Financial Institutions, Inc. (FISI) Q2 2020 Earnings Report, Transcript and Summary

Good morning, and welcome to the Financial Institutions, Inc. Second Quarter Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [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.

Thank you for joining us for today's call. Providing prepared comments will be President and CEO, Marty Birmingham and CFO, Justin Bigham. Director of Financial Planning and Analysis, Mike Grover, will participate in the Q&A 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 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 measures to GAAP financial measures were provided in the earnings release, which is filed as an exhibit to a Form 8-K. Please note that this call includes information accurate only as of today's date, July 30, 2020. I'll now turn the call over to Marty.

Thank you, Shelly. Good morning, everyone, and welcome to our second quarter earnings call. The past few months have been very challenging and eventful for our organization. We responded swiftly to the COVID pandemic in March, taking action to protect our associates and our customers by creating less dense work environments. Work from home and alternative work locations were implemented for as many associates as possible as well as non-essential business travel and visitor restrictions. Most branch lobbies were closed, and by-appointment-only protocols were implemented for those transactions requiring face-to-face interaction. In our new normal of working together yet apart, we implemented an array of actions to support consumers and businesses, including waiving certain fees, not reporting payment deferrals to credit bureaus and the granting of up to 90-day grace periods for consumer, mortgage and auto loan payments. $4.3 million of consumer loan payments were extended on average for 60 days, and forbearance was granted on approximately $633,000 in residential mortgages and monthly line payments on average for 90 days. Credit was thoughtfully extended to small business and commercial customers for working capital and operating purposes. And loan relief was provided to 135 small business customers, representing $19 million of loans; and 227 commercial clients, representing $383 million in loans. We were able to help approximately 1700 small businesses obtained $270 million of SBA Payroll Protection Program loans, helping to preserve an estimated 18,000 jobs in our markets, and we continue to work with customers on one-to-one to address unique needs during this time. We are staying in close contact with our commercial customers, making sure we understand their operating environments and business challenges, and offering assistance or solutions where possible. We completed a thorough credit analysis of our commercial loan portfolio, designed to uncover potential portfolio risks and help us navigate the credit cycle. We developed a watchlist of higher-risk industries to monitor on a go-forward basis. We review key credit relationships every week up to the executive level of the bank, tracking how businesses are performing. This is a joint effort completed by our lending, credit, risk and finance teams. All these accomplishments were achieved with 65% of our associates working remotely. Our organization transitioned very quickly from business-as-usual operations to a new standard of working together from multiple locations across our footprint. I'm so proud of the Five Star family's collective resiliency and adaptation to so many changes. To provide enhanced digital capabilities during a time when at-home access was critical, we moved forward in the second quarter with the multi-phase launch of our new online and mobile platform, Five Star Bank Digital Banking. Now more than ever, consumers and businesses need the ability to do their banking anywhere and any time. And we leverage the latest technology to provide new features and tools to improve the digital banking experience for our customers. The Five Star Bank Digital Banking platform provides a single dashboard to make payments and deposits, transfer and send money, create budgets, set financial goals, and easily integrate external investment, loan and other transactional accounts. Customer response to the platform has been very favorable, and we will continue to roll out enhancements over time. For example, over the summer, we will be launching a new digital account opening platform that will allow consumers and businesses to open most kinds of deposit accounts on any device. During the quarter, we also developed our reentry plan. We will be working differently as we reopen, and the approaches for reentry will vary by location. We have completed significant preparation, incorporating local directives with practical consideration for each location so that when associates come back and customers come in, they feel safe. Our protocols have been and will continue to be based on science and data. We have the infrastructure and operations in place to meet public health obligations and are putting in place additional layers of safeguards in all locations that could be monitored and revised as a appropriate. We brought back a portion of associates in two of our administrative offices, and so far, it has gone very well. We remain committed to maintaining a less dense workplace through the continued use of remote access and alternative worksites. By keeping at least 50% of our workforce remote, it will ensure resiliency and flexibility, should there be an uptick in community spread. Also critical to this next phase is maintaining our culture. If we envision staying in this operating state or even a modified version for an extended period, we must ensure that our organizational and cultural values stay intact. That means maintaining regular communication and making sure that our associates don't feel isolated for siloed. We all benefit from being an impactful and collaborative organization. That's part of our success, and we need to maintain and even strengthen that. Despite all the headwinds, we delivered strong results in the quarter. Net income was just slightly lower than the year-earlier period. And we generated the second highest quarterly pre-tax pre-provision income in our history. It was a good quarter for core fundamentals, and the benefits of a diversified revenue stream were evident. As I stated last quarter, we entered the crisis in a position of strength based on our diversified business model, strong levels of capital and liquidity, historically strong asset metrics, and a disciplined risk management and underwriting process. We remain focused on taking good care of our customers, our associates and our capital. And I believe we are well positioned to navigate the complexities of our current operating environment. It's now my pleasure to turn the call over to Justin for a discussion of results for the quarter. Justin?

Thanks Marty. Good morning, everyone. Net income was $11.1 million for the quarter or $0.67 per diluted share as compared to $1.1 million or $0.05 per share in the first quarter of 2020. You'll recall that the first quarter results included a $13.9 million provision for credit losses, reflecting deterioration in the economic environment due to COVID-19, the adoption of CECL and the impact of the partial charge-off of a single C&I loan. The after-tax impact of the higher first quarter provision was $0.59 per share. Pre-tax pre-provision income for the second quarter was $17.3 million, a $2 million increase from the first quarter of 2020 and $625,000 increase from the year-earlier quarter. Net interest income for the quarter was $34.2 million, an increase of $1.1 million from the linked quarter. The increase was driven by loan growth, primarily from PPP loans. Net interest margin was 3.23%, down 8 basis points from the linked quarter. The average yield on interest earning assets was 3.76%, a decrease of 39 basis points from the linked quarter. Cost of funds was 53 basis points, a decrease of 31 basis points. The decline in earning asset yield was driven by the impact of lower yielding PPP loans originated during the second quarter and a full quarter impact of the lower interest rate environment. Lower yields on PPP loans negatively impacted our earning asset yield by approximately 6 basis points. The cost of funds decline was driven by lower deposit and wholesale borrowing costs, driven by lower market interest rates and a favorable funding mix. Provision expense for the quarter was $3.7 million, and the allowance for credit losses on loans to total loans was 1.33% at the quarter-end as compared to 1.34% at March 31. If you exclude PPP loans, the ratio increases to 1.44%, an expansion of 10 basis points from the linked quarter. The allowance for credit losses on loans increased to $46.3 million at June 30, 2020 from $43.4 million at March 31, 2020. The higher allowance for credit losses considers the impact of COVID-19 and the economic environment on our primary loss driver, which is national unemployment. We use the Bloomberg economist weighted average forecast, which forecasts Q3 national unemployment at 10.4%, lower than the peak level of unemployment that was forecasted last quarter. However, we do forecast out six quarters, and the overall unemployment forecast for the next six quarters is higher-for-longer now than it was last quarter. In addition, our CECL quantitative model estimates expected credit losses using a reversion to the mean of the company's historic loss rates on a straight-line basis over two years. Our model also includes qualitative adjustments, both favorable and unfavorable in nature. Unfavorable adjustments broadly take into account incremental reserves attributable to COVID-19, partially offset by favorable adjustments attributable to massive U.S. government stimulus, support funding, including the SBA Paycheck Protection Program. Credit losses were minimal during the quarter, with net charge-offs totaling $786,000. Yet, as we know, the long-term impact remains to be seen. We don't expect a return to normalized levels of provision until the pandemic has worked its way through our economy. From a credit perspective, for both C&I and CRE, we are cash flow lenders as a primary source of repayment. As Marty addressed, relationship managers are staying very close to our customers, understanding and monitoring their operating environments on all exposures, especially those we have identified as higher risk due to the industry segment in which they operate. A key strength of our community bank model is the ability to develop deep ties to customers, through good times and bad, to understand their business needs, risks facing their business and the impact of government relief programs. For the CRE portfolio, property is a secondary source of repayment, providing additional comfort that we will be repaid. Our CRE portfolio exposure carries a loan-to-value of approximately 60%. For the C&I portfolio, we take additional comfort in collateral as a secondary source of repayment. Over 96% of our C&I portfolio exposure is secured by collateral. In addition, the vast majority of our C&I portfolio carry some level of recourse to the principals of the borrower, many of whom have long-standing relationships with our organization. Non-interest income was $130,000 lower than the first quarter of 2020. The key drivers were; first, service charges on deposits were $1.1 million lower, driven by our COVID relief accommodations of waiving or eliminating fees, in place for the entire second quarter. This initiative started on March 23 and ended on July 9. Second, insurance income was down $530,000, primarily due to seasonality and contingent revenue received in the first quarter each year; and third, investments in limited partnerships generated a loss of $244,000 in the quarter, resulting in a negative impact of $457,000 as compared to the first quarter. These factors were partially offset by a $1.2 million increase in the income from derivative instruments and a $453,000 increase in gains on investment securities. Our interest rate swap program facilitates risk management strategies for our commercial banking customers. The program was initiated in the fall of 2017, and performance reflects the continued growth and maturity of our commercial business. We sold some securities during the quarter that we believe have a higher propensity to prepay, resulting in the increase in gain on investment securities. Despite severance-related costs that netted to about $325,000, non-interest expense was $26.7 million, a decrease of $1 million from the linked quarter. The largest contributors to the decrease were: professional services expense was $572,000 lower due to the timing of audit fees, typically highest in the first quarter of each year, and the timing of fees for consulting and advisory projects. Other expenses decreased $288,000 as a result of lower education, travel and business development expenses due to stay-at-home orders, combined with lower indirect consumer lending-related expenses. Income tax expense was $2.4 million in the quarter, representing an effective tax rate of 18%. Moving to the balance sheet, growth in total loans was $249 million or nearly 8% from the end of the first quarter of 2020. Commercial business grew 39%, commercial mortgage grew 3% and residential loans grew 1%, while consumer indirect decreased about 2%. All PPP loans are reflected in commercial business, driving this quarter's growth in that category. Excluding PPP loans, commercial business decreased approximately $32 million, largely due to the paydown of commercial lines of credit. Broadly, these lines increased at the end of March into April, paying down in May and June. The line balances are down $27 million from 3/31 and down $19 million from 12/30/2019. Residential lending demonstrated improved performance during the second quarter, largely due to increased refinance volume, driven by the low rate environment. Total originations for the quarter were $63 million as compared to $41 million in the first quarter of 2020, an increase of more than 50%. Net gain on sale of loans more than doubled, increasing $427,000 over the linked quarter. The salable portion of our portfolio continues to grow and represented 37% of the pipeline as of June 30, 2020. Total deposits at quarter-end were $207 million higher than the end of the first quarter of 2020 and $522 million higher than June 30 of last year. The increase in deposits, primarily in demand and savings accounts, was largely the result of the impact of government stimulus programs, including the Paycheck Protection Program, economic stimulus checks, enhanced unemployment benefits and the deferral of tax payment deadlines, combined with pandemic-related changes in customer habits. Growth in the year-over-year period was also driven by our large municipal book. Deposits are at a seasonal low at the end of June and a seasonal high at the end of March. In addition, our brokered deposit portfolio was $167 million higher than the year-earlier period. In February of 2020, we entered into a long-term brokered sweep arrangement as a stable collateral-free alternative funding source to reduce reliance on FHLB secured borrowings and improve our available committed liquidity. Common equity Tier 1, Tier 1 and total risk-based capital ratios increased in the quarter. The leverage and TCE ratios decreased by 29 basis points and 16 basis points respectively because of the PPP loans added during the quarter. These ratio declines should be viewed as temporary as the PPP loans are 100% government guaranteed and are anticipated to have a short duration, as the overwhelming majority will either be forgiven or paid off within two years. The leverage ratio and TCE ratios, excluding the PPP loans, at June 30, 2020 were 8.83% and 8.2%, increases of 5 basis points and 30 basis points respectively. During the second quarter of 2020, the Company paid a common stock dividend of $0.26 per share, returning 39% of second quarter net income to common shareholders. The company has no intention of reducing the dividend at this time. Management and the Board of Directors will continue to closely monitor the economic environment and business trends and will prudently manage capital levels going forward. Consistent with the prior quarter, we will not be providing guidance at this time. The uncertainties related to the COVID-19 pandemic significantly widen the range of possible forecast outcomes, making it too difficult to project results with a reasonable level of accuracy. With that said, I'll now turn the call back to Marty for closing remarks.

Thank you, Justin. As we have discussed in previous quarters, our enterprise standardization program is focused on improving operational efficiency and future profitability while enhancing the associate and customer experiences. We have been assessing all lines of business and functional areas. Opportunities identified by the program have resulted in the implementation of robotic automation and the streamlining of processes and operations throughout the organization. Another outcome of the program was our July 17 announcement of changes in our retail branch network to better align us with shifting customer needs and preferences. The announced transformation will result in six branch closures and a reduction in staffing. Approximately 6% of the company's workforce was separated immediately in connection with the announcement. The impacted branches will close this October. These actions are expected to result in a charge in the third quarter of approximately $1.7 million, which is a combination of severance costs and real estate-related charges. Expected expense savings are anticipated at $2.6 million on an annualized basis. We plan to continue building market share beginning with two branch openings scheduled in the city of Buffalo next year. We are also expanding the services we offer across our operating footprint by offering in-branch, commercial lenders, certified personal bankers and wealth management and insurance professionals to provide customers with personalized, timely solutions. In summary, our company delivered solid net income and pre-tax pre-provision income in the quarter despite the many disruptions associated with the COVID-19 pandemic in a lower interest rate environment. We learned to work differently, yet efficiently, while providing essential continued support to our customers. Our company is sound and growing. We have strong levels of capital liquidity, a thoughtfully developed strategy, an effective risk management program and dedicated associates throughout the organization. We are well-positioned to continue to deliver essential financial products and services to our communities. Operator, this concludes our prepared comments, and we are ready to open the call for questions.

Thank you. We will now begin the question-and-answer session [Operator Instructions]. And the first question will come from Alex Twerdahl with Piper Sandler. Please go ahead.

First off, on expenses; I know, Justin, you said you weren't going to provide guidance, but just a clarification. Earlier this year, when you rolled out the enterprise standardization program, you had expected $5 million to $7 million of savings in 2020 and 2021. With the $2.6 million savings from the branch closures, would that be included in that number that you disclosed earlier this year? Or is this additional to that?

That is included in that number, Alex.

And then, I was hoping you could give a little bit more color on Slide 19, where you talk about the loan deferrals, and you give the numbers through the end of June, which is extremely helpful. But I'm sure a lot of these loans have come to the end of their initial 3 months in July, and I was wondering if you can give a little bit more color on maybe what you're seeing as some of these loans roll over, if you're seeing a good chunk of them return to paying or a lot of them being extended for another 3 months, or sort of what you're seeing?

Alex, let me start off by saying that, in the Finger Lakes region, which is greater Rochester in Western New York, which is greater Buffalo, the underlying economic activity was the first to open up relative to the way that New York state was managing the pandemic a few months ago. So we remain with cautious optimism that we will continue to perform as well as we have in terms of the COVID-19 cases. Our infection rate was half of Metro New York anyway. And today, if it was 14% at the height, we were at 7%. Today, it's under 1%. So we are seeing good economic activity starting to return, subject to the continued performance of -- in this pandemic environment. So that has translated well in terms of the performance of our customers. And as you may be aware, our official relief programs have concluded as of the end of June, and we have seen very few requests for additional support. And when we do, we are dealing with those on a one-on-one basis, whether it's consumer or commercial. As an example, in our commercial business, we've really only had less than 10 new requests for relief, so we feel good about where we stand today. I would say, across our residential portfolios, most of the borrowers have returned -- excuse me, a large majority of the borrowers have returned to paying-as-agreed status. And in our consumer loans, two thirds of them are returning to their contractual payment obligations. And again, in our commercial portfolio, we are watching that very closely, particularly those impacted industries. But for the most part, most of our deferrals in commercial were for three months. And as I said, the new requests have been very minimal since the end of June. Justin, how would you add to that?

Alex, I think Marty's spot-on relative to the top-right corner of Slide 19, the commercial box there. As Marty referenced, we've received less than 10 requests so far to extend another 90 days, which I think is pretty specifically what your question was. That makes us cautiously optimistic. Obviously, we can't predict the future there. But certainly, if there's a good sign, I guess that's as good a sign as we can have at this time. I do think that, as I think about three months ago, I got in my car and drove around locally versus today, it's so different. The other thing that I think makes most of the Upstate New York and Western New York banks cautiously optimistic is just what we're seeing around economic activity that's occurring in our local areas. Traffic is getting back to normal. Stores have lines out the door because they're not allowed to have more than a certain percentage of people in the store at any one time, but people are out and about. So everybody is wearing masks. And so that makes us, as I said and as Marty said, cautiously optimistic. Having said that, we don't know where this pandemic is going. Another flare-up could certainly send things in a very different direction. But I do think that, broadly speaking, as we said in our materials, we are seeing signs of stabilization, and we are seeing decreasing deferral activity. And as I said, we're hopeful that will bode well for the outlook that we have in Western New York.

And then, just a final question for me. Just kind of taking it the next step and talking about the provision, I think you said in your prepared remarks that you kind of expect the provision to remain elevated, just given the uncertainty out there. But as we think about the reserve as it ties to the provision, do you feel like, based on sort of the models out there and what you're seeing, that the provision is really going to be more dependent on how loans actually move and get downgraded and get charged off much more so than any of the modeling at this point, and maybe the reserve has actually sort of reached its peak level?

That's a good question, Alex. It's difficult for me to answer that question too specifically because, as I said in my prepared remarks, the current unemployment forecast is higher for longer. So if you remember last quarter, in the first quarter, it spiked up very, very high, and then it rapidly declined. And I think that was really driven by just a misunderstanding of what this pandemic was, and maybe it's only going to be 90 days, and we'll go right back to normal. And obviously, that hasn't happened. And so, now, it's elevated for longer. I can see a situation where that elevated-for-longer does get worse even though the unemployment rate might come down. It may not come down as quickly as we would like, particularly given our models using national unemployment. This is a unique pandemic where it's very isolated to specific, state-by-state, it's very different, right? So it's hard for me to say for sure. We also have qualitative factors that we're always evaluating and looking at. So I'm not going to say that we're thinking we're not going to need to build provision more. I think we very well may need to continue to build provision. My comment about elevated levels, I mean, if you look back historically at what our provision build has been, particularly prior to the pandemic, it's been very minimal. So these elevated levels that we have right now, the point that we were trying to make is that we expect that to continue. So as I said, I can't predict the future, but I'd be surprised if we don't continue to build provision, going forward.

Alex, I would just supplement Justin's comments to say that we do have a very disciplined model that supports our conversion to the CECL process, and you know we completed that in the first quarter. So our reliance on the outlook for the economy grounded in national unemployment is a major factor. So for us, it's going to be about the performance of our portfolio, as you're pointing out, the mix of our business unique to our company, and our interpretation of the future and where it's coming from. So since December, I think we've increased our allowance by 50% in a very responsible and prudent manner, which I personally feel good about relative to all the uncertainty that we're dealing with here today.

[Operator Instructions] Our next question comes from Marla Backer with Sidoti. Please go ahead.

Thank you. So I just want to follow up on one of the answers you just provided, which is that this is a very novel situation, to say the least, and the impact is sort of on a state-by-state basis. So the region where your operating footprint is, to what extent is it somewhat more reliant, let's say, on local tourism, the Finger Lakes region, so that national numbers for unemployment might not tell the whole story of what's going on in your particular market?

The Finger Lakes region certainly is one of the great recreational assets of our geographic footprint, but it's not an overwhelming economic driver. We've got a very strong manufacturing, agricultural, college and university and technology, high-technology components of our economy. In terms of our exposure to hospitality, we have very limited exposure in terms of recreational facilities in the Finger Lakes vacation type of concept that your question implies. Ours are moderately priced flagged hotels that are dispersed through our geographic footprint that are part of those communities, be it college communities, the Metro, Rochester, Buffalo, or the cities in the southern tier.

No, that I understand. I was thinking more in terms of local unemployment, perhaps, not match state unemployment or not [Technical Issues]. But from what you're saying, that's really not what's going on. And in terms of the bank closures, so should we assume that this is where you stand right now with your bank footprint? Or should we anticipate that there might be additional closures down the road?

Well, I think that this is an issue that our management team will continue to face. And again, it's driven by, as we said, consumer habits and their needs. So we'll continue to look at it. But right now, having just completed this part of our enterprise standardization project, I think we feel good about our existing geographic footprint. As we also indicated, where we are not physically present, we do think it's important to be there, for example, the branches that we're building in Buffalo. But we're keenly focused on the fact that the traditional utilization of branches of customer service and processing transactions is rapidly changing to multiple-use offices where we are prepared and can deliver financial, education, advice and the solutions that's consistent with the business model we've built, leveraging the core community bank for commercial and consumer customers as well as insurance, risk management solutions, and wealth management.

And then, my last question is, given the new [Indiscernible] you've built, what have you been seeing with some of those adjacent silos, the insurance and the risk management business? Did you see the same kind of shift towards remote basically taking up any of the impact of not being able to go in and see your risk adviser in person? Did you see those businesses sort of provide the same kind of flexibility [Indiscernible] the commercial bank was able to?

Yes. We have been able to work with those customers on a remote basis and take care of their needs.

Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Marty Birmingham for any closing remarks.

Thank you, Chad, very much, and I want to thank those that participated in our call this morning. We look forward to communicating with you again at the end of the third quarter.

And thank you, sir. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.