Mercantile Bank Corporation (MBWM) Q2 2018 Earnings Report, Transcript and Summary

Good day and welcome to the Mercantile Bank Corporation, Second Quarter 2018 Earnings Results Conference Call. All participants will be in a listen-only mode. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mr. Mike Houston of Lambert, Edwards and Associates. Please go ahead.

Thank you, Michelle. 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 of 2018. I am Mike Houston with ‎Lambert, Edwards, Mercantile’s Investor Relations firm, and joining me today are members of their management team, including Bob Kaminski, President and Chief Executive Officer; Chuck Christmas, Executive Vice President and Chief Financial Officer; Ray Reitsma, President of Mercantile Bank, Michigan; and Bob Worthington, SVP, Chief Operating Officer and General Counsel. We will begin the call with management’s prepared remarks and then open the call 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 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, Mike and good morning everyone. Thank you all for joining us. On the call today I’ll provide an update on overall performance, growth initiatives and asset quality. Then Mercantile Bank’s President, Ray Reitsma will review our loan portfolio development and progress for the quarter. Following Ray’s remarks, our CFO, Chuck Christmas will provide details on our financial results. Afterwards we will open the call for Q&A. We are pleased to announce strong quarterly results for the period, resulting from improved operating performance and balance sheet growth. This was evident in the healthy net interest margin, increased fee income, controlled overhead costs, sound asset quality and continued strength in our commercial loan pipeline during the quarter. Results are also supported by a lower regulatory tax rate. In particular, let me highlight several areas of strategic focus during the quarter as we look forward to the second half of the year. Our strong financial performance was led by a total revenue increase of $2.5 million or 8.1% from the prior year’s second quarter. Net interest income during the quarter largely contributed to the positive results and was up 7.5%, reflecting a higher level of earning assets and an increased net interest margin. We continue to build momentum and generate non-interest income with a 12.6% increase from the prior year’s second quarter. The increase to non-interest income was primarily attributed to higher credit and debit card revenue, mortgage banking activity income and payroll service fees. We remain very pleased with the continued growth in these areas of our business as a result of our ongoing strategic initiatives throughout the past several quarters. During the second quarter of 2018, the net interest margin remained at a healthy level of 3.92%, up slightly from the 3.85% in the prior year period. We are very pleased with the ongoing strength and the relative stability we’ve experienced in our core net interest margin, which depicts our continued focus on prudent loan pricing and sound asset quality. We believe these two areas of focus will lead to continued healthy margins throughout the balance of 2018 and into the future. Our asset quality performance metrics once again reflect a strong portfolio during the quarter. Full non-performing assets were $5.8 million at June 30, 2018 or 0.18% of total assets. Our lenders and management team continue to diligently monitor our loan portfolio, searching for potential signs of stress. The level of past-due loans remains nominal and loan relationships on the internal watch list have generally declined in number and dollar volume during the first six months of 2018. Total deposits decreased $10 million during the second quarter. However, the mix of total deposits was positively impacted as non-interest bearing deposits increased $54 million, while interest bearing deposits decreased $64 million. Borrowed funds for the quarter were unchanged relative to the prior year quarter end and wholesale funds continue to comprise approximately 11% of the total funding base, consistent with the linked quarter. Continued growth in non-interest bearing deposits and overall local deposit base remains a strategic priority for Mercantile. Turning to the Michigan economy, the trend lines that we have witnessed for many quarters remain positive. Employment in our primary market continues to grow and realistic conditions continue to be healthy. These favorable trends, coupled with our value added approach to banking and our wide array of products and services have allowed us to successfully attract new customers and retain existing clients. We remain confident that the strong financial results achieved during the first half of 2018 will continue in the current year period and beyond. That concludes my remarks. I’ll turn it over to Ray.

Thank you Bob and good morning everyone. To echo Bob’s sentiments on the quarter, we are very pleased with our strong financial performance during the first half of 2018 and how we are positioned to meet our growth and profitability objectives for this year and beyond. During the quarter, total loans expanded by $85 million. Commercial term loans funded to new and current clients totaled $142 million, up from $111 million during the first quarter of 2018, and consistent in magnitude with each quarter of 2017, which led to a growth rate of 7.6% during 2017. Our commercial loan portfolio grew $69 million during the second quarter, complemented by growth in our retail portfolio of $16 million. Included in these results is $10 million of loan growth funded by our Troy office, which opened in March 2017. We remain dedicated to growing the loan portfolio in a disciplined manner with continued emphasis on credit quality and risk based pricing. Based on expected new loan fundings and current commitments to fund construction projects of $160 million, we are confident that the commercial loan portfolio will expand in future periods. Although rising interest rates and limited housing inventories in our markets persist, mortgage banking activity is ahead of last year and the second quarter of 2018 marks the ninth consecutive quarter of residential loan portfolio growth for Mercantile. While purchase activity has increased, it remains constrained by a very tight inventory of homes for sale in our primary markets. With pre-qualification levels at an all time high, nearly doubling the second quarter of 2017 level, we believe we are well positioned to increase our market presence. That concludes my remarks and I’ll hand it over to Chuck.

Thanks Ray. Good morning everyone. This morning we announced net income of $9.4 million or $0.57 per diluted share for the second quarter of 2018. During the second quarter of 2017 we earned $7.3 million or $0.45 per diluted share. Net income for the first six months of 2018 totaled $20.3 million or $1.22 per diluted share, compared to $15 million or $0.91 per diluted share during the first six months of last year. The successful collection of certain non-performing commercial loans increased reported net income during the first six months of this year by about $1.7 million or $0.10 per diluted share, while a bank owned life insurance claim during early 2017 increased reported net income during the first six months of 2017 by about $1.1 million or $0.06 per diluted share. Excluding the impacts of these transactions, diluted earnings per share increased $0.27 or nearly 32% during the first six months of 2018 compared with the respective 2017 period. Net income during the second quarter and first six months of 2018 also benefited from a reduction in the corporate federal income tax rate, which was lowered from 35% to 21% effective January 1 of this year due to the enactment of the Tax Cuts and Jobs Act. Our effective tax rate has been 19% thus far in 2018 compared to almost 31% during 2017. We remain pleased with our financial condition and earnings performance 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 3.92% during the second quarter compared to an average of about 3.88% during the previous four quarters. In addition to ongoing benefits from the recent rate hikes from the FOMC, our yield on earning assets during the first six months of 2018 was positively impacted by successful collection efforts on several non-performing commercial loans. These efforts resulted in the recording of interest income that added approximately five and 15 basis points or your yield on earnings assets during the second quarter and first six months of 2018 respectively. Our cost of funds as a percent of average earning assets increased four basis points during the second quarter of 2018, similar to the five basis point increase during the first quarter of the year. The increases are a reflection of higher interest rates on certain money market deposit accounts, time deposits and borrowed funds, in large part due to the increase in interest rate environment. Excluding all purchase accounting interest income and interest expense entries, our net interest margin was 3.84% during the second quarter of 2018 and 3.81% during the first six months of 2018. This compares favorably to the 3.69% and 3.66% net interest margins during the second quarter and first six months of 2017 respectively. We recorded $0.8 million in purchase loan accretion of payments received on CRE pooled loans during the second quarter of 2018 compared to the $0.5 million guidance figure I had provided at the end of the first quarter. Based on our most recent valuations and cash flow forecasts on purchase loans, we expect to record further quarterly interest income, totaling about $0.4 million during the remainder of 2018, and then approximately $250,000 each quarter in 2019. In addition, we expect to receive in aggregate about $2 million in principal payments on purchase impaired CRE pooled loans over the next several years, which will be recorded as interest income upon receipt. We expect our net interest margin to be in a range of 3.85% to 3.9% throughout the remainder of 2018. This forecast assumes no further changes in the prime and LIBOR rates. Our interest rate risk measurement continued to reflect an improved net interest margin in an increasing interest rate environment. The quality of our loan portfolio remains very strong and with continued low levels of non-performing loans and loan charge-offs. Non-performing assets as a percent of total assets equals only 18 basis points as of the end of the second quarter. Similar to the first quarter of 2018, we recorded a net loan recovery of about $0.5 million during the second quarter of this year. Loan charge-offs totals just $0.3 million during the second quarter and less than $1 million during the first six months in total. We recorded a provisional expense of $0.7 million during the second quarter, in large part driven by commercial loan growth and modifications to environmental factors within our loan loss reserve methodology. We expect to record quarterly provision expense of $0.5 million to $1.0 million during the remainder of 2018. Our loan loss reserve totaled $21.2 million at the end of the second quarter was 0.89% of total originated loans. This coverage ratio has remained steady from many quarters and no significant changes are expected for at least the remainder of 2018. In regards to [inaudible], we hope to have our model up and running by the end of the third quarter and plan to run this new model in parallel to our existing model through the end of 2019. We recorded non-interest income of $4.6 million during the second quarter of 2018 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 of the income categories as expected, the income from our mortgage banking operations came in less than expected, in large part due to the higher proportion of our originated loans being booked to our portfolio instead of sold. In addition as Ray mentioned, the inventory of homes listed for sale throughout our markets, especially in the Western Michigan area remains low and is negatively impacting our new mortgage loan volume. For the remainder of 2018, we currently forecast non-interest income to total $4.9 million to $5.1 million during the third quarter and $4.6 million to $4.8 million during the fourth quarter. We recorded non-interest expense of $21.4 million during the second quarter of 2018, well within the guidance we provided at the end of the first quarter. Currently we expect quarterly non-interest expense to total $21.0 million to $21.5 million during the remainder of 2018 with our effective tax rate remaining at about 19%. We remain a well capitalized banking organization. As of quarter end, our bank’s total risk based capital ratio was 12.9% and in dollars was approximately $88 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.

Thank you, Chuck. We’ll now open the call to questions-and-answers.

[Operator Instructions] The first question comes from Brendan Nosal, Sandler O’Neill and Partners. Go ahead.

Hey, good morning guys. How are you?

Good morning.

Just want to start off with you know how your customers are feeling today, and then more specifically just given the back and forth that we’re hearing on the tariff side of things and what it can mean for the State of Michigan? How are you and your customers feeling about this issue or is it just kind of too early to tell?

Yeah Brendan, this is Bob. I think it’s really too early to tell. Obviously a lot of back and forth, what we’re all reading here in the media as far as how the tariffs might play out and further on how it will affect people here on the ground at West Michigan. I think everybody’s taking a wait and see approach. I think everybody is aware of the situation and it’s a very fluid situation as countries try to assemble their negotiating teams to figure out where this is all going. But I think the general feel from our client base is that people are generally optimistic about the economy. There is very few signs of distressed areas right now. I think its providing ample opportunities for growth for our clients and the overall sense is generally optimistic at this point.

Alright great, thanks for the color there. And then moving onto the fee side of things. The guidance for the last two quarters of the year, it feels like you tempered it a little bit. Is this just a function of what happened this quarter with you guys choosing to place more loans in portfolio as opposed to selling them or is there something else that’s going on in the fee guidance?

This is Chuck. I think most of that is surrounding the mortgage area, but I think it has more to do with the low inventory that we have out there. If you look at our pre-qualifications, we have twice as many pre-qualified borrowers right now than we did a year ago. There just is not enough housing inventory out there for those folks to buy their homes, and so that as I mentioned, that’s having an impact on our overall volume. But you are right and I already mentioned that we did sell less loans than what we were projecting. Most of it has to do with the fact of the bounces and jumbo versus conforming and so we go-ahead and portfolio those and those are virtually our all ARMs and so no significant interest rate risks. So both of those, but I think it has more to do – we are looking at our projections. I think it has more to do with the inventory issue than what we’re selling versus put it in the portfolio.

This is Bob. I can’t really overstate the impact of that low investor on the market right now. I think we told the story back in the most recent quarters, but it is so tight right now that home goes on the market and usually within a week they have – the seller has many, many offers and most of these offers are above the asking price and the home sells within a very short period of time. So that’s continued to be the same throughout 2018 and as Chuck mention, pre-qualifications are there, so if that frees up just a little bit, I think we’ll see a continued boost in our volume with the fact that people want to buy a home, but they just can’t find one that’s for sale.

Got it, okay, that makes a bunch of sense. And then you know last one from me on expenses, you were within the range you offered last quarter of you know $21 million to $21.5 million; you kept the range for the remainder of the year. Is there anything that makes you think you could potentially drop back to the midpoint or below the midpoint, or does it feel like where we were this quarter is probably a decent assumption going forward.

Yeah you know I mean hopefully we can be at the lower end range, you know. Obviously like all banks we run some accruals throughout the year for some expenses that are more lumpy throughout the year. Obviously we keep an eye on those. We feel really good about our accruals. A couple of them look like maybe they are a little bit over accrued, but obviously we’ll keep an eye on those over the next couple of quarters. So knock on wood, there might be a little bit of relief there. But for the most part you know, our operating framework is pretty consistent and we don’t have any you know significant one-time items that we’re currently looking at on the expense side. So we feel pretty good about the guidance. Hopefully we can be in the lower end, but I’m pretty confident we can be within that guidance.

Alright, great! Thanks for taking my questions.

Thank you.

The next question comes from Damon DelMonte, KBW. Go ahead.

Hi, great. So first question, just kind of touching on loan growth; can you talk about what areas of the footprint you are seeing the best opportunity for growth right now?

This is Bob, Damon, and I think as we talked about in prior quarters, I think so in the West Michigan area with Grand Rapids of the home based for the company and our largest market, we have the largest market presence and certainly providing a larger proportion of the share of the opportunities. So we are seeing some very good opportunities in all of our markets just relative to the size of those markers and the presence that we have there. But certainly West Michigan is the area where we continue to experience the greater growth translated into loans, but it’s going well in all of our markets.

Okay, great. And then on the deposits side, you know overall deposits were down a couple of percent, but you had some good non-interest deposit growth, though the categories kind of dragged that down a little bit. Was there anything unique to this quarter as far as you know the overall net outstanding decreasing or because you have a little color on what your outlook is for deposit growth.

Yeah Damon, this is Chuck, happy to do so. I think the decline is reflective of primarily CDs to public units. If there was one area that’s been crazy competitive and it’s been this way for quite a while now, it’s in the domain of our larger, you know jumbo sized public CDs. I think we are down to less than $90 million or it might be like closer to $80 million right now. And so if you scratch that out, even excluding the non-interest bearing checking accounts which continue to grow as you mentioned, we actually saw some growth in our core deposits. We treat our public units, for the most part the CD side anyways, more like wholesale funding and participate in that market as need be, and since we’ve had steady deposit growth on the local side and have been able to augment that at appropriate rates and matching maturities with some regular wholesale funding such as broker CDs and FHLB, we’ve kind of stepped out of that public unit markets, especially for the multimillion, they are very, very large CDs. We continue to have good relationships with the smaller municipalities, those that will invest you know say $100,000, $250,000 or may be $0.5 million. We’ve got good relationships with them. We can negotiate and be competitive there, but we just stepped out of the larger unit for now.

Okay, that’s good color, thanks Chuck. And then as it relates to the margin, I think your guidance for the remainder of the year was at 3.85 to 3.90 range; that takes into account the projected accretive yield; is that correct?

Yes.

Okay, and you had said that was around $700,000 for each of the remaining quarters in ‘18.

I said about $400,000 per quarter for ‘18 and then probably $200,000, $250,000 next year per quarter.

Got you, okay great, thanks for clarifying that. That’s all that I had. Thank you very much.

Thank you.

The next question comes from Kevin Reevey, D.A. Davidson. Go ahead.

Thanks, good morning guys.

Good morning. Kevin.

So first question is related to the number of FTE’s. It looks like there was some sizeable – it was a sizeable increase linked quarter. How much of that was due to hiring of new commercial lenders and residential mortgage lenders?

Yes Kevin, this is Chuck. The vast, vast majority of that increase is a reflection of our summer college internship program. This year we brought on 30 college students and we got great folks throughout our bank helping us out this summer. So a vast, vast majority of that is that college internship program. On the lenders side, we continue to always look for solid commercial and mortgage lenders to join us, and we’ll continue to endeavor to do so. But I think on an overall basis we would see, you know here at the end of the third quarter, our FTEs to go closer to where we were at the end of the first quarter and then just some very gradual increases on a core base is as we move forward just to hire additional folks as our assets and overall operations grow.

And then on the CRE line item, it looks like your owner occupied loan balances grew, but wasn’t as strong as you’re non-owner occupied. Are you seeing any significant pay downs in the owner occupied and can you talk a little bit about the competitive environment.

Sure, this is Ray. The owner occupied pay downs just resulted from the liquidity of our CNI borrowers. They’ve been experiencing strong performance and have made pay down’s here and there across the portfolio that just reflect the liquidity that they built up over time. On the CRE side, it’s a little bit more lumpy and we would you know just experience pay downs from time-to-time. It’s a good time to sell assets and from time-to-time our customers are doing that.

And then, line utilization looked like it was about 50% at the end of last quarter. Where was it at the end of the second quarter, did you see any significant bump up there?

Kevin, it continues to stay right around 50%.

Okay and then my last question is one of your competitors, I know there is an RFP out for municipal deposits at the state level. Are you guys competing for those deposits at all?

Not at the current time. As I mentioned before, that’s kind of an arena that we are pretty much staying on the sidelines due to the hyper competitiveness and the impact that’s having on rates. What we find is you know that tends to be very wholesales, it’s very rate driven and what we find is we can tap into the brokered market, broker CD market and/or the FHLB market at a cheaper price and we can actually get longer term CDs and advances which helps us manage our interest rate risk.

Great! Thanks guys.

Thank you.

The next question comes from John Rodis, FIG Partners. Go ahead.

Good morning guys. Chuck, did you say you had a small amount of interest recoveries this quarter? I think you said five basis points, did I hear that right?

That includes the accretion.

That includes the accretion, okay so a very small amount then. And then I guess Chuck your margin guidance of 3.85% to 3.90%, what does that assume for your excess liquidity since what interest deposits came down roughly, what $95 million or $100 million linked quarter. Does that assume they sort of stay at the lower level?

Yeah, we finally – after several quarters we finally got that down to the desired level of $40 million to $50 million and that’s where we’ve been throughout most of the second quarter. That’s where we are currently, and we expect to continue to stay at that level.

Okay, super. And then maybe guys, just one other question; you guys obviously increased your quarterly dividend by $0.02. So looks like it takes sort of your payout ratio to 35% to 40%. It that sort of a level you are comfortable with now?

I think our guidance has always been John to be 35% to 40%, but we try to be closer to that 40% level. So given our improved earnings performance as we’ve already talked about throughout the conference call, we saw the opportunity to go ahead and increase that a little bit more than $0.001 per share which we traditionally would have done for the third quarter, keeping us closer to that 40%. And obviously we’re looking at that dividend ratio as well and want to keep that you know competitive and getting that closer to 2.5%, 2.6%.

Okay, great, thanks guys.

Thank you.

[Operator Instructions]. The next question, Daniel Cardenas of Raymond James. Go ahead.

Hey, good morning guys.

Good morning Dan.

Nice quarter, Congrats! Just a quick question, I’m looking at your loan-to-deposit ratio. I mean you had some good loan growth this quarter, deposits were down modestly. Which loan-to-deposit ratio kind of hit that 104 level? Where do you kind of see that ratio building out throughout the end of the year and is this the high end of your comfort level or do you think it could go a little bit higher?

Yeah Dan, as you know we’ve been usually right around that 100% level. It trended up as you mentioned right at the end of the second quarter. Like I said, we’ve always been right around 100%, so obviously we’re comfortable there. I think the only possibility for that increasing a little bit depends on our use of FHLB advances. Obviously that kind of plugs the funding gap if we have one as we move forward. So it’s just kind of – its going to be that play between what we can grow from the net loan standpoint and see what we can continue to grow on the local deposit side. But I think on an overall basis that 100% to 105%, we are comfortable there and I think for the most part that’s where you can expect us to be.

Okay, alright. And then what does deposit betas look like this quarter for you guys?

Yeah, I think they are pretty similar. As I mentioned in my prepared remarks, our cost of funds as a percent of average earning assets to the other half of the margin were about four basis points. On an overall basis I think we are up five. The quarter before, it flip flopped that around maybe. Don’t really see any significant change there. Certainly as the fed continues to raise rates and it’s a very competitive environment out there, we’ll continue to certainly see some pressure, certainly on time deposits, public and others. Borrowed funds, you know FHLB, goes right off the LIBOR curve and our trust preferred are tied right at our 3-month LIBOR. So far we haven’t had to touch a large percentage of our consumer deposit products. We have had to touch on occasion our business, non-CDs, non-time deposits, but not any significant degree. So if the marketplace stays consistent, I would expect our cost of funds to continue to go up there four of five basis points a quarter.

Okay, perfect, perfect. All my other questions have been asked and answered. Thanks guys.

Thanks Dan.

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

Yeah, thank you. That concludes our conference call. Thank you for your interest in our company and we look forward to talking to you again at the end of the third quarter. Thank you again.

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