First Interstate BancSystem, Inc. (FIBK) Q2 2020 Earnings Report, Transcript and Summary

Good day, and welcome to the First Interstate BancSystem, Inc. Second Quarter 2020 Earnings Conference Call. [Operator Instructions]. Please note, today's event is being recorded. I would now like to turn the conference over to Lisa Slyter-Bray. Please go ahead, ma'am.

Thanks, Rocco. Good morning. Thank you for joining us for our second quarter earnings conference call. As we begin, please note that the information provided during this call will contain forward-looking statements. Actual results or outcomes may differ materially from those expressed by those statements. I'd like to direct all listeners to read the cautionary note regarding forward-looking statements and factors that could affect future results contained in our most recent annual report on Form 10-K filed with the SEC and in our earnings release as well as the risk factors identified in the annual report and our more recent periodic reports filed with the SEC. Relevant factors that could cause actual results to differ materially from any forward-looking statements are included in the earnings release and in our SEC filings. The company does not undertake to update any of the forward-looking statements made today. A copy of our earnings release, which contains non-GAAP financial measures, is available on our website at fibk.com. Information regarding our use of non-GAAP financial measures may be found in the body of the earnings release and a reconciliation to their most directly comparable GAAP financial measures is included at the end of the earnings release for your reference. Joining us from management this morning are Kevin Riley, our Chief Executive Officer; and Marcy Mutch, our Chief Financial Officer, along with other members of our executive team. At this time, I'll turn the call over to Kevin Riley. Kevin?

Thanks, Lisa. Good morning, and thanks again to all of you for joining us on our call today. Along with our earnings release, we have published an updated investor presentation that has some additional disclosures that we believe will be helpful to you. We have updated a few slides, and that update will be published this morning. The presentation can be accessed on our Investor Relations website. And if you haven't downloaded a copy yet, I would encourage you to do so. I'm going to start today by providing an overview of the major highlights of the quarter, and then I'll turn the call over to Marcy, so she can provide more detail on our financials. I want to begin to say about how proud I am with the whole organization. COVID-19 pandemic has presented an unprecedented set of challenges, and each turn, our team has figured out a way to keep our operations running smoothly, maintain a superior level of client service and capitalize on our new business development opportunities that are available to us. I would like to thank all of our colleagues for the hard work and the commitment that resulted in a strong financial performance in a very challenging environment. For the quarter, we generated net income of $36.7 million or $0.58 per share, and a pretax provision income of $66.6 million. In my mind, the real highlights of the quarter has to be the resiliency of our markets. We continue to be fortunate that many of our markets that we operate in have been among the areas of the country least impacted by COVID-19. Unemployment rates in our footprints, with the exception of Oregon, are slightly outperforming the national level. Montana, Wyoming and South Dakota remain in the top 14 states in terms of the lowest unemployment, while Idaho ranks third in the nation with an unemployment rate of 5.6%. Additionally, consumer spending trends, while mostly negative since the start of the year, have seen marked improvement and are well above levels witnessed in early April. This matches up to the anecdotal information that we hear from our bankers and clients across our footprint. Simply put, people have money in their pockets and they are spending. With our diverse business mix, we have been able to capitalize on pockets of strength that we are seeing in the economy. While our commercial borrowers remain cautious about making new investments, we are seeing strong demand in our residential mortgage and indirect consumer lending businesses. Our mortgage banking revenue were up 58% over the second quarter -- for the second quarter over -- of last year. While in the loan portfolio, residential real estate loans were up 18.5% and indirect consumer loans were up 14.1% on an annualized basis. In the mortgage business, we are not only benefiting from the increased demand for refinancing, but also from the steady employ of people relocating to Montana and Idaho, which is driving up more purchase volume. The resilience of our markets is also reflected in the strength of our asset quality. We saw declines in nonperforming assets and criticized loans during the quarter. And as of July 22, 64% of the loans that received a modification or deferral had either continued or resumed making their scheduled payments. These positive trends also reflected a strong underwriting in our portfolio and the limited exposure we have to industries most impacted by the pandemic. Today, we've had limited requests for second deferrals or modifications, and the majority of those are coming from clients in our hospitality industry. Another highlight of the quarter was the productivity and the efficiencies of our efforts around the Paycheck Protection Program. The investments we have made to adapt our lending to be scalable and the processes standardized over the past several years serve us well at getting our PPP application process up and running very quickly. We were getting loan applications completed and submitted in a matter of hours. As a result, we were able to process more than 11,000 applications that were approved for $1.2 billion in funding. Through our efforts, we earned $43.2 million in fees and gained $90 million in deposits from over 2,200 new customers. Time after time, we heard stories of companies being frustrated with the lack of response from their current bank, both large and small institutions and being impressed by the level of service and the speed with which we could get their PPP loans processed and approved. The PPP program turned into an amazing business development opportunity that enabled us to really demonstrate the value proposition that we offer, a bank that leverages technology and efficiencies, combined with unmatched level of personal service. Since bringing on these new clients, we have made significant progress on expanding our relationships. We are getting lots of messages from our bankers about clients moving over their deposit accounts, both business and personal, to First Interstate, and expanding their lending relationship to include other types of loans, including commercial lines of credit and equipment and residential real estate loans. We expect further progress with these new clients will positively impact our loan and deposit pipeline in the coming quarters. The experience of the pandemic has also underscored the strength of our deposit franchise. Our total deposits increased by $1.8 billion from the end of the first quarter with almost all of that coming in our lowest-cost deposit categories. In general, the increasing balances are coming from operating accounts of our commercial clients as their business continue to perform relatively well. And before I pass the call on to Marcy, I wanted to mention that we are excited that Michael Lugli joined our team as our new Chief Credit Officer. Michael comes to us from KeyBank, where he served the various roles for nearly 30 years. His extensive credit background, including asset recovery, health care, real estate, commercial banking, private banking and mergers and acquisitions, combined with his leadership experience makes Michael the perfect person to oversee our credit team and we are fortunate to have him with us. With that, I'd like to turn the call over to Marcy, so she can provide some additional details around our second quarter results. Go ahead, Marcy.

Thanks, Kevin, and good morning, everyone. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the first quarter of 2020, and I'll begin with our income statement. Our net interest income decreased $600,000 from the prior quarter due to an $800,000 decrease in accretion and interest recovery income, along with the impact from the Fed Fund rate we had in March. On a reported basis, our net interest margin decreased 38 basis points to 3.52% in the second quarter. Breaking down the major components of the change in our net interest margin, 26 basis points was attributable to the change in yields, with the decline in asset yields being partially offset by the decline in deposit costs; 8 basis points of the decline was attributable to the impact of the lower-yielding PPP loans; 2 basis points was attributable to a decline in interest recoveries and accretion income; and 2 basis points was attributable to the subordinated debt we took on in March. Excluding the impact of interest recoveries and loan accretion, our operating net interest margin declined 33 basis points to 3.44%. Our cost of funds for the month of June was 12 basis points, down from 20 basis points in March, so we will continue to see a bit of relief on that front entering the third quarter. During the second half of 2020, we have $556 million in CDs, or 54% of the current CD portfolio that will mature, and these deposits carry a weighted average rate of 1.14%. But other than the maturation and renewal of these CDs at lower rates, we don't think we'll have much more room to bring down deposit costs. While the repricing in our loan portfolio from the last fed rate cut has largely occurred, new loan production is coming on the books at 15 to 20 basis points below our average yield in the loan portfolio, excluding PPP loans. And we're seeing declining yields in the securities portfolio as payoffs from investments are reinvested at much lower yields. Given this pressure on the earning asset side, we expect to see some continued compression in our margin, although it should be pretty manageable. Moving to noninterest income, and as we stated in the earnings release, I want to point out that we have reclassified mortgage servicing revenues and direct costs related to loans sold to mortgage banking revenue. This is to be more consistent with how others in the industry are reporting. Our noninterest income increased $1.3 million quarter-over-quarter to $39.7 million. The increase was almost entirely due to a $3.3 million increase in net mortgage banking revenue, which includes a $5.5 million mortgage servicing impairment adjustment this quarter. Our mortgage banking revenue is benefiting from the strong demand for refinancing, which accounted for 71% of our total mortgage production in the second quarter. In May, our digital mortgage application portal began accepting applications for refinancing, which helps drive additional volume to this channel. In second quarter, we closed approximately $162 million of loans through the digital channel. Our pipeline for both refinance and purchase residential mortgage loans remained very strong as we started the third quarter. It's not quite at the record levels we saw in the second quarter, so it's likely we'll have revenues that are somewhat lower than this quarter, but still higher than historical norms. The increase in mortgage banking revenue in the second quarter was partially offset by lower revenue in a number of line items that have been impacted by COVID-19. Payment services revenue is lower due to the decline in the volume of transactions during the pandemic, mainly related to travel expenses as well as a higher percentage of the transaction coming through retailers that have negotiated lower interchange rates. Service charges on deposit accounts are lower for a couple of reasons. First, we saw a shift in behavior as clients have less opportunities for spending as a result of COVID restrictions, and we also made the decision to waive certain overdraft fees as part of our client support efforts. Lastly, wealth management revenues declined due to a drop in assets under management as a result of volatility in the market. Moving to noninterest expense. We had an increase of $600,000 from the prior quarter. This was primarily due to higher salaries and wages, resulting from higher levels of incentive accruals. Our base compensation is steady on a linked-quarter basis. However, in the first quarter, based on our initial expectations from the fed rate cut, we had accrued lower levels of incentive pay. As we began to see the impact from government stimulus and the PPP loan, we've readjusted our expectations and were able to catch up on our incentive compensation accrual this quarter. This increase in salaries and wages was partially offset by lower employee benefits expenses resulting from lower health insurance costs and lower payroll taxes. Most of our other expense items were relatively consistent with the prior quarter as we continue to keep a tight lid on discretionary spending while the pandemic is ongoing. One notable exception is occupancy expense. We need an adjustment to correct the depreciation on assets that were added at the beginning of the year, which increased our occupancy expense this quarter. We expect this expense to level back out to the low $10 million range per quarter, although longer term, there will be some opportunities for cost savings in this area. We have decided to permanently close 2 in-store branches that have already been closed due to the pandemic. This will result in a modest amount of cost savings. But the decline in branch traffic and the increasing reference for digital banking channels will provide us with an opportunity to continue to evaluate our real estate needs going forward, including continuing to transition certain larger branches to smaller, more efficient footprint. Moving to the balance sheet. Our total loans increased $1.1 billion from the end of the prior quarter, with all of the growth being attributable to PPP loans. Excluding PPP loans, our total loans would have been down a bit as the decline in commercial loans offset the growth we saw in the residential mortgage and indirect consumer portfolios. At this point, excluding PPP loan activity, we expect our loan portfolio to remain relatively flat to slightly up for the rest of the year as any new growth will most likely be offset with normal paydowns and payoffs. Our total deposits increased $1.8 billion from the end of the prior quarter, with most of the growth coming in noninterest-bearing deposits. We also saw significant growth in our repo balances, which were up 23% quarter-over-quarter. Moving to asset quality. We saw decreases in most problem asset categories. Our nonperforming assets declined $7.2 million, while our criticized loans declined by approximately $34 million. We recorded a provision for credit losses of $19.5 million, which covered our $2.3 million of net charge-offs in the quarter, while adding to our general reserve to reflect the downgrade in our economic forecast. This brought our allowance for credit losses to 1.46% of total loans when PPP loans are included or 1.64% when PPP loans are excluded. And with that, I'll turn the call back over to Kevin. Kevin?

Thanks, Marcy. Nice job. I'm going to wrap up with a few comments about our ability to manage through this crisis. We entered these crisis with a fortress balance sheet, a concertedly underwritten, well-diversified loan portfolio, a high level of reserves, excess capital and ample liquidity. And throughout this crisis, our balance sheet has even gotten strong. We've increased our allowance. We further increased our liquidity while maintaining a significant amount of excess capital. [indiscernible] will remain relatively constant over the second half of the period, and we will continue to generate solid earnings and pretax pre-provision income. Although the crisis has demanded a significant amount of time and attention, we continue to operate with a long-term perspective and execute well on technology initiatives that are strengthening our infrastructure, improving our scalability and enabling us to offer new digital banking features to our clients. Over the past year, we launched digital portals for mortgage lending and business in consumer credit cards. Further, we're actively engaged in efforts to roll out a new digital process for small business lending to really automate that process and reduce our time from application to approval and funding. We continue to see more retail as small business clients utilizing our digital banking tools and a number of digital interactions that we have with our commercial clients has increased nearly 50% from the beginning of the year. Online account openings for both demand deposits and saving accounts are up over 30% since the beginning of the year. We are allowing the crises to impede our progress in modernizing our bank. While others are retrenching, we are moving forward and investing in our franchise. At some point, and I don't know when will be, we will get back to a normalized environment. And when we do, we believe the progress we have made to enhance our technology platform will have us well positioned to capitalize on organic and acquisition growth opportunities that will be available and enable us to further increase the value of our franchise. So with that, I'd like to open the call up to questions.

[Operator Instructions]. Today's first question comes from Jared Shaw at Wells Fargo.

Could you give an update on sort of tourism trends and how that's impacting the hospitality portfolio and your expectations for sort of the trends there in hospitality? I guess, if you know what the occupancy levels are and activity levels, that would be great, too.

All right. Well, I'll start off a little bit and Marcy can follow-up with some of it. But we've talked to some of our hospitality clients. And they're saying that people are starting to travel more. And I would say the occupancy rate right now runs from 32% all the way up to 98% in the properties. And this is people who operate a number of hotels. So it's coming back and moving in the right direction. But in some pockets, it's stronger than other markets. And Marcy has some numbers with regards to the visitations up at Yellowstone. So Marcy, why don't you go over those?

Yes. So Jared, for just the Yellowstone visitations, year-to-date, we're down about 49%, and that's starting to come back since June. And so if you remember, the parts didn't even until June 1. And so what they're seeing is June of 2019 versus June of 2020. They're only down 32%. And so in general, in Montana and South Dakota, we are seeing tourism and it isn't like it's completely cut off. And to that point, they are going to have the surges rally this year. So we think we'll continue to see some increases there as well.

Great. And then, I guess, shifting a little bit. You're talking about the digital trends. Can you -- how is the mortgage origination digital uptake? Did you see increases there in terms of digital closing, application closing?

Yes. We continue to see that grow more and more each quarter. So yes, we believe that will continue to grow.

Our next question today comes from Gordon McGuire with Stephens.

Marcy, a few questions on the salaries line and just overall expenses. I was hoping you could quantify the incentive accrual catch-up this quarter. And then could you let us know whether you had any offsetting deferred compensation related to the PPP program? And then, I guess, just broadly, what do you think a good overall expense run rate is for us to be thinking about going forward?

Okay. So I think that the incentive catch-up was around $2 million to $2.5 million this quarter. So that will come down a little bit. Health insurance costs will probably level back out a little bit. So those 2 could kind of offset each other. In terms of capitalized PPP costs, it was less than $1 million, Gordon. So we believe that the normalized run rate will be right around that $95 million rate going forward.

Great. And I do -- just on mortgage. I appreciate the color on production coming down from record levels. But is it fair to say with the digital channel fully open to refi you've kind of reset what you're capable of here. Or do you anticipate over time a more meaningful reversion to historical production levels?

Well, I would say that we'll probably get back to more of historical production level. I think the thing is -- I think we might be a little bit above what we normally used to do because of the digital channel. But I don't think it's going to -- like all of a sudden, be a whirlwind of activity. I think we're going to get more activity. But just a little more than we've seen in the past. But -- so it's going to help us, but it's not -- it's not going to be huge.

One of the challenges, Gordon, is our inventory levels. So we just don't have the inventory that's going to allow a huge uptick, even if there was demand for purchase activity over and above what we're seeing. We just don't have the inventory out there in any of our -- across the footprint.

Understood. And do those -- does the digital channel pipeline, do those come over with different pricing in terms of gain on sale margins? I noticed the growth in fees, even on a gross basis, wasn't quite commensurate with the production level increase versus first quarter.

No, it has -- pretty much has the same sale gains as in all production. The good -- the thing is, at some point in time, it might have less costs associated with the speed at which we can get these loans done. So the cost of origination could go down.

Yes. And Kevin, just a follow-up on your commentary that as of July 22, 64% of modifications had resumed normal payments. I'm curious how many of the modifications had reached the expiration of their first period. Is there another group of modifications that still hasn't come to term yet that we should think about rolling back to scheduled payments?

Well, I think the interesting thing is this is a moving target. So I -- all I can give you is the information that I gave you with one other anecdotal thing. To date, we only have $47 million that we have moved into, which is a little bit over maybe 4% of the portfolio, has moved into the second round of deferral of the modifications. So right now, we only have $47 million out of the $1.2 billion that has received the [indiscernible]. So we believe it's going to come down substantially. Everybody is kind of trying to guess what it might be in -- we're somewhere around 15%, maybe 20%, that might -- of our current balances might look for in the second round, but most of it is returning to normal payments.

And our next question today comes from Matthew Clark at Piper Sandler.

On the favorable migration in criticized loans, can you give us a sense for what drove that? How much of that was just upgrading credits and so forth?

It was just upgrading some credits. Just -- there was nothing in particular that stood out that we just kind of went through our normal processes. We had some downgrades, some upgrades and upgrades just offset the downgrades. So -- but there was no, in particular, loans that stood out in that process.

Okay. And did you guys repurchase any stock this quarter? I didn't think so, but I wasn't sure.

No.

Okay, okay. And then on the PPP loans, I assume you're using a 24-month kind of accrual or you're using something shorter. And how do you plan to use a lot of those proceeds next couple of quarters?

I think the plan, it's supposed to go into the income bottom line. But the thing is that we are amortizing fees over the 24 months. We're not taking a shorter amortization period. And as Marcy said, we deferred very few costs against those fees. So as those loans are forgiven, we will record that as income.

And our next question today comes from Jackie Bohlen with KBW.

On that same line of questioning, did you have any loans that were forgiven during the quarter?

No.

We did not.

Okay, okay. And Marcy, do you happen to have the average balance of loans in the quarter, not the average amount of each loan, but the total average PPP loan?

$943 million.

Okay. And just lastly, in terms of thinking, and I realize this is a really challenging question to answer, but just your thoughts on how you're thinking about balance sheet size, excess liquidity and deposit flows? And how you might deploy some of that excess cash going forward?

Well, we're picking our places where we can deploy it, but the investor portfolio is not giving us a lot of great opportunities. But we're picking our places. But we're surprised with the amount of liquidity that we have here. I mean we funded PPP loans, and we believe that some of the people could utilize those balances. But as you saw, our deposits were up 1 point -- I mean our deposits were up $1.8 billion, and our repo dropped almost $200 million. We just -- we had an immense amount of liquidity come in. We don't know where that's going to settle out. But we're going to try to pick our places to deploy it, but I will never turn down additional deposits. We'll continue to take them in, and we'll try to deploy them the best way we possibly can. But we don't know where it's going to settle out, but it's some amazing growth.

Okay. Yes. No, I definitely agree on that. And as you think about the deployment of liquidity, are you looking -- and understanding that some of that could fluctuate, are you looking primarily at deploying into assets? Or might there be some liability reductions you might look to do with some of that core funding?

We don't have much liability reduction to do so. Most of it will probably be in the asset deployment.

And our next question today comes from Levi Posen with D.A. Davidson.

First, I wanted to ask about how you're thinking about the pace of your continued digital investment maybe versus what your thoughts were at the beginning of this year?

I would say that all these -- the speed of which we might deliver some of the digital capabilities, I would say, is faster than we thought at the beginning of the year. I think with the PPP process, we learned a lot about what we can do and how we can utilize some technology to really enhance the delivery of, say, small business lending. So I would say that we're probably going to be ahead of what we thought we're going to be able to deliver this year based on what we learned through the pandemic.

Okay. That's helpful. One question on credit. You mentioned that there were some offsetting downgrades. And I was curious if those were loans that had modifications. Or I guess what I'm getting at is maybe the approach to the $47 million of credits that did receive second modifications, were those included in the downgrades? Or what was your approach with them?

No. Really, the downgrade is just normal operating kind of way we look at the businesses out there. So there was nothing that was really associated with those deferrals.

[Operator Instructions]. Today's next question comes from Garrett Holland with Baird.

First, on the PPP program, it's clearly helpful revenue and capital benefit as you recognize the fees. But how confident are you, you can backfill that contribution, that revenue contribution as we move into next year and the vast majority of those loans are forgiven?

I can say I'm real confident that I'm going to put on over $1 billion of loans in the next period of time. So it's going to be hard to backdoor. I look at that as kind of a windfall and we'll continue to grow off our normal levels of performance that we've seen in the past. So I would say that it's going to be hard. But we are going to have to deploy a lot of this excess liquidity, even though those loans are forgiven. So we're going to benefit from the overall environment that we're living in, I would believe. But to say that we're going to grow loans by $1 billion, I can't stay in here and say that to you. We're going to do our best. But let's see what happens.

I think the thing that we could see come back a little bit, I think, get to a more normalized environment, some of our other noninterest income areas, service charges, payment services, that kind of thing. Hopefully, things will go back to a little bit more normal environment, we'll see those pick up again.

Marcy, that was my next question. How quickly do you expect those deposit service charges to bounce back?

The basis that...

Yes. We're already seeing them bounce back some. Because, again, we had waived some fees that we've basically turned off some overdraft fees and they're back to -- they're back on again. So we're seeing higher overdraft fees. And we're beginning to see things pick up a little bit. But travel is the biggest thing with payment services, and people still aren't traveling.

But one thing about service charge, I want to tell you, it was interesting anecdotal comment I'll make for you. We're in some communities that have some gambling establishments. And some of these areas, they said that when we go out and talk to the various markets then they had pretty much 0 overdraft fees. And that's because all the casinos were closed down. So I think what happens as some of these things open up, people go back to their normal spending habits. And some of those fees would start coming back. But they pretty much said they had no overdrafts in the whole market due the fact that all the casinos were shut down.

That is interesting. And then just lastly on credit. Clearly, a very strong quarter as you look across charge-offs, NPAs, credit size. I guess, just interested in your perspective on how you see this credit cycle playing out for First Interstate. You benefit from a number of tailwinds in the footprint. But I guess just best guess on when you see kind of these peak losses start to materialize or the migration you'd expect in the portfolio. I know you're taking a hard look at everything. Just any hot spots or potential concerns out there.

No. We have not found, like I said, we're looking for the tip of that iceberg, and we're searching hard for but we haven't found one. We don't know how it's going to play out, and I'll take a quote out of Jamie Dimon. There's probably going to be losses sometime that probably come in 2021. Do I know where those losses are? No. At this point, do I expect large losses? I don't see it. I think this is a different type of credit cycle. I know everybody is worried about different things, but I'm not seeing it in our environment. So it's hard for me to sit there and say that we're very concerned about credit quality because I'm really not. I haven't seen anything. So when I find something, you will be the first one to know because I don't want to surprise you guys. But I have not found anything that is of concern to me at this juncture.

And our next question is a follow-up from Gordon McGuire with Stephens.

Marcy, I was hoping you could reconcile the $8.6 million of PPP interest income with 8 basis points of NIM dilution from PPP this quarter. If I use the average balance you gave earlier, I get an effective yield of 3.7%, which would be, I guess, accretive to NIM, unless there's some offsets there. Can you help me put to that?

Yes. It rolls into some of the cash that came in, and that impacts that adjustment as well. I have those worksheets, Gordon, let me follow back up with you and I can give you kind of the exact kind of calculation when I went through to look at that.

And ladies and gentlemen, this concludes the question-and-answer session. I'd like to turn the conference back over to the management for any final remarks.

Well, I appreciate your time, and thank you for all your questions. And as always, we welcome calls from our investors and analysts. Please reach out to us if you have any follow-up questions, and thank you for tuning in today. Goodbye.

Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day.