Mercantile Bank Corporation (MBWM) Q2 2011 Earnings Report, Transcript and Summary

Good morning, and welcome to Mercantile Bank Corporation's Second Quarter 2011 Earnings Conference Call. [Operator Instructions] Today's conference is being recorded at the request of Mercantile Bank Corporation. If anyone has objections, you may disconnect at this time. I would now like to turn the conference call over to Ms. Karen Keller. Ms. Keller, you may proceed.

Thank you, Jamie. Good morning everyone, and thank you for joining Mercantile Bank Corporation's conference call and webcast to discuss the company's financial results for the second quarter ended June 30, 2011. I'm Karen Keller with Lambert, Edwards, Mercantile's Investor Relations firm. And joining me are members of their management team, including Michael Price, Chairman, President and CEO; Robert Kaminski, Executive Vice President and Chief Operating Officer; and Chuck Christmas, Senior Vice President and Chief Financial Officer. We will begin the call with management's prepared remarks and then open the call up to questions. However, before we begin today's call, it is my responsibility to inform you that this call may involve certain forward-looking statements such as projections of revenue, earnings and capital structure, as well as statements on the plans and objectives of the company's business. The company's actual results could differ materially from any forward-looking statements made today due to the important factors described in the company's latest Securities and Exchange Commission filings. The company assumes no obligation to update any forward-looking statements made during the call. If anyone does not already have a copy of the press release issued by Mercantile today, you can access it at the company's website at www.mercbank.com. At this time, I would like to turn the call over to Mercantile's CEO, Mr. Michael Price. Mike?

Thank you, Karen, and good morning, everyone. And thank you for your interest in our company. I'm extremely happy to report that the earnings momentum generated in the first quarter of this year has really taken a hold and expanded during the second quarter. our Chief Financial Officer, Chuck Christmas, and Bob Kaminski, our Chief Operating Officer, will detail the quarter where we saw significant increase in profitability, substantial decreases in our nonperforming assets and good performance in our margin and overhead measurements. While the nation's economic recovery remains unsteady and uneven and the clean-up work in our nonperforming assets is not yet over, we are very gratified that the hard work of our bankers employed during the past 3 years are starting to really to pay off. We feel confident to say that the worst effects of the Great Recession are behind us. And while we remain vigilant regarding our asset quality, we look forward to growing the franchise again. At this time, I'll turn it over to Chuck.

Thanks, Mike. Good morning, everybody. This morning, we announced that we recorded net income of $2.4 million during the second quarter of 2011 compared to a net loss of $0.7 million during the second quarter of last year. This $3.1 million improvement expands to $3.9 million if we exclude a federal income tax benefit recorded during the second quarter of last year. Net income totaled $3.5 million during the first 6 months of 2011 compared to a net loss of $3.6 million during the first 6 months of 2010. This $7.1 million improvement expands to $9.1 million if we exclude a federal income tax benefit recorded during the first 6 months of last year and onetime investment and loan sales gains recorded during the first quarter of 2010. The improved operating results reflect improvements in many key areas of our financial condition and operating performance but especially reflect a significant lower provision expense and a historically high net interest margin. We are, of course, pleased to be able to report a net profit for the second quarter of this year, our second consecutive profitable quarter after 2 years of quarterly losses reflecting improved economic conditions combined with the positive impact of numerous strategies developed and implemented over the past several years. Declining nonperforming asset levels, a clean loan portfolio along with home credit underwriting and administration practices, a vastly improved net interest margin, lower controllable overhead costs and improved liquidity position through substantial local deposit growth and dramatically reduced reliance on wholesale funding and strong and improving regulatory capital ratios provide us with cautious optimism as we look to our future earnings performance and overall financial condition. Yes, much work lies ahead and many headwinds continue to face Mercantile, the banking industry and the economy at all levels. However, we believe we are well positioned to succeed as a strong community bank and continue to play a pivotal role within the markets we serve. During the second quarter of 2011, we saw the continuation of very positive trends we reported during the past couple of years, and I'd like to touch on some of them. An improved net interest margin has provided substantial support to net interest income that has been negatively impacted by the decline in earning assets. Net interest income during the second quarter of this year was $13.2 million or 9% lower than the second quarter of last year. Average total earning assets declined by about $287 million between the second quarter of this year and the second quarter of last year. However, our net interest margin increased from 3.31% to 3.61% or about 9% during the same time period. The improvement is primarily due to a decline in our cost of funds but also reflects a relatively stable yield on assets resulting from as many strategic initiatives we have successfully implemented within the commercial loan function. Provisions to our reserve totaled $1.7 million during the second quarter of this year, a substantial decline from the $6.2 million we expensed during the second quarter of last year and well below the average quarterly provision amount during the past 3 years. For the first 6 months of this year, provisions to the reserve totaled $3.9 million, significantly lower than the $14.6 million expensed during the first 6 months of last year. Our loan loss reserve was $38.7 million as of June 30 or 3.45% of total loans. Despite the improved condition of our loan portfolio, the reserve coverage ratio remains relatively unchanged and is even up slightly from the 3.38% level a year ago. Local deposits and sweep accounts were up $52 million during the past 12 months and are up $277 million since the end of 2008. Combined with the reduction in our loan portfolio, we have been able to reduce our level of wholesale funds by about $890 million since the end of 2008. As a percent of total funds, wholesale funds have declined from 71% at the end of 2008 to 38% at the end of the second quarter. Overhead cost reduction strategies have been realized. Salaries and benefits, occupancy and furniture and equipment costs declined $0.3 million or about 5% during the second quarter of this year compared with the second quarter of last year. Nonperforming asset administration and resolution costs remain elevated. However, the costs reduced significantly during the second quarter. Nonperforming asset cost totaled $2 million during the second quarter of this year, well below the $2.5 million expensed during the second quarter of last year and the $2.8 million quarterly average over the previous 5 quarters. As with provision expense, we would expect a reduction in nonperforming asset administration and resolution costs in future periods as the level of nonperforming assets continues to decline. We remain a well-capitalized banking organization. As of the end of the second quarter, our bank's total risk-based capital ratio was 14%. And in dollars, is almost $51 million higher than the 10% minimum required to be categorized as well capitalized. At June 30, our bank's total risk-based capital ratio was $11.9 million and the surplus was $29 million, and that was a year ago. Those are my prepared remarks, I'll now turn over the call to Bob.

Thank you, Chuck. My catalyst this morning will focus on some of the details of the company's asset quality, as well as some product and customer acquisition initiatives. The second quarter 2011 saw a continued improvement in asset quality, metrics of Mercantile's loan portfolio, most notably the 18.6% drop in nonperforming assets for March 31 to June 30. This March 31, 2010, when NPAs were at a high, nonperforming assets had dropped 47% or $55.7 million. NPAs totaled $61.9 million at June 30, and that is broken down by the following loan types: $25.5 million in commercial real estate non-owner occupied; $10.8 million in commercial real estate owner occupied; $9 million in residential other owner occupied rental; $8.5 million in residential land development; $3.8 million in commercial non-real estate; $2.2 million in commercial land development; and $2.1 million in residential construction. Reconciliation of nonperforming assets for the second quarter is as follows: $12.1 million in principal payments; $2.5 million in sales proceeds; $5.4 million in loan charge-offs; and $700,000 in the valuation write-downs and other real estate. These reductions more than offset $6.5 million in NPA additions during the quarter. And that result was a $14.2 million reduction in nonperforming assets since June -- since March 31. Net charge-offs during the second quarter totaled $5.1 million, with $2.5 million of this total coming from residential real estate land development. Another $1.8 million came from residential real estate owner occupied and rental, and the rest of the charge-offs were distributed from among the other loan-type categories. 53% of the quarterly loan charge-offs were specifically allocated reserves prior to the second quarter. This quarter was another very productive one in terms of loan recoveries. Recoveries totaled $1.6 million for this quarter and $2.2 million for year to date. This is illustrative of Mercantile's practice of recognizing losses in a conservative manner and then continuing a very diligent collection process, which oftentimes results in some sizable loan recoveries. The provision expense for the second quarter was $1.7 million. While this provision is significant, it nonetheless represents a large reduction from the quarterly provision expenses being made in the recent quarters as it is determined by the bank's triple -- ALLL methodology. As was the case in the first quarter, the second quarter provision amount is reflective of the continuous stabilization and improvement of the asset quality metrics of Mercantile Bank. Past due loans, 30 to 89 days, were once again extremely low during the second quarter at about $200,000. In the area of new business development, the Mercantile staff remains fully engaged with new customer acquisition activities for loans and local deposits, as well as new business opportunities with existing customers. The loan focus is on C&I relationships plus owner occupied or non-owner occupied commercial real estate exhibiting appropriate and acceptable risk profiles. The new loan pipeline is as active with quality opportunities, as is has been since the onset of the recession. Commercial lines of credit held steady in the second quarter, reflecting an increased usage by customers of current asset financing availability compared to the reductions that we have seen in these, total during the recession. While the Mercantile loan portfolio did shrink in the second quarter, that contraction was primarily reflective of continued pruning of commercial real estate transactions that did not meet the profile or the characteristics that we desired for the portfolio. Mercantile continues active in the area of new product development towards commercial and consumer customer basis. In the second quarter, Mercantile introduced MercMobile Deposit, which is a mobile remote deposit capture product that consumers can use to make deposits from their smartphones. Additionally, during the quarter, Mercantile established a partnership with Bill.com that will allow us the opportunity to offer our commercial customers a cash flow management tool that will provide automated online customer-invoicing and vendor-paying programs. This solution can be fully integrated with the business's existing accounting systems. This accounts receivable and payable solution complements the suite of cash management products that Mercantile offers its commercial customers. These product introductions are continuing illustration of Mercantile's commitment to progressive and value-added relationship banking. That concludes my prepared remarks. I'll now turn it back over to Mike.

Thank you, Bob, and thank you, Chuck. And at this point, we'd like to open it up for any questions.

[Operator Instructions] And our first question comes from Terry McEvoy from Oppenheimer. Terence McEvoy - Oppenheimer & Co. Inc.: As we look at kind of a newer Mercantile model or balance sheet, less commercial real estate, more C&I, and a different funding source in terms of local deposits, maybe, Chuck, could you just talk about how does that impact, call it, a more normal net interest margin versus the balance sheet a few years ago? And it sounds like the expenses in the infrastructure has been adjusted potentially to take into consideration this newer model. Am I correct in that conclusion?

Yes, Terry. This is Chuck. Mike will probably have a comment on the last part of that. But I think with regards to the net interest margin, I mean, obviously, we are in a really, really crazy interest rate environment right now. So it's hard to kind of look out over the next 2 to 4 years, whatever it's going to take to get into more of a normalized interest rate environment and see how that impacts our margin. But it would make sense from what you're saying that if we have less of the higher-costing products of CDs and have more of the non-maturity deposits like interest-bearing checking accounts, the money market accounts, the savings and deposits, that would help our cost of funds. And we certainly believe as we go ahead and reshape the landscape of our commercial -- especially our commercial loan portfolio, we would think that, that would provide assistance to our assets' yield as well. So I certainly don't have the ability to say what our new margins are going to be as we go forward because of the flux of what the interest rate environment and the economic environment currently is and exactly where Mercantile ends up in regards to its balance sheet structure. But I think in relation to historical margins, we think that we would show an improvement somewhat similar to what we're doing currently.

Yes, Terry, this is Mike. I think we're very hard in that as we transition to this new look of Mercantile, if you will, we have transitioned to some of the highest margins we've ever had.

And from a cost structure standpoint, obviously, we have reduced our footprint with the closing of the 2 offices a couple of years ago and gone ahead and certainly looked at our staffing levels and all the different functions. And as we go and try to look at what Mercantile is going to look like going forward in some of the products and services that we have been offering and we think we'll be offering here in the future, we think the footprint, both from a physical facilities and the staff, it appears very sufficient currently. Terence McEvoy - Oppenheimer & Co. Inc.: And then just one other question. The decline in the FDIC insurance premium, is that a function of the de-risking in the balance sheet and the improvement in credit that Bob spent some time talking about? And is that sustainable in terms of the dollar amount that came through the income statement this last quarter?

The reduction that we saw that we reported is totally due to, or almost exclusively due to the change in the calculation by the FDIC in lowering the assessment rate. And it's more of an industry-wide reduction than anything Mercantile-specific.

Our next question comes from Stephen Geyen from Stifel Nicolaus. Stephen Geyen - Stifel, Nicolaus & Co., Inc.: Yes. Just a handful of questions. Looking at that first table, loan secured by real estate, just curious, Bob, if you can kind of give us some thoughts on the commercial buildings declining from $484 million to $429. Is there -- where there some sizable payoffs? Or maybe some thoughts on what you're seeing there this past quarter.

Yes, we did have some sizable payoffs and some loans that, as I mentioned in my commentary, didn't really fit the profile of loans that we're looking for, for the CRE portfolio. Either they were out of market; they were quite a stacked or were exhibiting risks that we weren't in the appetite for or a combination thereof. And so during the course of the quarter, you had a couple of sizable payoffs there that certainly accelerated the shrink in that part of the portfolio. But again, as we're looking to change the dynamics of our loan portfolio overall, those are the kinds of loans that we're looking to either price in a way that we can get paid for the, either the risk or the out-of-area situation or to have them with the bank altogether. And it's going to be a work in progress as we look to manage those shifts and the overall combination of the loan types in the portfolio. Stephen Geyen - Stifel, Nicolaus & Co., Inc.: And you guys have done a nice job reducing vacant land construction, both in the residential and the commercial side. I think it's around $75 million, $77 million now. Do you think that is kind of a good run rate near term? Or do you think there is potential that it could drop a little bit more?

It's a pretty good run rate. I think as you might imagine with the loans in that bucket, those are some of the, in many cases, some of the most distressed loans in the portfolio. And so we continue to work with the borrowers in many instances to look for global solutions to getting those assets out of the portfolio and off the bank's balance sheet. And in this quarter, we happen to have some pretty good successes there in making that happen, but, as I said, it's kind of a work in progress. And while we're seeing continued reductions there, sometimes they'll come in a larger chunk as we reach some solutions with some larger pieces of blend in all the loans. Stephen Geyen - Stifel, Nicolaus & Co., Inc.: Okay. And do you have a percent of lineage usage? Has it changed significantly in the last couple of quarters.

No, it's a great question, Steve. I don't have the specific percentage. But from an overall standpoint, what we've seen pretty much since the beginning of 2011 is a very steadiness or stabilization, if you will, of the line usages. Where we've been seeing significant declines over the last 3 years, the total amount outstanding has been pretty much unchanged for most of this year. Stephen Geyen - Stifel, Nicolaus & Co., Inc.: Okay. And last question. Cost of funds, do you kind of think that might be -- I guess, is there a potential for that to come down a little bit more? Or is that...

Yes, I think there is. We still have some higher-costing CDs, both locally, as well as brokered, and some FHLB advances, although they have maturities in the next year, are certainly at rates that are higher than the current market rates. And it certainly seems that any increases in interest rates will be further and further out now. So I think we'll see some declines, certainly not what we saw over the -- 2 or 3 years ago or even a little bit last year. But I think there is still some room for continued improvement with the cost of funds.

Our next question comes from John Barber from KBW. John Barber - Keefe, Bruyette, & Woods, Inc.: Could you just talk a little bit more about the general operating environment you're seeing in Michigan in terms of unemployment rates, vacancy rates? Any type staff with that?

John, this is Mike. I'll take a stab at that and then let Bob or Chuck enhance my comments. I think we're seeing a generally, in the state of Michigan a fairly decent recovery. We had a deep hole to dig out of. Unemployment is coming down but we started up at a higher level than most states. Fortunately, the Big Three have kind of come around a little bit and that has helped, especially on the east side of the state, get them going again a little bit. But, there's still challenges out there. It's uneven, like in most of the country. You get 3 or 4 snippets of good news out there and then you take 1 or 2 steps back. But generally, we continue to see some decent pickup in activity. Unemployment is better but still stubbornly high. Confidence is slowly coming back into the market. We are seeing customers now and prospects now actually looking to add equipment, buy some more inventories, which is something we haven't seen for a good 2.5, 3 years. So those are all positive signs but in no way would we say, boy, this is a V-shaped recovery.

Yes. I think for the standpoint of the real estate area, the supply-demand continues to be out of whack there and you see a lot more of supply than the demand that's there right now, especially in non-owner occupied real estate. And so residential real estate remains quite challenged as well. Although activity has picked up from where it was, there's still a supply-demand issue. And if you can, just log through that backlog of supply, you'll continue to see some low values there. But there definitely seems to be a floor that has been established. Then, I guess, should we call it stabilization. That's what we'll call it. But still it's one of biggest challenges remaining in that section of the economy. John Barber - Keefe, Bruyette, & Woods, Inc.: And the last one, another the part of the company strategic initiative involves reducing your exposure to commercial real estate. Could you just maybe ballpark how far along you are in that process? I know you said maybe it's the 6th inning. I'm not exactly sure where.

I don't know if I want to categorize it in terms of baseball game days. But in terms of the portfolio, obviously, we've got our priority list of ones that we want to shift from the portfolio. The NPA list is a big contributor to the reductions in some of the commercial real estate, as those have been some of the most challenged loans that we've dealt with. But as I mentioned, as smaller opportunities come along and some loans mature that aren't necessarily not performing but they're ones that we'd just as soon find a new home, there are opportunities there. In other cases, loans that we can live with the risk profile, and that is one that presents acceptable action for us so we can price those in a range that gives us an improved margin and lets us get paid for the fact that it's really the ideal kind of loan that we're looking for in this new environment.

[Operator Instructions] Our next question comes from Daniel Cardenas from Raymond James. Daniel Cardenas - Raymond James & Associates, Inc.: A quick question. On the improvements in nonperformers, was that pretty gradual -- or granular? Was that related to maybe just 1 or 2 larger credits?

It was pretty much across the board. We did have a couple of nice size ones, nice size credits in there but we did move a lot of credits in total as well, big and small. We're just -- that's probably a big part of the story and I appreciate you picking up on that. If you look at the reduction of NPAs in the last couple of quarters especially, we are very, very gratified by the velocity, the volumes, the results that our team's been able to generate. So while we'd like to say, boy, we can extrapolate that right out in 3 or 4 more quarters, we'll be all down to 0, we know that's not quite true. However, that being said, we'll take a 19% reduction quarter-over-quarter any day of the week. Daniel Cardenas - Raymond James & Associates, Inc.: And then on your comments regarding C&I lending. Can you comment in terms of what competition is looking like right now and where is it coming from primarily? The larger players or smaller players or both?

Yes, this is Mike again, and Bob may have some enhancements to the comments. But that's the real job that we're working very hard on right now and that is to find good C&I opportunities and to sell what Mercantile is all about, which is a very consultative approach and a very relationship-oriented approach. And we're seeing more opportunities out there than we have in a long, long time. Now, that being said, I think every bank is looking for good C&I business, so the competition is certainly very strong. We have specially have seen some of the big players come in with some aggressive rates. Rates that, really in our opinion, made very little sense. Rates that we've just determined that we're not going back to those days. We've worked awful hard to get our margin to where it is and where it should be and we're just going to let those opportunities slide by. But that being said, we know as a sales team that, that means we've got to do an excellent job of allowing those prospects and existing customers to understand the real Mercantile value proposition. Now we've been very happy that they've seen it generally over the last 2 or 3 years. Most of our very, very good customers have stuck with us through some very difficult times. We are seeing that even in new prospects, we're getting in new business, especially over the last couple of months, of prospects who understand that we may not always be the lowest rate in town nor do we want to be nor do we position ourselves that way anymore, but we bring a lot more value with the experienced team that we have, the products and services that we're able to offer and the stable relationships that we've become known for over the years of running this bank.

Yes. I think as we've seen in the past from some of the larger banks, they tend to change their focus quite frequently. And I think a lot of the businesses, the customers in the community, they do recognize that, because as I've seen, the quick about-face by some of the larger players within the last few years. So as Mike said, the value-added proposition, the relationship banking is really what we're focused on. And our team's executing the plan, and I think that, that is still very valuable valued commodity in the west Michigan marketplace. Daniel Cardenas - Raymond James & Associates, Inc.: Okay. Good. And then just one last question. Can you comment on TARP in terms of your thoughts and getting caught up in the dividend and then potentially repaying it?

Sure. This is Mike again, Dan. I mean that certainly TARP is on the top of the list of things that we talk about with our Board and the executive management team. We have a plan with TARP and we look to execute that plan here as soon as it's prudent to do so. But there's a lot of inputs to that plan and there's a lot of, I guess, things that we need to talk about among ourselves. And we expect to roll out a plan on TARP as soon as we can. But we really can't get specific as to time, but we can say our general intention is to pay it back, either all at once or in segments, just as soon as it makes sense to do so.

Thank you. At this time, we have no further questions. I would like to turn the call over to Mr. Price. Mr. Price, you may proceed for closing remarks.

Okay. Thank you very much, Jamie. And again, thank you to all of you for tuning in this morning and for your interest in our company. And we look forward to talking to you again in the third quarter.

You may disconnect your call. That concludes today's conference call. We thank you for attending today's presentation. You may now disconnect your telephone lines.