Independent Bank Corporation (IBCP) Q1 2018 Earnings Report, Transcript and Summary

Good morning, and welcome to the Independent Bank Corporation First Quarter 2018 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask a question. [Operator Instructions] This event is being recorded. I would now like to turn the conference over to Brad Kessel, President and CEO. Please go ahead.

Good morning. Thank you for joining Independent Bank Corporation's conference call and webcast to discuss the Company's 2018 first quarter 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, regarding the cautionary note, regarding forward-looking statements. 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. We are reporting a very good start to 2018 for the Independent Bank team, with a 53.3% increase in net income and a 50% increase in diluted earnings per share. For the three months ended March 31, 2018, we generated net income of $9.2 million or $0.42 per diluted share as compared to $6 million or $0.28 per diluted share for the same quarter one-year ago. This represents a return on average assets of 1.34% and a return on average equity of 14.04%. Strong loan growth, continued reductions in non-performing assets, and a lower federal corporate income tax rates were the primary drivers of this quarter's positive results. Our consistent quarter-over-quarter loan growth fueled a year-over-year and a sequential quarterly increase in net interest income of $2.5 million and $600,000 respectively. For the first quarter of 2018, we generated net growth in total portfolio loans of $52.6 million or 10.6% annualized. Also for the first quarter of 2018, we recorded a $315,000 loan loss provision expense. This was primarily to cover a portfolio loan growth as asset quality continues to be very strong, evidenced by our net recoveries of $169,000, and a decrease in non-performing assets of $1.6 million or 15.8%. Also significant for us immediately following our first quarter, we were pleased to announce we had completed the acquisition of TCSB Bancorp, the parent company of Traverse City State Bank on April 1, 2018. We are very excited to welcome the employee base and customer base for this attractive Northwestern Michigan market. Rob will provide more of an update in this subject in his remarks. Our operating footprint today includes 68 branch locations all in Michigan and 14 loan production offices, 12 of which are in Michigan and two located in Ohio. Effective April 1, 2018 with the acquisition of Traverse City State Bank, the 68 locations includes five branches in three counties in Northwestern Michigan. Slide 6 of our presentation provides a good view of this footprint as well as some bullet points on key economic metrics for our markets. The Michigan economy is now well into its ninth-year of recovery. The Michigan unemployment rate is unchanged in February 2018 at 4.8% from one-year ago, 0.7% above the U.S. unemployment rate of 4.1%. While the Michigan rate is a little higher than the national rate, I believe the difference is due to the number of individuals coming back into the workforce in the state combined with the gap between the skills and demand and the skills available. Michigan's workforce is 4.5 million strong and we continue to see job creation. Over the same time last year, payrolls were up 52,000 or 1.2%. Housing trends for the state continue to display evidence of strength, but also in some markets evidenced by a housing shortage. There were 22,000 housing starts in 2017, which is up 4% over the prior year. Existing home sales which totaled 184,000 in 2017 are expected to approximate the same level in 2018. Home prices were up 7.6% as measured by the S&P/Case-Shiller Michigan Detroit Home Price Index. On a more regional MSA basis, year-over-year Grand Rapids is up 10.5%, Warren-Troy-Farmington Hills is up 8.3%, and East Lansing is up 7.2%. The positive market trends are also evidenced by solid performance in the commercial real estate markets. In Metro Detroit, vacancy rates generally continue to trend positive. Through the end of 2017, industrial space was the strongest with just a 2.1% vacancy rate, followed by retailers at 5.6% and office at 15.5%. And in West Michigan according to Colliers International Q1 2018 report, vacancy for the industrial real estate sector is at 5%, retailers at 8%, offices at 14.6%, and apartments are strong at 5.5%. The continuation of the positive economic trends can be seen in our regional portfolios shown on Page 7. We have generated year-over-year loan growth in each of our Michigan regional markets. The Southeast Michigan region has produced the largest growth followed by the West Michigan region. We've also seen year-over-year deposit growth in three out of four regions. The exception being Southeast Michigan which decreased as a result of one public fund relationship reducing its CD holdings with our bank. The next couple of slides cover our balance sheet. Turning a Page 8, we provide a couple of charts reflecting the attractive composition of our deposit base as well as the continued growth in this portfolio over the last eight quarters, while working to effectively manage our overall cost of funds. Independent has $2.43 billion in total deposits of which 78% are transaction accounts. When comparing first quarter 2018 to the same quarter one-year ago, we increased total deposits by $52.2 million or 2.3%. This excludes brokered CDs. Our cost of deposits increased from 34 basis points to 38 basis points when comparing the first quarter of 2018 to the fourth quarter 2017. Similar charts are also reflected on Page 9, but in this case, we are displaying the balanced mix of our loan portfolios with 41% commercial, 42% mortgage, and 15% installment. We are very pleased to report our 16 consecutive quarter of net loan growth with total loan outstandings now aggregating to $2.1 billion. For the quarter, all three portfolios led by the mortgage portfolio with net growth of $39 million or 19% annualized, followed by the consumer portfolio up $9 million or 12% annualized and the commercial portfolio up by $4.2 million, despite several larger payoffs. Our capital position also continues to be strong with tangible common equity increasing to 9.54% from 9.45%. This is on the higher end of our 8.5% to 9.5% targeted TCE range. We increased our dividend in November 2017. However, based on the continued actual growth rate in earnings and expected growth rate in our future earnings, including the significantly lower corporate federal tax rate, we again increased our dividend in February of 2018 by 25% from $0.12 per share to $0.15 per share. As previously announced in January of this year, the Board reauthorized a 5% share repurchase plan. However, no share repurchases were made during the first quarter. This time, I would like to turn the presentation over to Rob Shuster to share a few comments on our financials, credit quality, the TCSB acquisition and management’s outlook for 2018.

Thanks Brad, and good morning, everyone. I am starting at Page 11 of our presentation. Brad discussed the increase in our net interest income during his remarks, so I will focus on our margin. Our tax equivalent net interest margin was 3.71% during the first quarter of 2018, which was up 2 basis points from the year-ago period and up 6 basis points from the fourth quarter of 2017. I will have some more detail comments on this topic in a moment. Average interest-earning assets were $2.61 billion in the first quarter of 2018 compared to $2.37 billion in the year-ago quarter and $2.57 billion in the fourth quarter of 2017. Page 12 contains a more detailed analysis of the linked-quarter increase in net interest income. There is a lot of data on the slide, but to summarize a few key points, the 6 basis points of linked-quarter margin growth was primarily due to the increase in short-term interest rates and an increase in average loan balances, particularly mortgage loans. Two less days in the first quarter of 2018 reduced net interest income by $248,000 compared to the fourth quarter of 2017. The average cost of funds was up 2 basis points to 0.44% from 0.42% in the fourth quarter of 2017. A little more color on new and renewal loan production and yields as follows. Portfolio loan production excluding mortgage loans originated for sale in the first quarter totaled $189 million of which 37% at variable or adjustable interest rates and 63% had fixed interest rates. The overall yield on this new and renewal loan production was approximately 4.54%, which is essentially equal to the first quarter 2018 total loan portfolio yield of 4.57%. We will comment more specifically on our outlook for net interest income for the balance of 2018 later in the presentation. Moving on to Page 13, non-interest income totaled $11.5 million in the first quarter of 2018, as compared to $10.3 million in the year-ago quarter and $11.4 million in the fourth quarter of 2017. Mortgage loan servicing caused most of the quarterly comparative year-over-year variability and non-interest income with the $1.46 million increase in the fair value due to price of capitalized mortgage loan servicing rights in 1Q 2018. We had a couple of reclassifications between non-interest income and non-interest expense due to implementing ASU 2014-09 on revenue recognition as described in the text of our earnings release. As detailed on Page 14, our non-interest expenses totaled $23.9 million in the first quarter of 2018 as compared to $23.6 million in the year-ago quarter. Like many other financial institutions, we did payout a bonus to our quarterly employees in the first quarter of 2018. That amount totaled about $300,000. Further rather than just being a one-time payment, we also put into place an ongoing incentive program for our hourly employees in accrued and additional $80,000 in the first quarter of 2018 for that plan. Our efficiency ratio reflects continued improvement as we gain additional operating leverage, primarily through growth in earning assets in the remix of earning assets from investment securities into loans. Investment securities available for sale decreased $33.8 million during the first quarter of 2018. Page 15 provides an overview of our investments at March 31 of 2018. Approximately 28% of the portfolio was variable rate and the estimated average duration of the portfolio is about 2.9 years. We sold $22.3 million of investment securities in the first quarter of 2018. Many of these sales were municipal securities where we saw market spreads narrow and we believe that holding these securities is less attractive with a 21% federal corporate income tax rate. Page 16 provides data on non-performing loans other real estate non-performing assets in early stage delinquencies. Total non-performing assets were $8.3 million or 0.3% of total assets at March 31, 2018. Non-performing loans decreased by $1.6 million or 19% during the first quarter of 2018. At March 31 of 2018, 30-day to 89-day commercial loan delinquencies were just 0.005% and mortgage and consumer delinquencies were just 0.39%. Moving on to Page 17, we recorded an expense provision for loan losses of $315,000 in the first quarter of 2018, compared to a credit provision of $359,000 in the year-ago quarter. We recorded net recoveries of $169,000 in the first quarter of 2018 virtually unchanged from loan net recoveries of $163,000 in the first quarter of 2017. The allowance for loan losses totaled $23.1 million or 1.11% of portfolio loans at March 31, 2018. Page 18 provides some additional asset quality data, including information on new loan defaults in unclassified assets. New loan defaults were just $0.9 million in the first quarter of 2018. The increase in classified assets primarily reflects one commercial loan relationship which is current that was classified as substandard in 1Q 2018. Page 19 provides information on our TDR portfolio that totaled $63.6 million at March 31 of 2018. This portfolio continues to perform very well with 94% of these loans performing and 93% of these loans being current at March 31, 2018. Page 20 provides information about our acquisition of TCSB Bancorp and its wholly-owned subsidiary Traverse City State Bank. As you know, the merger was effective on April 1 of 2018. This slide provides some first quarter 2018 financial data on TCSB. Excluding merger-related expenses, TCSB perform slightly better than their budget, producing net income of about $900,000 representing in ROA of 1.04% and loan growth was also slightly better than their budget. We are on track for completing the data processing, conversion in mid to late June of 2018 and expect to meet our goal for cost saves as we move into the third quarter of 2018. Page 21 is our initial report card for 2018. We compare our actual performance during the year to the overall outlook that we provided back in January of 2018. Overall, we believe that our actual performance in the first quarter of 2018 was better than our original outlook. We achieved actual annualized loan growth of nearly 11% in the first quarter of 2018. Typically our first quarter growth rate is slower due to seasonal factors, so we expect this growth rate to accelerate a bit over the next two quarters. First quarter 2018 net interest income grew 11.5% on a year-over-year quarterly basis, compared to our forecasted growth rate of 10% to 11%, so we were pretty much right on track with our forecast. We had a loan loss provision expense in 1Q 2018 of $315,000. This was better than our forecast because of better than anticipated asset quality metrics. We expect generally stable asset quality metrics during the remainder of 2018, so loan growth is anticipated to be the main driver of our loan loss provision. 1Q 2018 non-interest income was above our forecast due primarily to the fair value increase in capitalized mortgage loan servicing rights. We expect non-interest income to be within our forecasted range in the next few quarters, excluding any volatility associated with changes due to price in the fair value of capitalized mortgage loan servicing rights. Actual 1Q 2018 non-interest expense was a bit above our forecasted range, but if you exclude the $0.3 million bonus for hourly employees and the $0.2 million of merger expenses we fall within the range. The second quarter of 2018 will be noisy as we bring TCSB on board and also record an increase in merger expenses. Finally, although our effective income tax rate was 18.2% in the first quarter of 2018, we expect an effective income tax rate of about 20% going forward in 2018, excluding the impact of any non-deductible merger expenses. 1Q 2018 income tax expense was reduced by approximately $0.2 million due to the tax benefit of stock awards that vested. That concludes my prepared remarks, and I would now like to turn the call back over to Brad.

Thanks, Rob. And wrapping up our prepared remarks, we have listed our ongoing strategic initiatives on Slide 22 of our deck. Three points to be made here. First, we want to continue the rotation of and growth in earning assets for balanced growth in our loan portfolios. Second, we will continue to hold the line on expenses and look for opportunities to gain further efficiencies. Along those lines, for our efficiency ratio, our near-term target range is now in the mid-60% range and longer term target is in the low-60% range. Finally, having reached our return an asset and return on equity targets of 1% and 10% respectively and taking into consideration, the recent reduced federal corporate income tax rate, our new return on asset and return on equity targets are 1.2% or better and 12% or better respectively. At this point, we would like to open up the call for questions.

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Brendan Nosal with Sandler O'Neill.

Hey. Good morning, Brad. Good morning, Rob. How are you?

Good morning. Good.

Good morning.

Just wanted to start on the margin here. I think the 6 basis points of expansion was certainly better than I was looking for. So it was nice to see. Can you just kind of square this quarter’s performance with the outlook for a relatively stable margin? And then maybe you talk a little bit about whether you think you can get some more benefit from this level of 3.71%, should the Fed raise rates again later on in the year?

Well, excellent question. And I think as I said in my comments, we've benefited in two ways during the first quarter. One was the continued rotation in the loans and out of investment securities. And then secondly, we had some benefit from the rise in short-term interest rates. And I’d also say, we at least today been able to lag an increase in cost of funds, and particularly on the deposit side. And I think the real question going forward is going to be what is going to be happening with deposit costs? Certainly we're seeing in our markets more people moving those rates up. But even having said that, I think we're in a position where, one, we’re slightly asset sensitive. Two, the incoming loans are – in the first quarter that I mentioned this in my comments are coming in at yields pretty much equal to the entire loan portfolio yield than in prior quarters that was not the case, new growth was lower than the overall portfolio yield. So that was pulling the other way on the margin. So that's sort of behind us. So certainly I think if we could continue to do what we've been able to do on deposit costs, we probably have some opportunity for a bit more margin expansion. If that proves not to be the case, I think at worst we’ll at least be able to hold the line. Brad, I don’t know if you want to add anything?

No. Rob, I think you're right on point. I think what we've seen here in the last quarter or two and it's been a little bit disappointing, but we’ve had some really nice looks at some deals and they haven't gone our way. And as we've seen in the competitive landscape, some lower longer term fixed rate financing. So there's a balance there between getting the deal at a thinner margin and not getting the deal, and we have to continue to look at that. And then like Rob said on the deposit side, we are just really sensitive to how hard we’ve worked to build the deposit portfolio up to this point and we hate to just see it run off because we're being too stingy with our deposit pricing so – but we're optimistic for the balance of 2018.

All right. That's fantastic color. Thanks. And then moving over to expenses, you guys still think that 1% expense growth for the organic company is still achievable for the full-year? I only ask because even if you back out the $300,000 of bonuses and the merger expenses in the first quarter, it feels like the organic expense base would have to come down a little bit through the remainder of the year to get to that 1% number. Just any thoughts of, kind of, how you see the trajectory going through the remainder of the year?

Yes. We do expect that. The first quarter is historically our highest non-interest expense quarter, and there's two primary drivers. One is for anyone in the north you'll get this, snow removal costs. We had almost 400,000 of snow removal costs in the first quarter of this year. And then the other one is payroll taxes. There is a number of payroll taxes. Some of which have a low thresholds, but those go down a fair amount once you move into the second and third quarter because people are hitting all the limits for things like Michigan unemployment tax, federal unemployment tax, and then for some, employer FICO as well. So those two categories traditionally come down and that’s why the first quarter is elevated quite a bit. So we do expect to move down on the original organic company.

All right. Fantastic. Thanks for taking my questions. I’ll step back for now.

Thanks Brendan.

The next question comes from John Rodis with FIG Partners.

Good morning, guys.

Hi, John.

Hey, Brad. Just maybe – just a big picture question for you with the acquisition now complete, just talk about your thoughts on potentially future acquisitions versus buybacks versus even increasing the dividend more, so just sort of capital management in general?

Sure. So I think that we have tried to be clear up to this point and really the approach is going to be a continuation of this and our Company would like to grow organically, first that's our first priority, and we've had again 16 consecutive quarters of loan growth. So a continuation of that is priority number one. In terms of the dividend, as I mentioned in my remarks, we had increase in November of 2017 and that was on a sort of on pace with annual increase that we had developed a post recapitalization. But then with the passage of the tax law reduction in rate and just looking at where we see earnings going forward, we then announced an additional 25% increase in our dividend in the first quarter. So we're probably on pace now to keep on that schedule in terms of annual increase would be our goal, so again, probably first quarter of 2019 unless something materially changes. And in terms of M&A, I think this transaction with Traverse City has been terrific. It's the first deal that Independent has done post great recession, and we had series of goals that we’re looking to achieve, and it's going as expected or even better than expected. I think really key to it has been for us bringing across the leadership from that bank and they are staying in the market and now just having changed jerseys that we're now wearing the Independent Bank jersey. And so where we do – where we look at other deals, we’re open to that with the game plan going forward is not predicated that we have to do another deal. And then I think you can look at sort of the metrics on the deal we did and I think that Traverse City gives you an idea of sort of what some of our parameters are and in terms of size, 10% of our size and either adjacent to our filling in some of our markets, those are some of the things that we looked at. So John, that give you hopefully a little bit of color of what's our - in our head in terms of capital management, and finally, we continue to say we want to target TCE in that 8.5% to 9.5% range. And we are running a little bit high on that. But if the worst thing we do is run a little heavy on capital, I’m okay with that.

That makes a lot of sense Brad. Thanks. Rob maybe just one quick question for you, on the securities portfolio. So last year the portfolio was down about 14%, 15% year-over-year. Would you expect on a percentage basis a similar decline this year or how should we sort of think about that over the next few quarters the securities portfolio?

No I think for liquidity and other reasons, we would not anticipate that level of decline going forward. I think we may drift down a bit, but the first quarter we had as I mentioned the $23 million almost of sales, and that was really driven more from an opportunistic standpoint. We had some concern after the tax law change that municipal securities might move down pretty sharply in price, and we really didn't see that. We saw spreads contract significantly and we just decided that made sense to take advantage of that narrowing the spread, and so we were able to liquidate a fair amount of munis and it was basically a kind of a breakeven trade, but we reinvested the proceeds at much higher yields with the same or less duration. So we're going to look for those type of opportunities, I think the one thing that we feel strongly about is as we move higher in our loan to deposit ratio that the composition of the securities portfolio has to be more and what we would call highly liquid pledgeable type of securities, which would – which again would suggest that munis, which tend to be a little less liquid and a little bit longer term would not be as much part of the picture and instead we'd be moving into other categories where we think again we can get higher yields in similar durations. So bottom line about the question, I think it will drip down maybe a bit, but not certainly at the rate it did last year.

Okay. Makes sense Rob. Thanks guys.

The next question comes from Damon DelMonte with KBW.

Hey. Good morning, guys. How you doing today?

Good, Damon. Thank you.

Great. I guess my first question kind of just circling back on the margin. You guys have done a really good job of keeping your interest-bearing deposit cost down. I think they're only up by 4 basis points this quarter. What are some of the dynamics that you are seeing across your footprint that's allowing you to keep those the funding cost in check? And I think if we look at other banks around the country, I think we're seeing much more pressure and just kind of wondering what you guys are seeing in your neck of the woods?

Well, first off it's competitive, and it's not like – our markets are materially different than what you're seeing around the country. I think one of the keys is for independent is we historically have not tried to sell ourselves and price and rather we train to hold ourselves out based on service. So as long as we can be competitive on price and then deliver on the service, we feel that will be okay. And for quarter-after-quarter or year-after-year, we continue to make a push internally to cross-sell the relationships to get that checking account. We have thousands of just smaller balance checking accounts that make up that portfolio. And quite honestly, probably little smaller balance aren’t – is rate sensitive as maybe some of the higher balances. And so we have strategically to try to maybe be a little bit more active in pricing of the higher balanced accounts. And so, I think finally Damon on this and maybe Rob can chime in with some of his thoughts, but going forward probably more likely that our rate have changed and cost of funds is moving a little bit more with what we're seeing in terms of the market rates. Rob, I don’t think you have anything to add?

No, I just would echo that, I think one of – and you are asking about differentiators. I think one of the key differentiators is and it goes back to our historical totally free checking days. We have a lot of smaller balance DDA accounts. And like Brad said, I think those balances tend to be less rate sensitive. If you are averaging 10,000 in a checking account, the rates 10 basis points versus 25 basis points it's not material to that individual depositor, but you spread that across 100,000 accounts, and it's significant to our cost of funds. So we have put into place strategies on the pricing that really focus on what that average balance and relationship is about deposit account, and so I think that is where we benefited a bit.

Okay. That’s a good color. Thank you. And then I guess with respect to the loan portfolio, how comfortable or what's the comfort level for letting the one- to four-family loans become as a percentage of total loans? I think we’re somewhere in the low 30% range now and if you look back that to a year-ago quarter, you're probably in the low 20% - 22%, 23% in the first quarter 2017, so are you willing to let that go?

Well, one of the beauties of the Traverse City deal was they – their portfolio was 81% commercial. So they're going to add a significant amount about $244 million on the commercial side with only $29 million in consumer and $27 million in mortgage. So it’s going to help significantly on the portfolio rebalance and give us a bit of room to run. I would say the other thing as we've made several programmatic changes to try to shift production to more salable on the mortgage side. I think, but one thing I would say though in the heavy purchase market, particularly where we are now in markets with more jumbo production that we are going to get growth in mortgages, but I do think the rate we grew at last year will not be indicative of the rate we grow at this year on that side, and again, going back to the Traverse City State Bank acquisition that gives us quite a bit better balance now in the portfolio.

Okay, got it. I think that's pretty much all that I had. So thank you very much. Appreciate the color.

The next question comes from Kevin Swanson with Hovde Group.

Good morning.

Good morning.

Most of my questions have been answered. I just have one follow-up kind of loans questions. So the loans deposits have been kind of steadily increasing over the last couple of years. I mean I think with the updated numbers that you guys gave from Traverse City; it looks like they’re a little over higher than you guys. Kind of what levels are you aiming at for and what are you comfortable with in terms of loans to deposits?

Well, I think we like to stay on the high end in that 90% to 95% range and that really move above that. I think, at that point, which starts to pressure managing the margin, I've seen it another bank releases where they are over 100% in that incremental funds you're bringing in our at today's rates, which especially with a flat curve, you might get dollar growth in net interest income, which is a good thing, but it certainly can push your net interest margin the other way. So I think that's kind of where we feel like we're comfortable and ensure focused to see what we could do on deposit growth and also what we could do on the lending side, do not push away organic originations, but try to make sure as much as we can in the mortgage side. It continues to move towards salable rather than portfolio.

Yes. Rob, I think I’d had too. One of the advantages to our strategy of putting on more mortgage collateral is that we can borrow with that through Federal Home Loan bank, so that provides a funding source as opposed to if it was a different type of asset class.

Okay. It makes sense. Thanks guys. Appreciate it. End of Q&A

This concludes our question-and-answer session. I’d 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, and we wish everybody a great day.

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