First Financial Bancorp. (FFBC) Q2 2015 Earnings Report, Transcript and Summary

Good day and welcome to the First Financial Bancorp Second Quarter 2015 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 Eric Stables, Director of Investor Relations. Please go ahead.

Thank you, Emily. Good morning, everyone. And thank you for joining us on today’s conference call to discuss First Financial Bancorp’s second quarter 2015 financial results. Discussing our financial results and the pending acquisition of Oak Street Holdings Corporation will be Claude Davis, Chief Executive Officer; Tony Stollings, Chief Operating Officer; and John Gavigan, Chief Financial Officer. Before we get started, I would like to mention that both the press release we issued yesterday, announcing our financial results for the quarter and the accompanying supplemental presentation are available on our website at www.bankatfirst.com under the Investor Relations section. Additionally, please refer to the forward-looking statement disclosure contained in the second quarter 2015 earnings release, as well as our SEC filings for a full discussion of the company’s risk factors. The information we will provide today is accurate as of June 30, 2015, and we will not be updating any forward-looking statements to reflect facts or circumstances after this call. I will now turn the call over to Tony Stollings.

Thank you, Eric. Yesterday afternoon we announced our 99th consecutive quarter of profitability. Net income for the quarter was $18.9 million, an increase of approximately 19% over the second quarter of last year. Earnings per diluted common share for the quarter were $0.31 with return on average assets of 1.05% and return on average tangible common equity of 11.6%. We continue to see good opportunities to organically grow our balance sheet with competitively priced high quality loans and longer duration low cost deposits. Our relationship oriented product structure in our market oriented community banking model enable our local leadership teams to better serve our clients in a more meaningful way. We are beginning to see positive loan growth that is more in line with our long term expectations of mid to high single digits. Loans increased by $89 million or 7.5% on an annual basis over the first quarter and we are optimistic that the momentum we are seeing in the origination pipeline will result in continued balance growth. As we discussed during the call last quarter, we are also very encouraged by the amount of new high quality development occurring throughout the markets we serve. We have funded approximately $48 million of the $156 million committed to new real estate construction projects during the first half of the year. Our balance sheet is well positioned for growth as the remainder of these commitments are advanced over the next several months. Last week we announced the acquisition of Indianapolis based Oak Street Holdings Corporation, a $240 million Specialty Finance Company that provides financing, secured by commissions to insurance agencies throughout the United States. As mentioned in our press release the acquisition is expected to close within 30 days. An overview of the transaction which Claude will discuss in a few minutes was included in the supplement to the earnings release yesterday afternoon. Our ability to generate sustainable earnings growth combined with our strong capital position will continue to support additional acquisition opportunities that are aligned with our strategic objectives, such as Oak Street as well as significant long term organic growth. Before I turn the call over to John, I’m pleased to report that in conjunction with the earnings release yesterday we announced a quarterly dividend of $0.16 per share to be paid October the 1st. This translates into a 3.4% yield based on yesterday’s closing price and remains on the upper end when compared to our peer banks. With that, I’ll turn it over to John to discuss our second quarter performance. John?

Thank you, Tony and good morning everyone. Net interest income for the second quarter was $58.7 million, essentially flat when compared to the linked quarter as growth in the balance sheet and overfunding cost were offset by lower yields on earning assets. Net interest margin was 3.62%, on a fully tax equivalent basis, compared to 3.67% in the prior quarter with the five basis point decline being slightly higher than we anticipated due to a decline in the yield on investment securities during the period. The yield on the securities portfolio was impacted by prepayment activity during the quarter as well as the mix of reinvestment in recent months and is expected to improve during the third quarter. Given the continued low interest rate environment and excluding the impact of the Oak Street Acquisition, we expect net interest margin to continue to trend lower through the balance of the year similar to the first half. While average loan balances increased by only $22 million when compared to the first quarter, period-end loans increased by $89 million or 7.5% on an annualized basis and in line with our long term growth projections as a significant amount of new loan production funded during the last few weeks of the quarter. The effective yield earned under loan portfolio declined 6 basis points from the first quarter to 4.45% as we remained biased towards floating rate, loan production in preparation for rising interest rates. Our deposit gathering activities continue to produce a well balanced strategic mix of core transaction accounts and low cost time deposits. Average total deposits increased by $124 million or 8.8% on an annualized basis when compared to the linked quarter with solid growth in both interest bearing and non-interest bearing deposits. End of period deposits were essentially unchanged from the prior quarter. As we discussed last quarter, we continue to aggressively manage deposit pricing. The cost of interest bearing deposits decreased by 3 basis points to 42 basis points during the period, similarly the total cost of deposits decreased by 3 basis points to 32 basis points partially offsetting the reduction in loan yields. Non-interest expenses for the second quarter was $21 million, a 22% increase compared to the linked quarter. Accelerated discount from acquired loans that paid in full during the period increased by $2 million from the first quarter while income related to FDIC loss sharing activity increased by $700,000 and gains on sales and mortgage loans increased by $500,000. The company also recorded gains on sales and investment securities totaling $1.1 million during the quarter. Non-interest expense increased by $700,000 or 1.5% over the prior quarter to $48.8 million. Employee’s salary and benefit expense increased by $500,000 compared to the linked quarter driven by slightly higher head count and a full quarter’s impact from annual merit increases. Other expenses increased by $800,000 or occupancy related expenses declined by $600,000 during the quarter. Non-interest expense for the quarter also included a non-recurring expense of $300,000 related to a legal settlement. For the balance of the year and including the Oak Street Acquisition, we expect quarterly non-interest expenses to total approximately $50 million on an operating basis. Turning now to asset quality, we are pleased with our credit team’s efforts and the resolution activity during the quarter. These efforts resulted in significant declines in our non-accrual loan, non-performing and classified asset balances during the period. Net charge-offs for the second quarter totaled $3.3 million or 27 basis points of average loans on an annualized basis, due primarily to $1.7 million commercial real estate charge-off related to a debt restructuring during the period. Provision expense for the second quarter was $3.1 million, a $1 million increase from the first quarter as a result of charge-off activity as well as the higher level of accelerated discount on covered and formerly covered loans. Consistent with the declines in criticized and classified assets during the period, the allowance for loan losses declined modestly to 1.09% of total loans at June 30th. Further, the allowance for loan losses and remaining purchase accounting loan marks, net of indemnification asset as a percentage of total loans declined to 1.27% as of June 30th, from 1.43% as of March 31st. As we have previously commented, we believe this is a useful measure of the total credit risk protection on our loan portfolio. Additional detail regarding this metric can be found in the 8-K filing associated with our second quarter earnings release. Finally, capital levels for the second quarter remained strong. Total shareholder’s equity increased during the quarter by $7 million, or 1% to $802 million. Likewise, tangible book value per share increased to $10.65 per share as of June 30th from $10.54 per share as of March 31st. We ended the period with the tangible common equity ratio of 9.08%, a Tier 1 ratio of 12.35% and a total capital ratio of 13.31%. With respect to the recently announced acquisition Oak Street Holdings we expect the fund in all cash acquisition with liquidity at the bank and anticipate that proforma capital ratios will continue to exceed the well capitalized minimums at both the holding company and bank levels. While we do not need to raise additional capital in order to close and operate Oak Street for the foreseeable future, we continue to evaluate our overall asset growth trajectory; dividend level, capital stack efficiency and potential share repurchase opportunities. Given that our capital composition is essentially 100% common equity, our Tier-2 component could make sense and we are evaluating a regulatory qualifying transaction, infact we assumed in our modeling that slightly more than half of the Oak Street purchase price was supported by subordinated debt. While market conditions were dictate the timing and terms of any offering, our board evaluates capital management strategies at least quarterly and it is certainly included in our near term capital planning. We do not anticipate that a sub-debt offering or capital planning strategies would result in a material net impact on our earnings performance. With that, I will now turn it over to Claude to discuss the Oak Street acquisition.

Thanks, John. And thanks to those joining the call today. We are excited about the opportunity to partner with the team at Oak Street and enable them to achieve their growth potential. Oak’s Street’s well developed business model is a good strategic complement to our existing commercial business and we are excited about the strong cultural fit between our organizations and Oak Streets growth and profitability profile. As Tony mentioned earlier, an overview of the transaction was included as a supplement to the earnings release yesterday afternoon and I will touch on some of the most relevant points. Founded in 2003 and headquartered in Indianapolis the Oak Street had $238 million in loans as of June 30th. These loans which are predominantly floating rate yield approximately 9%. Oak Street generally describes one relationships worth than $1 million as core [ph] and loan relationships greater than $1 million as strategic. Our balance sheet and strong capital position will enable Oak Street to more actively pursue the strategic loan market and we expect Oak Street to continue to experience strong loan growth. Upon closing, we will pay off all existing warehouse funding lines and replace them with a much lower cost funding sources available to the bank with the combined impact driving approximately 20 basis points of margin expansion and $0.16 to $0.20 of earnings accretion per diluted share during the first full year of operation as a subsidiary of First Financial Bank. The tangible book value dilution of approximately $1.10 per share is expected to be fully earned back in under five years. Total deal costs are expected to be approximately $3 million pretax the majority of which will be recognized during the third quarter. Although primarily focused as a vendor to insurance agencies the Oak Street loan portfolio is well diversified across geographic boundaries, insurance carrier names, insurance product lines, agency size and their core versus strategic designations. Likewise the loans are well collateralized by commissions that are re-directed from the highly rated carriers directly to Oak Street the required cash collateral accounts, business assets of the agencies and personal guarantees of the borrowers. Oak Street has implemented solid underwriting and credit review standards as confirmed in our due diligence review is 60% of their outstanding loan balances. Additionally, Oak Street has developed a robust and scalable loan originations servicing platform which monitors the expected cash flow from the commission books on a daily basis. This proprietary technology platform could be leveraged across other asset classes including existing First Financial business lines and product sets. Please refer to the supplement for additional information about the Oak Street transaction. This concludes the prepared comments for the call and we’ll now open it up for questions.

[Operator Instructions] Our first question is from Scott Siefers of Sandler O'Neill & Partners. Please go ahead.

Good morning, guys.

Hi, Scott.

John, I think first question is probably for you, just want to make sure I’m clear on the margin guidance. You suggested in the second half of the year continued compression similar to the first half. You are talking about the core margin compression you guys experienced in the first half or I think the first quarter had a little noise in it, so to put some numbers on it you’ll be thinking 3 to 5 basis points a quarter in continued compression, is that fair?

Yes I think you got it Scott. We – as you said there was a little bit of noise in the margin in the fourth quarter, but to your point there we expect less than 5 basis points of compression on a quarterly basis.

And Scott, this is Claude. That excludes the Oak Street.

Yes, perfect thank you. And then the second question is on Oak Street specifically, just kind of reconciling the $0.16 to $0.20 EPS accretion in the first full year with $1.10 of kind of book dilution and then finally you know four to five year on record. I think it suggested that the pace of accretion to earning should accelerate through that earn back period, so I guess if you guys could address what you are thinking about the pace of growth for that company as you looked out over the course of the next several years, I think in the slide presentation you guys have suggested they have done about 25% annual growth for the last few years and I think it sounds like you are going to be able to do bigger loans now that they are attached to your balance sheet but maybe if guys could just speak to the expectations in the years beyond the first year?

Sure Scott, its Claude. You are correct, the earned back assumption assumes accelerated EPS accretion impact and it is through the ability for us to help them fund and grow their loan book. Their past or last five year compound annual growth rates have been at 25%, or so we have not assumed that level of growth, in fact quite a bit less than that but we expect strong growth and as a result increasing EPS accretion.

Okay. All right, that’s perfect. Thank you very much.

You bet.

Our next question is from Chris McGratty at KBW. Please go ahead.

Hey good morning everybody.

Good morning, Chris.

Just a question I just wanted to clear on the accretion the $0.16 to $0.20 did that factor in the debt?

Yes.

Okay, so that assumes you guys raised some half the purchase price and subset. Okay, on the expenses if you can help me with now this transaction and your prior bank deals, I think the $50 million was the run rate for the back half of the all in. As we head into next year are there any other synergies that we should be assuming or should be just be assuming kind of expenses growth rate of inflation?

Yes Chris, specific to the Oak Street deal you know significant cost saves were not part of the equation around that deal, so I wouldn’t model anything to that affect. I think to your point the $50 million run rate that we expect for the back half of this year and then probably to your point some inflation on top of that is probably the best way to think about it.

And this is Claude, I think the only caveat to that is that we continue as we have done in the past to look at efficiency opportunities within the core bank and evaluate are there expense opportunities there none had asked at this point but I think to John’s comments those are probably the safest assumptions to use.

Okay, just one last one if I could. You know you’ve been running the efficiency kind of low 60s does this deal at all kind of alter to kind of how you can run the company or its kind of that low 60s, does this deal at all kind of alter kind of how you can run the company or its kind of that low 60 still the target kind of looking out into next year?

I think given their margin expansion that they provide to us in terms of Oak Street as well as their loan efficiency ratio that should be added to additive and improve our efficiency ratio level.

Thanks.

Yep.

Our next question is from Emlen Harmon with Jefferies. Please go ahead.

Hey, good morning, guys.

Good morning, Emlen.

In terms of – you guys are going to have a fair amount of excess capital still after this acquisition closes. In terms of the opportunities out there where do you see better opportunities whether in the kind of specialty lending area versus the more traditional bank space?

Sure, Emlen. We do –first of all, I think as we’ve talked about before and I think most things articulate. First we are going to use our capital to support our organic growth rate. We’re going to look at opportunities like we did with the Oak Street transaction. And as we said before we continue to evaluate both whole bank as well as product line, M&A, specialty finances one of those areas that we think we understand well, we think we had some real success in, so that would be top of mind area. I would say that for the foreseeable future though we’re going to focus on kind of Oak Street supporting their growth. And one of the points I made in my comments and we make in the slides is that one of the great things about Oak Street as a company is they had a really management team, a full kind of platform that we think we could kind of look at other asset classes potentially using that platform in addition just to the insurance agency space. So we’re hoping combination of our organic in the bank as well as supporting the growth in their traditional area of insurance agency finance but also looking at other asset classes as well.

Got it. Thanks. And I’m obviously – I mean this is obviously an opportunity that looks like its going to have a pretty high return on the capital employed. Do you see more traditional bank deals that could compare to this or does it feel like these specialty and lending opportunities tend to be higher return and maybe you’re seeing more attractive opportunities in this form?

Well, I think every situation is unique. I think we’re all aware that bank deal pricing g has moved up and it’s competitive enough that at least to this point since our deal last year in Columbus, we’ve not seen any opportunities that we think had the type of return that the Oak Street deal has for. Now, as we go forward its really situational specific. But the point is I think for us strategically we’ll look at all options and always pick what the higher return is.

Okay. Thanks. And then could you provide us with the update on the spread between originated loans and what’s running off today?

Yes. We’ve seen a little compression in that negative spread here in the quarter. So, we’re encouraged by that, but its still there, its still impacting our margin, but we’ve seen some compression in that and we’ve also seen over the last few quarters trend down in our overall payoff levels as well.

All right. Thanks guys.

Thanks.

Our next question is from Jon Arfstrom of RBC Capital Markets. Please go ahead.

Thanks. Good morning, guys.

Hi, Jon.

Hi, Jon.

Couple of things here, can you talk a little bit about the construction optimism and maybe little more on the type and location of some of the strength you see in?

Sure, Jon. Construction lending is not a huge part of our portfolio, but it has been one that we’ve seen good growth in the first half. We’ve pointed out because of the unfunded portion of it and the fact that our originations have been higher than what it appears our balance growth has been. The location of it has been predominantly in the metropolitan areas where we operate, so Cincinnati, Indianapolis, the Columbus, Ohio market and the Dayton, Ohio market has been the areas of the most substantial growth. And it cut across a few asset classes, multifamily obviously continuous to be a strong area. Healthcare is another strong area. And then some what I would call build the suit or specialty areas where we had strong credit tenant already in place, so it’s been a combination but across those geographies.

Okay. Good. John is Oak Street duty, your asset sensitivity? I believe you said, are these all are variable rate type loans?

Yes. There are predominantly variable rate loans so that certainly helps, it really depends on the funding mix, but we expect to probably fund it predominantly with variable rate funding. So it will be neutral to positive to our asset sensitivity.

Okay. And when you say variable rate funding are you talking about deposits or debt or you know I guess my assumption was you just drop it on the balance sheet and utilized – push up your loan to deposit ratio or you’re seeing something different here?

Yes. I think we’re looking to fund it probably with the mix of retail deposits with some broker deposits, but that’ll be will fairly short and variable rate.

Okay. And Oak Street was warehouse funded predominantly, is that right?

Yes. Correct, Jon with bank warehouse lines of credit.

Okay. And then what drives losses in the business and maybe talk a little bit about provision in reserve requirements, I guess I look at this as pretty much C&I lending. But give us an idea of kind of losses and the provision in reserves you’re thinking about?

Yes. I think as we noted in the slide deck Jon the credit quality of the portfolio is really strong. They’re charge-off last year at 2014 were 30 basis points of average loans. We expect a longer term run rate to be something closer to 50 basis points. I think it’s more similar to an asset base lending with the tender commission book as collateral. So its really around monitoring those tender commission books and monitoring the performance there, but we think they do it – continue to do it well as they have their credit risk profile is attractive.

Okay. All right. Thanks for the help.

Thanks, Jon.

Our next question is from Andy Staff of Hozart Volume. Please go ahead.

Good morning.

Hi, Andy.

What do you expect effective tax rate to be in the back half of the year?

Andy, I think it should be similar to the first half of the year. There can be some minor quarterly fluctuations there, but in that 33% range.

Okay. And were there any meaningful non-core items in other non-interest income?

No, there were not.

Okay. And my last question how did Oak Street’s capital, our credit quality fair during the financial crisis?

It faired well, I mean, they saw some increases in charge-offs but nothing significant, certainly compared to the yield that they earn on their loans. So that’s one of the things we look at was a life to date loss rate which has been very strong, very solid. And as we’ve pointed out in the deck, I have seen charge-offs and anything originated since 2011.

Okay. Great. Thank you.

Thank you.

Our next question is from Erik Zwick of Stephen. Please go ahead.

Good morning, guys.

Good morning.

Just a one follow-up on Oak Street, as you move into those larger strategic as you categories them loans, any different expectations for yields and losses on those loans?

No expectation is difference in loss. We’re certainly kind of employed the same strong credit standards that they’ve employed to-date. You know, yield, I think you – anytime we have larger loans they tend to be little bit lower yield than the core, what we would view as small in traditional banking terms. And as we get into that strategic market in a more meaningful I’m sure we will see some variation in yield based on the quality and strength of the borrower. But we’ve assumed some of that in our modeling for the deal.

Okay, great. And then switching gears to asset sensitivity and in the press release you make some comments regarding adding more variable rate loans and changes investment portfolio to position yourself for increasing rates. Can you just talk a little bit about how your asset sensitivity might fair under a parallel increase in rates versus maybe more flattening scenario where the short end moves higher?

Sure. I think our interest rate sensitivity really hasn’t much. We continue to pivot around risk neutral position. We have taken some actions in recent periods. We terminated our pay fixed receipt float interest rate hedges that we had against our floating rate, public body deposits and our index money market deposits as our sensitivity improved there. So we continue as I said that pivot rate around neutral, the loan production that we’ve seen in recent period as well as some of our investments strategies on the securities portfolio should help improve our asset sensitivity as we go forward.

Okay, great. And then finally just loans, it sounded like you indicated that there was a pick up in growth towards the end of the quarter, any particular segments or areas where you saw that most?

No, I mean, I think it was a combination predominantly in the commercial area. So a good mix of C&I as well as some of the investment commercial real estate, so combination of the two, as well as we’d a strong June in our franchise finance business and that the pipeline in that business continues to grow and I think we’ll have a solid third quarter.

Great. Thank you very much.

Thank you.

[Operator Instructions] Our next question is a follow-up from Scott Siefers with Sandler O'Neill. Please go ahead.

Hey, guys. Just wanted to kind of segway on the overall loan growth question, so the year started a little slower but it sounds like you guys are feeling pretty good about the back half of the year. Is your sense, Claude that based on the pipeline as you see it today and the strength that you cited for example in June that second half growth could accelerate from the 7.5% and the period growth that you saw in the second quarter or are we now at kind of steady state for both end of period and averages just on a core basis?

Yes. Scott I would probably, I’d be a little cautious just because we’ve seen choppiness over the last couple of years. I think we still feel good about that mid to high single-digit growth rates through the back half. Pipelines are strong. We feel good about those pipelines like you mentioned and I referenced, we had a strong close to the quarter, a strong beginning of the third quarter, so we’re encouraged. But I would probably be more comfortable of assuming an ongoing mid to high single-digit type number as oppose to seeing it accelerate.

Okay. All right. And that’s perfect. And I think the final question is its just goes back to rate sensitivity. I guess you guys are little unique and that you still have some legacy benefit embedded in the margin from some of the deals that you did few years back and its obviously much smaller than its been, but kind of represent sort of steady drag. Do you guys have a sense for how much rates would have to increase at the short end for you guys to be able to overwhelm that quarterly run off and have the margin advance on a reported basis?

I don’t know that we calculated quite that way Scott, I think the ongoing impact. Our covered book now is probably down in the mid 200. Net yield beyond the indem is now I think John in the sevens.

Yes, Sevens

So, if you look at that difference versus kind of book coupon or loan coupon, we think that total impact is probably 10 basis points or less. So, we’re hopeful that you’ll see if rates begin to rise and it’s more of a parallel shift versus the fattening that would be positive for us. But to your point there is still some of that accretion is there.

Okay.

And we don’t really forecast with rising rates as well as in our planning.

Yes. Okay. All right. That’s perfect. Thank you guys for taking follow-up

You bet.

Our next question is from John Rodis of FIG Partners. Please go ahead.

Good morning, guys.

Hi, John.

Hi, John.

Just back to Oak Street a second, have they had issues in the past with fraud with the brokers?

Maybe one or two, but nothing significant or material to the financials, I think any of us in the lending business had some frauds from time to time, but nothing as significant.

I mean it’s probably that what little bit of volatility they’ve had in their history has been related to that, but not a meaningful number at all.

And the important thing for us was the direct connections into carriers and the detail now individual policy that secure the loans.

Okay. Fair enough. And then just one other question I guess acquisition there was Bank of Kentucky the deal that was recently completed, have you seen any pick up in business or any fallout from that acquisition?

I would say, nothing material meaningful in either direction, obviously any time there is disruption in the market everyone including us tries to take advantage of that, but obviously BB&T is a good bank and we’re certainly kind of working on that area in that loan book, but I would say, nothing material to our results at least either way.

Okay. Thanks guys.

Thanks.

Our next question is a follow-up from Chris McGratty of KBW. Please go ahead.

Thanks for taking the follow-up. On the loss sharing around the accelerated discount previously covered loan is up $2 million, can you help me with how should we thinking about it now that you loss shares have expired? What are those just continue should we putting some level contribution in the numbers and I think there was a provision, modest provision offset? Thanks.

Yes. Sure Chris. As you noted commercial loss share expired in the fourth quarter of last year, so we no longer have an associated reduction in the indemnification asset when formally covered commercial loans payoff. So it’s tough to say. We can really predict what level of payoff we’re going to see there early payoffs. We did see some increased activity there this quarter including a large franchise relationship. But in terms of go forward, tough to predict, it could be some volatility in there at the end of the day, we will get the income whether its through accelerated discount or through the margins as the loans don’t payoff and I’m – sorry, you had a second part of that question.

I was just wondering if we should be factoring that into our estimates, so at some level I guess the answer is what you are steering us to?

Yes, yes.

Okay. Just a last, so maybe I miss it. On the pro forma capital ratios I can appreciate the regulatory comments, but do you remind us where your TCE targets are and I think, correct me if I’m wrong your capital will go to like around 8% from little over 9%, is that a fair mark with your accretion?

I think it’s a fair ballpark Chris, but in terms of targets we set them on the leverage the Tier 1 and then total risk based. And we’ve set them at the Basel III minimums plus the buffer that they include, plus 200 basis points, is how we look at those as our internal targets. So we don’t set a TCE target per say, we set them all off the regulatory ratios.

Okay. But the TCE were the deal is roughly around – is kind of your based on your math on the book value solution, right?

Yes. We don’t have in front of us, but its very close to that, yes.

All right. Thank you.

You bet.

This concludes our question and answer session. I’d like to turn the conference back over to Claude Davis for any closing remarks.

Great. Thank you. And thanks everyone for joining our call today and thanks for your interest in First Financial.