First Bank (FRBA) Q2 2019 Earnings Report, Transcript and Summary

Good morning, and welcome to the First Bank Second Quarter 2019 Earnings Call. [Operator Instructions] Please note, that this event is being recorded. I would now like to turn the conference over to President and CEO, Patrick Ryan. Please go ahead.

Thank you. I'd like to welcome everyone to First Bank's Second Quarter 2019 Earnings Call. In addition to myself and Peter Cahill, our Chief Lending Officer, there are a couple of new voices on the call today. Andrew Hibshman, our Chief Accounting Officer will be filling in Steve Carman who had some planned family time away and given the importance of our deposit gathering initiatives we've asked Emilio Cooper, our Chief Deposit Officer to join as a regular member of call going forward. But before we begin, I'll ask Andrew to please read the Safe Habor statement.

The following discussion may contain forward-looking statements concerning the financial condition, results of operations and business of the First Bank. We caution that such statements are subject to a number of uncertainties and actual results could differ materially, and therefore you should not place undue reliance on any forward-looking statements we make. We may not update any forward-looking statements we make today for future events or developments. Information about risks and uncertainties are described under item 1A, Risk Factors in our annual report on Form 10-K for the year ended December 31, 2018, filed with the FDIC. Pat, back to you.

Thanks Andrew. I'd like to start at a high level then I'll it over to the team to provide some additional information. We spent some time digging into the numbers for the quarter, and we tried to come up with an estimate of what we thought sort of the normalized results were. And per our analysis, it appears that the bottom line earnings were pretty much in line with prior quarters, and that's based on an adjustment for the provision to a level more consistent with what we've been providing in prior quarters as well as what results would have been had we kept our prior 21% tax rate. So when looking at a couple of those factors, we estimated, call it a pro forma net income of about $4.1 million, which is basically in line with where we've been for the last few quarters. Balance sheet growth, in essence, is basically being offset by margin compression and noninterest expense growth that was taken on in late 2018. Given that some of the factors are out of our control in terms of the shape of the yield curve, and while we're obviously working hard to grow core deposits, we wanted to spend a lot of time looking at what's been happening on the expense side to get a sense for where and if there may be opportunities there. And when we took a look at expense growth from late 2018, we looked and saw that we basically had the rough equivalent of 10 net new hires to the team since the third quarter of 2018, and those net new hires came in three areas, two of the areas more strategic and one more operational. The two strategic areas of growth were our PA market expansion, which we've talked quite a bit about in the past. Our Southeastern PA West Chester lending team joined in the spring of 2018, and I'm pleased to report that group now has over $100 million in their loan portfolio. And the West Chester branch in Pennsylvania opened in August of 2018, and that branch now has $25 million in deposits, which we think is a nice start. The other area of strategic growth and hire was the buildout of our commercial deposit gathering team; that came in two areas. We added a couple of folks in the direct sales force, and we also added to the strength of our cash management operations team. The third area related more to back office hires that were necessary to support the overall growth of the bank. The good news is that as we move forward, we believe these strategic investments will continue to help us improve earnings and move from where we're probably closer to breakeven right now to starting to generate bottom line incremental returns as we move forward. We also took steps this year to stop noninterest expense growth. As many of you know, expenses had been growing sort of in the 5% to 7% range prior and we've done a couple of things to keep expense growth in check. We had two regional presidents that we did not end up replacing. We found two branches that we were able to consolidate and we had a couple of other vacancies that emerged, which we did not fill. Furthermore, we're looking at additional cost savings opportunities. We're doing a review of our overall staff structure and efficiency. And we've commenced a review of "other expense categories" and we're looking at outlining cost reduction opportunities in other areas. It's worth noting that a portion of the expenses incurred in Q2 2019 include about $150,000 of nonrecurring items specifically related primarily to the Fiserv conversion and that's in addition to the over $100,000 in merger-related costs, which were also in the expense numbers in the second quarter. So the key question is, what are the levers we have to drive our return to earnings growth? And I think the levers are threefold. We have the core commercial deposit gathering initiatives, which we believe can continue to reduce the gap between our cost of funds and our competitors that will come from an improvement in mix as well as the bank, being slightly liability-sensitive, will create some opportunities for reduction in our cost of funds as we move forward, assuming the Fed ends up moving. We also have expense management opportunities, as I mentioned. And the third lever, I believe, is continued opportunities of M&A and EPS accretion that can come from those opportunities. Looking at the balance sheet quickly, there were some positive signs in the second quarter. We were up over $50 million in loan growth. And within the noninterest-bearing deposit category, we had over $22 million in growth in that area despite the conversion. So that was good news as well. On the income statement side, our net interest income was up over $500,000 from the prior year quarter and up almost $2 million for the first half of this year when compared to the first half of 2018 and noninterest income was up 20% from prior quarters. Regarding our regional structure and updates, we have added a couple of high-quality RMs to our PA team. Those were replacement hires, not net new additions. So we feel really good about the strength and quality of the team we have in place in PA right now. And we did see a return to loan growth in the greater Bucks County region in Q2, and we saw continued loan growth in the Southeastern PA West Chester market and we continue to see a robust pipeline in all of our regions. Lastly and quickly on the tax rate, as many of you know, there's been uncertainty in New Jersey about some changes to the corporate tax code. We believe that there is less uncertainty now and that things are coming into focus a little bit. Based on discussions with our advisers, we believe the right estimate today that we have is our go-forward rate for our effective tax rate is 25.8%. And you'll see that led to not only a higher tax rate in the second quarter using that 25.8%, but we also had a onetime adjustment to take in the second quarter related to the lower tax rate that we had used in Q1 and Andrew will get into a little more detail on that. It's worth noting that while 25.8% is our current estimate, we believe there are actions we can take going forward that will allow us to hopefully drive that rate down a little bit, hopefully somewhere in the range of 1% to 2% as we move forward throughout the remainder of this year. At this time, I'd like to turn it over to Andrew to discuss additional financial details for the second quarter.

Thanks, Pat. With the challenges to the flat-inverted treasury yield curve and competitive deposit environment, we've really been focused on the performance of our net interest margins. In addition, we received some clarity in Q2 from New Jersey related to the legislation passed last July and what that would mean to our annual effective tax rate. Looking first at our tax equivalent net interest margin, our margin for the second quarter of 2019 was 3.37% compared to 3.63% for Q2 2018, which was a decline of 26 basis points. The combination of a higher interest rate environment during 2018, coupled with stealth competition for deposits, resulted in a 57 basis point increase in total interest bearing deposits, which outpaced our 16 basis point increase in total earning assets. Our tax equivalent margin for the first six months of 2019 compared to the same period in 2018 produced similar results as our margin declined 22 basis points to 3.41% compared to 3.63% for the six months ended June 30, 2018. On a linked-quarter basis, our net interest margin was 3.37% for the three months ended June 30, 2019, 8 basis points lower than our margin in the first quarter. The lower margin was also due to higher total interest bearing cost of 10 basis points for the comparative quarters, with our asset yields remaining relatively flat. So what do we think happens from here regarding the margin? The ongoing inverted yield curve presents challenges, particularly related to loan pricing, and deposit competition continues. However, we believe that deposit cost pressures have rescinded somewhat. And with an expected Fed move next week, we hope to drive deposit costs lower. Emilio will discuss shortly the progress we are making in attracting lower cost core deposits. The immediate impact of a rate cut will most likely have somewhat of a negative impact on our margin as we have more assets and liabilities that are directly tied to market yields. However, over a six to twelve-month time horizon, our liability is sensitive, with a large number of CDs maturing. In conjunction with our focus on attracting lower cost core deposits, we will be focused on lowering costs on our interest bearing deposits. We are hopeful that with these strategies, we can maintain a stable or maybe slightly declining margin, with opportunities for improvement that the yield curve environment improves. Regarding our effective tax rate, clarifications from New Jersey issued during the second quarter related to the combined company reporting structure resulted in the calculation of a higher New Jersey state income tax expense and a higher annual effective tax rate. Our six-month effective tax rate, as Pat mentioned, was 25.8% as of June 30, 2019 compared to 20.01% for the first quarter of 2019. This required a catch-up accrual in Q2 of 2019, which resulted in a three-month effective tax rate of 33%. This equated to approximately $300,000 in additional tax expense in the quarter. Had we had used the 25.8%, it would have been $300,000 lower. Based on our current interpretation of New Jersey tax law, we believe that we can implement additional tax planning strategies during the second half of 2019 that can lower our effective tax rate somewhat from the 25.8%. As Pat mentioned, we think possibly as low as 24% effective annual rate for the year. Pat discussed earlier also, he talked a little bit about the enhanced credit cost or a higher credit cost during the quarter, which was reflected in a $1.7 million provision during the current quarter versus the average provision of $756,000 for the previous eight quarters. The higher credit costs were mainly due to a slightly elevated charge-off and increases in nonperforming loans in our C&I and owner-occupied CRE portfolio, which Peter will address later in the call. While we believe asset quality metrics remain healthy and expect provisions to normalize in the subsequent quarters, we'll continue to monitor our portfolio and for further deterioration, and the level of our allowance will be adjusted accordingly. Net income for the second quarter of 2019 was $2.8 million or $0.15 per diluted share compared to $4 million or $0.22 per diluted share for the second quarter of 2018. Net income growth, the primary driver of our profitability, was $14.2 million for Q2 2019, an increase of $531,000 or 3.9% compared to $13.6 million for the second quarter of 2018. Net income for the six months of 2019 was $7.1 million or $0.37 per diluted share compared to $8.1 million or $0.44 per diluted share for the same 2018 period. Net interest income for the comparable period was $2 million or 7.5% to $28.2 million. As Pat discussed, a more normalized net income for the quarter would have been approximately $4.1 million or $0.22 per share. This was calculated using the previous eight quarters' average provision of $756,000 and a 21% tax rate. As we look forward from a balance sheet perspective, loan growth remains consistent. Asset quality metrics are healthy. And even with an overall decrease in deposits of $7.3 million during the quarter, we made significant progress in a key strategic focus area, attracting lower-cost commercial deposits as evidenced by our $22.8 million increase during the quarter in noninterest-bearing deposits. With the current rate environment, it presents a challenge from a margin perspective. Should the fed lower rates, we are prepared to reduce our deposit rates accordingly and continue to use cost-effective sources to support our loan growth. We are also very focused on controlling costs. As Pat mentioned, we recently closed two underperforming branches and are managing noninterest expense as we grow as evidenced by the flat expenses over the past three quarters. We also hope to gain efficiencies with our Grand Bank acquisition, which we plan to -- still plan to close at the end of the third quarter of this year. We continue to have a goal of moving our efficiency ratio below 60% over the next several quarters. To further discuss our results in lending is Peter Cahill, our Senior Lending Officer. Peter?

Thanks, Andrew. As Pat mentioned earlier, net loan growth in the second quarter was $51.5 million, a 15% improvement from the $34 million included in the portfolio in the first quarter. It's been a portfolio of $178 million or 13% since June of last year, and all that grew since then towards the end. Our six-month run rate from January through June of this year would result in growth for the year of approximately $171 million or 12%. I spoke last quarter of our efforts to get fully staffed in our Pennsylvania region. That effort took most of the second quarter, but I'm pleased to report, from a relationship management headcount perspective, we are still all open, we have a good pipeline there and are beginning to move more business through that pipeline. Regarding the new business pipeline, bank-wise, the potential for loan growth continues to be good. Our pipeline of loans adjusted for the probability has been down or was down slightly at 03/31/2019 in comparison to year-end 2018. Those remain above the 2018 average of around $162 million. At 06/30, the pipeline stands at $192 million and has averaged $181 million over the past six months. Those averages reflect a 12% positive difference when you compare 2019 to 2018. We continue to work hard in finding new C&I relationships, and we continue to see good opportunities for an investor real estate business. Our relationship managers have been focused, not only on loans, but on the generation of new deposits. We have some relatively new business anchors and treasury management staff on the retail side that we are into working closely with thus far. Emilio Cooper will talk more about deposits shortly. So despite somewhat of a slow start to the year in the first quarter, we've picked up the pace in the second quarter, and all the regions are reflecting good activity and this should continue in the second half of the year. As far as asset quality goes, we did experience some deterioration of some of the metrics in the second quarter. Delinquencies were up a bit at 6/30. The nonperforming loans increased from 50 basis points in March to 94 basis points in June. As the release points out, most of this was caused from one commercial relationship that we're working with closely. As we have in the past, from a new business perspective, we focus only on what we believe are high-quality loans. Our underwriting standards have not changed. We see quality asset growth, and we're not, by any means, focused only on yields. Additionally, we continue to monitor the loan portfolio closely, including the formal, very detailed asset quality review meeting that's held every quarter. Here, within a portfolio that is set for us, we have directors, and the portfolio remains well diversified. The relationship we had has slipped a little bit sideways, as well as we believe, an isolated issue, and there doesn't seem to be any signs of any trends that are concerning. Just to touch upon, one of the things I had mentioned, I will say, at the last call, was replacement of credit underwriters in regional offices and adding loan administration staff in the regions as well. We think this will lead to a level of responsiveness that will equate to more efficiency and be a competitive advantage for us. We now have underwriters in two of the four regions and we're interviewing others as we speak. I should also mention that we recently hired an experienced credit officer to join us, she signs off on many of our larger loans and is a member of our Management Loan Committee. She, along with the relatively new credit department manager, are already contributing very positively to the business generation process. I've also mentioned our core system conversion. That's, for the most part, behind us, that places into the first quarter a very few glitches as far as the lending area is concerned, and we're moving forward. And as we have in the past couple of quarters, we continue to work with the staff at Grand Bank. We announced that merger a few quarters ago, and everyone is well prepared for that anticipated plan. So in summary, signs are good for continued growth. We believe we have our hands around asset quality, and we are all-hands in a manner to continue to expand our business carefully in all of our markets. That's it for my first quarter lending report. I'd like to turn it over now to Emilio Cooper to discuss positive deposit initiatives.

Great. Thanks, Peter. Overall, deposit results for Q2 were mixed. As Andrew stated, total deposits declined $7.3 million during the quarter. In Q2, we dedicated time and focus on our customers and colleagues to prepare for and execute on our core system conversion from Jack Henry to Fiserv. We successfully led the team through the core conversion at the end of March and partnered with our customers through April and May to ensure their satisfaction and a high degree of comfort with our new banking system. During the period leading up to conversion and directly after, we slowed our acquisitions and implementation of complex commercial operating deposit relationships for obvious reasons. We also reduced our CD rates and discontinued our promotional money market products to allow our team time and reduced new account volume to focus on our systems conversion. That strategy worked and the conversion was a success. As a result, we were able to get the teams reengaged halfway through the quarter on new acquisitions in building the deposit pipeline. Due to this, we posted declines in core deposits in April and May and returned to growth in June. The bright spot in the quarter was that we grew our noninterest-bearing deposits by $22.8 million during the second quarter driven by augmentation in existing commercial accounts and new customer acquisition in the month of June. We are focused on a number of initiatives to drive continued strong noninterest-bearing growth through year-end, coupled with equally strong growth in total deposits. Given where we are in the economic cycle, we have an enhanced focus on liquid accounts such as savings in money market. We also are positioning ourselves for retention of our renewing CDs as we progress through the remainder of the year. Our primary focus is on growing our noninterest-bearing deposits, and we have many key initiatives underway to accomplish that goal. Our deposit pipeline is strong and continues to grow daily. Some of the key initiatives underway include the following. Enhanced collaboration between business bankers and commercial lenders, we're launching cash management training for our lenders and branch managers this quarter, and we're launching online accounts opening. We are excited about the capabilities and enhanced flexibility our new core system provides to us as we feel strongly about the ability to offer more competitive and enhanced cash management products and services at a fair value. We see a growing need in our marketplace for an alternative to the larger institutions. Our strategy is taking hold, and we are looking forward to the growth and shift in our deposit mix we see developing. That wraps my Q2 update. Back to you, Pat.

Thank you, Emilio. At this point, I'd like to turn it back to the operator to start the Q&A.

[Operator Instructions] Our first question comes from Nick Cucharale with Sandler O'Neill + Partners. Please go ahead.

Good morning, gentlemen.

Hi, good morning, Nick.

Just starting with the C&I credit that moved to nonaccrual, it sounds like a fluid situation, but can you share with us the industry, geography or other details you find pertinent?

Yes. I mean given that there is some fluidity there, I think it's better not to get into specifics on the credit per se. I mean as we said, it is C&I. We do have a portion of the collateral's real estate base that we think is high-quality. So from that standpoint, we're going to obviously learn more as the situation unfolds. I think there is a scenario where things could work out fine and one perhaps where maybe not as good, but we're prepared for either scenario based on steps we've taken in the quarter and we just got to let it play out a little bit.

Fair enough. Secondly, you posted solid loan growth this quarter, and it sounds like the pipeline is up quarter-over-quarter from Peter's report. You had previously mentioned a mid-teens growth rate for the full year. Is that still a good target?

Yes. Listen, we're not internally telling folks, hey, we no longer want to hit that number. But I think, from my standpoint, given the activity and the fact that I think it's prudent to make sure we're being very, very thoughtful on the credit side at this point in the cycle, I think if we end up somewhere in that 10% to 15% range, I think that will be fine.

Okay. Great. And then you've mentioned in your prepared remarks a few initiatives to manage operating expenses. I was just trying to quantify that going forward. Is the $9 million still a good organic run rate? Are you looking for a reduction in that level going forward?

Yes. I mean it's -- listen, I'm looking to find ways to get it down. At this point in the projects, the life cycle, we don't have a specific target ironed out and a goal we've set that we can share. But certainly, I think we've taken steps to keep us at a flat level. And now the second phase, if you will, is looking for efficiency opportunities, which we hope will be able to drive those expenses lower going forward. So we don't have a stated target there yet, but it's certainly something very much on our radar.

Okay. And then lastly, Andrew, I just want to clarify your NIM guidance a little bit. Did you say a slight reduction in the coming quarter and then stability which is predicated on lowering deposit costs, is that correct?

Yes. I think if the Fed moves, there's going to be some immediate impact on the asset side before we can make some adjustments on the deposit side. But I do think, ultimately, we should be able to see it stable or potentially even get some benefits on the deposit side because we had such a slug of CDs that are maturing over the next six to 12 months. So I think immediate impact will be slightly negative. We've kind of quantified potentially 5 basis point effect on asset yields, but I think that will quickly shift back to a fairly stable margin from where we're at now and maybe even from opportunities for improvement on the margin as we go further.

Great, thanks for taking my questions.

Yes, thank you, Nick.0

Our next question comes from Joe Fenech with Hovde Group. Please go ahead.

Hi guys, how are you?

Good Joe, how are you?

Pretty good. Pat, there has been, as you know, quite a bit of M&A activity recently in New Jersey, being sort of centrally located in the state, do you guys see specific dislocation opportunities, either in terms of the customer base that you target or a shakeout of talent from some of these deals?

Yes. I mean listen, M&A, we'd like to be involved in the M&A, but it creates opportunities either way because no matter how good you think you are in the integration side, it always creates a little bit of uncertainty. And so certainly, from our standpoint, if you look at the four or five deals that have been announced in Jersey and a couple of others in PA, we do see those as opportunities. And we're constantly looking to try to take advantage of that customer uncertainty that comes along with M&A. And obviously, if there's larger banks that are doing the buying, we think that helps us even more. So yes, I think it's an opportunity, a little hard to quantify, but certainly, we believe that dislocation is a net positive in terms of customer acquisition.

Okay. And then it looks like some real nice growth, as you pointed out, noninterest-bearing. The overall deposit balance is lower. Emilio's explanation of the dynamics there was helpful. Maybe just your thoughts on balance sheet liquidity here and whether or not liquidity is also, with the 107% loan-to-deposit ratio, is also entering your thought process in terms of lowering that loan growth guidance just a bit?

Yes, definitely. I mean listen, we're still seeing lots of good lending opportunities. We obviously want to be extra thoughtful on credit quality. We like to think that we're always extra thoughtful, but you've got to pay attention to what's going on in the market around you. But listen, if we can drive significant core deposit growth, we'd love to have that ratio, 107%, come down to the point where we're back closer to 100%. And so, the short answer to your question is yes. How we're able to find success in our deposit gathering will impact ultimately what we decide to do on the loan growth side because we don't want to see the loan-to-deposit ratio move really much higher from where we are. So...

Yes. That's helpful. And have you guys quantified how much you kind of lost in April and May through the systems conversion? And then maybe, I guess, maybe a portion of that increase in the loan-to-deposit ratio was a bit artificial because of that situation and normalizes, had been able to quantify maybe how much was lost?

Well, I would tell you that there is unfortunately a fair amount of fluctuation across accounts that, month-to-month, it's really hard to be able to isolate specifically what would have happened if. But certainly, what we would normally hope to see is strong growth in the noninterest-bearing, coupled with growth in other categories. We obviously saw some declines in some other categories there. So I don't have a specific number. But obviously, when you take your sales force and you reallocate a significant portion of their time to calling on existing customers, working through any conversion-related issues, resolving issues, whatever it might be, that clearly is an impact. I just -- I don't have a number for you, Joe.

Got you. But just -- it does seem like the point is, I guess, that the 107% might be artificially high. That's not kind of a function of the -- how the business is running, it's just it kind of had that dislocation in the early part of the quarter. So I appreciate that. I guess -- go ahead.

No. Just because I was agreeing with you, that's all.

Okay. Turning to capital, guys, even with Grand, it would seem, Pat, you have excess capital. Can you talk about your appetite for share repurchase with the stock here sub-120 a book and how that stacks up against other opportunities to deploy the excess, especially with slowdown of loan growth too?

Yes. I mean it's a great question. It's certainly something that is on our radar at the Board level. One of the unfortunate items that impacts that equation that's hard to quantify is future M&A. so if for example, if you knew hey, M&A opportunities aren't going to be out there, and you probably look at the share repurchase a little bit differently, then if you're thinking that the M&A market is going to be robust and you want to make sure you got good capital to take advantage of those opportunities. So we're trying to weigh those factors effectively, Joe, but it's definitely something that's on the radar at the Board level and we're taking a good hard look at.

Okay. And then last one from me, I appreciate the sensitivities around discussing the credit relationship. Can you give us a rough estimate though, Pat, of the size of it?

Yes. Well, the loan relationship in question is a sort of plus or minus $8 million.

Okay. Thanks a lot. I appreciate the time.

You got it, no problem at all.

[Operator Instructions] Our next question comes from Joe Gladue with Alden Securities. Please go ahead.

Hey, good morning.

Good morning, Joe. Just first off, I guess just one, can you remind is how much is the loan portfolio as tied to LIBOR for fund?

It is about 20%, a little less, Andrew?

A little than 20%, I think now. 15% to 20% is repricing. Some of that -- some of those loans are already at their floor. So it might be a little bit -- I'd say closer to probably 15% will actually be affected by a Fed cut.

Yes. So the 20%, that's maybe looking at cash.

Yes. Right. Yes, so we also have Fed funds and some investments, but not a lot. So probably, overall, if you're looking at the total balance sheet, 20% is probably is a good number that will be affected by a 25 or whatever basis point cut that the Fed does.

Okay and I was just wondering, I guess, the – those onetime swap referral fee at the fund, how much is that exactly?

That's a good question. I don't have that right in front of me. I want to track that down. I mean there does seem to be more interest rate now in the borrowing side on exploring floating rate and/or swap options, and there definitely was a little bit of an uptick in the quarter from that. But it's also something that we're doing more of and so I wouldn't call it a total onetime event, but perhaps a little bit higher in the quarter than what we've seen in the past, although, we certainly think we can continue to layer that into our noninterest income as we move forward.

Joe, I believe -- I'll follow up with you, but I believe it was around $100,000. But I will follow up and get you the exact number.

Okay, all right, thank you.

No problem.

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

Okay. Well, thanks very much for everybody that took the time to join in, in the call. We appreciate it, and we look forward to regrouping next quarter. Thank you very much.

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