First Interstate BancSystem, Inc. (FIBK) Q3 2012 Earnings Report, Transcript and Summary

Good morning, and welcome to the First Interstate BancSystem Incorporated Third Quarter 2012 Earnings Call and Webcast. [Operator Instructions] Please note this event is being recorded. I’d now like to turn the conference over to Ms. Marcy Mutch, Investor Relations Officer. Please go ahead.

Thanks, Laura. Good morning. Thank you for joining us for our third quarter earnings conference call. As we begin, I’d like to direct all listeners to the cautionary note regarding forward-looking statements and factors that could affect future results in our most recently filed Forms 10-Q and 10-K. Joining us this morning from management are Ed Garding, our Chief Executive Officer and Terry Moore, our Chief Financial Officer. Ed will begin by giving you a general overview of the company’s results and review credit quality information. Terry will follow-up with specific information behind the quarterly results. At this time, I’d like to turn the call over to Ed.

Thanks, Marcy. I’m going to start by saying, I’m Ed Garding and I approved this message. Hopefully, you are as sick of hearing that as I am. Let’s talk about First Interstate for a few minutes. We reported third quarter earnings of $15.3 million, which is an increase of 26% over last quarter and 38% over a year ago; and again, as I’ve said, $0.35 per share for the quarter. We are pleased with the strong level of earnings this quarter, which were driven by record high residential real estate activity. If you read our release yesterday, you saw we had $11.7 million in income from the origination and sale of residential real estate loans, which represents an increase of 24% over last quarter and 112% increase over the same quarter last year. Our focus on gaining market share in the home loan business is paying off, with historically low rates refinancing activity of 62% of our volume. However, the year-to-date purchase volume through the third quarter has already exceeded the total purchase volume for all of 2011. At this point, it looks like we'll have a strong fourth quarter as we've experienced record high applications over the last 30 days. The tremendous synergy our employees have applied to gain market share has been aided by the fact that we've had some competitors for this business leave our markets. Of course there’s still competition, but we've developed expertise and efficiency in our mortgage lending process. This will help us gain even more market share, particularly in purchase activity as the economy continues to improve. Terry will be reviewing the rest of the income statement with you in more detail, so I'd like to move on to some of the other highlights of this past quarter. As far as loan growth goes, we saw an increase in total loans this quarter as a direct result of our decision to retain 10-year and 15-year residential mortgages in the portfolio. In addition, our indirect loan portfolio increased by $13 million. This portfolio performs very well and has historically reported delinquency and non-performing ratios well below national averages. Commercial loans were down by $48 million mostly due to loan payments, not charge-offs or anything like that. Looking ahead, retaining more of our residential mortgage production will help to offset the typical seasonality that we see in our loan volumes during the fourth quarter. With agriculture, construction and tourism all coming to a season end, these people are effectively finishing their harvest and paying down the lines of credit. So outside of mortgage lending, we anticipate loan demand for the fourth quarter will be soft and that outstanding loans will remain relatively flat over the next couple of quarters. Let's move on to credit quality. We are continuing to make good progress. This is the eighth consecutive quarter we've seen a decline in credit size loans. The construction and real estate portfolio continues to shrink as we resolve problem loans in that category. As of September 30, 13.5% of the construction real estate portfolio was non-performing. But that's compared to 25% at the end of 2011, contributing to total non-performing assets decreasing to 2.7% of total assets. That's a decline of 38 basis points quarter-over-quarter and is the lowest it has been since the first quarter of 2010. This quarter most of the decline was attributable to our successful efforts to dispose of other real estate. During the third quarter, we had $3 million of additional other real estate, $2 million in write-offs on existing other real estate, but $15 million in sales. So the net went down from $53 million to about $39 million in total other real estate. Result of this is a 26% reduction in other real estate from the end of last quarter. Real estate sales and our footprint typically experienced seasonality. So while we may not see this level of sales activity in the fourth quarter, we also aren’t anticipating any large upswings in the other real estate balance. Non-accrual loans declined modestly by $7 million and evaluating the larger credits that flowed into the nonaccrual category, $9 million was in the commercial and commercial real estate portfolios involving just 2 lending relationships. So over the last 12 months we have seen significant improvement with a 30% decline in our non-performing assets, and a 38% decline in our non-performing loans. We are very pleased with the magnitude of progress we’ve made. As you’d expect with the decline in non-performing loans other real estate is higher than it was a year ago. However, as I just mentioned, we had success in disposing of a significant amount of other real estate this quarter. We continue with our long-term strategy of undertaking the resolution of problem assets in an effective manner, which is one we ultimately think is beneficial for our shareholders. We expect to make substantial strides to bring down non-performing asset ratios over the next 12 months as we resolve the remaining pool of problem loans and dispose of other real estate. Let’s move on to local economic conditions, while improvements in the economy haven’t yet translated into much loan growth, we continue to see positive trends in the economic data across our footprint. We are still fortune to have some of the lowest unemployment rates in the country, with South Dakota at 4.4%, Wyoming at 5.4%, and Montana at 6.1%. Energy remains a significant factor in our economy. If you recall, we have significant energy resources in coal, oil, gas, and wind, particularly in Montana and Wyoming. We think the opportunities in the energy sector, in the supporting industries, will continue to grow. Just some proof of that, we just this week had a groundbreaking for a new $140 million wind farm just north of Billings, Montana, and there is already a lot of wind energy already up and running in both Montana and Wyoming. Ag commodity prices remain elevated and despite the drought conditions in parts of our region, our Ag customers had a good year. We are just finishing the sugar beet harvest and are seeing record crop yields and record prices. Cattle and grain prices are also near record highs, which have counterbalanced lower yields in the drought areas. Here in Billings, which is our largest market, the housing market is strong and should continue to be a positive catalyst for our mortgage lending business. There is a limited amount of inventory on the market and we’re seeing new construction at the highest level in 3 years. In regard to the entire First Interstate region, housing values are stable to improving. Tourism was better than 2011 and energy activity is very good with regard to oil and wind, although fairly weak in regards to coal and natural gas. With that overview, let me turn it over to Terry, for more detail regarding earnings.

Thanks, Ed, and thanks to all of you for joining us this morning. I’d like to start our conversation with net interest margin. Our net interest margin revenues held fairly steady quarter-over-quarter, which was aided in large part by one extra accrual day. Net interest margin dropped a 11 basis points from last quarter, but as a reminder last quarter’s NIM was 4 basis points high due to the recovery of 766,000 of interest on loans, which had been formally on non-accrual. This quarter, we had a small net expense of charged-off interest. And that being said, a 7 basis points drop net of that is still rather substantial. As we look at more details there, our average loan yield was down 16 basis points from last quarter, once again that same recovery of charged off interest contributed to our impacted 7 basis points in that adjustment of loan yield. But furthermore as you can see from the loan mix and the earnings release, most of our loan growth has been in residential mortgages which are at a much lower rate than commercial or commercial real estate which is having an impact on our average loan yield. Additionally, the interest -- the increase in interest bearing deposits in banks, which are mainly funds held at the Federal Reserve Bank earning 25 basis points was a further drag on the margin. The yield in our investment portfolio declined 8 basis points from last quarter to this most recent one. Obviously, QE3 has resulted in investment yield being pressured down even further for the foreseeable future. Duration of the $366 million of purchases in our investment portfolio this past quarter, was approximately 3.7 years with an estimated yield of only 1.4%. We remain disciplined and are sensitive to stretching duration as well as credit risk. That being said, we do have opportunities to deploy some of the funds currently at the Federal Reserve Bank and pickup a little more yield. Once again, the shift in the deposit mix largely into non-interest bearing deposits help to drive the decline in cost of funds to just 43 basis points, down a significant 7 basis points from last quarter. As a side note, we exceeded $6 billion in total deposits this quarter, which is the highest level of deposits in the company’s history. Non-interest bearing deposits continue to grow and comprise over 24% of our total deposits. As we mentioned last quarter, we have $45 million of fixed rate trust preferred securities currently at a weighted average fixed rate of 7.06% that will reprise favorably at the end of this year. Based on current rates, the additional lift in net interest margin next year is 3 basis points, which will help mitigate net interest margin compression in 2013 as well as contribute toward earnings per share. In the current interest rate environment, there is no doubt we will continue to experience net interest margin pressure going forward. Current economic conditions are resulting in competition for loans and pricing pressures are having an impact. Investment yields will continue to be pressured downward and we have limited opportunity to reduce cost of funds. Net interest margin will likely decline a few more basis points next quarter. Although, I wouldn’t expect the decline to be at the same magnitude as we’ve recorded here for Q3. Provision expense has declined about 20% from the prior quarter to $9.5 million and is the lowest quarterly provision that we’ve had in 4 years. As Ed indicated, we expect credit trends to continue to improve and anticipate seeing further declines in provision expense over time. In total, non interest expense was on par with last quarter. However, salaries and benefits were up $2.3 million over last quarter. As we look at the salary component, about half of the salary increase is attributable to an increase in compensation due to our higher earnings levels with the balance of the increase due to several items, including the extra accrual day along with commissions and overtime expense for our employees involved in mortgage lending activities. As far as the increase in employee benefits component quarter-over-quarter, there was over a $700,000 swing in the value of assets held in the differed compensation plan. This adjustment flows through employee benefits with an equal offsetting entry to the other income line. As we’ve said before, accounting requires this reporting treatment which can lead to swings from quarter-to-quarter on these 2 line items, depending on the market value changes of the underlying assets. However, there is 0 impact -- net impact on earnings. Capital levels remain strong with Tier I common capital at 11.8%. We have evaluated the impact of Basel III is currently proposed, and as we understand the current proposal and its potential implications to us, we would continue to meet the well capitalized guidelines. With that I’ll turn it back to Ed to wrap things up.

Thank you, Terry. To summarize both our performance and our prospects for the future, our year-to-date net income is 35% above last year. This is due to improved loan quality, higher level of home loan volume and controlling expenses. Our prospect for the future probably sounds like most other banks in the country, net interest margin is shrinking, loan growth is flat and consumer compliance costs are increasing. We think we can offset this with improving loan quality, increased non-interest income and taking advantage of operating efficiencies that we have been identifying. We know that we need to learn how to remain profitable with a smaller net interest margin and we’re taking the needed steps to accomplish that. We are now ready to open up for questions, and I will just direct traffic. Our Chief Credit Officer, Bob Cerkovnik is with us, so if Terry or I don’t have immediate answers we will turn to Bob for some of the questions too. So let’s start that.

[Operator Instructions] And the first question comes from Brad Milsaps with Sandler O’Neill.

Terry, just maybe a little bit more on the margin, particularly as it relates to net interest income. Looks like this quarter you guys increased the overall size of the balance sheet quite a bit, obviously with the residential mortgage loans and you talked about deposits growth still being strong. Do you anticipate that you’ll continue to increase the size of balance sheet and sort of you’d able -- you would try to able yourself to muscle through the margin compression whereby you can kind of hold net interest income flat or grow it obviously like you did this quarter?

Brad, as it relates the future and particularly the balance sheet size, I would look at deposits being relatively flat, going forward they may inch up a little bit, but we’ve had a significant growth of deposits over the last 2 or 3 years. And I would envision that deposit growth will flatten out a bit and that would keep our balance sheet from growing much larger over the next couple of quarters. Is that the nature of your question Brad?

Yes, I guess it's a long one to say, I mean are you willing to -- are you willing to sacrifice the margin in order to support your net-interest income? In other words, can you keep net-interest income kind of in this range, even with the margin compression you're talking about?

Well I think I tried to make clear that maybe the range is declining and that I would expect that we’ll see a few basis points each calendar quarter over the next several quarters of further compression.

Okay and then on the expense side of things, the other expense category was down quite a bit from the June 30 quarter, I know there was about $1.5 million charitable donation in there in the second quarter, but there looks like there was improvement beyond that, is that still some fall through from lower credit remediation cost, just kind of curious kind of to think about run rate going forward.

I'd say for the most part, Brad that I don't have that exact number in front of me but that would not be true. We did have in second quarter of last -- 2 quarters ago, second quarter, about $0.5 million of one-time cost in regards to the disposition or repayment of our trucks that we did in late June, so that was not recurring as well. And so the rest is just other noise in there and that the cost of collection and legal cost et cetera around dealing with the problem credits is not subsided at this point.

And our next question comes from Brett Rabatin of Sterne Agee.

Wanted to ask a question also on the margin and just Terry you talked about deploying some cash obviously you had higher cash balances during the quarter. Can you talk about how significant an investment you are talking about, and then what should we be buying in terms of the portfolio?

We wouldn’t deem that we need $500 million of overnight liquidity, is an appropriate level of liquidity and it would be comfortable to have that operated a couple of $100 million less. That being said, we don’t have a strategy to just instantly increase our loan -- investment portfolio by $200 million. I would see our investment portfolio slowly growing kind of on a dollar-cost average concept over time as long as this liquidity stays in place, and we will continue to increase the overall asset side of the investment portfolio. We’ve had a lot of liquidity as you can tell, in the last quarter I reported we had over $350 million of investment purchases and we will probably have in that kind of range again or perhaps even more here in fourth quarter. So the kind of investments that we would invest in are not different than what we’ve done in the past, but perhaps a good proxy would be the nature of what we acquired in this third quarter, which were about -- of that $365 million, about $240 million were mortgage-backed CMO product, about $100 million were agencies, callables and bullets and the reminder with municipal and a couple of small corporates. So that kind of a mix is not unusual or atypical to what we’ve had in the past and I would expect some composition that would look like that as we continue to maintain and most likely grow that investment portfolio in relative dollars.

Okay, that’s helpful. And then, I wanted to ask about the mortgage banking. Obviously, it’s a little more geared towards refi and purchase, but that number has been a lot stronger in the past year and a half, I know you’ve made some investment in the platform. Can you talk about 2013, Ed maybe, and just -- or Terry, and just talk some about investments you’ve made and if refi does obey, kind of how you see that business in over the next 12 months maybe?

Yes, I will respond to that, Brett. In regards to investments, we’ve made a spin more around software than people. We just continually try to make the process, the internal process from application to closing, to selling, to the secondary market go quicker and become more automated. So we’ve worked on that and are continuing to work on that especially actually in the part of taking loan from closing to delivering and selling to the secondary market. So we find efficiencies there. And you are right, we are seeing more purchases and less refinancing as months go on and the economy continues to strengthen in our region. And in addition to that we will probably also be doing more Internet based mortgage lending within our territory than we’ve done in the past.

Okay. And then any thoughts maybe on 2013 and also let’s say refi goes down quite a bit, is there -- do you have any methods of keeping that from following in the same type percentage ranges as the percentage of refi?

I think it’s hard to imagine that we’ll have the kind of volume that we’ve had this year. But that said, we don’t see it dropping off the cliff either, partly because we continue to see competitors get out of the business, the high cost of compliance is driving smaller competitors out of the business. And secondly, as I said, as we see the economy strengthen, we’re seeing more purchase activity.

And the next question is from Jeff Rulis of D.A. Davidson.

Just looking at some of the segmented loan data, looks like C&I after a couple pretty good quarters of growth reversed that trend and maybe if you could explain kind of what -- is there anything seasonal in that figure or what drove the -- and I guess maybe the outlook for that. Does that couple with your kind of flattish growth expectations, would that apply to C&A as well?

Jeff, I’m going to have Bob Cerkovnik, our Chief Credit Officer address that. So go ahead, Bob.

Yes, Jeff. Thanks for calling in Jeff. What we’re seeing is, this last quarter is some large pay downs that we had and as you’ve well heard from banks it is that there has been very steep competition out there. What we are talking about is, our construction category continues to go down, which falls into that bucket and then we are still making construction loans, but we are seeing outflow resolving a lot of our problem credits and you can see from our criticizing cost rate numbers that are coming down. So that is part of that from our commercial portfolio. Overall, I continue to expect that commercial loan activity will remain flat for the next couple of quarter.

Okay. And yet another question on the mortgage side, Ed. I -- just to make sure I understand, looking at that fee income line from mortgage banking, do I sense a subtle change in the strategy that if you are looking to portfolio more that line item in the fee income side could weaken and outside of just as you mentioned sort of alluding to maybe drifting in just overall activity year-over-year, is that correct?

Yes, basically, I think that is. If we portfolio more, the markup so to speak from selling to the secondary market goes away. So that concept is true, but the percentage that we are portfolio-ing and will continue to portfolio is pretty small compared to the total. And the only thing we’re holding is fixed rate 10-year or 15-year fully amortizing loans. So a little bit off of what you ask, we’re not holding anything that has any real perceived risk in it either.

Okay. And then maybe one quick last one if I could, for Terry, just on the tax rate. Could we assume -- you saw a little bump up, but if you were in the mid, say $0.30 range on earnings, is it 34% to 35% rate reasonable, you guys had kind of been running in the 33%, 34% in the $0.20 range?

Yes, that would be a good conclusion Jeff. And as our pretax earnings continue to grow, we would expect that the tax rate would continue to inch up.

And next we have a question from Tim Coffey of FIG Partners.

Terry, I was wondering on the mortgage, since everybody is asking question about that, I might as well get mine in. What was the loan sale margin?

I have a little trouble hearing you. Did you say, what is the loan sale margin?

On the mortgage business, yes, the mortgage as you sell this quarter, what’s the margin loan?

It’s different from day to day and from loan to loan. I can tell you that on a target basis, we’re trying to get gross fee income of about 2.1% on all loans. And again, in some loans, we get 3%, some loans we get 1%, but 2.1% is the target so to speak across the company on all loans. Some of that would be service release premium, some of it would be margin, some of it would be an origination fee.

Okay. That’s helpful. Ed, looking at the OREO, specifically the construction bucket, do you have any data points on what the current value of those are versus the original value?

We do. Bob is -- wait a minute, Bob Cerkovnik is saying maybe we don’t. Let me, let Bob answer that then.

Tim, could you repeat the question for me please?

Sure, I was wondering, on the current OREO balances it was in the construction bucket. Do you have any data points on what the current valuation of those are versus the original value?

We do Tim, but I really don’t have those in front of me. And those would be tough to track depending on product type, whether it be land subdivisions or a residential construction product.

Okay. That’s not a problem, not a problem. As we kind of look at effort of disposition of the OREO, are you anticipating greater charge offs or has the market come up to meet you where you can start getting rid of these properties at a quicker pace than previously?

I will try to answer that Tim. I figured it would be awfully optimistic to predict the values of the OREO coming up. But historically when we take the property into ownership, we get it appraised and immediately write it down to current appraised value and if you track our sales, our sales have been extremely close to what that appraised value is and what we have written it down to. So that said, we don’t see anything material in the way of losses on the sale of OREO going forward.

Okay, that’s helpful. Another question on the charge offs, do you see the need to charge-off the same amount as you have in recent quarters?

I'm going to turn that one over to Bob.

No, Tim, we don’t.

Okay. And then Terry, if I guess for a quick second, are there anything within kind of the capital structure, debt related, trust preferred, stuff like that, that you’d be interested in redeeming right now?

Thanks, Tim. There are no opportunities at the very instant moment. They’re all subject to a 5-year lock out that end at the end of this year. My highest interest in conversation, that will be held here in fourth quarter will be more around the perpetual preferred stock, it is callable in beginning in January of 2013 at par over the next 5 years. And so we’ll now begin to have that conversation this quarter and I would expect that there would be some redemption in the future of that particular capital structure.

Okay. And what is the amount outstanding on that?

That is $50 million and it’s priced at 6.75% dividend cost.

And our next question is from Jonathan Walton of Wells Fargo.

I was just curious with regard to the TruPS redemption was it redeemed at par?

The redemption that we had in June, Jonathan, was redeemed at par and that was a $40 million tranche and what we redeemed was the -- we have several different tranches I think about 7 that we had and that was the highest costing one that we had.

Okay, I understood. And there are no trust outstanding on your balance sheet, is that correct?

No. We would have $80 million of remaining trust preferred securities in several different tranches that are available for call starting at around the end of this year, and they are priced pretty attractively each differently, but probably on average somewhere around LIBOR plus around $260 million would be an estimate. So those are still favored and a pretty low cost form of funding. So perhaps someday and depending on Basel, those maybe redeemed. We would not be looking to redeem those in the next few quarters.

And the next question is from Jacque Chimera of KBW.

I had a question heading back over into the OREOs properties that were sold during the quarter, just, I guess separating them into the smaller properties and the larger properties, I know those are 2 different markets. How are bids looking for the properties that you sold? Did you receive more than you had in past quarters?

Bob Cerkovnik will answer that for us Jacque.

Yes, Jacque, we have.

And is that on both -- all sizes of properties or is there one market that’s getting more bids than the other?

It’s across the board, Jacque. It’s depending on which market.

Okay. And looking to the 775,000 gains that was booked in the quarter was that a blend from different sales or was there one property in particular that influenced that?

It was a blend.

And then just looking back over, you mentioned in your prepared remarks, just some of the fee growth that you were looking to develop to offset some of the NIM pressure, how are some of those initiatives coming?

And that one would be for me to answer, Jacque, and we have teams of people working on various projects, but I would say it’s coming along fairly well as witnessed by improving fee income and I’m talking about things like our credit card portfolio of course mortgage lending, which we’ve already talked about quite a bit; wealth management, our total revenue in wealth management for example is up $1 million from last year; our cash management products for commercial customers; and even debit that -- which interestingly is holding steady to up because there is more activity, there is less of a discount on debt, but more activity going on.

And next we have a follow-up from Brett Rabatin of Sterne Agee.

I just wanted to ask a follow-up on loan pricing and you guys were kind of talking earlier about impact of nonaccrual loans and then in last quarter you obviously have been nonrecurring item, that affected the loan yields. Can you talk about just where you are seeing current originations versus the current portfolio yield and if intensified pressure from competitors has impacted C&I or commercial real estate?

Yes, I will let Bob answer it, but it will tell you that the thing that we’re seeing and of course across the country is that there is just too few borrowers out there all being chased by too many banks, so there is certainly competitive pressure, but Bob do you want to be more specific about rates that we are seeing.

Yes, Brett, the rates are extremely low, we are seeing a little more competition in certain markets on the 7-year and 10-year fixed stuff and the terms that we are seeing are also very competitive. I think Ed, summed it up very well, is there just a lot of borrowers are just holding off until they see some signs in the economy to really start asking for additional request on their lines and are actually paying down their lines.

Okay. Going back to the original question, where are you originating on average, Bob if you have an idea, loans today versus the current portfolio yield?

On rate?

Right.

Yes, rates can be -- for our high quality borrowers, we can be in the 4.5% down to 4% range and then it goes up there. We are trying to price where we have a strong bias towards obviously pricing per risk and that scale goes up considerably. We are seeing pressures under 4%, too, and depending on the quality of the borrower, we are going with those rates, too, so.

Okay. And then just one last one, loan floors, how much of the portfolio is it loan floors and what does that piece of the portfolio look like?

Brett, Terry Moore. In terms of floors, we have about just around a $1 billion of our variable rate loans are under the -- or at the floor, so that has not changed in the last year. It’s well held relatively constant.

And next we have a follow-up from Jonathan Walton of Wells Fargo. He dropped out of the queue. [Operator Instructions] Showing no further questions, I’d like to turn the conference back over to management for any closing remarks.

No, there are no closing remarks. Thank you for your time.

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.