First Commonwealth Financial Corp (FCF) 2016 Q3 法說會逐字稿

Good afternoon, everyone, and welcome to the First Commonwealth third quarter 2016 earnings release conference call. All participants will be in listen only mode.

(Operator Instructions)

After today's presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to Ryan Thomas of Finance and Investor Relations. Please go ahead.

Thank you, William. 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 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, we'd 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 third quarter earnings conference call. We appreciate your interest and investment of time in our Company. Joining me this afternoon is Jim Reske, Our Chief Financial Officer.

Our third quarter net income of $17.2 million enabled earnings per share of $0.19, an ROA of 1.02%, and an efficiency ratio of 57.3% on an unadjusted basis. All are improved figures by historical standards at First Commonwealth. Net income and EPS represent the best quarterly results in a decade.

The third quarter benefited from a buoyant net interest income stemming from solid loan and deposit growth during the year and a stable margin. Importantly, third quarter expenses of $38.7 million remain well-controlled and provision expense of $3.4 million for the third quarter was down over the prior quarters.

Although Jim Reske will explore important particulars in a minute, let me just share some brief thoughts on credit, growth and our recent acquisitions. Lingering on credit, as I mentioned, our provision expense this quarter was $3.4 million. As we reflect on our quarterly provision expense, over the last 13 quarters, 9 of them have come in at this level of $3.4 million or less. However, we recognize that our recent credit costs have been lumpy. As I shared the last quarter, we have identified the problem energy loans in our portfolio, and have appropriately graded the risk. The larger problem energy credits have been reserved for, and the average balance of the remaining energy credits is significantly smaller.

Our loan growth of roughly 6% year over year stems primarily from the commercial lending function, which has grown almost 13% during that period, and has really offset some planned runoff in other loan categories. We've seen nice growth in commercial real estate lending, but remain well below regulatory guidelines for commercial real estate with CRE equal to only 224% of total capital.

The third quarter mortgage funding total of over $65 million represented the best quarter since the inception of that business just two years ago, and generated $1.2 million in gain on sale income. Annualizing the third quarter's production implies a run rate of $260 million, and we expect that to continue to grow as we incorporate our new Ohio partners.

Regarding our Ohio expansion efforts, we recently announced the acquisition of 13 branches from FirstMerit in [McNassel] and Canton, Ohio as well as the acquisition of Delaware County Bank in central Ohio. Those acquisitions are achieving important milestones and are on track. We expect to close and convert the FirstMerit branches in early December. Our observed deposit attrition is tracking the attrition rate we had initially modeled.

Similarly, our merger with Delaware County Bank, just north of Columbus, Ohio, is off to a strong start with good early dialogue between both teams. Our targeted legal close and conversion for Delaware County is in the second quarter of 2017. We are enthused about both opportunities and the opportunity to enter these vibrant markets with really capable teams already in place.

As I reflect on our stronger third quarter results, and our recently announced acquisitions, it is clear to me that our significant systems conversion project in 2014, that operation excellence has been an important catalyst to do several things. One, to lower our operating costs and improve our efficiency. Two, to free up dollars for critical investments in mortgage and other lending teams. And three, to further enable our digital solutions for our clients and really get to market with those same solutions more quickly.

To give you just a few examples, since the conversion we have launched an enhanced online and mobile banking platform. We've launch mobile deposit. We have launched Apple Pay, Samsung Pay and Android Pay as virtual wallets for both debit and credit cards. We have launched online lending and online deposit account opening platforms. We have launched a new consumer credit card product that is designed to get into the queue of a digital wallet. We have launched account aggregation and a personal financial management tool. And we have launched mobile person-to-person payments.

These are important milestones for our clients and our future, and there is more to come. We now believe that our mobile online and bill pay usage and product offerings are equal to, and in many respects, ahead of our peers.

Finally, as we look forward towards 2017 and beyond, I just want to share a few of our operating initiatives and strategic themes. To ensure our credit costs converge with and eventually outperform our peer group, number one. Two, to ensure that our northern Ohio and central Ohio investments, to include Delaware County Bank and the FirstMerit branches, achieve their financial targets for profitability growth and efficiency while hitting important milestone dates. Three, continue to move decisively towards the digital future for our clients. Four, ensure costs are well-controlled. And five, move toward and maintain a 1% ROA.

And with that, I'll turn it over to Jim.

Thanks, Mike. As Mike already shared, we had a strong quarter. On the one hand, $0.19 of EPS and 1.02% ROA, along with a core efficiency ratio of 56.7%, represent breakout results for First Commonwealth. On the other hand, these results [nearly] represent the continuation of the strong underlying results of the first two quarters, which had been masked by credit costs in each of the first two quarters.

Compared to the second quarter, the $0.05 improvement in EPS is driven almost entirely by a $7 million decrease in provision expense. As you may recall, last quarter we set aside $7.5 million in reserves against a single loan. We charged off $6.5 million of that loan in the third quarter, and released the excess reserve, leaving us with provision expense of $3.4 million in the third quarter.

Comparing the linked quarters, net interest income was up by $500,000 on a margin that improved by 2 basis points to 3.29%. The margin benefited from positive replacement yields, and our LIBOR based commercial loans got a small lift from the increase in one-month LIBOR rates in the third quarter. As for the rest of the income statement, a $1.5 million increase in non-interest income compared to last quarter was almost [critically] offset by a $1.3 million increase in non-interest expense.

To clarify, non-interest income benefited from a $470,000 positive swap valuation adjustment in the third quarter. You may recall that this swap adjustment was a negative $531,000 last quarter, so a change it represented a $1 million positive swing in non-interest income, accounting for most of the $1.5 million improvement. However, non-interest income did benefit from continued progress in mortgage gain on sale income. On the other hand, the $1.3 million increase in non-interest expense was driven by a $1 million negative swing in the reserve for unfunded commitments, which was a reversal of the $540,000 last quarter, but a $503,000 expense in the third quarter.

Net interest income has been steadily increasing all year even though interest expense has increased slightly. Non-interest income has steadily improved all year as well, and non-interest expense has remained well below our $40 million per quarter target. On a year to date basis, earnings per share was $0.47 for the first three quarters of this year, which is slightly ahead of the $0.45 we earned in the same period last year, despite provision expense that is $11.5 million higher than last year.

The combination of strong interest income, together with significantly lower operating costs, more than offset elevated credit costs so far in 2016. Specifically, net interest income is $7.6 million ahead of the first three quarters of last year, driven by $287.8 million of loan growth as well as improved yields in the securities portfolio due to some restructuring of the portfolio we did late last year, which was previously disclosed. And secondly, our operating costs for the first three quarters of 2016 were $6.5 million less than they were for the same period last year, driven primarily by the restructuring of our retail and consumer businesses in 2016.

Aside from financial performance, the third quarter was noteworthy for the announcement of two acquisitions in quick succession. As Mike stated in our earnings release, we are strongly encouraged by the results of this quarter, but much of our future success depends upon our ability to successfully integrate both transactions sequentially.

We have previously disclosed financial details of each transaction, and will provide additional guidance for you as appropriate in the ensuing quarters. For now, I would clarify that we expect each transaction to add to both revenue and non-interest expense. The non-interest expense will be additive to the targeted $160 million annual run rate of our standalone expenses that we often talk about. We expect that this will ultimately leave us with a core efficiency ratio that remains under 60%, but we anticipate that there could be some variability in that ratio as the transactions are integrated.

Finally, keep in mind that we expect to recognize merger related expenses related to the branch acquisition of $2.2 million in the fourth quarter, which is in addition to $300,000 of expenses related to the transaction that were recognized in the third quarter. For the acquisition of DCB, we expect to recognize merger related expenses of $10.8 million in the second quarter of next year when that transaction closes. In other news, our effective tax rate was 29.5% in the third quarter.

With that we will take any questions you may have.

(Operator Instructions)

Bob Ramsey, FBR.

Good afternoon. First question I had for you was about the derivative mark to market swing, which I know you mentioned in your prepared remarks. Can you just remind me what it is that makes that swing quarter to quarter and if there is a move in short term rates, if there would be any impact on that line?

Actually, I've had -- especially a couple times -- we have with us our Chief Treasury Officer, Mark Lopushansky, and I'm going to turn the mic over to him just for one moment to answer this as well.

One of the primary drivers is the actual market value of the interest rate swaps because the credit exposure is a function of the market value. So when we see interest rates move up, we actually see a positive change in the market value of the underlying swaps and that's what actually happened this quarter.

Just as a proxy, I think the 10-year swaps rate moved up by about 9 basis points. So the credit exposure of that market value actually returned a positive adjustment. Does that make sense?

Yes. And so is it fair to think then it's the 10-year swap that your most sensitive to here?

The reason I picked the 10-year is that's probably a proxy for our entire portfolio. Our swaps basically started back in 2008, and on average we had 10-year swaps and probably 7-year swaps. So the 10-year is probably a good proxy for that overall adjustment.

Great. Okay. Thank you. The other question I have for you had to do with profitability. I know you noted that your ROA is north of 1%, best level it has been in several years, which is great. Just kind of curious with the acquisitions coming on board, if you have got targets either in terms of ROA or return on tangible equity for the business once you've been able to fully assimilate the deals?

We certainly expect our ROA to be above 1% and to have some nice revenue synergies as well as the ones that we've stated on the calls for both deals. We are working through our budgets and forecasts, quite frankly, for 2017 and 2018 through November and December, but certainly expect it to have a positive impact.

Yes, Bob, our target has been 1% ROA for a long time and we're of course obviously very excited to achieve that this quarter. Integrating two deals sequentially, as we're trying to be clear about, we do expect there to be some noise in that, but ultimately our long term goal still remains to keep the ROA above 1%.

Okay, great. Thank you.

John Moran, Macquarie.

Hey, guys, how is it going?

Hey, John.

Just on the OpEx outlook, and Mike, I think you sort of alluded to cost control as one of the key objectives as you look out into 2017. You guys have done a great job, I think, on a core basis of keeping it down.

And I know there will be some noise coming in with the branches here in December and then 2Q with the deal closing, but on a core First Commonwealth basis, do you feel good about the ability to keep that well under $40 million throughout 2017, or are some of the digital investments and stuff going to start to tick that up a bit?

I think without the acquisitions we would feel very good about that, but the operating expenses we'll be adding for the 13 branches will be about $6.8 million on an annualized basis, and with Delaware County Bank, it looks like about $9.8 million, and then moving a little higher than that. Up to $13 million or so. So that's going to add to our expense base, but our revenue will need to out run that.

And since you mention it, John, it's a great question. We've targeted that $160 million figure and we've talked about it for some time. Obviously, as we do more acquisitions and we grow, we will need to continue to invest in our businesses.

So we're probably going to migrate to really talking about net efficiency ratio, the core efficiency ratio and the stated efficiency ratio, as opposed to just a dollar figure target. In the near term, though, we do think that, yes, the acquisitions are going to add to the dollar figure of what we have to spend, but the core rest of the bank should be operating right about that $160 million level. At least for the near-term and probably next year.

Got you. Okay. That's helpful. And then the other one that I had was just on the growth -- and maybe you can just give it a little bit of context. I know a lot of banks have seen slower growth in 3Q, maybe even more than what would be expected just given regular seasonality. But maybe you could give a quick comment in terms of what you are seeing in the footprint and then how pipelines are looking for 4Q?

Yes, the pipelines look good. We have been fairly disciplined with a rather large portfolio of our indirect auto business and purposely ran that off just given the spreads.

The downdraft there year over year is over $70 million. I think that will continue. We like the prospects of the business long term, particularly if short term rates start to move up a little bit. So we're kind of hanging with it. So that's obviously impacting a little bit of our growth.

There is really an ebb and flow to the C&I and the commercial real estate business. We have pretty good pipelines as we head into the fourth quarter.

We've also really looked closely at our risk appetite. We've had a little energy exposure and just paring some things from time to time, and so just readjusting that. We think with a full team in Ohio that will more than offset that and get us back up to -- our guidance has been mid single-digits and hopefully we can get to where we are consistently a little bit on the high end of that.

Okay. Thanks very much.

Thank you.

(Operator Instructions)

Collyn Gilbert, KBW.

Thanks. Good afternoon. Jim, would you mind just going through -- and if you covered it I apologize, but your thoughts on the NIM? I think you had suggested that maybe the range was going to be in the 3.20% to 3.30%, so it obviously came in at the high end of that range and just maybe just what you see as the dynamics going forward from here?

Yes, thanks. I appreciate the question. It is not pleasing to us, obviously, that it's coming in at the high end of the range.

There are couple of things that happened in the middle of this year that are going to change as we go into fourth quarter. Before we had pursued a branch acquisition, we were pursuing deposit growth to keep up with our loan growth and had offered some kind of certain market specials for certain types of deposits. Some of those will start rolling off in the fourth quarter. So that should help the margin a little bit.

And then, obviously, the bigger effect is going to be the impact of the branch acquisition, which should close here towards the end of the fourth quarter. So there won't be a tremendous effect on the branch acquisition in the fourth quarter because it's going to close towards the end, but some effect. But it's going to start replacing the short term borrowings with the longer term deposits at a cheaper rate.

The effect could be particular pronounced if the Fed raises rates in December, then if we hadn't done the branches, our short term borrowings would've raised up almost immediately, obviously, with the branches placed in short-term borrowing, the rates on those borrowings would not be going up. So those will come into effect.

All that being said, we had -- I think when we announced the branch acquisition, we had said that we expected from that probably about a 5 basis point improvement in the margin. That wasn't baking in a rate increase in December, that I just mentioned, so I do not mean to confuse that issue. So that would -- just as result from the branch acquisition probably take the margin -- our expected range of the margin from 3.20% to 3.30%, up to more likely 3.25% to 3.35%.

This is Mike. I would just add, somewhat encouragingly, as we look at our corporate banking, small business and our mortgage loan portfolios and what we're adding volume on here in the last quarter, those spreads seem to be above our 12 month rolling average, and as Jim shared in his comments, our replacement yields for newer loans seem to be now eclipsing the runoff.

The other thing I would share, just anecdotally, as I talk to our lenders, they do feel like credit structures have stabilized a bit and they are not -- and I quote -- they feel like they are not feeling the pricing pressure that they have had over the last few years. So for what it's worth.

Okay. That's very encouraging. Okay. And then just in terms of outlook for credit and provision, I know you had indicated, obviously, there's some lumpiness here as we go forward, but is it -- just thinking about the strategy around the reserve and how you see that evolving as we look out?

Lower. (laughter) I know you and I have talked about this a lot. Lower. We stubbed our toe a little bit with energy, otherwise the core performance over the last four quarters have been clearer sooner. I think we're little bit more reticent on energy going forward. And we have to be very thoughtful and discerning regarding some certain segments. So I will keep you posted as the story unfolds here.

Okay. All right. That's helpful. I will leave it there. Thanks, guys.

Thanks.

(Operator Instructions)

It looks like we have no further questioners, so this will conclude our question and answer session. I would now like to turn the conference back over to Mike Price, President and CEO, for any closing remarks.

Appreciate your interest in our Company and look forward to seeing a number of you in the next quarter or two, either on the road or at your conferences. Thank you very much.

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