Financial Institutions, Inc. (FISI) Q2 2019 Earnings Report, Transcript and Summary

Good morning, and welcome to the Financial Institutions, Inc. Second Quarter 2019 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. Shelly, please proceed.

Thank you for joining us for today's call. Providing prepared comments will be President and Chief Executive Officer, Martin Birmingham; and Chief Financial Officer, Justin Bigham. During the question-and-answer portion of the call, they will be joined by Chief Banking and Revenue Officer, Bill Kreienberg; and Director of Financial Planning and Analysis, 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 historical SEC filings, which are available on our website for a 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 for these non-GAAP financial measures to GAAP financial measures were provided in the earnings release, which was filed as an exhibit to the Form 8-K. Please note that this call includes information that is accurate only as of today's date, July 30, 2019.I'll now turn the call over to Marty.

Thank you very much, Shelly. Good morning to those participating this morning, and welcome to our second quarter earnings call. It was another strong quarter for our company with net income of $11.4 million or $0.69 per share. Pre-tax pre-provision income was $16.7 million, 6.1% higher than the first quarter of 2019 and 9.9% higher than the second quarter of 2018. This represents the highest pre-tax pre-provision income in our company's history for the second quarter in a row.We continued to execute our long-term strategy to achieve sustained incremental earnings, and I'll briefly summarize a few of the measures most relevant to executing our strategy.Our critical relationship-based commercial and residential loan portfolios experienced strong growth in the quarter. Consumer business loans grew 7.4%., Commercial Mortgage loans increased 1.7%, and residential real estate loans were up 2.1%. In contrast, the Consumer Indirect portfolio decreased by $27 million or 3% during the quarter. And at quarter end, it comprised 27.8% of our total loan portfolio, down from 31.2% 1 year ago.We continue to maintain pricing discipline in our indirect line of business, resulting in lower production. In addition, we took advantage of a strategic opportunity and sold a small pool of $21 million in indirect loans, generating a $143,000 gain.Total deposits at quarter end were $37 million lower than the end of the first quarter and $210 million higher than the year earlier period. The decrease from March 31, 2019 was the result of an $86 million decrease in public deposits due to the seasonality of municipal deposits partially offset by a $49 million increase in nonpublic deposits.The increase from June 30, 2018 was the result of a $27 million increase in public deposits combined with a $183 million increase in non-public deposits largely as a result of successful business development efforts.Our net interest margin increased by 4 basis points compared to the first quarter of 2019 driven by our balance sheet strategy to redeploy investment securities into loans. The increase compared with the second quarter of 2018 was 12 basis points. We continue to manage expenses in the quarter as reflected by our improved efficiency ratio of 59.79% compared to 60.99% in the first quarter of 2019 and 60.14% in the year-earlier quarter. Another positive outcome for the quarter was a strong increase in our TCE ratio. TCE increased 32 basis points in the quarter to 7.77%, this is the highest TCE for our company since December of 2011.I'll now turn our call over to our CFO, Justin Bigham, who will provide additional details on results as well as current outlook for the remainder of 2019.

Thanks very much, Marty. Good morning, everyone. I'll begin by providing commentary on a few key items with comparisons to the first quarter of 2019. Net interest income was $32.5 million, up $672,000 from the linked quarter. The increase was driven by growth in average loan balances and net interest margin combined with the impact of one additional interest accrual day in the current quarter.Net interest margin for the quarter was 3.28%, up 4 basis points from the linked quarter. Margin expansion was primarily driven by a continued improvement in our interest-earning asset mix. Our average yield on loans was 4.82% in the current quarter, up 5 basis points from the first quarter.The average yield on interest-earning assets was 4.29%, an increase of 6 basis points from the linked quarter. Our cost of funds increased 2 basis points as compared to the first quarter, which is up to 101 basis points. Total loans increased by 1.4% from the end of the first quarter as a result of growth in commercial and residential lending partially offset by the decrease in Consumer Indirect, as Marty referenced.Provision was $2.4 million in the quarter, up $1.2 million from the first quarter, yet still lower than our historical experience. Net charge-offs remained low at $1.2 million, $533,000 lower than the first quarter of 2019. Net charge-offs to total average loans of 16 basis points was our lowest quarterly level in more than a decade.Nonperforming loans increased by $5.7 million in the quarter because of the downgrade of one commercial credit relationship. Allowance for loan losses to total loans was 1.09% at quarter end, up 2 basis points from last quarter, and the allowance from loan losses was 300% of nonperforming loans compared to 574% at the end of the first quarter.Noninterest income was up slightly in the quarter at $9.2 million compared to $9.1 million in the linked quarter. ATM and debit card charges were $296,000 higher primarily due to higher levels of consumer activity. The net gain on sale of loans was up $225,000 because of the previously described sale of a small pool of indirect loans combined with higher gains on sale of mortgage loans.Insurance income was $506,000 lower than the first quarter due to the seasonality of this line of business. Noninterest expense in the first quarter was $25.0 million, relatively flat as compared to the first quarter.Salaries and employee benefits expense was down $752,000 from the first quarter primarily due to favorable health claims in the second quarter and higher payroll taxes incurred in the first quarter.Advertising and promotions expense was up $566,000 from the linked quarter due to timing related to the bank's branding campaign. As we stated on the first quarter call, the timing of advertising and promotions expense will vary quarter-to-quarter. A continued focus on efficiency drove quarterly operating leverage year-over-year.I'll now provide our current outlook for the remainder of 2019. We continue to expect mid- to high single-digit growth in our total loan portfolio for the full year of 2019 driven by commercial and residential loan production. We also continue to expect the Consumer Indirect loan portfolio to decrease to 25% to 27% of total loans by year-end.For noninterest expense, we continue to expect a range of $25.5 million to $26.5 million per quarter with variability reflecting the timing of incentive compensation, health care and marketing costs.Several other key areas of our outlook for full year 2019 remain unchanged as well. We continue to expect mid-single-digit growth in nonpublic deposits, mid-single-digit growth in noninterest income, an efficiency ratio within a range of 59% to 60% and an effective tax rate within a range of 20% to 21%. We currently expect full year net interest margin to be in the middle of the previously provided range of 3.25% to 3.35%. Approximately $100 million of securities were converted into loans during the first 6 months of the year. The Securities portfolio totaled $805 million at June 30, and we believe that by year-end, it will be between $780 million and $800 million, depending on the seasonality of municipal deposits. Therefore, we expect to redeploy between $5 million and $25 million of securities into loans in the second half of 2019, ending our redeployment initiative.Regarding provision, we expect a more normalized level of provision for the last two quarters, in line with our historical experience. In the first half of 2019, Financial Institutions delivered very healthy growth in core operating profitability, and we expect that to continue through the second half. I'll now turn the call back to Marty.

Justin, thank you very much. Our organization continually seeks ways to serve our communities because we understand that helping communities supports our ability to be successful. Accordingly, we invest in and support the communities we serve through voluntary activities, financial investments and product offerings. We recently published our second Community Report in which we describe our many community efforts, including products and services, grants, sponsorships and volunteering. The report is posted on the Five Star Bank website, will be posted on the FII Warsaw website shortly and printed copies are available upon request.Over the past 12 to 15 months, we have focused on a few issues impacting the investment community's perception of our company. These include the size of our Securities portfolio, the size of our Consumer Indirect loan portfolio and our lower than many peers tangible capital equity or TCE ratio.First, as I mentioned earlier in the call, we have been redeploying Investment Securities into higher-yielding loans for several quarters. At June 30, our Investment Securities portfolio totaled $805 million or 18.7% of total assets. This compares to the peak of $1.1 billion at June 30, 2016, when Securities comprised 29.5% of total assets. This initiative has had a very positive impact on profitability, and is a driving factor for 2019 NIM growth.Second, we've worked to rightsize Consumer Indirect loan portfolio by reducing loan volumes and increasing yield. We also took advantage of the opportunity to complete a small sale in the quarter. At June 30, Consumer Indirect loans comprised 27.8% of our total loan portfolio, down from the peak of 35% at December 31, 2013. Third, tangible capital has grown significantly through the retention of earnings and prudent issuance of capital.At June 30, our TCE ratio was 7.77%, up 161 basis points from 6.16% on March 31, 2017. Over this same period, our common equity to assets ratio increased by 140 basis points from 7.99% to 9.39%. We expect these ratios to continue to grow as we generate capital through the retention of earnings. These actions, combined with our management team's disciplined approach to expense control, resulted in positive operating leverage in the quarter as well as an improved efficiency ratio.Having made significant progress in these areas, we are now about to deploy improvement initiatives to identify and take advantage of opportunities to improve efficiency while enhancing customer and employee experiences. These opportunities include expense savings and or incremental revenue opportunities. We look forward to providing details on this program later this year.Before I conclude my prepared remarks, operator, I want to thank my teammates for their hard work and commitment to the execution of our initiatives, supporting each other, our customers and our communities [indiscernible] to the strong quarter and the outcomes we have just reported. And we're ready to open the call for questions.

We will now begin the question-and-answer session. [Operator instructions] Our first question comes from Alex Twerdahl of Sandler O'Neill.

Just first off, Justin, I think you want -- I kind of missed your margin guidance. Can you just repeat that? I think you said middle of the previously guided range. But was that for the -- just for the back half of the year? Or is that for the full year margin? And can you just tell us what rate assumptions you have in that guidance?

Sure. That's a full year. I did say we're narrowing a little bit by indicating we'll be -- we expect to be in the middle of the range, plus or minus, of course, a basis point here or there. And as far as what our assumptions are, we've essentially modeled one decrease in rates tomorrow as part of that guidance to look at what the impact on our margin would be.

So it's fair to assume that given that the margin has been 3.24% in the first quarter, 3.28% this quarter, to assume it's going to be around 3.30% for the full year, that would imply it should be above 3.30% for the back two quarters of the year. Am I thinking about that right?

You're thinking about that right.

Okay. Great. And then on to the expense guide, we're $25.5 million to $26.5 million, unchanged. However, you were below that guidance a little bit in the first two quarters. I know, there's some timing issues, but should we expect now that maybe you should be towards the upper end of that range in the back two quarters as some of those things that maybe did not impact the first two quarters could kind of hit in the back half of the year?

Alex, it's really hard to sort of peg that number given some of the volatility of -- for example, our -- we mentioned how, this particular quarter, we were lower, which was driven by some of the medical costs. And it's really difficult to sort of peg that number, which is why we provide that range. From my perspective, we'll start to see some relief in the salary and benefits line from taxes, et cetera, but we're going to start to see some more seasonal increases on the medical expense side. So -- and then we've got the sort of volatile advertising and branding campaign. So it's just difficult to really peg one number within a quarter. So we really just need to stick to that range that we've provided on a quarterly basis.

I think, those are two -- Alex, I think, those are two good examples, though, that health care, we've been able to migrate the company to high deductible plans and the seasonality of those kicking in when the deductibles are fulfilled. We do expect that.

Okay. And then a final question for me, just on the auto sale this quarter. I know it's something you guys have experimented with, I don't know, 10 years ago or something like that and now you're seeing a little bit again. Is this kind of just sort of the reintroduction, some experimentation in terms of what the market would give you for these loans? Or is this going to be a more consistent part of the business, just -- and is it going to be a tool just to keep the portfolio kind of flat relative to other loan growth? Or do you think, at some point, it'll actually help you reduce the portfolio in a more meaningful way?

Alex, this is Bill Kreienberg. You're right. We hadn't done a sale for nine or 10 years. This process was something where we just wanted to test the market, get the market to evaluate a portion of our portfolio, get appreciation for our credit underwriting and metrics in the portfolio, our pricing, et cetera, and also see what the market would bear for it. I think it was just part of an overall strategy, as we've said, to gradually reduce the indirect auto portfolio, as we're able to increase the buckets of residential and commercial, which is our strike points for full relationship banking, so depository relationships, cash management, insurance, wealth management cross-sell. So it was just something that we successfully completed, and we're going to keep it in the back of our mind as we go forward and continue to analyze the size of the Indirect portfolio in our bank.

Okay. But not necessarily something we'll see every quarter but potentially as you kind of reevaluate things going forward?

That's correct, Alex. Not necessarily.

Our next question comes from Matthew Breese of Piper Jaffray.

Just thinking about the mix shift. You noted that you're about $100 million of the way through the mix shift and that, looking ahead, there's about $5 million to $25 million left to go, which I think, puts you at the bottom half of the initial range of $110 million to $160 million of a mix shift. And so I'm just curious, given the positive benefit it's had on the margin throughout this timeframe, why not more aggressively pursue it? And what are the limiting factors from continuing down this path?

Yes, Matt, there's a lot of considerations that we need to take around liquidity and other aspects. From our perspective, we're going to pause when we get to that point. It's not necessarily out of the realm of possibility that we might do some more, but it won't be this year. We're going to continue to monitor and assess. As you know, we have a fairly large municipal portfolio. And those municipal relationships require us to sort of securitize those deposits with our Securities portfolio. So there are some limiting factors to us going much lower. It also puts us at a percentage of assets that is in line with our peers. And so overall, we think that's sort of the prudent level to get to. Should we see opportunities to go a little bit lower, I certainly think we'll explore those. But that's sort of where we're ending up for the year at this point.

And then just continuing the margin expansion because of the mix shift has been a -- certainly a tailwind for you. Just thinking about the fundamentals of the book and with the Fed cutting, if the mix shift were to stop and we were to get a Fed cut, how does the margin react to that? Is there compression from a Fed cut? If we were to get a Fed cut in December, right, and the mix shift is paused, what is the initial reaction from the margin?

So our initial reaction to a Fed cut is relatively neutral to slightly favorable.

And then maybe just one step further on that. What is the percentage of the loan portfolio that is exposed to either prime or LIBOR?

About 30% of our loan portfolio is prime or LIBOR exposed.

And then I did want to learn more about the Commercial credit that was downgraded this quarter. What was the nature of that credit? Can you give us any idea of collateral support, where we are in the workout process and thoughts on resolution?

So that was a legacy credit in our Southern tier market. It was a long-term customer. It's been on the books for quite some time. The downgrade itself was precipitated by one of the guarantor's bankruptcy, which had been triggered by unrelated financial issues to this project. We have immediately put it into work out. We're meeting with management, working out a plan of reorg or rehabilitation and recovery. We're also exploring a lot of options relative to this credit. And I think, in conjunction with our finance and risk teams, we've appropriately reserved for the loan. But that's really the extent that we'll provide comment now.

Okay. Okay. And then my last one is just the drop in insurance revenue this quarter. I know it's a seasonally weak quarter, but when I compare it even year-over-year, it's down quite a bit. First, what happened? What drove such a significant decrease year-over-year? And then secondly, is there -- how should we be -- does this set a new bar on what we should be expecting out of that business line? Is it more like $4 million versus the $5 million we've been historically running at?

So a good question, Matt. A couple comments relative to the insurance line. So we've been going through this change to a bank-owned agency, which we've described in a couple of our calls. This particular quarter, add seasonality into it due to the inconsistency of some profit sharing, which is a little bit lumpy year-over-year. Also a year ago in this quarter, we had a kind of a onetime transactional commission on a construction project, which, when measured against this quarter, obviously showed a decrease. I'd say, overall, we've now take a lot of the variability out of the entire book. And in 2018, our top 10 customers comprised only 15% of the total agency revenue.So our overdependence, which was present when we bought the agency in '14, where the top 10 customers comprised 30% as we note down. We're also seeing a great deal of synergy with our commercial lines, with our residential mortgage lines in terms of cross-sell. So our pipeline is good in this business. We have quite a bit of sales activity happening. We also have additional incentives that we're working on with our commercial and residential and wealth teams to support the insurance business. One of the other factors, if you take what we talked about a few minutes ago with the Indirect book, our agency does provide insurance coverage for indirect loans, VSI, et cetera. So as that portfolio goes down and the number of loans we originate goes down, it does cause the drop in that portion of the insurance agency's revenue. But to conclude, I'm very pleased with the direction of the agency. We've got a lot of good things going and it's very profitable, and we're not ready to change the thought on where we're headed for this year.

Okay. So we shouldn't put too much emphasis on this quarter's results versus the year ago?

No. I would agree with that statement. I would not.

Our next question comes from Joe Fenech of Hovde Group.

Hey guys, on capital, you certainly seem to have moved past the point where you get questions about your comfort level with capital. You've got the 8% TCE ratio in sight. Can you re-rank for us the stack of capital management priorities, as capital continues to build? Do higher dividends move further up the priority list? Is it share repurchase, M&A, organic growth? Just give us a sense for how you're thinking about your options there as your capital situation changes.

Well, Joe, I just would emphasize that we have been carefully listening and communicating to folks like yourself, shareholders and investors, and this has been a key issue of discussion. So in terms of how we've managed our capital account and continue to build it through the retention of earnings, you're right, we're pleased in terms of how close we can -- we're coming to the 8% level, which, for us, as I said, was a record level since 2011. So we still have, as you well know, significant growth opportunities. And as we continue to grow our loans, which is a capital-intensive activity, that certainly will provide capacity for that as a priority. The dividend has always been something that's been important from a total shareholder experience perspective at our company. And beyond that, as you all have seen, we've made some strategic investments to expand and enhance our business model in terms of our wealth management and insurance investments, and a share buyback would be the lowest of those priorities at this point in time.

And then just a follow-up question on the auto loan sale. Not asking for specifics but just looking for the profile of the buyer, was that another bank? Is it private equity or some other party?

Joe, I appreciate the question. We're really not providing any information relative to that.

And then back to the prior question. Is part the limiting constraints and thought process on the auto book? Is that, over the longer term, you guys just feel like it's a product that's in demand in your markets. You're good at it, you've got the expertise. And so we're probably more likely to see you prune around the edges once you get to your stated targets rather than further reduce it sharply from that point? Is that a fair assessment?

It is, Joe. We're -- we've always been very pleased with our indirect auto line of business. It's very well run. We have people that have been in this business for 30 years in this market. We know the market. We know the dealer body. So as we contract, I still think the plan for us strategically is to have this as one of our core offerings and a core line of business.

I would absolutely agree with that, Joe. And Joe, again, this is a consistent theme that we've been working on as a management team, listening to the feedback. This is a great business, and we still stand by that. And we look forward to continuing to manage it appropriately from a balance sheet perspective. And very pleased with the opportunity we were able to cap lifetime in terms of all that is required to conduct a successful sale. That infrastructure is in place and that option is available to us as we continue to go forward.

[Operator Instructions]. This concludes our question-and-answer session. I would now like to turn the conference back over to the President and CEO, Mr. Marty Birmingham for any closing remarks.

And thanks very much. Thanks all for attending the call. We'll look forward to our next quarterly call.

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