Mercantile Bank Corporation (MBWM) Q2 2017 Earnings Report, Transcript and Summary

Good morning and welcome to the Mercantile Bank Corporation Second Quarter 2017 Earnings 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 would now like to turn the conference over to Bob Burton. You can please go ahead.

Thank you, Brian. 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 2017. 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; 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 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, Bob Kaminski.

Thank you, Bob, and good morning, everyone. Thank you all 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. As Bob said, we’re joined on the call today by Mike Price, Mercantile’s Chairman; and Ray Reitsma, Mercantile Bank’s President. Mercantile’s consistent performance continue in the second quarter of 2017, with strong net interest income performance producing earnings per share of $0.45, which met both our expectations and consensus. We remain on track to deliver a strong year of financial performance consistent with our guidance. In particular, let me highlight several accomplishments and areas of strategic focus. During the quarter, commercial term loans funded to new and current clients totaled $152 million, resulting in an annualized growth rate of 12% during the first-half of the year, which is at the high-end of our guidance and outlook. This performance reflects both efforts of our lending team and underlying Michigan economy that continues to demonstrate strength. Overall, our pipelines are solid and we are encouraged by the opportunities we see over the remainder of 2017 in all of our markets. Net interest income was strong, reflecting a robust and relatively stable net interest margin and growth in earning assets. Although mortgage loan production was on track for the quarter, we saw greater than expected percentage of mortgage loans placed in our portfolio rather than sold, together with higher than expected amortization of mortgage servicing rights, this produced a result in noninterest income that was below expectations. At the same time, we saw solid performance in other fee generated areas, including credit and debit card fees and payroll processing fees. Our net interest margin stayed steady against our guidance. We remain very pleased with the strength and stability of our core net interest margin, reflecting our continued focus on loan pricing discipline. It’s worth noting that our net interest income is expected to benefit from further rate increases 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 0.23% of total assets. The Bank continues to be in extremely strong position here. As evidence of our strong capital position and demonstrated our continued commitment to shareholder return, we earlier today announced the quarterly cash dividend of $0.19 per share for the third quarter, providing an annual yield of about 2.4% based on our current share price. Our outlook is that, the overall healthy employment and business expansion being reported for Michigan will continue, particularly within our largest markets. It was reported earlier this month that the Grand Rapids metro area witnessed more job growth than any large metro area in the nation during 2016. Michigan economy continues to gain strength, as the state unemployment rate dropped below the national average to 4.2% as of May. Home prices continue to rise throughout the state. At the halfway point of 2017, our markets are healthy, our financial condition remain strong and our operating metrics are solid. Looking to the second-half of 2017, we see additional opportunity to participate in the economic strength of our markets, as Michigan’s premier community bank. That concludes my initial remarks. At this time, I’d like to turn it over to Chuck.

Thanks, Bob, and good morning to everybody. This morning we announced net income of $7.3 million, or $0.45 per diluted share for the second quarter of 2017. During the second quarter of 2016, we earned $7.4 million, or $0.46 per diluted share. Net income for the first six months of 2017 totaled $15 million, or $0.91 per share – diluted share compared to $16 million, or $0.98 per diluted share during the first six months of 2016. The bank owned life insurance benefit claim during the first quarter of 2017 increased diluted earnings per share by $0.06, while the repurchase of trust preferred securities at a large discount during the first quarter of 2016 increased diluted earnings per share by $0.11. Therefore, on a more core basis, earnings per diluted share equaled $0.85 during the first six months of 2017, compared to $0.87 during the first six months of last year. We remain pleased with our financial condition and earnings performance and believe we are very well-positioned to continue to take advantage of lending and market opportunities by delivering consistent results for our shareholders. Our net interest margin was 3.85% during the second quarter continuing at a relatively stable trend. Our loan yield is benefiting from recent rate hikes from the FOMC, with each 25 basis point increase in the federal funds rate equating to about a 9 basis point increase in the loan yields. Although interest rates have increased in recent periods, the overall interest rate environment remains low and when combined with strong competition for loans that remain somewhere – some downward pressure on our loan yield. Our cost of funds which had remained very stable for the past two years did increase during the second quarter, in large part, reflecting higher time deposit offering rates and greater reliance on wholesale funds. We recorded $1.3 million in purchase loan accretion and payments received that are formally CRE-pool loans during the second quarter of 2017, compared to $500,000 guidance I had provided at the end of the first quarter. Payoffs on two credits that were formally in the CRE-impaired loan pools during the second quarter accounted for a majority of the higher than expected level of income. To a large degree, the higher level of income reflect the change in the accounting treatment for our pool of CRE-impaired loans to the cost recovery methodology as of year-end 2016. As a reminder, as of year-end 2016, payments received since the merger lowered the recorded investment on this particular pool to zero. In accordance with cost recovery methodology, accretion income is no longer recorded on this pool, but instead all payments made by borrowers are immediately recorded as interest income. We currently expect to receive a minimum of about $5 million in principle payments on these particular loans in future periods, which were recorded as interest income upon receipt. Based on our most recent evaluation and cash flow forecast on purchased loans, we expect to record further quarterly interest income totaling about $0.6 million during 2017 and into 2018. Please note this forecast is largely based on schedule payments and forecasted accretion entries. We expect our net interest margin to be in the range of 3.75% to 3.80% throughout the remainder of 2017. This forecast assumes no further changes in the prime and LIBOR rates. Our interest rate risk measurements continued reflecting improved net interest margin and an increasing interest rate environment. The overall quality of our loan portfolio remains very strong. Nonperforming assets as a percent of total assets equaled only 23 basis points as of the end of the second quarter and net loan charge-offs equaled only $1 million during the first six months of 2017, or 8 basis points on an annualized – as an annualized percent of average total loans. One commercial loan relationship accounts for a vast majority of the net loan charge-off figure, or about two-thirds of the gross loan charge-offs recorded in 2017. We recorded a provision expense of $750,000 during the quarter – second quarter, in large part driven by commercial loan growth. We expect to record quarterly provision expense of $750,000 to $1 million during the remainder of 2017. Our loan loss reserve totaled $18.3 million at the end of the second quarter, or 0.86% of total originated loans. The decline in the reserve coverage ratio during the second quarter primarily reflects the charge-off associated with the commercial loan credit that have been reserved in prior – have been reserved for in prior periods. No significant changes from the current level are expected for the remainder of 2017. We recorded noninterest income of $4 million during the second quarter of 2017 compared to the guidance of $4.7 million to $4.9 million provided at the end of the first quarter. While we recorded increases in most fee income categories, as expected, income from our mortgage banking operations came in less than expected, despite volume that was close to forecast. The lower performance was predominantly caused by a higher proportion of loans being booked to our portfolio instead of sold in a higher level of mortgage servicing right to amortization. We are exploring our options to sell a greater percentage of our mortgage loans in future periods. We currently expect noninterest income to total between $4.4 million and $4.6 million during the third quarter and between $4.1 million to $4.3 million during the fourth quarter. We recorded noninterest expense of $19.9 million during the second quarter of 2017 very similar to what we expensed during the first quarter and with – within the guidance we provided at the end of the first quarter. Currently, we expect quarterly noninterest expense to total between $19.8 million and $20.2 million during the remainder of 2017, with our effective tax rate to remain just under 31%. We remain a well-capitalized banking organization. As of quarter-end, our Bank’s total risk-based cap ratio was 12.7%, and in dollars was approximately $76 million higher than the 10% minimum required to be categorized as well capitalized. Those are my prepared remarks. I’ll now turn the call back over to Bob.

We’ll now begin the question-and-answer session.

We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Kevin Reevey with D.A. Davidson. Please go ahead.

Good morning, guy. How are you?

Good morning.

Fine.

Good morning.

So just get some color on the loan growth by geography? Was it more from your recent expansion in the southeast Michigan, or was it more board-based between western, central and southeastern Michigan?

We had good growth in all of our markets. I think though that the leader in terms of the pipeline, the strength and our growth continues to be the West Michigan area, Kent County, Ottawa County, where we have our largest and well-established lending teams and markets, and that was the leader. But we had nice growth and lending opportunities in all of our markets.

And then line utilization, did that change at all from the first quarter to the second quarter? And if so, what was that number?

I think the line utilization was up a little bit in the second quarter from the first quarter. I don’t have the exact numbers in front of me at this moment, but that’s a moving target. And I think at the end of the first quarter, we were down, and so we captured some of that in the second quarter. So I think, year-to-date it’s probably been the level. But – so that’s kind of a moving target.

And then just last question, it sounds like Grand Rapids is really doing extremely well. Was there particular industry, or sector that is really contributing to the vibrancy of their market?

I think, it’s really broad-based. If you look at some of the news reports of what’s happening in Grand Rapids, obviously, the medical presence in Grand Rapids has been a big boost to the local economy and the industries that support that. We have some technology industries coming to town with the new switch facility out in Southeastern Kent County and just a good grassroots strength in the many small privately-held companies that make up the West Michigan economy for so long. Those companies are all experiencing good growth opportunities in their respective industries. Job market is really strong right now, and it’s really a challenge to keep good – keep and retain good workers because of the low unemployment rate, basically a full employment economy here in West Michigan. So it’s really exhibited strength as the leader throughout the state, which as a whole is doing very well.

Thanks, guys. I appreciate the color.

The next question comes from Matthew Forgotson with Sandler O’Neill & Partners. Please go ahead.

Hi, good morning, everybody.

Hi, Matt.

Hi, Matt.

Good morning.

So year-to-date, it looks like loans have advanced about 12% on an annualized basis. Just based on the current pipelines, do you think that this growth is – this pace of growth is sustainable in the back-half of 2017?

I think, as we said for a long time now, the pipelines have been really strong and loan finding is rather uneven and choppy sometimes, especially with large commercial – heavy commercial focus and that when the customers fund loans can be difficult to predict sometimes. I think what you see in the last two quarters is reflective of the good strong pipelines that we’ve been talking about for sometime now. And I think based on where the pipeline stand right now, I think we’ll continue to see good strong growth in the upper single digits for 2017 as a whole when it’s all said and done.

Okay, great. In terms of deposits, up nicely one quarter, but still down just a smidge year-to-date. Can you talk a little bit about deposit competition in the market and then your plans for balancing loan and deposit generation going forward?

Yes, Matt, this is Chuck. In regards to our deposits numbers from year-end to current, just as a reminder, with our commercial focus, we have significant deposit withdrawal, especially during January of each year, as many of our commercial customers make their quarterly tax payments to the IRS. Just looking at some of the larger ones, I believe the number was around $90 million and I’m sure there was more than that, those were just some of the bigger checks we saw coming through. So typically what we see is, from that standpoint if we isolate that, we see a big decline in January of every year and then that builds up and then we see that again in January. So I think what’s a better way of looking at our deposit trends is probably looking at it from more of – from what you guys see publicly from a March standpoint and then going forward from that day to kind of get that that occurrence out of those numbers. But you definitely hit on a big issue that we talk about and spend a lot of time here at the Bank. Obviously, we’re enjoying some really, really strong loan growth and lots of opportunities with very strong pipeline. So it’s incumbent upon us to make sure that we’re funding that appropriately and certainly we endeavor to fund as much as we can with local deposit growth. I think there a lot of different effort out there whether it’s part of our commercial loan relationships that we have in the way that we price loans accordingly. Certainly want to be relatively aggressive, but not leading the market when it comes to deposit rates and certainly looking at our different deposit offerings that we have out there, and if we want to tweak any products from a different –a variety of different ways that we can do that. We have gotten over the course of last quarter, a quarter-and-a-half, we’ve gotten more aggressive with pricing our public unit CD rates, as well as enhancing our money market offerings. And we definitely have especially towards right at the end of the second quarter, but we’ve seen it so far here in the first three weeks or so in the third quarter we’ve seen some really, really nice new deposits coming to those endeavors. And we’re cautiously optimistic that we’ll continue to see those successes. But certainly as we go forward, we’re going to continue to look at our offerings, our rate, how we stack up to our competitors. We meet formally every month with a committee that does nothing but that. And so it’s definitely all hands on deck when it comes to local deposit growth. In the meantime, we certainly avail ourselves to wholesale funding, primarily FHLB advances, but some broker deposits as well. We continue to – when we do have to go out there and get those deposits and those funds, we continue to keep a close eye on our interest rate risk management practices. And as a result of that, we typically go, what I would call, long-term when we have to go out there and get those funds, the FHLB probably has an average term of five to six years and the broker deposits usually around three to four years. So we’re about 50-50 fixed and floating. And while we typically blew in that five years and occasionally we’ll do a seven year, this allows us the opportunity to go ahead and do some match money if you will. Certainly, I think this is banking industry overall. It’s still pretty difficult to get local depositors to go along on their deposits. They are still staying relatively short on the CDs notwithstanding a couple of specials that are out there. So we would rather obviously grow a 100%, or fund a 100% of our loan growth and local deposits, that’s not possible right now, given the numbers that we’ve had. But we’re doing a really good job of growing local deposits. In the meantime, we’ll get wholesale fundings and we’ll make sure we take advantage of going not relatively long to make sure we manage our interest rate risk in years three to five.

Okay, great. I appreciate all that color. Thank you, Chuck. I guess, last one for me and then I’ll hop out. Just in terms of the decision to book more residential production on balance sheet this quarter, can you explain to us how you got through it? What the retention ratio was this quarter and ultimately where that might trend in coming quarters? And kind of what dynamics you would need to see a change in order to migrate more towards a gain on sale as opposed to retention play?

I think for the second quarter what we saw was just the opportunities that present themselves for the ability to book some loans in the portfolio. And that was a concerted effort for us for 2017, because as we’ve seen our numbers over recent years, our residential mortgage portfolio had a shrunk. And so we intentionally look to retain some of those loans to keep that balance leveled off and not necessarily growing tremendously, but to level off. And with that, we saw some good opportunities through some new loan programs that we’ve created in 2017 to be able to avail ourselves of that opportunity. I think going forward that we continue to see obviously the benefits of loan sales on secondary market keeping our options open to be able to do that. And as Chuck said in his comments, we’re looking at avenues to be able to find ways to either retain those loans and portfolio, or if we choose to sell them to be able to sell them to the appropriate investors as well. So the strategy is to maintain a good balance there to keep the portfolio level, at least, and to provide us maximum flexibility to book good strong loans in the portfolio that would merit that. But the ability and the intention to definitely sell the majority of our loans on secondary market as we have in the past is the ongoing strategy.

Yes, and I’ll add some color to that Matt, this is Chuck, again. Typically, what we’re doing in a very simplified way of saying it is, we were selling our fixed rate loans making sure that we are adherent to Freddie Mac’s standards in regards to underwriting those loans. But we’re primarily keeping our arm loans, which are predominantly five and seven-year lack of periods. So really when we were underwriting those loans, especially the way that we’re putting that product – those products together, we weren’t necessarily looking at what the market expectations were on those loans. And now that we see that we’re doing more arm loans than we are mortgage fixed rate loans in large part, as I mentioned, some of the different programs that we have. What we have found is that, we need to tweak our arm underwriting a little bit mostly as things to do with like the index we’re using and things like that that will make them more easily sellable to the secondary market kind of just meeting more of those expectations and what’s generally sold in the market. Those are relatively easy fix. Those fixes those are all something that we do internally here and really don’t have much of an impact if any on the customer. So we’re kind of looking at that just to make sure that when we balance out what we’re able to sell and looking at that the arm loans are tending to be a little bit higher composition of our product offerings and what we’re actually underwriting. This will give us some flex by making these changes that will give us the flexibility if we so choose to sell our arm products into the marketplace.

Great. Okay, thank you very much.

Thank you.

The next question comes from Damon DelMonte with KBW. Please go ahead.

Hey, good morning, guys. How’s it going today?

Morning.

Morning. So my first question, could you just guys just give us a little bit of an update on the Eastern Michigan expansion into the Detroit area? I know you guys have hired some commercial lenders there. Can you maybe give us an update on their progress and kind of what you see kind of come down the pipe with these guys?

Yes, it’s going well, as we had some good expectations for them, I think so far they’ve met expectations with the new customer introductions that they’ve been able to make to the Bank and also provide introduction of Mercantile to that market again. And I think, we’ve been pleased with what we’ve seen there. And I think the overall expectations is that the balance of 2017 will continue to perform very well as they have for the first few months that they’ve been on an operation. They continue to make new loan introductions to that market and keep the expansion growing there. But it’s gone very well so far it met expectations at very least, and we look forward to continued opportunities from them for the balance of the year.

Okay, great. And then when we talk about the sizable growth that you guys saw, particularly in the commercial portfolio this quarter. Are all these loans originated by you guys, or is there any certain national credits that you guys have been adding?

No, they’re all originated by our folks later locally.

Okay. Do you have any shared national credits?

I think we may have one in the Bank that’s been with us for a number of years now, but that is the extent of it.

And that’s a local loan.

Local loans.

Made by another bank that we participated with, but it is a….

The local credit.

Yes, within our market.

Yes.

Okay.

It’s just that the guide that it meets the guidelines.

Okay, great. And then, obviously, credit quality continues to be rock solid. Is there anything that’s concerning to you guys at this point? Anything maybe that’s kind of under the radar that’s starting to percolate that you guys are paying closer attention to any – I know the general economy throughout your footprint is very strong, but I didn’t know if there’s any color you could provide on maybe some areas that might be giving some concern?

I think as always we remain very diligent and looking at our portfolio as a whole and customers individually to make sure there we identify any signs of any potential problems at early stage. I think, as we said and I said in my comments, the Grand Rapids market is going very strong right now. There has been a lot of development of residential real estate in downtown Grand Rapids. And I think that’s meeting some peoples radar screens as far as potential for overheating. So we’re keeping a close eye on that as we do in all of our markets, but especially the ones that are really hot right now. But I think overall, we see broad-based strength in our markets from an economic standpoint. But as always, we remain very diligent look for any signs, any early warning signs of that concern. As we have interactions with our clients and as they’re doing with their customers and their specific industries.

Gotcha. Okay, that’s helpful. And then it’s my last question probably for Chuck. Did you say that the accretive yield impact was $1.3 million this quarter?

Well, that would be – that would include the accretable yield, as well as the payments received on those CRE loans that were private that were formerly part of that pool that technically isn’t accretions.

Okay.

So I just want to be clear there. So the $1.3 million includes accretion, but it also includes payments received on those CRE loans. And again, we had two payoffs of some larger size credits that were formally in that pool that they got that number up. So again, my estimate, if we just go with forecasted accretion that’s still out there, as well as scheduled payments that are on that CRE pool, that’s why I came up to 600,000. If we happen to get some additional payments of that CRE pool for whatever reason if they saw a collateral or they refinance another bank, we would expect that number to be higher.

Got it.

And again of that CRE pool, there is about $5 million that we expect to collect in future periods.

Okay, great.

That’s a principal -- that’s principal amount.

Principal amount, got it. Okay, that’s helpful. Thank you very much.

Thanks, Damon.

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

Good morning, guys.

Good morning.

Bob maybe just to circle back on the earlier question on loans. Did I – I just want to make sure I heard you right. You said you thought you guys were on track for upper single-digit growth this year?

That’s correct.

Okay, which would sort of imply a little bit of a slowdown in the second-half. But to your point, these things aren’t linear, so that makes sense?

No, that’s provided. It’s a moving target and pipelines remain good and healthy and strong. But trying to predict quarter-by-quarter loan growth is a little challenging and you get the line draw factor that overlay that as well. So I think we’re sticking by the thoughts of high single digits.

Fair enough. And just a follow-up question on the Eastern Michigan troy expansion. Can – I mean, are you in a position to say how much in loan balances are outstanding right now from that group?

No, not at this point, I don’t want to get into the specifics in terms of loan funding for any particular market that specifically. But as I said, very pleased with what the folks have done there. And I think our efforts have been very well received by customers and clients – potential clients in that market, both from a loan and deposit standpoint. I think they were also very pleased with our sweeter treasure products that we have to offer that maybe they haven’t seen before from their competitor banks in that market. So overall, very, very pleased with the efforts there.

And what about just with some of the market disruption with the [indiscernible] chemical deal. Any opportunities – additional opportunities for more lenders to be brought on?

I think, as we said in past quarters, we’ve had some good new hires from a residential mortgage lending standpoint in 2017. We’re always in the – on the watch for good people that would be good cultural fit for Mercantile Bank. But we’re very pleased with the staff that we have and they’re all doing very well in terms of production and their sales outreach into our markets to be able to keep the momentum going from a sales standpoint.

Okay. And then just final question, can you maybe just talk about capital management? You guys increased the dividend. You haven’t still got authorization for the buyback and maybe just thoughts on the M&A environment?

From a capital standpoint, our tangibles has got – they’re brought 9.7%. We stated before that over time, it really like that – get that down under 9% and maybe perhaps as low as 3.5%. But love to do that all with organic growth and leverage that capital as best we can. Certainly, we want to make sure that we’ve got a nice healthy cash dividend program every quarter. We did, as you mentioned, we did raise it a $0.01 share and which we do from time-to-time. And we want – we’ve been keeping that payout ratio, which is 35% and 40%. We think that makes good sense. It provides that we think a competitive yield currently at 2.4%, as Bob said. So we’ll continue to look at dividends. Obviously, we did a special dividend late last year. I haven’t had any conversations with the Board about doing that again. But obviously, we’ve done in the past, so it’s something that we can talk about as we go forward. But the emphasis at the fact that it was a special dividend. We want to make sure that we’ve got sufficient capital to fund our – to manage our organic growth and any possible M&A deals that may come our way, especially if there’s some cash consideration involved. From the stock buyback, the good news is, we’ve had a nice stock appreciation over the last 12 to 15 months at $32, $33 and we’ve been trading for quite a few months now. We think that’s a little bit high compared to our tangible book value. And so we’ve been staying out of the market, but we certainly have $15 million or so left in our current plan. And we can certainly avail ourselves to go ahead and engage back into some stock buybacks if and when we think that that’s appropriate. Again, it seems like a little rich to us right now, but it is out there and something that we can take a hold of it if we want.

Okay.

From an M&A standpoint, while we always remain opportunistic on that front, our things have been relatively quiet. We hear potential opportunities that may be fully about in the market, but nothing at all eminent or concrete. But we obviously continue to be opportunistic for opportunities that may be a good cultural fit for Mercantile style of banking and the type of people that comprise the Mercantile team.

Okay, makes sense, guys. Thank you.

Thank you, John.

This concludes our question-and-answer session. I would like to turn the conference back over to Bob Kaminski for any closing remarks.

Yes, so thank you for your interest in our company. We look forward to talking to you again after the third quarter. That concludes the call. Thank you.

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