Mercantile Bank Corporation (MBWM) Q3 2015 Earnings Report, Transcript and Summary

Good morning. And welcome to the Mercantile Bank Corporation Third Quarter 2015 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Bob Burton from Lambert, Edwards. Please go ahead.

Thank you, Laura. 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 third quarter of 2015. I am Bob Burton with Lambert Edwards, Mercantile's Investor Relations firm. And joining me are members of their management team including Michael Price, President and Chief Executive Officer; Robert Kaminski, Executive Vice President and Chief Operating Officer; Chuck Christmas, Senior Vice President and Chief Financial Officer; and Sam Stone, Executive Vice President. 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, www.mercbank.com. At this time, I would like to turn the call over to Mercantile's President and Chief Executive Officer, Mike Price.

Thank you, Bob, and good morning, everyone. Thank you for joining us to discuss our third quarter 2015 results for Mercantile Bank Corporation. On the call today, our CFO Chuck Christmas will provide details on our financial results, followed by COO Bob Kaminski with his comments regarding loan development, growth initiatives and asset quality. EVP Sam Stone is also on the call with us today. Hopefully you've all had the chance to review our earnings release. We reported then income of $0.45 per share with – prepared with $0.35 in the prior year period. The third quarter of 2014 contained a $1.3 million in pretax merger related cost. Reflecting these cost, the year ago adjusted earnings per share was $0.40. With these positive results, the bank has extended it's very strong performance this year. The press release was the number of important financial highlights, but in particular, we're very pleased with continued momentum in new loan generation which Bob Kaminski will detail in a moment. The third quarter results also underline our gains in areas of strategic focus across our business. As I said a moment ago, our loan generation was strong in the quarter as we originated a $145 million to new business, while maintaining our discipline around credit quality and appropriate pricing. Our team is doing a great job, particularly in our largest markets. Although the yield curve still ways our net interest income results across the industry, we generated above the average performance in net interest margin which was ahead of our guidance for the quarter and the year. Improving the earning asset mix with a primary driver of profitability improvement and underscores a key benefit of combing the deposit base of legacy Firstbank with the larger market exposure of Mercantile. We continue to shift our mix of interest earning assets out of lower yielding securities and enter higher yielding loans, resulting in a relatively stable yield on total earning assets, despite the slow interest rate environment. This rebalancing is a competitive advantage that can enhance the spreads that which we do business in the near future. Fee income and area of opportunity for Mercantile accelerated during the quarter and produced strong growth of 47.5% in non-interest income in the current quarter compared to the third quarter of 2014, reflecting higher levels of both mortgage banking and credit and debit card activities. Overall we are very pleased with these results and expect to realize additional performance opportunities as we close the year. As evidence of our strong capital positive and demonstrating our commitment to shareholder return, we earlier today announced a quarterly cash dividend of $0.15 per share for the fourth quarter, providing an annual yield of about 2.8% based on its current share price. Looking forward to the remainder of 2015 and beyond, we see further opportunity participate in the developing economic strength of our markets as Michigan's premier community bank. Our business activity levels reflect a healthy economic trends that are being reported for western and central Michigan. Suggesting growth will continue through the coming months. At this time, I'd like to turn our call over to Chuck.

Thanks, Mike, and good morning everybody. As Mike noted, this morning we announced net income of $7.3 million for the third quarter of 2015, a net income of $20.5 million for the first nine months of the year. On a dilutive earnings per share basis, we earned $0.45 per share during the third quarter and $1.23 per share during the first nine months. Given that the merger we're the Firstbank with effective on June 1 of last year, comparisons between the third quarter and especially the first nine months of this year with respect to periods in 2014 are difficult to make. However, we are pleased to report that our 2015 results reflect a successful integration of the two making organizations and the leveraging of the strengths that each organization provided to the new company. We are very pleased with our financial condition and earnings performance for the third quarter and first nine months of 2015. We believe we are very well-positioned to take advantage of lending and market opportunities to enhance our strong position as Michigan's community bank, while delivering consistent results for our shareholders. Our net interest margin was 3.87% during the third quarter continuing a relatively stable trend over the past five quarters, during which the margin range from 3.79% to 3.95%. the stability of our net interest margin primarily reflects our ongoing strategy to fund a large portion of our net loan growth with the earnings from the lower yielding securities portfolio. Average loans represented about 83% of average earning assets during the third quarter of 2015, compared to 79% during the third quarter of 2014. In large part reflecting the ongoing very low interest rate environment and competitive pressures, our yield on total loans has generally been on the declining trend. However, our yield on total earnings assets has remained and it take range. The collection of some larger prepayment penalties during the third quarter added approximately 3 basis points to our yield on assets and net interest margin. We recorded loan discount accretion totaling $1.4 million during the third quarter of 2015, relatively similar to the prior three quarters, and about $0.2 million higher than the third quarter of last year. Based on our most recent evaluations, we currently expect to record further loan discount accretion totaling about $1.1 million to $1.3 million per quarter during the fourth quarter of 2015 and into the first half of 2016. Actual accretion amounts reported in future periods may differ from our forecast due to a variety of reasons including periodic re-estimations and the payment performance of the acquired loan portfolio. Our cost of funds increased 3 basis points during the third quarter compared to the second quarter, and large part reflecting the completion of purchase accounting fair value adjustments relating to Firstbank's time deposit portfolio as of July 31. We have been reporting a quarterly reduction in interest expense of almost $0.6 million, which decline through low $0.2 million during the third quarter. We expect our net interest margin to be in the range of 3.70% to 3.80% during the fourth quarter of 2015. While the ongoing very low interest rate environment continues competitive pressure – compression pressure on our net interest margin. We expect to continue to use lower yield being accessed overnight investments and cash flows for monthly pay downs on lower-yielding mortgage-backed securities and the periodic maturities and costs on lower-yielding U.S. government agency and municipal bonds to fund a large a portion of our expected loan growth during the remainder of 2015 and in the 2016. The overall quality of our loan portfolio, combined with the recoveries of prior period loan charge-offs and the eliminations of and reductions in many specific reserves, have produced a positive impact on our loan loss reserve calculations and allowed us to make no or negative provisions in the 11 consecutive quarters and in 14 out of last 15 quarters. We recorded a negative provision expense of $0.5 million during the third quarter and $1.5 million during the first nine months of the year. Gross loan charge-offs equals only $0.2 million during the third quarter, and total $5.0 million for the first nine months of the year. Recoveries of prior period loan charge-off equals $0.2 million during the third quarter and totaled $2.6 million for the first nine months. Resulting annualized net loan charge-offs as a percent of average total loans were essentially zero during the third quarter and 0.15% during the first nine months of the year. A vast majority of the gross loan charge-offs thus far in 2015 was associated with one large commercial credit that was resolved during the second quarter. Our loan loss reserve totaled $16.1 million at the end of the third quarter. The reserve for originated loans at $15.8 million equaled 1.04% of total originated loans at quarter end. As of September 30, the allowance for originated loans was comprised of $13.9 million in general reserves relating to non-impaired loans. $0.8 million in specific reserve allocations relating to non-accrual loans, and $1.1 million in specific reserves on other loans primarily accruing loans designated as trouble deck restructures. We recorded non-interest income of $4.3 million during the third quarter of 2015, reflecting a $1.4 million increase compared to the third quarter of last year. The improvement was led by a $0.5 million increase in mortgage banking income and a $0.2 million increase in credit and debit card fee income. We also recorded a $0.2 million refund of Michigan business tax during the third quarter of 2015. With caution at mortgage banking income and recoveries on certain acquired charge-off loans can be difficult to forecast, we expect quarterly non-interest income to be around $3.5 million to $3.7 million during the first quarter. We recorded non-interest expense of $19.7 million during the third quarter of 2015, a decline is $0.7 million from the second quarter with $0.5 million over the high end of our guidance. Accruals for our 2015 bonus program were higher than forecasted, due to our strong earnings performance during the quarter that solidified our comparisons with certain bonus metrics. Loan processing cost came in higher due to robust mortgage banking activity, while problem asset resolution costs were higher, primarily due to legal costs and valuation rate balance on our residential property segment. We are currently projecting quarterly non-interest expenses totaling in the range of $19.5 million to $20.0 million during the first quarter. Our effective tax rate expect to remain in the 31% to 32% range. We remained a well capitalized banking organization. At the end of the quarter, our bank's total risk based capital ratio was 13.7% and at dollars it was approximately $92 million higher than the 10% minimum required to be categorized as well capitalized. As part of a $20 million comes back repurchase program that we announced back in January, we have repurchased approximately 765,000 shares at a total all-in cost of $15.2 million during the first nine months of the year. The weighted average all-in cost per share is $19.89. Funding from the stock repurchase program has generally been provided via cash dividends from our bank, and any further stock purchases would likely be funded in the similar manner. Those are my prepared remarks. I'll now turn the call over to Bob.

Thanks, Chuck and good morning, everyone. New client acquisition was one of the highlights for Mercantile bank in the third quarter, in which $145 million in loans to new and existing customers were about. This follows new loans of a $120 million and a $100 million from the second and first quarter respectively. The composition of loan growth consisted of a good mix among C&I, owner occupied commercial real estate and non-owner occupied commercial real estate. We also experience significant funding on commercial construction commitments, as projects advance through the part of the construction season. The concentration of this funding was centered in our larger urban markets. The current banking environment in Michigan is good. Most Michigan banks are presently experiencing loan growth, the ball categories reflecting increases in totals. Mercantile's net loan growth was $46 million for the third quarter, reflecting normal loan run-off, asset sales by customers resulting in early loan pay-offs and some refinancing of debt away from Mercantile by customers who pursued aggressive rates from secondary market sources or local competition. The Mercantile lenders continue to have robust activity in their loan pipelines, reflecting a purposeful sales strategy with a relationship of banking focus as a center piece of their client acquisition activities. Asset quality for Mercantile bank was steady during the third quarter, reflecting a solid performance and is the lowest to increase at a rate which outpaces the rest of the nation. Those are my prepared remarks. I'll now turn it back over to Mike.

Thank you, Bob, and thank you Chuck. Laura, at this time we'd like to open the call up to questions.

Thank you. We will now begin the question-and-answer session. [Operator Instructions] And our first question will come from Matthew Forgotson of Sandler O'Neill.

Hi, good morning, all.

Good morning.

Good morning.

Chuck, the prepayment penalty income this quarter, can you provide that in dollar terms?

Yeah, I think what we've been averaging Matt is about a $150,000 a quarter or $50,000 a month. And prepayment income came in about $165,000 higher than what that run rate has been. So $164,000 in addition to the normal $150,000 show that we average.

Okay. In terms of the reducing from securities into loans, I think I'll ask in this way, how much more capacity do you have both in terms of pure rotation from securities into loans as well as with regards to the loan to deposit ratio?

Yeah I think – I'll answer the first one first, that was pretty easy. We're at about $50 million more to go that we can reduce the investment portfolio and put those moneys into loan portfolio. It's happening pretty quickly this quarter while the breaks coming down like they have over the last few weeks, we've gotten quite a few calls. So some of that $50 million is now sitting in Fed funds and at fed awaiting some loan growth this quarter. But above $50 million from the end of September that we have to go, so we would expect that to – some of that certainly will happen in this quarter but certainly bleed into at least the next couple of quarters of next year. In regards to loan to deposit ratio, that’s not a ratio that we look at very much Matt. We look at other ratios and other relationships in regards to our liability side. We kind of look at more asset separately and the liability separately.

Okay.

And again we want to get that securities – we want to get the securities portfolio down at about 11%, overnight investments is about 2% of earning assets and then the loans through the rest.

Okay. So, it doesn’t sound like you would – just based on how you look at your liquidity profile, it doesn’t sound like you would bock it running a loan to deposit ratio higher than a 100%?

No, but one of the things you got to remember is that those repurchase agreements are really a sweet program that you see in our balance sheet. We have been averaging $150 million or so, and that really is checking account money tied into sweet accounts from our some of our larger commercial customers. So when you're doing that – so when you're doing that loan to deposit ratio, I would suggest that you adjust that and throw those repurchase agreements into the deposit mix and you'll see that the number will follow through the 100%.

Okay. And then lastly, then I'll hop out. In terms of your share repurchase capacity loan through 76% of the current authorization, can you give it a sense your appetite for potentially reloading with the fresh authorization?

Yes, this is Sam. We'll be having that under consideration during the fourth quarter and as Chuck reviewed, the capital ratios it appears that there certainly is capacity to do some more, but we'll get more specific about that later in the fourth quarter.

Thank you very much.

Thanks, Matt.

And the next question comes from Damon DelMonte of KBW.

Hey, good morning guys. How are you doing?

Good morning, Damon. Fine, thanks.

Great. My first question is relating to the margin. Chuck, I think you had said that there was a three basis points of benefit from the prepayment penalty income. Is that correct?

Yeah, the three basis points of the 165 that I mentioned earlier that was higher than the average that we typically get.

Okay. So if you take that up to $3.87 that puts you at about $3.84 for the quarter which is actually up a basis point from last quarter. When you talk about your fourth quarter outlook, you're talking in the range of $3.70 to $3.80, that kind of seems like if you take the midpoint it seems like a pretty sizable job quarter-over-quarter. Is there something from the accounting perspective that maybe it would be driving a lower margin, especially when you have additional remixing of earning assets that happened?

Yeah, that is a great question and there is a couple of things going on there, yeah. One is, you got to remember that the third quarter we still had some of that benefit from the time-to-time deposit adjustment back from the merger. So that will be fully gone in the fourth quarter, so there is an impact there. And then also our accretion or the loan portfolio from the merger was higher than what we expected and what the runs would indicate during the third quarter, so we're kind of bringing that back down to what our model is showing. But we had in the third quarter is what we typically have each quarter but we certainly don’t build in our model is that we typically have one or two larger loans that were acquired, non-impaired loans that were part of the merger. You get paid off or typically refinance through competition. They're just offering terms that we're not comfortable with. So while we hate to lose the relationship, certainly any discount that’s associated with those credits is immediately brought into income. So we always look at our re-estimation, we're not really adjusting for those more onetime type events, we're looking at more of a normalized amortization and pay-off standpoint. So I think if you reduce that time deposit adjustment and get that loan accretion down to more of a normalized or at least estimation standpoint that will get us into the $3.70.

Okay.

The other things moving around is overnight investments and there are some timing differences between what's going on with the investment portfolio and what's going on with loan growth. And what we've seen so far this year on an average basis is that overnight investments have been – we want to get that down about $40 million, and it's been running pretty consistently in a $55 million to $60 million and obviously only earning 25 basis points as an impact on the margins as well. So I kind of bumped that number back up to a little bit higher than what has been running just to be conservative when I was putting that guidance together.

Okay, that’s helpful. Thank you. And then I just kind of switching over to loan growth and the outlook there, your commentary seem to paying a pretty positive picture for your markets and the parts of Michigan that you guys operate. We saw high single digit loan growth this quarter, do you feel comfortable if that’s a sustainable level as you close out 2015 and head into 2016?

Well, based on what we're seeing let's say is current pipeline activity as well as potentially new opportunities that we're seeing out there who approach with relationship building and up being out there in various communities. Certainly I wouldn’t discourage that notion because it's been pretty robust throughout this entire year and if not for some of the pay-offs we received that'll be even higher. So I think that seems to be a pretty sustainable level from our standpoint at this point in time.

Okay, that’s helpful. And then just kind of technical question on the loans. In the press release for the total retail loans, there it seems like to be a significant drop from last quarter to this quarter which being wonderful family mortgages, but then there seems to be a significant increase in home equity and other quarter-over-quarter. Do those only get swift or is there some sort of reclassification between those types of loans?

No, that’s probably a good [indiscernible] putting that chart together. So, they both been relatively steady on a slight decline but they're likely that I just flipped those numbers.

All right, that makes sense. Okay, that’s all that I had. Thanks a lot guys.

Thank you.

Thanks.

And the next question is from John Rodis of FIG Partners.

Good morning, guys.

Hi John.

First question, I guess just back to the buyback. Am I correct you guys got maybe 200,000 shares under the current buyback, is that right?

No, volumes that we have achieved – we're trying not to be the ones pushing the price, and I think we've been successful in that because most days that we're active in the market were in the lower half of the volume weighted average price and some days we don’t go in the market, that seems to be running – we don’t want to get in the way of anybody who might be trying to accumulate a position.

Yeah, makes sense. Chuck, just a question for you on the operating expense guidance. So you went from roughly $19 million last quarter to, I think you said $19.5 million to $20 million this quarter for the fourth quarter I guess. Was that mostly related to bonus accrual and maybe higher salary expense for mortgage or what was driving that increase?

Well, I mean there is a little bit of everything. Certainly the bonus accrual, as we go through the year we can get more confident in what our projections are. We do have nine different metrics out there that we've got to keep an eye on. And so as the year has gone on we've got more and more confidence. So we've been building that especially over the last couple of quarters. And certainly there are – the grand rapids area base mortgage lenders around commission, so there was a little bit additional commission there with that robust activity that we had. So, I think it's more of an increased – obviously when we have an increase in fee income we're going to see some increases in the overhead as well. So there is some variability there that fee income does go down a little bit. It seems like hard press that we're going to be able to match mortgage banking income for the last couple of quarters in the fourth quarter. If from anything else we're getting into a slower fourth quarter season, so then some of the loan processing cost that we have to record obviously will come down a little bit. So there are some variability there that’s built into the income statement.

Okay, maybe just final question for you Bob, just on credit, and obviously credit – your trends are very strong and stuff. But are you seeing any sort of issues that trouble you or just looking out going forward?

I don’t want to jinx anything but with the emergence of new problem loans has been very normal, very low and it continue with our trends of improving asset quality and so we're very pleased with that. We had normal things that popup all the time and our crews are definitely working on them as long as exhibits, some signs of stress of strain but nothing of the ordinary or there will be a reflection of a bigger problem that’s out there in any of the sector so we're encouraged by that.

Okay, makes sense. Thanks guys.

Thank you.

And next we have a question from Kevin Parks of Hildene Capital.

Yeah, actually guys all of my questions are addressed. Thanks.

Thanks, Kevin.

[Operator Instructions] And our next question will come from Daniel Cardenas of Raymond James.

Hey good morning, guys.

Good morning, Dan.

Just a couple of quick questions. Can you guys on your [indiscernible], do you have that number for the quarter?

I had that number earlier and I didn’t bring it with me, I can issue that to you Dan. I know it went down a little bit but I don’t have in front of me.

And then maybe some comments on competitive factors on the lending side. Are you seeing a pick up from any of the larger players in terms of competition or they'd be more aggressive in terms of pricing and/or rate and or structure?

This is Bob. I wouldn’t say it necessarily picked up, it's been pretty intense competition throughout the year and we're seeing it from larger banks as well as the smaller banks and credit unions queue. But I wouldn’t necessarily say it's changed a lot, it's very strong and intense and you see every once in a while some coming in and putting forth a very aggressive rate and those are the ones that we have been shown the discipline to walk away from but I think our relationship with bank will keep stress in getting back to. In the end that holds the day for us because customers at our markets they still appreciate that and they understand what it means to bank with us. Those benefits they'll get with that relationship with the Mercantile bank and those with the customers that at end of the day that were, we want to bank with us, as the ones that appreciate the bank we can add. We're going to get good competitive rate but it won't be some of these crazy rates that are out there that are here today gone tomorrow from some of the competition that we see from many different sources.

Okay, good. And you may have mentioned this and I'm sorry if I missed it, but in terms of your loan pipeline, how does it compared to say a quarter ago?

I'd say it's pretty similar. We've had some significant fundings obviously but there is been new things – new credit relationships that have merger into the pipeline. And so, we look out and we see that they've been able to replenish what's been booked and that’s been very encouraging sign for the coming year.

Okay, good. And what's the dollar amount of your pay-offs, pay downs this quarter?

I don’t have that on the top of my head.

I would – if I had to just add at this point I would say around $50 million would be the kind of a pay-offs if you will. We normally get about $50 million just the normal amortizations. We grew about a $150 million so…

That’s as quick and dirty as we speak.

Yeah, quick and – very quick and dirty with about $50 million in pay-offs.

Okay, and is that above and beyond normal?

That'd be $50 million above and beyond normal monthly amortizations.

All right. And then last question just in terms of the M&A environment. Are you beginning to hear more chatter right now or is it quite, I mean how would you describe the current M&A environment and your footprint?

Dan, it's Mike. Not a lot changed really from the last couple of quarters. Lot of people talking about lot of things but nothing I would say stands out to say where we're at [indiscernible] a lot of activity or where it's dying down. I think it's a matter of finding the right fit for organizations and I know there are a lot of conversations going on and obviously we keep our eyes open as we've always said over the years but we're pretty particular as I've said numerous times it took us 17 years or 16 years to do the first one, so it was a great one. So, we want to make sure that we keep that kind of record out, but I would say we'd continue mainly to be focused on organic loan growth but we keep our antenna up for any good potential M&A transactions.

Yeah, I mean we probably don’t have wait till 2030 to see another one?

It's got to be somebody else besides being announcing it if we wait that long, but I guess the point to that all is that, we're not an organization that feels like we have to do a deal to be successful. We did one because we saw the real benefits of it, we've prosecuted that game plan to a great success and the next one we do we want to be able to look at our investors in the eye and say, we have great path and it's like we did with Firstbank that this is going to be a real win for our shareholders. So that does eliminate a lot of transactions that we look at because sometimes the dilution or the strategic fit or the cultural fit just isn't there.

Yeah, great. All right, good quarter. Thanks guys.

Yeah, thank you.

And next we have a question from Eric [indiscernible], Bank Investor.

Hi, good morning.

Hi, Eric.

Hi. I just had a couple of follow-ups on the – just with net interest margin front. Can you give us an idea of the $145 million of loans you've booked in the quarter, what the yields look like there versus what has been rolling off? And then the second part of my question is, if you look at the business that you're originating and you look to originate over the next couple of quarters, where is the most competition coming from on the price side, is it CRE loans, is it C&I – where do you see most of that stress?

I'll answer the first one and I let the other guys attack your second question, Eric. I think what we see – on a pretty consistent basis and actually pretty close to what we had budgeted, our loan yield declines on a core basis about two basis points a month. So we're looking at about a six basis point per quarter decline in our core yield on our loan portfolio. So the yield curve hasn’t been changing too much but we normally play the zero to five year bucket, and so we can get as we think consistent loan growth through the next four, five quarters like we have been getting in the past four, five quarters it would seem to us that that trend will likely continue that two basis point or so month decline in the yield portfolio.

As far as the second part of your question, the competition is pretty furious in all areas of the loan types that you mentioned. Well I must say that the commercial real estate side that’s probably where we probably see a greater competition. It's one of the reason that we had cultural industrial type of relationships. We have the ability to enhance your income through other source of the revenues with treasury sales, products and things like that that were able to go to supplement the interest rate. And you got less than that with commercial real estate, it's just more based on a pure rate and fee situation on the loans book, so but that being said it's fairly furious in all areas and from all source of the competition.

Okay. And any kind of color on just again the loan yields like what we're seeing new product versus what's been rolling off?

Yeah, I think Eric, it's a difficult one to put in complications above and beyond what I've already indicated with the [indiscernible]. As you expect, it depends on exactly what loan are they, lines credit type, prime or LIBOR, are they five year blue and fixed rate deals on commercial real estate or fully amortizing loans equipment. So it's kind of all over but again I think when you look at our numbers, if you look at the composition of our loan portfolio, if you look at our pretty consistent net loan growth how that impacted our loan yield that’s been pretty consistent as well.

Okay, thanks Chuck. I appreciate that.

You're welcome.

And this concludes our question-and-answer session. I would like to turn the conference back over to Mike Price for any closing remarks.

Well, thank you Laura. And thank you all for your interest in our company and we look forward to talking with you again after yearend. This ends the call.

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