Financial Institutions, Inc. (FISI) Q2 2018 Earnings Report, Transcript and Summary

Good day, and welcome to the Financial Institutions Incorporated Second Quarter 2018 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Shelly Doran, Director of Investor Relations. Please go ahead.

Good morning, and thank you for joining us today 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, 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 Web site for our Safe Harbor description and a detailed discussion of the risk factors relating to forward-looking statements. We'll also discuss certain non-GAAP financial measures intended to supplement and not substitute for comparable GAAP measures. Reconciliations of these non-GAAP measures to GAAP financial measures were provided in yesterday's earnings release, which was filed with the SEC yesterday as an exhibit to our Form 8-K. Please note that this call includes information that's accurate only as of today's date, July 27, 2018. I'll now turn the call over to President and CEO, Marty Birmingham.

Thank you, Shelly. Good morning, and once again, welcome to Financial Institutions' second quarter earnings conference call. We do appreciate your participation. The company's performance in the second quarter was strong, and I'm very pleased with our results. We continued to execute our strategic initiatives and remained focused on delivering strong returns for our shareholders. Total loans at quarter end were up 4% over the previous quarter and up 15% as compared to the prior year. We continue to be pleased with all categories of loan growth and anticipated sustainability. Total C&I, CRE and small business loans increased 7% from March 31 and 22% from June 30, 2017. Both the C&I and CRE pipelines grew in the quarter. The personnel additions we made last year and early this year in our residential mortgage loan business are generating strong growth in this line of business. Residential loans were up 3% from the first quarter and up 13% from the prior year period. Our consumer indirect auto loan portfolio increased by only about 1% during the quarter. We continued to see upward rate movement in this business and expect that trend to continue. Portfolio quality remained strong as evidenced by delinquency levels well below industry averages and net charge-offs near the low end of our historical experience. Total deposits were $118 million lower than March 31 because of seasonality of our municipal business. Total deposits were $130 million higher than June 30, 2017, due to successful efforts in our municipal and retail banking business activities. Non-public deposits were 5% higher than 1 year ago and 1% higher than March 31. As a strategic organization, we are continually reviewing initiatives to leverage our very attractive deposit franchise and maximize core deposit growth. We remain focused on expense control as evidenced by an efficiency ratio of 60.14% in the quarter. Our quarterly return on average assets was 1.18% and return on average equity was 12.7%. As noted in yesterday's press release, our provision for loan losses was very low in the quarter due to a combination of factors influencing the allowance. Kevin will provide additional information regarding the allowance and provisions in his comments. We also demonstrated the continued commitment to our long-term strategy of diversifying income, with the second quarter acquisition of HNP Capital, a Rochester-based investment advisory firm. The acquisition filled a gap in our wealth management business by providing coverage of the Rochester MSA and beyond, complementing Courier Capitals coverage of Buffalo and the western portion of our operating footprint. Courier Capital and HNP combined have over $2 billion of assets under management. I'll now turn the call over to Kevin Klotzbach, our CFO, who will provide an overview of financial results and our outlook for key areas for the remainder of the year.

Thank you, Marty. Good morning, everyone. I'll begin with a review of our financial results. Net income was $12.2 million in the quarter, $5.9 million or 95% higher than the second quarter of 2017. The most significant contributors to this increase were the provision, which was $3.8 million on a pretax basis in the second quarter of 2017 as compared to $40,000 in the current quarter. The provision was negatively impacted in the prior year due to a downgrade of one commercial credit relationship, increasing the allowance by approximately $925,000. In the current quarter, the provision was very low because of a combination of factors. These factors include a lower level of historical net charge-offs; an increase in the value of collateral associated with impaired loans; and improved qualitative factors that include, but are not limited to, national, local economic trends and conditions, the regulatory environment, and levels and trends in delinquency in non-accruing loans. Second, net interest income was $2.7 million higher in the quarter due to organic loan growth. The third contributing factor was the lower effective tax rate. Net income was $2.9 million higher than the first quarter of 2018. This increase is primarily attributable to a well provision and a lower salaries and employee benefits expense. Net interest margin for the quarter was 3.17%, down 2 basis points from the first quarter of 2018. Our average loan yield increased 7 basis points, contributing to an average loan yield on interest earning assets of 3.88%, up 8 basis points. Our cost of funds was 71 basis points, up 10 basis points from the first quarter of 2018. Savings and money market accounts were up 8 basis points, time deposits were 16 basis points higher, and our average short-term borrowing rate was 33 basis points higher. We continue our efforts to convert a portion of our marketable securities portfolio into loans during the quarter. Our securities portfolio decreased by $45 million primarily due to maturities and payments received on municipal bonds and mortgage-backed securities. These proceeds were used partially to fund loan growth. Non-interest income was $435,000 lower in the first quarter of 2018. This is largely the result of $568,000 of income from investments in limited partnerships recognized in the first quarter as compared to just $123,000 in the current quarter. Income from these investments is difficult to predict, as it fluctuates based on the maturity and performance of underlying investments. Investment advisory income was up $133,000 from the first quarter, driven primarily by the June 1 acquisition of HNP Capital. Insurance income was down $381,000 as compared to the first quarter of 2018, largely because of seasonality. The first and third quarters of our insurance income continue to be higher than the second and fourth quarter because of annual contingent commission revenues and the timing of commissions and commercial accounts. As we mentioned last quarter, as SDN transitioned its book of business to a higher composition of personal alliance, we will experience lower seasonality in this income category. Also contributing to this decline were non-renewal in one agency specialty lines of business. The impact of the non-renewal was partially offset by new commercial business. Moving on to expenses. Salary and employee benefits expense was down $558,000 compared to the previous quarter, primarily as the result of approximately $1 million of first quarter non-recurring expenses partially offsetting this was higher compensation expenses related to organic growth initiatives. Advertising and promotion expense was $256,000 lower in the quarter as compared to the first quarter of 2018. As you will recall that in February, we launched a new brand campaign to increase awareness of the depth of our services we offer in banking, wealth management and insurance and the increased awareness of Five Star Bank in our key urban growth markets. The first quarter campaign launch resulted in an increase in expenses over historical level. This expense line item will continue to fluctuate because of timing of certain aspects of the campaign. The high level of anticipated expense for the balance of the year is incorporated into our operating expense guidance. Our credit metrics are very good as a result of the disciplined credit cultural Five Star Bank. Second quarter charge-offs annualized were just 24 basis points. 15 basis points lower than our 10-year average of 39 basis points. By comparison, net charge-offs were 30 basis points in the first quarter of 2018 and 29 basis points in the second quarter of 2017. Our ratio of non-performing loans to total loans was 34 basis points as of June 30 as compared to 38 basis points at March 31 and 50 basis points at June 30 of 2017. The effective tax rate was 19.7% in the second quarter. And as you may recall, 19.6% in the first quarter, reflecting the lower corporate federal tax rate attributable to the Tax Cuts and Jobs Act. I'd now like to provide our updated outlook for the full year in some key areas. We continue to expect high single digit to low double-digit loan growth in our portfolios for 2018, with growth in commercial and residential mortgage lending at a higher rate than our consumer indirect. We continue to plan for mid- to high single-digit growth in non-public deposits. We currently expect net interest margin for the full year to fall within a range of 3.15% to 3.25%. We currently expect the non-interest income in 2018 will be within a range of $35 million to $36 million, relatively flat as compared to 2017. However, keep in mind that this outlook does not include any security gains nor any non-recurring items, which totaled $2.5 million in 2017. We expect non-interest expense for the third and fourth quarters to be within a range of $24 million to $25 million per quarter. We believe the efficiency ratio for the entire year will be within a range of 59% to 60%. Our goal is to keep the efficiency ratio below 60% every year. We expect to continue to convert a portion of our marketable securities portfolio into loans and we currently expect the total 2018 conversion to be between $140 million and $180 million. And we continue to expect our effective tax rate for 2018 to be in the range of 19% to 21%. With that said, I'd like to now turn it back to Marty.

Kevin, thank you very much. And before we move to our questions portion of this call, I want to provide a few updates on key strategic topics. First, an update on our branding program. This is a 3-year campaign and the first phase is focused on increasing awareness of our brand and our offerings. As we increase awareness with consumers and businesses, we will be included in their consideration set when they're choosing their financial partner. The lead metrics for measuring impact at this point are based on website access and early indications are incredibly positive. For March through June of 2018 versus the same period in 2017, total users are up 39%, new users are up 43%, number of sessions is up 21% and mobile users have increased by 170%. And while it is too early in the process to evaluate success based on revenue impact, we have seen some impressive numbers in new accounts. For March through June 2018 versus the same period in 2017, total new checking accounts, representing consumer and commercial combined, increased 18% and new to bank customers with the checking account increased 10%. Anecdotally, I can tell you that I have been receiving a great deal of positive feedback from friends and colleagues about our marketing campaign. I believe it is making a difference. We'd also like to let you know that we recently published our first community report. It is posted on the Five Star Bank website under the About tab. As Five Star bankers, we are very proud of the many ways we invest in the success of our communities through our programs, products and services. I encourage you to take a few minutes to read our Inaugural Community Report to better understand the many ways that our bank and our associates are contributing to the positive outlook for our communities. At Five Star Bank, we recognize that positive actions can have a significant impact on the lives of our neighbors and we are proud of the ways we are able to help. We are also committed to supporting our associates. We understand that the most vital part of our past, current and future success is the Five Star family, comprised of all the employees of Five Star Bank, SDN, Courier Capital and HNP Capital. We work as a team in welcoming environment of trust, integrity and respect and have established a five-star experienced cultural framework to support employee engagement. We conduct surveys every 6 months to measure engagement and we just wrapped up our most recent survey. Metrics are trending upward, however, we still have room for improvement. We continue to use survey results and employ responses to identify ways to improve employee engagement so that we can deliver on our promise to put our customers' financial well-being at the heart of everything we do. With that said, I believe we are now ready to proceed to question-and-answer section of the call. So Michelle, can you please open up the lines for questions?

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

Good morning all.

Good morning, Joe.

Good morning.

Guys, you've done a real nice job in the transition of the balance sheet. I think investments are now down to less than 19% of earning assets compared to just over 22% a year ago. Can you update us on your ultimate target of where you'd like to see that go? And how that's likely to maybe play out over the next few quarters?

Yes. So we have a 2-year old time horizon on that. We're looking at, as our guidance would indicate, $140 million to $180 million in this calendar year. We're significantly through that -- more than halfway through that number at this point. We also have a targeted number in mind for next year that we haven't discussed yet. We think the portfolio needs probably stabilize somewhere between $700 million and $800 million of total securities. So we'll have to look at it more closely as we get closer to that -- those targets.

Okay, that's helpful, Kevin, thanks. And then similar question on the loan portfolio. I know you haven't deliberately looked to shrink the indirect auto book. The transitions just sort of happened naturally with commercial loans growing at a faster pace. Not that you necessarily have a specific target there, it's just dependent partly, I guess, some of the markets we want to bear, but ultimately, a similar question, where would you like to see the loan composition settle out in rough terms, given what the outlook you've got in front of you that you're looking at?

So Joe, we have -- you're right, that's exactly what is happening, organically. As we have emphasized our commercial activities as well as our residential lending activities, that -- the growth rate of those respective activities has been more robust than our indirect and that percentages of our portfolio will continue to slow down as others slowed up.

Joe, this is Bill Kreienberg. Strategically, as a Community Bank, we see the value of a full relationship with the customer. Commercial gives us a greater opportunity for deposit acquisition cross-selling to our fee-based businesses. So we're taking advantage of the market right now and we have a pretty good focus on commercial.

Okay, thanks. And then, guys, there was an article on The Buffalo News in late May about this Buffalo-Rochester area fraud situation. There were few banks mentioned, yours was not one of them. Can you comment as to whether or not you have any exposures to that situation?

Joe, this is Bill again. We don't typically disclose customer information about whether we have or have not made loans to individuals or companies. We're of course aware of the events surrounding the borrowers that you've mentioned. We monitor that as well as all regional and economic news and trends so that we can make good credit decisions.

Okay. And then, I guess, lastly for me. Can you guys talk about the pace of hiring so far this year? Where you've added people and how many? And compare that to the hiring pace that we saw last year when you were pretty active. I know you brought on a team here fairly recently. And if you can also comment on the state of that dislocation opportunity that we've seen in your markets from the merger activity, the key First Niagara transaction over these past couple of years.

I think the pace of hiring or recruitment to the company has slowed to year-over-year comparison. We're very excited by the new talent that has joined our team that's helping us drive the company forward. Selectively, where there's opportunities, we're always looking for good people across every function in the company, driving the front side as well as helping us support the operational integrity at the backside, Joe. But this concept of dislocation in the market and disruption continues to play out and we've talked about that in the form of a first wave when the strategic combination of First Bank and KeyBanc was announced and ultimately happened. And then a second wave, as both customers and associates impacted by that strategic combination, we considered after having spent a year or so in that combined organization and taking advantage of the attractiveness of the employment opportunity we present. But as we go forward, I think our opportunity continue to leverage our accessible responsive community, highly effective and functioning community banking platform will continue to drive competitive advantage for us as we go forward.

Okay. And then how about on the whole bank M&A front? I know there hasn't been much activity in your markets, whether conversations are perking up at all in light of this general pickup in M&A industry-wide or within your markets or just outside?

So within our markets, we're aware of, there's good operators of our Community Bank competition. And our perspective is that everybody is keeping their head down and taking advantage of these opportunities that are in front of them from driving their business forward. We continue to be good listeners and as well we're continuing to build relationships across the board. But M&A continues to be pretty quiet in upstate New York.

Okay. Thank you guys. That's it from me.

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

Good morning guys. How are you doing today?

Good morning, Damon. Great.

Good morning, great. So my first question, I'm just wondering if you guys can give a little bit of color on the pricing dynamics with deposits across your marketplace. The guidance for the margin from this point, for the most part, it's a little bit higher than where it was this last quarter. I think Kevin, I think you said 3.15% to 3.25%. So I'm just kind of wondering what are you seeing in the way of the deposit side of the margin component?

Yes. So we're seeing some more aggressive CDs specials being offered in our market space, no doubt about that. And there is some pressure on the cost of funds as evidenced by our reports. We've also seen a flattening of the yield curve, which, although we thought there would be a flattening of the yield curve, we weren't quite sure would be this dramatic. I mean, if you look at the 2s to 10s, it got down to 25 basis points a couple of weeks ago. So there's pressure there on the margin as well. But the fact to your question about the cost of funds, selective CD pricing, there's some pressure for -- in the market space for that money.

Okay. And then, obviously, this quarter, there's a very minimal provision, which is a big change from kind of what we've seen in the last 4, 5, 6 quarters or so. So how do we kind of think about the provision while we're going forward? Was this something you did this quarter and assessing your provision that resulted in such a low provision or could you provide a little color around your outlook for that?

Sure. So with respect to the current quarter, the provision has become very formulaic-driven. And all the components of the formula were very favorable, including the items that I talked about, the economic trends, the credit losses that we experienced and the recognition of credits within the commercial loan portfolio. So they were all very favorable. And because it is so formulaic in nature, it drove an outcome, which was unusually low, admittedly. With respect to provision, we don't give guidance, quite frankly. But I would just -- I'll refer you to the previous 8 to 12 quarters where our provision toggled between approximately $2.8 million and $3.8 million.

Okay. Fair enough. Okay, that's all I had for now. Thank you.

Thank you, Damon.

[Operator Instructions] The next question comes from Michael Breese of Piper Jaffray. Please go ahead.

Close enough. Good morning, guys.

Good morning.

Hi, Matt.

Hi, Matt.

I wanted to talk about the fee income guidance for the whole year flat from 2017. I guess, I was surprised by that given the acquisition of HNP, which look like it had a nice positive impact this quarter. And so I was curious, one, how should we see that investment advisory line trend for the remainder of the year? And then, two, what are the offsetting factors that would keep things flat?

So it -- if you adjust for last year's non-recurring items, it's really not flat. We had security gains and we had a contingent liability reversal that added up to about $2.7 million in total. So we're not likely to experience those same events this year. So it's -- on an adjusted basis, I wouldn't look at it being flat. HNP joined us on June 1. So -- and it was an organization that has $344 million under management and -- so relatively small compared to Courier Capital, but nonetheless, it does drive some income. But again, we're halfway through the year before the acquisition acquire -- was made. So the amount of time that they're contributing to the fee income is far less than, obviously, in annualized amount.

Okay. All right, understood. And then going back to the margin following on Damon's question. Certainly, it seems like there's more upside than downside in your guidance. Is that driven primarily by the mix shift? Is there enough in that -- in the mix shift to drive expansion in the back half of year? And is that supported by maybe your month of June, March and could you share that with us?

Yes. So we don't talk about monthly results in any of our analysis, but I'll give you those. We did adjust the guidance down 5 basis points as a result of the pure mathematics of the fact that the first quarter was 3.19%; the second quarter was 3.17%. The mix shift from securities to loans is clearly helping. But at the same time, we have above $400 million of federal home loan bank borrowings. The pay down on that is 1% in the second quarter; it actually exceeded 1% because of the timing of it. But nonetheless, it's 1% in nature. And because of our ability and advantage to originate more loans and particular commercial loans at this time that balance has been a little bit higher than we originally anticipated, which puts pressure on the margin.

Okay. And that 3.15% to 3.25%, that's for the full year, that's not for the back half of the year, accurate?

That's correct. That's for full year, including -- that would include the 3.19% and the 3.17%. That's correct.

Understood. Okay. All right. I will leave it there. Thank you.

Thanks Matt.

The next question comes from Stan Westhoff of Walthausen & Company. Please go ahead.

Good morning, everyone.

Good morning.

I just wanted to touch back on this loan loss provision or essentially there -- lack thereof. You called out the net charge-offs have been historically low, but you kind of put up the net charge-off number of that's been kind of in that range of what you've been putting up for the past year or so. Can you try to break down that really more what was really driving that favorable loan loss provision that you've had here?

This is Mike Grover, Chief Accounting Officer. So as we indicated in the press release, there's really three things. In addition to the net charge-off experience, we saw an increase in collateral values supporting our impaired loans and then also some improvement in qualitative factors.

Okay. I mean, the qualitative factors is kind of subjective. And then getting into the collateral aspect, did you get updated assessments on properties, what was driving that?

Yes, we did.

And they were just done this quarter, so they're very fresh?

Correct.

Okay. And going back to that net charge-offs, I mean, it seems a little odd. They said you've put up net charge-offs in that 25 to 30 basis point range on an annualized basis. But then you've commented that they're historically low and they never really change much.

Well, as we look at it for the last 10 years, our net charge-offs to average loans have ranged from 26 basis points in 2016. That was our low mark and our high mark of 54 basis points in that period. Our average over that period has been around 39 basis points. And so I think that's the context for the remarks we've made.

Okay. Thank you very much.

This concludes our question-and-answer session. I would like to turn the conference back over to Martin Birmingham for any closing remarks.

Michelle, thank you very much. I want to thank everyone for their participation this morning. We will look forward to continuing the conversation at the conclusion of the third quarter. Thank you.

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