Independent Bank Corporation (IBCP) Q4 2017 Earnings Report, Transcript and Summary

Good day, and welcome to the Independent Bank Corporation Fourth Quarter 2017 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Brad Kessel. Please go ahead.

Good morning, thank you for joining Independent Bank Corporation's conference call and webcast to discuss the company's 2017 fourth quarter and full year results. I am Brad Kessel, President and Chief Executive Officer and joining me is Rob Shuster, Executive Vice President and Chief Financial Officer. Before we begin today's call, it is my responsibility to direct you to the important information on Page 2, as well as the cautionary note regarding forward-looking statements on Page 3 of our presentation. If anyone does not already have a copy of the press release issued by Independent today, you can access it at the company's website www.independentbank.com. The agenda for today's call will include prepared remarks followed by a question-and-answer session and then closing remarks. To follow along, I will begin with Slide 5 of our presentation. Today we reported fourth quarter 2017 net income of $1.7 million or $0.08 per diluted share versus net income of $5.9 million or $0.27 per diluted share in the prior year period. The fourth quarter 2017 includes additional income tax expense of $6 million or $0.28 per diluted share due to a net deferred tax asset revaluation. Excluding this $6 million one-time expense, our adjusted net income was $7.7 million or $0.35 per diluted share. This compares favorably to our third quarter 2017 net income of $6.9 million or $0.32 per diluted share. Our adjusted net income for the fourth quarter of 2017 produced a return on assets of 1.11% and a return on equity of 11.28%. Our growth in earnings and earnings per share on a sequential and year-over-year quarterly basis is a direct result of our continued execution to rotate out of lower yielding investments into higher yielding loans while controlling expenses. During the fourth quarter of 2017, strong loan origination activity produced net interest income of $23.3 million. This represents a $3.1 million increase or 15.1% from the year ago quarter. Our team continues to produce very good organic growth on both sides of our balance sheet while remaining asset sensitive. Portfolio loans grew by $81.7 million or 16.7% annualized. This represents the 15th consecutive quarter of loan growth for Independent Bank. At the same time we continue to see improvement in asset quality metrics with low past dues and continued reductions in nonperforming assets. Our core funding improved with year-over-year quarterly growth in checking and savings balances of $99.5 million or 5.7%. To complement our solid organic growth on December 4, 2017 we announced an agreement to acquire TCSB Bancorp, the parent company of Traverse City State Bank. The integration of TCSB is moving forward with both management teams working very well together. At December 31, 2017 our tangible book value per share grew to $12.34 per share up from $11.62 per share for the same quarter one year ago. Reflecting the growth in our earnings combined with our strong capital levels, as well as in consideration of the reduced federal corporate income tax rate at January 22, 2018, we announced a 25% increase in the quarterly common stock cash dividend to $0.15 per share effective February 15, 2018. For the year ended December 31, 2017 the company reported net income of $20.5 million or $0.95 per diluted share. This compares to net income of $22.8 million or $1.05 per diluted share in 2016. Excluding the $6 million one-time expense related to the revaluation of our deferred tax asset, our adjusted net income was $26.4 million or $1.22 per diluted earnings per share. On this adjusted basis we achieved a 16.1% growth in net income, a 16.2% increase in earnings per share, a 1% return on assets, and a 10.1% return on equity. The 1% or better ROA and 10% or better ROE were goals that we established several years ago. Very important to the 2017 results were the fact we ended the full-year with six basis points to average portfolio loans in net recoveries. This compares favorably to the previous years' low six basis points net charge-offs. Today Independent Bank is the fourth largest bank headquartered in Michigan. Our branch network is a combination of rural, suburban and urban markets. Over the last 12 months we have expanded our presence in the Southeast Michigan market with new loan offices in Ann Arbor, Brighton, Dearborn and Grosse Point in addition to opening a loan office in Traverse City, Michigan. We also entered the Ohio market opening loan offices in Columbus and suburb of Akron Ohio. These loan offices are staffed with experienced mortgage banking professionals. We added to our team as a result of disruption in the marketplace associated with multiple bank mergers. Our announced acquisition of TCSB includes five full service branch locations in the Northwest Michigan market. The economic conditions in our markets continue to be generally favorable. Our balance sheet growth continues to come from our more urban and suburban markets. Michigan's unemployment rate was 4.6% in November 2017, 0.5% lower than one year ago and 0.5% above the November 2017 U.S. unemployment rate of 4.1%. At a high level, our Southeast Michigan and West Michigan markets exhibit the greatest strength and growth potential. Common themes in many of our markets is that of a shortage of skilled labor and housing. Accordingly we are witnessing historically record low home listing times, rising residential real estate values and an increase in new construction. The commercial real estate outlook also continues to be positive evidenced by positive trend lines in commercial, industrial, office and retail occupancy rates. The favorable economic conditions have translated into very positive loan origination and deposit gathering results for Independent Bank. Page 9 contains a good summary of our loans and deposits by region. We have seen year-over-year loan and deposit growth in each of our four Michigan markets with the exception of our Southeast Michigan market where we have seen a slight decrease in total deposits principally due to the intentional runoff of some higher cost municipal funds. Independent's total deposits as seen on Page 10 were $2.4 billion at December 31, 2017. This is comprised of $1.85 billion or 77% transaction accounts. Total deposits increased $32.9 million or 1.5% since the same quarter one year ago when excluding brokered CDs. We are seeing some limited pressure in our markets on the deposit pricing front particularly in the public funds sector. Our cost of deposits continues to be relatively low at 34 basis points but did increase three basis points this past quarter. We are monitoring closely and actively managing so as to retain core while also limiting the effects of rising rates on our deposit base. As seen on Page 11, loans including loans held for sale increased to $2.06 billion at December 31, 2017. The commercial team generated net growth of $16 million or 7.6% annualized during the quarter despite several large payoffs. Our new commercial originations continue to be very granular in size, diverse in industry and a good mix between commercial and industrial at commercial real estate. The pipeline is good when comparing to last quarter and same quarter one year ago. The consumer lenders and indirect desk generated solid consumer installment loan originations for the quarter, however net loan balances were down by $2.5 million or 3.1% annualized. This is not unusual for this line of business and we do expect the annual seasonal slowdown to continue into the first quarter 2018. Our mortgage team originated $214 million and we sold $118 million during the fourth quarter of 2017. For all of 2017 we originated $871 million and sold $423 million, as compared to 2016 when we originated $428 million and sold $313 million. For the fourth quarter we grew our mortgage portfolio by $68.2 million or 35% annualized. The mortgage pipeline is solid, however we do look for seasonal slowdown in the first quarter of 2018. Page 12 provides some information on our capital, as well as a fourth quarter rolling average for return on assets and return on equity. Our next level of performance targets are at 1.25% or better ROA at 12% or better ROE. We are targeting tangible common equity to range between 8.5% and 9.5%. Tangible common equity totaled 9.5% of tangible assets at December 31, 2017 as compared to 9.70% one year ago. Our plan continues to be to retain capital for organic loan growth and return capital through a consistent dividend payout plan and share repurchase plan. Earlier this month the Board of Directors of the company authorized a new share repurchase plan for 2018. Under the terms of the share repurchase plan the company is authorized to buy back up to 5% of its outstanding common stock. The plan is authorized to last through December 31, 2018. For all of 2017 we did not repurchase any shares. At this time, I would like to turn the presentation over to Rob Shuster to share a few comments on our financials, credit quality and management's outlook for 2018. Rob?

Thanks Brad, and good morning everyone. I am starting at Page 13 of our presentation. Brad discussed the increase in our net interest income during his remarks, so I will focus on our net interest margin. Our tax equivalent net interest margin was 3.65% during the fourth quarter of 2017 which is up 20 basis points from the year ago period and down one basis point from the third quarter of 2017. I will have some more detailed comments on this topic in a moment. Average interest-earning assets were $2.57 billion in the fourth quarter of 2017 compared to $2.37 billion in the year ago quarter and $2.52 billion in the third quarter of 2017. Page 14 contains a more detailed analysis of linked-quarter increase in net interest income. There is a lot of data on this slide but to summarize a few key points, interest income and fees on loans increased by $0.8 million on a sequential quarterly basis due primarily to an increase in average balance of $94.6 million that was partially offset by a decrease in the average yield on loans to 4.49% in 4Q '17 from 4.55% in 3Q '17. We provide details on the various loan portfolios on this slide. A decline in net interest recoveries on previously charged-off or nonaccrual loans reduced our overall net interest margin by one basis point in 4Q '17 versus 3Q '17. The average cost of interest-bearing liabilities moved up by five basis points on a sequential quarterly basis due primarily to growth in brokered CDs and other borrowings that were utilized to fund loan growth. The weighted average cost of savings and interest-bearing checking accounts moved up five basis points from 0.15% to 0.2%. A little more color on mew and renewal loan originations and yields are as follows; new and renewed commercial loan originations totaled $112.7 million in the fourth quarter of 2017 of which 35% was fixed rate and 65% was variable rate. The weighted average interest rate was 4.60% with an estimated weighted average duration of 1.7 years. New consumer loan originations totaled $22.9 million with a weighted average yield of 4.62% and an estimated weighted average duration of 3.32 years. Finally, new portfolio mortgage loan originations totaled $126.8 million of which 71% was fixed rate and 29% was variable or adjustable rate. The weighted average interest rate was 4.11% with an estimated weighted average duration of 4.31 years. This origination figure includes the full approved amount for new home equity lines rather than the amount drawn. We will comment more specifically on our outlook for net interest income in 2018 later in the presentation. Moving on to Page 15, noninterest income totaled $11.4 million in the fourth quarter of 2017, as compared to $13.2 million in the year ago quarter and $10.3 million in the third quarter of 2017. Our mortgage banking operations caused most of the quarterly comparative year-over-year variability and noninterest income due to a decrease in mortgage loan servicing income as 4Q '16 included a $2.4 million recovery of previously recorded impairment charges on capitalized mortgage loan servicing rates. We include a table in the text of our earnings release that breaks out mortgage loan servicing into its component parts. Net revenue fair value changed due to price and fair value change due to paydowns. The fair value change due to price which we view as not being a part of our core results was a positive $356,000 in the fourth quarter of 2017 or $0.01 per diluted share on an after-tax basis. The fair value change due to paydowns was a negative $515,000 in 4Q '17. We view this as being part of our core results. The 10 year treasury rate increased by seven basis points during 4Q '17 from 2.33% to 2.40% and the longer term mortgage rates increased a bit resulting in the small positive fair value adjustment due to price. The volume of mortgage loan originations and sales increased on a quarterly year-over-year basis but gains on mortgage loans only increased slightly as competitive pressures adversely impacted our loan sales profit margin, and largely offset the volume increase. As detailed on Page 16, our noninterest expense totaled $23.1 million in the fourth quarter of 2017 as compared to $24.9 million in the year ago quarter, and $22.6 million in 3Q '17. This year-over-year decrease was primarily because 4Q '16 included $2.3 million of litigation expense. This variance was partially offset by an increase in compensation and benefits. Performance-based compensation increased by $1.2 million in 4Q '17 versus the year ago quarter. About 75% of this increase was due to a true-up of our accrual under our management incentive plan. For the first nine months of the year we have been accruing at about target level and we ended the year at about 114% of target on an overall basis. For the earnings per share component, the Board of Directors used $1.22 which excludes the impact of the deferred tax asset revaluation. Our efficiency ratio continued to improve in 2017 and declined to 66.1% in 4Q '17 compared to 67.4% in 3Q '17. Investment securities available for sale decreased $25.9 million during the fourth quarter of 2017 as funds from runoff were utilized to support portfolio loan growth. Page 17 provides an overview of our investments at December 31, 2017, approximately 27% of the portfolio was variable rate and much of the fixed rate portion of the portfolio is in maturities of five years or less. The estimated average duration of the portfolio is about 2.8 years. Page 18 provides data on nonperforming loans, other real estate, nonperforming assets and early-stage delinquencies. Total nonperforming assets were $9.8 million or 0.35% of total assets at December 31, 2017. Nonperforming loans decreased by $0.2 million and other real estate decreased by $0.5 million during the fourth quarter of 2017, 30-to-89 day commercial loan delinquencies were just 0.002% and mortgage and consumer loan delinquencies were 0.41%. Moving on to Page 19 we recorded a provision for loan losses expense of $0.4 million in 4Q '17 compared to a provision of $0.1 million in the year ago quarter. As just outlined, asset quality metrics improved across the board and we recorded $0.7 million of loan net recoveries in 4Q '17. Thus loan growth was the driver of the provision expense this quarter. The allowance for loan losses totaled $22.6 million or 1.12% of portfolio loans at December 30 2017. Page 20 provides some additional asset quality data including information on new loan defaults in unclassified assets. New loan defaults were only $1.7 million in 4Q '17. Page 21 provides information on our TDR portfolio that totaled $64.9 million at December 31, 2017 a decline of $3.2 million during the fourth quarter. This portfolio continues to perform very well with 92.6% of these loans performing and 90.7% of these loans being current at December 31, 2017. Page 22 is our final report card for 2017. We compare our actual performance during the year to the original outlook that we provided back in January 2017. Overall we believe when excluding the $6 million of additional income tax expense related to our deferred tax asset revaluation that our actual performance during 2017 was better than our original outlook. But enough about 2017, now let's take a look at 2018. Page 23 represents our initial outlook for 2018. We have broken down the various categories between our standalone expectations without Traverse City State Bank and what we expect to add once this acquisition is complete. Overall in 2018 we expect strong loan growth to fuel our low double digit increase in net interest income. We expect steady asset quality metrics in noninterest income and noninterest expense levels excluding Traverse City State Bank and excluding merger related expenses that are comparable to 2017. Finally, we expect an effective income tax rate between 19% and 20%. That concludes my prepared remarks and I would now like to turn the call back over to Brad.

Thanks Rob. In summary, we are pleased to report continued solid performance for the fourth quarter and full year of 2017 with significant growth in pretax earnings, growth in loans and core deposits, and excellent asset quality metrics. As we look ahead we will continue to invest in our markets and in our people. We are focused on driving high performance with balance sheet growth and strength, quality earnings, sound risk management practices, per share value, and strong profitability levels. We continue to build on a positive momentum generated for the last five years. At this point, we would like to now open up the call for questions.

[Operator Instructions] Our first question comes from Damon DelMonte with KBW. Please go ahead.

So my first question could you just give us a little update on the timing of the closing of the transaction and maybe some of these steps you guys are taking behind the scenes to be ready to integrate once the deal does close?

Sure Damon. To start off I would say the integration is on schedule. The two teams are working very well. We are targeting a closing of the transaction the end of the first quarter and followed by a conversion of the system's in the second quarter in the June-ish timeframe. We had our team on-site - many members of our team on-site on multiple occasions and we at this point are [rating] [ph] fulfilling a commitment that we made to their people in terms of letting them know where they fit on the roster going forward. And at this point I feel pretty good about the targeted cost save assumption and where that's coming in at. So we have filed our initial S-4 registration statement and we've either already today or later today will probably have an amendment to that. And so things are going very well and Rob I don’t know if you want to fill anything else here.

Only thing I'd add is we’re actually looking for the effective date to be April 1 of the merger. So it would not impact our first quarter numbers and then we would have really the full second quarter period to get all the purchase accounting entries done. And as Brad said, expect to have a mid June conversion date and if you look at Page 23 on the initial outlook on the noninterest expenses, you kind of see what our expectations are on a go forward basis by quarter with the addition of Traverse City State Bank.

Probably question for Rob here with respect to the margin on held in quite well quarter-over-quarter. Could you just talk a little bit about some of the dynamics that could influence the margin either way as we go into 2018?

Well really the - I think the kind of thing everyone is really focused in on is deposit costs and what might occur there as Brad mentioned we’re seeing right now limited pressure on deposit rates other than in the treasury management area with public funds and larger corporate deposits. There certainly has been a movement up there as well but when you tack on the potential for two or three more increases in 2018 certainly we'd expect to start to see some upward movement in retail deposit rates. But overall from a modeling perspective we would still expect to see our margin pretty stable to maybe a slightly higher and that would be from two sources. One would be the continued remix of a greater amount of loans in a bit less in investment securities. And then as Brad had mentioned on an overall basis, we still remain slightly interest rate sensitive so we anticipate net interest income rising as rates come up during 2018.

Got you, okay.

But overall I would say the margin relatively stable. But the one other thing I’d mention is the TE yield is going to come down a little bit because of the lower tax rate but that is a pretty small adjustment maybe a basis point or so.

And then with regards to the loan growth, so again you're calling for 15% to 18% overall IBCP only loan growth. Could you talk a little bit about the - I know you referenced in here commercial loans, mortgage loans, consumer but where do you feel like you’re going to get the most growth out of which of those three areas. Is it going to be from portfolioing mortgage loans because of your expanded origination platform or do you see it coming more in the commercial side.

I think our objective is to try and get as much balance as we can with commercial we’d like to have that certainly be a significant driver. I think standalone we probably expect to see a bit more on the mortgage side although and we may have mentioned this on last quarter's call as well we've made some programmatic changes to try and shift more volume from the portfolio to salable origination volume. But one aspect of that origination volume that we do expect to continue on into 2018 that Brad referenced is a construction lending is still quite strong in our markets because of I think A) a period of time where there was very little of it and two, just the lack of inventory. So we're still seeing I think strong construction lending and at least during the period of time all those loans are in the construction phase they remain in the portfolio. So again probably a little bit more on the mortgage side but trying to get as much balances as we can from the consumer side and then particularly the commercial side.

Our next question comes from Scott Beury with Boenning & Scattergood. Please go ahead.

So I guess in terms of growth just to follow-up on that. Do you have any idea geographically or industry any characteristic that you're seeing in terms of the commercial opportunities and the marketplace right now?

Well, I think just going up to 30,000 foot the two markets that are strongest for us in terms of commercial would be Southeast Michigan and West Michigan. And we foresee that continuing. In terms of an industry concentration actually we're pretty diverse and I think you just go through our portfolio by the largest concentration we have is maybe the senior housing and followed by probably manufacturing but it's a very diverse. And also as I said in my comments, it’s got very mix between C&I and CRE in fact we target a 60/40 mix there. We're probably running closer to 50-50 which we’re fine with.

I guess then I think there is a bit info on the slide on kind of the TCP increase on the lending side. Looking at funding your loan deposit is still in 80s, I was just curious if you could kind of provide any color on the dynamics or the thought process or ramping up the broker funding during the quarter and kind of what your expectations are there for 2018?

Well as Brad had mentioned the one area of deposits that we're down during 2017 was time deposits and we had a particular large relationship with the municipality and during the course of 2017 that particular relationship declined by about 70 million and we really replace those funds with brokered CDs. We just during the year as we bid on those funds they were able to obtain higher rates than what we could find in the brokered CD market. So really we just rotated out of that one large municipal relationship into the brokered CD market. And then in addition to that rotation we added some wholesale funding a little bit of FHLB advances and a little bit of brokered CDs to support loan growth. The other thing we did during the course of 2017 and where the brokered CDs work well for us is we did use derivatives about 45 million of interest rate caps and 15 million of fixed pay swaps to lengthen the duration of the brokered CDs. And one of the reasons we like the brokered CDs as we could get sub LIBOR funding in the market at least at the present time. So they work well from a funding perspective, they lineup well with what we're trying to do on the derivatives side and the purpose of those derivatives was really because we've added some longer duration assets particularly on the mortgage side, we wanted it to in order to stay interest rate sensitive we wanted to add some longer duration funding. So they operate well there and I would expect to see us to continue to have some increase in brokered CDs over the course of 2018 because loan growth is likely to outstrip the non-brokered CDs deposit growth.

And then kind of one follow-up to that, just generally speaking who are the competitors that you are seeing that are really getting aggressive in pricing on the public funds deposits?

Scott I guess I can jump in first, Rob you can follow-up but credit unions, we look at weekly rate shop they’re at - typically at the top of the chart across product lines. The large regionals we've seen a more active in rate changes week-to-week, so.

Probably the other one that you are seeing on the public funds sector is various types of mutual funds that municipalities can invest in. So they would be largely backed by government securities and those rates have moved up a fair amount over the course of 2017. So if you go back a year, year and half ago there wasn't nearly the competition from the money funds that we’re now seeing today. So those would be the primary sources of competition on the treasury management side.

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

I would like to thank each of you for your interest in Independent Bank Corporation and for joining us on today's call. Have a great day.