loans than our securities portfolio and other alternative assets. So the loan growth technically [ph] increase our nominal interest earnings.

Okay. And then hopping on back to the expenses, what would you say is a good run rate per quarter in 2015 now that the systems conversion is completed?

We believe that looking forward to 2015, we will be able to keep our non-interest expense below $40 million a quarter.

Okay. And then my last question is really around non-performing assets we took out [ph] this quarter. It looked like there was a single project or a single loan that were not performing. Could you give some color around that? What was the type of project and what happened?

Yes, it was a construction company that really specialized in waste water and water treatment facilities for -- I mean they support entities. And they were doing a local project and just the kind of thing that haunts construction companies -- change orders and disputes and the bonding company came in and the bonding company hired our contractor to finish the project. And we’re really going to find out where we’re at over the next four to five months as that project comes to completion. And we’ll probably -- that company will probably go through a liquidation now. And it’s a company that we put a specific reserve of $2 million against our exposure here and I think in that event, we’ll really begin to play itself that we felt very comfortable with that. And that it will play itself out probably in the second quarter on the equipment side and probably in the third and fourth quarter on the real estate side of the collateral we have there.

Okay. And was this entire year long or were there any support of participation?

No, this was a C&I loan that -- it was somebody that we’ve done business with quite a good time.

Okay. That’s all I had. Thank you, guys.

Thank you.

Thank you. I’m showing no further questions. At this time, I will now turn the call back over to Mike Price for closing remarks.

I would just thank you for your continued interest in First Commonwealth and your questions. And as questions arise, as you move to your modeling, don’t hesitate to call Jim and I. And we look forward to seeing a number of you over the course of the next quarter or so. Thank you