Mercantile Bank Corporation (MBWM) Q4 2016 Earnings Report, Transcript and Summary

Good morning and welcome to the Mercantile Bank Corporation Fourth Quarter and Full Year 2016 Results 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’d now like to turn the conference call over to Robert Burton. Please go ahead.

Thank you, Karrie. 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 fourth quarter and fiscal year 2016. I’m Bob Burton with Lambert Edwards, Mercantile’s Investor Relations Firm. And joining me are members of their Management team, including Michael Price, Chairman; Bob Kaminski, President and Chief Executive Officer; and Chuck Christmas, Executive Vice President and Chief Financial Officer; and Ray Reitsma, President of Mercantile Bank of Michigan. 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 obligations 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, Bob Kaminski. Bob?

Thank you, Bob, and good morning, everyone. Thank you for joining us. On the call today, I will review the quarter and provide an update on loan development, growth initiatives, and asset quality. Then our CFO, Chuck Christmas, will provide details on our financial results followed by Q&A. We're also joined by Mike Price, now Mercantile’s Executive Chairman; and Ray Reitsma, who is President of Mercantile Bank of Michigan. Those of you who have not met Ray, he is a 13-year Mercantile veteran and most recently West Region President and Senior Lender. Under Mike Price’s leadership, Mercantile established a strong track record through the first three quarters of 2016. I'm pleased to report that the trend continued into the fourth quarter and produced record operating income for the year. We finished 2016 with a net interest margin of 3.86% for the year, new commercial term loan originations of $549 million, and 21% growth in diluted earnings per share over fiscal 2015. In particular, let me highlight several accomplishments in areas of strategic focus that underline our optimism. During the quarter, commercial term loans funded to new and current clients totaled 120 million, consistent with the solid performance we have seen all year. As I noted, commercial loan fundings for the year approximated $549 million, and our commitment to fund construction projects totaled $102 million. At the same time in the fourth quarter, this successful loan generation was offset by certain activities that collectively totaled $65 million, and significantly contributed to the net $28 million reduction of the loan portfolio during the quarter. Vectors contributing to this shift include lower customer line usage, payouts on watch list credits, syndication of a large commercial relationship, and some trimming of loans in industries where we are approaching our internal concentration limits. Overall, our pipelines continued to be solid as they have been throughout 2016. Noninterest income let by fee income and residential mortgage activity, was stronger than forecast. Chuck will touch on this further in his comments, but let me note that we continue to gain momentum with production, operational excellence, and the product array in our retail mortgage area. During the fourth quarter, our newly hired mortgage lenders began to contribute in earnest to our overall results, as evidenced by a quarterly volume increase of 54% compared to fourth quarter of 2015. We look forward to growth in this area of business in 2017. The net interest margin stayed steady against our guidance. We remain very pleased with the strength and stability of core net interest margin, reflecting our continued focus on loan pricing discipline. It is worth noting that our net interest income is expected to benefit from any further rate hikes initiated by the Federal Open Market Committee. We continue to experience peer-leading asset quality, which is reflected in the very low level of nonperforming assets, representing only 0.21% of total assets. The Bank continues to be in an extremely strong position here. As evidence of our strong capital position and demonstrating our continued commitment to shareholder return, we earlier today announced a quarterly cash dividend of $0.18 per share for the first quarter, providing an annual yield of about 2.0% based on our current share price. While we did not make any purchases under our active stock buyback plan during the quarter, we have purchased 168,000 shares year-to-date at a weighted all-in cost per share of $22.23. Entering 2017, our financial condition is strong and our operating metrics are healthy. Looking forward, we see healthy additional opportunity to participate in the economic strength of our markets as Michigan's premier community bank. Our outlook is that the overall healthy employment and business expansion being reported for Central and Western Michigan will continue, particularly within our largest markets. The Michigan economy overall continues in a positive direction. Employment in our primary markets has increased 2.5% compared to the year-ago period, and Michigan's unemployment rate approximates the national average. Additionally, the real estate conditions in our market continues to be healthy. That concludes my initial remarks. At this time, I'd like to turn the call over to Chuck.

Thanks Bob and good morning everybody. This morning, we announced net income of $8.1 million for the fourth quarter of 2016 and net income of $31.9 million for all of 2016. On a diluted earnings per share basis, we earned $0.49 per share during the fourth quarter and $1.96 per share for all of 2016. Our earnings performance reflects a 22% increase in diluted earnings per share during the fourth quarter of 2016 when compared to the fourth quarter of 2015, and a 21% increase in diluted earnings per share during all of 2016 when compared to all of 2015. We are very pleased with our financial condition and earnings performance for the fourth quarter and all of 2016, and believe we are very well positioned to take advantage of lending and market opportunities while delivering consistent results for our shareholders. Our net interest margin was 3.72% during the fourth quarter, continuing a relatively stable trend during the past 10 quarters. The stability of our net interest margin primarily reflects the growth of the loan portfolio as a percent of earning assets during this time frame, in large part by funding a majority of our net loan growth with monies from the lower-yielding securities portfolio. Average loans represented 85% of average earning assets during 2016 compared to 82% during 2015. We expect loans to comprise about 86% of total assets in future periods. Primarily reflecting the ongoing low interest rate and competitive environments, our yield on total loans has generally been on a declining trend. However, our yield on total earning assets has remained in a relatively tight range due to the earnings asset reallocation strategy, which when combined with a steady cost of funds, provides for a stable net interest margin. In addition, our net interest income and net interest margin during the first three quarters of 2016, were positively affected by calls on US agency bonds that had been purchased at a discounted price. Accelerated discount accretion totaled $2.2 million during the first nine months of 2016, adding 8 basis points to the net interest margin for all of 2016. We did not record any accelerated discount accretion during the fourth quarter. An elevated level of funds on deposit at the Federal Reserve Bank of Chicago weighed on our net interest margin during the fourth quarter of 2016. Our average balance during the quarter was $125 million compared to $59 million during the first nine months of the year. The elevated level of funds reflect a combination of a reduction in total loans outstanding and growth in local deposits, and resulted in an 8 basis point reduction to our net interest margin during the fourth quarter. Through a combination of expected net loan growth and scheduled wholesale funding maturities, we believe the balance of funds on deposit at the Federal Reserve Bank of Chicago will decline to the desired level of around $50 million during the latter half of the first quarter of 2017. We recorded loan discount accretion totaling $1.7 million during the fourth quarter of 2016, $0.6 million higher than the average during the previous four quarters, and higher than the guidance provided at the end of the third quarter. The elevated level of discount accretion reflects the change in the accounting treatment for our pool of purchased CRE impaired loans as of year-end 2016, whereby we switched to the cost recovery methodology. As of year-end 2016, payments received since the merger lowered the recorded investment to zero. In accordance with cost recovery methodology, the net deferred gain of $1.0 million was immediately recorded as interest income. In future periods, accretion income will no longer be recorded on this pool; but, instead, all payments made by the borrowers will immediately be recorded as interest income. We currently expect to receive a minimum of $6.3 million in principal payments on CRE pooled loans in future periods, which will be recorded as interest income upon receipt. Based on our most recent valuations and cash flow forecast on purchased loans, we expect to record further quarterly interest income totaling about $0.5 million during 2017. Please note that this forecast ignores scheduled balloon maturity dates on the purchased loans that formerly comprised the CRE impaired loan pool. Instead, we assume those loans will be renewed at similar terms to current terms on the balloon date. As a result, interest income related to the former CRE pool loans recorded in future periods may differ from this forecast. We expect our net interest margin to be in a range of 3.65% to 3.70% through-out 2017. This forecast assumes no changes in the prime and LIBOR rates. Our interest rate risk measurements continue to reflect an improved net interest margin in an increasing interest rate environment. The overall quality of our loan portfolio remains strong. Non-performing assets as a percent of total assets equaled only 21 basis points as of year-end 2016, compared to only 23 basis points at year-end 2015. Net loan charge offs equaled only $0.2 million during the fourth quarter, and only $0.6 million for all of 2016. As a percent of average loans, net loan charge-offs equated to only 3 basis points on an annualized basis during the fourth quarter and for all of 2016. We recorded a provision expense of $0.6 million during the fourth quarter and $2.9 million for all of 2016. The provision expense during 2016 was primarily driven by loan growth, as well as a second-quarter assessment change in our economic and credit concentration environmental factors, the latter equating to about $0.5 million in provision expense. We expect to record quarterly provision expense of $0.5 million to $1.0 million during 2017. Our loan loss reserves totaled $18 million at year-end 2016. The reserve for originated loans equaled 0.95% of total originated loans at year end, virtually unchanged from year-end 2015. We recorded noninterest income of $4.6 million during the fourth quarter of 2016, compared to $4.0 million during the fourth quarter of 2015. For all of 2016, noninterest income increased $5 million over the amount recorded in 2015. We recorded increases in virtually every fee income category, led by a $0.9 million increase in service charges on deposit accounts. We also recorded a $3.0 million gain from the repurchase of certain trust preferred securities during the first quarter. Subject to potential fluctuations in mortgage banking income, we expect noninterest income to total $4.3 million to $4.5 million during the first quarter of 2017, $4.7 million to $4.9 million during the second and third quarters, and $4.4 million to $4.6 million during the fourth quarter. We recorded noninterest expense of $18.4 million during the fourth quarter of 2016, compared to $20.1 million during the fourth quarter of 2015. For all of 2016, we recorded noninterest expense of $77.1 million, compared to $79.4 million for all of 2015. A majority of the improvements during both time frames is associated with the efficiency program we announced in late October of 2015, that was largely fully implemented by the end of the first quarter of 2016. Our fourth-quarter noninterest expense was relatively low compared to the previous three quarters, due to overaccrued positions in certain overact [ph] categories and a reduction in FDIC insurance assessments. We expect quarterly noninterest expense to total between $19.5 million and $20.0 million during 2017, with our effective tax rate at around 31.5%. We remain a well-capitalized banking organization. As of year-end 2016, our Bank’s total risk-based capital ratio was 13.1%; and, in dollars, was approximately $84 million higher than the 10% minimum required to be categorized as well-capitalized. Those are my prepared remarks. I will now turn the call back over to Bob.

Thank you Chuck. I will now be happy to entertain your questions.

We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Matthew Forgotson of Sandler O’Neill & Partners. Please go ahead.

Hi good morning gentlemen.

Good morning.

Just wondering how you are thinking about loan growth here as we move through 2017. Are you thinking mid-single digits to upper-single digits?

Yes, I think that’s generally the trend that we’re looking to see from loan growth. As you saw in the fourth quarter and then throughout 2016, we had some great successes with relationship banking and that whole approach, and the fundings were there. And as we outlined in the fourth quarter, there were some things that happened that had offset that. But, yes, I would say that’s a fair assessment.

Okay. And then as you think through your expense base, I guess, $18.4 million in the fourth quarter of the year, Chuck, how much should we attribute to the – I guess it was a comp accrual reversal?

Yes, I think the difference between what we actually reported and what the guidance was, was mostly related to reversals of accruals, especially in professional fees. This was one of the things that we have to try to judge what the whole year is going to be, and we try to expense it equally over the whole year. And as we got into the latter stages, we saw that we had overaccrued on some of those areas, which obviously is good news. The other item came from the FDIC. It was reported that as of July 1, banks under $10 billion were going to get a reduction in insurance assessments. We were waiting throughout the third quarter for the FDIC to officially state that they had reached that target. They didn’t state that officially until October. So during the third quarter, we accrued our FDIC expense at what we had been. We got that official proclamation during the fourth quarter. So we were able to reduce that extra, if you will, that took place in the third quarter, plus the fact that our overall expense was down as required by the FDIC insurance loss.

Okay. So on FDIC insurance, what would you use as a good run rate?

I believe that's going to run around $0.25 million a quarter. It's a reduction of about $130,000 a quarter, about one-third.

Okay, great. And then just lastly, and then I'll hop out. In terms of the excess liquidity that you have on balance sheet, did I hear you correctly, to say that you expect that to ultimately stabilize in the back half of the first quarter, at around $50 million?

That's correct. $50 million is our desired level. And again with the expected net loan growth and we got some wholesale funding maturities, both broker deposits as well as some FHLB advances, we'll be able to get that down to the $50 million level towards the end of the latter half. I think the average will be $50 million for the latter half. By way of example, we got about $100 million there right now.

Thank you.

The next question comes from Brian Zabora of Hovde Group. Please go ahead.

Thanks, good morning.

Good morning, Brian.

Good morning, Brian.

A question on the margin, the outlook: you have a little bit of a decline from the fourth quarter, not much. But just wanted to get a sense, is that a function of the accretion that you received in the fourth quarter, and that was kind of sped up to some degree in some of the changes that were made, and the reason for maybe the margin kind of down a little bit is a function of lower kind of accretion effect given what you saw on the fourth quarter?

Yes, it's probably – Brian, it's mostly a function of the accretion that we expect to record conservatively compared to what we actually record during the fourth quarter. Again, that fourth quarter had about a $1 million catch-up from the net gains, were sitting in that pool that we're able to immediately recognize when that pool kind of disbanded, if you will. Again, we took a very conservative approach in our calculations in regards to the accretion in that former pool by going with just the scheduled payments. Those loans – again, they were purchased impaired loans – they are sitting in our workout group and being actively worked out by that group. And from time to time, they are able to get higher-than-scheduled payments; maybe due to collateral sales; certainly due to maybe payoffs at other banks, those types of things. So, what we went with and what is reflected in my guidance for the margin is reflecting just scheduled payments on those credits.

Okay, great. That's helpful. And then your expectations on fee income, could you give us maybe some sense of how you expect mortgage to perform in this environment? Do you still think mortgage could be up in 2017, given the hirings that you've done and the increased emphasis on the product?

Yes, I think we feel pretty good with our expectations for fee income throughout 2017. You hit the one that has the most volatility in it. Obviously, the interest rate environment can weigh heavily on what we're able to record. We are budgeting a little under $4.4 million in mortgage banking income for all of 2017, is what we think. And obviously there's some seasonality to that. But we've got the group of folks that we hired throughout – in primarily the latter part – or, excuse me, the early part of last year. So we see strong momentum in that group and expect to perform very well throughout 2017; again, notwithstanding what the interest rate environment may do to us. We would expect, as we go forward with the team that we've got, that the mortgages around the purchase will be stronger, and not so much reliance on refinance activity that we have seen in the past.

Great. And then my last question: some of the pruning that you did on the loan side regarding the syndications and maybe some reductions to concentrations, do you feel like you've completed everything that you wanted to do? Or could we see some additional pruning in 2017?

No, that's really a moving target, Brian. I think the things that happened in the fourth quarter, some of them were anticipated; some of them were more recent events that happened. And so we try to – we make decisions based upon what our strategic initiatives are; and in terms of pricing, in terms of credit quality, in terms of concentrations. So it's kind of a moving target. And I think obviously the ones experienced in the fourth quarter were impactful. I can't say that things won't happen during 2017 that will put a similar situations for us, and we will take it as it comes and deal with it. But the thing that we are very confident in and comfortable with is our pipeline remains very solid. And as you saw on the fourth quarter, loan fundings were consistent with what we saw throughout 2016 as a whole. And that's really the thing that we can control is our relationship building, our activities on the loan generation side, and the things that are proved as a result of those activities.

Well, thanks for taking my questions.

Thank you.

Our next question comes from Damon DelMonte of KBW. Please go ahead.

Hi, good morning, guys. How is it going today?

Good morning, Damon.

Chuck, just to circle back on the margin: so you gave a range of 3.65% to 3.70% for 2017. Did you say that that does not include any potential increases by the Fed?

That is correct. That assumes no changes in the prime rate or the LIBOR rates from where they were at the beginning of the year.

Okay. So, basically you are saying from the 3.72%, we'll see a slow bleed on the margin, just given where new loan production is coming on, and old loans are exiting the bank?

That's part of it; but also lower accretion, as well, is in our calculations.

Lower accretion? Okay. And you said the accretion was going to be around $500,000 per quarter?

Yes.

That right? Okay. And then just on the tax rate, did you say that you expect around 33%?

31.5%

31.5%? Okay, got you. Okay. I think that was it. I think some good questions were asked, and I should be all set. Thank you very much.

Thank you, Damon.

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

Good morning guys.

Good morning John.

Good morning John.

Chuck, just back to the yield accretion, you just – $500,000, roughly, per quarter in 2017. If we look ahead to 2018, and I know there's a lot of variables, but last quarter you said around $300,000 a quarter in 2018. Is that still a good number?

Yes. The wild card on there is going to be those balloon maturities. I think it would probably be closer to the $500,000 in 2018. And again, that assumes some of these credits that are in that CRE pool are scheduled for balloon maturities, which obviously gives us some leverage. But I went with the conservative approach and said, let's just assume that we have to renew those, that balloon, and stay with similar terms and similar cash flows. With that as a backdrop, I would expect 2018 to be similar to 2017. 2017, apart from the CRE pool, most of that accretion is on the mortgage loans. And those, of course, are longer term. So I wouldn't expect too much change from 2017 to 2018, assuming that a majority of these CRE loans are still with us in 2018.

And then the $6.3 million number you threw out in your commentary, that's the total yield accretion remaining?

That is what we have – that's what we have identified in that CRE pool, the aggregate dollars, principal dollars that we think we will collect on those credits, given the financial strength of the borrowers, the collateral analysis, those types of things. So, that's what we would have on our books if we did not have the offsetting credit market.

Okay.

What the borrowers owe, in aggregate, legally is higher than that.

Okay, okay. Performing TDRs, do you have the number at the end of the year?

They didn't give that number to me yet, John. I'll give that off-line as soon as I get that.

Okay.

I don't think it's a materially different.

Okay. Your credit quality remains strong. But you did see, I guess, an increase in NPAs, and it looks like it was in C&I. Just any comments on that.

No, no. Just through normal review, analysis of the portfolio, I think the fact that our numbers were so low, if you had even one credit or two credits would pop on there it makes it a period like it went up a lot, but nothing unusual there.

Okay. And then, Chuck, you said that tax rate, 31.5%. Just if we do get a change in tax rates going forward, all things considered, if we see like a 5 percentage point reduction or a 10 percentage point reduction in the federal rate, do you think most of that flows through for you guys? Would you realize the vast majority of that?

I think a vast majority. I think we're all trying to get our hands around what that does to the municipal portfolio. So, the devil is in the details, but I think overall it should flow through.

Okay, okay. Thanks, guys.

Thank you.

[Operator Instructions] Our next question comes from Daniel Cardenas of Raymond James. Please go ahead.

Good morning guys.

Good morning Dan.

All my questions – most of my questions have been asked and answered, but just one quick one. Given the strong performance in the stock price here in 2016, and given where you are trading on a price to tangible book, does that do anything to your appetite for M&A?

I think the way we approach M&A is the way we always have done. We look at opportunities that come down the pike that are a good fit for us from a cultural standpoint, and obviously look at the financial metrics, too. So I think the fluctuations in stock price are more of a minor piece and to the overall picture of what's a good M&A fit for Mercantile Bank.

Okay. Good. All right, that's all I have for right now. Thanks, guys.

Thanks Dan.

Our next question is a follow-up from Matthew Forgotson of Sandler O'Neill & Partners. Please go ahead.

Sorry, not to beat a dead horse; but just on the accretion, you are guiding $500,000 or so per quarter across 2017. Is it fair to say that that's the stabilized level of accretion we should expect with incremental benefit from the $6.3 million as that's recovered?

Yes. The $500,000 per quarter, Matt, includes the scheduled payments on the CRE pool.

Okay. So that's all-in?

Yes, it is.

Okay, thank you.

Yes.

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

Well, thank you again for your interest in our Company, and we look forward to speaking with you again after the first quarter. So this concludes the conference call today.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect your lines. Have a great day.