Good morning, and welcome to the Mercantile Bank Corporation First Quarter 2020 Earnings Results Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mike Houston, Investor Relations. Please go ahead.

Thank you, Grant. Good morning, everyone, and thank you for joining Mercantile Bank Corporation's conference call and webcast to discuss the company's financial results for the fourth -- for the first quarter 2020. I'm 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; and Ray Reitsma, President of Mercantile Bank, Michigan. We will begin the call with management's prepared remarks and presentation to review the quarter's results then open the call up to questions. However, before we begin today's call, it is my responsibility to inform you that this call may involve certain forward-looking statements such as projections of revenue, earnings and capital structure as well as statements on the plans and objectives of the company's business. The company's actual results could differ materially from any forward-looking statements made today due to the 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 first quarter 2020 press release and presentation deck 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?

Thanks, Mike and good morning, everyone. At the conclusion of our call in January when we told you that we look forward to speaking with you in April, none of us could have imagined how our world was going to change in just a few short months. On the call this morning we will provide details of our performance for the first quarter as usual, but we will also spend a significant amount of time in our comments discussing the items, which we believe will be of interest to you in the wake of the COVID-19 pandemic. COVID-19 has obviously created a life-threatening crisis around the globe. As February ended, it became more and more apparent that the virus was rapidly spreading in the United States and action had to be taken. First and foremost, Mercantile worked expeditiously to ensure the health and safety of our employees and customers and our detailed response is noted on slide 3 of the presentation. As concerns over the pandemic in the U.S. and Michigan started to grow, Mercantile worked to limit face-to-face contact with our customers beginning on March 18 eventually leading us to the full closure of our lobbies beginning -- of our lobbies with Governor Whitmer's stay-at-home order on March 25. Customers are able to continue fulfilling their banking needs with our drive-thru facilities, video banking machines and electronic banking. Since the beginning of the crisis for example, our daily retail online banking logins have almost doubled. Regarding our staff as mentioned on slide 3, since March 23 at any day we generally have over 75% of all employees working remotely from home. And some of the gracious feedback from our customers can be seen on slide 4. As we have discussed in recent years, Mercantile has worked continuously since the…

Thanks, Bob. Our loan portfolio increased $45 million in the first quarter of 2020 with each of our markets contributing to that growth. Our pipeline remains solid as well with $77 million of commitments in commercial construction and development loans, which we expect to fund over the next 12 to 18 months should a semblance of normal construction activity resumed during that time frame. Our asset quality remains strong as non-performing assets totaled $3.7 million or one-tenth of 1% of total assets at March 31. We recorded non-interest income during the fourth quarter of $6.5 million, up $1.8 million or 38% from the prior year first quarter excluding $1.9 million in non-recurring items related to that quarter. This improved level of non-interest income was largely driven by increased mortgage banking income, reflecting the success of ongoing strategic initiatives designed to increase market share and a higher level of refinance activities stemming from a recent decrease in rates continuing to enhance mortgage banking income through increased market share including an increased share in the purchase market remains a priority and we will continue to hire proven mortgage loan originators when we are able. We also recorded continued growth in the quarter in other fee income categories including credit and debit card income, service charges on accounts and payroll processing fees. Credit and debit card income has trended downward as stay-at-home orders were implemented in March and are scheduled to remain in effect through April 30. The exercise of discipline related to overhead costs as we focus on efficient delivery systems in all of our lines of business remains a priority. The onslaught of the COVID-19 virus provided an opportunity to demonstrate the value of community banking combining high-touch service with strong capabilities. As Bob mentioned our electronic banking capability allowed us…

Thanks Ray, and good morning, everybody. Starting on slide 13, this morning we announced net income of $10.7 million or $0.65 per diluted share for the first quarter of 2020 compared with net income of $11.8 million or $0.72 per diluted share for the first quarter of 2019. Proceeds from a bank-owned life insurance claim and a gain on the sale of a former branch facility increased net income in the prior year period by $1.8 million or $0.11 per diluted share. Excluding the impacts of these transactions, diluted earnings per share increased $0.04 or approximately 7% during the current year first quarter compared to the prior year first quarter. Moving to the slide 14, interest income on loans declined due to the FOMC rate cuts aggregating 225 basis points since the beginning of the third quarter in 2019 with 150 basis points of those cuts occurring in the first quarter of 2020. Interest income on securities benefited from a $1.8 million in accelerated discount accretion from called U.S. Government agency bonds during the first quarter of 2020. In total, interest income was down $0.7 million during the first quarter of 2020 compared to the first quarter of 2019 or down $2.5 million if the accelerated discount accretion is excluded. Interest expense declined in all categories during the first quarter of 2020 when compared to the first quarter of 2019, reflecting the declining interest rate environment. Net interest income declined $0.3 million during the first quarter of 2020 compared to the first quarter of 2019 or $2.1 million if the accelerated discount accretion is excluded. Provision expense totaled $750,000 during the first quarter of 2020, relatively similar to the $850,000 we expensed during the first quarter 2019. We elected to postpone the adoption of CECL as permitted by the CARES…

Thank you, Chuck and thank you Ray. That now concludes management's prepared remarks. We'll now open the call up to the question-and-answer session.

[Operator Instructions] Our first question comes from Brendan Nosal with Piper Sandler. Please go ahead.

Hey, good morning guys. How are you?

Good morning, Brendan, fine and you?

Fine, first off I just wanted to thank you at the level of disclosure you guys offered in the slide deck, definitely very helpful. So on questions too, just starting off on the level of the reserve. I get that NPVs are pretty stable. Charge-offs was really benign and you guys talked to delayed CECL implementation. But I guess even so just kind of looking at the level of unemployment claims coming out of Michigan, it seems like it's one of the harder hit states. So just help me square up kind of the relatively stable reserve level versus the stress that we're seeing in the Michigan economy right now.

Yes. Brendan, as we mentioned, as we all know there are so many moving parts to a reserve calculation. And of course now that we have the incurred model as well as the CECL model. And per my comments, my prepared remarks, we thought it best just trying to manage the process and given the massive uncertainty when it comes to the economic forecasting process, which we all know is a significant impact on the calculations within CECL, we thought it very appropriate to continue to use the incurred model. I think it's served us quite well since we performed back in 1997. And yes, it is an incurred model and it definitely starts with migration. But like everybody else has used the model, we do have the nine reserve environmental allocation factors that we're certainly going to consider and we did consider at the end of March and we did make some adjustments. So we will obviously be relying very heavily on those. And then quite frankly, we need to see how this is going – this environment is going to impact our borrowers over the next – especially in the next couple of quarters. And true Michigan has definitely been hard hit. That was already stated by Bob. But we also note that when you look at Michigan's primary presence, those areas have not been as hit hard with most of the cases being in Southeast Michigan. So there's somewhat of a separation there. But obviously, it does affect the economy for the entire state. One of the interesting things with CECL is that upon adoption our day one calculation actually showed a reduction of our reserve of $700,000. So by not adopting CECL at least out of the gates on a day, one calculation we actually increased…

All right. Thank you so much for of your thoughts there. I certainly appreciate all of the problems of adopting CECL especially in light of an unprecedented environment. Just a follow up to those comments. If we are on the old incurred loss methodology and kind of credit migration it's such a big component of what provision expense in the open reserves should be, I mean could the actions that you guys have taken and other banks have taken, whether it's forbearance or deferrals, does that slow down the trajectory of migration such that reserve building is pushed out even further as those credits are under a deferral?

Yes. I think one of the things I want -- I should have stressed in my long-winded answer to your first question was that our migration -- our bank and many banks, but our bank has had very minimal losses really over the last five, six, seven years and recognizing that and if you go through our migration calculations, there's a lot of our loan categories where even a grade four or five rate loan would have zero or very, very small allocation to it. What we did a long time ago was we actually adopted minimum or deminimis reserve allocation factors for our five primary categories of commercial loan or five primary segments along with each grade. That was quite a significant increase in the amount of cost if you will or the amount of reserve we were required to carry, as part of our migration. So, our migration numbers were very, very small, but we put in place these deminimis calculations. Quite frankly, that was one of the big differences between our incurred model and our CECL model was that the CECL model did not allow for these deminimis or these minimum reserve allocation factors. And if you look at the decline that I mentioned reserve allocations for commercial loans between incurred and the CECL, it was really the elimination of those deminimis numbers. So obviously, we did not feel comfortable with that because we thought, it was very appropriate to include some deminimis numbers in our reserve calculations, given the very, very clean level of our asset quality of our loan portfolio over the last five to seven years, which obviously was driving a lot of our migration. In regards to your second question here, we're going to continue to work with our borrowers. Our lenders are talking to our borrowers on a regular basis. Based on those discussions, if it's determined that we need to downgrade credits, we're certainly going to do that. But it's just going to take a while for this to shake out of it. So -- and every customer is going to be impacted in a very different way. It's very difficult to do a carte blanch. This is what's going to impact everyone and everyone's going to be treated equally or impacted equally that's just not the case. Especially with commercial lending, I think maybe that can have a little bit better of an impact if you're looking at a retail lending base. But in commercial lending, every single borrowing relationship we have is different and it needs to be looked at on its own merits. That's why we have the grading system. That's why we rely on our grading system to really drive our reserve balance.

Yes. Brendan, this is Bob. I'll add to what Chuck said and just reemphasize what he said earlier that, our loan loss reserve methodology has served us very well over the years during good economic times and under challenged economic times. And we'll see how it all plays out with CECL over the next couple of years as to the adoption and the eventual adoption of that by all banks. But we feel really good about our methodology. We feel really good that our customers are very solid going into this crisis. They were across the board. Portfolio had great strength. Customers are performing very well. I think that will serve them and us very well as we work through this crisis and whatever comes down the road as a result of the shutdown of our economy. So that's very fortunate that we had that strength going in. But as Chuck said we'll continue to analyze each customer and look at their situation understanding where their revenues are coming from and the economy eventually gets reopened here in Michigan. And I think the Governor and all legislators are working on that to make sure that we don't go overboard with the restriction, but make sure that we continue to flatten the curve. And I think the results are showing that that's happening. And I think once that proves to be a sustained pattern then you'll start to see some of the nonessential businesses allowed to be reopened back up and that will bring some certain relief to our customers and customers in our communities that have been shut down. And as a result the unemployment numbers are very high. There's no question about that. When you drive through town parking lots are empty. So you're going to have unemployment. But I think the measures will serve us well. The state will emerge from the crisis. And the county will be reopened and businesses back to work and employees back to work.

All right. Perfect. Thanks for the comment. And then last one before I step back. So on the PPP program $500 million of loans approved so far, looks like the average fee is about 2.8%. So just to make sure I have the math right here. That's roughly $14 million of origination fees that you expect to accrete into NII over whatever the life of the loans ends up being. Is that correct?

That is correct. And then we have about $1 million -- and then we have about -- just to add to that we have about $1 million in direct origination costs that we'll defer and net debt with those fees over the life of loans as well.

Got it. Thank you

Our next question will come from John Rodis with Janney. Please go ahead.

Good morning guys.

Good morning.

Actually my question was just asked and answered on the average fee on the PPP loans. But obviously guys a lot of uncertainty and stuff. But Chuck, just curious and I get all the moving parts and stuff. But when you stress the loan portfolio any thoughts on sort of cumulative losses over the next few years?

No. That's -- we've actually run several different models if you will John. We had our -- back in early 2017, we went through a formal -- we hired a vendor to do a formal stress test of our loan portfolio using the stressed environment that the Fed had set out for the DFAST and CCAR testing that year. And we felt pretty good. It didn't surprise us. The results didn't surprise us when they come back. Given that the loan portfolio hasn't changed much in its makeup and its characteristics, we kind of use those same inputs, if you will and we apply it to our current portfolio. We think that that's a sufficient proxy without having to go through the process and the cost of redoing that. And again we think that's a good proxy because of the ongoing similar characteristics of our portfolio notwithstanding the growth. And as you might expect, we definitely see in both the three scenarios the base case the one and two; obviously, we would see an increase in provision expense. Certainly well and above and beyond an annualization of what we expensed during the first quarter. We're in unprecedented time. So it's so hard to put a scenario out there of saying this is what's going to happen. Hopefully this is going to be a relatively -- the depth of it of the environment are going to be relatively short-lived, per Bob's comments, I won't repeat that. I think he's spot on to how long this crisis is going to impact. And again it goes back and not trying to repeat myself to answer another question, but we're a commercial bank and it's going to impact all of our commercial borrowers in a different way. And quite frankly a couple of our…

No. You're right. It's hard to tell what the new normal is going forward. So just switching gears, Chuck, you said that the margin without specific guidance I think you said -- I just want to confirm. You said you expected it to be down in the second quarter and then sort of stable in the second half of the year. And then just to confirm though when you say down in the second quarter are -- is the right way to think about it down from backing out the discount accretion? So, the sort of the core margin in the first quarter was roughly 3.42% I think. So, down from that level in the second quarter?

Yes. I think -- yes, you're exactly right. That's what my comments were relaying was that we had a core of around 3.40% 3.42% and that we would expect further reduction in the second quarter given the fact that the FOMC rate cuts happened in early March. So, we'd get a full quarter of that. Now, having said that, and again, we can go into lots of different scenarios, a lot of our prime-based loans which is half of our floating rate loans hit their floors at the beginning of March. So, not every loan went down by the 100 and some odd basis points -- 150 basis points that the Fed reduced by. And then, of course, my comments on the 30-day LIBOR that was 99 basis points. We already see that LIBOR coming down this month, which I would have expected with some solidification of the markets that are out there. But again lots of moving parts there, so I didn't really want to give specific guidance there just because of all the moving parts. But yes, I would say there's definitely going to be a reduction of our core margin notwithstanding the PPP program in the second quarter compared to our first. But then I would expect again on a core basis to be relatively steady for the rest of the year once we get out of any major changes in any of the indices that support our loans.

Okay. Makes sense. Okay guys. Thank you and be safe.

Thank you.

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

Hey good morning guys. How is it going today?

Hi Damon.

So, quick question for Ray. On the loan growth you saw this quarter in C&I, how much of that was attributable to increased line utilization? And what was line utilization rate last quarter to this quarter?

Yes, Damon, this is Chuck. Of our loan growth, just to kind of back it up a little bit, about half of it was residential mortgage loans basically held for sale portfolio then the other half was net loan growth on the commercial side. I just want to make sure that we got that math right. We saw some increases in line balances towards the end of March, but it wasn't anything out of the ordinary. I don't -- I mean the level of change wasn't anything out of ordinary. We're a commercial bank and we've got lots of lines of credit. So, we see our line balances fluctuating $5 million $10 million $15 million on a day on average. And I would say that while we saw some gradual increases towards the end of the first quarter, it wasn't anything out of the ordinary to what we typically see in a daily basis. And on an overall basis, our line utilization continues to be around 50%. And I would also just stress the fact that our line balances are supported by borrowing formulas. And so while customers may have the need to come in and borrow off their lines of credit and we're more than happy to do so, so long as they're within our borrowing formula. And certainly any slowdown that they may be seeing in their business because of the current environment may have a negative impact on the maximum amount that they can borrow under existing lines. So, again, sorry to say it again but lots of moving parts there. But we have not -- on an overall basis, we have not seen any major spike in line utilization. Of course, $500 million in loan funding to PPP has certainly helped their cash flow situation.

Got it. Okay. And then just to kind of circle back on the PPP. You may have said this and I may have missed this, but the $14 million in fees, obviously, you said $1 million in expenses associated with that. Does that all come in on -- when the loan is originated or is that spread out over the life of a loan? I may have missed that comment.

Yes, we are supposed with emphasis on supposed to get the fee within five days of funding. Although for us we were -- I thought we got to give so much credit to our team in what they've done over the last three weeks to basically work with over 1,500 borrowers and putting the applications through and now we're funding these loans. I think our fundings as of this morning or last night we're up to $485 million. So, we're almost through the initial wave that we've got and we are certainly hopeful that Congress refunds that or put more money into that program because we have more customers waiting. Not $500 million I think we're definitely through the largest amount, but there are other borrowers out there that would like the assistance and we would like to get it to them. What we're finding -- as we find -- what we found getting into the PPP program we're finding getting in the Federal Reserve's liquidity program. And now we're finding -- trying to get our fees is that everyone's trying to figure this out on the fly. So, this is not a criticism of anyone. This is all brand new and everyone's trying to figure it out one step at a time. And so we got through the origination process. Now, we're actually with banks working with the Treasury on getting these origination fees and what type of reporting that we have to provide to them because they don't know the degree that we funded them. They definitely know what we've asked for what our borrowers have asked for and what they have approved. Because the fees are based on when we fund they don't know that. So, now we're finding that there's a reporting mechanism that we need to provide to them that will then initiate them paying us the fees. So, they're supposed to pay it within five days of funding but that assumes that we're providing them that information on that day and there's definitely some catch-up coming with that. Having said all that I would think that we're going to be caught up within the next week or so on that on getting those funds in.

Damon, this is Bob. I want to just pause for a second and follow-up with something that Chuck said. I wanted to give our team here at Mercantile every one on our team's strong thank you and congratulations for being able to work through this PPP process continuing to work through it. We had all hands on deck, you get people from all different areas of the bank regardless of what they did in their regular day job, helping with the process to make sure that we've got these applications in processed entered into the system and approved by the SBA. And we wanted to include some of the comments in our deck just to reflect some of the feedback we have heard from customers that express appreciation some of the things that they heard that were going on at other financial institutions where the process hadn't gone smoothly. And as Chuck said, this is a new process. We're all trying to work through it. But I give tremendous props to the Mercantile team for the work that they did making it as smooth of a process as we could for our clients through some very challenging times for everyone. And I want to just take a couple of seconds to say that because they really deserve it and I can't thank them all enough.

Okay. Great. Well this is another data point as to why community banks are so important to the success of our banking system. So congrats to your team. Just one quick more -- one more quick follow-up question on that. So Chuck, when we think about these fees like have much of them hit in the first quarter? Or do we kind of model in the majority of the $14 million coming in here in the second quarter?

Yes. I mean that's going to be -- the $100,000 question Damon is, we expect -- obviously don't know we've never been through this again. We expect the majority of our borrowers to ask for forgiveness soon after going through their borrowings to pay their salary mortgage payments rent payments and utilities. So when that happens, we would expect that that will be towards the end of May and into June, when they would actually get to that standpoint to that milestone, if you will. So working through the forgiveness, we believe a lot of it will really be a third quarter event. But we definitely would expect that some of that will tail off through the rest of the year. It is 1% financing and I think some of our borrowers will like that and ask for forgiveness later on down the road. We just don't know how they're going to react. We look at ourselves and think okay a majority are going to ask for forgiveness, once they've gotten through the two months of cash flows, but it's hard to know. But my opinion and in doing my internal analysis is that we expect the majority of that to fund through in the third quarter and a little -- most of the rest in the fourth quarter.

Got it. Okay. That's all that I had. Thank you and stay safe out there.

Thank you, Damon.

[Operator Instructions] Our next question will come from Brendan Nosal with Piper Sandler. Please go ahead.

Hey, guys. Just one follow-up for me. On slide 10, you lay out all of the COVID impacted industries. And obviously, it adds up to a decent chunk of kind of the total commercial loan balances. Which of these are seeing the most stress today? And which of these sectors kind of have you guys most concerned as this pandemic plays out over the next few months?

This is Ray. I would say that movie theaters are one key area that we're focused on. They're completely closed and effectively have no revenue. So that will be an area of focus. And restaurants are reduced to drive-thru only in some cases a complete closure and others. So that'll be another. And hotels, hotels lodging are significantly impacted by the inability to move around and travel for business and leisure. So I'd say those three are three key areas.

I will stress though Brendan that as we said earlier, over the years as part of our risk mitigation concentration processes, we look to partner with what we feel are very strong borrowers. And as we commented earlier going into this crisis most of our borrowers were in very solid financial condition and they had the ability to certainly weather the storm probably more so than many other tested clients you could bank in our communities. That said, Ray made some very good points though about businesses are dark right now. And that's why I think people in our state are working very hard to strike a good balance between flattening the curve and reducing the virus, but also making sure that we're not exceedingly harming the economy more than we have to, to accomplish that. So it's a balancing act, but those are all the - we're looking at our entire portfolio because there are some areas that probably the longer this thing goes on we'll have some surprises and some things that will have some unintended consequences from an economic and commercial standpoint, but we continue to monitor the whole portfolio. But we wanted to put this out there for the risk industry that we see are the biggest immediate impact industries of the closures so far.

Yeah, that all makes sense and it's definitely helpful detail. Last one for me. Just looking at new retail payment assistance inquiries, looks like inquiries peaked around the end of March early April then came down. Is that just kind of timing due to when – what payments were due? Is that why that came down? And would you expect inquiries to increase again as we get to the end of April?

I think the way, I would answer that – the way I would answer Brendan is that a lot of people that are either laid off or partially laid off or in some challenged income situation. They want to keep making their payments early and they will – as long as they can. And I think the inquiries at the start were say, hey, what are my options in case I need to go on a payment relief program? And so I think the longer this goes on certainly the more customers you'll have partaking in those pay relief opportunities. So, again, as we said there are a lot of moving parts. A lot of it depends upon the depth of this crisis and the duration of the crisis. And so we've been very pleased with the performance of our clients so far. But certainly the longer it goes on the more they'll be challenged and will also certainly partake more in these relief programs.

Yeah. Got it. All right. Thanks guys. Stay healthy.

Thank you.

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

Yeah. Thank you, Grant. And thank you all very much for your interest in our company and participating in the call today. We hope you and your families stay healthy and safe. This concludes the call.

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