First Commonwealth Financial Corporation (FCF) Q3 2020 Earnings Report, Transcript and Summary

Good day, and welcome to the First Commonwealth Financial Corporation Third Quarter 2020 Earnings Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Ryan Thomas. Please, go ahead.

Thank you, Jason, and good afternoon, everyone. Thank you for joining us today to discuss First Commonwealth Financial Corporation's third quarter financial results. Participating on today's call will be Mike Price, President and CEO; and Jim Reske, Chief Financial Officer; Brian Karrip, Chief Credit Officer; and Jane Grebenc, our Bank President and Chief Revenue Officer. 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 have also included a slide presentation on our Investor Relations website with supplemental financial information that will be referenced throughout today's call. Before we begin, we need to caution listeners that this call will contain forward-looking statements. Please refer to our forward-looking statements disclaimer on Page 2 of the slide presentation for a list of descriptions and -- risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Today's call will also include non-GAAP financial measures. Non-GAAP financial measures should be viewed in addition to and not as an alternative for our reported results prepared in accordance with GAAP. A reconciliation of these measures can be found in the appendix of today's slide presentation. And with that, I will turn the call over to Mike.

Thanks, Ryan. The team and I here are pleased with the quarter. And we're enjoying playing some offense in our consumer lending businesses. Over the last several years, we've made significant investments in our digital capacity, our regional business model to spur growth, our fee businesses, and a stronger consumer lending platform. The fruits of these investments are apparent in our third quarter results. With several recent efforts like project THRIVE, we have made these investments while maintaining positive operating leverage and improving our efficiency. Third quarter core earnings per share of $0.24 was consistent with last quarter, even as we further increased loan loss reserves. The core efficiency ratio improved to a record low of 54.45% and the core pretax pre-provision ROA strengthened to 1.74%. Core pretax pre-provision net income was $41.1 million, up some 14% over the second quarter. The company achieved record quarterly fee income of $26.7 million, an increase of $4.9 million from the previous quarter. This more than offset a $4.4 million increase in provision expense to $11.2 million. Several important themes continue to unfold, namely: first, in the third quarter, credit was solid and we continue to build loan loss reserves to recognize the impact of the pandemic. Excluding PPP balances, the allowance for loan losses as a percentage of total loans increased 10 basis points to 1.38%. Including previously disclosed day 1 CECL adjustment, the coverage ratio, excluding PPP loans would increase to 1.59% as seen on Page 10 of the earnings supplement. The reserve build was driven by several qualitative factors in our incurred loss model, which Brian will cover during his remarks. Our nonperforming loans fell from $56 million at the end of the second quarter to $49.7 million at the end of the third quarter. On Page 13 of the earnings supplement, COVID-19 deferrals totaled 2.68% as of July 24. Those deferrals fell to 17 basis points as of October 23 or last Friday. Similarly, on Page 12 of the earnings supplement, deferrals on the commercial portfolios most impacted by COVID, declined again from 3.4% on July 24 to 14 basis points as of last Friday. I believe we are well positioned at this stage of the pandemic with a strong balance sheet that can weather uncertainty. Next, third quarter fee income as a percentage of revenue was 28.8%. We are particularly proud of this number as it reflects years of focus and investment as we've diversified our revenue stream. Our third quarter fee income was driven by strength across multiple business lines. First, interchange income was $6.4 million, up roughly $500,000 over the second quarter. The team's retention of households and execution through 5 smaller acquisitions has really borne fruit here. Mortgage gain on sale income was $6.4 million, with a record quarter of $240 million in production. As an aside, 40% of these loans were not sold and remain on our balance sheet. Again, we [ delivered ] our way into this business just over 5 years ago. Despite lackluster industry-wide small business demand, SBA gain on sale income was $1.4 million, which also contributed to fee income. Despite our smaller size in some of our larger metropolitan markets in which we compete, our 2020 SBA origination performance now ranks us #2 in Western Pennsylvania and #4 in Northern Ohio. Also on the fee income front, trust revenue totaled a record $2.6 million as well. The third theme is loans. Loans grew $33 million or 2% on a linked-quarter basis as the consumer lending business led the way. And commercial lending, however, utilization of lines of credit fell some $55 million from 38% at the end of June to 34% at the end of September as businesses investment and working capital utilization has stalled. Our mortgage, branch-based consumer and indirect lending businesses have been robust even as underwriting standards have been tightened. Fourth, the net interest margin contracted about 18 basis points to 3.11% in the third quarter despite respectable loan growth and resilient loan spreads, particularly on the consumer side. Net interest income, however, was virtually unchanged, falling only $300,000 to $66.7 million. Excess liquidity and negative replacement yields on loans were the primary drivers of the decrease in NIM. Jim will provide more color here. Fifth, core noninterest expenses were down $63,000 for the quarter to $52.3 million even -- $52.3 million even as we continue to invest in our digital platform and tools for our clients. Importantly, the team launched a new digital platform in mid-September called [ Banno ], which replaced both our online banking and mobile banking platforms. The team also completed the conversion of our larger businesses -- business customers to our new treasury management system. We also added the person-to-person payment option of Zelle. These launches impacted well over 200,000 consumers and small businesses and by all accounts went smoothly. And with that, I'll turn it over to Jim.

Thanks, Mike. This was a very solid quarter for us. Core earnings per share matched last quarter's results even with $6.9 million of reserve build. And we hit consensus estimates even without any PPP forgiveness. This is a significant point that's easy to overlook. While our provision expense of $11.2 million came remarkably close to the consensus expectation of $11.1 million, our spread income came in roughly $3.5 million lower than consensus expectations, and yet we still hit consensus. To be completely fair, this differential in spread income is likely the result of our own previous guidance that PPP forgiveness would take place in the third and fourth quarter of this year. And as such, it would have been perfectly reasonable to expect third quarter net interest income to benefit from the acceleration of PPP premium amortization. In reality, we had no such PPP forgiveness income in the third quarter. Instead, strong fee income made up for the lack of PPP forgiveness income. At this point, we do not expect any significant PPP forgiveness until the first and second quarter of next year. Our core earnings figures excluded 2 nonrecurring expense items from our results. $3.3 million of expense associated with a voluntary early retirement program and $2.5 million of expense associated with the branch consolidation effort, both of which have been previously disclosed. These efforts combined with other expense initiatives are expected to help keep noninterest expense flat in 2021, not only by allowing us to continue the reduction in total salary expense that we have benefited from in 2020 due to our hiring freeze, but also by absorbing increases in other expenses as we return to a more normal operating environment. Brian will provide commentary in a moment on credit, but I'd like to provide a little more color on a few things before turning it over to Brian. First, our stated NIM was 3.11%, but was affected by negative replacement yields, a shift in mix toward consumer loans and most importantly, in average excess cash position during the quarter of approximately $343.3 million or about 4% of average earning assets. Consistent with prior disclosure, we calculate a core NIM excluding the impact of PPP loans and excess liquidity of 3.28% in Q3. The NIM should benefit in the near-term from time deposit and other deposit repricing, as well as some balance sheet management efforts designed to move excess customer funds off balance sheet, thereby reducing excess cash. These efforts are expected to help offset negative replacement yields and keep the core NIM relatively stable in the near term. Over the course of next year, however, we currently expect the core NIM ex PPP to continue a path of modest contraction in the 3.20% to 3.30% range. Second, Mike mentioned that our fee income of $26.9 million was very strong in Q3, up by nearly $5 million from last quarter. Because much of this was driven by mortgage, fee income is expected to seasonally adjust to approximately $24 million to $25 million in the fourth quarter. And finally, I know Mike already mentioned this, but if you look at Page 10 of the supplement, you will see graphically what we have verbally explained in prior quarters, that even though we delayed the adoption of CECL, the addition of our day 1 CECL number to our current incurred ALLL results in a reserve of $101.2 million and a reserve coverage ratio of 1.59%. I can add that reserve figure is not materially different from our internal parallel CECL runs as of September 30. So even though facts and circumstances may change before we adopt CECL next quarter, not the least of which is the economic forecast, our cumulative reserve building in 2020 under the incurred model has left us in a very good position ahead of CECL adoption next quarter. And with that, I'll turn it over to Brian.

Thank you, Jim, and good afternoon. It's good to be with you again. As outlined in our investor deck, credit quality was solid for the third quarter in spite of the uncertain economic environment. As expected, delinquencies ticked up modestly due to the runoff of stimulus and a reduction in payment relief. We are cautiously optimistic by the improvement in unemployment and the reopening of the economies in Western Pennsylvania and Ohio. We continue to be watchful of our deferral roll-off reports to evaluate our borrowers as they resume full payment status. Net charge-offs for Q3 were $4.3 million, which includes approximately $1.2 million in consumer charge-offs. Net charge-offs annualized were 0.27%. Our NPLs improved approximately $6.3 million to 47 -- $49.7 million, improving to 0.78% from 0.88% of total loans, excluding PPP loans. This is the second consecutive quarter for us to report an improvement in NPLs. Reserve coverage of NPLs rose to 177% from 145%, again, excluding PPP loans. Similarly, our NPAs improved $6.7 million to 0.80% percent of total loan assets from 0.91%. We conducted yet another loan-by-loan review of the higher risk portfolios and adjusted risk ratings as appropriate. Our proactive approach to risk ratings resulted in criticized loans increasing approximately $60 million, while classified loans increased modestly. These trends formed the backdrop of our approach for loan loss reserve in the third quarter. As shown in the slide deck, the provision for the quarter totaled $11.2 million, which resulted in a reserve build of $6.9 million under our incurred loss model. The allowance for loan loss as of September 30 totaled $88.3 million as compared to $81.4 million at June 30. The reserve balance grew to 1.38% excluding PPP loans from 1.28%. Let me offer some color related to the reserve build for the quarter. Net charge-offs were $4.3 million. We had a slight increase in specific reserves of approximately $500,000. Our standard qualitative reserves increased approximately $900,000 quarter-over-quarter, reflecting a mix of economic conditions. Our COVID qualitative overlay reserve increased by $4.7 million for Q3 to $14.6 million. We released approximately $1.9 million in consumer reserves due to improving deferral experience as well as improved economic conditions. We increased our high-risk portfolio reserves by approximately $6.6 million, largely due to increases in the overlay reserves for our hospitality and retail portfolios. Thank you. And now let me turn it over to Mike.

Thanks, Brian and Jim. And operator, we'll now take questions.

[Operator Instructions] First question comes from Steve Moss from B. Riley Securities.

Just starting off with the -- just on credit here. Obviously, nice decline on the deferrals. Just wondering with the addition -- additional reserves for hospitality and retail, I believe, as well. What are the thoughts of possible redeferrals? Or kind of how are you thinking about possible credit formation in those books?

Brian?

Well, if I understand your question, Steve, as for the deferrals, this is playing out how we thought it would play out. As these forbearances or deferrals or modifications roll further, we are spending the time to evaluate each credit on a name by name basis. And oftentimes, it really starts with management, if we understand our borrowers, their commitment to the properties, we understand what they'll do with it. We can do a thorough analysis and take a look at whether the credit needs to migrate from a pass rated to a special mention or onto a substandard. And so as you roll off the deferrals, oftentimes, that does necessitate a real meeting and understanding of liquidity of recourse and how we address each credit on a name-by-name basis. Did I answer your question?

Yes. And I guess just as you think about where things are progressing, what are you seeing for your customer performance when it comes to hospitality and restaurants?

That's a good question. So we've dissected the portfolio in a number of different ways. We sliced it into business, in college campus, leisure and resort style properties for our hotel book. We keep coming back to recurring themes, which is we are seeing continued improvement in that portfolio, although it is uneven and slow. We come back to the right people are supporting their properties. Let me give you some anecdotal evidence. I think it will help. Occupancy, average occupancy from 13 of our properties for August was 51%, that ranged from a low of 35% to a high of 79%. When we compared the same properties back to June, it was 29%, and now we're up to 51%. We are seeing increasing occupancy. Similarly, we are seeing an increase in ADR. And so as we think about these hotel properties, ADR's up to $111. That's an increase from roughly $90 in June. So anecdotally, we're seeing improvement. Our portfolio is getting an awful lot of internal scrutiny. When we went into this pandemic, we were about 63% LTV, and we covered 154 basis points. And so it's worthy of ongoing monitoring and managing the credit risk.

Steve, this is Mike. Just to add a little bit more color. When -- we're honored, we really had a combinations quickly upfront. And then in the first deferral period, we made a credit decision. We made a commitment not to pick -- kick the can down the road irrespective of what might have happened with the government or other types of programs. And I think Brian and his team did a really good job of calling balls and strikes and getting the credit into the appropriate category of classified or watch. And that's why you see a little movement in those categories this quarter. Is that helpful?

Yes. That's helpful for sure. And then in terms of business activity and loan growth, you had modest positive loan growth from the consumer side of the business. Just kind of curious, it sounds like that will probably continue into this quarter. Kind of curious what you're seeing on the commercial side in terms of pipelines and business activity there?

Yes. The pipelines on the commercial side are a little shallow. I mean the things that we're getting are really just through a lot of effort and better execution. That being said, in small business, for example. And I think this is more of an execution and just our ground game is getting better and better. We're up about 33% in approved small business loans from the -- through the third quarter of last year to this year. And we also are seeing that kind of peak through our SBA lending. A lot of that is triage. We're doing on credits that just might have some kind of systemic credit weakness in adding an SBA guarantee. But I just think, as I said in my opening remarks, we're seeing lower utilization because of working capital lines of credit. It's just not the same level of investment yet on the commercial side. On the consumer side, we're seeing good activity. I mentioned mortgage. We're at a record in mortgage originations. Jane Grebenc, our Bank President, just shared with me before the call that only 46% of ours are refis because we still have a mortgage business that's growing organically. On the consumer lending side year-over-year through our branches, our applications are up 25%. Online real estate applications are up 89%. I mentioned small business lending up 33%, and indirect auto was up 29% year-over-year. So there's enough there on the consumer side that carried the day for us in the third quarter. And on the small business side, this is just the way it is in recessions in my lifetime, that volume -- or that -- those pipelines will be dampened for a season.

Okay. That's helpful. And then I guess last question for me and then I'll step back. In terms of -- you completed the repurchases in the texture I see, kind of curious how you're thinking about the possibility of repurchases forward or other capital deployment?

Yes. Jim?

Yes. We have no further share purchase authorization right now. We are very pleased with the execution of the remaining portion of our previous authorization. We started that the last week of September when the -- all the bank stocks were down, we're able to retire those shares right around book value, which is very accretive. And so we're very pleased with how that came out. But right now, there's no further authorization plan. We'll watch it closely though because the bank is still quite profitable, and we're still generating capital, and it will depend on our projections for loan growth and how much capital -- internal capital generation we need to capitalize that for the loan growth. And if there's excess capital, that would present an opportunity for further repurchases. So we're very -- like I said, we're very pleased about how that program took place, and we hope it was perceived as our confidence in our future prospects, really taking shape.

The next question comes from Russell Gunther from D.A. Davidson.

On the expense side of things, I wanted to circle back to the targeted expense saves from the branch reduction. I believe it's $8 million on an annual basis. How much of that considering other franchise investment do you guys expect to be able to drop to the bottom line?

Jim, you might have those numbers. But I know it's not all of it with our digital investment.

No. No. Thanks for asking. That's why we'll be -- Russell, what we've been trying to be clear about is what our expectation is for the net of that kind of expense reduction, what the implications are for our total noninterest expense. In part because, as I mentioned in my prepared remarks, we've already gotten the benefit of some of the expense reduction because of the hiring freeze that we've done already this year, which has saved us in salary expense. One byproduct of that, by the way, is that even though we're consolidating 20% of our branches, we expect actually very little job loss at the time of consolidation because we will be able to move people into open positions. So from a community perspective, that's very positive. But like I said, that means we're actually experiencing some of that benefit right now in our earnings stream. So I think the total amount we said last time was about $8 million. And of that amount, about $2 million is going to be reinvested in other investments. I think at about $4 million as our EBIT is saved from the hiring freeze in terms of current -- the headcount reduction we managed so far this year, and that will leave $2 million left over. But there are so many moving pieces right now. We're trying to stay very consistent on this message and say all of this goes together into the mix and allows us to keep our expense base in 2021 flat to 2020.

That's very helpful, Jim. And very clear. I guess, just the one follow-up would be as a part of project THRIVE, are there other measures being considered beyond the salary freeze and branch reduction that we might talk about either today or in the near future?

Yes. We're looking at everything from some of our benefits in health care. We're looking at everything as on the table. And just trying to dial it in appropriately given the spector of this pandemic and interest rates and what it means for the long-term financial path we have. It's -- we've been really good over the years about operating leverage. And we think about that in all of our budgets from quarter-to-quarter and from month-to-month. And that's where we have to live and how we have to think, and I think all businesses, quite frankly, are like that. Jim, anything you want to add?

I do. Yes. So we added some disclosure right in the text of our earnings release on operating leverage. And I don't know how common this is. I can tell you that internally, at the start of the pandemic, when the Fed cut rate was 150 basis points, and we like every other bank saw the impact on our margin, immediately thoughts of positive operating leverage started to go away. We thought, well, it's going to be a very difficult year to achieve positive operating leverage. But we were very pleased to have these results, and we published this. And like I said, it's on Page 2 of our earnings release, about how our core revenue increased $4.6 million from the previous quarter and $6.4 million from the previous year, while core noninterest expense will increase $39,000 and $2.9 million from the previous year. So we're extremely proud of the fact that we've been able to generate positive operating leverage in this environment. I appreciate the question.

I appreciate the answers there. Switching gears to loan growth a bit. I heard you loud and clear on the commercial pipeline. Growth this quarter was consumer-driven. Just want to get a sense for how that would translate going forward? Should that dynamic continue? And what are you thinking overall on organic growth?

We think it will. I'll -- Jane, do you have a thought there? Or two, you would like to share?

Thanks, Mike. I expect that fourth quarter will continue with muted commercial growth. The pipelines are light, but I think the small business and the consumer businesses will continue to be strong through the fourth quarter.

And then last question for me. You guys mentioned the kind of core -- how you're thinking about the core margin going forward, the $320 million to $330 million range? It looked like core loan yields were down in the high single digits this quarter. I guess if we think about the moving pieces what needs to come together to be at the higher end of that range? What are the bigger drivers? Is it getting the excess liquidity off the balance sheet and continuing to reduce funding costs? Do you have the ability to mitigate further core loan yield compression? I'm just curious as your thoughts as to the bigger drivers to the $320 million, $330 million.

Yes. We have a few irons in the fire here. Jim?

Yes, sure. Thanks for the question. There are a few things that go into that overall guidance of keeping them relatively stable. And I can maybe give you a little more color that hopefully would be helpful. I mean you have to keep in mind that the whole PPP program in which we are a fairly large participant among banks our size, was the effect of that was adding a layer of fairly thin margin assets on top of the balance sheet. So while that produced net interest income and which fell to the bottom line, for which we're very thankful, it did have the effect of suppressing the overall loan yield and brought loan -- the overall loan yield down. The other thing that has a large effect and actually, mathematically, even the larger effect is all the excess cash on the balance sheet. As I mentioned in the remarks, $343 million average, 4% of average earning assets. So there are a couple of things that we're doing. I mentioned we're working with clients to move some of those excess funds into sweep accounts that can sweep some of those excess funds off balance sheet, that will improve the NIM just by getting that ultra thin layer of non-cash off the balance sheet. And then on the deposit side, there's also some room for improvement. If you look at the back of press release financials, you'll see we have $700 million in time deposits at 1.28% and well, about $200 million of that mature in the fourth quarter. And so those will reprice downward at least 100 basis points in a little -- actually a little more than 100 basis points down. And then there are another $100 million of deposits that are money market deposits that have guaranteed interest rates for a time. And that's -- those are priced actually at 1.39%. And so those will also come down to lower rates of -- generally 5 or 10 basis points by the end of the fourth quarter. So that's $300 million of deposits that will save over 100 basis points in the quarter. That and moving some of the excess funds off-balance sheet should all help the NIM. Now the offset to that, and we're very honest about this, our continued negative replacement yields on loans. And so we see those 2 factors offsetting each other and then keeping them bouncing around in this kind of stable range core NIM over the next quarter.

Next question comes from Collyn Gilbert from KBW.

Maybe my first question, just on the FDA outlook. Mike, you've given kind of where your strength lies there and your positioning in your regions. So it seems pretty positive. How should we be thinking about kind of the fee contribution of SBA going forward? And it's been a little bit lumpy, but do you think it can be kind of a meaningful contribution as we look into the fourth and beginning of next year?

We do. First of all, we think it's an important part of our mission within our respective communities and to find ways to thoughtfully get deals done and protect the bank. But also -- and through the pandemic, PPP was such a big part of that, we really have the talent. Jane has hired a gentleman who is running our consumer lending function that has built big SBA lending platforms. Part of project THRIVE is not just expense, but it's also revenue. And we will make a big play to grow that business over the next few years. Jane, why don't you add some color there to Collyn's question.

Thanks, Mike. And thanks, Collyn, for the question. We really credit water, Collyn, in the SBA business for a full 3 or 4 months as we were working through PPP. And although the pipelines are a bit light now, we expect 2021 to be a good SBA year for a couple of reasons. The first is the gain on sale on PPP. SBA loans has been very strong of late, and the pipelines are starting to fill up, and the regional business model is creating very good partnerships with the SBA BDOs as well as the middle market and small business lenders in region. So I think I'm bullish on the business.

Okay. Okay. That's great. That's helpful. And then just last question. Can you, Jim, just on the buyback -- I appreciate your comments about just kind of keeping an eye on capital build or where you might need the capital to grow loans. But I guess just to hold you a little bit tighter in terms of near-term catalyst or what you need to see in the near-term to kind of -- that would cause you maybe to reengage more aggressively on the buyback?

Yes. It's not much more complicated than that. I hope -- thanks for asking, Collyn, and just one thing I may hope you may have noticed. We're trying to present the tangible common ratio and the other ratios, both with PPP and without them in the press release. And so our tangible common ratio is down to 8.4%, but some of that is this the need to capitalize those PPP assets, and that's there's no risk weighting the tangible common ratio, obviously. And so we're presenting it both with and without -- and without PPP, the tangible common is at 9%. And what we have said in the past is that while we have no formal target for tangible common equity, below 8%, it's your little thinly capitalized, and above 9%, you're running with excess capital. Now we are in the middle of a global pandemic. We're watching this as we go along, just like everybody else. And so obviously, no one wants to be thin on capital, but we need to make sure we're mindful of using that capital thoughtfully and being good stewards of that capital. If it gets much higher than that then we need to put it to work somehow. If we can't put it to work by leveraging in loan growth then yes, we will look at further buybacks. But it's hard to give you any definitive trigger to say if it's a 9.1% will get reengaged buyback program. It doesn't work that way. We'll look at multiple factors, credit, capital, economic outlook, all those things and make a decision at the time.

Next question comes from Steven Duong from RBC Capital Markets.

Just back on the margin. Your loan yields ex PPP was 3.97%, it's down 17 basis points. I guess going through next year, do you see that tapering off? So I guess, by the fourth quarter of next year, where would you see -- expect to see the core loan yield?

Yes. Steve, it's a good question. It's a nice technical question. I don't have an exact answer for you because we don't have a projection on that at exact production. I will tell you that in general, right now, the commercial loans, even now that the Feds cut rates, the yield curve is flat, the 10 years in the 70s or 80s, and we had these low -- lower for longer expectations. The commercial loans are still coming on in the mid-3s, the consumer loans are coming on in the low-3s. That will probably continue for the foreseeable future. And so if that continues, you'll see the loan -- overall loan yield come down a bit, but it won't -- it probably won't go below 3%. And so if we can keep the loan yields coming on in the mid- to low 3s, we can get our deposit costs trending towards 0 that allows us to maintain a reasonable margin and build capital. That's kind of a big picture we're looking at it. Sorry, I don't have more direct equation, like an exact projection for you on fourth quarter 2021 loan portfolio.

No, no. I quite understand. That's perfect. That's exactly kind of the color that I was interested in. And then just another one on PPP, the fees. How much was that in the interest income this quarter? I'm sorry if I missed it. And how much do you have remaining going forward?

We didn't mention it, but I can pull it up for you, if you give me one second. There are -- hang on I'll get it for you in a moment here. I think it's about $570 million of PPP were average balances in the third quarter and the -- here it is, $572.4 million, that was the average PPP balance in the third quarter. The yield on those loans, I think we did disclose that somewhere. That's about 2.7%. That's the 1% stated yield, plus the amortization of the premium over time. It's about 2.7%. The total earnings on those loans with the -- all of that together was about $3.8 million of net interest income.

But Jim, I don't think any of that was from fees. Was it?

No. That would be the quarter's worth of interest income and fee amortization that we're taking over the 2-year life of the PPP loans.

Right. So the $3.8 million includes the interest and the amortization. Is that correct?

Yes, yes, yes. But no accelerated amortization. So what we did in this year -- yes, yes, yes. We thought by now, we'd have a whole bunch of PPP forgiveness, so we'd be rushing all that amortization forward and taking into income. We didn't have any of that in the third quarter, and now we don't expect any until the first half of next year.

Okay. So we just have to back it out of the 2.7% yield on your average balance, you get the [indiscernible] fee.

Yes. And actually, what you're doing, if you do that, and you also take out the average cash balance we had of $344 million, which earn next to nothing. That gives you a new average earning asset figure. And that's how we did our core income calculation.

Got it. And then your CD book, you gave some good color on the runoff next quarter. Are you looking to replace that? Or are you looking to just let it run off and going forward into 2021, given that you have all this excess liquidity?

We're not looking to replace it. So what we found in this environment that there's not much rate-seeking behavior left. The -- for example, our 12-month CD rack rate is 10 basis points right now. And when these CDs roll off, a lot of them are 12-month CDS, not all of them, but when they roll off, about 60% tend to roll into the rack rate. That's probably pretty close to the industry experience. But that's what we're seeing right now. And to be honest, a lot of the ones that don't, we'll just move into one of our savings accounts or a checking account. They won't roll into a CD, they'll take it out and the deposits will stay with us just in some other form. So our strategy for now has been to not pursue those with higher rates and let them roll over, we obviously don't need the funds. And so we've been letting those roll over at rack rates and seeing quite a bit of -- like I said, run that 60% rollover figure.

Got it. Most of them?

Yes.

Yes. Steve. This is Mike. Just a reminder, we probably had a much lower percentage of CDs heading into this pandemic than most of our peers. We had -- between our noninterest-bearing checking accounts at 25% plus in our money market rates, we had a very low-cost of funds. And so we're not chasing CDs for our funding, and that's another factor at playing as we think about that. So those are predominantly small business deposits and middle market deposits as well. So I don't think we'll have the pressure there that perhaps others might to keep the households.

If I could build on that, if I could just build it because that Mike's comment gives me a chance to make another point. Going into this crisis, we had a very finely tuned balance sheet. We had because of the recent Santander branch acquisition, paid down all our borrowings. And so the balance sheet was funded really with core deposits without any borrowings. That was a really good thing and a great position to be in, and it was intentional. We wanted to "pay off our debts" and that puts us in a great position going into the crisis. But what that means is we did not have high cost borrowings that we could pay down when rates fell. And so that's been reflected in our margin as we've gone forward. So that does mean we're left empty hands, and we are thinking about the strategies. Like I said, some of the sweep accounts do with excess cash off balance sheet. We're doing all those things we can, but it's important to understand the nature of our balance sheet going into this crisis and what that means for us.

Right. And does basically most of your CD book mature by the end of next year?

I think that's right. I don't know if I have the exact number on that, but most of this -- if there's $700 million left and $200 million maturing in the fourth quarter, mostly we go within 12 months or mature in 12 months rollover.

And is there -- on your securities and bank deposits that -- the extra liquidity, is there a target percentage of earning assets that you ultimately would like to get through once we're on the other side of this pandemic?

There isn't an official target. So the answer is -- direct answer is no, there's no official target. I could tell you our general philosophy over the last several years has been to keep the securities portfolios relatively stable by reinvesting cash flow and let the rest of the balance sheet grow around it, such that the percentage of the balance sheet represented by securities fell. So say, 5 or 6 years ago, it would have been in the mid-20s. And then here it's fallen into the mid-teens, and then it's actually fallen further with the addition of over $0.5 billion of PPP assets. So that's been the general philosophy. So we are -- look like many other banks, we're looking at the types of opportunities and securities, and it's very difficult to get yield unless you reach for very long duration. I will tell you that we have seen some of the larger banks that reported earnings so far in this cycle have said that they are purposely not investing any cash. They're going to stay in cash, and they're not going to take on that risk. We don't have that philosophy. We want to move excess cash off the balance sheet, if possible. But if there's some portion of remaining excess cash, we will judiciously put some of that to work. We don't want to extend duration and hurt ourselves too much, but we have an obligation to get some earnings on that, albeit, on the sidelines forever.

Got it. And then, Mike, just last one for me. Just coming out of this pandemic. Is there a profitability target that you're aspiring to if we're in this lower-for-longer rate environment?

Not an absolute, but a relative. Part of our theme for Project THRIVE was to come out of this, a stronger institution and top decile profitability. And we've really moved our efficiency. We'll continue to do that. And then we've built -- we have a lot more ores in the water on the revenue side than we did 4 or 5 years ago. I mean, Jane and the team have built a mortgage up from scratch, SBA. Consumer lending, we're getting traction. That's such a nice counterbalance to. We already have a pretty good commercial franchise. The team is doing a nice job of building out small business of lending and banking as an SBA. Indirect business is really -- the spreads there are going up. Even though they're probably hurting our margin a little bit, they still are accretive and profitable. So just the nature of the company has changed and then our geography has changed, too. And our business model and how we go to market, line of business and now regional is really creating good teamwork cross functionally, which leads to deeper households, more better cross sells, better customer satisfaction. Our brand playing bigger in those respective communities, great communities like Cincinnati, Columbus, Northern Ohio, our rural mark that's Pittsburgh. So just feel like strategically, we're moving in the right direction. And I think it's important that our trends on the profitability side continue up. And they have, over the course of the last 3 or 4 years. And although the absolute number might be lower than it was pre pandemic. And with the new reality of the interest rate environment, relatively speaking, we think it will fare well there.

The next question comes from Frank Schiraldi from Piper Sandler.

It's actually Justin Crowley on for Frank this afternoon. So just a couple of last ones here for me. So clearly, strength on the resi and consumer lending side, which we've talked about at length at this point, not something that's totally new. I was wondering if sort of from a high level, you could characterize your approach in weighing resi versus commercial? Even sort of looking out over the immediate term, not necessarily just over the next quarter. Obviously, as we head into year-end, you mentioned the shallow commercial pipeline. So not sure if you would put out there a targeted percentage that you got resi get to as a percentage of the whole book? Or how that could change as you start to see commercial demand pick up over the coming quarters?

Yes. Our philosophy has been pretty simple, and that was just to have more balance between our consumer and our commercial businesses. And we've achieved that, and we really started that journey several years ago. And we also started a journey to go from more variable to more fixed rate and more balance there as well. And fortunately, we had pretty good impact on that before we got to this pandemic. I mean ideally, love to get to 50-50, I think the economy will snap back and our commercial will be off to the races with higher spreads, and then we might have the same challenge 3 or 4 years from now. But I mean, wherever the opportunity -- we like having strong consumer businesses and commercial. Our commercial is strong, demand is weak. We're thankful we invested in consumer here in the last few years because it does tend to be a bit kind of cyclical. And so I think it's good to have both. In terms of the specific part that's for resi mortgage, we have some caps. I probably won't share those with you on this call, but we are pretty disciplined on the credit side. In terms of the complexion of everything from our commercial real estate to our sic codes, and we have hard caps in terms of the amount of loans that we'll make, but 50-50 balance would be ideal. And I think right now, we're just okay.

Okay. Great. That's really helpful. I appreciate the color there. And then sort of just bouncing off of that, looking at fees in the mortgage banking line item. I guess as we get through this wave of refis, how much will depend on that breakdown between resi -- or the consumer in resi versus commercial? And what you decide to portfolio or sell off? So I guess what I'm really asking is how much investment and focus would be going into the fee income side of that going forward when there's not as much of an emphasis on holding more resi, just given the lack of commercial growth within the portfolio?

Okay. I'm going to put to the expert on this one. Jane?

If I understand the question, I don't think that they're mutually exclusive. We've always targeted somewhere around 60% to the balance sheet and about 40% that we sell. And that's about what we're doing right now. At any given time, however, we can we can pivot and we can pivot quickly because we underwrite for sale. So we give ourselves a fair amount of flexibility at the deal level. Did I get your question?

Yes. No, no, I appreciate that. That's helpful. And then just one last one here for me. We've talked about it at length at this point. But just on the expense side, I appreciate the guidance, the helpful color looking into next year in terms of where you think things could shake out. And you discussed some of these strong digital adoption metrics. So taking that, Projects THRIVE, the branch consolidation and looking at the consolidation, from what I can tell you -- you were one of the first movers on that back in July, and we've seen a number of these as of late. So even from 3 months ago, have you seen a meaningful change that would cause you to maybe take another look at the branch count or take another look at [Audio Gap] digital? [Technical Difficulty]

Wow, is, frankly, you're still out...

Did I -- I don't know if you caught any of that. I just had quite a bit of feedback on my line.

We did, and it was probably for about 30 to 40 seconds. So we apologize. I don't know where that came from. But I think you're -- I hate to ask you to repeat the question.

No, that's fine. So it was just...

No, no. So Jane, do you have a thought? I think we caught the front end of it, so...

Mike, I think I understood the question. With the gist of the question, whether we've got a next wave potentially of branch consolidations on the horizon?

Yes. I mean, I'm not like trying to pin you down and say, when you're going to announce your next branch consolidation plan. But again, you were one of the first banks to proactively announce one of these plans. I was just wondering if -- as we've gone through this pandemic and we've seen consumer preferences and adoption methods of online options change. Has that -- is that at least planted the seed to maybe take another look and ask yourself how useful is -- are all of these branches? Could we slim down?

Yes. So from that at this time, we also, I think numerically went a little bit deeper than some of the other banks. We were at 25% of our network. And we think that's just about where we want to be, but we still like branches. We're bullish on branches. Lots of that consumer loan growth is coming from branches. And so we feel really good about where we are right now. And we run a very, very efficient branch network.

Yes. Just one adjunct to Jane's comment is our branches have been open and our lobbies have been by appointment. And that's been an opportunity culturally for us to do a lot of outbound calling, which has really spurred our loan growth. And it's just a little paradoxical, that we've had a lot more outreach to customers from our lobbies than ever before. So I love what that's doing in terms of building a better sales culture and that the branch people have been terrific.

We have a question from Joe Plevelich from Boenning and Scattergood.

My question, 2. First one is, do you expect to generate positive operating leverage next year, given some of the challenges on the NII and NIM side?

We do, but I'll let Jim answer that question, too. He's currently putting together the budget for next year.

Yes. So some of that's still in the state of flux, but look, that's still our goal. Look, and I think that, that's been our long-term plan for a long time. If we're able to hold operating costs flat and then maintain some reasonable margin and continue the trajectory on fee income. That -- I don't have exact numbers for you next year, but that is to our long-term goal.

And the other question is, what do you think the best use of capital will be for next year? Would it be continue with buybacks or possibly think about something more strategic on the M&A front?

So we generally think the best use of capital is organic growth. Organic balance growth, as Mike was laying up before balance between consumer and commercial lending. And then if we have opportunity to do M&A that is both strategic and financially accretive, that generally is preferable over buybacks. But if you're still generating excess capital and you don't have those opportunities then buybacks are a viable option.

The next question is a follow-up from Steven Duong from RBC Capital Markets.

Just 2 quick follow-ups. Just on the branch reduction, sorry if I missed it. Have you guys -- what are your expectations on just the impact of deposits from that?

Yes. We expect -- I think the branches that were consolidated, deposits at risk, we thought would be less than 5% of the deposits of the company, mathematically or arithmetically. And we feel like we can hang on to most of those in those households, most importantly. And just given the proximity of the consolidated offices.

Got it. Appreciate that. And then just a last quick one. I noticed that you have 40% of your employees working-from-home currently, I believe. How much do you think this would be permanent for you? And to the extent that it is, would that potentially adjust your real estate strategy further?

It absolutely could. We have -- we're really wrestling with this. We're looking for that leases and also facilities that we might sell and just getting a little leaner. We expect that 40% number perhaps to go down a bit. But anybody else want to take a shot at this one? We talk about it a lot. I don't know that we have a definitive critical path forward. But as part of our Project THRIVE is our work-from-home and our long-term real estate needs. And one of the reasons we got after branches this year, and we actually started it in March, even though we announced it in July. And so we could get the branches consolidated in December and before the end of the year and go into 2021 clean. And that will allow us to take a look at office buildings and other things that we might close and consolidate into other facilities. And we do have plans for a building or 2. Jane, do you want to add anything to that or Jim?

The only thing I would add, Mike, is that I think I've been -- first of all, I've been really pleased with the progress that our facilities group has made with disposing of the real estate as a result of the branch consolidations. So that's been a big win. And because our consolidations, I think, were announced earlier than some other competitors. We've got those branches to market faster. So that was terrific. With respect to the multiuse buildings where we've got groups of employees, I think that will be a little bit more at the edges. And the reason I think that is the humans miss the other humans. And they like working with each other at least part of the time. So we'll need to figure out exactly how to make this work long term. But I don't think they're all going to be at home all the time. They're getting fatigued.

Understood. I appreciate that. And so it just sounds like down the road, maybe the end of next year when we're through this on the other side, there could be another look back at your real estate and maybe some possible -- slightly at least some possible trimming down going forward?

Absolutely. We don't let a lease renew without being ruthless about it. I mean our real estate footprint looks dramatically different today than it did 5 years ago, 6 years ago, 7 years ago. It's just that it was not -- I mean, it just couldn't be done all at once, slow and steady.

We like to think we get better every year and where we started a decade ago in terms of our fee income as a percentage of our revenue, our efficiency ratio, our return on assets was quite different. And we've had dozens of initiatives to just to get where we're at. And we're constantly changing and moving our feet, and that will continue and certainly around the expense side. I mean we have to produce operating leverage and earnings per share growth.

There are no more questions in the queue. This concludes our question-and-answer session. I would like to turn the conference back over to Mike Price for any closing remarks.

Just thank you. I always say that I appreciate the partnership. I appreciate when you get us in front of prospective investors. And your investment in us and the feedback that we get from you, both direct and indirect. So thank you so much, and look forward to being with a number of you over the course of the next quarter. So virtually, I think. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.