Financial Institutions, Inc. (FISI) Q4 2017 Earnings Report, Transcript and Summary

Good morning and welcome to the Financial Institutions, Inc. Fourth Quarter 2017 Earnings Call. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Shelly Doran, Director of Investor Relations. Please go ahead.

Good morning, and thank you for joining us for today's discussion. Providing prepared comments on the call will be President and Chief Executive Officer, Marty Birmingham; and Chief Financial Officer, Kevin Klotzbach. For the question-and-answer session, they will be joined by Chief Corporate Development Officer and General Counsel, Bill Kreienberg; and Chief Accounting Officer, Mike Grover. Today's prepared comments and Q&A will include forward-looking statements. Actual results may differ materially from forward-looking statements due to a variety of risks, uncertainties, and other factors. We refer you to yesterday's earnings release and our historical SEC filings, all available on our website, for our Safe Harbor description and a detailed discussion of the risk factors relating to forward-looking statements. We will also discuss certain non-GAAP financial measures intended to supplement, and not substitute for, comparable GAAP measures. Reconciliations of these non-GAAP financial measures to GAAP financial measures were provided in yesterday's earnings release, which was filed with the SEC yesterday as an exhibit to a Form 8-K and is available on our website. Please note that this call includes information that is accurate only as of today's date, January 30, 2018. I will now turn the call over to President and CEO, Marty Birmingham.

Thank you, Shelly, and good morning and welcome to Financial Institutions' first earnings conference call. We are very excited to host this call. And it's our hope that this and future calls will provide useful information for existing and potential shareholders and analysts; information that will help the investment community better understand our business, our strategies, and our outlook. We delivered EPS growth in the fourth quarter higher than many expected, assisted by strategies implemented as a result of the passage of the tax reform bill on December 22. In the limited window of time following passage of the Act, our team worked diligently to determine appropriate actions that were responsive to issues created by tax reform and to drive positive outcomes for our shareholders. Kevin will provide more details on this topic later in the call. In 2017, we continued to deliver solid financial results in a challenging interest rate environment. We experienced strong loan growth and solid nonpublic deposit growth during the year and continued to demonstrate diligent expense discipline. While many of you understand the fundamentals of our markets, since this is our first call, I want to briefly review our economic backdrop. Businesses in our footprint will continue to benefit from Governor Cuomo's Regional Economic Development Council initiative in 2018. In December, round seven awards were announced with more than $286 million awarded to support more than 400 projects in the Western New York, Finger Lakes, Southern Tier, and Central New York regions. Awards were granted to a wide range of projects, including the agriculture and food processing sector, expansion of the region's long-standing entrepreneurial culture, sustainability, technology, and next-generation manufacturing. We are encouraged by this process because it has brought together the government, business, college/university, and not-for-profit sectors to drive realistic economic development strategies and tactics. We believe that greater Buffalo and greater Rochester regions have an abundance of resources essential for sustainable long-term growth and development. The transformation continues, away from paternalistic manufacturing employers to a diverse array of high-tech industries, including advanced manufacturing, data science, agriculture/food, information technology, and more. We see this region as innovative, with the great benefit of a well-educated and committed workforce. Also, we are located within a day's drive of every major Northeast and Midwest market without the high cost of doing business in a large market. We also see growth opportunities in our core legacy markets. We are the number one or two bank in most of the towns and villages we serve, and there is great value in these relationships. We have and continue to see commercial opportunities and recently bolstered in our resources by reinforcing local leadership to focus on this geography. The Corning-Elmira corridor continues to be a great place to do business. Our markets are stable and our expectations for growth have been, and continue to be grounded in sustained, moderate growth. This, combined with opportunities available to us because of ongoing disruption in our markets, and the fundamental competitive advantage associated with delivering an energized, locally focused, accessible, and capable community bank platform, I am encouraged about our Company's prospects. Loans at year-end were up 5% over the previous quarter and 17% as compared to year-end 2016. Total commercial and industrial, commercial real estate, and small business loans increased 7% from September 30 and 24% from December of 2016. As we've shared previously, key hires that we've made in our commercial lending teams over the past 24 months continue to attract new customers and generate new loan business. Our pipeline did decrease from September to December 31, 2017, because of very high volume closed in the quarter. However, it is still very strong. Our expanded residential mortgage lending team is also showing promising results. In 2017, we added eight loan officers along with the underwriters, processors, and closers necessary to process their production. Residential real estate loans increased 4% in the fourth quarter. Consistent with the fundamental theme for all of our business activities, given our small market share, particularly in the Metro areas of Rochester and Buffalo, opportunities for growth remain very promising. In addition, our residential mortgage lending business is scalable, and can support additional loan officers as they become available. With the addition of most of our mortgage loan officers in the second half of 2017, we saw our pipeline in loan fundings increase. At year-end, our pipeline was indicative all of our loan officers producing at capacity, given seasonality. As a result of these factors, we expect solid increases in all aspects of our residential mortgage lending program in 2018. Consumer indirect loans were up 2% in the quarter, and volume continues to be strong in this line of business. Used car values have strengthened. However, it remains to be seen how long that will continue. Portfolio performance was consistent with expectations for the year, and our strong and stable historical performance with normal seasonal trends. We expect a decline in national new car sales in 2018, but we do not believe it will be material enough to significantly impact our market areas. We see some signs of improving pricing in our markets. However, the effects are muted by credit unions who have moved very little on pricing. We will remain diligent and disciplined to ensure that we meet our return thresholds in this business. Nonpublic deposits were 9% higher at December 31, 2016 -- as compared to the prior year at December 31, 2016, and 1% higher than September 30, 2017. We remain focused on leveraging our very attractive deposit franchise, and will continue to adapt our tactics to maximize core deposit growth. Before I turn it over to Kevin, I would like to speak for a moment about the importance of supporting the communities in which we operate. We understand that our success is directly linked to the success of our communities. And we make investments of time and money through volunteer activities, charitable investments, and product offerings. In 2017, we added a Community Development Officer to coordinate and provide strategic direction for our CRA initiatives and outreach programs across our footprint. And we also added two Community Development Loan Officers who work to increase access to loans and products such as the Federal Home Loan Bank's First Home Club program in low-to-moderate income neighborhoods. They also promote financial literacy through workshops and other educational opportunities. Recent tax reform will reduce our federal income tax rate in 2018 and all future periods, providing opportunities to strengthen relationships with our communities as well as our customers and employees. The first action we took was a one-time award of $500 to our employees not covered by certain incentive programs. More than 70% of our associates will receive this award and they will be eligible to participate in a new profit-sharing program to be based on the Company's 2018 performance. With that said, I'll now turn the call over to our Chief Financial Officer, Kevin Klotzbach, who will provide an overview of financial results and our outlook for key areas in 2018. Kevin?

Thank you, Marty. Good morning, everyone. I have a bit of a cold today so I apologize in advance for the quality of my voice. I'll start with a review of the fourth-quarter financial results. Net income was $11.1 million in the fourth quarter, $2.8 million higher than the third quarter of 2017 and $2.4 million from the -- higher than the same period one year earlier. Net interest margin was 3.25% for the quarter, up 8 basis points from the third quarter and up 3 basis points from the fourth quarter of 2016. Positively impacting the margin this quarter was about $300,000 of yield maintenance fees relating to the prepayment of mortgage-backed securities and payment deferral program fees on loans. Our yield on investment securities improved from 2.45% to 2.53%. And our loan yield increased from 4.24% to 4.29%, resulting in an average yield on interest earning assets of 3.78%, up 7 basis points from the third quarter. In spite of higher market rates, our cost of funds was lower in the quarter due to the mix of our funding sources. Our average public deposit balances, which carry a relatively low cost of funding, were higher; and balances on average short-term borrowings were lower. This favorable mix more than offset higher market rates. Our cost of funds was 53 basis points in the fourth quarter, down 1 basis point from third quarter of 2017. Savings and money market accounts were 1 basis point higher, and time deposits were up 6 basis points. Our short-term borrowing rate was up 11 basis points because these rates tend to increase in concert with the Federal Funds rate increases. There was no change in the cost of interest-bearing demand or long-term borrowings. Moving on to noninterest income, I would like to point out that a significant driver of the $250,000 increase in investment advisory fees in the quarter as compared to the third quarter was the acquisition of assets of Robshaw & Julian. This bolt-on transaction was completed at the end of August. Insurance income was down when compared to the third quarter by about $270,000. Approximately $100,000 of the decline was due to the Bank's group credit insurance program, in which dividends were received annually in the third quarter. The remainder of the decrease was primarily due to SDN income, which varies based on quarterly transaction volume and type. We continue to make progress on the evolution of SDN from an entrepreneurial agency focused primarily on commercial property and casualty to a Bank owned agency that includes a personal lines division covering -- offering auto, homeowners, and life insurance. This process has opened up the opportunity to grow the employee benefits practice. Noninterest income year-over-year, excluding securities gains and contingent consideration liability adjustment of 9 -- and a $911,000 of non-reoccurring debt benefit proceeds in 2016 was up 4%. We remain focused on expense control and we're very pleased to achieve a 59.62% efficiency ratio for the quarter and a 60.65% ratio for the year. We did experience an increase in salaries and employee benefits as a result of a full quarter's expense for our recent mortgage loan officer hires and the Robshaw & Julian team. We also saw an uptick in the benefits expense related to the high cost of specialty pharmaceuticals. I would also add that the advertisement and promotion expense increased in the quarter as we gear up for the first-quarter 2018 rebranding initiative. This is a program that has been in the works for quite some time. And we believe there will be significant opportunities for us resulting from the enhanced awareness of our brand and our capabilities across our footprint during and after the campaign. Loan loss provision in the quarter was up $1.1 million compared to third quarter and up $600,000 from the fourth quarter of last year. We experienced an uptick in charge-offs in the quarter, and the provision continued to grow as loan portfolios grew. 2016 was an exceptional asset quality year for us in terms of downgrades and charge-offs, and 2017 was a reversion back to the norm. Between 2008 and 2017, net charge-offs to average loans ranged from a low of 26 basis points in 2016 to a high of 54 basis points, resulting in a 10-year average of 39 basis points. Our 2017 net charge-offs were 38 basis points, very close to that 10-year average. During the same 10-year period, our ratio of nonperforming loans to total loans ranged from 27 basis points to 91 basis points, with 2016 again at the low end. The 2017 nonperforming loan ratio was 46 basis points, 10 basis points below the 10-year average. Income tax expense for the quarter and year was positively impacted by an estimated $2.9 million reduction due to the Tax Cuts and Jobs Act, primarily driven by a revaluation adjustment to our net deferred tax liability. We had a net deferred tax asset position on the balance sheet at the end of 2016. However, we took steps in 2017 to accelerate deductions and defer revenue for tax purposes, effectively creating a deferred tax liability at December 31, 2017. I'd now like to spend the next few minutes providing our outlook for 2018 in some key areas. We expect high-single-digit to low-double-digit growth in our total loan portfolio. We also expect commercial and residential lending to grow at a higher rate than consumer indirect. We plan for mid- to high-single-digit growth in nonpublic deposits. We anticipate a net interest margin within a range of 3.2% to 3.3%. We expect that noninterest income in 2018 will be relatively flat as compared to 2017, at or around $35 million. It is important to note that our 2018 expectation does not include any security gains, which totaled $1.3 million in 2017; nor nonrecurring items, which totaled $1.2 million in 2017. Noninterest expense is expected to be within a range of $23 million to $24 million per quarter. There will be some variability due to the timing of incentive compensation, healthcare expenses, and marketing costs. We believe the efficiency ratio will be within a range of 58% to 60% for the full year. Our goal is to be below 60% every year. In 2018, we plan to continue execution of our long-term strategy to convert a portion of our marketable securities into loans. And lastly, we expect that the effective tax rate for 2018 will be within a range of 19% to 21%. And now I'd like to turn it back to Marty.

Kevin, thank you very much. And before we open the line for questions, I do want to offer a few observations on 2017. In light of significant growth opportunities in our markets and our capital position, we took advantage of favorable market conditions and completed an equity offering. Another positive outcome of this process is reflected in our tangible capital ratio, which increased to 7.17% at year-end versus the low 6s in early 2017. Increased levels of capital support our long-term strategy of transitioning low-yield, low risk-weighted marketable securities into higher-yielding, higher risk-weighted loans. We expanded our residential mortgage lending platform, which will lead to growth in this line of business where we have plenty of balance sheet capacity. This is also a business grounded in loan and deposit relationships, with the opportunity to cross-sell wealth management services and insurance. We added a wealth management business bolt-on to Courier Capital subsidiary, boosting noninterest income. Our commercial lending teams continue to be very energized and focused on new business. And we added professionals to our credit delivery team to further support our disciplined credit culture during this time of strong loan growth. We opened a new financial solution center in downtown Buffalo, expanding our presence in this important growth market. And lastly, we relocated our Rochester regional administrative center to downtown. Our commitment to lease 2.5 floors, plus a new branch, has increased our presence and visibility in this key market, especially given the branding and signage rights obtained. 14-foot-tall letters, comprising Five Star Bank signs -- illuminated signs are located on all four sides at the top of this 20-story building, visible from major expressways and airport landing patterns, and lighting the sky over downtown Rochester. Overall, it was a terrific year for us, and we made progress on our strategic goals and initiatives while building a foundation for future growth. I look forward with excitement to all the opportunities and possibilities that 2018 has in store for us. And at this point, operator, this concludes our prepared remarks, and we are now ready to open the line for questions.

[Operator Instructions]. The first question comes from Joe Fenech of Hovde Group. Please go ahead.

I have a few questions. First on the loan growth, guys, it was obviously really strong last year at 17%. I appreciate the guidance, Kevin, for the loan growth for high-single-digit to low-double-digit growth for this year. My question, though, is that's sort of been your guidance for a while now, and you guys have significantly exceeded that. So do you feel it's just prudent to be more conservative on the guidance? Or are there specific reasons why you think the loan growth might slow from 2017?

Joe, I think as we've talked -- this is Marty speaking -- we have benefited from disruption that we've described to the market in terms of large banks coming together in strategic combinations, creating an opportunity for smaller banks. And we did benefit; the first wave of disruption translated, for us, in the form of attracting strong talent. And in 2017, that was our first full year of the talent that we've attracted, the commercial loan officers specifically having an impact in our performance. So we do think that they did benefit from quick opportunities coming their way, and that the growth rate in our commercial will moderate as we go forward; and these opportunities have been cycled through to business at the bank.

Okay, that's helpful. And then Marty, just switching gears for a second. Can you update us on the M&A strategy? The past few deals, you have looked to bolster fee income. Is that where you want to stay focused in terms of M&A? Or would you all consider a traditional whole bank M&A deal? And if so, what would be some of your rough parameters there in terms of geography, size, and pricing considerations?

Joe, we have worked very hard to document our plans and strategies in the form of a very comprehensive and realistic strategic plan that's grounded in the opportunities in our marketplace and the capabilities of our team. And we process opportunities, strategic and otherwise, as they come through the funnel of our plan and the priorities that we have identified -- the goals and the initiatives and priorities. That being said, we've been focused on driving organic -- converting organic growth opportunities because those are the ones that are right in front of us, right in front of us in our front door, so to speak, in the geographic footprint we're operating in. And they end up being more in our control; and we think, over the long-term, less risk for our shareholders. To the extent that strategic opportunities surface relative to either whole bank or consistent with our fee-based business activities, we're open to those. And we would take a look at those and act accordingly.

Okay, that's helpful.

Joe, as you know, whole bank acquisition in upstate New York has been very, very modest over the last 10 years. And this is why we're -- I answered the question the way I did.

Got you. And in terms of the overall margin, it's been very steady. Last year, at this time, you guys were sitting with a sub-80% loan to deposit ratio, and now you are 85%. The investment portfolio also was basically flat year-over-year, so you've been shifting the mix on the earning asset side, as you said you would do. Does that remain the playbook for this year, generally speaking? Continue to get more loaned up, and maybe to continue to get that positive shift in the mix of earning assets in terms of loan versus securities, and that maybe helps you to keep that -- is that's sort of what embedded, Kevin, in the margin guidance you gave?

You're absolutely right. The shift in mix is occurring as we have held historically, over the last couple years, the securities portfolio constant, and we've increased our loan portfolio. I would say in 2018 that there will be an emphasis towards not reinvesting in the securities portfolio. So we'll actually see a little bit more dramatic decline in the securities portfolio. We will continue to produce loans, hopefully, at or about the levels we indicated.

And do you have a rough target, longer-term, Kevin, in terms of where we see securities bottom out as a percentage of the earning asset base?

We do not have a specific target, although I would say that it is significantly lower than where we are today.

Got you. Okay. And then, guys, you had some significant investment spend over the last few years in terms of people, infrastructure, technology. You talked about that in your opening comments. How does that look in terms of big picture for 2018? Anything on the horizon in terms of meaningful investment spend, or does that slow down a bit this year relative to the past few years?

Relative to the past few years, I would suggest that it should be moderating, Joe. It's part of our relocation of the administrative center in Rochester. A significant part of that investment really represented bolstering and enhancing the capability of our IT and redundancy to support the stability of our IT function. And from a personnel perspective, to the extent there are opportunistic hires, as I said, strategically we would consider those. But, overall, I would suggest that incremental investment should be moderating in 2018, and play it forward from there.

Okay. And then last one for me. Marty, you opened the call with comments about the investment by the state and how positive that has been. Banks in your market are growing well. How would you say, in general, underwriting standards are holding up? Are you seeing competitors starting to stretch at all during these good times? Or are underwriting standards, for the most part, holding up in the markets that you operate in?

My observation is that underwriting standards continue to hold up. Part of the reason that we haven't seen a lot of M&A in upstate New York over the last 10 years is the fact that the market has generally been pretty conservative from an underwriting perspective. Because the economy doesn't have the tendency to have boom/bust cycles of significant growth followed by curtailment in growth, our bank -- the approach of the banking industry has been relatively conservative and grounded in reality of slow to moderate growth and stable underwriting approach.

The next question comes from Alex Twerdahl of Sandler O'Neill. Please go ahead.

First off, I was just wondering if you could update us on any initiatives you have to grow deposits right now. And maybe talk a little bit in that NIM guidance that you provided, Kevin, what you are assuming for deposit costs throughout 2018.

One of the things, Alex, that we did comment on, in Kevin's comments, relative to the guidance and our expenses for the year includes increased branding and marketing. And we've worked hard to evolve our platform from one that was exclusively tied to a strong community bank to one that includes a very strong and capable community bank supplemented by our ability to provide insurance and wealth management insurance services. So we are doing some incremental activities to support branding and awareness to drive opportunities across our product offering and capabilities. So beyond that, Kevin?

On the NIM, Alex, a couple things. One is you could see it in the prepared remarks today that the oscillation between heavier periods of time of public deposits and correspondingly lower overnight borrowings has one dynamic on the margin. Obviously lower cost, better margin. And we cycle through that twice a year, as you probably recall. With respect to the guidance, what we've seen thus far in the correlation between our cost of funds pressure on retail deposits, in particular, and rising interest rates has been relatively modest. We expect that to pick up a little bit. And we have embedded some of that into our projections as we go forward into 2018.

Okay, great. And then just a little bit more color on the expense guidance that you gave, Kevin, $23 million to $24 million; that's great for the full year. But can you just remind us, some of the moving parts, quarter-to-quarter? Specifically the $500 awards, is that -- will that all hit in the first quarter of 2018? And then I know that you guys self-insure, so benefits are a little bit elevated in the back half of the year. Can you just maybe give us a little bit more of the quarter-to-quarter expectations for expenses?

You're absolutely right with respect to the medical benefits. They do tend to be fourth-quarter-heavy, and we saw that again this year -- or last year, 2017. We haven't specifically identified the rollout of the second half of our program for the employees. So I can't tell you when that -- what quarter that might occur in. But the first portion of that occurred in the first quarter, or will occur in the first quarter.

Okay, great. And then just a final question, maybe a little bit more color. You had a little bit of a rare blip in C&I charge-offs during the quarter. Is there anything to that?

These are what we have talked to you about in the previous quarters. We've actually worked through resolution, and these were the final actions to put that through our process. So, one was a larger credit, and then we had a smaller credit, and they cycled through. Thematically, I don't -- we continue to see the portfolio performing in a very strong way, consistent with our historic performance.

The next question comes from Damon DelMonte of KBW. Please go ahead.

So my first question, just kind of dealing with the loan loss provision. Kevin, could you put a little guidance around the expectations for that? Should we expect something a little bit higher than this year because of the sustained loan growth? Or do you think something similar to this level is -- last year's level is a reasonable run rate?

We talked quite a bit about the fact that 2016 was an outlier with respect to credit performance, and 2017 was a reversion to the norm. We expect that we'll stay within that norm that we talked about in the prepared remarks. We also expect that those percentages will be applied to a higher base; and then, therefore, we'll see higher provisioning and higher total credit losses.

Got you, okay. All right, that's helpful. And then with regards to the public deposit balances that you guys have, could you remind us what the total amount of public deposits are?

Rough number, about $900 million. It oscillates up and down between $150 million between peak and trough. We got close to $1 billion this year. At one point, I think we capped out very close to $1 billion, just under it. And it drops down about $150 million at the other end of the cycles.

And how much of that is actual operational accounts with the municipalities or the towns and villages versus the bid relationships?

Approximately $60 million to $80 million ends up being a bid type product, versus the remainder is not typically bid.

Okay. All right, that's helpful. And then I guess as my last question, and you guys may have touched on this, but the whole rebranding campaign that's going on right now, is that more or less just like a -- from a marketing perspective and the relocation of some of the operations? Or is there something more material that's happening with this?

As I mentioned and you've observed, we've been executing against our plan and enhancing our overall operating model. And so we've had a very strong Five Star Bank community bank platform that we've been taking advantage of and driving forward, bringing it to new markets where we're not as well known. As well, we've supplemented our model through insurance and wealth management services that our existing customer base doesn't have a strong command that we're in that business. And obviously in the new markets, it's totally new. So we are taking advantage of the opportunity to brand and market the Company in a way that connects all those very important dots. And obviously increased market recognition in Rochester and Buffalo is very consistent with the themes that we've been trying to go after in terms of a $31 billion deposit market, as measured by the FDIC numbers, where we have very modest market share, less than 4%.

The next question comes from Matthew Breese of Piper Jaffray. Please go ahead.

Just touching on the mix shift a little bit more, given the size of your municipal deposit book, does that limit the extent to which you can shrink the securities portfolio? And then as a follow-up, if it doesn't, are you seeing more success on the MULOC product, allowing you to use those municipal deposits into loans?

To answer the second part first, we are seeing more customers embracing the MULOC option. And I don't believe in the -- over the course of this year or next that the pledging requirements for municipal deposit will inhibit our ability to decrease the loan security portfolio.

Okay. And to what extent do you think you can shrink the security portfolio, then?

As I mentioned earlier, we don't have a target right now. We do believe it is significantly lower than where it currently is. And a good majority of the securities that mature in 2018 will not be reinvested into securities.

Okay. And then just thinking about the shape of the yield curve, obviously a sizable backup in the five and the 10 year. Just curious where you've been able to pass that on in terms of products; and, conversely, where some of those increased yields have been competed away.

We haven't really seen as lockstepped of an increase in the loan yields, or the loan rates that we're able to achieve with the steepening of the yield curve yet. And I'll point out to you, for example, the 30-year fixed rate mortgage, which we don't put a lot on the books but I think is a classic example that everybody watches. The 10-year, as you know, is backed up to 2.70%. And we haven't really seen the 30-year fixed rate mortgage pop through 4%. So that would be one example where the correlation seems to be lagging a little bit. And what I've sensed so far is we're getting a little bit of yield compression or we're getting a little bit of tightening to the curve relative to loans, and obviously the Treasury curve. So, more to come on that. I think we'll see a little bit more correlation as we go forward.

Got it, okay. And then just sticking on the resi book, can you just give us a sense of your secondary mortgage capabilities, and to what extent that might contribute to the $35 million noninterest income next year -- or this year?

As you know, we developed our residential mortgage production capability substantially last year. We added eight MLOs. We've also hired a professional executive to manage our pipeline and to do the secondary market activities. We're in the midst of developing a complete suite of sale opportunities, whether that be private transactions and/or government programs. So we're well into it, but it will be more developed later in the year.

This concludes our question-and-answer session. I would like to turn the conference back over to Marty Birmingham, President and Chief Executive Officer, for any closing remarks.

Well operator, thank you very much for your assistance this morning. I want to thank all the participants and the opportunity we had to talk about our fourth quarter, as well as outlook on key parts of our business as we go forward in 2018. We'll look forward to continue to build on this dialogue in the next several quarters. Thank you very much.

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