Good day, ladies and gentlemen, and welcome to the First Internet Bancorp Third Quarter 2023 Earnings Conference Call. At this time, all lines are in listen-only mode. Following the presentation, we'll conduct a question-and-answer session. [Operator Instructions] This call is being recorded today, October 26, 2023. I will now like to turn the conference over to Larry Clark from Financial Profiles, Inc. Please go ahead, Mr. Clark.

Thank you, Sergio. Good day, everyone, and thank you for joining us to discuss First Internet Bancorp's financial results for the third quarter of 2023. The company issued its earnings press release yesterday afternoon, and it's available on the company's website. In addition, the company has included a slide presentation that you can refer to during the call. You can also access these slides on the website. Joining us today from the management team are Chairman and CEO, David Becker; and Executive Vice President and CFO, Ken Lovik. David will provide an overview, and Ken will discuss the financial results. Then we'll open up the call to your questions. Before we begin, I'd like to remind you that this conference call contains forward-looking statements with respect to the future performance and financial condition of First Internet Bancorp that involve risks and uncertainties. Various factors could cause actual results to materially be different from any future results expressed or implied by such forward-looking statements. These factors are discussed in the company's SEC filings, which are available on the company's website. The company disclaims any obligation to update any forward-looking statements made during the call. Additionally, management may refer to non-GAAP measures, which are intended to supplement but not substitute for the most directly comparable GAAP measures. The press release, available on the website, contains the financial and other quantitative information to be discussed today, as well as a reconciliation of the GAAP to non-GAAP measures. At this time, I'd like to turn the call over to David.

Thank you, Larry. Good afternoon, everyone, and thanks for joining us today as we discuss our third quarter 2023 results. Starting with the highlights on Slide 3, I would like to discuss some key themes for the quarter. We generated strong deposit growth during the quarter, bolstering our liquidity profile and driving down our loan-to-deposit ratio below 92%. We also continued to transition the composition of our loan portfolio and optimize our overall balance sheet mix. As new origination yields were up 50 basis points from the second quarter to 8.92%, and they were up over 360 basis points from the third quarter of 2022. At the same time, both the pace of deposit cost increases and the rate of compression in our net interest margin were the slowest they've been in five quarters. Moreover, while one month does not make a trend, we were encouraged by the month-over-month increase in our net interest margin in September. Recognizing that macroeconomic and geopolitical factors remain outside of our control, we continue to believe that our net interest margin and overall net interest income have likely bottomed out and will follow an upward path from here. Another highlight for the quarter was our SBA team's continued outstanding performance. The team again posted its highest level of quarterly gain on sale revenue to date, which was up over 14% from the second quarter, driven primarily by a strong increase in the sold loan volume. Following our exit from the consumer mortgage business earlier this year, our mix in non-interest revenue has shifted from what was an overreliance on the cyclicality of the low multiple mortgage business to what we believe is a more consistent, reliable, and growth-oriented revenue stream regardless of the interest rate environment in SBA. Our nationwide SBA team is doing…

Thanks, David. Now turning to Slide 4, David covered the highlights for the quarter from a lending perspective, so I will just provide some additional color. Consistent with our focus on variable rate and higher yielding asset classes, we were pleased that our third quarter funded portfolio origination yields continued to increase from the second quarter. Because of the fixed rate nature of some of our larger portfolios, there is a lagging impact of the higher origination yields on the overall loan portfolio. However, as new origination yields have been consistently higher throughout 2023, we expect the overall loan yield to continue to increase in future periods. Our SBA, construction and franchise finance channels continue to have very strong pipelines. There is one caveat to our outlook on loan pipelines that I will speak to in a little more detail later, that being the possibility of a government shutdown in November and the potential impact on the SBA pipeline. As David just said moments ago, some macroeconomic and geopolitical factors remain outside of our control. If we avert a shutdown, and similar to what we accomplished in the second and third quarters, our goal is to fund a portion of this production using cash flows from other portfolios as we continue to rebalance and optimize the composition of the total loan portfolio. Moving on to deposits on slides 5 through 7, deposit balances continued to increase and were up $229 million or 6% from the end of the second quarter. The majority of the deposit growth during the quarter came from CDs with strong demand from consumers and small business. We originated $428 million in new production and renewals during the quarter at an average cost of 5.14% and a weighted average term of 15 months. These were partially offset…

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. [Operator Instructions] Your first question comes from Nathan Race from Piper Sandler. Please go ahead.

Yes. Hey, guys, good afternoon. Thank you for taking my questions.

Hey, Nate.

Hey, Nate.

Just kind of want to clarify the margin outlook for the fourth quarter. I appreciate the guidance for loan yields up. I think it was 20 basis points to 25 basis points versus the third quarter, but it sounds like the margin pressure is going to continue, but should slow versus the pace of pressure from 2Q into 3Q. And then with the Fed remain on pause, hopefully we get some stability, if not expansion starting early next year. Is that the right way to think about the trajectory?

Yes. I mean, as I said I think we think the inflection point is the third quarter. As we continue to optimize the loan book and pick up more yield there, I think with regards to deposit costs, especially with the CD re-pricing gap narrowing and frankly a lot of our deposits really tied to direct moves in Fed funds. I mean, we do not forecast deposit costs really increasing all that significantly in the fourth quarter. And again, notwithstanding forces outside our control, we expect net interest income, net interest margin to be up in the fourth quarter.

Well, you’re spot on, Nate, and that is predicated on the Fed not bumping anything here in November, which indications are – they’re going to stay the course. So we got a shot. If you go back, as Ken made the comment, the excess cash on the balance sheet as that rolls off here this quarter, we think that will get us back in that positive vein. If we had not had the excess cash in the third quarter, we’d only had a compression on them of 300s of a point. So I think I agree with Ken, I think we’ve hit rock bottom on that compression and should start to see it expand here in the fourth quarter.

Okay. And within that context, it sounds like the pipelines are in pretty good shape and loan growth should pick up in the fourth quarter. I apologize if you guys alluded to this earlier, but just in terms of what are loan growth expectations for the fourth quarter and perhaps even looking out to 2024 as well.

I mean I think we’ll probably continue to see loan growth in the fourth quarter similar to what we saw in the third quarter, maybe a little bit more. And again, to remind folks that we are some of our longer-term fixed rate portfolios, we’re kind of letting some of those really cash flow off and just replacing those balances with SBA franchise construction. So we’re obviously going to be able to pick up yield and optimize the portfolio But fourth quarter probably similar to a bit more than the third quarter and looking into next year, some of the loan growth within individual line items will be pretty strong, but again, those will be offset by declines in others. So it could be mid single digit growth or mid to high single digit growth next year.

The one caveat that could change that, as we were just talking a minute ago, Nate, is if the SBA either stops and we're prohibited from selling, we do have a strong pipeline of loans here in the queue that will get closed here in the fourth quarter. If we put those on the balance sheet and that growth percentage is going to blow up pretty quickly. But as Ken said, we're probably looking at 2% to 3% per quarter of loan growth going forward for the fourth quarter here as well as per quarter through 2024.

And that's not annualized growth per quarter.

Annualized would be at about 9% to 10%, 2% to 3% per quarter annualized around 10%.

Okay, yes, just clarifying there. And is the expectation, obviously you guys did a great job of growing deposits in the third quarter. Is the expectation that based on what you're seeing in terms of new client wins and just where your pricing is across your products, that deposit growth can largely keep pace with loans going forward?

Yes, we think it'll keep pace with loans. We'll actually see a little shrinkage here when some of the CDs roll off. One of the things we didn't talk about in the call, but during the third quarter in particular, we rolled out some really nice features as add-ons to our small business checking accounts. We now have a forward looking cash forecast for them built into the product, as well as automated cash sweeps that they want to keep x balance in a checking account to move the rest to a money market. It'll move both ways. They just set a balance at the end of the day. We're really getting some good traction on that small business checking account. We won an award last year of being one of the best in the country. And with the new features, we got a really nice new automated tool on the front end to help with the opening process. So, yes, that volume is picking up and that's by far the cheapest funds that we have in the institution. So, yes, continued growth there. We're doing real well with the consumer, kind of post COVID small businesses and consumers learn that they really don't need to have that traditional bank and our pricing and products are much better than the normal community banks. So we're seeing nice pickup without a real ton of advertising and expense to go with it and it's really worked well for us.

Got you. If I could just ask a couple last questions on credit quality, particularly curious on the franchise growth. I mean, that's been really impressive over the last year or so, balances up around 100%. Just curious in terms of underlying credit quality there. We've seen some issues within the franchise space thus far in earnings season. So just curious what you guys are seeing there in terms of any criticized migration and just kind of how comfortable you guys are growing that portfolio to a certain level going forward.

Yes, I mean, historically, I mean, to date, we've had 300,000 of charge offs. To date, we've had pretty good credit quality. I think it’ll probably – over time, there probably will be some charge offs there, but so far, I mean, to date, delinquencies have been very low. Continue to stay on top of it and monitor the portfolio, but I think probably like small business, there may be some pop ups here and there, but I don't think there's any – from our perspective, there's no systemic real issues with the franchise to date.

I actually set in on the Credit Committee Meeting this morning, and we had one account that was over 30 days, and we got a check in this morning that took them off the delinquency list. If it clears, we should end the month here with absolutely no delinquency in that portfolio. So, as Ken said, and historically apple pie has been around 10, 12, 13 years. Historically, they haven't had about a 1.6% loss ratio, but so far we're doing well.

Got it. Great to hear. And then just lastly, in terms of the charge-offs this quarter, how much of it was related to the – I think it was a bank alliance loan that we've been talking about the last couple of quarters versus just kind of the small number of SBA loans that were called out in the press release.

You know what, the bank alliance deal was a couple quarters ago. We did have really the charge offs can be boiled down into two components, one piece of it being a handful of smaller SBA loans. And then we did charge off, we were a participant in a deal and the lead bank put the loan, pooled it as part of a larger pool of loan sales, and we worked with them on that, but we had to take a small charge as the sale price was less than the carrying value.

Got it. So the C&I loan charge off in the third quarter was separate.

Yes, but it was not – to be clear, it had nothing to do with the bank alliance deal from earlier this year.

Got you. And based on what you're seeing across portfolio today, imagine, it's fair to maybe expect some moderation charge off levels going forward.

Yes. It's an intriguing time, the bump up in interest rates, particularly on some of the older SBA loans that when we bought that first Colorado portfolio. Again, we discussed two or three in credit this morning that are getting deferments from the SBA world that will hopefully help them through the crunch. But we had people there that were at 3% from the beginning days of their loan that are now paying 11.5 to 12, and it is just putting a squeeze on them. But nothing systemic, no particular vertical in the lending area. That's a problem, and I think we'll continue to see some of these one off things, but stabilization and bumping the rates will help immensely, no question about it. And if at some point in 2024, we start to see them go down, we'll be in great shape. The SBA does have a lot of tools to help some of these smaller guys to go to an interest only basis to actually give them total payment deferment for 60, 90 days, up to six months in some cases. So we're playing by the rules, and as I said, credit committee this morning numbers are still down over what we finished at quarter end, and looking good but who knows what might pop out?

Got it. Makes sense. I appreciate the color. Thank you, guys. I'll step back.

Thank you.

Thanks, Nate.

Thank you. Your next question comes from Mike Perito from KBW. Please go ahead.

Hi, this is Mike's associate Andrew filling in. Thanks for taking my questions.

Sure.

I just wanted to start off here. I was wondering if you could give some more color on the back space. I know you commented on that new partnership you launched. I was just kind of wondering what's the appetite look like for new partnerships and what kind of maybe revenue expectations can we see from some of the new partners you've onboarded in the last few quarters?

Well, I was actually at Money20/20 on Tuesday. I heard that's where Mike's out there kind of running around as well. We had great meetings out there with all of our partners from increase to treasury prime to – we saw actually probably a half a dozen of the fintech companies that we're working with. Most importantly, spent a fair amount of time with [indiscernible] So it's looking good. Everything takes always a little longer than you think it's going to get things up in line.But as Ken said in his comments, we had a nice boost up in deposits, the payment services side. We’re processing over $1 billion a month in payments and still continuing to grow quite significantly month over month. Jaris [ph] I was hoping to have them live here kind of mid-month in October. We’ve got a couple T’s to cross and I’s to dot. We should be live by month in early November at the latest. So everything’s positive. We have a number of folks that we’ve been completing due diligence that are live and into pilot programs and are actually opening real accounts with real customer [indiscernible]. So it’s first quarter next year. It should be really, really strong and hopefully we’ll get a couple over the finish line and turn up some volume here in December. Obviously, the credit card world shuts down. I think this year the blackout date is November 10. So we’re pressing real hard to get a couple through final due diligence in order to get their credit card systems moved and repointed our direction before November 10. So if that doesn’t happen, then it goes into mid-January before they reopen. But not a tremendous amount of impact here in the fourth quarter. But we could – I think first quarter next year, we’ll make as much as we did in the whole calendar year here of 2023.

Great. That sounds amazing. I appreciate the update. Maybe just jumping around a bit here. Could you provide a little color maybe around the ROA? Kind of what’s a reasonable target there for 2024 or kind of what the expectation is as some of these initiatives kind of pull through?

Yes. I mean, I think as we look into – I mean, I think we feel good about what next quarter looks like. And I think over the quarter of little over the course of next year in terms of like, NII, we should continue to see gradual improvement quarter by quarter. In terms of NIM improvement and NII improvement, we expect the SBA team to continue to grow next year as well. David talked about the BaaS initiatives and the revenue opportunities there. So I mean, I think, look, it’ll be a little bit lighter in the front end of the year, probably similar to fourth quarter, probably a little bit better than fourth quarter, maybe in the mid 40 basis point of ROA. But I think by the end of the year, by fourth quarter, we’re looking to be back up north of 80 and perhaps closer to 90 basis points.

Great. Appreciate that. And then just last question for me and then I’ll hop back. Any room for buybacks to accelerate here? I know there’s some good activity there in the third quarter. But maybe just is there any acceleration here in fourth quarter and then into 2024?

One of the things that we’re focused on, and we know the outside world pays a lot of attention to it the TCE. We fell under seven. Our goal is to get us back above seven at the current time at the price. We really can’t be out of the market on share repurchase, but we’re diligently paying attention to that 7%. If by chance the Fed does nothing and the long-term rates come back and AOCI drops down yes, we’ll stay in actively purchasing. I think we’ll do something. I doubt that we’re going to expand much over what we did last quarter, particularly, hopefully the share price continues to climb as well as our numbers are getting better. So – but when we’re trading 30%, 40%, 50% a book, we can’t afford not to purchase shares back. But it’ll be a balancing act, really, kind of keeping an eye on TCE as well as the price of the shares. So we’re in the market, we’ll stay in the market. But it won’t be probably as aggressive as we were in the first half of the year, but we’ll stay out there.

Great. Thank you. That’s all for me. I appreciate all the color.

Great. Thank you.

Thank you.

Thank you. Your next question comes from George Sutton from Craig-Hallum. Please go ahead.

Thank you. David, you mentioned in your script that you’ve grown to be the 9th largest SBA player. What is your goal? What is the governor to your growth? How much more can you expand in that area?

George, we really don’t have any limitation out here. I think we’re going to finish this year at about 380. My guys will be beating on me here. But we haven’t forecasted for 440, 450. I think they got a real shot at 500 next year. And you’re going to be hearing phones drop all over the office here, the folks that are listening in on the call. But I wouldn’t be surprised to see us get pretty close to 500 million next year. As long as we’re selling 75% the insured portion and getting a good return on that. We’re in great shape. I would say we could run up to probably 1 billion on our internal portfolio and $0.25 on the dollar. That gives us a lot of room for new production. So if we start bucking them and holding them on the balance sheet, that could slow down the gross number a little bit. But as Ken said a couple of minutes ago, we’re getting an 11.5%, 12% yield versus a 5% or something on the purchase side. It makes sense to hang on the balance sheet, but anything less than 1 billion, we have no qualms whatsoever in keeping it going.

And I wanted to make sure that I understood the 11% opportunity in terms of because you were couching it in the sense that the government could shut down and I think therefore would hold more. Was I hearing that correctly or what would motivate you to increase the amount that you’re holding?

If the government closes, we’ll hold the assets because we can’t sell them in the secondary market if the government’s not there to make the transfer. So we’ll hang on to them. That could reopen if they’re down for a couple of days, it’ll reopen in a week to 10 days to get the machine oiled and back running, they’re down for 24 hours, they’re going to come right back. So might put a little lag in there. The return, as Ken said, and I’m going to blow this up. So you can go back and fact check me, but we grew the sales by 20%, but the actual sales yield we got was down 30% over last quarter. If that continues to decline, if the market is saturated, a lot of banks across the country are not buying assets or boosting their balance sheets. So if the market falls off and I can only get a 5% or 6% purchase price, why would I sell an 11.5%, 12% asset? Because I’ll make that back up in 12 months. So it’s really two focuses. Government shutdown could slow it down as well as if the yields in the secondary market continues to soften. We’ll just keep them on the balance sheet.

Perfect. That’s it for me.

Thank you, Sutton. Nice to hear from you.

Thank you. Your next question comes from John Rodis from Janney. Please go ahead.

That was close. Hey, good afternoon, guys.

Hey, John.

Hi, John. How are you?

Good. Good, David, Ken. Ken, maybe just back – circling back to the margin. I think last quarter you talked about by the fourth quarter of next year, the margin could sort of be 190 to 195. Do you still think that’s possible?

Yes. I think there’s a pathway there. I mean, certainly into the 180-ish range and the upper bound of that, but yes, I think we still feel good about that outlook.

Okay. Okay. And again, you feel like this current – the third quarter was sort of the inflection for the margin and net interest income dollars.

That’s how we feel right now. Again, the caveat of things that are out of our control. But right now, at least with our forecasts [indiscernible] and what we saw, I think, as David said in his comments, we were – we probably hit bottom in July and August in terms on a monthly basis. And in September we had a nice rebound there. So the trajectory is already going up.

Interest expense actually dropped September over August by over $400,000, and portion some higher cost funds walked out, and we shrunk cash just a little bit, but we really are leveling off, and when our peers are out here at 30 basis points, 40 basis points on CDs, having to buy in today's market for 400 plus, as Ken said, our CD average out here now, what's coming up for renewal is in a 440, 450 range, and if we pick them up at 490 at 30 basis point move to us, it's going to be nonexistent. So we really, really do think we hit the bottom of the barrel on them compression.

Okay. Good. Ken, maybe just two other things on expenses, you upped the target $20 million to $21 million, would you still expect for next year sort of mid-single digit growth off of, I guess the fourth quarter level?

Yes, probably. Yes, that sounds, that's about right.

And then also on the fee income side, I think last quarter you talked about growth of 15% to 20% next year, is that still sort of a good ballpark figure?

If they hit my $500 million number I just threw out, it's going to be better than that.

I'd rather see you under promise and over deliver, David.

Then book in the 440 that they're telling me and you'll be okay.

Yeah.

I think you're okay with that assumption, John.

Okay. Okay. Okay, guys. Thank you.

Thank you.

Appreciate it. John, sorry I missed your show, buddy. I had a conflict. I couldn't get out of, but I'm sure Ken and Nicole did a great job.

No problem at all.

All right. Thank you.

Thank you. Your next question comes from Brett Rabatin from Hovde Group. Please go ahead.

Hey, guys. Good afternoon. Thanks for the questions.

Hey Brett.

Hey. I wanted to go back to the loan yields and you talked about 20 basis points to 25 basis points of improvement in the fourth quarter. They were up 9 basis points in 3Q. What's the – can you talk about the loans that matured 3Q versus 4Q and then maybe if you have a maturity schedule for 24 out of the fixed bucket?

Yes. I think the loan yield; some of it is just timing of funding. The opportunity for us on the loan book is, again, we continue to let some of the lower stuff come off. And we have – we had good quarter-over-quarter growth in construction, but the timing of that was probably a little bit more weighted on the back end of the quarter. So that impacted the yields a little bit in terms of for the quarter. And then we had good production in franchise for the quarter. That sets us up for a good starting point for the fourth quarter. And obviously, the SBA balances were up as well. So I just think with some of the production perhaps being a little bit more weighted in the back end of the third quarter, it sets us up really good for the fourth quarter in terms of loan yield improvement. I guess looking over the course of the next, let's just call it the next 18 months, in terms of our variable rate loans are about 20% of our loan portfolio today. And then when you take into account what's going to mature and also pay down in our fixed loan portfolio, I mean, we're probably looking at almost $1.1 billion or so, about 30% of the loan book that's going to turn over between now and the end of 2024. So for us, a lot of the loans aren't necessarily renewals. They just mature and they're replaced with new loans or new borrowers. But as we remix and optimize the compensation, we're just going to see a lot of good loan repricing and loan replacement, if you will over the next 15 months.

A lot of our municipal portfolio also, Brett, has semiannual payments on it, so we get a big bump in June and we also get a big bump in December. We've got, I think this quarter, $20 million plus in repayment on the municipal loans and that's the 2.5%, 3.5%, 4% paper, so that'll help as well.

Okay, that's helpful. And then you guys talk about some of the CDs that are coming off the books and those rates versus the market CD rates that you're seeing obviously in the 5%, and a 5.6%, where are you guys pricing CDs today and how does that contrast to the CDs that are rolling off the books here in the fourth quarter?

Right now we're priced in that six to 12-month range in the upper fours and what's going to be rolling off is going to be on the commercial side, it's going to be about 5.5%, and on the consumer side it's about 5.12%, 5.14%, so we should pick up 40 basis points, 50 basis points and plus we hope to reduce the outstanding cash. A lot of that's going to roll during December. We have over $157 million, I think, coming up for maturity in the month of December and we'll probably see about half of that go away, so it's late in the quarter but it should still have an impact on our interest expense.

Okay, and then just lastly, the DDA growth this quarter, can you talk about that and if that's the start of a trend or if that was a function of particular clients or business?

Yes. Most of that growth and interest bearing demand is actually BaaS deposits, which we've been continuing to grow, obviously over the last two to three quarters, but most of that growth is BaaS within that category.

Okay. What about the non-interest bearing piece, Ken?

The non-interest bearing, sometimes that can be a little bit volatile. Some of the – there can be some big balances that impact that because a lot of times in our construction business when the sponsor, the borrower puts equity into the deal upfront, they'll put that into a non-interest bearing balance here and then that gets drawn down, but as we do more construction, it'll go up. So that's probably the biggest piece of any quarter-to-quarter movement in that line item.

We also have some municipal sites that, Brett, like the City of Fishers here, come mid-November, they'll have a big pop when they get property taxes in and that'll set in a non-interest account for 30 days, 60 days until they get it reallocated, so there's some seasonality in some of our municipal deposits.

Okay, all really helpful. Thanks so much.

Appreciate it, sir. Thank you. See you next week.

See you next week, that's right.

Thank you. There are no further questions at this time. I'll hand it back to David Becker for closing remarks. Mr. Becker, you may proceed.

Thank you, Sergio, and thanks everybody for joining us on today's call. As we look forward to 2024 and beyond, we remain extremely excited about the future and the opportunities here. Strong performance in the commercial and consumer lending teams, including our growth in the small business construction lending and further growth opportunities with the fintech partnerships and banking as a service are expected to drive greater revenue growth, which combined with stabilized deposit costs. We believe will translate into the stronger earnings and the increased NIM over the course of the next year. As fellow shareholders, we remain committed to driving improved profitability and enhanced shareholder value, and we certainly thank you for your time today and have a good afternoon. We appreciate it. Thanks.

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines. Thank you.