Mercantile Bank Corporation (MBWM) Q2 2019 Earnings Report, Transcript and Summary

Good day, and welcome to the Mercantile Bank Corporation Second Quarter 2019 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, Ben. 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 2019. 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, SVP, Chief Operating Officer, and General Counsel. We will begin the call with Management's prepared remarks and then open up the call for 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'd 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, we will provide an update on our overall performance and financial results along with our key areas of strategic focus. At the conclusion of our comments, we open the call for question-and-answer session. We're very pleased to deliver strong operating results for the second quarter and first half of 2019. Our strong financial condition sustains strength in commercial and residential mortgage loan originations and loan pipelines give us confidence that the strong results achieved during the first six months of the year will provide the foundation for solid performance throughout the balance of 2019. The second quarter operating performance includes growth in net interest income, resulting from a higher level of earning assets. Our net interest margin remains strong reflecting our ongoing emphasis on loan pricing discipline, and sound underwriting. Increased non-interest income and well managed overhead costs were also strengths for the quarter's results. Our team's emphasis on building and cultivating value added relationships continues to successfully attract new customers, as well as retain existing clients. We remain pleased with the growth and fee income. The increase in mortgage banking activity income reflects the success of continuing strategic initiatives designed to increase market penetration while almost a jump in refinance activity spurred by the recent decline in residential mortgage loan interest rates. Growth of mortgage banking activity and income through expanded market share remains a priority for the company. Our strong team of mortgage bankers coupled with our wide range of products and services allow us to continue to build deep client relationships. Ray and Chuck will provide more detail in all of these areas momentarily. Turning to the Michigan economy, trends remain steady as deployment in our primary markets continues to improve and real estate conditions remain healthy. We will continue to watch these indicators closely for any longer term slowing or inflection point. The ongoing cash dividend program including the announcement of an increased third quarter regular dividend earlier today exhibits our commitment to enhancing total shareholder return. We remain confident in our ability to optimize future growth opportunities. Mercantile's robust core profitability, strong capital position and healthy commercial and residential mortgage loan pipelines position us well for a solid performance for the balance of the year despite the potentially volatile interest rate environment in which we currently operate. As always, we continue to monitor both micro and macro economic activity and our focus remains on creating and leveraging opportunities whatever the economic climate. We're excited about our ability to expand in our markets and continually improve results in both the near and long term. That concludes my remarks. I’ll now turn it over to Ray.

Thank you, Bob. We pleased with loan growth during the first half and particularly in the second quarter growing at an annualized rate of 9.2%, approximately $134 million and $259 million in commercial term loans to new and existing borrowers were originated during the second quarter and in the first six months of 2019 respectively as our lending teams focused on identifying new customer relationships and meeting the needs of our existing customer base. Our pipeline remains strong and steady as well with $129 million of commitments on commercial construction and development loans to be funded over the next 12 to 18 months. We continue to expand and establish the Mercantile culture within our Southeast Michigan operations and are pleased with the results. In the second quarter, our Southeast Michigan office grew total loans by $23 million. Our asset quality continues to improve as non-performing assets declined to $4 million or 0.11% of total assets at June 30. We delivered non-interest income during the second quarter of 2019 of $6.3 million compared to $4.6 million during the prior year second quarter. Non-interest income during the second quarter of 2019 included a bank owned life insurance claim of $1.3 million. Excluding this item non-interest income still increased a $0.5 million or 10.9% compared to the corresponding 2018 period. The higher level of non-interest income primarily reflects increased mortgage banking activity and credit and debit card income. Residential Mortgage originations jumped 29% from the prior-year quarter which reflects the success of our strategic initiatives to increase our market share. Continuing to enhance mortgage banking income through increased market share remains a priority, and we will continue to hire proven mortgage loan originators as we are able. We expect that the positive trends we experienced in the first half of the year will continue through the balance of the year as declines in residential mortgage loan rates increased refinancing activities and create opportunities to expand our mortgage banking portfolio. That concludes my comments. I will now turn the call over to Chuck.

Thanks Ray, and good morning to everybody. This morning we announced net income of $11.7 million or $0.71 per diluted share for the second quarter of 2019 compared to second quarter of 2018 net income of $9.4 million or $0.57 per diluted share. Net income during the first six months of 2019 totaled $23.5 million or $1.43 per diluted share compared to net income of $20.3 million or $1.22 per diluted share during the first six months of 2018. A bank owned life insurance claim during in the second quarter of 2019 increased net income by $1.3 million or $0.08 per diluted share. Excluding the impact of this transaction, diluted earnings per share increased $0.06 or almost 11% during the second quarter of 2019 compared to the second quarter of 2018. Bank on life insurance claims and a gain on the sales of a former branch facility during the first six months of 2019 increased reported net income by $3.1 million or $0.19 per diluted share, while the successful collection of certain non-performing commercial loan relationships during the respective period in 2018 increased reported net income by $1.7 million or $0.10 per diluted share. Excluding the impact of these specific transactions, diluted earnings per share increased $0.12 or nearly 11% during the first six months of 2019 compared to the first six months of 2018. We remain pleased with our financial condition and earnings performance and believe we are very well positioned to continue to take advantage of lending the market opportunities while delivering consistent results for our shareholders. Our net interest margin was 3.79% during the second quarter higher than the range of 3.70% to 3.75%, we provided in April in large part reflecting strong loan fundings in the beginning of the quarter that resulted in a lower level of excess liquidity, as well as higher than expected purchase accounting related interest income. Our cost of funds as a percent of average earning assets increased 5 basis points during the second quarter of 2019 compared to the 19 basis point increase during the first quarter of 2019. The increase in our cost of funds during the first three months from 2019 primarily reflected a higher level of wholesale funds in a time deposit campaign, while the cost of funds increased during the second quarter primarily reflects a full quarter impact of that time deposit campaign that ended in early April. We had increased our reliance on wholesale funds during the latter part of the fourth quarter and into the first six months - into the first month of the first quarter due to strong commercial loan fundings and seasonal business check-in account withdrawals for tax and bonus payments. As expected, we continue to see a replenishment of fund balances and business checking accounts. Based on our current liquidity position and funding projections it appears that we'll be able to slightly reduce our wholesale funding reliance during the remainder of 2019. We recorded $0.6 million in purchase loan accretion and payment received on CRE pooled loans during the second quarter of 2019. Based on our most recent valuations and cash flow forecasts on purchase loans, we expect to record additional quarterly interest income totaling $0.2 million throughout the remainder of 2019. Also, we expect to receive in aggregate about $1.6 million in principal payments on purchase impaired CRE pooled loans over the next several years which will be recorded as interest income upon receipt. Assuming the FOMC reduces the federal funds rate by 25 basis points on July 31 as is widely expected by market participants, we expect our net interest margin to be in a range of 3.70% to 3.75% during the remainder of 2019. The overall quality of our loan portfolio remains very strong with continued low levels of non-performing loans and loan charge offs. Non-performing assets as a percent of total assets equaled only 11 basis points at the end of the second quarter. Loan charge offs totaled less than $0.1 million during the second quarter and totaled less than $0.3 million during the first six months of 2019. We recorded a small net recovery during the second quarter with year-to-date net loan charge offs equaling less than $0.1 million. Provision expense for the second quarter totaled $0.9 million in large part reflecting commercial loan growth. We expect to record quarterly provision expense in a range of $0.5 million to $1.0 million throughout the remainder of 2019 assuming a steady economic environment. Our loan loss reserve totaled $24.1 million at the end of the second quarter or 0.89% of total originated loans. This coverage ratio has remained steady for many quarters and no significant changes are expected during the remainder of 2019. With regards to CECL, we have now completed our initial framework and we will be working to fine tune that framework and assumptions during the remainder of 2019. Based on initial results, we believe the impact of adopting CECL at the beginning of 2020 will not have a material impact on the balance of our loan loss reserve or our operating results. We previously provided color on our fee income performance for the second quarter and first six months of 2019. I will add that we expect quarterly non-interest income to be in a range of $4.8 million to $5.2 million during the remainder of 2019. We've recorded non-interest expense of $22.1 million during the second quarter of 2019 up about 3% when compared to the second quarter of 2018. The higher level expense primarily resulted from increased salary costs mainly reflecting the employee merit pay increases and higher stock based compensation expense. Currently, we expect quarterly non-interest expense to total in a range of $22.7 million to $23.2 million during the remainder of 2019 with our effective tax rate remaining near 19%. Total deposits increased $156 million during the first six months of 2019 comprised of $99 million growth in local deposit and a $56 million increase in broker deposits. We experienced typical seasonal reductions in business checking account balances primarily in January for taxes and bonuses, while we are seeing the replenishment as expected as well as with account growth associated with new C&I lending relationships. We discontinued our time deposit special in early April and plan to maintain our traditional time deposit pricing strategies for at least the near term. At the end of the second quarter, wholesale funds comprise 17% of total funds up from 16% at year end 2018. The increase reflects an influx of broker deposits and Federal Home Loan Bank advances to fund strong commercial loan growth and the seasonal business checking account withdrawals. Currently, we expect to reduce the level of wholesale funds throughout the remainder of the year and in 2019 around 16%. We remain a well capitalized banking organization. As of June 30 2019, our banks total risk based cap ratio was 12.4% and in dollars was approximately $78 million higher than the 10% minimum required to be categorized as well capitalized. We were not active in buying back our stock during the second quarter, but do have $20 million available in our current buyback plan. Those are my prepared remarks. I'll now turn the call back over to Bob. Thank you.

Thank you, Chuck. That now concludes management's prepared comments. I will now open the call - open for the Q&A.

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

I just wanted to start off on the margin here. Definitely appreciate the clarity on kind of what the first Fed rate cut would mean for the NIM. I mean as we look out past July, it looks like there is the potential for a couple of more rate cuts going forward. I mean is it fair to assume that kind of the 10 basis point reduction in the margin outlook for the rest of this year for one rate cut, would kind of mean the same thing for each incremental rate cut or is the first one a little more painful than the later ones.

You know it's obviously a pretty difficult answer - question to answer only because of the timing and what we can do with deposit rates but with 50% of our commercial loans are floating and looking at the structure of our deposit base, I would say that you know a reduction of 7 to 9 basis points in general would make sense each time the Fed lowers rates 25 basis points at least in the near term. As we go out further we certainly have CDs and some Federal Home Loan Bank advances that were taken out over the years that would reprice to a lower level. So timing is everything. But I would say a 7 to 9 basis point reduction at least in the front end would be logical.

And then moving on I guess just the general health of the economy feels like every article I read and everybody I talked to, it feel that everyone's on a recession watch but every bank that I speak with just said that they don't really see anything in their markets that indicates a turn in the economy. I mean and based on your prepared remarks it seems that you guys kind of feel the same way. I mean is there anything you're seeing that indicates a slowdown at large.

We as we look across our client base and the economy in general I think we are seeing generally the strength that we've seen for the last several quarters. From time-to-time there are pockets of slowness on a one off basis from a client or two, nothing that appears to be systemic or anything on a long term basis but as you indicated we are all on - recession watch making sure that we on the early end of any signs that represents a red flags but we just aren't seeing those right now.

And then last one for me. Just help us understand the fine tuning of the expense guidance. Is this a function of you know adding more mortgage lenders than you would have expected previously or is there anything else going on in the expense base?

No, I think that's most of it. As we got - lenders been in - vast majority of our lenders - mortgage lenders are on commission, so as we see the increased activity we did have to increase the commissions surrounding that but overall it's pretty steady.

Our next question is from Kevin Reevey, D.A. Davidson. Please go ahead.

So Ray or Chuck, I was wondering if you could give us some color as far as what kind of yields are you getting on the new commercial loans that you're booking versus kind of what's on portfolio. And if you can kind of talk give us some color you talked about loan pricing discipline in this environment, if we could get some color on that would be great. Thank you.

Sure. This is Ray. I'd say that in general the new debt that we put on reflects pretty closely what is already on the books, and it's a competitive world out there and we do from time-to-time increase or have to face increased pressures as we price loans. But we take a lot of care to make sure that in each relationship that we enter into that the total package is mutually beneficial to the client and the bank and we look at the whole relationship and make sure that when you take the mix of deposits and fee income and spread that the whole package makes sense relative to return on capital. And as a result, we end up with a fairly consistent yield between the new business that we put on and the existing business that continues to be there.

As you go from client-to-client as Ray said there are some pressures from time-to-time from a competitive standpoint, and while customers understand from our standpoint what we're looking for and they're particularly rate sensitive, then we see an opportunity to look and see if there are more deposits that can be brought over from the relationship or other services that we could engage them in to generate some additional fee income, and other ways to keep our overall customer profitability where it needs to be, but still remain competitive from a pure rate standpoint on the credit.

And then you had some pretty strong growth on the non-owner occupied loan category. Can you talk about what type of non-owner occupied loans you're booking and kind of the structures there?

The portfolio is generally kept the same proportions that it's had in the past. And you know owner occupied, non-owner occupied the terms remain consistent with what we've done in the past. Our commercial borrowers are trying to be as - commercial industrial borrowers are trying to be as efficient as possible with their space and when they expand it's because they really need to. And so the efficiency and use of this space is really excellent, and as a result it's a pretty strong portfolio, we have pretty strong clients that are expanding.

Our next question is from Daniel Cardenas with Raymond James. Go ahead.

Maybe if you could talk a little bit about your loan growth outlook for the second half of the year, just kind of given strong growth in this quarter, do you think that tempers down a little bit. And then in conjunction with that looking at a loan to deposit ratio of about 110% does that factor in - does that factor into your loan growth outlook in terms of maybe slowing it down a bit?

Our loan growth opportunities we expect to continue to fund loans at a similar pace to what we've done in the past. We've been very consistent over a fairly large number of quarters and what we fund. As always the payoffs and pay downs that we receive in the normal course of business are unpredictable but will occur, and so it's very hard to predict those. But we feel very confident in the backlogs that we have and the outlook that we have that will continue to fund at a pace very similar to what we've funded in the past.

And in regards to the loan deposit ratio, - I know it’s the ratio has looked at a lot and we certainly pay attention to it. We look more at our wholesale funding program on an overall basis, which obviously takes into account the Federal Home Loan Bank advances. And as we've talking before, we made it a significant principle and practice on our part is that over the last few years as we were occasionally booking or regularly booking, five year fixed rate balloons on a commercial loan side we wanted to make sure that we from a portfolio basis matched funding that. As we look at the cost of Federal Home Loan Bank advances versus broker deposits, and that four to seven year category which is where we generally go. It was probably on average 20 basis points to even 40 basis points cheaper to take down FHLB advances versus broker deposits. So that obviously helps our margin we're doing the right thing from a longer term perspective and doing some match funding. But when you do calculate things like a loan to deposit ratio, obviously it has a negative effect if you will results in that ratio being relatively high versus if we would have gone more to the broker deposits. So I think it's - that 110% you know we've always been and Dan you know, we've always been a bank that's probably been between 95% and 105%. So we're comfortable with that. I think any deviation from that general range is more reflection of how we're managing our wholesale funding program more than anything else. On an overall basis the structure of our balance sheet has stayed quite consistent over time.

And then just jumping over to credit quality I mean it doesn't look like things can get too much better than where they stand right now. Is there any sector of the loan portfolio that's causing you any concern or you're beginning to pay maybe beginning to pay a little bit closer attention to.

You know as you said on prior calls this year and last year, we've continued to diligently monitor the portfolio. The numbers really speak for themselves as far as the strength and our assessment of we feel the quality of the portfolio. Doesn't mean that we're not looking for issues and making sure we're staying plugged in very closely to our borrowers looking for signs of stress and strain. But I think the quality of the portfolio reflects the management team and our lenders diligently administering the portfolio and the overall strength of the economy which continues to be quite high.

Then last question for me in terms of just capital utilization I know you guys didn't buy back any shares this quarter, is that - was that just purely a mathematical decision based decision?

Yes. This is Chuck, Dan. One of the things when - when we look at our capital ratios, we know that's probably a little bit on the high side. Obviously we want to have some powder for our growth. Want to make sure that we've got sufficient capital if the economy is slowing down. Just want to make sure we got sufficient capital for any of those types of periods. We talk about M&A before. We're not very - we definitely look at any books that are provided to us. But don't have a strong interest in doing M&A but if we did, it would be helpful to have a little bit excess capital on our balance sheet to help that potential transaction. But I think you know we realize we're a little bit on the high side. As a reminder, we were relatively aggressively buying back our stock in the fourth quarter of last year into the first couple of weeks of this year and at the same time we did the special dividend in the fourth quarter. So we have paid attention and we continue to pay attention to our capital ratios. And I am sure all of you saw, we did replace our existing stock buyback plan with a new one and the reason why we did that was there are old ones or the existing one at the time was only down to about $6 million and availability. So we went ahead and did a new plan for $20 million that we - that terminated the existing plan. So we have the ability to buy back stock obviously, we're taking a look at our - at our price. But thing we also look at is, we do lots of calculations internally. For example, the one that we keep a close eye on is the level of our commercial real estate portfolio as a percent of our risk based capital. Obviously, you get over 300% and there's a whole new layer of scrutiny that is put on by regulators and various investors as well. We're right around 250% on a book balance basis and we stayed there consistently. We kind of like that spot, it will go a little bit higher, but we really don't want to go above 300%. And when we look at our pipeline, we still have some additional opportunities and non owner occupied commercial real estate, we always will. Obviously, we need to be diligent in who we partner with and the pricing and the structure that we do. But so when we look at capital and we're looking at a regulatory capital ratios, looking at tangible, that's very, very important, of course but also some of these other measurements that we do, we want to make sure that we maintain in good stead with the expectations that are out there as well. On a regular basis, we continue to go to dividend about 40% of our net income, which is right now producing a yield of over 3%. So we think that's relatively attractive to existing and potential new shareholders. As we go forward, we're always talking with our corporate board in regards to our capital levels and what we should do with our dividend. Obviously, we've got to talk about the dividend level at least every quarter, but also look at the potential for using the buyback plan doing a special cash dividend those are part of the mix, part of the recipe as well. And they'll continue and we'll continue to take a look at that and again, in relation to some of the other internal measurements that we use capital with.

So it's Chuck kind of summarizes there a lot of things that go into the soup, but regarding capital management is something that we are constantly watching and in conversation with our Board to make sure that capital and all the other levels are at levels that we want them to be at and at the current time and into the future as well.

[Operator Instructions] Our next question comes from Damon Del Monte with KBW. Please go ahead.

Lot of good color, a lot of good questions asked and answered on the call. So just a couple of quick follow-ups. Chuck on the margin guidance, I think you said 370 to 375 that's for the full year from where we are after the first half of the year?

That would be for the third quarter and for the fourth quarter of this year. And that assumes the one rate cut here at the end of July.

Okay. So…

So, yes, let me I should out - since you asked the question Dave, let me add a little color. You know, one of the things that's going to be helping our margin as we continue to see replenishment of our business checking accounts that it's helping to for the rest of this year until we go through the whole cycle again, that is helping to mitigate the - the negative impact of a lower interest rate environment for the remainder of this year.

If nothing else happened, the margin could be impacted by 7 to 9 basis points off of this quarter's 3.79 .But you have some benefit from that offset to that, I guess from the inflow of lower cost deposits,

Yes, which obviously our free deposits. And then also, as I mentioned in my prepared remarks, that would help us have some reduction in our wholesale funding program as well.

And then just looking at the loan portfolio, I know it's a small percentage, it's only 12% but it is taking higher - I'm talking about residential mortgages here. What are your thoughts on continuing to grow that segment? Are you trying to kind of leverage the investments you've made in the mortgage area and keep some more of these loans on the books?

You know, what we got to do Damon is relatively simple is, you know, if we're going to make a fixed rate mortgage loan, we want to sell it. And so we'll structure that that we can generally sell it to Freddie Mac or Federal Home Loan Bank. We do have some other private investors that will - buy jumbos and some other things. As we work with prospective borrowers, new home buyers or folks that are refinancing and it looks like, for whatever reason, they're not going to be sellable, we'll go ahead and put them into generally a 5 1 or 7 1 arm and then we'll put those into under the balance sheet. So it's quite rare if we put a long term fixed rate mortgage onto our balance sheet. It's kind of more of the catch basin if you will of those that can't be sold and we go ahead and put them into an arm product. And usually why we can't sell them is generally not a - because of the borrower's financial health, it's usually something to do with the property or some other metric that the Fannie or Freddie or Federal Loan Bank doesn't like. So on a overall basis, you know, we saw a nice pickup in the percentage of loans that were originated during the second quarter that were sellable. I think we're over 70%.We had been running more recently in the last couple of years, around 45% so it's good to see that. We would rather be able to sell every mortgage loan that we make. But we know that that's not possible but if it's not possible, we have the ARM products that we can put our folks into and put those on the balance sheet, you know for that five or seven year period when they'll probably look to refinance or look otherwise, and maybe at that point in time they'll be sellable loans.

Our next question is from John Rodis of Jenny. Go ahead, please.

Just a quick question, I guess just loan flaws. What percent of your loans have flaws on them and I guess how far down your rates have to go before they sort of kick-in in general?

Yes, I don't think, you know, we've gone you know, occasionally we've gotten some flaws I think rates would have to go down a ways before some of them started to kick in. That was something that, you know, we were trying to get into loans as we saw rates going up, knowing that at some point rates are going to go down. But that makes for a little bit of a difficult discussion with the borrowers but rates are going up. Why are you asking to put floors on. So we do have some, I don't have the actual mathematics in front of me but my guess, just from looking at the loans, the way that I do, John, is that it's not a high percentage and that it would take some cuts before we start hitting those floors.

Okay, so probably what, less than 20% Chuck or.

Yes, I would say it's probably a pretty good number and it would probably take three or four rate cuts before we start seeing the impacts of those.

Yes. So down 75 or 100 or something.

Yes. When we start seeing the impact.

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

Thank you very much for joining us on the call today and for your interest in our company. We look forward to speaking with you again in October. So the call is now concluded. Thank you.

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