Good day, and welcome to the Financial Institutions, Inc. Fourth Quarter 2019 Earnings Conference Call and Webcast. 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 Ms. Shelly Doran, Director of Investor and External Relations, Executive Vice President and General Counsel. Please go ahead.

Thank you for joining us for today's call.Providing prepared comments will be President and Chief Executive Officer, Marty Birmingham and Chief Financial Officer, Justin Bigham. They will be joined by Chief Banking and Revenue Officer, Bill Kreienberg, and Director of Financial Planning and Analysis, Mike Grover for the question-and-answer portion of the call.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 of 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, January 31, 2020.I'll now turn the call over to Marty.

Thank you, Shelly. Good morning and welcome to the fourth quarter and year-end earnings call.We are pleased to report another strong quarter with net income of $13.1 million or $0.79 per diluted share. Pre-tax pre-provision income for the quarter was $16.1 million. 2019 was a year of great accomplishment for our Company, with the highest net income and pre-tax pre-provision income in Company history. Results were driven by many factors, including growth in commercial and residential loans, the positive impact of our balance sheet repositioning, including the rotation of securities into loans and rightsizing our consumer indirect portfolio, gains from our timely investment securities sale, our interest rate swap program, expense control, and benefits from tax credit investments, which were a natural extension of our commercial real estate and community development programs. We remain focused on driving long-term shareholder value and are continually seeking opportunities to improve profitability, evident in diverse ways we generated revenue in 2019.Growth in total loans was 2% in the quarter, with a strong 6.8% increase in commercial mortgage loans and a 2.5% increase in residential loans partially offset by decreases in commercial business and consumer indirect. Fourth quarter C&I volume was lower than expected due to two large commercial loans that were expected to close in the quarter, but did not close until after year end.Consumer indirect loans continue to decrease as we maintain our focus on growing relationship-based loan categories, commercial and residential, and scaling back consumer indirect lending, especially outside of our footprint. This portfolio decreased by $13.6 million or 1.6% from September 30th and at quarter-end, it comprised 26.4% of our total portfolio, down from 29.8% one year ago. Yield on the consumer indirect portfolio for the quarter was 18 basis points higher than the third quarter of 2019.Total deposits at quarter-end…

Thanks, Marty. Good morning, everyone.I’ll provide commentary on a few key areas with comparisons to the third quarter of 2019. Net interest income was $33.2 million, up $690,000 compared to the linked-quarter. This was primarily the result of higher average interest-earning assets, combined with the impact of net interest margin expansion. NIM for the quarter was 3.33%, up 4 basis points from the linked-quarter. The average yield on interest-earning assets was 4.22%, a decrease of 7 basis points. Cost of funds was 89 basis points, a decrease of 11 basis points. NIM was positively impacted by 2 basis points in the quarter as a result of unexpected commercial loan prepayments. The remaining NIM expansion was primarily the result of the October rate cut coupled with higher average public deposit balances that positively impacted our cost of funds as expected.Provision for loan losses was $2.7 million in the quarter, up $809,000 from the third quarter but in line with historical experience and our expectations. Net charge-offs were $3.8 million, compared to last quarter's $4.6 million. In the fourth quarter, we had a $1.9 million in commercial business charge-offs, primarily due to one $1.5 million loan. In the third quarter, we had $3 million partial charge-off related to a commercial credit that was downgraded in the second quarter. Otherwise, our asset quality has remained strong, as evidenced by our level of nonperforming loans and asset quality ratios. Nonperforming loans were $8.6 million in the quarter, a decrease of $1.1 million. Allowance for loan losses to total loans was 95 basis points at quarter-end, down 5 basis points from last quarter and the allowance for loan losses was 353% of nonperforming loans, compared to 324% at 9/30/2019.Noninterest income was down $2.7 million in the quarter. The key drivers were, first, insurance was down…

Thank you, Justin.I'd like to provide an overview of the commercial loan and credit environment in our markets. First, I'll provide a few thoughts on the commercial real estate. We continue see a steady and consistent pipeline because we focus on a fairly narrow type of commercial real estate customer with a track record of execution in a portfolio that consistently generates cash flow. For our commercial team, it's all about consistency. We are seeing increased paydown activity in commercial real estate, primarily due to our unwillingness to compete on rate for permanent long-term loans. For example, we have an unexpected $11 million payoff from a customer in the fourth quarter, the customer refinance with Fannie Mae at rate and term we would not match. Our overall C&I pipelines remains steady and our expansion in the Central New York region continues to payoff, as we now have two lenders there with growing pipelines.Regarding the credit environment, we're still seeing strong amount of activity, quality remains good and we're picking our spots. Strategic focus for our organization has been and continues to be on the importance of credit discipline and we have not used our credit standards. We are also still experiencing the benefit of customers moving business from large banks.And lastly, it is important to note that we benefit from operating in a very stable market, not typically subject to cyclicality. Our performance ratios continued to strengthen in the fourth quarter. Return on average assets was 1.21%, 2 basis points higher than the third quarter of 2019; for the full year, it was 1.14% compared to 0.95% in 2018. Return on average equity was 11.88%, also 2 basis points higher than the third quarter; for the full year, it was 11.61% compared to 10.18% in 2018. And our TCE ratio increased to 8.05%, up 6 basis points from September 30th, 2019; and up 90 basis points from year-end 2018.As I said in my opening comments, 2019 was a year of accomplishment for our Company. We generated strong financial results, invested in our customers, our communities and our associates. We positioned our balance sheet to improve profitability and continued to diversify noninterest income. We also made strategic technology and transformation investments that position us well for future success. We are looking forward with anticipation to the launch of both the Five Star Bank Digital Banking platform and the positive impact of enterprise standardization initiatives. We believe these investments will help us continue to move our Company forward to deliver more value for those we serve and for our shareholders.Operator, this concludes our prepared comments. We're ready for questions.

[Operator Instructions] The first question comes from Alex Twerdahl of Piper Sandler. Please go ahead.

Just first off, I wanted to ask a couple more questions about the enterprise standardization program. I think, I heard in your prepared remarks that you expect to see around $5 million to $7 million of savings. I'm not sure if that's this year or annually and sort of the timing and when that’s going to come into place. And then, it also sounds like at least some of that’s going to be reinvested. And I’m just trying to figure out how much of that over time will actually drop to the bottom line.

So, Alex, what I can tell you is that the guidance that I provided incorporates our perspective on those benefits. I can also tell you that it's our expectation that about half of that range we're going to see in 2019 -- I'm sorry, 2020, with the remaining half in the following year. And as I said, our guidance has incorporated any reinvestment that's required as a result of that initiative.

Okay, thanks. And then, is it also expected to provide additional revenues as well or is it primarily an expense initiative?

Well, I think Alex -- this is Bill Kreienberg. As an example, we expect to create a greater customer experience through this efficiency process. For example, we believe in our mortgage group. We can cut down the time from application to commitment, improve communication with our customers, which net example should drive more sales, drive a better customer experience. So, we will see outcomes like that throughout the standardization project.

Alex -- and I'll just reiterate, from a guidance perspective, to help you with your question a little bit further, we've only put an assumption in for what we feel confident we will get. And so, from the perspective of the 5 to 7, you should think about that as being primarily expense-oriented.

Great. And then, based on what you are saying in terms of the remaining half of this cost saves being realized in 2021, should we expect further efficiency ratio improvement in ‘21 as well, down from that 57 to 59 range by the fourth quarter?

We haven't looked at that yet, Alex. As far as how you should think about it, I mean, every organization is going to experience some expense growth every year. So, certainly, there's going to be some benefit that we’ll see in 2021, but we haven't modeled the impact of that yet.

Okay. And then, Marty, in your loan guidance commentary, for 2020, does that or at least contemplate sort of similar levels of pay down to what you’ve been seeing recently?

I think it does. We have, in our planning for 2020, incorporated a lot of discussion from our vendors up. And it does incorporate the current market conditions and the activity that's going out there.

Okay. And then, just final question for me. Just as we kind of think about CECL conceptually, over the next couple years and kind of coupling with the fact that you have this consumer indirect portfolio that's becoming a smaller percentage of the overall pie. Does that suggest that maybe all else being equal, just that mix shift alone should cause reserves to come down under the CECL model over time?

So, I mean, I think intuitively, Alex, the way you're thinking about it is the right way to think about it. But just remember that if total loans are growing, then our CECL provision will grow. So, it is a loan-by-loan analysis. Having said that, I think you're right that indirect represents a higher reserve rate in CECL than our commercial book. So, from a weighted-average perspective, it could start to come down on a weighted-average basis, but the overall reserve will likely continue to increase as long as we continue to grow our loan portfolio.

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

Hey. Good morning, guys. How is it going today?

Great. Good morning, Damon.

Good morning, Damon.

Great. So, just a quick question on the margin, Justin, I think you gave a good range of 330 to 340. Could you just remind us a little bit about the seasonality of the public deposit and when we may see a little bit of a boost to the margin when you bring those lower cost deposits in?

Sure. I can help you with that. So, our public deposit book, as I look at the seasonality of that book, it tends to be -- we just obviously -- you've got the back half of the year. We are going to start to see it increase in February. It will peak out in March, late Match, it peaks, and then starts to come back down again. So, that's more on a sort of spot balance perspective. So, obviously, the averages trail those spot results. But, that is the seasonality. And I think if you look at the commentary we've provided in each quarterly call this year, you can expect exactly the same types of seasonality as we've seen this year for future years.

Okay, great. That's helpful. And then, with regard to the digital banking component of the two initiatives, is the expected benefit from that implementation included in the noninterest income guidance this year?

Yes, it is.

Okay. So, when do you expect to have that up and fully running?

So, we're describing it right now at the back half of the year. We don't have a specific date that we can disclose at this point. But, we are -- that is what we're targeting right now is the back half of the year. And we have put in, as we said, some benefits associated with it in that timeframe.

Got it. Okay. And then, just lastly is just from a modeling standpoint, so these higher expenses that you're going to see in the first half of the year, related to these initiatives, that's primarily going to be in the professional services line, or is it going to be spread into multiple categories? Like, [Multiple Speakers] by bringing more people on, things like that?

So, we're going to see our typical -- I'll think about it this way. Our typical seasonality that we have is going to continue to exist. So, in the first quarter, there's going to be increases to our salary and benefits line associated with merit, associated with extra tax expense as a part of the payoffs of folks, bonuses, et cetera. FDIC is coming back as well. And then, in addition, we will stay at elevated levels associated with what we're paying for these consultants.

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

My question on efficiency was answered, but just a couple others here. I guess, Marty or Justin, with the TCE ratio being over 8%, that's a significant milestone for you all. Can you talk about what you think an optimized TCE ratio would be for you? And once you get there, would you reorder at all the capital management priorities that you have? All the things being equal, like the price of the stock, assuming that, and then also given the slower pace of loan growth that you're projecting, which I'm assuming will translate to a faster pace of capital build. Any updated thoughts I guess on capital management?

We've always been comfortable with the capitalization of the company, Joe. And we try to be responsive and responsible in terms of the TCE ratio and driving the increased number that we currently sit with today. I think, the highest and best use of our capital is to reinvest it in the business, to support our growth initiatives. As you -- we'll monitor it closely with our board relative to the priorities of how we allocate capital in light of, as you're pointing out, our growth projections. But, the highest and best use clearly from my perspective is to continue to invest in the Company, supporting our growth.

Okay. And then, you’ve all have done a nice job transforming the balance sheet the last few years, and I appreciate the continuation of that with some of the targets that Justin outlined, I guess this morning in terms of the loan portfolio mix that you're targeting. If you look out longer term, I guess similar question on capital, is there optimal mix, a balance sheet mix or revenue mix or however you want to look at? And what does your profitability look like at that optimal balance sheet mix? So, I guess, it's just a simple way of asking longer term targets for mix and profitability.

So, we haven't really provided longer term targets for mix and profitability. But, I mean, we're going to continue certainly for 2020, as described in the guidance with the focus. And I anticipate this focus will continue beyond 2020 on relationship business. So, the indirect auto business is not a relationship business. We're going to continue to right-size that with a focus on those relationships. So, the only other piece of information I can give you and feel comfortable giving you is, from a securities perspective, we're going to target 18% to 19% of total assets for securities. So, we're not necessarily looking to make any changes there. So, from a mix perspective, that will obviously, if our assets continue to grow, we will need to continue to grow slightly our securities portfolio. But, from a mix perspective, I think it's more of the same answer to your question, Joe.

So, we feel really good about our business model. We've made some investments strategically. We've got a really strong and high-performing community bank where we can deliver education advice and solutions to all of our consumer and commercial clients and supplement that with the wealth management and risk management that our insurance brokerage provides. So, that translates, as Justin is talking about, into the relationship-based activities at the bank level of loans and deposits with core customers as well growing our noninterest revenues and reducing reliance on the NIM business as we continue to push forward.

Okay. I appreciate all that. I guess, just the follow-up, with CECL and the appreciated I guess projected impact on provisioning and whatever else. Does that change at all any thoughts on how you want to manage the business longer term? So, for instance, if CECL didn’t exist, it kind of felt like after last quarter that the balance sheet transition was -- that phase was done. But, maybe you’re just kind of waiting for the fourth quarter to kind of officially provide projections for this upcoming year. Was CECL coincidental to this next phase of the balance sheet transition or the does it impact your thinking on that?

I don't -- I think, I'm going to address it the way you started with the question was, is CECL going to change the way we run the business, and I think the short answer to that at this time is no. But, I think, the entire industry is going to be really interested to see how CECL impacts banks on a quarter-to-quarter basis, particularly as economic forecast change. And then, I think the banking industry as a whole is going to have to react to that however they see fit.

Okay. And then, last one for me. I guess, there has been some pickup in M&A activity in your markets. Just remind us, especially with a little bit more capital management flexibility of the M&A strategy and kind of how you think about M&A for the company?

So, we're obviously open to those possibilities and we are well aware of the transactions that have occurred, Joe. I think, from our perspective, we want to be very disciplined in terms of the pursuit of those transactions, those opportunities and making sure that they are incrementally positive in the ways that you would expect them to be relative to accretion, dilution and earn back. And, from our perspective, we feel good about the execution of our strategic plan, pursuing organic growth and especially relative to the transaction just occurred.

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

Thanks, operator. I just want to thank everybody for their participation this morning. We’ll look forward to continuing to build our dialogue with you in future quarters.

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