First Commonwealth Financial Corp (FCF) 2011 Q2 法說會逐字稿

I would like to welcome everyone to First Commonwealth's second quarter 2001 earnings conference call.

At this time I will turn the call over to Rich Stimel, Communication Manager at First Commonwealth. Rich?

Thank you. As a reminder, a copy of today's earnings release can be accessed by logging on to fcbanking.com and selecting the Investor Relations link at the top of the page and then selecting News on the left-side of the page. We've also included slide presentations on our Investor Relations page with supplement financial information that we will reference throughout today's call.

With me in the room today are John Dolan, President and CEO of First Commonwealth Financial Corporation; Mike Price, President of First Commonwealth Bank; Bob Rout, Executive Vice President and Chief Financial Officer; and Bob Emmerich, Executive Vice President and Chief Credit Officer. After brief comments from management, we will open the call to your questions. Before we begin I would like to caution listeners that this conference call will contain forward-looking statements about First Commonwealth, it's business, strategies and prospects. Please refer to our forward-looking statements disclaimer on page 2 of the slide presentation for a description of risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements.

Now I would like to turn the call over to John Dolan.

Thank you, and thanks for joining us this afternoon, everyone.

Yesterday we announced our second quarter financial results. While we are encouraged by the fifth consecutive profitable quarter, earnings have remained tempered. Market loan demand is generally low and we continue to work through credit costs. Our earnings performance largely reflects both the progress we've made and the challenges we faced. It seems to be almost unanimously held view that the banking landscape has fundamentally shifted. With that shift, comes the uncertainty of new regulations and the ever-changing competitive environment. A question becomes exactly, how different will the new operating environment be and when will we get there?

Regardless of the depths and duration of these changes, First Commonwealth will continue to focus on the areas we believe that will allow us to thrive in the long run and provide consistent and growing earnings. As we near the completion of our balance sheet restructuring, we are pleased with the improved mix and reduced credit risks in our investment and loan portfolios. We've also mitigated our liquidity risk and at the same time effectively maintained our asset sensitivity interest rate position. The stabilization of our earnings allows our capital position to improve as well. All of this was done as we look closely at what has transpired and what we anticipate will transpire from the regulatory standpoint.

We refined our policies, practices and our business model accordingly. We have allocated significant time and resources to assessing of our governance and risk management infrastructure. And we believe this will serve as a good foundation no matter what the future holds. Even in the areas that are proven to be the most challenging, we continue to make progress. While the overhang of our credit expenses has dampened earnings, we stay true to our more stringent risk appetite guidelines that we've established. I mentioned earlier there are plenty of economic headwinds remain. And this obviously makes it tougher to grow loans. We anticipate loan growth will be a challenge throughout 2011, but year-to-date we have grown C&I loans roughly $30 million, and that was partially offset by a significant decline in investment real estate.

Nonetheless, our loan portfolio's decreased significantly since June 30, 2010. It's also worth noting that the relative stability of the housing and employment market in Western Pennsylvania has been a positive dynamic for the consumers and businesses in our region. So as challenging as our headwinds may be, our region has been relatively fortunate in some ways.

Like most banks, we've seen larger overhead costs as a result of the evolving regulatory requirement and a collection and repossession expenses. But our continuous improvement efforts have led to process and technology enhancements that have allowed us to serve the customers more effectively without sacrificing the quality of service.

Excluding credit related expenses, noninterest expense has decreased more than $3 million in the first 6 months of the year. At the same time, our customers have indicated higher satisfaction levels, and that started from levels that were high compared to our competitors on average. As we look forward, our brand remains strong and well regarded in our market. Our calling efforts are more disciplined and position us well for small business and middle market growth. Our low cost deposit growth remains strong while we believe the most significant benefits of the development of the Marcella Shale remains in the future. We have seen both direct and indirect opportunities from their retail wealth and corporate banking perspective. The dedicated employees throughout our organization continue to face head-on the challenges of the last 2 years. We still have a lot of work to do, but we believe that our progress ultimately will lead to a stronger institution and a stronger financial performance for all of our stakeholders.

And now Bob Rout will discuss the details of our financial results.

Good afternoon, everyone. I'm going to provide a little more color to the information that's been provided in the earnings press release and also to supplement John's opening overview comments.

Our year-to-date net interest income has decreased $13.4 million for the first 6 months of 2011 as compared to the same period last year. Most of that decrease is the result of the balance sheet restructuring and de-risking that we have done over the past 12 months which resulted in a $610 million reduction in average earning assets. That restructuring included; Holding back on any security leveraging activities that utilized barred funds; Selling off approximately $200 million of municipal securities for tax reasons and credit concerns; Drawing in our credit underwriting guidelines with respect to size, geography and types of lending activities; Changing up the mix of deposits with more transactional accounts rather than single service CDs; and we shored up our capital position with an $81 million common stock rates.

Now, not all of that restructuring has been voluntary, as we have seen some loan run-off with the re-emergence of the secondary market, particularly in the commercial real estate sector. But we really like how this balance sheet is positioned with respect to funding mix, the investment portfolio, interest rate risk, liquidity and capital. Not only does it place us well for any potential economic or credit shocks, it is well poised for an uptick in the economy when that does occur. The remaining piece of that restructuring is working through those large complex troubled loans where progress is being made.

Our net interest margin rate declined by 7 basis points between those same 6 month periods. Some of that is the result of removing higher risk investments from our portfolios. Some of that is the result of some new loan yield pressures as the competition heats up for the few quality new loan deals that are out there in the market today. And some of that we believe is temporary caused by a 6 basis point decline in LIBOR rates this past quarter. 23% of our commercial loans are LIBOR-based.

Bob Emmerich will talk in detail about credit issues this quarter, but I did want to note one change in the accounting for nonperforming, Cold Trust Preferred Securities. This is a small, technical accounting issue, but I wanted to head off any questions. The industry has been struggling for a consistent accounting treatment of nonperforming, full trust preferred securities. And the issue is, does nonperforming TruPS get reported as a nonperforming asset, or is this classification already accomplished in the other-than-temporary impairment process? We have $17 million of such securities.

Recent guidance we've received in the case that the industry is moving towards not including these securities as a nonperforming asset. Plus, from a practical standpoint, this just means that the interest received from these securities now get recognized in the income rather than as a reduction to principle. We had $1.5 million of security gains this past quarter from the sell of our [Parkville] stock following the announcement of their merger. It's also worthy to note that for 3 consecutive quarters we have not experienced any additional, other than temporary, impairment on our trust preferred portfolio, and that makes us at least hopeful that issues with that portfolio have stabilized.

In the fee revenue area. We like all banks are feeling the effects of new regulations and changes in consumer behavior with respect to NSF revenues. Card interchange revenue has continued strong, steady growth. This is now an $11 million to $12 million annual revenue line item for us. We are still going through the analysis of how recently implemented federal rules are going to impact this product.

Some other restructuring efforts that have been going on in our wealth management department. Those efforts include reconfiguring product lines into teams that can deliver comprehensive and customized financial plans and solutions, enhanced training and new pricing schedules. These efforts in combination with the little Marcella Shale stimulus are now starting to take hold as evidenced by a $600,000 year-over-year increase in trust revenue.

2 other areas of note and noninterest income is a $1 million gain on a private equity investment with one of our corporate finance clients. And partially offsetting that gain is a $500,000 reserve on the market value of a commercial loan swap that went into nonperformance status this past quarter.

We continue to make great progress on our efficiency initiatives with a 93 average full-time equivalent staff reduction year-over-year and actually 138 positions through the first 6 months of this year. Here too, as with the balance sheet restructuring, we are approaching that initiative in a rational and a methodical manner. Across-the-board cuts are easy, but during the operational efficiencies with a more surgical approach, it leaves the organization in a better and more sustainable position.

Every functional area of the Bank is being reviewed, and the opportunities are large. Our overriding theme for these reviews are that we first and foremost, want to look for ways that make us easier to do business with than the competition. If we can do that effectively, the numbers will fall in place naturally. Despite this progress, noninterest expense was negatively affected by $900,000 of severance cost, ongoing costs of working through the large troubled debts, and a $4.1 million charge down on an Oriole property. We are targeting this property for sale at auction in the third quarter.

Lastly, we always get questions on effective tax rates, ours is currently 21.3%. So with that I will turn over the discussion to Bob Emmerich for a recap of what's happening in credit.

Thanks, Bob. In the second quarter, first Commonwealth continued to make progress in improving its asset quality, although there are still challenges remaining. Some of the signs of progress, the level of classified loans dropped $61 million to $307 million. There were no significant loans that became newly classified in the second quarter. The Bank completed foreclosures on 3 investment real estate loans and transferred those assets to OREO moving those assets further down the path to resolution. Those assets included the West Palm Beach property we have disclosed previously, the office building in downtown Pittsburgh we have disclosed previously and a western Pennsylvania medical office property. We returned the $12 million loan to a landfill in western Pennsylvania to accrual status, although the loan terms will keep this loan classified as a TDR.

Despite these positive movements, total NPAs were up $18 million. We placed a $14 million substandard C&I credit on nonaccrual and the provision for that loan was increased by $4 million. This borrower provides computer consulting services to government entities.

Two substandard investment real estate loans, both approximately $5 million, had balloon payments that came due during the quarter, and both loans were extended. Those extensions triggered classifications as troubled debt restructurings. Both loans have been amortizing and the extensions continued the same amortization payments.

Other items, the Bank took a write down as Bob mentioned of $4.1 million against a food processing plant that has been in OREO for 2 years. That write down was the result of new appraisals received, and the carrying value was reduced. We have been marketing this property since we acquired control of the plant in February from a previous lessee. If the sale is not concluded from those efforts, we plan to auction the property in September. We continue the work out of a large relationship with a real estate developer in eastern Pennsylvania who is involved in apartment and lot development. During the quarter we charged off a $1.2 million unsecured line of credit. We placed a $3 million mixed-use property on nonaccrual and we increased the reserve on an $8.5 million lot development loan due to the receipt of a new appraisal. This relationship consists of multiple projects with different ownership structures. Each project is evaluated separately on its own merits and receives treatment appropriate for its status.

The net charge-offs for the quarter were $10.7 million versus the provision expense of $9.1 million as the Bank took charge-offs on 2 loans that had previously been provided for. The $1.2 million unsecured line of credit mentioned above and $2.2 million was charged off on the $8.6 million land development loan in Nevada. That loan continues to carry a reserve of $2.4 million. The ALLL at quarter end was $75 million, or 1.88% of total loans. The reserve coverage of nonperforming loans was at 51%. That coverage ratio has been impacted by the Bank's practice of writing down its nonaccrual commercial real estate loans to the as is value of the collateral, and the impairment analysis of the bank's TDRs.

For loans that have payment streams, the impairment analysis is based on discounted cash flow rather than collateral shortfall. The reserve level for those loans is typically lower than what would be required from an analysis of collateral shortfall. In summary, the bank is making measurable progress on resolving its asset quality issues, although there are still problem credits whose resolution could resulting volatility to its operating results in future quarters.

I will now turn it over to Mike Price.

Thanks, Bob. My focus this afternoon will be primarily the commercial loan portfolio. We've experienced a $225 million in loan balance runoff this year. Of that, $162 million was commercial. And as Bob Rout just touched on, this has strained spread revenues. It will take time to safely build these balances back to where they were prior to 2010. In terms of loan contraction, we feel some of the same headwinds we felt last quarter, namely first, our loans are being originated and reviewed within a lower risk appetite. More appropriate for a Western PA Community Bank. We are adhering to an approach that we laid in place 2 years ago, which includes loan size, geographic and concentration limits, particularly in commercial real estate.

When we look at the decrease in the commercial portfolio since the peak of $450 million or so, a considerable majority of this decline stems from reducing the risk profile of our loan portfolio. Some large second, some large quality borrowers have refinanced in the conduit markets, or just simply deleveraged as a result of stronger balance sheets. For us the amount of payoff activity has been unprecedented by historical standards. Third; soft demand. Fourth; exiting the traditional closed and mortgage business some years ago as we've talked about. That adds about $20 million per quarter to runoff. And to a lesser extent, fifth, the workout of large nonperforming credits has contributed roughly $30 million to the runoff in the last 6 months.

Despite these commercial loan headwinds, we are seeing signs that portend well for the future. On the commercial side, our C&I loans are growing, in quarter-to-quarter, and attrition in the rest of the commercial portfolio has slowed. We've booked roughly $200 million in new volumes through the first half of the year which compares very favorably to $70 million at this time last year. And this has occurred without a palpable increase in demand. The improvement is a function of strengthening the team, strategic focus and really better sales and service rigor.

While we are not excited about some of our quality customers paying off some larger loans, as I mentioned earlier with the conduit market springing up, there still good customers and we will have the opportunity to lend to them again. This too I think will reach its natural conclusion. Lastly, we are seeing fundamental improvement in the overall mix of the portfolio as the new loans have been decidedly C&I as opposed to commercial real estate.

We are oftentimes asked how much of the commercial loan activity can be attributed to the Marcellus Shale. It's becoming a meaningful number for us. We are probably 15% of commercial and small business success can be traced back to the Marcellus Play. And we anticipate this will be a key driver of growth in our region for years to come.

In closing, our revenue engines and retail banking, corporate banking and wealth management are more competitive than ever. We feel our credit infrastructure has been strengthened significantly. Of our 3 lines of business, both our retail bank and wealth management businesses are in line with expectations. In corporate banking we have made great strides in building a stronger Pittsburgh middle-market offering that really now includes a capable treasury management function. Objectively, our customer service measures, as John mentioned earlier, are high relative to our competitors and our brand is well perceived in the marketplace.

Thank you for your time and interest in our Company. And we will turn the call over to the operator and open it up for questions.

We will now begin the question-and-answer session. (Operator Instructions) Our first question comes from Bob Ramsey of FBR. Please go ahead.

Hi, good afternoon, guys. I was hoping you could give me a little of more information about the piece of REO that you all have taken the $4 million charge on. Maybe give us some indication of how large the asset is overall, when it was originated, when it was last appraised and whether, I guess when it was moved into REO and valued. Was it valued based on market values or anticipated cash flows?

This is Bob Emmerich. I wasn't here at the time it was moved in, but I don't recall the exact amount it went into OREO. But it has been in OREO for over 2 years now. And the most recent - - we get a new appraisal every year. We appraised it this past June, and that resulted in the $4.1 million write-down. Could you restate your question again?

I guess that's most of it, even without knowing sort of the exact size of it. I mean, is it a $10 million loan, or $20 million loan, or a $5 million? Can you give some sense of the size? And then when it was appraised last year? Was the carrying value based on an appraisal based on market values, or based on maybe cash flows if it's a piece of commercial real estate?

The valuations both this year and last year were based on market value, not cash flows.

And without disclosing exact amounts, since we are going to put it up for auction, I'd say it's mid-teens is probably as close as I would like to get on the relative size of the credit. Does that help?

That does help, that does help. Thank you. And I guess with it being in REO for over 2 years, I'm guessing this has been something where maybe something has fallen through in the past or has it been just been a very difficult property to move? It would seem to me that's a long time to hold a piece of REO.

We entered into an agreement with an entity that operated in the plant, we had a lease. It was expected to be a lease purchase agreement, and that did not come through.

We decided to market it and sell the plant, but we had to get the lessee out of the building first. So, we had to go through the legal process to do that. So, that's why this has been a longer term REO asset than what you would normally expect.

Fair enough. I guess this quarter there was another increase of about $7.5 million in REO as well. Could you talk about maybe what moved in there this time?

We had 3 significant - - reasonably significant pieces going in for about $12 million. 1 is the office building in downtown Pittsburgh that we've previously disclosed. And then also the land down in West Palm Beach, which we previously disclosed.

We had a smaller medical office building that went through foreclosure, we took into REO. That was the total of $12 million, and with a $4 million write-down it was a net $8 million increase.

Last question and I will hop back up. Last quarter you all had indicated that you would like to have loans over $15 million sort of managed down to a level of about 50% of risk-based capital. Could you just maybe just give us an update with what those balances are today and where you stand for that cycle?

We are still making progress on that goal. We've reduced those balances to about $398 million, which gets us to about 58% to 59% of risk-based capital. So, we've continued to make progress on that, but I think we are probably getting to the point where we feel it's an appropriate level. And probably won't be an impact to our loan growth, going forward.

Okay. And are you guys anticipating that you will be able to see some modest growth in the back half of the year?

I think - - this is Mike. I think we will be flat to up slightly.

Okay. Thank you guys.

Thanks, Bob.

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

Hi, good afternoon, guys. How are you?

Great, Damon, how about you?

Great. Thanks. I kind of have some more of a theoretical question here. What are your thoughts on trying to aggressively go after the nonperforming loans you have by doing some sort of a bulk loan sale and kind of clearing house at 1 point? Do you talk about the opportunity that you have with the Marcellus Shale.

You talk about your strong capital position in the investments we made in the franchise to kind of capitalize on that market dislocation and organic opportunities from the Shale activity. It seems like a lot of your energy and resources are being continually sucked up by dealing with these ongoing credit issues. What is the thought process here of trying to just clean house and get rid of everything all at once so you can move forward?

That's a fair question, Damon. I think it seems like our energies are sucked up in these credits because that is what we focus on when we get on these calls. But, reality is we have a team that works on those. It's different than the team that goes out and works on loan growth. We will always continue to look at strategies to reduce those credits.

1 strategy would be to liquidate a group of those loans. Others we've looked at and will continue to loan-by-loan. And at this point in the cycle, it doesn't appear that it's the right thing to do for the shareholders yet to sell them at such a discount that the market pricing them at. So, we will continue looking at it, but we don't think this is great point in time to do that.

Okay. As for your concentration risk does, I apologize if you've answered this question. But where do you stand at the number of credits that are greater than that $15 million threshold?

Yes, Bob Emmerich. We are trying to focus on the excess as a percentage of capital and not units so much anymore, so I don't know if we are disclosing the units per se. We were down on the excess from $435 million, down to $398 million. It stood at 59% of risk-based capital and our goal there was to get down to 50%. So, we are continuing to make progress on that, and that's where we are at.

Fair enough. I guess the last 1 on loan pricing. Could you provide a little color as to what you are seeing in the market as far as competition and levels of pricing?

The pricing hasn't changed - - this is Mike. The pricing really hasn't changed the last couple quarters as I mentioned on a prior call. We kind of saw pulpable [sic] downshift in pricing about a year ago. In fact, in August of 2010. But through spring and into the summer here, we haven't seen a lot more downward pressure, at least on the deals that we are doing. And it's very competitive. Where we tend to walk is when it gets competitive on structure.

Okay. That's all I have for now. Thank you.

Thanks, Damon.

Your next question, and pardon the pronunciation, comes from Mark Schaefer of Stern Agee. Please go ahead.

Good afternoon, guys. Hi, Mike. I just had a question on the margin. I know you guys stated that a lot of the compression had to do with your average during the assets coming in. But, this last corner looks like your security yield came in very aggressively, and the security's portfolio remained relatively flat. I was just wondering, what did you guys kind of reposition into, or is it much shorter duration?

This is Bob. I think it's just the normal replacement of securities maturing. Well, actually this is the first full quarter of the reduction in those municipal securities as well. Those had a higher yield than putting them into the agencies that we've reinvested in, as well.

But the question was, did it go up?

No, it went down. Yes. Absolutely, the municipal securities would have a big impact.

Was that your question, Mike?

It was. Thank you. As we think about the NIM moving forward, it seems like there is still going to be some difficulty growing the loan portfolio. Should we expect to see the NIM continue to contraction over the next several quarters?

Mike, this is Bob Rout. I think there's going to be some pressure on the NIM, going forward until things settle out with the interest rate environments. We still have some room on the deposits to move down. We are not seeing any upward movements in either bonds or secured replacement securities. Yes, I think there will continue to be some pressure.

Okay. And then just when we look at that $4 million write-down, I'm assuming that cost is then going to come in somewhat next quarter from the current level. That expense has bounced around a lot over the last several quarters.

Are you talking about noninterest expense?

I'm talking about the $4.2 million that was used to write-down the OREO property.

Okay. Well, we had a write-down in the second quarter of last year, $2.2 million, and a write-on this quarter of $4.1 million. I don't think we had anything significant in the last quarter.

As we think about that expense line moving forward, can you give us a little guidance or thought process on what you are seeing? Are we going to go back to kind of that $2 million level, or are we going to stay at pretty significant levels in that $4 million range?

Well, it's hard to tell what these properties are going to be liquidated for. When we bring it into other real estate owned - - that's the valuation adjustment. And then of course when you liquidate it out of there, you might have an additional gain or loss. We write it down to the appraised value, and we think the appraisals are appropriately designed so that it's hard to tell what that number would be, but we think that it's going to be driven by the changes in the ORE.

Okay. Just 1 last 1. You stated as a percentage of total risk-based capital the loans over $50 million are down to 59%. That $435 million, what was that as a percentage of total risk-based last quarter?

64%.

Thanks a lot, guys.

64? Did you get it, Mike.

Thank you.

(Operator Instructions) Our next question comes from Andrew Stapp of B. Riley.

Hi, guys. Mike just ask my remaining questions.

All right. Thanks, Andy.

Sure thing.

Our next question comes from Collyn Gilbert with Stifel Nicolaus. Please go ahead.

Thanks. Good afternoon, guys. Equally, most of my questions have been answered, but just a few additional ones. The loan growth that you guys saw this quarter, it looks like most of it was outside of Pennsylvania. Can you just talk a little bit about what's driving that?

This is Mike. We have a government contracting business in the Beltway, and we've had a deal or 2 there. That would be part of it.

Okay. That's helpful. And then just on the interchange fee, I know you don't fall into the realm of Durban, but it's area that's kind of been growing. At the risk that it trickles down to banks of your size, have you quantified what the potential income loss could be on that line item?

Well, if you listen to the legislators, it's going to have no impact on us, but I think that's unrealistic to expect that. We had done an analysis when the number was $0.12.

That time we were talking about $7 million was the potential downdraft on that revenue line. So, it's probably half of that or so would be reasonable to be what the number is, but it's really hard to tell.

It's hard to tell how fast the merchants are going to be able to switch their models around to prefer a lower-cost provider instead of us. And it's also harder to tell the larger banks are likely to come up with additional revenues to offset that, despite the fact that we don't have a reduction yet theoretically. We will still be able to take a look at some of those increases so, what's offset -- or we might be able to have the offsets before we have the reductions.

Okay. That's helpful. Thanks. And then just finally, if you covered this already I apologize, but the $1.2 million in asset sales that you saw this quarter, what was that?

Bob Rout. It was a private equity investment that we had with 1 of our corporate finance customers.

Okay. Okay. That's great. That's all I had. Thanks, guys.

Thank you.

(Operator Instructions) Our next question comes from Mac Hodgson from SunTrust. Please go ahead.

I was going to ask if you're making any product changes to offset kind of regulatory headwinds? It sounds like, John, that you are evaluating it but haven't made any changes yet. Is that fair?

That would be fair.

Okay. And then also any kind of color or opportunities for you guys to make new hires? Obviously, it's a challenging low growth environment. I know you've mentioned a hire or 2 related to the energy sector in prior calls to support the Marcellus Shale. Any other opportunities to go out and be more aggressive on new hires to help loan growth?

Yes, this is Mike. As I mentioned, we were building and have built - - continue to build the middle market lending function in Pittsburgh. I think we are now up to 4 hires in that space year-to-date. So, we've continued to do that and into the second quarter and looking to get another lender or 2 as well. What we feel like we've had some success there.

And in same thing down in the business banking sector. As we had our employee meeting this morning, probably 3 business bankers in the last 2 quarters as well. So, good complement and we seem to be able to continue to attract good talent to augment our business banking and our commercial lending function.

Our business banking would be small business lending.

Under $1 million, and then the corporate is over $1 million, generally.

Okay, great. That's helpful. Thank you.

Thank you.

I'm showing no further questions at this time. So, I would like to turn the conference back over to our speakers for any final remarks they may have.

I think all of you for investing some of your time to take a look at our performance. And I thank you for your questions. We look forward to talking to you again next quarter.

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