First Commonwealth Financial Corp (FCF) 2016 Q2 法說會逐字稿

Good afternoon, and welcome to the second-quarter 2016 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.

Thank you, Nicole.

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've also included a slide presentation on our Investor Relations page with supplemental financial information, as well as a slide deck for today's branch acquisition announcement, that may 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 statements.

And now I'd like to turn the call over to Mike Price.

Thank you, Ryan, and welcome to our second-quarter earnings conference call. We appreciate your interest and investment of time in First Commonwealth. Joining me this afternoon is Jim Reske, our Chief Financial Officer.

This morning, we reported second-quarter earnings of $0.14 per share, or $12 million, which was in line with the previous quarter. Despite some good underlying performance trends, earnings were negatively impacted by a $7.5 million specific reserve for a mine safety equipment supplier whose revenues are closely tied to the coal industry.

This morning, we also announced the acquisition of 13 branches in Canton and Ashtabula, Ohio, from FirstMerit. This opportunity stems from the proposed merger of Huntington and FirstMerit announced earlier this year. This acquisition brings us $735 million in deposits, and $115 million in consumer and small business loans.

More importantly, these branches will add 34,000 new consumer and business households, and another platform to build upon. We anticipate that this branch acquisition will complement our loan production office in Cleveland, our mortgage loan production office in Stow, Ohio, our bank in Columbus, and our mortgage LPO in Dublin, Ohio. I will begin with the trends in the second quarter, and then speak to the acquisition, before turning the call over to Jim.

Net interest margin remained relatively stable at 3.27% and net interest income grew for the fourth consecutive quarter. Loans grew at 4.2% annualized. As we reflect on the strong growth year to date, the bulk has occurred in commercial real estate to include construction, followed by a modest bump in C&I lending.

Deposits grew 8.6% annualized. Expenses remained flat to down at $37.4 million, despite our continued commercial and mortgage buildout in Ohio. The efficiency ratio fell below 58%.

Fee income increased $1.8 million on a linked-quarter basis. This is due, in part, to improved mortgage gain on sale income, as well as better interchange income and strong corporate banking fees. Our mortgage platform just crossed $50 million in booked quarterly originations, as that business continues to scale up steadily.

Standing in the way of a strong quarter was a $10 million provision expense stemming largely from a $7.5 million specific reserve for a $10.5 million loan to a mine safety equipment supplier whose revenues are closely tied to the coal industry. We were one of four regional banks in a $55 million facility that we moved to non-accrual this past week. The credit had previously been identified as substandard, but was still accruing. This follows several quarters of heightened credit costs that stem largely from the deterioration in three energy-related credits and one steel servicing company.

I cautioned during our call last quarter that we could experience additional strain as we continue to work through a handful of credits that have been negatively impacted by the downturn in energy and commodity prices. This particular credit was the largest of the problem loans that we have been monitoring closely.

Shifting gears to our acquisition of 13 branches in northern Ohio, this is a logical continuation of our Ohio strategy in a contiguous market that we know well. The demographics are similar to Pennsylvania, with a little stronger growth. The execution risk is low; however, we assume some 10% runoff in deposits between announcement and closing.

The branches will provide over $700 million in low-cost funding, enabling us to pay down borrowings, and helping us lower our loan-to-deposit ratio from 112% to below 100%. This opportunity is immediately accretive to earnings with a healthy IRR. We expect to earn back the tangible book value dilution in less than five years.

Like our Columbus acquisition last year, these branches in Canton and Ashtabula will serve as a platform to build our mortgage, brokerage, and business banking capabilities. Once the deal closes, which we expect will occur in the fourth quarter this year, we should have approximately $680 million in loans and $750 million in deposits in the state of Ohio. These 13 branches are appreciably larger in deposit footings than our current average and are already surrounded by mortgage lending offices I mentioned earlier in Stow, Ohio, and a commercial loan production office in Cleveland. This is good, measured progress, considering we hung our first sign on a building in northern Ohio just two years ago with the opening of our business center in Cleveland.

With that, I'll turn it over to Jim.

Thanks, Mike.

We are excited about this branch transaction that we announced this morning and the long-term opportunities it presents. I will discuss the transaction in some detail in a moment, but first, let me say a word or two about the second quarter. Mike has already addressed credit, but a few other items are worth mentioning.

First, spread income was up slightly compared to last quarter, benefiting from strong loan growth early in the year and a relatively stable margin. Deposit growth was actually much stronger than loan growth in the second quarter, reducing the loan-to-deposit ratio slightly from 111.7% at March 31 to 110.5% at June 30. Average loan balances grew by $88.1 million, while total average deposit balances grew by $131.6 million.

Non-interest expense of $37.4 million was down $700,000 from the first quarter, and benefited from the previously announced retail restructuring, which was in full progress in the second quarter. We expect non-interest expense to normalize somewhat in the remainder of 2016 at a level that is still below our $40 million quarterly target before taking into account the effects of the branch transaction that we are announcing today. In sum, our revenue growth, combined with effective cost containment, is helping us execute on our goal of sustainable positive operating leverage, which we've now achieved for four quarters in a row.

Now, let me turn to the transaction. From the moment that we learned about the opportunity to acquire these branches several months ago, we understood that this represented a unique opportunity for the Company in four ways. First, it builds on our successful Ohio expansion strategy and is consistent with our previously announced strategy to expand in contiguous geographies in Ohio, adding to our branch presence in Columbus, our commercial loan production office in Cleveland, and our mortgage loan production offices in suburban Akron and suburban Columbus.

Second, the deposit and loan mix here is very attractive. Only 4% of the deposits are time deposits, and 36% are transaction accounts. The loans we are acquiring are all associated with branch households and have a yield of over 4%.

Third, (technical difficulty) funding to pay down short-term borrowings, the acquisition will result in minimal expansion of our balance sheet. We will, in connection with the transaction, discontinue the remaining authorization on our buyback program; as the transaction is more accretive than the buyback, it represents a more strategic use of our capital.

And fourth and finally, the replacement of short-term borrowings that have a three-month duration with core deposits that have a duration of approximately five years or add to our asset sensitivity. We intend to monetize some, but not all, of this asset sensitivity by moving some of our variable rate assets further out in the yield curve through the use of macro swaps. This is nothing new for us, as we've successfully executed this strategy several times in the past few years. And even after we do the swaps, we will be more asset-sensitive than we are today.

In terms of financial impact, we don't want to explicitly forecast earnings, but I will provide some direction for you. On the revenue side, we are going to replace short-term borrowings with the deposits we are getting here. We are also getting a $115 million loan portfolio, which we will obviously grow over time, so that will provide some additional interest income.

These two items together drive approximately $6.3 million in additional [spread income] in the first year, which we expect will grow over time. We anticipate approximately $1 million of additional spread income from the macro swap strategy that I mentioned earlier, along with roughly $0.5 million of accretable yield.

We expect to see incremental fee income of approximately 1% of total deposits. And on the expense side, we expect that this will add approximately $6.5 million to $7 million of operating expense annually, in addition to amortization expense associated with the core deposit intangible that we will be creating here.

The result is a transaction that strategically is a perfect fit, and financially is quite compelling. Mike already mentioned that it is immediately accretive to earnings, and provides a healthy IRR. The transaction also provides a meaningful improvement to ROA, ROE, and the net interest margin, accelerating our financial progress.

And with that, we will take any questions you may have.

Questions from the group?

(Operator Instructions)

Our first question comes from Bob Ramsey of FBR.

Hi, good afternoon, guys. On the expenses, obviously, a really good quarter on the expense front. I know you said in the prepared comments that expenses will probably normalize below the $40 million level you all have talked about in the past before adding on the transaction.

Could you just provide a little more detail in where you're thinking about the expense level for your legacy operations? Because you were well below $40 million this quarter, and now that you've got the efficiency ratio, really in the mid 50s, Where does that normalize a little bit higher here too, or how are you thinking about efficiency today?

Well, we are probably down about 118 FTE year-over-year. That's in part due to what we're doing at our branches and our transformation there with our staffing model, and we expect that we'll staff up a little bit between -- will probably take half of that 118 back. And we are looking really to pay for our investments to include this acquisition, and I think Jim, we're estimating this is going to add about $6.5 million in costs that will really hit the ground in the first quarter of next year.

Yes, so hopefully we can compensate for that and still be around the $40 million mark.

And as we get closer to closing that acquisition, we'll provide further guidance to the extent that we're able to. And so there's always a little bit of noise going on in the non-interest expense and different things, so it's hard to pin it down to the dollar. And I know we've been below our $40 million target, so when we say below $40 million target, you can think of that as a $30 million, $40 million kind of range for the normalized non-interest expense.

There was some benefit this quarter as this whole retail restructuring was unfolding, as Mike just mentioned, there's going to be some additional hiring that's going on. So it will normalize a little bit higher than that, but not tremendously so. And then we expect to use those savings and enable us to hire other people and pay for those other investments in the business going forward.

Okay, great. And then I know you've talked today and in the past about realigning the branch, staffing, et cetera. Think you guys said with the branches you're acquiring that there are not any planned layoffs. I'm just curious how the staffing model in the First Merit branches compares with where you guys are going or you've gotten to at First Commonwealth?

They have more staff, but they also have more customers per branch in transaction, and they also have a very nice, robust non-interest bearing and savings book of business. They have very little time, and I just think they're running almost $60 million per branch, or about $57 million, $58 million. And we are really running well short of that, probably just a little over $30 million.

Yes, I'd say something like a little over $40 million.

Yes, and so they will need a little bit more staffing, and we'll keep that staffing in place at least for a year.

Okay, great. And then I know you talked about with using this to deploy capital, that you were going to scale back or discontinue share repurchases in the immediate term. What is the pro forma TCE when the deal closes? Do you have that number by any chance?

Yes the pro forma tangible common equity ratio will get close to 8%. It looks like the deal will have about a roughly 60 basis point impact on tangible common equity. Now we're going to make a little money and retain earnings between now and the end of the year because we expect to close this transaction in the fourth quarter, but there will be definitely impact on tangible common equity.

Got it. Great, thank you very much for taking the questions.

Thanks.

Our next question comes from Matt Schultheis of Boenning.

Hi, good afternoon.

Hi, Matt.

Away from the deal a little bit, you did have very strong deposit growths in the quarter and just was wondering if you could shed some light into whether you're running specials, whether you've got some new relationships that brought in large balances or what the drivers behind that were.

Really two things. We've really refocused our branch staff on deposit gathering, quite simply. We also hung a little rate and then we pulled back the rate pretty quickly, and we were just testing the price elasticity of deposits. But that was probably two-thirds of the growth and then probably the other one-third was just more accounts. We grew our households, I think in the second quarter, about 67 basis points, or almost 1%, which was a nice outcome as well.

Okay, and then back to Bob's question about branch staffing. As we look forward, can we -- and excuse me if you're already down this path a little bit, can we expect some more technological advancements? We're seeing smart kiosks being put into certain branches and other technologies that are effectively replacing branches.

Have you started down that path? Can we expect to see more of those investments, if you have, or what's your attitude about them?

Yes, we just opened a new branch in our downtown Greensburg office that really has enhanced APM and other new technologies for customers. We also are really focused on really getting our mobile or bill payment percentages up in past years, and just really image ATMs will be a big part of the answer.

We're also looking at smaller footprint branches with appreciably smaller square footage, so all of the above. I think the most important piece is to get the staffing scaled to the transaction volume, which has decreased in the branches. That's actually gone up in ACH mobile and another in deposit mobile, deposit capture and in other places.

So just trying to scale it for what the customer preference is. We're also freeing up and we have a close eye on expenses, simply because we have to have continued to invest in digital, which we've done.

Okay, thanks for your time today.

Thank you, Matt.

Our next question comes from Collyn Gilbert of KBW.

Thanks, good afternoon guys.

Hi, Collyn.

Wondered if you could, Mike, just give us a little bit of color as to what you're seeing in the loan growth buckets and what your outlook is there. And if you feel like these deposits -- I know you ran through some of the accretion that you expect, but if you think these deposits could accelerate your longer term loan growth views. But just curious to get a little more color there on the loan side.

Yes, I think the branches will help accelerate our loan growth in Ohio. I think the slide deck that we provided you, we go from about $145 million eight quarters ago to well over $0.5 billion prior to this acquisition, and that's just with four branches, an LPO and two mortgage offices. So we definitely feel that this will help us continue that trajectory.

I think as we look at the texture of the loan growth, I would say admittedly over the course of this year in particular, it's been a lot of commercial real estate. We're still at 235% of capital, so we have a little runway. But we've seen nice quality projects, warehousing, supply chain for larger companies, grocery store and really good class A tenants in some larger metro markets.

And we've really followed some quality developers out of western PA and in Columbus and northern Ohio, and so that's really been the bulk of it. And consequently, we have a pretty nice construction portfolio that will continue to be drawn down upon probably through the remainder of the year that will give us a little bit of a tailwind. I see these markets perhaps, they're getting pretty built up, and so we just need to be cautious at this point.

Actually I'll add to that just a little bit from a big picture perspective, because one of the things we're saying about this branch deal is that it's a perfect fit strategically because of our Ohio expansion that's already underway, but also financially. So one of the issues we've talked to you and others about is the loan deposit ratio and as a whole, we've got tremendous opportunities for loan growth, and that's put our loan to deposit ratio in the 110% to 112% range.

We have had success in rates in deposits, we will -- deposits growth in the first quarter matched the loan growth and the second quarter actually exceeded it. But to the extent we have those loan growth opportunities and the loan to deposit ratio comes under pressure, it puts additional pressure on the margin. So by getting these additional three quarters and $1 billion of deposits and paying that (inaudible), that gives a lot more runway because it will take a loan to deposit rate to back down under 100% and just relieve that kind of pressure on the margin.

And actually to that point Jim, and if you have it in the slide deck I apologize, but just specifically, what the borrowings that you're paying down were carrying what in the way of costs?

Yes, right about 46 basis points. They're all short-term borrowings, one to three months.

Okay. And then just -- sorry, go ahead.

I was just going to say by the time they close, obviously they will all be in the overnight bucket, and we'll pay those off when we get the funds from the deposits.

Got it. Okay, and then in terms of mortgage banking, obviously it was a great quarter, it sounds like things are starting to come together in that regard. What is your outlook from here as to where you think that revenue line can go?

We're at about $50 million a quarter and that's generating about $900,000 in gain on sale. We're still keeping more in the books than we thought we would. We probably are at about 40%, and we're keeping the construction perm that's a little larger balances.

I think over time you'll see the mix will change probably more towards 25% portfolio and about 75% gain on sale. So you'll see the gain on sale move up a little bit probably over the course of the next year or so, and it's driving the portfolio nicely.

In terms of what that can scale to, I think we're just finding out. I think initially we thought it might scale a little quicker, but we're pleased with where it's at. I think we've kept the cost structure in line, I think we run a clean shop, which is very important in this day and age from a regulatory standpoint.

I would hope that it could continue to scale at this pace, but we'll see and we'll keep you posted. I'll be happy to share that origination number with you from time to time so you can keep track of us.

Okay, that's helpful and then Jim, just to the margin, obviously you've talked about the dynamics of the branch deal. But just putting that aside just within the core business, there's been some stabilization, it looks like, a little bit on the asset side, but how are you seeing that NIM trend over the next few quarters?

Still staying really within that $320 million, $330 million guidance I had given earlier. In this quarter on the commercial side we saw replacement yield essentially neutral.

Now, we did have, as Mike alluded to, some deposit specials as we're gathering some deposits here in the first quarter, that probably cost about 2 basis points in the margin. So that's why it went from $329 million to $327 million so that's why we're referring to it as relatively stable at this point. This transaction is because we're going to be picking up deposits that have an average cost of 22 basis points and paying down borrowings at 46 is going to help the NIM a little bit, maybe 5 basis points or so.

Okay, that's helpful, and then just final question on credit. So Mike, you'd indicated that what you saw this quarter was one that had been on your watch list as you guys were looking at some of these credits. Can you just give us an update of the ones that you're monitoring and then maybe where -- what those loans or just what you're seeing in general might affect future provisioning?

I think last quarter I gave you guidance on about six or seven credits that I enumerated. The credit in the first quarter, which is the steel servicing, was in this one this quarter were the two largest there.

When we look into just each portfolio, let's just start with petroleum and natural gas. That is currently at about $67 million, about $26 million I think, and that's probably close to the same number as last quarter I shared is non-pass and there's two credits in there.

One is you've heard me talk about before, just a longer term shallow gas operator direct loan, about $3.7 million. And another one, and this is probably the only new name to the group, is tanks for frac and brine water on the Marcellus and the Utica, that's about $3.4 million. So the dollar amount in that pipeline has fallen a bit.

And then when we look on the coal side here, the coal side we have about $31 million in outstandings and really, there's the credit this quarter, which was $10.5 million which we took a $7.5 million specific reserve and then it drops way off. The next credit really in the pipeline is about $1.8 million that we're watching closely, and that's a surface mining company. And we've had a lot of these kinds of names in our portfolio over the years, probably a couple dozen in each, coal and natural gas, and I think that's one of the things that gave us a certain degree of comfort through the Marcellus and the Utica as we got involved in this five or six years ago. Hope that's helpful.

Yes, that's very helpful. And then just the one credit this quarter, you had mentioned it was one of four other banks participated, was it local participations, or would this have been classified more as a [SNIK] credit?

These were just in our state and in adjacent state, those banks.

Okay, I'll leave it there, thank you.

(Operator Instructions)

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

We appreciate your interest as always, look forward to being on the road with a number of you over the course of the next quarter and talking to investors. Thank you and have a great afternoon.

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