First Financial Bancorp (FFBC) 2006 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Irwin Financial third-quarter results conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session.

I will now turn the call over to Mr. Will Miller. Mr. Miller, you may begin.

Thank you, [Tatiana]. Good afternoon and thank you for joining us. I'm joined today by Greg Ehlinger, our CFO, and Jody Littrell, our Controller.

Before we start with our presentation, I want to make you aware of important cautionary disclosures in connection with the forward-looking statements we will be making on this call. The cautionary disclosures are in our written press release and at the beginning of Item 2 of Part 1 of our report on Form 10-Q for the third quarter of 2006, which was filed this morning.

In the third quarter, we saw several positive results, reflecting trends and initiatives that we've discussed over the last several conference calls. First, our commercial segments continue to perform exceptionally. Second, in general, credit quality is good. Our nonperforming assets declined 15%, and while we do see a bit of a deterioration in delinquencies in the Home Equity segment, this was primarily due to the acquisition of very seasoned loans in a clean-up call of a securitization. Third, we continue to have work to do in the Home Equity segment but there are signs of progress. Net interest revenues increased nicely, and expenses are down to where we expected they would be after the restructuring we did in the second quarter. Fourth and finally, we've substantially completed the sale of our conforming conventional first mortgage operations. This represents a substantial step in the strategic repositioning of the Corporation to be an organization with more predictable and growing earnings.

Now, I'd like to expand a bit on each of these points. In the third quarter, our Commercial Finance and Banking segments again recorded very solid earnings. Notwithstanding the tightly competitive environment, both segments have broadened their geographic mix and product offerings. The commercial bank expanded again in the third quarter with two new branches in Phoenix, and by entering new markets in Reno and early in the fourth quarter, Albuquerque. The Commercial Finance segment again reported record net income, in fact earning more in the third quarter than in all of 2004. It has expanded its product line to include professional practice financing and a new IT leasing product. We believe the progress made in these two segments will help us produce the more profitable and predictable results we want for Irwin Financial.

Credit quality continues to be good. 30-day delinquencies declined in our largest portfolio, Commercial Banking, increased slightly at Commercial Finance, but increased more meaningfully in the Home Equity portfolio, primarily reflecting the acquisition of the seasoned loans I mentioned a moment ago As I said, nonperforming assets declined 15%. At the same time, we continue to see evidence the economy is slowing, which we believe could lead to a rise in delinquencies going forward. However, we think we are in a good position to absorb higher losses, as our current reserve levels reflect this view of the economy at 213% of nonperforming loans, up from 167% just a quarter ago.

Results in our Home Equity segment were below expectations. However, as I noted, we did see an increase in net interest revenue of 10% over the second quarter, and we've achieved our targeted cost savings from our restructuring of the retail segment earlier this year. We expect this segment to be profitable in the fourth quarter and in 2007.

During the third quarter, we sold substantially all of the conforming conventional first mortgage segment operations known as Irwin Mortgage, including the majority of the associated mortgage loans and mortgage servicing rights. Today, we announced that we've signed a definitive agreement with New Century to purchase certain assets, assume certain obligations, and offer employment to a significant portion of the employees related to the mortgage servicing operations of Irwin Mortgage.

In summary, while we've seen improvement in our consolidated results, they are still not back to the level we believe we can achieve. We continue to think the decision we made to focus our resources and capital into growing our commercial lines of business, as well as the restructuring we've undertaken at our Home Equity line of business, will result in improved consolidated results in 2007. We continue to make good progress in our multi-step process of reducing the volatility of earnings while moving our capital and resources into growing and more predictable segments of the banking business.

Now, I'd like to turn the call over to Greg Ehlinger, who will discuss our financial results in more detail.

Net income from continuing operations for the third quarter of 2006 was $9.2 million or $0.31 per diluted share. This is down from $0.46 per share a year earlier but up from the $0.30 per share we reported in the second quarter of 2006. Return on equity from our continuing operations was 6.8% compared to 10.4% a year earlier and 6% last quarter.

Consolidated net revenues for continuing operations decreased modestly on both a year-over-year and sequential-quarter basis. This decline reflects a decline in the Home Equity segment, in their incentive servicing revenues, and losses on warehouse and pipeline hedges, which are marked-to-market while the majority of the hedged loans are not marked in a corresponding manner.

Noninterest expenses were up modestly year-over-year and decreased 1% on a sequential-quarter basis.

Our consolidated loan and lease portfolio was $5.1 billion at the end of the quarter. This is a 16% annualized increase compared to the end of the second quarter, reflecting growth in each segment. Approximately $100 million of the increase resulted from the call of home equity loans previously used as collateral in asset-backed securities, which had amortized to the point of enabling clean-up calls. As I will discuss in more detail in a moment, these loans directly contributed to the increase in delinquencies and nonperforming assets in that segment. Home equity mortgage loans held for sale totaled $174 million, up from $148 million at the end of June.

At the end of the third quarter, deposits totaled $3.8 billion, down from 4.1 billion a year ago and down 100 million from the end of the second quarter. This reflects a competitive environment for deposits and reduced demand on our part due to the sale of our mortgage assets.

We had 523 million or $17.56 per share in common shareholders equity as of September 30. At quarter end, our Tier 1 leverage ratio and total risk-based capital ratios were 10.8% and 13.5%, respectively, compared to 10.3% and 13.1% a year earlier.

During the quarter, our Board authorized management to begin the share repurchase program contingent upon the sale of the Mortgage segment. Now that we've completed that sale, we expect to begin those repurchases during the fourth quarter.

Nonperforming assets were 52 million or 87 basis points of total assets as of September 30. This is down from 77 basis points a year ago and 94 basis points at the end of June.

Our allowance for loan and lease losses totaled $71 million, up $17 million year-over-year and $4 million from the end of the quarter.

The ratio of on-balance sheet allowance for loan and lease losses to nonperforming loans and leases was 213% at quarter end compared to 134% last year and 167% at June 30. Our consolidated loan and lease provision from continuing operations totaled $9.1 million, largely due to the acquisition of the seasoned home equity loans in the clean-up call noted earlier.

I will now turn to some detail by segment, beginning with Commercial Banking, which earned net income of $8.3 million, up 8% year-over-year and 5% over the second quarter of 2006. This reflects increases in net interest income from loan portfolio growth and a one-time $250,000 favorable net adjustment from low income housing credits.

While competitive conditions continue to be difficult, loans outstanding at quarter end totaled $2.8 billion, representing 9% growth over the past year and a 7% annualized growth during the quarter.

Net interest margin was 4.27%, up from the most recent quarter as excess liquidity has been redeployed into higher-yielding loan assets. We expect to continue to see this level of net interest margin in the segment for the near future.

Credit quality continues to be very strong. 30-day and greater delinquencies declined to 12 basis points, unchanged from a year earlier but down from 31 basis points at the end of June, 2006.

Our provision for loan and lease losses of $1.7 million compared favorably to net charge-offs of 1.3 million during the third quarter, and our nonperforming assets declined to $17 million from 30 million at the end of the second quarter.

Our Commercial Finance line of business net income of $3.3 million in the third quarter, a 29% increase from a year ago and up 12% from the second quarter. The segment's loan and lease portfolio now totals $1 billion, a 31% increase over the past year and an annualized increase during the third quarter of 18%. Net interest income totaled $10.4 million, up 1.5 million over the last year and a $300,000 sequential quarter increase.

Net interest margin declined modestly during the quarter to 4.27% from 4.95% a year ago and 4.5% during the second quarter, primarily reflecting the continued portfolio mix towards franchise finance loans from small-ticket leases.

Loan and lease fundings totaled $147 million during the quarter, compared to $119 million a year earlier and $164 million in the second quarter. Our loan and lease provision in this segment totaled $1.6 million, up from 1.5 million last year but down from 1.8 million during the second quarter. Net charge-offs increased to 1.2 million, up from 1.1 million in the third quarter of 2005 and 900,000 in the second quarter of 2006. Our 30-day greater delinquencies totaled 57 basis points at September 30, down from 59 basis points a year ago but up from 42 basis points at the end of June.

Our Home Equity business lost $300,000 during the quarter, compared with income of 2.2 million in the third quarter of '05 and a loss of 400,000 during the second quarter of '06. The third-quarter loss was principally the result of elevated loan loss provisions required for the acquisition of the seasoned loans we've discussed earlier. This represented the last clean-up call of our pre-2002 securitizations of home equity loans.

Also contributing to the third-quarter results at Home Equity were losses on derivatives, which are economically hedging loans and pipeline and the warehouse for which hedge accounting under FAS 133 is not applied. We expect the offsetting benefit of this hedge to be recognized when the loans are sold.

Loan originations totaled 254 million in the third quarter, up from 211 million in the second quarter. This reflects our planned growth in the brokered channel.

While delinquencies increased on a quarter-to-quarter basis, credit quality continues to meet our expectations. Our 30-day and greater delinquencies in the on-balance sheet portfolio increased to 3.49% from 2.61% at the end of the second quarter. Delinquencies without the reacquired loans would have been approximately 3%. We're monitoring this increase in delinquencies, but due to the size of our loss reserves and as the increase was largely driven by the acquisition of seasoned loans, we are not concerned at this point. Our loss provision increased to 5.9 million from 3.1 million a year ago and 3.7 million in the second quarter. Again, this was elevated due to the acquisition of the seasoned loans.

Net charge-offs were 2.7 million during the third quarter, compared to $2.4 million during the second quarter. Also included in results from continuing operations was a loss of $2 million for the parent and other consolidating operations, compared to losses of 1.4 million in the second quarter. Included in the $2.8 million loss was $1 million related to the call premium and write-off of debt issuance costs upon the call of ISC Capital Trust IV.

The discontinued operations related to our conventional Mortgage Banking segment recorded an after-tax loss of $13.4 million in the third quarter, compared with net income of 5.3 million a year ago and a $6.1 million loss in the second quarter. We completed the sale of the mortgage banking line of business origination operations, including the majority of its loans held for sale. This asset sale resulted in a loss of $6.4 million, including disposition costs, and we recognized 5.5 million of that 6.4 million in the third quarter--pardon me, in the second quarter, with the remaining 900,000 recognized in the current quarter.

Additionally, in September, we sold 90% of the mortgage servicing rights, and during October, sold the remainder of the servicing asset. The third-quarter MSR sale resulted in a loss, net of hedging, of $5 million. During the quarter, we also recorded servicing asset amortization of $8.2 million. The result of the MSR sale is a $172 million increase in Accounts Receivable and is the principle reason our consolidated capital ratios did not increase by the full amount of the MSR asset sales. We believe the MSR receivable will be substantially collected by early 2007, as we finish shipping the MSR portfolio. Additionally, disposal losses in connection with contract termination costs and severance benefits were recorded in the third quarter. 0.5 million of costs were recognized in the second quarter, and an additional $7.4 million were recognized during the third quarter of 2006. We now believe we have taken the bulk of the disposal charges required to sell the segment. In total, the disposals cost us approximately $12 million after-tax or $0.40 per share.

In summary, our commercial lines of business continue their steady progress and produced solid earnings during the third quarter. They continue to make good progress in balancing the costs of investment in market development against growth in revenues and net income. Our consolidated margin was stable and credit quality remains good, and while progress is slower than originally anticipated, we believe we have taken the right steps to return the Home Equity segment to acceptable levels of profitability. Finally, we completed the sale of substantially all of the Mortgage segment.

Tatiana, Will, Jody and I would to open the call up to questions, please.

Thank you. We will now conduct the question-and-answer session. (OPERATOR INSTRUCTIONS). Ross Demmerle, Hilliard Lyons.

Good afternoon. I have three separate questions, the first being on the Home Equity lending side. I'm not sure if you've got figures there for what charge-offs were or generally are for those home equity loans that were made before 2002, that you said (indiscernible) you've taken back. I guess as a follow-up to that, how are post-2002 loans different than pre-2002?

Then secondly, what do you think are acceptable returns in terms of profitability for the home equity line of business? I guess a return on assets would probably be the best way--or return on equity might be the best way to look at that.

Then finally, I think you said that part of the $2 million loss at the holding company level, part of the $2 million loss at the holding company level was 1 million and it was attributable to the early prepayment penalty. So would we assume that a run-rate for that loss going forward would be 1 million? Thanks.

Did I have too much there to go with?

We were just writing down all three to make sure we answer them. (multiple speakers)

Ross, losses in the pre-2002 portfolio in Home Equity will have a sort of peak loss rate of 6 to 7%, which is probably 150 to 175% of what we expect to have on the current portfolio that we are producing today. Those are loans, you may recall, that in the late '90s and early part of this decade, we were originating. The FICO scores on those loans are down closer in the mid 650, 658, 659 type of numbers, whereas our portfolio today has about a 700 FICO on a weighted average basis.

The return that we are looking for in the Home Equity space, we think we can get the returns into the 13 to 15% range. This has been a return on equity. Obviously, 2006 has been a difficult year to track that with restructuring charges that we took earlier in the year. Then because we're not trying to get FAS 133 treatment on our pipeline and warehouse derivatives, there's some noise in the third quarter in addition to the noise that bringing on these seasoned loans had in the provision and some of the delinquency numbers that you're seeing in the third quarter. But I think we believe that, in 2007, we can make good headway to get into that 13 to 15% return level.

On the parent company loss, a $2 million run-rate is a pretty good run-rate. We did have the $1 million debt issuance cost in this quarter, but we also had a couple of other adjustments, including a tax adjustment that was a one-time adjustment due to a tolling of a tax reserve that we had. So somewhere in the north side of 1 million to 1.5 million to 2 million--I'm sorry, 1.5 million to $2 million is an appropriate run-rate.

Okay, thanks for your answers.

Edward Hemmelgarn, Shaker Investments.

Could you just talk a little bit about what the plans are for this? You're getting a fair amount of cash, I guess, for the businesses that were sold; you've gotten some of it or you will get it by early next year. Outside of the share repurchase plans, you know, what are your specific plans in the near-term and I mean, what will you invest it in and then what are your long-term plans?

Thanks, Ed. Basically, the short answer is a combination of the share repurchases and the anticipated asset growth in the three lines of business that we have going forward. The growth prospects, in our view, of the Commercial Banking business, the Commercial Finance business and the restructured Home Equity business are all attractive to us. We believe they can add significantly to their portfolios in 2007, and we need to have capital to support that in the Commercial Banking business. As you know we've opened four offices within the last six months or so, two expansion offices in the Phoenix area of Glendale and Mesa, and we've entered a new market in Reno and now just in the fourth quarter have entered another new market in Albuquerque. Our history with those new market expansions is that they can produce a pretty good rate of growth, particularly in their early years.

So what we're going to do with the capital that we've freed up is essentially look at how fast our asset growth rate comes, relative to our planning assumptions, and to the extent that we are growing prudently and with a credit worthy portfolio at or about our plan levels, we will execute the share repurchase that we've talked about. To the extent that we don't get that asset growth, that would actually create greater capacity to increase the share repurchase. If we have more opportunities to attractively reinvest the capital in growing existing lines of business, we might trim back the share repurchase. But that's how we are looking at it.

Are there any in some of these new markets out West? So far, you've really been doing more de novo start-ups or at least recently. Are there any opportunities to get smaller banks, start-up operations, that might be good fill-in?

Yes, we speculated on that for some time, that the high rate of de novo formation, you know, five to ten years ago, would begin creating opportunities for acquisition in some of these markets. But we continue to find that our lift-out strategy, where we are able to attract a seasoned banker in Reno or Albuquerque who is looking for the opportunity to join an organization like us where they can really do customer-focused banking the way it used to be done and is increasingly rarely done in very large banking organizations but who don't then have to have the hassle of doing a start-up themselves is--that continues to seem to us to be the most attractive way to expand from a return-on-investment and return-on-equity point of view. You don't pay big acquisition premiums. You have to underwrite some losses for a couple of years but in the end, the cost basis we have in these new markets is much more attractive; you don't have goodwill. Frankly, you get to build a clean portfolio from scratch as opposed to buying the entirety of an existing portfolio in an acquisition. We just find it a more attractive way to grow.

Do you have a target or I guess idea of what you might be thinking about in terms of a range of new branch openings each year for the next two or three years?

Well, we tend to budget on the assumption we will open about two a year, but of course it then turns out to be overwritten by when we find the really attractive talent that wants to join us. So if we went through a dry patch in terms of our recruiting, we might not open one in an entire year. On the other hand, as happened in this last year, we found two very attractive new markets where we had exactly the right kind of person we wanted to come start that market for us, willing to join us, and the same time, we have the opportunity to cover the Phoenix market more completely. So, you know, that's essentially our approach. It has to be gated by the availability of the talent.

Okay. Lastly, you just--regarding the (indiscernible), how long is it typically taking to reach breakeven level on these de novo branch start-ups (multiple speakers)?

We get to breakeven at about a year and a half, and we get--historically we've been able to get to our target midteen rate of return in about three years.

Okay, thanks.

Brian Hagler, Kennedy Capital.

Good afternoon, guys. I guess with all the noise in the numbers the last few quarters, can you just talk about what the gain on sale in the home equity unit trends have looked like, what you expect maybe in the fourth quarter and if you plan on selling more or less volume?

Yes, Brian, there has been a lot of noise and a lot of it comes about because of our decision not to try to get FAS 133 treatment on our derivative book that hedges the warehouse and the pipeline. So I will remind folks that, in the first half of the year, we had almost $6 million worth of derivative gains, I think 2.9 million in each of the first two quarters. Leveraging off that mark-to-market gain of 2.9 million at June 30, we had loans that had good effective economic hedges when we closed the books in June with the gain on the hedge but then we took that--had to take the loans into market and obviously with the hedge gain, we didn't get quite the same gain on the loan sales we might otherwise have had, because the gain was embedded in the derivatives that we took in the second quarter. You know, here in the third quarter, we had about 2.7 or $2.8 million of derivative losses. Again, we think that the hedge effectiveness is there and we ought to be able to see some of that value dome through when we sell those loans in subsequent quarters.

The market overall is pretty tight in margins on the secondary side. There's obviously a lot of concern about the housing market and mortgage loans in general. Our target, longer-term, is to see if we can get 1 point or more on the second mortgage loans and obviously less than that on the first mortgage loans that are becoming a bigger piece of the business. I think they were about 25% of our production in the third quarter. So you know, it should average out close to 1 point, weighted closer to that with second mortgage loans and to the extend that the first mortgage production picks up, it would be less than that.

You mentioned you will get the offsetting gain when you sell the loans. I mean, do you think that will be over the next couple of quarters, or do you have an idea on timing?

Yes, generally that warehouse turns in 90 to 150 days or so.

Okay, great. Thanks.

(OPERATOR INSTRUCTIONS). We have no further questions at this time.

Okay. Well, thank you all for joining us. We look forward to talking to you again in late January for our fourth-quarter and full-year results. Thank you very much.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may all disconnect.