First Commonwealth Financial Corp (FCF) 2015 Q3 法說會逐字稿

Welcome to the First Commonwealth Financial Corporation third-quarter 2015 earnings release conference call. (Operator Instructions). Please note this event is being recorded. I would now like to turn the conference over to Ryan Thomas, Vice President of Finance and Investor Relations. Please go ahead, sir.

Thank you, Chad. 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. We have also included a slide presentation on our Investor Relations page with supplemental financial information that will be referenced throughout today's call.

With me in the room today are Mike Price, President and CEO of First Commonwealth Financial Corporation, and Jim Reske, Executive Vice President and Chief Financial Officer. After brief comments from management we will open the phone call to your questions. For that portion of the call we will be joined by Bob Emmerich, our Chief Credit Officer, and Mark Lopushansky, our Chief Treasury Officer.

Before we begin I would like to caution listeners that this conference call will contain forward-looking statements about First Commonwealth, its businesses, 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 statement. Now I would like to turn the call over to Mike Price.

Hey, thanks, Ryan, and welcome to our third-quarter earnings conference call. Jim Reske and I appreciate your interest and investment of time in First Commonwealth.

Our earnings of $0.14 per share in the third quarter fell short of our expectations and particularly following earnings of $0.15 per share in the second quarter and $0.16 per share in the first quarter. Let me begin by briefly sharing some highlights for the quarter and then, just as importantly, our path forward.

On a positive note our loan portfolio grew $80 million or over 7% annualized in the third quarter. The commercial side of the Bank was the catalyst with our commercial real estate portfolio growing $74 million and the CNI portfolio growing another $27 million for the quarter.

I would also add that our commercial loan growth in 2015 has been balanced geographically with opportunities in Western PA, Cleveland and the Columbus market. With CRE growth has also been balanced by project type to include multifamily, office, hospitality and retail.

The second highlight is just simply our margins have stabilized over the last five quarters. Together stable margins and loan growth add up to top-line or net interest income that is beginning to grow and exhibit positive operating leverage.

Our third-quarter noninterest income fell largely due to a quarterly fair value adjustment on interest-rate swaps that Jim Reske will elaborate on. The linked quarter swing here was large and roughly $1.4 million. However, as we take a step back, noninterest income to include wealth revenue, some fees, deposit fees and interchange have strengthened throughout the year. Expenses are flat year-over-year and overcame some unusual items that Jim will also elaborate on.

An important item this quarter is credit. Provision expense increased $1.6 million to $4.6 million. In short, this increase is largely due to a $6.1 million loan to a manufacturer whose revenue stream is tied to steal and mining. Although our NPL and NPA numbers are still very favorable, we saw some stress in select C&I credits.

Even though we do not have a lot of exposure in oil and gas, the low energy prices have had an impact on drilling activity in our footprint. This dampened results for the companies that provide ancillary services for drillers. We've also seen a handful of companies impacted by the recent volatility in commodity prices.

The path forward for us financially is clear. First we will continue to focus on growing our top line and really realizing the investments in commercial banking, Columbus, Cleveland and mortgage banking. We have some good momentum here and I will just mention four items.

Commercial thinking is performing well and has a deep meaningful pipeline. Anticipated draws on already approved quality construction projects represent 100 -- over $100 million in future takedowns. Wealth is turning the corner and both trust and brokerage income are improving. [Traxman] mortgage is driving gain on sale income.

We have also had nice recent wins with hires in that business. The mortgage business also pushed through the breakeven point in the third quarter after making their first loan just one year earlier. We are also optimistic about continued growth in traction in Columbus and Cleveland.

Our First Community acquisition closed on October 1 and the system conversion weekend is set for November 6 and 7. We have already attracted a good corporate banker as the bank president and a high-performing mortgage loan officer.

The second focal point in the path forward, and particularly important in this environment, we'll have to be steadfast with expenses and continue to reconfigure work in certain areas. We need to pay for investments and keep expenses flat to down. This will be hard work but we are committed to it.

Third, we need to have consistently lower credit costs and they are vitally important to any bank. Despite strain and a handful of credits I would be remiss if I did not share that our total delinquency percentage for the portfolio in NPAs and NPLs are really at 8- to 10-year lows.

A couple of other items that may be of interest to investors -- we had success this quarter in executing on various digital and payment initiatives. The team rolled out several new global enhancements including consolidating our mobile remote deposit capture and person-to-person payments into our mobile banking app and adding some other functionality with mobile. We also enabled Apple Pay and started to issue our EMV chip cards.

So we had a lot of activity and I continue to be pleased with how quickly we can bring new features and solutions to the market. Our effort last year to successfully roll out our technology platform and get the requisite savings has allowed us to invest in these new features in addition to adding a mortgage banking group and complete insurance company acquisition while keeping our expenses flat. So with that I will turn it over to Jim to some more detail and color commentary.

Thanks, Mike. The third quarter was impacted by three items. First, we settled a disputed tax assessment with the state of Pennsylvania which increased non-interest expense by $709,000.

Second, we performed our usual quarterly mark-to-market of our swap positions which resulted in a $783,000 reduction in non-interest income. Since this was a positive adjustment of $593,000 in the second quarter, the linked quarter swing was a $1.4 million headwind.

Third, provision expense reflected specific reserves for two commercial credits totaling $2.5 million.

As we mentioned in our earnings release, we are proud to announce the completion of our acquisition of First Community Bank in Columbus, Ohio. The legal closing of that transaction took place on October 1, so the one-time cost associated with the purchase of First Community Bank, which we expect to total about $1.3 million, will be reflected in fourth-quarter results, not third-quarter results.

Now I will turn to the major sections of the income statement. First of all, net interest income at $47.6 million was up over the linked quarter and the same quarter a year ago. Strong loan growth of $80.1 million in the third quarter helped offset lower loan yields and maintain net interest income.

Our net interest margin in the second quarter was relatively stable at 3.25%, down only 1 basis point from the linked quarter and from the year ago period. The overall yield on earning assets was unchanged. Lower yield on loans were offset by higher volume and conversely lower volume on securities was offset by higher yields. Yields on newly originated loans were actually up in the third quarter compared to last quarter, but not enough to offset the effect of runoff yields.

Overall loan yields declined 5 basis points primarily due to negative commercial loan replacement yields which stands in contrast to the positive commercial loan replacement yields that the Bank experienced in the first two quarters of this year. However, the margin benefited from an improvement in the mix of earning assets and securities were only 21.5% of average earning assets in the third quarter as compared to 24% in the second quarter. And the yield on the securities portfolio improved by 9 basis points.

The total cost of deposits declined from 16 basis points to 15 basis points over the quarter. Total deposits decreased by $48.6 million over last quarter due to a $36.9 million decrease in more expensive time deposits, of which $11.4 million was the intentional runoff of broker time deposits. Non-interest-bearing demand deposits increased by $9 million over the prior quarter and by $82.2 million over the prior year and currently comprise over 25% of total deposits.

Loan loss provision expense of $4.6 million in the second quarter increased by $1.6 million over the linked quarter primarily as a result of a $600,000 increase in general reserves and $2.5 million in specific reserves on two commercial loans, as I mentioned earlier. Nonperforming loans fell by $4.3 million to 89 basis points of total loans, down from 1% last quarter, and nonperforming assets fell to 1.13% of total assets down from 1.16%.

The reserve coverage of nonperforming loans increased from 106.3% last quarter to 118.8% this quarter. The Bank's ratio of reserves to total loans increased to 1.06% at June 30 -- at September 30, excuse me, and its general reserves as a percentage of non-impaired loans was relatively unchanged at 97 basis points.

Our non-interest income continued to experience positive underlying trends despite the impact of the fair market value adjustment of our swap positions mentioned earlier. We saw increases in a number of fee line items compared to last quarter including trust, deposit service charges and mortgage banking.

Mortgage has added $1.9 million in gain on sale income year to date. When compared to the third quarter of last year mortgage, insurance and retail brokerage and debit card interchange fee income have all shown improvement.

As I mentioned, fee income was negatively impacted by our normal quarterly credit revaluation of swap counterparties. This swings from quarter to quarter and as a result of the swaps we have in place on approximately $395 million of commercial loans. These loans have desirable variable-rate exposure and at originated generated swap fee income, but our exposure to the swap counterparties must be mark-to-market every quarter to reflect their fair value.

This quarter the swap adjustment was driven by a 40 to 50 basis point increase in corporate bond spreads which in credit terms increases the calculated probability of default of the swap counterparty. The adjustment was also driven by a 47 basis point decrease in 10-year swap rates between June 30 and September 30, which increases the calculated loss given default because it would hypothetically make it more expensive for the counterparty to unwind the swap if they did default. Despite this mark-to-market adjustment we are encouraged by the steady underlying growth trends in fee income.

Turning to non-interest expense. Our total non-interest expense decreased by $400,000 compared to last quarter. But the quarterly comparison is strongly affected by two items in the second quarter: a $1.1 million write down of a collection of REO properties and a $400,000 write-down for the sale of a building. Third-quarter expense was also impacted by the shares tax settlement I mentioned earlier.

Adjusting for these items, quote/unquote, operating expense was $39.2 million in the third quarter, relatively unchanged from $38.7 million in the prior quarter and below our $40 million target. In fact, we have been able to achieve positive operating leverage over the past year as operating expense was up over $100,000 over the third quarter of last year while revenue was up by $900,000 over the same period.

Of course operating expense is a non-GAAP concept and a full reconciliation to GAAP figures can be found on page 12 of our earnings release supplement which is available on our website. In other news, our effective tax rate was 29.35% at the end of the second quarter. And with that we will take any questions you may have.

Operator, questions.

(Operator Instructions). Bob Ramsey, FBR.

First question for you. Could you just remind me what it is that drives the Pennsylvania share tax expense? I am sure we have talked about it in the past. I just -- I don't have a good sense of it in my mind today.

Yes, actually, I can give you some detail. But you have to bear with me because it is -- there is a little bit of detail behind it. We actually issued trust preferred securities in 2008. And this capital is accounted for as minority interest in a non-controlled subsidiary since it was issued through a trust just like all trust preferred. And at the time of issuance this was not included in the total equity capital line on the Bank's call report and so it wasn't subject to the Pennsylvania shares tax, which taxes capital.

In 2009 the call report format was modified and a new line item was added called Total Bank Equity Capital and that line did include minority interest. The state of Pennsylvania assessed shares tax on us for the years 2011, 2012 and 2013 based on that figure. We argued that the shares tax was never intended to collect tax on minority interest since minority interest was specifically excluded from total equity capital at the time the tax statute was drafted. And we are very confident we will prevail on the merits.

So we paid the tax and appealed but we didn't believe any loss was probable at all. And in addition, no cases on this issue had settled in Commonwealth Court in Pennsylvania through the end of the second quarter. But during the third quarter that court settled its first case with this issue which set the precedent for all the other appeals of this issue going forward.

And now as near as we can tell, because some of this isn't public, this issue really affects about -- only about six banks in Pennsylvania. And in the third quarter three of these banks settled with the state. So as soon as that happened our counsel advised us that regardless of our confidence of prevailing we are unlikely to achieve any better result than the settlement. So we settled for 2011-2012 and we accrued the full cost for the 2013 settlement even though that remains pending. But all of it now has flown through the income statement.

Hey, Bob, this is Mike. This is the separate issue from the shares tax issue and the stalemate between the state legislator and the governor. And this has been on and off the table, an increase in shares tax for Pennsylvania banks, and that will play itself out over the next quarter or two, I am sure.

Okay, great. Barring any change in the tax assessment rate without the sort of one-time true-up here, what is the right level for us to think about that tax on a forward basis.

The overall Pennsylvania shares tax?

Yes.

I think it -- I latest we have heard from the state legislature is that it is going to -- [as it relates to polls] it remains unchanged. I think the latest press with the governor taken out of his latest tax proposal. So we are hoping that remains unchanged, although I do think it is still open to debate.

I guess what I am -- maybe I will ask it a little differently. Assuming it is unchanged, I mean is about $1 million a quarter the right level for First Commonwealth just sort of looking back historically?

Yes, that is. $4 million a year, $1 million a quarter.

Perfect. Shifting gears, net interest income, certainly nice to see a little bit of loan growth this quarter. As you all kind of talked about, securities balances were lower and so you didn't see as much growth in earning assets. Just curious how you are thinking about that mix shift trade off on a go-forward basis. Is the plan to continue to sort of bring down security balances or are they at a level that they are flat or up from here? Or how are you thinking about overall earning asset growth?

Well, the securities fell in part because at the time there really wasn't an attractive alternative that we could purchase at what we felt was an acceptable yield. I think ideally we would probably keep them flat or let them leak down a little bit, but really continue to grow our loans at a similar clip to this quarter.

Yes that is right. I mean the preference long-term is to have a better earning asset mix by having good solid loans that replace securities over time. Particularly in the third quarter we had about $125 million of very low yielding agency securities that were called and the yield on those were sub 1%.

And so with those off the books that actually increased the securities yield. We also had a little bit of success on purchasing some municipal securities and looking through into the fourth quarter we picked up some municipal securities from our acquisition of First Community in Columbus so that should help the securities portfolio yield a little bit.

Okay, great. And obviously on margin, as you guys highlighted, you have certainly gotten to a level where it looks like there is a lot more stability there which is nice to see. The mix shift helps. I mean in the current rate environment until the Fed does whatever it does is maybe a basis point of compression a quarter a good way to think about give or take the trajectory?

Well, I think the way we think of it is not a kind of steady trend of 1 basis point compression a quarter but rather bouncing around a little bit in the mid-3.2 range. So right about where we are in the 3.2s. As we talked about on the past couple quarters, some of this is just reflected by the replacement yield picture which just swings, it changes quarter to quarter. So if the Fed doesn't move and there is no change in rate picture I think it is going to hover right around in that range.

Yes, and we have been a little asset sensitive and we have taken a little duration and we are putting about 20% of our mortgages on the books. And then as well as we are taking a little duration on the commercial real estate at five to six years and that has been growing nicely.

So, I think we will be able to combat that somewhat, Bob. And if you look at it over the last five quarters, I think we had one quarter that was an outlier with the Federal Home Loan Bank dividend, but otherwise it has been right in the [3.22 to 3.25 or 26] I think is the range.

Yes.

That is from memory.

Yes, okay. No, that is right, it makes sense. That is good; I will hop out and give someone else a chance, I may hop back in. Thank you.

John Moran, Macquarie.

Hey, just on OpEx, and you kind of alluded to it here in your prepared remarks. But a pretty good outcome here this quarter, sub 40. Is 40 really -- and I think you sort of said book is going to be a challenge, but we are steadfast here. We want to see it flat to down. 40 is still the kind of -- the bogie, right? I mean, that is what we ought to be thinking about in terms of run rate there?

It has been the bogie this year. Obviously we just did an acquisition which will change things a little bit going forward. So, if there is new guidance we can give you that next year. But for now we are still trying to absorb those new costs through running as efficiently as we can.

And then with the mortgage business, as we ramp up there to our plan there could be some pressure on that. We are going to try to take some future costs out to compensate for that and pay for that investment. But we are trying to keep it tight and as flat as we can.

Okay. And the first community adds, if I am remembering correctly, about $1 million a quarter. And then you guys were targeting a conversion in -- sometime in November, is that correct?

Yes, we are going to convert here in 10 days and in terms of the numbers around First Community --.

It is not $1 million a quarter of NIE, of non-interest expense, it is probably more like $500,000. I mean -- it is a relatively small acquisition, so we're going to try to be as clear as we can on the overall financial impact. I think what we said at announcement is that it is about $0.01 a share accretive.

Right.

So, $0.01 a share overall is $1.2 million, $1.3 million of net income a year in our share base. But it just gives us a strategic access to the Columbus market what we expect to grow.

Right. And we will have -- we have 25 corporate bankers now and we have added three in Northern Ohio and we are looking, we have one and looking to add another one in Columbus and really supplement a pretty robust portfolio of probably over $200 million in Central Ohio and now well over $100 million in Northern Ohio. So we like our traction there and so we are adding some cost, but we really, in that business and corporate banking, we really expect some nice operating leverage and growth.

Okay, that is helpful. I just wanted to kind of circle back on the replacement yields. And I think they were running north of the book yield for the first half of the year and then we dropped down a little bit here. Is there anything going on with either mix or is this just general competition that you guys kind of follow in the market?

Actually in this quarter our gross yield on the loans went up, but the loans that fell off were just higher yielding than in prior quarters. So that differential was greater even though the fact that I think this past quarter our three-month average, particularly on the corporate side, is really out running our 12-month. So -- do you have the number?

Yes, I do. So like the just sort of new volume origination for the total loan portfolio we put on loans in total at 13 basis points higher rates in the third quarter than we did in the second quarter. So, that's good.

This loan replacement yield story really reflects some of the lumpiness we have with prepayments in the commercial portfolio. So, it can be positive for a couple quarters and then negative for a couple quarters. A lot of that -- like we have talked about many times, a lot of the portfolio, about $1.3 billion of the total $4.5 billion of loans is linked to LIBOR. So, when rates rise we will be in a good position.

But the replacement yield story is really not so much driven by contractual pay offs in a way that you could see a slow and steady path that you could predict, it is really driven by prepayments and that is more difficult to predict. So we think it will bounce around a bit.

Got it, that is definitely helpful. So the actual production yields were higher linked quarter, it is just that what fell at was even higher?

Yes.

Okay. And then the only other one that I wanted to kind of circle back on, and you guys sort of hit it, around credit quality and some weakness in manufacturing tied to mining, not a big direct oil and gas exposure, but second order kind of outcomes. And any sort of additional sort of color that you could provide around that would be helpful.

Yes, the Company that we had the allocation on just is a manufacturer of engineered type products and their sales have really dropped precipitously. They'd sold primarily to steel and mining and they have gone from -- probably been cut in half and over a two-year period they went from probably 10% margins to break even and now showing a little loss, they have a little leverage on their balance sheet and they are working through it.

They put a little equity in, maybe $1 million or so. We have a $6 million loan here now with a $1.9 million allocation. This is a Company that a lot of us on the team knew 20 years ago and you just work with them and we worked through it. And so, we have probably another story like that that is probably a company a third the size and that was the other part of the specific reserve, about a $600,000 reserve on a $1.6 million loan.

And so, just seeing a little strain there. It doesn't mean the companies won't work through it and we won't be able to work with them. But you have seen commodity prices, aluminum, petroleum, drop 20%-25% in probably the second quarter. And it is just spilling out on some good companies that have some leverage.

I was just going to add, you will see some disclosure on this in the 10-Q that we published, as we have in past quarters. But just to give you a picture overall, we talked about overall exposure to oil and gas at $145 million, that is total commitments. Actual outstanding loan balances are about $70 million. And about 81% of those are not to direct [oil and gas] exploration, they're to the ancillary businesses as Mike talked about.

Yes.

And within that is really only about 4 credits that are all past rated and about $40 million worth in the ancillary business sector that we think might have some exposure here to lower oil and gas prices.

That is helpful. And then just kind up a follow-up to that. In terms of second order sort of spillover impact just in general slowness with completions down and rig count dropping off a cliff and everything else. Are you guys seeing a lot less activity in that part of the footprint that is impacted or is it still reasonably healthy and things that have been drilled are kind of continuing to produce obviously?

Yes, just two thoughts there is the pipeline infrastructure has probably -- there's still a nice investment there. I think once that dot is done it could be a little bit more of a drop-off, actually. But there has been a precipitous drop in drill count nationwide and in our part of the vineyard. And what has voided a bid is just the pipeline infrastructure. So in 5 or 10 years -- 3 years you can get the gas out of the field. And there is significant investment there still.

Sure, okay. Got it. Thanks very much for taking the questions.

(Operator Instructions). Collyn Gilbert, KBW.

Just a follow-up while you are on the track of the credit discussion. Do you happen to have or can tell us what the reserve is on those $70 million of outstandings tied to oil and gas?

I can't do that probably on the fly.

Okay.

We probably can get back to you on that or I will see you within a week here.

Okay, all right. All right, that is good. And then just on the credit discussion, I think it has been -- I think almost every quarter I think so far this year there has been somewhat of a specific reserve added to the portfolio. And I know that the narrative is it is kind of one off, there are certain situations here and there.

Is that how you feel as you look into 2016? Or I am just kind of curious how kind of the trends that we have seen thus far this year maybe impact how you are thinking about things next year?

Great question, Collyn. I think that when you look at the complexion of our portfolio on the commercial side, which is about 62%-63% of the overall portfolio, it is pretty equally split between commercial real estate and C&I. And on the commercial real estate side these are good times. And so, we don't have I think any nonperformers right now in commercial real estate. And we have underwritten pretty tightly through the cycle.

On the C&I side we are seeing just a little dishevelment with oil and gas and I think it is just the nature of C&I, there might be more little cuts and bruises. I think it is really caused by commodities and commodity prices I think this year. I think until probably the first quarter of last year or so there was still a little bit of a spillover from the last lending cycle. That is pretty much all gone.

But I think it is the nature of C&I in that portfolio that when we -- if we get into another commercial real estate cycle I think I like having the C&I asset. It is a little harder work, you have to have a secured credit department to follow it. But I think it is probably a more consistent stream of credit costs.

Okay, okay, that is helpful. And then just on the mortgage banking line, the $1.2 million that you guys put up this quarter, was that all mortgage banking or was there a commercial loan sale in there? Or I'm just trying to think about that line going forward and the growth.

Yes, about -- a little over $800,000 of that was mortgage banking. There was a resolution of the prior credit that was a gain on sale from some OREO properties about [350] or so.

So as you look at that line year to date, I think Jim nailed it, it is 1.8-1.9 of that [2.2]. And we are portfolioing about 20% selling about 80%.

Okay. And your expectation is that application volume and origination volume will still be as strong in the fourth quarter and kind of in the out quarters just given what -- some of the internal initiatives that you all are doing?

Yes, we are probably at a rate right now of $35 million to $40 million a quarter and we feel that that will continue to grow and should accelerate a bit with the acquisition in Ohio and some talent we have gotten there. And as we look to next year we think the purchase refinance mix and the portfolio and sale mix will stay about the same.

Okay. Okay, great. Thank you very much.

(Operator Instructions). Bob Ramsey, FBR.

Just had a couple things. The increase in criticized loans this quarter, was that sort of some of this commodity driven softness, if you will, or was there anything else in the criticized increase?

It was. There was probably 4 credits across the Bank that had that kind of exposure that we saw some strain with.

Got it. Remind me on fee income, the insurance line I think is seasonally weaker in the fourth quarter. Can you just remind me how much of an impact we should be penciling in there?

I guess I wouldn't characterize it as necessarily it is going to be seasonally weaker for us in the fourth quarter. We've actually tried in that business line to take some of our insurance that we -- agency business that we do for ourselves and spread it out over the 12-month period or move some of that seasonality.

So, with the acquisition we did of the insurance agency last year it is up nicely year on year, but it is probably going to be more of a steady progression in the kind of seasonality you are thinking about going forward.

Okay. No, that is helpful. And I guess looking out there was a lot less seasonality in 2014 than earlier years. So maybe the business has evolved. On the tax line, what is a good tax rate to use on a go-forward basis? You guys have come in a little bit under sort of what I thought these past couple quarters. I am just curious if we should still be thinking 30% or whether it might be a little under that?

Yes, we think our effective tax rate right now is 29.35%. So you could -- if you are modeling about 30% you are probably in the right ballpark.

Okay, that is all I've got. Thank you.

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

Just thank you for your time. I know this is a busy time of the season for you and just appreciate your thoughtful questions and look forward to being with a number of you over the course of the next quarter or two. Have a great day.

The conference has now concluded. Thank you for attending. You may now disconnect.