Independent Bank Corporation (IBCP) Q2 2018 Earnings Report, Transcript and Summary

Good morning and welcome to the Independent Bank Corporation’s Second Quarter 2018 Earnings Conference Call. [Operator Instructions] Please note 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 second 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 for 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 quarter for the Independent Bank team, with a 48.7% increase in net income and a 33.3% increase in diluted earnings per share. For the three months ended June 30, 2018, we generated net income of $8.8 million or $0.36 per diluted share as compared to $5.9 million or $0.27 per diluted share for the same quarter 1 year ago. This represents a return on average assets of 1.12% and return on average equity of 10.57%. Strong organic loan growth, the addition of Traverse City State Bank and a lower federal corporate income tax rate were the primary drivers of this quarter’s positive results. Our consistent quarter-over-quarter loan growth, coupled with the TCSB merger, fueled a year-over-year and a sequential quarterly increase in net interest income of $7.5 million or 35% and $5 million, 21% respectively. For the second quarter of 2018, we generated net growth in total portfolio volumes of $101.4 million or 19.6% annualized. Also for the second quarter of 2018, we recorded a $650,000 loan loss provision expense. This was primarily to cover portfolio loan growth as asset quality continues to be very strong evidenced by our year-to-date net charge-offs of $48,000 and non-performing assets of $10.8 million or just 0.33% of total assets. Also significant for us during the second quarter, we were pleased to complete the merger with TCSB Bancorp, the parent company of Traverse City State Bank, on April 1, 2018 and the corresponding data processing conversions in June of 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 on this subject in his remarks. Turning to Slide 6 in our presentation, for the six months ended June 30, 2018, we have generated net income of $18 million or $0.78 per diluted share compared to $11.9 million or $0.55 per diluted share in the year ago period. This represents a 51% increase in net income and a 42% increase in diluted earnings per share. Our operating footprint today includes 68 branch locations, all in Michigan and 14 loan production offices, 12 of which are in Michigan and 2 located in Ohio. Effective April 1, 2018, with the acquisition of Traverse City State Bank, the 68 locations includes 5 branches in 3 counties in Northwest Michigan. Slide 6 of our presentation provides a good view of this footprint. The Michigan economy is now well into its 9th year of recovery. At June 2018, Michigan unemployment rate at 4.5% is up slightly from one year ago and 0.5% above the U.S. unemployment rate of 4%. 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 in demand and the skills available. Michigan’s workforce is 4.5 million strong yet Michigan payrolls, while up has slowed when comparing current year to same period one year ago. Housing trends for the state are generally strong and commercial real estate occupancy levels also continued to be favorable. The continuation of the positive economic trends can be seen in our regional portfolios shown on Page 8. We have generated year-over-year loan growth in each of our Michigan regional markets. The Southeast Michigan region has produced the largest growth. We have also seen year-over-year deposit growth in three out of four regions, the exception being in our Southeast Michigan region, which decreased as a result of one public fund relationship reducing its CD holdings with the bank. The next couple of slides cover our balance sheet. Turning to Page 9, 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 $2.8 billion in total deposits, of which 76% are transaction accounts. When comparing second quarter 2018 to same quarter one year ago, we increased total deposits by $87 million or 4%. This excludes brokered CDs and $288 million of deposits acquired in the TCSB merger. Our cost of deposits is up 10 basis points on a linked quarter basis and is up 22 basis points when comparing to the same quarter one year ago. Similar charts are also reflected on Page 10. But in this case, we are displaying the mix of loan portfolios. We continue to target a diversified loan mix, with the largest portfolio being our commercial book of business. At June 30, 2018, our loan mix included 44% commercial, 39% mortgage and 15% installment. Excluding the portfolio loans acquired in the TCSB merger, we are very pleased to report our 17th consecutive quarter of net loan growth, with total loans outstanding now aggregating to $2.5 billion. Despite experiencing a larger level of pay-offs or pay-downs, commercial loans were up $9.3 million or 4.3% annualized. The pay-offs or pay-downs were related to a combination of asset or business sales and reduced levels of line usage. Consumer installment loans were up $42 million or 52% annualized and portfolio mortgage loans were up $50 million or 22% annualized. Our capital position also continues to be strong, with tangible common equity moving from 9.54% at March 30, 2018 to 9.41% at June 30. This change primarily reflects the impact of the TCSB merger and is within our targeted TCE range of 8.5% to 9.5%. On July 23, the Board of Directors declared a quarterly cash dividend on the common stock of $0.15 per share. This dividend is payable on August 15 to shareholders of record August 6, 2018. We do have in place a 5% share repurchase plan. However, there have been no share repurchases in 2018. At 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 the second half of 2018.

Thanks, Brad and good morning everyone. I am starting at Page 12 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 3.93% during the second quarter of 2018, which is up 33 basis points from the year ago period and up 22 basis points from the first quarter of 2018. I will have some more detailed comments on this topic in a moment. Average interest-earning assets were $2.96 billion in the second quarter of 2018 compared to $2.42 billion in the year ago quarter and $2.61 billion in the first quarter of 2018. These significant increases reflect both the Traverse City State Bank merger and organic loan growth. Page 13 contains a more detailed analysis of the linked quarter increase in net interest income. There is a lot of data on this slide, but to summarize a few key points, as I stated, the linked quarter net interest margin increased by 22 basis points. Second quarter 2018 discount accretion of $628,000 on the TCSB acquired loan portfolio increased the linked quarter net interest margin by about 8.5 basis points. The balance of the linked quarter increase in the net interest margin of 13.5 basis points was a combination of organic loan growth, a rise in short-term market interest rates and the contribution of net interest income from the TCSB merger. As Brad mentioned, the average cost of interest bearing liabilities moved up by about 10 basis points on a linked quarter basis. Given the core data processing conversion that occurred in mid-June 2018, it is difficult for me to isolate the above referenced 13.5 basis point linked quarter increase in the net interest margin between IBCP on a standalone basis and TCSB on a standalone basis. However, given the relative size of each and considering TCSB’s standalone earning asset yield in cost of funds in April and May of 2018, we estimate that the increase in the net interest margin was about equally divided between IBCP and TCSB. 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 14, non-interest income totaled $12.3 million in the second quarter 2018 as compared to $10.4 million in the year ago quarter and $11.7 million in the first quarter of 2018. Our mortgage loan servicing caused most of the comparative quarterly year-over-year variability in non-interest income. We have a table in the text of our earnings release that breaks out mortgage loan servicing into its component parts, net revenue, fair value change due to price and fair value change due to pay-downs. The fair value change due to price, which we view as not being a part of core results was a positive $518,000 or $0.02 per diluted share after-tax in the second quarter of 2018 compared to a negative $648,000 or $0.02 per diluted share after-tax in the second quarter of 2017. The year-over-year increases in interchange income and interchange expense were primarily due to the implementation of ASU 2014-09 is described in the text of our earnings release. As detailed on Page 15, our non-interest expenses totaled $29.8 million in the second quarter of 2018 as compared to $22.8 million in the year ago quarter and $24.1 million in the first quarter of 2018. This year-over-year increase was primarily in compensation and benefits, occupancy, data processing, merger-related expenses and the amortization of intangible assets. Much of the increases reflect the impact of the TCSB merger. In addition, performance-based compensation increased due to our anticipated actual performance relative to targets and the new incentive compensation plan for hourly employees that was implemented in the first quarter of 2018. Investment securities available-for-sale decreased $38.5 million during the second quarter of 2018 as funds from runoff and sales were utilized to support portfolio loan growth. Page 16 provides an overview of our investments at June 30, 2018. Approximately 29% of the portfolio was variable rate and much of the fixed rate portion of the portfolio is in maturities or average lives of 5 years or less. The estimated average duration of the portfolio was just over 3 years with the weighted average tax equivalent yield of 2.91%. Page 17 provides data on non-performing loans, other real estate, non-performing assets and early stage delinquencies. Total non-performing assets were $10.8 million or 0.33% of total assets at June 30, 2018. Non-performing loans increased by $2.5 million and other real estate was essentially unchanged during the second quarter of 2018. We placed one $2.1 million commercial construction loan relationship on non-accrual in the second quarter of 2018. At June 30, 2018, this loan was just over 30 days past due. Because of our very strong collateral position, we had no allowance for loan loss on this credit at quarter end. At June 30, 2018, 30 to 89 day commercial loan delinquencies were just 0.04% and mortgage and consumer loan delinquencies were 0.42%. Moving on to Page 18, we recorded a provision for loan loss expense of $650,000 and $580,000 in the second quarters of 2018 and 2017 respectively. Loan net charge-offs were relatively insignificant at $217,000 in the second quarter of 2018. Thus loan growth was the primary driver of the provision expense in the second quarter. The allowance for loan losses totaled $23.5 million or 0.95% of total portfolio loans and 1.08% of originated loans at June 30, 2018. Page 19 provides some additional asset quality data, including information on new loan defaults and on classified assets. New loan defaults were $4.4 million in the second quarter of 2018. Page 20 provides information on our TDR portfolio that totaled $61.5 million at June 30, 2018, a decline of $2.2 million during the second quarter. This portfolio continues to perform very well with 94.5% of these loans performing and 93.1% of these loans being current at June 30, 2018. Page 21 provides some additional detailed information about our April 1, 2018 merger with TCSB Bancorp, Inc. Hopefully, this information, combined with Page 22, will help you understand our expectations for the balance of 2018 and beyond. To summarize our preliminary estimates of the fair value of assets acquired and liabilities assumed, we recorded a total discount of $6.48 million or 2.2% of the acquired TCSB portfolio loans. This discount will be accreted into interest income and we provide estimates for the level of accretion for the balance of 2018 as well as for 2019 and 2020 on this slide. We recorded core deposit premium of $5.8 million, which represented 2.7% of core deposits. This intangible asset will be amortized on an accelerated basis over 10 years. Once again, we provided estimates for the level of amortization for the balance of 2018 as well as for 2019 and ‘20 on this slide. We have recorded a $1.39 million discount on the TCSB subordinated debentures issued and outstanding that we assumed. This discount will be accreted to interest expense over the remaining life of the debentures on a straight line basis, which equates to about $20,000 per quarter. About $550,000 of discount in total was recorded on time deposits and borrowings exclusive of the subordinated debentures. This discount will be accreted into interest expense over the remaining lives of the related instruments and we estimate this accretion at approximately $80,000 in the third quarter of ‘18, $65,000 in the fourth quarter of ‘18, $160,000 in 2019, and $60,000 in 2020. We recorded $29 million of goodwill in the TCSB merger. This intangible asset will be tested for impairment on a periodic basis. The integration efforts went as planned with no significant issues. We are on track for our projected cost saves of 31% of TCSB standalone non-interest expenses or about $0.9 million per quarter beginning in the third quarter of 2018. Finally, TCSB merger-related expenses totaled $3.1 million and $3.3 million for the second quarter and first 6 months of 2018 respectively. We expect only a minor amount, less than $100,000 of TCSB merger-related expenses in the third quarter of 2018. Page 22 is our update for 2018. We compare our actual performance during the year to the original outlook that we provided in January of 2018. Overall, we believe that our actual performance in the first half of 2018 was better than our original outlook. We achieved annualized organic portfolio loan growth, as Brad mentioned, of approximately 19.6% and 15.4% for the second quarter and first 6 months of 2018 respectively. We expect full year 2018 organic portfolio loan growth consistent with the first half of the year or about 15%. Second quarter 2018 net interest income grew significantly on a year-over-year quarterly basis and the net interest margin increased to 3.93% as I mentioned earlier. We expect the net interest margin to be stable to slightly increasing over the balance of 2018 and the further expansion of net interest income to be primarily a result of growth in the average balance of loans. We had a provision for loan losses expense in the second quarter of 2018 of $650,000. And given the forecasted loan growth, we would expect to see a provision expense for loan losses in the third and fourth quarters of 2018. Second quarter 2018 non-interest income was above our forecast, primarily due to mortgage loan servicing income. We expect non-interest income in the $11.5 million to $11.7 million range in the last two quarters of 2018 absent any fair value increases or decreases in capitalized mortgage loan servicing due to price. Second quarter 2018 non-interest income expense was above our forecasted range due largely to the TCSB merger and related expenses as well as an increase in performance-based compensation. We expect non-interest expense in the $25.2 million to $25.8 million range in the last two quarters of 2018. Finally, we expect an effective income tax rate between 19% and 20% in the last two quarters of 2018. That concludes my prepared remarks. And I would now like to turn the call back over to Brad.

Thanks, Rob. In wrapping up our prepared remarks, we have listed our ongoing strategic initiatives on Slide 23. 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 these lines, for our efficiency ratio, our near-term target range is in the mid-60% range and the longer term target is in the low 60% range. After taking into consideration, the recent reduced federal corporate income tax rate, our return on asset and return on equity targets are 1.25% and 13% or better respectively. At this point, we would like to now open up the call for questions.

[Operator Instructions] The first question comes from Brendan Nosal with Sandler O’Neill & Partners. Please go ahead.

Hey, good morning guys. How are you?

Good morning.

Just to start off here a few on expenses. I guess, first question here is, does your expense forecast include the CBI amortization expense you laid out earlier? And then secondly in terms of timing of TCSB cost savings, do you think you are going to get pretty much all of that in the third quarter or will some bleed into the fourth quarter and early 2019?

The answer is yes to both those questions. The forecasted range does include the increase in the core deposit intangible amortization and we largely expect all the cost saves to be in place in the third quarter.

Alright, great. Appreciate the color there. And then just one on M&A, I mean I heard from a number of midsized regional players in and around your markets this quarter starting to talk up again the idea of Michigan-based M&A. So I am just curious if you are hearing increased interest in M&A within the state of Michigan and then now that TCSB is fully in the numbers and the integration is more or less done, just update us on your thoughts for additional deals going forward and what you might be looking for?

Sure, Brendan. So on the point of Independent and our appetite on M&A, so on the buy side, we have said quarter-after-quarter really our primarily use of capital is geared towards organic loan growth. And as we reported today, we have now 17 consecutive quarters of organic loan growth. So, that will continue to be the primary driver for us in terms of growing our earning asset base. The merger with Traverse City went very well and at the same time it was our first merger in many years and we learned a lot from that. We like the way it went. And if there were opportunities that had a similar profile in terms of financial metrics, earn back, EPS accretion, size, attractive market, we would be interested. In terms of just the Michigan market as a whole, I think it does appear that the price level demanded by sellers has gotten – has increased and what that may do is create actually maybe more of a disconnect between buyer and seller I don’t know. But at Independent, we have again said publicly that our primary goal is to operate in the best interest of our shareholders, create shareholder value and we will continue to operate that as our objective.

Alright, that’s it. Thanks for taking the questions, guys.

Our next question comes from Damon DelMonte with KBW. Please go ahead.

Hey, good morning guys. Thanks again for always providing such great clarity and guidance in your remarks. Just a couple of quick follow-ups. Rob, I think I missed what you had said about the expected accretable yield impact on the margin going forward, could you repeat that?

I didn’t really mention the impact on the yield from accretion. I sort of went through each of the dollar amounts, but what I did say about the margin is we expect to be stable to slightly increasing and I don’t anticipate at least for the next couple of quarters, a significant change in the impact of the various accretion items on the margin. So it was roughly 8 basis points in the second quarter and I think it will be a similar impact the next couple of quarters, so not much change at least for the next couple of quarters.

Okay, that’s great. Thank you. And then your outlook for the loan growth, you had said about 15% kind of going through the back half of the year, what areas are you expecting to see that? We have had a decent ramp-up in mortgage loans this year and during 2017, do we expect it to continue in that category or are you going to expect to see more growth on the commercial side?

Damon, I think that first off for the second quarter, we had very strong growth on the consumer installment side and much of that was fueled from our indirect desk, which finances RV and marine-type paper. I would imagine we have a solid third quarter there, and then it will probably tail off and that’s very typical. On the mortgage side, we have had a pretty strong second quarter in terms of portfolio growth and that will probably be an equivalent level maybe Q3, maybe a little less and then again taper off in Q4. And then I think on the commercial loan side, we have actually – I like the pipeline that we have there today. We mentioned in my remarks that we have had a little higher level of higher than normal payoffs. So I am hopeful that we actually have a little bit more of a pickup on the commercial side based on what’s in the pipeline today.

Okay, great. That probably – yes, those are the only two main questions I had. Again, I appreciate the detail you provided in your prepared remarks. Thanks.

Thank you.

Our next question comes from Kevin Swanson with Hovde Group. Please go ahead.

Good morning, guys.

Good morning, Kevin.

Can you guys just talk about how the impact of a larger balance sheet with Traverse City now and have you guys have been able to flex that, your skills and ability is in the balance sheet over to them at all yet or what the outlook looks like to that?

Well, their balance sheet was predominantly loans. They did not have a significant investment portfolio. So, there really wasn’t – we didn’t have to do any, what I would call financial engineering relative to the balance sheet. I think where we have been able to help is they had several loan participations, because they were limited in size of what they could have on their balance sheet and some of those have been brought back in full. So, that’s where we have been able to benefit them. And then in addition, their ability now to pursue larger relationships in the Traverse City market I think is a significant enhancement. And I think over time too, we have got a little bit broader array of treasury management products. So, I think that can also benefit them on the commercial side. In terms of their deposit base, their deposit base was somewhat similar to ours, but they had a bit more focus on commercial relationships. And I think the one area that we maybe of benefit over time is balancing that out with some more increase on the retail deposit side, along with their strong relationship on their commercial accounts, so really not that much they had. As I mentioned earlier, they had an attractively priced trust preferred security that was at LIBOR plus 220, so that was something we wanted to retain, but of course, as part of the purchase accounting entries, we discounted that, about $1.4 million and that’s getting accreted into interest expense. So that brings that attractive rate sort of up to a more market rate for trust preferred, but still that’s as I said a very attractive instrument, so really not much to do at the time of merger, more where we can add sort of on a long-term basis to their growth in that very attractive market.

Great, that’s really helpful. I guess my next question and then my final question was just on, can you give us an idea of kind of the deposit landscape you guys are seeing? Is there anybody out there doing anything crazy? It looked like the cost of funds went up a little bit, but still relatively low.

Well, I think there is, we are seeing CD specials that certainly are at, what I would call, market rates from a wide variety of competitors. And so I think over time, CD costs are going to ramp up a bit. We are not – I don’t think we are seeing anything real crazy on sort of the non-maturity deposit front although I think in the treasury management side of things where you are dealing with municipalities and other governmental units and larger commercial accounts. Certainly, there has been pressure to move money market rates up, because you have competition not just from banks, but from money market funds now as well. So over time, that’s been moving up a bit. I think the real key for everyone is for those banks like us that have a lot of non-interest bearing deposits, do you start to see much in the way of rotation out of those non-interest-bearing deposits into interest-bearing deposits and thus far we have not seen a lot of that. And I think one of the things that we benefit from is we have a lot of smaller balanced retail accounts. So there is not as much pressure there is what you would see if you had a lot of higher balanced accounts.

Great. Thanks.

Our next question comes from John Rodis with FIG Partners. Please go ahead.

Good morning, guys.

Good morning, John.

Rob just one quick question on the securities portfolio, I guess given your outlook for continued loan growth, should we kind of assume it’s flat to down some I guess on the second half of the year?

That’s a great question in one word discussing a lot is where do you kind of level off? I think if we got below 10% of assets, we would feel that just from a liquidity standpoint, we kind to need to maintain it at that level. So we are at about 451 now, 10% of assets, would maybe be 350ish or so. And I think as we move to that level, we would also change sort of the makeup of the investment portfolio. Now, it’s sort of been a complement to our yields. So we have included things like asset-backed securities and municipal securities where we could get a little bit better yields, but they are not pledgeable as collateral. So I think we moved to things that would be much more liquid and pledgeable as collateral as we move down to that number. So even though what represented less of our assets, it would be a more liquid portfolio in terms of borrowings. So I think you would see sort of a bit of a drift down toward that 350 figure over the next four to six quarters.

Okay. Thanks for the thoughts, Rob.

Yes.

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

We would like to thank each of you for your interest in Independent Bank Corporation and for joining us on today’s call. We wish everybody a great day.

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