Financial Institutions, Inc. (FISI) Q1 2022 Earnings Report, Transcript and Summary

Hello, and welcome to the Financial Institutions, Inc. First Quarter Earnings Conference Call. My name is Katie, and I'll be coordinating your call today. [Operator Instructions]. I'll now hand over to your host, Shelly Doran, the Director of Investor Relations, to begin. Shelly, please go ahead.

Thank you for joining us for today's call. Providing prepared comments will be President and CEO, Marty Birmingham; and CFO, Jack Plants; Chief Community Banking Officer, Justin Bigham and Director of Financial Planning and Analysis, Mike Grover, will join us for Q&A. 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 Investor Relations website for a 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 measures to GAAP financial measures were provided in the earnings lines filed as an exhibit to form 8-K. Please note that this call includes information that may only be acted as of today's date, April 28, 2022. I'll now turn the call over to President and CEO, Marty Birmingham.

Thank you, Shelly. Good morning, and welcome to our first quarter earnings call. Our positive momentum from 2021 continued, and we delivered another quarter of very solid results with net income of $15 million or $0.93 per diluted share. These results were lower than the linked in prior year quarters, primarily as a result of a more normalized operating environment and some of the unique impacts of the pandemic environment moderated. We recorded a more typical level of provision for credit losses after 4 straight quarters of benefit, and recognized lower revenues related to the PPP program. Pretax pre-provision income was $20.7 million, a $1.9 million decrease from the fourth quarter of 2021 and a $3.3 million decrease from the first quarter of 2021. The declines were largely the result of lower ACP revenues totaling $1.1 million this quarter, down from $2.8 million and $3.6 million in the fourth and first quarters of last year, respectively. In the first quarter of 2022, we announced our first commercial expansion outside of our operating footprint. John Mangan was named Senior Vice President, Commercial real estate executive and Mid-Atlantic President, and he leads 3 commercial real estate relationship managers in the Baltimore and Washington, D.C. region for Five Star Bank. Consolidation within the Baltimore and D.C. financial services sector created an opening for us to capitalize on opportunities where community banking approach provides a competitive advantage. Our Mid-Atlantic team of 4 commercial banking officers started with Five Star in mid-February, and they have been working diligently to build a strong loan pipeline. We look forward to establishing the Five Star brand in this new market and becoming a strong partner for the communities there. Our strong track record of credit disciplined loan growth and well-defined strategic and risk frameworks give us confidence in the expected positive outcomes of this exciting expansion beyond our operating footprint. We continue to leverage available talent to expand our commercial platform through the recruitment of commercial professionals and are also considering the establishment of other loan production offices in viable markets outside of our existing footprint. During the first quarter, total loans grew $54 million or 1.5% from December 31, commercial business decreased 2%, commercial mortgage increased 2%. Residential real estate loans were relatively flat and consumer indirect was up 5%. Excluding the impact of PPP loans, the commercial business portfolio grew 2% and total loans were up 2.2%. Triple P loan forgiveness continued in the quarter and outstanding decreased from $55 million at year-end to $31 million at March 31. We are seeing an increase in commercial credit line utilization driven by opportunistic buying of inventory by customers to deal with supply chain constraints. Our commercial real estate pipeline remains robust. We work with known quality sponsors and they are presenting high-quality, viable projects. While developers are facing cost increases for materials and extended delivery dates, they continue to demonstrate the ability to manage these incremental expenses while maintaining acceptable underlying cash flow of projects. In Residential real estate, first mortgage volumes are down, but we are seeing an uptick in the home equity category. We are also experiencing compressed spreads in the secondary market gain on sale, putting pressure on revenue. We continue to invest in both the back office and frontline sales force of this key line of business, focusing on operational efficiencies. Growth in our consumer and direct auto portfolio continued in the quarter as we benefited from high auto valuation, good access to quality credits through our dealer network of more than 500 franchise new auto dealerships and strong credit discipline. This asset class provides the opportunity to deploy excess liquidity in a loan category with short duration, strong credit performance and comparatively higher yield characteristics in the current environment. The indirect auto line of business remains a core competency for us, and we have a demonstrated track record of consistent performance through economic expansions, recessions and stagnation. The allowance for credit losses on loans to total loans was 110 basis points at quarter end, up 2 basis points from December 31 due primarily to an increase in qualitative factors, reflecting economic uncertainty associated with higher interest rates in global political unrest. The increase in qualitative factors was partially offset by continued low levels of net charge-offs at $787,000 or 9 basis points this quarter, favorable national unemployment and a reduction in our overall specific reserve levels. Overall portfolio credit performance continues to demonstrate stability with a low level of nonperforming assets at $9.6 million. It's now my pleasure to turn the call over to Jack for additional details on results and an update on 2022 guidance. Jack?

Thank you, Marty, and good morning, everyone. I'll begin by providing commentary on performance in key areas with comparisons for the fourth quarter of 2021. Net interest income was $39.6 million, $1.3 million lower than the linked quarter, primarily as a result of lower revenue in connection with PPP loans. Approximately $25 million and $64 million of PPP loans were forgiven in the first quarter of 2022 and fourth quarter of 2021, respectively, with related fee accretion of $970,000 in the first quarter as compared to $2.6 million in the linked quarter. Approximately $1 million in 2020 vintage loans and $31 million of the 2021 vintage bonds remain on the balance sheet at quarter end. NIM on a fully taxable equivalent or FTE basis, for the first quarter of 2022 was 311 basis points, down 4 basis points from the linked quarter and down 18 basis points from the first quarter of 2021. Both PPP and excess liquidity continued to impact NIM. Given the lower level of remaining PPP loans outstanding and associated forgiveness, there was a $1.7 million reduction in PPP interest and fees on a linked quarter basis, resulting in an 11 basis point reduction in NIM. Partly offsetting the PPP impact was a significant reduction in short-term interest-earning deposits of $104 million, which resulted in approximately 6 basis points of NIM expansion in the current quarter. We continue to experience a stable level of cash flow on our investment securities portfolio, which is primarily comprised of mortgage-backed securities with low to moderate duration. These securities provide ongoing cash flow that has generated incremental yield over federal reserve balances. Cash flow from the portfolio allows for reinvestment into loans or additional investment securities as rates have increased. Our cost of funds was flat at 22 basis points in the current quarter as compared to the linked quarter. Noninterest income of $11.3 million was $352,000 lower than the fourth quarter. Revenue categories of the largest changes quarter-over-quarter were as follows: Insurance income was $754,000 higher, primarily as a result of the timing and level of contingent revenue received in the first quarter each year, combined with growth in the commercial lines business and income from limited partnerships was up $501,000 based on the activity and performance of underlying investments. We experienced a net loss on the sale of residential mortgage loans of $91,000 compared to a net gain of $482,000 in the previous quarter. Sales volumes and margins have moderated substantially in 2022, and we incurred a loss in the first quarter due to the current fair market value of pipeline commitments. These losses will be recovered when the loans are sold. Income from derivative instruments was down $516,000 based on the number and value of transactions and the impact of changes in fair market value. Noninterest expense was $238,000 higher than the linked quarter, primarily as a result of higher salaries and employee benefits, driven by investments in personnel, annual merit increases, promotions and the impact of higher payroll taxes incurred in the first quarter each year. Income tax expense was $3.4 million in the quarter, representing an effective tax rate of 18.7% and compared to $4.2 million and an effective tax rate of 17.7% in the fourth quarter of 2021. Accumulated other comprehensive income decreased by $54 million in the quarter, driven by an increase in the unrealized loss position of our available-for-sale securities portfolio. Intermediate maturities of the treasury curve negatively impacted the market valuation of our investment portfolio due to its 5-year duration. We do not consider any component of this portfolio to be impaired because it is primarily comprised of agency wrapped mortgage-backed securities that are implicitly and explicitly guaranteed by the U.S. government. The unrealized loss position does not impact our forward earnings metrics as we expect these securities to mature at a terminal value equivalent to par. As these securities rolled down the curve, we continue to redeploy cash flow into the loan portfolio or current coupon bonds. The decline in AOCI negatively impacted our TCE ratio by 97 basis points in tangible common book value per share by $3.52. The accounting driving this impact is short term given the high quality of our investment portfolio. Over time, we expect our TCE ratio and tangible common book value per share to return to prior levels. We provided slides in our investor presentation available on the Investor Relations website that show the various components of the quarterly change in both of these measures. I'll now take a few minutes to provide our current outlook for 2022 in key areas. We continue to expect mid- to high single-digit growth in our total loan portfolio with commercial and indirect loan categories driving this growth. Guidance assumes that forgiveness or repayment of the majority of the remaining $31 million of PPP loans during the next 2 quarters. We continue to plan for low single-digit growth in nonpublic deposits. We are focused on attracting new consumer and commercial deposit accounts and expect the positive impact of these new accounts to be partially offset by an expected decline in the average balance per account. Reciprocal and public deposits are projected to be relatively flat, consistent with our experience in the first quarter. We are increasing the top end of our guidance range for full year NIM by 7 basis points. The range is now 305 to 317 basis points, excluding the impact of triplet activity. There will continue to be noise in our NIM relative to PPP forgiveness, although muted relative to 2021. So we continue to guide on NIM, excluding PPP. NIM guidance reflects the increase in the Fed funds rate that occurred in mid-March. As a reminder, we are guiding them using a spot rate forecast, which was recalibrated with the spot rates as of 3/31. We do expect further interest rate increases. However, the number and magnitude are difficult to predict. We continue to expect a higher investment securities portfolio due to carryover from our 2021 excess liquidity position, which will put pressure on NIM in the first half of 2022 as we deploy liquidity from the investment portfolio into loans. Guidance also reflects our historical experience for deposit betas that range from 0% to 30% for nonmaturity deposits. As a reminder, our NIM fluctuates from quarter-to-quarter due to the seasonality of public deposits and its impact on both our earning asset and funding mix. In quarters where our average public deposit balances are higher due to seasonal inflows, the second and fourth quarters. Our earning asset yields are lower given the short-term duration of the deposits and limited opportunities to invest the funds. Our balance sheet remains relatively neutral. We saw a modest level of NIM compression in the first quarter as expected with the lower level of PPP revenue and expect NIM to expand throughout the remainder of the year if the current rate environment persists. Approximately 35% of our loan portfolio, excluding PPP, is indexed to variable interest rates. We maintain our projection of low single-digit growth in noninterest income, excluding gains on investment securities and noninterest income categories that are difficult to predict, such as limited partnership income. We also expect continued pressure on mortgage banking revenue as a result of lower anticipated refinance activity and tightening of gain on sale spreads due to the interest rate environment. We continue to expect an increase in the mid-single-digit range for noninterest expense, which is expected to range from $31 million to $32 million per quarter. Q1 expense is lower than guidance due to the timing of certain projects and initiatives that were deferred to the second quarter. Our spend in 2022 includes investments in strategic initiatives, including further enhancements to our new customer relationship management solution, digital banking and Banking-as-a-Service. We expect these investments to begin producing incremental revenue in 2022. However, full benefits are likely to be realized over the coming years. Our expectations for efficiency ratio remains the same within a range of 59% to 60% for the year. 2022 efficiency ratio is impacted by upfront costs associated with our aforementioned investments and strategic initiatives that we expect to recoup in later periods, driving our expectation for improvement in future efficiency ratio. We continue to anticipate that the 2022 effective tax rate will fall within a range of 19% to 20%, most likely towards the low end of the range given the first quarter results. Guidance includes the impact of the amortization of tax credit investments placed in service in recent years. We continue to evaluate tax credit opportunities, and our effective tax rate would be positively impacted by taking advantage of further investment opportunities. We expect net charge-offs to remain within our annual historical range of approximately 35 to 40 basis points. Although first quarter net charge-off activity remains benign, similar to our experience in 2021. Our overall focus includes executing on strategic initiatives that will improve profitability and operating leverage over time. We believe that achieving results in line with the guidance provided, will drive these outcomes. That concludes my prepared remarks. I'll now turn the call back to Marty.

Thank you, Jack. We completed our stock repurchase program in the first quarter of 2022. During 2021 and 2022, we repurchased about 802,000 shares or 5% of shares outstanding at an average price of $29.63 per share. Our buyback strategy allowed us to efficiently deploy capital in a scenario with a short-term earn-back period of less than 2 years. We remain focused on efficient and optimal capital allocation and deployment. In February, our board increased the common stock dividend by 7.4% to $0.29 per share per quarter or $1.16 per share annualized. This was the company's 12th consecutive annual dividend increase, demonstrating our ongoing commitment to shareholder return. As I commented in the earnings press release, we continue to make thoughtful investments in people, process and technology to advance our digital strategy. Our digital strategy delivers meaningful and differentiated experiences for our customers, drives operational efficiencies and creates new revenue opportunities through Banking-as-a-Service. We are making investments in building partnerships that identify and take advantage of opportunities to set us apart and drive growth. We are adding offerings to our pipeline for bank customers and potential BaaS clients. During the fourth quarter call, I talked about these efforts and a few initiatives underway, and I'd like to provide a brief update today. We are making pushes into digital payments, both consumer and commercial, along with becoming one of the first banks to offer crypto access to retail customers beyond the very wealthy, among others. CHUCK, our peer-to-peer payments network allows customers to send money from their Five Star Bank account and enables the recipient to choose where they want the money to go. We remain on track for launch in early summer 2022. Beyond CHUCK, we went live with auto books in February of 2022, which streamlines accounts receivables and payables for small businesses and is integrated into Five-Star Bank's digital banking platform. Additionally, we are exploring adding digital payment tools for commercial customers that strengthens our treasury management capabilities. We are nearing go-live for offering Bitcoin to consumers in partnership with NYDIG. We've completed our internal beta testing and are awaiting regulatory feedback before enabling this exciting offering for our customers. Our deep banking expertise, coupled with legacy and ongoing investments in technology, partnerships and talent has created our BaaS operating system, which will enable our fintech partners in nonbank financial firms looking to offer banking products and services to their customers. These BaaS partnerships provide the opportunity for additional fee revenue, interest income and insight into consumer trends. We are collaborating with partners on several exciting opportunities that will drive our BaaS line of business, and we'll announce them as they come to fruition. We filed our proxy statement yesterday afternoon, both the proxy and annual report are now available on our Investor Relations website and our annual meeting website, proxydocs.com/fisi. In conclusion, it was another good quarter on many fronts for our company, and I thank my associates for their ongoing dedication and contributions. Operator, this concludes my prepared comments, and we're right to open the line for questions.

[Operator Instructions] We take our first question from Bryce Rowe from Hovde Group.

Let's say, I wanted to maybe start on the expansion in the D.C. area with the commercial lending team there. Marty, maybe you can speak to kind of the opportunity, how you size it up from a balance sheet perspective, what the timing might look like there? And then how you feel about other opportunities that might be in the pipeline?

Thanks for the question, Bryce, and your participation this morning. We are very enthused about the opportunity to work with this team in the Baltimore, Washington market. Effectively, a complete team lived out coming out of the Howard Bancorp acquisition by FNB Corp. And I've spent time join calling with this group, they're seasoned, they're professional. Our Chief Commercial Lending Officer, new John, their leader, having worked together over the course of their careers over the past 30 years. So we were introduced to them by one of our senior executives, and they're now introducing us to a market that's broadened our horizon significantly. You'll see it of our federal government, and there's a big need, as we talked about in our prepared comments, for community banking involvement in terms of working with the segment of the market. So as we speak today, their pipeline is ramping up. It's approximately $100 million. They've already closed 1 loan associated with investment-grade sponsor, tenant, if you will, constructing a new headquarters in Baltimore. And I'm aware of a couple of mandates that we've received where it reflects the opportunity of working with deeply experienced, deeply tenured owners and developers were low loan to values and stable properties. So we're very bullish on it. I think as we speak about LPOs and further opportunities, there's some logical ones right down through way. We're already operating on the fringes of Syracuse in that market, and we'll continue to think about how to formalize an organized commercial effort there as well. So we're open to these opportunities. Given the technology that exists today, the mandate to have a contiguous footprint to help drive the noncredit services is not as important as it once was. So we're going to do it thoughtfully as we have here, and we're open to those possibilities.

And maybe some clarity around the expense guide, does it include -- I assume it includes this team here.

Bryce, this is Jack, and thanks for the question. Yes, that's correct. Both the loan growth guidance of the mid- to high single-digit level and the expense guidance are inclusive of the LPO expansion of that mark.

Okay. That's helpful, Jack. And then maybe one more for me. You guys called out some of the qualitative factors going into the allowance and some of the puts and takes relative to the drivers of the allowance. Can you speak to those? Are you having to get creative in terms of finding ways to maintain the allowance at this level and how the qualitative factors kind of work into the allowance methodology.

Sure, Bryce. And one of the areas from a qualitative standpoint that impacted our allowance model this year was some of the growth in the indirect portfolio. That's an asset class that we're extremely comfortable with. But just given the continued expansion of that portfolio, it did drive up some of the qualitative factors -- we also re-anchored our qualitative factors this quarter, which impacted the model to a certain extent. But in our current coverage ratio, we're comfortable with that coverage ratio today. And certainly, as you could imagine, uncertainty related to the economic outlook and global political unrest, make the coverage ratio difficult to forecast. If we look forward, though, we do expect a more normalized level of provisioning in 2022 to cover MCOs as guided as well as overall loan growth.

Our next question comes from Marla Backer from Sidoti.

So I want to dig a little deeper into your answers to the prior one of questions. In terms of the loan growth guidance. So are the conversations that you're having today or that your loan officers are having today suggesting that there's a little bit of waiting on the sidelines until we see some stability in interest rates or until we see what the increase in interest rates might be? Or are you encouraged by the tone of these conversations that we could see loan growth accelerate a little bit in the near term rather than the second half of the year.

So kind of starting from a macro level, credit disciplined loan growth has been a strategic focus of our company for a long time. And we've been taking advantage of organic growth opportunities in our existing footprint where we're filling a very important gap relative to how community bank operates and delivers credit services. So Marla, we for -- over a sustained period of time have been delivering high single-digit ultimately, loan growth for the balance sheet. And in the commercial segment, we continue to take advantage of numerous an array of opportunities in both our -- in commercial, small business, commercial C&I and commercial real estate. So our pipelines remain consistent, and I would say, steady and ultimately sustained. We're going to benefit from the incremental LPO office that we established in the first quarter, but we feel good about the outlook for our ability to continue to drive organic loan growth...

Okay. And then switching gears a little bit. You did comment on how the technology access makes a contiguous operating footprint a little bit less of a mandate today than it was perhaps a couple of years ago. And so your entrance into the Baltimore, DC markets. Does this, in any way, impact your strategy vis-a-vis Buffalo and Rochester or is that strategy still in place as it was?

So that strategy is still in place. I think that we remain very eyes wide open relative to the impact of digital adoption in the world, certainly in our industry with our customers, with our prospects in terms of balancing our ability to deliver the bank in a very confident and personal and accessible manner for our customers, while at the same time, ensuring that they have -- they're empowered to access us through technology and digital solutions that meet their needs. So we'll constantly think about the balance between our commitment to a physical footprint as well as supplementing and complementing that through our digital solutions that empower our customers, consumer and commercial.

Okay. And then last question, which is more of a housekeeping one. It comes out of this conversation that we're having now. Do you foresee any additional branch closures in 2022?

Marla, this is Jack. At this stage of the game, we don't have any branch closures in our strategic outlook.

Our next question comes from Alex Twerdahl from Piper Sandler.

Just sort of start with the NIM guidance that you gave, Jack, can you just -- would you mind going through it just one more time? I think you said 305 to 317 ex PPP, what's the starting point NIM that you're kind of using as kind of the starting point for that NIM guide?

So when we look at our results for this quarter, we came in at 311 basis points. And then when you back out the impact of PPP, we were at 305. And we took the first quarter results and rolled forward using the spot rate as of March 31 to update that guidance, which resulted in an increase on the longer end of 7 basis points from what we originally guided.

Okay. And -- can you just remind us, do you have any sort of guidance? I think the forward curve has now got something like 8 hikes for this year. Can you give us a little bit of guide on kind of what the expectations per hike is, given the 35% of loans that are indexed to variable and maybe go through some of the other cash flows that you're expecting over the next 12 months?

Yes. From a cash flow standpoint, we saw a pretty healthy amount of cash flow come off the securities portfolio in the first quarter. And over the next 12 months, we're modeling another $200 million to come off of the securities portfolio itself. We didn't model on a per hike basis per se. But when you layer in the forward curve based upon the Fed guidance, I think that we could see another potential for 5 to 7 basis points of expansion, assuming that we're able to maintain our deposit betas. And I mentioned that our nonmaturity deposit betas were modeled at 0% to 30%. We also look at our [ SEDAR and ICS ] portfolio, which is our reciprocal deposit base, which has a higher deposit beta, that ranges from about 55% to 65% as well. So that's based upon our experience during the last rate hike in the 2018 period. It may be a little bit different this go around, but I think we're being fair in using that historical experience in our modeling.

Okay. The cash flows on the securities you alluded to, the $200 million plus whatever came this quarter. Is that -- are those coming off higher than what new securities are going on at -- or are they kind of around the book yield?

The cash flow that's coming off is right around the book yield.

Okay. And then can you maybe talk a little bit about new loan yields that you're seeing in your market for commercial paper? I kind of gotten some answers that are all over the board from some of your competitors?

Yes. This is Jack. I mean from a competitive standpoint, as you can imagine, the market is highly competitive right now as most banks continue to have excess liquidity on their balance sheet that they're looking to deploy into this higher interest rate environment. From a yield standpoint, I'll talk about credit spreads a little bit. We have seen a slight amount of tightening in credit spreads, but not to an extent that makes me nervous, and it's generally in line with our experience over the past 12 months.

So what does that translate to, if you're putting out a new commercial real estate loan today, like what kind of yield was that roughly would that translate to?

I mean I'll talk about the credit spreads again. I think that generally, if you look at where our loans were pricing in the past 12 months and then add in the ship in the federal home loan bank curve, that would approximately equate to the new loan yield that we're seeing in the market.

Okay. And what are those credit spreads? Can you give me -- just trying to make it ultra tie together with the NIM guide?

There -- I'm not going to pinpoint them exactly, but they're above 200 basis points.

Okay. And then just shifting back to the commentary on the lenders in D.C., are you going to need a branch down there?

No, we're not. The application that we filed is for a limited production office, which essentially allows for us to generate commercial loans and accept commercial deposits in that space digitally.

[Operator Instructions] We take our next question from Damon DelMonte from KBW.

This is Matt Rank filling in for Damon DelMonte. I hope everybody is doing well today. I appreciate the update on the digital initiatives. My first question is, do you still expect the Bitcoin wallets to launch by the end of the second quarter? Or do you think the regulatory review could delay that?

We do think we're shooting for end of the second quarter, early summer. We want to -- as we said, we completed our beta testing, friends and family. We're certainly ready, but we want to make sure that we're very collaborative with our regulators and understand what their expectations are, and so we move up to them.

Okay. And will that be expanded to additional crypto currencies and if that expansion has and does that require a whole another regulatory review? Or will that be quicker additions?

Yes. At this point, we're just focused on the partnership we have with NYDIG.

Okay. Got it. And then my last question, just regarding share repurchases. I know you said you went through the plan. Do you have any updated outlook going forward for the rest of the year?

This is Jack, and thanks for the question. We continue to identify opportunities to efficiently deploy capital and potential to build dry powder, so to speak. So though that's an barrel that's in our quiver and something that we can consider as we continue to provide outlook for future periods.

[Operator Instructions] We currently have no further questions. I'll hand it back to our speaker team for any final remarks.

Thanks for your support. So taking this important discussion. We look forward to continuing the dialogue with our second quarter results in July.

Thank you for joining. This now concludes the call. Please disconnect your lines.