Mercantile Bank Corporation (MBWM) Q3 2018 Earnings Report, Transcript and Summary

Good day and welcome to the Mercantile Bank Corporation third-quarter 2018 conference call and webcast. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Mr. Mike Houston, investor relations, Lambert, Edwards & 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 third quarter 2018. I am Mike Houston with Lambert IR, 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, Senior Vice President, Chief Operating Officer, and General Counsel. We will begin the call with management's prepared remarks and then open 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 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. Bob?

Thank you, Mike, and good morning, everyone. Thank you all for joining us today. On the call today we will provide an update on our overall performance and financial results along with our key areas of strategic focus. We will also discuss loan development, growth initiatives, and asset quality. Afterwards, we will open the call for a question-and-answer session. We are pleased to announce that our current-quarter operating results represent a continuation of the robust performance demonstrated during the first half of the year resulting from improved operating performance and balance sheet growth. This is evident in the healthy net interest margin, strength of our commercial loan pipeline, which was highlighted by our consistent loan funding and second consecutive quarter of solid net loan growth, along with the continuation of our sound asset quality. We also generated increased fee income in most areas and continued our diligent control of noninterest expense during the quarter. As has been the case year to date, results are also supported by a lower regulatory tax rate. Ray and Chuck will provide more details on all these areas momentarily. Turning to the Michigan economy, the directional trend remains positive. Employment in our primary markets continues to grow and real estate conditions continue to be healthy. These favorable trends, coupled with our value-added approach to banking and our wide array of product and services, have allowed us to successfully attract new customers and retain existing clients. Our strong financial performance during the first nine months of 2018 positions us to meet profitability and growth targets in the fourth quarter and beyond. Lastly, we are pleased to announce an increased fourth-quarter dividend and special dividend as evidence of our confidence in the bank and commitment to enhancing total shareholder value. Our sustained strength and core profitability, sound capital position, and healthy commercial and residential mortgage loan pipelines position us to finish the year in strong fashion and to take advantage of future growth opportunities. That concludes my remarks. I will turn it over to Ray.

Thanks, Bob. During the third quarter, total loans grew by $61 million and commercial term loans funded to new and current clients totaled $119 million. The funding activity is consistent in magnitude with the first two quarters of 2018, contributing to an annualized growth rate of 7.2% during the first 9 months of 2018 and quarterly originations during 2017, which resulted in a growth rate of 7.6% for the year. During the third quarter, the commercial portfolio grew $44 million, complemented by growth in the retail portfolio of $17 million. Included in these numbers is $14 million of loan growth funded by our Troy office, which opened in March of 2017. Note that our pipelines continue to be solid, as they had been through the first half of 2018 and all of 2017. And that our commitments to fund construction projects currently total $152 million. We continue to build momentum in generating noninterest income, with quarter-over-quarter gains in payroll service revenue of 15% and in credit and debit card revenue of 13%. We look forward to growth in these areas for our business and the remainder of 2018 and beyond. Mortgage production increased in the recent quarter and expanded to the highest level in the past three years. Despite mounting headwinds in 2018 related to rising interest rates and a constrained supply of homes for sale, our mortgage team has improved our competitive position relative to the market and increased our market share as a result. The current mortgage pipeline suggests continued growth despite our cautious outlook for the mortgage environment. Noninterest expense grew slightly faster than expectations in the quarter, reflecting increased salary costs, including annual employee merit pay increases and higher stock-based compensation expense as well as pay increases for hourly employees. The wage increase for hourly employees reflects our strategy of reinvestment of a portion of the savings from the Tax Cuts and Jobs Act in 2017 in our employees, customers, and community. Our employees are talented and dedicated and these investments are consistent with our service-based approach to the market. Our third-quarter asset quality performance metrics once again reflect the strong portfolio. Total nonperforming assets are $5.8 million at September 30 or 0.18% of total assets. Our lenders and management continue to diligently manage our loan portfolio, searching for potential signs of stress. Average total deposits during the third quarter were up $68 million compared to the respective 2017 period, reflecting an $88 million increase in local deposits and a $20 million decline in brokered deposits. Average borrowed funds during the third quarter were essentially unchanged relative to the prior-year third quarter. And wholesale funds currently comprise 11.2% of the total funding base. Continued growth in our local deposit base is a strategic priority. That concludes my comments and I will turn it over to Chuck.

Thank you, Ray, and good morning to everybody. This morning we announced net income of $10.1 million or $0.61 per diluted share for the third quarter of 2018. Comparatively, during the third quarter of 2017, we earned $8.3 million or $0.51 per diluted share. Net income for the first 9 months of 2018 totaled $30.5 million or $1.83 per diluted share compared to $23.3 million or $1.41 per diluted share during the first 9 months of 2017. Interest income related to purchase loan accounting entries increased net income during the third quarter of 2018 by $0.3 million or $0.02 per diluted share and net income during the first 9 months of 2018 by $2.7 million or $0.16 per diluted share. During the respective time period in 2017, net income increased $1.1 million or $0.07 per diluted share and $2.6 million or $0.15 per diluted share as a result of purchase loan accounting entry. A bank-owned life insurance claim during the first quarter of 2017 increased reported net income during the first 9 months of 2017 by $1.2 million or $0.07 per diluted share. Excluding the impacts of these transactions, diluted earnings per share increased $0.15 or 34% during the third quarter of 2018 over the third quarter of 2017 and by $0.48 per diluted share or 40% during the first 9 months of 2018 compared to the same time period last year. Net income during the third quarter and first nine 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 year-to-date effective tax rate has been about 19% compared to approximately 31% during the same time period in 2017. 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 while delivering consistent results for our shareholders. Our net interest margin was 3.87% during the third quarter, similar to an average of 3.89% during the previous 4 quarters. Our net interest margin has benefited from the rate hike by the FOMC over the past couple of years and from the recording of interest income, which stem from the periodic successful collection effort on purchased and certain originated impaired commercial loans. Our cost of funds as a percent of average earning assets increased 5 basis points during the third quarter compared to 4 basis points during the second quarter and 5 basis points during the first quarter of this 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 increasing interest rate environment. Excluding interest income associated with purchase loan accounting as well as adjusting for excess liquidity maintained at the Federal Reserve, our core net interest margin for the third quarter of 2018 was 3.83% compared to 3.65% during the third quarter of 2017 and 3.82% during the first 9 months of 2018 compared to 3.65% during the same time period in 2017. We recorded $0.4 million in purchase loan accretion of payments received on CRE-pooled loans during the third quarter of 2018, in line with the guidance figure we provided at the end of the second quarter. Based on our most recent evaluations and cash flow forecast on purchased loans, we expect to record additional quarterly interest income totaling about $200,000 during the fourth quarter of 2018 and throughout 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% during the fourth quarter of 2018 and throughout 2019. This forecast assumes no further changes in the prime and LIBOR rates. Our interest rate risk measurement continue to reflect an improved interest margin and an increasing interest rate environment. The overall liquidity of our -- the overall quality of our loan portfolio remains very strong, with continued low levels of nonperforming loans and loan charge-offs. Nonperforming assets as a percent of total assets equaled only 18 basis points at the end of the third quarter. We have recorded a net loan recovery in each of the 3 quarters of 2018, totaling $1.1 million for all of 2018. Loan charge-offs totaled just $0.2 million during the third quarter and only $1.1 million during the first 9 months. We recorded a provision expense of $0.4 million during the third quarter, in large part driven by commercial loan growth. We expect to record quarterly provision expense of $0.5 million to $1.0 million during the fourth quarter of 2018 and throughout 2019, assuming a steady economic environment. Our loan-loss reserve totaled $21.7 million at the end of the third quarter or 0.88% of total originated loans. This coverage ratio has remained steady for many quarters and no significant changes are expected for at least the remainder of 2018. In regards to CCEL, we expect to have our model up and running by the end of the fourth quarter and plan to run this new model in parallel to our existing model through the end of 2019. We recorded noninterest income of $4.7 million during the third quarter of 2018, lower than the guidance provided at the end of the second quarter. While we recorded increases in most fee income categories as expected, income from our mortgage banking operation came in less than expected, in large part due to a higher proportion of our originated loans being booked to our portfolio instead of sold. In addition, the inventory of homes listed for sale throughout our market, especially in the Western Michigan market, remains low and is negatively impacting our new mortgage loan volume. We expect noninterest income to be in a range of $4.3 million to $4.5 million during the fourth quarter of 2018. We recorded noninterest expense of $21.7 million during the third quarter of 2018, slightly above the guidance provided at the end of the second quarter. Currently, we expect quarterly noninterest expense to total $21.5 million to $21.8 million during the fourth quarter, with our effective tax rate remaining about 19%. While we expect a special $0.75 per-share cash dividend we announced this morning to have an approximately 40-basis-point negative impact on our bank's regulatory capital ratios, we remain a well-capitalized banking organization. As of quarter end, our bank's total risk-based capital ratio was 12.8%, and in dollars was approximately $87 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. At this point, we will open the call up to the Q&A session.

[Operator Instructions]. The first question comes from Brendan Nosal of Sandler O'Neill & Partners. Please go ahead.

Just wanted to start off on loan growth here. Looking at the quarter, things seemed really, really solid, especially within C&I. Just hoping you could add a little bit more color on the overall lending environment. What are customers saying to you guys? What pockets of the footprint are performing the best today? So anything you could add there would be great.

Yes, this is Bob Kaminski. I will make a few comments and then Ray can chime in if he has additional things to add. But yes, we had another really good solid quarter with net loan growth. Fundings are consistent with what we've seen throughout the course of the last many quarters. And it really reflects our relationship banking model doing business as our lenders are getting some really nice opportunities with new and existing clients in all of our markets, most especially in the Western Michigan area, where we have our largest concentration of commercial credit. Again, continues to look very solid with our pipeline for the coming quarters. And getting some really good opportunities on all different kinds of loans, but most especially in the commercial industrial arena with lots of new loan opportunities and opportunities with potential new clients in that loan type as well. So very positive. I think as we talked about the past, we didn't experience an extreme amount of loan pay-offs in the third quarter, which certainly benefited those fundings dropping to the bottom line in terms of net loan growth. But as we have in the past, we always have been very consistent with our fundings and that's reflective on our relationship banking method of doing business.

I would add to that, that it's a reflection of the fact that our calling officers have been calling for a long period of time and building relationships with the C&I market. And those have continued to bear fruit and have steadily added to our opportunities as they have in the past. So we continue to have a real consistent flow of opportunities that we've been able to take advantage of.

All right, great, great. And then moving over to the expense side, it looks like the new range for the fourth quarter is a little bit higher than what you'd offered previously. If I recall correctly from the last call, it sounded like just based on the way that accruals are going throughout the year, it sounded like you could even move to the midpoint of that old range. I'm just kind of wondering how things have evolved over the past 90 days to get you to the new range for the last quarter of this year.

Yes, Brendan, I think it's just more of a reflection of reality that's going through as we continue to build our Company and which include making sure our facilities are up where they need to be, our technology is up where it needs to be, adding more and new people to our staff as they become available. So I think there's expenses, as you said, and I indicated they are higher than what we had expected 90 days ago. But what I like about the increases in expenses is they are all related to supporting our continued growth. And we continue to look at all of our technology and our facilities with a long-range vision. And we know that making some investments today are going to pay off, not necessarily in the current quarter with the associated expense, but in the future years as those facilities, that technology, and the people that we add to our group will obviously enhance our income as we go down the road.

All right. That all makes sense. And then last one from me, moving over to the capital side. Definitely nice to see the announcement of the special today and also the increase in the regular dividend. Just curious to hear what led you to this decision. And then looking forward, is it fair to think that at a TCE ratio of roughly 10% like this quarter, you guys might think about getting creative again?

Brendan, this is Bob Kaminski. I will answer the question first and Chuck can chime in on the backend. But it's something that we with our Board have conversations with all during the course of the year. As you know, we get this question every quarter since the previous special dividend, which was about a couple years ago now. And we look at in terms of our overall profitability, how our capital base has continued to increase and strengthen. And so we saw it as a great opportunity to reward the shareholders with not only the increased quarterly dividend, but the special dividend at the end of the year. So it's part of our capital planning process that we continue to do on an ongoing basis and the Board as well as management felt it was time to go down that path this year.

All right, great. Thank you for taking my question.

The next question comes from Kevin Reevey of D.A. Davidson. Please go ahead.

So a first question is the impact from the tariffs. Are any of your business customers feeling the impact from that? And then do you anticipate that to have any negative impact on your business if the tariffs continue to remain in effect over a longer period of time?

This is Bob. I will answer the question first. I think all of our customers are keeping a close eye on the economic situation as it pertains to the tariffs and I think people are still trying to sort out how it may impact them. It seems to be a changing, evolving situation on a daily basis as you see some new agreements coming into play, some other areas where it's not looking as promising at the moment. So I think it totally got the attention of our clients and certainly us as well as we look to have them help us understand their business model and how these various situations may impact them from a sales standpoint and from a supply standpoint. So yes, on that, I think everybody is just really in a wait-and-see mode at this time to determine what's coming down the road.

And then Ray, earlier in your prepared remarks, you talked about your strategy is focused on growing local deposits. Can you give us some color on that and talk about the competitive environment for growing local deposits?

Yes, the local deposit environment is very competitive. But what we've really focused on is making sure that our loan opportunities and our deposit opportunities are coupled, that when we do one, we get the other. And that's been very effective. The cash management tools that we bring to the market have also helped us bring in the requisite C&I deposits that go along with that loan growth in that particular category. So the investments that Chuck talked about earlier, some of those reside in those categories and have helped us to continue to grow that deposit base. And we compete very well with the regional and national players as well as the community bank players that particular market.

Kevin, this is Chuck. If I could just add on to Ray's comments more specifically to a particular market, and that is the public unit CD market. That is one that we definitely want to be competitive and we want to maintain relationships, especially with those municipalities that do additional business with us. Maybe they have their core operating checking accounts with us, maybe they have some savings or money market deposits with us. But that has -- and I think I've said it several times on previous calls. That is one market that has been incredibly aggressive on pricing from a competitive standpoint for at least two years now. And that's not changing and I think it actually is a little bit worse as we sit here today. So in general, for those municipalities that are just looking to place CDs, we're not being very competitive because I don't think that the rates are appropriate. They are getting very, very close to brokered and wholesale funding rates, which don't make very much sense to me. But again, those that we have more relationships with -- again, other deposit relationships; sometimes we have some loan relationships -- those we continue to actively manage, make sure we are competitive in the rates that we're offering. But the net of all this is that we have seen a rather significant decline in our balances on public unit CDs. And the nice thing is, per Ray's comment, we've been able to offset the vast majority of that with increases in operating accounts from the C&I customers that we have brought over. So we are down to only about $60 million, $65 million in public unit CDs. I think most of that is what I would call core, that there are some additional products and services that we have out there with those folks. But obviously, that does play in the overall number, so I wanted to make a couple comments on that when it comes to our net deposit growth. We are doing a very, very good job not only on getting deposits on the C&I side, but also managing our products, managing our marketing to bring in deposits that are long-term in nature and not just trying to bring in deposits at a relatively higher rate and hope that you keep them at maturity somewhere down the line. So again, we continue to focus on that relationship banking and we see a very good progress, certainly not only on the loan side, but on the deposit side as well.

Appreciate the color. Thank you very much.

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

Just a quick follow-up on the deposit commentary. I think your loan to deposit ratio was 108% this quarter. Obviously the impact of lower deposit base and continued strong loan growth. Is there any concerns about that getting to a higher level? Or is there any plans that you could maybe put into place to accelerate the more normalization of that ratio?

Damon, this is Chuck. As you know, we've historically been around 100%, maybe 105%. Relatively high, I think, compared to the industry, but that is a level that we have consistently been at and the management team and the Board feel comfortable with that. We kind of -- not that we ignore that ratio, but the one that we are more concerned about is obviously on the other side of the balance sheet is our loans to assets, our investment to assets. Making sure that we've got sufficient liquidity at the Federal Reserve to make sure that we are taking care of daily fluctuations in our balance sheet. That's the asset side. On the liability side, what we want to do is just kind of manage that overall wholesale funding number. As Ray has indicated, it's around 11% right now and it's been there for quite a few quarters now. And that's the overall way that we manage the balance sheet. I think one of the things that's come into play with the lower deposit is over the past many quarters now, we moved away from brokered deposit from a wholesale standpoint and put more of our money into the FHLB advances. Those -- we try to go long term. If we have to dial for funding purposes, we generally go long term on the FHLB advances. We do fixed-rate bullets and generally four to seven years. And we try to -- on a global basis try to match fund some of the fixed-rate commercial loans that we are putting on our books, which a vast majority of the time are five years and occasionally a seven-year balloon. And what we see in the marketplace on the brokered side is there's not a lot of liquidity out there when you get past even two years. A lot of CD folks don't want to go past that in a rising interest rate environment; they like to stay short. And so what ends up happening is to generate enough money in the brokered market to, say, get a five-year CD, you got to pay out pretty high premium to convince those investors to go a little bit longer. And some of the other banks are out there trying to do what we are doing, is trying to lengthen the duration of our liabilities. So you end up with a pretty high premium on brokered deposits over the FHLB that is quite significant. So it doesn't make any sense to go get brokered money that's more expensive versus the FHLB money. But again, per your point, it does have some play into the loan to deposit ratio.

What I'll also add, Damon, that, as Ray talked about on the loan fundings and the opportunities there on the C&I side, we're very excited. Because with those new C&I relationships, we're also coming in some cases some significant deposit relationships. And so our continued focus on bringing C&I into the bank is going to benefit us not only from the deposit standpoint, but from the treasury standpoint. And they all kind of fit together with our technology investments that we continue to make. So from a long-term view, I think we're very excited. And as Chuck talked about from the wholesale funding standpoint, it supplements those fluctuations and ebbs and flows in the client deposit base.

And then lastly here, Damon, I would just go back to my previous comments about public unit is those relationships we want to keep. We are aggressive on our pricing, but in general, if it's just a CD public unit, we are not [Technical Difficulty] loan to deposit ratio.

Got it. That's great color; thank you. And then with respect to the outlook for loan growth, it sounds like the backdrop continues to be in place. Healthy economic activity happening, pipelines remain strong. Obviously first quarter this year, you saw some outsized payoffs, which put a damper on overall growth, but the last few quarters have been pretty strong. Do you feel comfortable replicating something like this quarter in the fourth quarter from a growth perspective?

Yes, I think from the standpoint of our growth, I think what you'd expect from us is our consistent loan funding, which we typically rip off each and every quarter. But as we talked about in the past, those payoffs, sometimes they don't give you a lot of advance notice. In some cases, clients are negotiating for a sale of an asset, either their business as a whole or a piece of real estate. And many times you don't get significant forewarning on that. So they happen and they occur, but as we talked about in the past, when there are paydowns, they'll just go to the clients of the bank. They typically want to invest in something else, which generally will require a borrowing event from us down the road. So it comes in cycles. And each year, we have a quarter or two where there is heavy amounts of payoffs, a concentration of payoffs, and the timing of which is hard to predict. But I think what you can always count on from us is a good solid loan funding base, which we continue to do each and every quarter, and making our pipeline more confident in those abilities going forward as well.

Good, all right. And then I guess just lastly, on the noninterest income this quarter, the other noninterest income line looked to be a little bit lower than what we saw the first couple quarters of the year. Was there anything unique to that, Chuck?

As you ask that question, I don't have anything off the top of my head. But let me go back to my office and think about that and I'll get back to you. As you might expect, there's just a lot of hodgepodge of different categories that go in there. Nothing comes to mind that is just one item. I can't think of --.

Yes, that's fine. Okay, that's all that I had for now. Thank you very much.

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

Bob, maybe just a follow-up for you on the special dividend. I'm just curious, given the pullback in the stock and so forth, just curious how the Board weighed maybe the special dividend versus potentially a buyback or get more aggressive, given current price levels.

I think the way we view it, as I mentioned on the previous questioners, we look at the capital clients' standpoint on an ongoing basis. And I think the determination for a special dividend in the fourth quarter was something that had been in the conversation for the second half of the year. And I think as far as buybacks and the things that you know that we have those in our quiver of arrows to partake in should those opportunities arise going forward. But it always fits into the overall capital management standpoint and a special dividend was one we've utilized in the past. And we felt with the Board that it was time to do that, given our capital levels and our continued strong profitability.

Yes, and I would just add to that, John -- this is Chuck -- is that our resulting capital ratios are still very sufficient for who we are and what we look like and what we want to do from an organic growth standpoint. But we still have some dry powder, plenty of dry powder in there in the event that we do want to start buying some of our stock back, depending on what the price is doing. Obviously down at some of the levels that it has unfortunately been at over the last few days, it's getting more to the point where that might be something that we might want to do. But as you might expect, we've been in a blackout period and we will be here for the next couple of days. So we continue to look at our stock price on a regular basis. Though we got the stock buyback plan out there and that is something that we can certainly avail ourselves if the timing comes out right.

And Chuck, remind us what's left under the current plan. Is it --?

There's about $20 million left, I believe.

Either $15 million or $20 million, one of those numbers.

Okay. And then just one other question, guys. I guess it was last week, there was a deal announced in your Michigan markets, MDTF. Just any thoughts there, any opportunities, so forth?

I think from an M&A standpoint, as we've said on past calls, we continue to be interested as potential acquiring targets become available or if and along those lines we build relationships with failed bankers in our region. And as we talked about also in the past, culture is extremely important to us. And so as we look at potential partners from an acquisition standpoint, the culture is something that we are very picky about and very specific about that it has to be a good match for us. And so that is the overriding factor as we look at potential targets from an M&A standpoint.

Okay, fair enough. Thanks, guys.

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

Thank you. We want to thank you for joining us for the third-quarter conference call. We look forward to talking to you again in January. This concludes the call.

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