Independent Bank Corporation (IBCP) Q3 2019 Earnings Report, Transcript and Summary

Good day, and welcome to the Independent Bank Corporation's 3Q '19 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mr. 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 2019 third quarter results. I am Brad Kessel, President and Chief Executive Officer, and joining me is Rob Shuster, Executive Vice President and Chief Financial Officer. Also joining us today is Steve Erickson, Executive Vice President and Treasurer. Before we begin today's call, it's my responsibility to direct you to the important information on page two 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 Web site, www.independentbank.com. The agenda for today's call will include prepared remarks followed by a question-and-answer session and then closing remarks. As previously announced, Steve Erickson will be taking on the role and responsibilities as Chief Financial Officer for IBC following Rob's retirement on January 31, 2020. There is no doubt we will miss Rob upon his retirement. However, I am very pleased that we are able to find and attract an individual like Steve, and that we are able to do so with a transition period allowing Rob and Steve to work together through a couple of quarter-ends and year-end in the budgeting process. Today, we are reporting third quarter 2019 net income of $12.4 million or $0.55 per diluted share versus net income of $11.9 million or $0.49 per diluted share in the prior year period. This represents year-over-year increases in net income and diluted earnings per share of 4.4% and 12.2% respectively. Overall, I'm very pleased with our third quarter as we were able to report strong results for the bottom line, both net income and earnings per share, fueled by growth in net interest income and increase in net gains on mortgage loans and a credit loan loss provision, primarily as a result of net recoveries and previously charged-off loans. Additionally, we had a very good quarter of loan originations. Both portfolio and saleable production, which net of portfolio mortgage loan sales and reclassification still yielded net overall loan growth for the 22nd consecutive quarter. Asset quality continues to be very strong, with low past dues, and an acceptable level of watch credits. Additionally, we crossed the $3 billion mark for deposits. Turning to slide five of our presentation with a little more detail on the quarter, impacting our third quarter results for both 2019 and 2018 are the changes in the fair value due to price of our capitalized mortgage loan servicing rights. For the three months ended September 30, 2019, a decline in the fair value of our capitalized mortgage loan servicing rights due to price, decreased non-interest income by $2.2 million or $0.08 per diluted share after-tax. This compares to a $610,000 increase in fair value due to price of -- or $0.02 per diluted share after-tax for the three months ended September 30, 2018. Positively impacting the third quarter of 2019 was a reduction of non-interest expense of $300,000 or $0.01 per diluted share after-tax related to the company's use of its FDIC small bank assessment credit, approximately $400,000 of assessment credit remains available to offset future expense. For the third quarter of 2019, our return on average assets and return on average equity were 1.42% and 14.64% respectively. These ratios increased to 1.58% and 16.34% respectively when excluding the after-tax impact of the MSR changes in the assessment credit. Also for the quarter, our efficiency ratio at 63.8% was up slightly from the year-ago quarter of 63.6%. This third quarter 2019 ratio improves to 61.5% when excluding the after-tax impact of the MSR changes in the assessment credit. For the nine months ended September 30, 2019, the company reported net income of $32.6 million, or $1.40 per diluted share compared to net income of $29.9 million or $1.27 per diluted share in the prior-year period. Slide seven of our presentation provides a good overview of our footprint. Turning the slide eight, Michigan business conditions continued to generally be favorable with low unemployment, some job growth, affordable housing, and continued good demand for commercial real estate. We continue to closely monitor the impact of the GM UAW strike on our customer base, as well as the Michigan market as a whole. We're optimistic with last week's announced tentative settlement and are hopeful that Union does in fact ratify the settlement and resume production. Our original portfolios as shown on page nine, our two strongest growth regions are the Grand Rapids region up $79 million in loan balances and our Southeast Michigan region up $55 million in loan balances. Some of the regional declines in deposits reflect the migration of larger deposit customers into reciprocal deposits. The next couple of slides cover our balance sheet. Turning to page 10, we provide a couple of charts reflecting the attractive composition of our deposit base as well as continue growth in this portfolio while working to effectively manage our overall cost of funds. Independent has $3.05 billion in total deposits, of which $2.43 billion or 80% are non-maturity deposit accounts. When comparing third quarter 2019 to the same quarter one year ago, we increased total deposits by $262 million or 10.1%, this excludes broker deposits. Our total cost of deposits was flat on a linked quarter basis and is up 25 basis points when comparing to the same quarter one-year ago. Our success in growing deposits while manage the overall cost has been primarily through growth in our commercial deposits and the sale of our insured cash suite product to public fund entities. Similar charts are also reflected on page 11, but in this case, we are displaying our loan portfolios. We continue to target a diversified loan mix with the largest portfolio being our commercial book of business. At September 30, 2019, our loan mix included 42% commercial, 38% mortgage, 16% installment and 4% held-for-sale. Total loans outstanding now aggregate $2.85 billion including $124 million of loans held-for-sale. The commercial portfolio grew by $13 million or 4.4% annualized during the quarter. Consumer installment loans were up $19.1 million or 17.1% annualized for the quarter primarily through our indirect lending line of business, which targets Michigan Marine, Power Sports RV dealers. The mortgage originations for the quarter increased to $329 million up from the second quarter's $241 million and up from the third quarter one-year ago of $232 million. Portfolio mortgage loans declined by $16.3 million, primarily due to $46.5 million of executed or pending portfolio mortgage loan sales. In terms of capital management earning assets were up 6% year-to-date reflecting all organic growth. Our capital levels continue to be strong with tangible common equity to tangible assets of 8.71% at September 30, 2019, which is essentially unchanged from the June 30, 2019 level. This level is well within our targeted TCE range of 8.5% to 9.5%. We paid a quarterly cash dividend of $0.18 per share on August 15, 2019. During the first nine months of 2019, the company has completed the repurchase of 1,204,688 shares at a weighted average purchase price of $21.82 per share. At September 30 2019 274,298 shares remain in the 2019 share repurchase plan. This time I would like to turn the presentation over to Rob Shuster to share a few comments on our financials, credit quality, CECL and our outlook for the balance of 2019.

Thanks, Brad, and good morning everyone. I am starting at Page 13 of our presentation. Brad discussed the year-over-year increase in our net interest income during his remarks. So I will focus on our margins. Our tax equivalent net interest margin was 3.76% during the third quarter of 2019, which is down 15 basis points from the year-ago period and down 11 basis points from the second quarter of 2019. I will have some more detailed comments on this topic in a moment. Average interest earning assets were $3.29 billion in the third quarter of 2019 compared to $3.04 billion in the year-ago quarter and $3.19 billion in the second quarter of 2019. Page 14 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, the linked quarter tax equivalent yield on loans declined 13 basis points and the tax equivalent yield on investments declined 17 basis points. This primarily reflects lower market interest rates, particularly short-term rates. In addition, investment yields were negatively impacted by a $25.2 million increase in the average balance of lower yielding interest bearing cash balances due to a seasonal increase in deposits. We were generally able to offset the adverse impact of lower yields on earning assets by a $93.8 million increase in the average balance of earning assets. The average cost of funds declined by two basis points to 0.84% in 3Q 2019 from 0.86% in 2Q 2019. We'll comment more specifically on our outlook for the net interest margin and net interest income for the balance of 2019 later in the presentation. Page 15 compares our quarterly average cost of funds to the monthly average effective federal funds rate during the quarter and the spot federal funds rate during the quarter. Moving on to page 16, non-interest income totaled $12.3 million during the third quarter of 2019 as compared to $11.8 million in the year-ago quarter and $9.9 million in the second quarter of 2019. Mortgage banking related activity namely gains on mortgage loans and mortgage loan servicing caused most of the quarterly comparative year-over-year variability in non-interest income. Brad already discussed the changes in the fair value due to price of capitalized mortgage loan servicing rights. Our capitalized mortgage loan servicing rights asset of $16.9 million at September 30, 2019 represented a value of just 68 basis points on our $2.5 billion of mortgage loan servicing. 3Q 2019 net gains on mortgage loans increased to $5.7 million compared to $2.7 million in the year-ago quarter. The increase in these gains was due to increases in mortgage loan sales volume, the mortgage loan pipeline and our profit margin. Mortgage loan application volume was very strong in the third quarter and continues to be strong at the start of the fourth quarter. In addition, we had $36.6 million of portfolio mortgage loans in process of sale at September 30, 2019 on which we expect to record a gain on sale of approximately $1.1 million October. As a result, we expect another strong quarter of gains on mortgage loans to end 2019 followed by our normal seasonal slowdown in the first quarter of 2020. As detailed on page 17, our non-interest expenses totaled $27.8 million in the third quarter of '19 as compared to $26.7 million in the year ago quarter and $26.6 million in the second quarter of '19. Actual third quarter '19 non-interest expenses were just slightly above the high-end of our projected range of $27 million to $27.5 million. We'll have more comments on our outlook for non-interest expenses later in the presentation. Investment security is available for sale increased to 9 -- increased by $9.3 million during the third quarter of 2019. Page 18 provides an overview of our investments at September 30, 2019. Approximately 31% of the portfolio is variable rate, and much of the fixed rate portion of the portfolio is in maturities for average lives of five years or less. The average duration of the portfolio is about 2.65 years with a weighted average tax equivalent yield of 3%, which is down 12 basis points from June 30 of '19. Page 19 provides data on non-performing loans other real-estate non-performing assets and early stage delinquencies. Total non-performing assets were $8.4 million or 4.24% of total assets at September 30 of '19. Non-performing loans decreased by about $700,000 during the third quarter of '19. At September 30, 2019, 30 to 89-day commercial loan delinquencies were just 0.04% and mortgage and consumer loan delinquencies were just 0.35%. Moving on to page 20, we recorded a credit provision for loan losses of $271,000 and $53,000 in the third quarters of 2019 and 2018, respectively. We recorded loan net recoveries of $516,000 and $950,000 in the third quarters of 2019, and 2018, respectively. Finally, the allowance for loan losses totaled $26.1 million or 0.96% of portfolio loans at September 30, 2019. Page 21 provides some additional asset quality data, including information on new loan defaults and unclassified assets. New loan defaults were just $4.3 million through the first nine months of 2019. Page 22 provides information on our TDR portfolio that totaled $50.2 million at September 30, 2019, a decline of $1.9 million during the third quarter. This portfolio continues to perform very well with 95.2% of these loans performing and 92.7% of these loans being current at September 30, 2019. Page 23 provides a detailed timetable for our implementation of the CECL accounting standard. I'm proud to say that we were one of the very first community banks to publicly disclose the estimated impact of CECL on our allowance for credit losses. In our second quarter 2019 Form 10-Q, using June 30, 2019 data we disclosed an estimated increase of $9.5 million to $11.5 million in our allowance for credit losses under CECL. Using September 30, 2019 data, the estimated increase moved down slightly to a range of $9 million to $11 million. The primary factor driving this expected increase is the longer contractual maturities of our mortgage loan and consumer installment loans segments. In addition, the midpoint of our range uses a two-year economic forecast period and a two-year reversion period. Page 24 is our update for 2019, where we compare our actual performance during the year to our original outlet that we provided back in January 2019. Overall, we believe that our actual performance in the third quarter of '19 particularly when factoring out the negative fair value adjustment due to price on capitalized MSRs was better than our original outlook. We achieved actually annualized loan growth of 2.3% and 7.2% for the third quarter and first nine months of 2019 respectively. Our loan growth was purposely slowed in the third quarter of '19 due to our decision to sell or securitize $46.5 million of portfolio mortgage loans. Of this total $9.9 million was sold in the third quarter of '19 and $36.6 million was transferred to help for sale at September 30, 2019. And the sale will settle in October 2019. Nearly all of the $36.6 million is being securitized with Freddie Mac, and we intend to hold most of these securities. So you will see an increase in available for sale securities in the fourth quarter of 2019. The portfolio mortgage loan sales were done for asset liability management reasons, including continuing to balance the mix of our overall loan portfolio. As a result, we now expect our 2019 full-year actual loan growth to be just a bit below our original 8% to 9% goal. With the shape of the yield curve, and the additional expected cuts in the federal funds rate, we do expect some continued downward pressure on our net interest margin. As I stated last quarter, we reduced our original forecasted growth rate of 10% to 11% for net interest income for all of 2019 down to 8% to 9%. That updated forecast assumed 25 basis points cuts in the federal funds rate in July, September, and December. At this point, we still feel comfortable with the 8% to 9% full-year increase range. As to our net interest margin, I wanted to make some comments about our efforts to maintain it despite a difficult environment. On the cost of funds side, we did utilize interest rate caps that totaled $150 million at September 30, 2019 to manage the cost and duration of wholesale funds, particularly broker deposits. As a result of our use of caps, we can take advantage of lower market interest rates. In fact, we have about $197 million of broker deposits maturing during the fourth quarter of 2019, with an average cost of 2.07% that we expect to replace at rates on average at least 25 basis points lower. As to the rest of the deposit base, we continue to proactively manage funding costs and walk the fine line of retaining and growing deposits, while pushing down interest rates where we can. Bottom-line, we expect our future cost of funds to drop more quickly than the 2 basis points you saw in the third quarter of '19. On the asset side, we continue to try and extract every basis point possible on both loans and investments. I heard an analyst ask another bank about interest rate floors on loans in a recent conference call. Only about 6% of our variable rate commercial loans have interest rate floors. In contrast, about 90% of our variable rate home equity loans have floors. However, we would need to see an additional drop in interest rates of about a 150 basis points before a lot of these floors would begin to kick in. Thus our variable rate loan portfolio will continue to be susceptible to lower prime or LIBOR rates. Looking longer term if history is a guide, our lowest net interest margin over the last several years was 3.52% during 2016, when average short-term interest rates were still well below 1%. As to the loan loss provision, we expect generally stable asset quality metrics during the last quarter of 2019. So loan growth is anticipated to be the main driver of our loan loss provision. We would not expect to see a credit loan loss provision in the fourth quarter of '19, as the third quarter benefited from strong net loan recoveries. Excluding the negative fair value adjustment due to price on MSRs, our adjusted third quarter non-interest income would have been well above the high-end of our forecasted range due primarily net gains on mortgage loans. We expect net interest income to be above the high-end of our forecasted range in the last quarter of '19, due to strong mortgage banking revenues, excluding any volatility associated with changes due to price and the fair value of MSRs. With respect to non-interest expense, we expect to be at the high-end of our forecasted range in the last quarter of 2019. We are above the range that would likely be due to a strong bottom-line performance that impacts our performance-based compensation accrual at year-end. Finally, our effective income tax rate was 20% in the third quarter of '19, which was exactly in line with our forecast. That concludes my prepared remarks and I would now like to turn the call back over to Brad.

Thanks, Rob. On October 22, 2019, we announced that our Board of Directors appointed Ronia Kruse to the Boards of the Corporation and the bank. She will also serve on the Corporation's Audit Committee. Ms. Kruse is the founder and CEO of OpTech, a talent development and solutions firm providing services to Fortune 1000 and government clients. OpTech provides innovative solutions for clients in the areas of analytics, cybersecurity, application development, and connected vehicles. Prior to founding OpTech, Ms. Kruse was a senior tax consultant for a Big 4 CPA firm, where she specialized in international tax planning. She is a Certified Public Accountant, is active in a variety of organizations, and has served on the investment committee of Belle Michigan to help evaluate potential emerging technology portfolio companies. We are delighted to and add Ronia to the Boards of Directors of both our parent company and the bank. She's -- is a dynamic executive, who brings us a unique ability to leverage technology, develop talent, and provide insight on the digital economy. In addition, her background with a big 4 CPA firm makes Ronia an important addition to our organization. Finally, we have listed our strategic initiatives on Slide 25. During the first nine months of 2019, we have made significant progress in each of these areas. We believe successful execution on these initiatives will continue to drive strong returns as a community bank at the center of all our strategies, staying focused on serving our customers and investing in our markets and in our people. At this point, we would know like to open up the call for questions.

We will now begin the question-and-answer session. [Operator Instructions] Our first question is from Brendan Nosal with Sandler O'Neill and Partners. Please go ahead.

Hey, good morning, guys. How are you?

Good morning.

Good morning, Brendan.

I just want to start off on the margin. I appreciate all the color you gave on some of the things you're doing to pushback on the cost of funds, as well as trying to maintain on the asset side. If you could just kind of wrap up those moving pieces into what you think it means for the NIM in the fourth quarter that would be helpful, and then, what each incremental rate cut thereafter you think would mean for the margin?

Well, for the fourth quarter, I don't expect to see the same magnitude of drop that we had in the third quarter, the 11 basis points. I think it would be somewhere maybe in between, so in that six to seven basis point range. I think a lot of it is just going to depend on asset mix a bit and then just some timing on the cost of funds side. Longer term in part of why I gave that sort of long-term data point of 352 that was when rates were down, and not they had come up from zero, but not much. So, I kind of feel like that sort of a low watermark for us. So I would see maybe a bit of a drift down, but not toward that kind of levels. So we're at 376, so maybe a bit of a drift down, but hopefully all of our efforts will result in stabilizing it not too far away from where we're at right now, and the other real goal is to continue to drive earning asset growth. So, the dollars of net interest income continue to grow.

Understood, that's definitely helpful. And then if I can sneak one more in there, just moving onto the C side of things, obviously a very, very good number here in this third quarter after you remove the MSR noise, and I appreciate the outlook for the fourth quarter to be above the high end of the range, but as I look at things, given continued strength in the mortgage market and then the $1.1 million gain you expect to take, it seems like fees could be meaningfully above the high end of that $11 million to $12 million range next quarter. So I guess just one, want to make sure I'm thinking about that correctly, and then two, if you could give a finer point on how much above that $12 million mark you think you could be?

Well, that's a great question. I think given where the pipeline is and new application volume and as you mentioned, the million dollar gain on the $36.6 million that moved into held-for-sale, I would certainly see a number approaching as strong as we were in the third quarter. I think the one caveat I will give you is with the way we record the fair value adjustments, the pipeline is likely to be lower at December 31 versus where it was in September 30. So that's going to cause us to have a downward adjustment, and it's really going to be the magnitude of how much does that pipeline drop because actual loan sales are going to be as strong or stronger. So, the wildcard is kind of the change in fair value related to the pipeline, and to the extent that that holds up, in app volumes hold, it could be again a number very similar to where we were in the third quarter if the app volumes have a more of a seasonal decline, then it could be off a bit, but I certainly would expect it to be lead to us being meaningfully above the high end of the range.

Rob, I would add to that. In the third quarter 2019, we had a very strong swap fee income quarter to about half a million dollars.

Yes. That's another non-interest income. So we may not be quite at that level in the fourth quarter, but the gains I would expect to be pretty strong in the fourth quarter. I know I'm not giving you an exact number because it's tough to project the one item on the pipeline, but I would be surprised if we are meaningfully above.

No, that's very helpful color. So, thanks for walking me through the moving pieces, and thanks for taking the questions.

You're welcome.

[Operator Instructions] Our next question comes from John Rodis of Janney. Please go ahead.

Hey guys, good morning.

Good Morning, John.

Good Morning, John.

Rob, it's been great working with you over all these years. I guess you'll have a little extra time to play some golf next year.

Yes, hopefully…

You won't have to worry about interest rates and all that exciting stuff in the yield curve, but just…

I'll be a shareholder, so I'll still worry about it.

Don't worry about it too much. Hey, just a quick question, just on your thoughts on the buyback, obviously, you've still got -- what about 270,000 shares remaining between now and year end and then just thoughts on re-upping the buyback plan for 2020?

Yes. So I guess, John, I'll jump in there. So we had through the second quarter a very, very strong buyback activity. In fact, we completed the full initial authorized amount of 5% and then our board re-upped an additional 300,000 shares. And in the third quarter we had a small amount of purchases for the third quarter. I would say going forward, we will continue to have the program in place and so it would expire at the end of 2019. I would think that our board would re-up that for 2020. And we continue to look at all the opportunities that we have to put our capital to work. And it's a balancing act, and so the pace that we were buying at through the first half of the year obviously is slowed down, but perspectively, we could do some purchasing, but not probably not nearly at the pace that we were at before.

Okay. Fair enough. Thanks for it.

Yes, I think that covers it well. I think the other thing is it's a good lever if organic growth and earning assets and loans slows a bit maybe its economic factors in the marketplace, but it's a good lever to try and continue to produce growth in earnings per share, if there is some slowdown in asset growth.

Yes. And I expect the stock will probably -- stocks will -- bank stocks will probably remain volatile. So, just one other question, you guys sort of addressed it a little bit just as far as the GM strike and you know, maybe it's going to be over soon, but just your comments, it doesn't sound like you've seen any meaningful negative impact yet from the strike? Is that correct?

Yes, it's a - so we internally consult with our client base and there is no doubt that, this has as impacted, the Michigan markets and the national markets. If you go back to pre-strike, there was some positioning by both parties that I think they had set themselves up so that for a short period of time they could, survive without maybe being too negative. And so, while this has gone on, I think longer than what people expected and anybody really wanted it, it appears that they're, they're close. And so, hey, in our markets, on the supplier side there have been layoffs, as production has slowed or ceased. But when we canvas our portfolio of clients, really they are looking longer-term and quite frankly, they're bullish on 2020. I mean, there's a lot of uncertainty in the market, but there are definitely optimistic about 2020.

Yes, so…

Yes. I was going to add, we haven't seen anything impact wise either in the retail portfolio mortgages or consumer loans or on the commercial portfolio where, you know, it's affected someone's ability to make their payments.

Okay. Thanks, guys. Thanks for the comments.

Our next question comes from Kevin Reevey with D.A. Davidson. Please go ahead. Good morning.

Good morning.

Good morning, Kevin.

Good morning, Kevin.

Rob, congratulations on your retirement, well deserved. And Steve, I'm looking forward to working with you again.

Thank you, Kevin.

Okay. So first question is, I was just curious, were there other - are there any other levers on the asset side of the balance sheet that you can pull in order to mitigate margin compression in a lower rate environment?

I think the thing that we're just working the hardest on is trying to, where we can hold the line in - maybe expand margins a little bit on new lending. I kind of went through the fact that floors are not going to prevent on the variable rate loans a downward drift there. But I think those are the two key elements is just trying to expand margin a little bit. And other than that, I think earning asset growth and getting more dollars of net interest income is the other key.

Okay.

And the other thing I would say, and we have a slide on it. We do have a decent amount of the portfolio that is fixed rate now to the extent to get prepayments. You can still have some drift down there as well, but we're reasonably balanced in those portfolios between fixed rate and variable rates. So we may not have quite as much pressure as maybe someone who has a vast percentage of their commercial portfolio with variable rates.

And then your fixed rate loans and most of them structured such that if there is an early prepayment that there is a prepayment fee that you can capture to kind of to better fit a bit from the last of the higher yield asset?

That is correct on commercial. So, virtually all of the commercial loans that are fixed rate would have some form of yield maintenance or prepayment penalty that is not the case on retail loans. So that on retail loans, that's just not acceptable in the marketplace. So those loans there is know the ability to refinance without penalty. But again, the one thing I would say is margins have kind of improved in the mortgage banking space. So that what we call the primary secondary spreads have widened down a bit. So hopefully that will help on the mortgage side.

Okay. And then lastly, given CECL and then your focus on consumer lending, do you expect to see any changes on your focus given the impact of CECL?

That's a great question. I would say that we would be -- as we have been this year, I think we would be active in doing some portfolio, loans sales without a recourse to try and moderate the growth rate there. I think longer-term, the performance it's more of a timing thing than anything else. So, the credit losses are whatever they ultimately are. And I think over time we'll probably refine where provisioning levels are. I think when - at the start everyone is sort of in the same bucket of maybe being a bit on the conservative side as you start down the path with CECL in terms of the modeling, and I think over time you'll get better on that. So I think over time it's not going to affect our desire to do consumer financing both mortgage and the RV Power Sport Marine. But I think we'll try to maybe regulate those growth rates through sales.

Great, thank you. Appreciate the color.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. 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, and we wish you all a great day.

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