Independent Bank Corporation (IBCP) Q3 2022 Earnings Report, Transcript and Summary

Hello, and welcome to today's call. My name is Candice, and I will be your moderator. All lines have been placed on mute during the presentation portion of the call for an opportunity for question-and-answer at the end. [Operator Instructions] I would now like to pass the conference over to our host, Brad Kessel, President and Chief Executive Officer. Please go ahead.

Good morning, and welcome to today's call. Thank you for joining us for Independent Bank Corporation's conference call and webcast to discuss the company's third quarter 2022 results. I am Brad Kessel, President and Chief Executive Officer and joining me is Gavin Mohr, Executive Vice President and our Chief Financial Officer; and Joel Rahn, Executive Vice President, Commercial Banking. Before we begin today's call, I would like to direct you to the important information on Page 2 of our presentation, specifically the cautionary note regarding forward-looking statements. If anyone does not already have a copy of the press release issued by us today, you can access it at the company's website, independentbank.com. The agenda for today's call will include prepared remarks followed by a question-and-answer session and then closing remarks. Independent Bank Corporation reported third quarter 2022 net income of $17.3 million, or $0.81 per diluted share versus net income of $16 million, or $0.73 per diluted share, in the prior year period. This represents increases in net income and diluted earnings per share of 8.4% and 11% respectively over the third quarter of 2021. For the third quarter of 2022, we generated an annualized return on average assets and return on average equity of 1.40% and 20.48%, respectively. Our successful expansion into new markets and the addition of new banking talent has enabled us to continue capitalizing on the significant business investment occurring throughout our state of Michigan. This has led to strong core results in the third quarter of 2022 with $3.8 million growth in net interest income, a 23 basis point expansion of our net interest margin on a linked quarter basis and net growth in each category of loans as well as growth in total deposits including non-interest bearing deposits. In addition, our asset quality metrics continue to be very good, with low levels of past due loans, commercial watch credits and non-performing assets as well as net loan recoveries for the quarter. The continued growth of our franchise and increase in profitability is directly related to the growth in our team, our expansion into higher growth markets, and our entire team capitalizing on attractive lending and deposit gathering opportunities with increasing business investment in the state of Michigan. This investment in the state of Michigan includes the electric vehicle industry, clean energy infrastructure, and the trend of onshoring of supply chains, which is driving job growth, business formation, and expansion. For the nine months ended September 30, 2022, the company reported net income of $48.3 million, or $2.27 per diluted share compared to net income of $50.4 million, or $2.30 per diluted share in the prior year period. For 2022, this represents an annualized return on average assets and return on average equity of 1.35% and 18.56%, respectively as compared to 1.53% and 17.32% for the same period last year. I am very pleased that we are able to continue to grow deposits, which increased 3.4% during the third quarter of 2022, and now total $4.3 billion at September 30, 2022, an increase of $209.9 million from the start of the year. This increase has spread across non-interest bearing, interest-bearing checking, reciprocal and some brokered time deposit account balances. We have been able to generate this deposit growth while keeping our overall cost of funds low at 33 basis points this past quarter. That said, while we have been successful in lagging our cost of funds during the initial fed rate hikes, we do expect to see an increased deposit beta going forward. We have included in our presentation a historical view of our cost of funds as compared to the Fed Funds Spot rate and the Fed Effective rate from the last rate hike cycle through the most recent quarter end. It may or may not be indicative of what we will see prospectively, but it does provide a good historical view of our company and its cost of funds during a rising rate environment. At this time, I would like to turn the presentation over to Joel Rahn to share a few comments on the success we were having in growing our loan portfolios and provide an update on our credit metrics.

Thanks, Brad. On Page 8, we will provide an update on our well diversified loan portfolio. In total, our portfolio grew $151 million in the third quarter, led by our commercial portfolio, which increased $79 million. This continues our trend of strong quarterly earning – commercial loan growth. Through the first nine months of the year, our commercial portfolio has increased $204.7 million, representing 22.7% annualized growth rate. While we expect that pace of growth to moderate in the fourth quarter and into next year, our pipeline remains strong, and we believe this supports a low double-digit rate of growth as we head into 2023. In terms of our residential activity, despite economic headwinds, our mortgage portfolio increased by $71 million during the third quarter as origination shifted toward more portfolio lending. Consumer installment lending softened in the quarter with that portfolio increasing $1.3 million as we intentionally limited our new production in order to preserve our liquidity to fund the strong growth we are seeing in commercial loans. Overall, we are very pleased with our solid loan growth and believe we are on track to continue our planned asset rotation from the investment portfolio to higher yielding loans. Turning to Page 9, we provide detail on our $1.4 billion commercial loan portfolio. C&I lending continues to be our primary focus, representing 64% of the portfolio. Manufacturing is the largest concentration within the C&I segment, comprising approximately 11% or $156 million. The remaining 36% of the portfolio is comprised of commercial real estate with the largest concentrations being industrial at $119 million or 8.4%, and retail at $113 million or 8.1%. It's worth noting that of the $520 million of new commercial loan volume generated in the first nine months of the year, $334 million or 64% is C&I versus $186 million or 36% investment real estate. By design, the portfolio is very granular in nature, and our credit metrics demonstrate that this portfolio has held up very well through the pandemic and resulting supply chain pressures. Page 10 provides data on our non-performing loans, other real estate and non-performing assets and early stage delinquencies. Total non-performing assets were $4.2 million or 0.08% of total assets at September 30, loans 30 to 89 days delinquent totaled $2.3 million at September 30, unchanged from December 31, 2021. While there is growing concern about the health of the consumer, early stage delinquencies in our installment portfolio remain stable and at low levels, largely due to our focus on prime and super prime borrowers, and as a reminder, almost all of this portfolio is comprised of secured loans. At this time, I'd like to turn the presentation over to Gavin for his comments, including the outlook for the remainder of the year.

Thanks, Joel, and good morning, everyone. I am starting on Page 11 of our presentation. Page 11 highlights our strong regulatory capital position. The reduction in the CET1 ratio and the total risk-based capital ratio is due to risk weighted asset growth. Net interest income increased $6.1 million from the year-ago period. Our tax equivalent net interest margin was 3.49% during the third quarter of 2022, which is up 31 basis points from the year-ago period and up 23 basis points from the second quarter of 2022. I'll have some more detailed comments on this topic in a moment. Average interest earning assets were $4.61 billion in the third quarter of 2022 compared to $4.3 billion in the year-ago quarter and $4.49 billion in the second quarter of 2022. Page 13 contains a more detailed analysis of the linked quarter increase in net interest income and in the net interest margin. Our third quarter 2022 net interest margin was positively impacted by two factors. The increase in yield on investments made up 15 basis points and change in loan yield and mix that equaled 30 basis points. These increases were partially offset by an increase in funding costs of 22 basis points. We will comment more specifically on our outlook for net interest income and the net interest margin for 2022 later in the presentation. On Page 14, we provide details of our interest rate risk position. The comparative simulation analysis for the third quarter 2022 and second quarter of 2022 calculates the change in the net interest income over the next 12 months. All scenarios assume a static balance sheet. The base rate scenario applies the spot yield curve from the valuation date. The shock scenarios consider immediate, permanent and parallel rate changes. The increase in the base rate, forecasted net interest income in the third quarter of 2022 compared to the second quarter of 2022 is primarily due to the increase in rates, which resulted in higher forecasted earning asset yields, lower betas on interest-bearing deposits been modeled and earning asset growth. Most of the increase in interest income consisted of higher yields on variable rate earning assets, which outpaced increases on deposits. Secondarily, actual increases to deposit rates was less than previously modeled. The shift in sensitivity is primarily due to slower liability repricing due to slightly lower deposit betas. Currently, 25.4% of assets reprice in one-month and 39.3% reprice in the next 12 months. Moving on to Page 15. Non-interest income totaled $16.9 million in the third quarter of 2022 as compared to $19.7 million in the year-ago quarter and $14.6 million in the second quarter of 2022. Third quarter 2022 net gains on mortgage loans totaled $2.1 million compared to $8.4 million in the third quarter of 2021. The decrease in gains was due to decreases in mortgage loan sales volume and in the mortgage loan pipeline as well as lower loan sale profit margins. Mortgage loan applications have slowed and the mortgage production mix has rotated to a lower percentage of sale of mortgages. Positively impacting non-interest income was a $4.3 million gain on mortgage loan servicing due to a $3.2 million or $0.12 per diluted share after-tax increase in the fair value due to price and a $1.1 million decrease due to pay downs of capitalized mortgage loan servicing rights in the third quarter 2022. As detailed on Page 16, our non-interest expense totaled $32.4 million in the third quarter of 2022 as compared to $34.5 million in the year-ago quarter and $32.4 million in the second quarter of 2022. Compensation increased $1.3 million compared to the prior year quarter due to raises that were effective at the start of the year, a decreased level of compensation that was deferred in the third quarter of 2022 as a direct origination cost on lower mortgage loan origination volume, and an increase in the lending personnel. Performance-based compensation decreased $2 million due primarily to a decrease in mortgage lending volume and lower performance level within the Corporate Incentive Compensation Plan compared to the third quarter of 2021. The third quarter of 2022 included $0.4 million of expense related to the reserve for unfunded lending commitments due to an increase in the expected loss ratio. We will have more comments on our outlook for non-interest expense later in the presentation. Page 17 is our update for our 2022 outlook to see how our actual performance during the third quarter compared to the original outlook that we provided in January of 2022. Our outlook estimated loan growth in the low double digits. Loans increased to $151 million in the third quarter of 2022 or 18.4% annualized, which is above our forecasted range. Commercial mortgage and installment loans all experienced growth in the third quarter 2022. Third quarter 2022 net interest income increased by 18% over 2021, which is higher than our forecast of low single-digit growth. The net interest margin for the third quarter of 2022 was 31 basis points higher than the third quarter of 2021, net interest margin of 3.18%, which is higher than our original forecast. The third quarter 2022 provision for credit losses was an expense of $3.1 million or 0.37% annualized. This is above our forecasted 2022 full-year provision range of 0.15% to 0.20% of average total portfolio of loans. The primary driver of the increase in the provision for credit losses was an increase in the pooled reserve and subjective allocations due to loan growth. Non-interest income totaled $16.9 million in the third quarter of 2022, which was within our forecasted range of $13 million to $17 million. Third quarter 2022 mortgage loan origination sales and gains totaled $209 million, $157.5 million and $2.9 million, respectively. The decrease in net gains on mortgage loans sold was primarily due to lowered sales volume and decreased profit margin on mortgage loan sales. Mortgage loan servicing generated a gain of $4.3 million in the third quarter of 2022 due primarily to a positive $3.2 million fair value adjustment due to price. Non-interest expense was $32.4 million in the third quarter within our forecasted range of $30.5 million to $32.5 million per quarter. Our effective income tax rate of 18.6% for the third quarter of 2022 was at the lower end of our forecast. Lastly, we purchased 181,586 shares, an average cost of $22.08 for the year-to-date period in 2022, but we did not purchase any shares in the third quarter as we are focused on preserving capital to increase our tangible common equity ratio and support our continued strong loan growth. That concludes my prepared remarks, and I would now like to turn the call back over to Brad.

Thanks, Gavin. Each quarter, we share a high-level view of our key strategic initiatives. As we head into the fourth quarter of 2022, our focus will continue to be on the rotation of our earning and asset mix out of the lower-yielding investments into higher-yielding loans, growing our deposit base while managing our cost of funds, and controlling our non-interest expenses. While we maintained disciplined expense management, we are also continuing to make investments that we believe will enhance our ability to generate long-term profitable growth. While there is an increasing concern about a potential economic slowdown, at this point, we continue to see healthy economic conditions and loan demand in Michigan, and we are excited about the opportunities we have to continue our growth trends for the remainder of 2022 and into 2023. Operator, at this point, we would now like to open up the call for questions.

Thank you. [Operator Instructions] So our first question comes from Damon DelMonte of KBW. Your line is now open. Please go ahead.

Hey, this is [Matt Renck] filling in for Damon DelMonte. Hope everybody is doing well. I just wanted to get your updated thoughts on where you see deposit balances trending given the current rate environment and then also the investments you mentioned earlier in the state of Michigan?

Yes. Sure, Matt. We have had continued success in growing the deposit base. That said, I think it's getting harder. It's definitely more competitive. I think part of our – much of our success is a function of a number of things. One, the investments in C&I lenders over the last few years has resulted in growth in our commercial balances. Two, I think our investment in our core technology platform and the ONE Wallet has helped us remain competitive on the consumer base. And then thirdly, Independent has a fairly strong Municipal segment that we service with our treasury team. In the municipal base, in our markets, continues to have significant cash levels and funds coming in from the federal government. So I think that's been a lot of our success. And I think we can continue it going forward, but I think it's going to be more difficult.

Okay.

And the second part of your question...

Sorry, go ahead.

Yes, sure. The investments in Michigan, and we actually put together within a slide in our deck here. There has been quite a large number of announcements of large investments from General Motors to Ford, LG Energy, Gentex, Stellantis and so on, all talking about new dollars coming into the state in billions in the electric vehicle industry and the clean energy industry. And then also, we're just experiencing and seeing a lot within our customer base more and more onshoring of their supply chain. So for all those reasons, we are pretty optimistic about loan growth prospects going forward.

Okay. Great. And then just one last question for me. Given the current like economic forecast, are there any areas of your loan book that you're keeping a closer eye on or that maybe you've stepped back from lending to?

We over the years have worked hard to build a very granular portfolio. Again, the Commercial segment is the largest. And within that, we tilted towards having more C&I lending, but it's very granular. And we have a very strong mortgage portfolio. Again, FICO is north of 750 and good DTIs and LTVs. This past quarter, we did temper back the – some portions of the installment portfolio and particularly in the RV segment. I think it continues, and we're seeing some of the manufacturers there report really strong earnings. But we're just cognizant of the increase in collateral values that we've seen over a fairly short period of time. So that's maybe the one segment, but overall, we feel very good about all the portfolios.

Great. Thank you. I'll step back.

Thank you. Our next question comes from Erik Zwick of Hovde Group. Your line is open. Please go ahead.

Good morning, guys.

Good morning.

I wonder if I could just start and maybe a bit of a follow-up to the loan growth question. You've also indicated that you'll continue to seek to rotate the assets a bit some coming out of the lower-yielding securities and going into loans. So is it the right way to think about that the average earning asset growth would likely be slower than the loan growth that you're actually adding over the next few quarters?

Yes. That's an accurate statement.

Okay. Thanks. And then just looking at the expectations for the non-interest expenses, I know there was a new branch opened in 3Q and inflation continues to be a pressure for a number of segments of your business probably. Do you feel confident that you can stay within that targeted range? I guess you kind of get closer to the high end of the 32.5% thinking to stay within that range as we head into 4Q? And maybe any thoughts about 2023?

Yes. I think we're in the early stages or intermediate stages of our 2023 budgeting process. And no doubt, a lot of effort is going into looking at all the expense categories. And over the years, I think we've done a pretty good job of keeping expenses down. We are expecting to see an increase in some comp, obviously, as overall, we have high levels of inflation, but we have been making through this year reductions in various segments where volumes are down. And we guess we do have the New Holland branch that opened, but we have some offsets to that. And we continue to look at investments in automation where as an example, recyclers within our branches can be – save us money. So I think we can, but we'll have a better feel as we pull together the 2023 budget, and then we thereafter give a little bit more guidance on 2023.

Great. Thanks for the color there. And just last one, just thinking about capital allocation today and that you didn't buy back any shares in 3Q. I'm curious if that was maybe kind of driven by outlook for growth and keeping capital on hand for loan growth or whether you're just looking to be more conservative and hold on to capital with the uncertain economic environment and how you're thinking about potential share repurchases in 4Q as well?

Yes. And this is Gavin. So yes, the capital focus is on loan growth. I think when you're showing the double-digit growth rates we are, that's the best use of capital. I would say regarding the economic uncertainties, we believe we're appropriately reserved. You're going to see reserve to total loans today at 150. So I think it has much more to do with the loan growth we're experiencing versus economic uncertainty.

Great. Thanks for taking my questions today.

Thank you.

Thank you. As there are no additional questions registered at this time, I'd like to hand the conference back over to Brad for closing remarks.

In closing, we would like to thank our Board of Directors and our senior management for their support and leadership. We would also like to thank all of our associates. I continue to be so proud of the job being done by each member of our team. Each team member in his or her own way continues to do their part toward our common goal of guiding our customers to be Independent. Finally, 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.

Ladies and gentlemen, this concludes today's conference call. Have a great day ahead. You may now disconnect your lines.