First Merchants Corporation (FRME) Q4 2008 Earnings Report, Transcript and Summary

Hello, and welcome to the First Merchants Corporation fourth quarter 2008 earnings conference call. All participants will be in listen only mode. (Operator Instructions). During this call, management may make forward-looking statements about the company's relative business outlook. These forward-looking statements and all other statements made during the call that do not concern historical facts are subject to risks and uncertainties that may materially affect actual results. Specific forward-looking statements include, but are not limited to, any indications regarding the financial services industry, the economy, and future growth of the balance sheet or income statement. (Operator Instructions). Now, I would like to turn the conference over to Chief Executive Officer, Michael Rechin. Mr. Rechin?

Thank you, [Ryan] and good afternoon. I appreciate the interest of our listeners today and welcome to our earnings conference call for the 12 months ending December 31, 2008. Joining me today are Mark Hardwick, our Chief Financial Officer; Dave Spade, Chief Credit Officer, and John Martin, Deputy Chief Credit Officer. I’ll lead off by highlighting our 2008 results and then adding comments on our highest priority objectives for the coming year. Mark Hardwick will follow me with some additional commentary on our financial results. Dave Spade and John conclude the details on our portfolio composition and its credits condition. We’re all available for question-and-answer dialog after our prepared remarks. In the release that was let go before lunch time today, we would have seen that First Merchants Corporation earned $1.14 per share in 2008, and $0.01 per share in the fourth quarter. The annual earnings compared with $1.73 earned in 2007, and $0.51 earned in last year’s fourth quarter. At the end of the earnings release, I referred to five specific priorities for 2009 and beyond. I would like to address each of those separately in my thoughts before giving way to Mark, Dave and John who will add greater detail around the financial results, capital positioning and credit quality. I think I’ll begin with our acquisition of Lincoln Bank Corp closed at year-end. We successfully closed the transaction on December 31 and are moving towards an April integration of their systems in the field and back office. The core processing integration will be coincident with the signage and name changes for the Lincoln franchise. Our branding work and initial customer contact effort have also been initiated. Our work in the adoption of common process has also begun in areas such as credit policy, credit adjudication and portfolio management.…

Thank you, Mike. I would first like to thank the accounting team of First Merchants and Lincoln for working such long hours over the last month to complete the consolidation of the year-end financial statements to include the completion of the actual onsite field work by BKD, our outside auditing firm. For everyone in the call, today thanks for your interest in First Merchants Corporation. As Mike mentioned, First Merchants Corporation reported earlier today its fourth quarter and 2008 net income and EPS results and the earnings per share for the year totaled $1.14, a decline of $0.59 from 2007 total of $1.73. Net income for the year totaled $20.6 million compared to 2007 total of $31.6 million. The quarter is difficult to discern given the complexities of closing the Lincoln acquisition on December 31 of 2008 and several extraordinary non-interest income items and non-interest expense items, which I will discuss in a few moments. Total assets reached a record $4.8 billion at quarter-end, an increase of $1 billion, from the December 31, 2007 total of $3.8 billion. Of the $1 billion increase, the completion of the merger with Lincoln accounted for $876 million. Loans and investments, the Corporation's primary earning assets, totaled $4.20 billion, an increase of $876 million, or 26% over the prior year. Loans accounted for $846 million of the increase as investment securities increased by $31 million. And of the $876 million increase, Lincoln accounted for $637 million in loans and $122 million of investments. And these numbers are all included in our press release. The Corporation's allowance for loan losses as a percent of total loans increased from 98 basis points to 131 basis points during the year, a $20.7 million increase. Provision expense exceeded net charge-offs by $12 million and Lincoln added $8.7 million…

Thank you, Mark. As Mike and Mark mentioned, First Merchants Corporation has continued to see challenges presented by a deteriorating economic environment at state, local and national levels. These weaknesses have manifest themselves in higher levels of non-performing assets and loan delinquencies in some areas of the Corporation. The credit department’s special assets officers, the local bankers and others continue to manage through problem loan identification, aggressive collections, legal actions in the marketing of other real estate owned. I would discuss the trends and changes to our loan portfolios during the fourth quarter I will also highlight how we planned to continue to manage our risk assets as the economic issues continue in this country. As of December 31, 2008, First Merchants Corporation solved the non-performing assets plus 90-day delinquencies, increased from $63 million to $73 million for the existing bank franchise. With the addition of Lincoln Bank assets to the December 31 totals, those NPAs increased slightly more than $112 million. Total non-performing assets plus 90-day passthrough accounts represent 2.34% of actual assets and 2.83% of total loans and other real estate owned at the year-end. The top five non-performing relationships including other real estate owned represented 24.5% of total non-performing assets at the end of the quarter. All of these five assets were identified during previous quarters and specific action plans have been developed to either move the assets out of the bank or to sell the other real estate owned. With the inclusion of non-performing assets from Lincoln Bank at year-end, total non-performing assets moved from $63 million on September 30, 2008 to the $112 million total I spoke about on December 31, 2008. Of that $49 million increase, $10 million of that was attributed to First Merchants Corporations while $39 million was allocated to Lincoln Bank…

Thank you. Dave. I think as you heard in Mark's comment, today's credit risk management challenge extends beyond the loan portfolio. During 2008, I believe we dealt aggressively with the risk elements in our investment and BOLI portfolios. We're fortunate to have a diversification of investment classes that should limit additional loss exposure subject in large part to the future direction of the financial sector’s strength. I would like to return for a minute to our Lincoln acquisition briefly. Lincoln has a long history with Indianapolis customers particularly on the growing south and west quadrants of the city itself, well placed physical franchisee in growing communities and a market recognized leadership team. Our combined team covering Indianapolis market will be focused on improving credit quality and growing our deposit base under the First Merchants name. There is an availability of talent in the market and then our company will allow us to diversify Lincoln’s portfolio mix from its current real estate orientation to a more balanced coverage of the central Indiana marketplace. I guess I would say in summary I like our market positions. Significant market share in several substantial mature Indiana markets like Muncie, Indiana, Lafayette and Anderson coupled with expanding market share in Columbus, Ohio and Indianapolis Indiana. Behind Chicago, these are the two best growth markets in the Midwest. We know our earnings potential. We’ve seen at it. We also understand the climate at hand and the growth that it calls for, the tempered growth and the work that needs to be done. The five priorities I listed in my earlier remarks will be our guiding posts to include items that we can control such as our expense level, the execution on the Lincoln integration and in some aspects to the net interest margin. Dave described the resources that will be attributed to improving our credit quality, both on the front door as we greet new customers and continue to lend patiently as well as handling the portfolio at hand and Mark and our financial team were work as they have been ensuring we have the liquidities to take advantage of the opportunities that they present themselves. So, this point after a more detailed calls and we have normally provided relative to this specifics of the income and expenses, our team would be open for question [Ryan].

(Operator Instructions). Our first question comes from Brian Hagler of Kennedy Capital. Brian Hagler – Kennedy Capital: Hi, good afternoon.

Good afternoon, Brian. Brian Hagler – Kennedy Capital: Mark, I think you said that your tangible common equity ratio was 5%. Just wanted to get I guess your thoughts on if you guys have laid out kind of a target range for that in the past and if you feel like it will organically grow the share?

At the board level, we’ve said nothing below 5% with an eye towards growing the tangible capital ratio to 6. And we've been doing that pretty steadily over the last couple of years. As I mentioned the purchase accounting adjustments that 25 basis points or so out of the tangible capital ratio. Capital ratio were a little unexpected and yet they accrue into income over the next several years, so we’ll get a nice add back of that amount. At this stage, we are continuing to just evaluate our overall capital position, the impact of the TARP within the CPP program, which doesn’t have a tangible common equity component and continuing to assess our competitors and the need to potentially have some kind of an increase in the common equity position. But at this state, our board and our management team have not elected to move forward with any type of capital rates. The earnings beyond dividend should add in the range of $10 million to our equity ratio in the coming year. So we are continuing to monitor just earnings over dividends, the impact of OCI and how the purchase accounting adjustments will creep back in the capital. Brian Hagler – Kennedy Capital: Okay and I appreciate that and what was tangible book value at the end of the year?

I don’t have I think it was about 10.80.

I think that’s right I think it was right about $11 Mark. Brian Hagler – Kennedy Capital: Okay and then finally you mentioned in the credit commentary that consumer loan charge-off at 90 days past due? Is that a change this quarter and if so did that lead to maybe kind of a say double counting but a little more charge-offs in that category, the normal or [VOAs] had that policy?

We got a little more aggressive with respect to that. We had not always recognized charge-offs on auto loans for example at the 90-day status and we decided to do that. So, that stepped up our write-offs more than the past and then we used the 180-day issues with respect to junior liens and first mortgage loans to write those and aggressively mark those down with the appraisal information. Brian Hagler – Kennedy Capital: So, you kind of want to stand on 90-days on all those categories now?

Right and those really got written into our overall policy, so that we’re consistent. Brian Hagler – Kennedy Capital: Okay thanks a lot guys.

Thanks Brian.

Our next question comes from Brian Martin of Howe Barnes. Brian Martin – Howe Barnes Hoefer & Arnett Inc.: Hi guys.

Good afternoon Brian. Brian Martin – Howe Barnes Hoefer & Arnett Inc.: Can you guys just give a little color, just given the capital - as far as the growth goes for over '09, as far as is it something a plus growth and maybe just more remixing of the portfolio or just kind of what your expectations are there? You've been growing the C&I book pretty nicely over the last 12, 15 months and kind of wondering what’s your expectations look to '09?

Brian its Mike. I'll answer that for you. Our orientation towards being a middle market, lower middle market C&I lender will continue not only in our core franchise but its part of the orientation we are going to try and bring to Lincoln’s franchise as well. Similar to the pruning of our own loan portfolio, and indirects will take that same discipline to the Lincoln portfolio as well and the originate and sell mentality around residential mortgages will also be applied there, which is a policy and a practice that Lincoln has adopted in great regard already. So, I think you will see, a flattish looking residential mortgage component, a shrinking indirect and installment component and then a growing C&I piece, perhaps less than what you’ve seen in the past which has been a high single to low double-digit number probably end of the middle single digits, a function both of what we see as loan demand and just the standards that we feel like we are appropriate for underwriting in 2009. Brian Martin - Howe Barnes Hoefer & Arnett Inc: Okay. All right thanks and then on the margin and you guys have talked about getting the TARP proceeds. I mean if you do get this, can you just talk a little bit about what impact that has on the margin? I guess based on what your expectations to do with the TARP capital?

Yeah I can speak to that Brian. We have shared a couple of different models with our Board and our expectation really is to overtime, if we were to bring a $116 million. And we would like to move $116 million into the loan portfolio and look at another $116 or so in the investment portfolio. Obviously, the investment purchase happens pretty quickly and then you would kind of looked at the bond portfolio run off into the loan portfolio to create some of the growth. But the EPS impact, the margin impact on the bottom line of net interest income is just a little over $6 million of positive margin because the cost of carry of the CPP program and its dividend, or the $5.8 million in dividends is below the line. So as we've assessed the cost of the warrants, the limited amount of margin that we can create without excessively leveraging the capital, it ends up being somewhere in the $0.08 to $0.12 range as far as EPS dilution. So at this stage, given current environment capital positions and we are looking at, doing something modest with the dollars but obviously it allows us to continue moving forward with some of our growth initiatives in the loan portfolio. Brian Martin - Howe Barnes Hoefer & Arnett Inc: Okay, all right. And Mike you mentioned a little bit. Just I mean the expenses were little bit higher than I guess I was looking for this quarter and you talked about some, and Mark talked a little about that in the call. I guess as far as the future evidence of some of the realignments you talked about Mike in the quarter, I guess can you give some thought as far as what I guess quantifying that as far as what do you expect on the expense side going forward? Or what we might see some and then I guess some assuming that the OREO and legal type of the expenses this environment will remain I think I was just wondering what piece you could control maybe bring a little bit lower?

Well I mean the absolute most controllable is direct salary expense and again kind of two pieces on that Brian. The first one is our evaluation right from the date of the definitive agreement of the talent mix and needs in the Lincoln franchise. And those decisions have been made. And so we’ll hit all our targets with relative to expense management at Lincoln but the point of my comments extended well beyond that both in regard to what we think is the behavior in 2009 around our highest compensated bankers about 90 participants and the plan that I referenced and then a very modest growth in the balance of our employee mix. But I think it’s safe to say that it would be a 1% time that or less quarter run rate at the salary level for existing First Merchants employees. And then the other area that we’ve just put some bright lights on is what I consider to be some discretionary expenses around travel prudent entertainment and a bunch of lower dollar items that aggregate into a sizable number. Brian Martin – Howe Barnes Hoefer & Arnett Inc.: Okay, and then maybe Dave, I mean I just missed this trend right down the - you talked about the increase at Lincoln this quarter on the non-performing side I guess the other piece seem to be the $10 million to $11 million at the lead bank in it. Didn’t sound like any of the top five credits changed, But that additional add of $10 million in the quarter at the lead bank what was driving that and I guess a series of smaller credits was it one large credit and just by category what is it more C&I? Was it commercial real estate?

I think with that it was probably a mix of C&I and commercial real estate. Most of land development where we recognized at the slow down and the issues regarding sell out of lots really impacted that credit. So we did move them to non-accrual. Brian Martin – Howe Barnes Hoefer & Arnett Inc.: Okay that’s all I have. Thanks guys.

Thank you.

That does conclude our Q&A session. I would now like to turn the call over to our conductors for any closing remarks.

I would just echo my appreciation for the attentions to our detail of our results. We feel fortunate to have put together four quarters in 2008 that were profitable but clearly the second half of the year and the climate we’re operating in began to wear on our portfolio both in the loans and in the securities. I hope our efforts described today speak to our 2009 treatment of such. We look forward to talking you again in the April timeframe around our first quarter results. Thank you.

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