First Interstate Bancsystem Inc (FIBK) 2010 Q3 法說會逐字稿

Good morning and welcome to the First Interstate BancSystem Inc. Q3 earnings release conference call. All participants will be in a listen-only mode. (Operator instructions). After today's presentation there will be an opportunity to ask questions. (Operator instructions). Please note, this event is being recorded. I would now like to turn the conference over to Ms. Marcy Mutch, investor relations officer. Ma'am, please go ahead.

Thanks, B.J. Good morning. Welcome and thank you for joining us for our third quarter earnings call. Today we will be making some forward-looking statements regarding quarterly provision for loan losses, net interest margin, income from the origination of sale of loans, loan growth and non-performing assets. We may also make other forward-looking statements, including statements about our plans, strategies and prospects. I need to remind you all that forward-looking statements are subject to various risks and uncertainties. Therefore, our actual results may differ materially from those expressed or implied by such forward-looking statements. For a full discussion of risks and uncertainties associated with our forward-looking statements, please refer to our securities filings, in particular the risk factors section of our most recently filed Forms 10-K and 10-Q.

Joining us from management this morning are Lyle Knight, our Chief Executive Officer; and Terry Moore, our Chief Financial Officer. Lyle will begin by giving you a general overview of this quarter's results along with some observations on our markets. Terry will follow up with more specific information behind the quarterly results and provide a general review of credit quality information. Also with us this morning is Bob Cerkovnik, or Chief Credit Officer. Bob will be available during the question and answer time to address questions concerning our loans and asset quality.

At this time I would like to turn the call over to Lyle Knight.

Thanks, Marcy. Good morning and thank you for joining us on the call.

Last night we reported earnings for the third quarter of $7.9 million. That compares to $5.8 million for the second quarter of 2010. Our improved performance is reflective of our well-diversified business mix. By that, I mean, while commercial and commercial real estate loan demand was relatively weak, we did see particular strength in our residential mortgage originations. We are one of the largest mortgage lenders in our markets. We're in a good position to capitalize on any increases we see in demand.

We continue to experience positive trends in revenue generation with increases in both net interest income and non-interest income as compared to the second quarter. An increase in earning assets along with a shift in the mix of deposits and, of course, the benefit from one additional accrual day resulted in an increase in our net interest income. Increased revenues from the origination and sale of residential real estate mortgages, along with lower provisions and lower OREO expenses helped drive the increase in earnings relative to last quarter.

We saw a decline in our net interest margin to 3.89%, or 7 basis points less than last quarter. There were a number of factors that contributed to the net interest margin decline, which Terry will review with you in detail. Like provisions and OREO expenses decreased from last quarter, of course, they continue to dampen our results.

The third-quarter loan loss provision was $18 million, and we had write-downs to OREO of $2.4 million. We also continue to build reserves as a result of the provision continuing to exceed net charge-offs. The allowance for loan losses of $120 million have increased 19 basis points to 2.7% of total loans, which is up from 2.5% -- 2.51%, to be exact -- of total loans as of June 30. Reserves will remain elevated until we see a consistent leveling-off or a decline in our non-performing assets. As expected, we continue to see growth in non-performing assets. As of September 30, non-performing assets are $237 million or 3.24% of total assets.

However, Terry will report to you in a few minutes that when you drill down into the non-accrual loans and the restructured debt, you will find a significant portion of these loans remain in performing status.

We take a long-term view of creating and protecting shareholder value. This means we manage aggressively through difficult credits. We typically avoid wholesaling notes or collateral when higher values can be obtained through orderly resolution or liquidation. This will probably lead to elevated levels of restructured debt in the next few quarters, but this is an acceptable trade-off from our perspective. Throughout our history this process has proven to be an effective approach to loss mitigation and we believe this strategy is in the best interests of the bank, the communities we serve as well as the Company's shareholders.

As for our local economies, unemployment levels remain stable and below the national average. And in most of our markets, we see stable property values.

Now, as you already know, this has been a great season for tourism. Visitation to the national parks have been up, with Yellowstone National Park having a record-breaking season. Agriculture has also had a very good year. We have witnessed high crop yields, and prices have been strong for both grains and cattle. You will remember that our strategy for future loan growth resides in our diversified communities with a special emphasis now on energy, which includes coil, oil, natural gas and now even the wind industry. We currently have a strong presence in the health care industry, and we are focused on providing additional credit and fee-based services to this growing sector.

We continue to see a slow-growth, low-rate environment in the national economy continues to create a level of uncertainty which has, in fact, diminished our loan demand. We are eager for consumers and business confidence to return to a level that encourages investment. In the near-term our focus will be on areas around, number one, controlling problem assets; number two, maximizing net interest margin; and, number three, controlling non-interest expenses.

Now, with that high-level overview, let me turn it over to Terry for details.

Thanks, Lyle, and thanks to all of you for joining us this morning. As Lyle reported, earnings for the third quarter were $7.9 million with diluted earnings per common share for the quarter of $0.18 per share. This compares to $5.8 million in earnings and diluted earnings per common share of $0.14 for the second quarter of 2010.

Net interest income this quarter grew to nearly 1% from last quarter, yet the net interest margin ratio declined 7 basis points in Q3. As you can imagine, maintaining net interest margin in this environment is quite challenging. Although we had an increase in deposits of 1.7% and we were able to decrease our cost of funds 12 basis points during the quarter as a result of a shift in the deposit mix away from higher-costs time deposits to lower-cost deposits, we did not overcome the entire impact from the decreased yield in our investment portfolio.

Loan yields have held up well over the past several quarters with only a 13-basis-point decline from Q3 of 2009. That's pretty good in this low interest rate environment. However, the increase in charged-off interest, our new non-accrual loans this quarter totaled $1.2 million or $700,000 more than Q2, impacting the net interest margin by 4 basis points.

In addition, lower balance sheet leverage was a negative factor in the margin as our loan-to-deposit ratio declined to 75.4% in the third quarter from 78.6% last quarter. During third quarter, over $400 million of investment securities were purchased, resulting in a net increase in the portfolio of $194 million. These purchases were invested principally in US agency debentures and mortgage-backed securities. We continue our consistent, conservative investment strategy, unwilling to extend maturities to pick up minimal yield improvement. The weighted average duration of the securities portfolio remains less than two years.

We have further opportunities for improvement to cost of funds, especially time deposits. While we value deposits and view them as a critical long-term funding source, our focus will be on maintaining the deposit base at a reasonable cost in this current rate environment. However, we expect to experience net interest margin pressure until we begin to see an increase in loan demand.

Non-interest income increased by $3.8 million to $24.9 million from $21 million in Q2. This increase was primarily due to an increase in residential loan origination income. As we said last quarter, we anticipated a strong July and August, and as rates remained low, this carried through to September. Based on current production, we will have a strong October as well. We saw a change, however, in the mix of activity this quarter with refinancing activity accounting for 69% of the loan originations in Q3 compared to only 39% in Q2. Obviously, if rates remain at current levels, we would expect to see a gradual tapering inactivity by year end. However, if rates continue to decline or drop, we should see increased volume.

Non-interest expense increased $2.6 million or 4.7% from Q2. The majority of this increase was due to mortgage servicing rights impairment, which increased $1.7 million from the second quarter. If rates were to continue to drop and refinancing activity increases, we could expect the impairment to continue to be a significant number. However, if mortgage rates remained steady or perhaps even increase, we will not see an increase in refinancing activity and would expect impairment to have little or no impact in Q4.

Let's turn our attention to the credit. The second quarter provision for loan loss of $18 million is equivalent to 1.59% annualized provision to average loans. Of the $18 million provision, 60% or $10.8 million was allocated to specific reserves with the remainder to general reserves. While 56% of the total third-quarter provisions were attributable to the Flathead, Gallatin and Jackson markets we've discussed in the last couple of quarters, these three markets represent only 21% of our total loan portfolio.

As we have discussed the last two quarters, non-performing assets are expected to increase with our estimate that they will peak mid-2011. We've seen a reduction in other real estate of $7 million since June 30. This change is reflective of sales of $7.6 million, write-downs of $2.4 million and net additions to OREO of $3 million. Of the $2.4 million in write-downs, 55% is attributable to the three distressed markets that we've been discussing. This is reflective of decreasing property values in those specific markets. And with abundance of property for sale in those particular markets, we don't anticipate any quick uptick in values.

However, things moved in the right direction during Q3 with sales of OREO exceeding additions to OREO. A small net gain on the sale of OREO properties would suggest that the current values of OREO are reasonable.

Non-accrual loans grew to $174 million this quarter, an increase of $34 million over Q2. Of total non-accrual loans, 77% reside in the commercial real estate and construction real estate portfolios. Also, of the total non-accrual loans, 59% are in our Jackson, Flathead and Gallatin markets. Worth noting as well as is that, as September 30, 84% of non-accrual loans were current.

The increase in this quarter in TDRs consisted mainly of three relationships in the owner-occupied commercial real estate portfolio. 48% of our restructured loans are owner-occupied commercial real estate, and 22% are commercial loans. And again, 87% of our TDRs are performing as agreed.

We did see a significant drop in our delinquencies this quarter. Last quarter was a bit of an anomaly in which we told you the largest spiking was due to 10 credits in our distressed markets. Subsequently, of those 10 credits, eight are now current and two have moved to a non-accrual status. For the two loans placed on non-accrual, there was sufficient collateral, and we did not report any additional impairment. We continue to place emphasis around collection efforts and we are seeing fewer loans make it into the delinquency bucket.

We are also continuing to dedicate resources and oversight to credit quality. In particular, Jackson, the Flathead and Gallatin markets have been provided with additional resources and monitoring to address these credit issues. As demonstrated by the drop in the delinquency rates, we are seeing these steps help mitigate credit issues.

I will now turn it back to Lyle.

Thanks, Terry. You are all aware that Congress passed the Small Business Jobs Act, which is intended to encourage small business lending by community banks. One of the tools they are using to encourage this is to make available at additional capital to community banks with under $10 billion in assets. Certainly this is a good sign that the politicians are focused on increasing small business growth during these uncertain times.

While we agree that increased lending to small business will be a good sign of economic recovery, we believe that we have sufficient capital and sufficient liquidity to fund any loan demand that we will see in our markets. Therefore, we have no plans to participate in this program. Our capital levels remain strong despite being above the well-capitalized ratios. There are expectations in the current environment that capital should in fact be in excess of these ratios. The proposed Basel III plan confirms that we are heading toward higher capital. Right now, our capital is sufficient to support any organic growth that we will see in the coming year. And, while we are not actively seeking M&A opportunities, we are open to exploring each prospect that meets our criteria of geographic proximity, cultural alignment, growing markets and accretive to shareholder value.

As we said last quarter, it seems the economic recovery lost momentum throughout the spring, and that has continued into the summer months. Nonetheless, our belief continues to be that, although the economy is vulnerable, from our perspective in our markets we are not forecasting a double dip, of course, absent any major negative shock. Our outlook continues to be positive and we will look for modest economic growth over the next few months.

With that, B.J., let's open it up for questions.

(Operator instructions) Jeff Rulis, D.A. Davidson.

Terry, I had a question about your statement about 84% of non-accruals are current. It seems sort of high, and I guess two questions on that. The first would be, the pressure to put those into that classification -- is that regulator-driven? And then the second question would be, of that current bucket, is there a group of those loans that are close to going back on full accrual status?

Jeff, it is not regulatory driven. It would just be our practice and methodology we've used in a conservative way over the years. And so there is no change in methodology or process. And it perhaps is a bit high, but through the summer months it might be a high mark from a percentage basis, as there's a lot more business and activity that occurs through the summer. And, obviously, there would be a handful of credits that would be close to being upgraded back to an accrual status, but not a substantial portion of that portfolio, Jeff.

I guess I take that high level of current non-accruals and then couch that versus your comments about a peaking of NPAs, rising NPAs through mid-2011, with the addition of some payoffs and/or charge-offs. What's driving the further thought that you are going to see an increase in NPAs?

Jeff, this is Bob Cerkovnik, and it's really based upon our trend. While I feel that there are some positive things happening in our credits because we have been very aggressive in looking at credits and what we are doing, as a Company we are very quick to put something on non-accrual and very slow to put something back on accrual. And we follow all the regulatory guidelines. In fact, the regulatory agencies have never, at least in my tenure here, have not put something on non-accrual that we hadn't already identified.

But if you look at the trend in our NPLs over the last three quarters, there's an upward trend and I cannot sit there and say, they are going to flatten out or go on just because of the way we look at our credits, that there will continue to be a rise in looking at our projections that we have out, looking at all credits over 500,000. We have just decided that that's where we think we will peak out at. I hope that answers your question.

Got it, that's okay. And then, lastly, just interested in the OREO sales in the quarter. You did move some out, and sequentially your OREO costs were down, suggesting that your marks are pretty close to true market value. Is there anything in particular on those sales that those were better suited for mitigating loss? Or, would you say that, across the balance of your other real estate owned, that that experience would be similar?

That experience would be similar, and we are very aggressive when something comes into our OREO of writing it down.

Okay, thanks.

Matthew Clark, KBW.

Just first as a comment, I think in the release about high levels of non-accrual loans this quarter with all loan categories except ag showing increases, can you give us a better sense as to what might be showing up maybe on the C&I front and in resi mortgage, maybe? Just trying to get a sense for the increase, the incremental increase this quarter by loan type.

Yes. Matthew, really, the increase was driven by our A&P portfolio, which was comprised of, really, three different credits, and then our owner-occupied, which was really comprised of five credits. And our TDRs -- we had two larger, three larger TDRs that we had that we are working with our borrower on. And we lowered an interest rate or made some concessions, and obviously that would go into a TDR status. So those are really the two areas.

Anything on the commercial and industrial, then?

No, nothing of significance.

And then, within the owner-occupied, those five, can you describe the type, broadly speaking, type of properties?

The owner-occupied would be -- one was a large home in Jackson, and the other one would be a [truss] plant that we have in our South Dakota market.

Okay. And --

And we would have one -- I'm sorry. We would have one commercial credit that was in our Bozeman market that we think is improving tremendously and we hope to be -- see some improvement here this quarter.

Okay, and then the slight decline in potential problems -- is that -- do you expect that to be a sustainable trend, or do you think that could bounce around a little bit? And then as a follow-onto that, in your expectation with non-performers to potentially peak in mid-2011, does that assume deterioration, really, outside of the construction-related portfolio that might blend into CRE as well? But just thinking about just construction, are you making any assumption about any deterioration outside of construction with that forecast?

Not really. We probably see some, but most of that deterioration we'd continue to see in our CRE portfolio. Potential problem loans went from $286 million to $279 million, and that was really due to some pay-downs and some charge-offs.

Okay, thank you.

(Operator instructions) Brad Milsaps, Sandler O'Neill.

I just wanted to see if you guys could maybe talk a little bit more specifically about the A&D book. I know you mentioned last quarter that most all of these loans mature in the next 12 months. As you guide into the winter months here, which are typically seasonally weakest, just going to see if you could maybe divide that portfolio into what you view as pass rated or maybe a potential problem. And, obviously, you've disclosed what the NPLs are, but just a little more color in and around that particular portfolio.

I can answer. When you talk about where we're seeing our problems in the A&D book, if you look at our potential problem loans, we have about 9%, or $32 million of our total problem loans sitting in those. And when I look at our criticized declassified numbers, that book is approximately 40% -- over 40% criticized. So it gives you kind of a flavor for that we are very, very cautious of that book in looking at it. And everything is looked at on a quarterly basis, Brad, for any deterioration as we get new appraisals in.

Sure, what types of severities or discounts of value are you seeing as those appraisals roll in?

I could give you a general look of where we look at in our problem markets, but the rest of our markets are very stable. We are not seeing a whole lot of deterioration in most of our markets. When you look at the Jackson, Flathead and Gallatin Valley markets, from its peak we are seeing probably an 18% to 20% decline -- or, excuse me -- a 38% decline. And then -- and from the last 12 months, we would say, on average, we are seeing an 18% decline in those three markets, in our CRE loans -- appraisals, excuse me.

So those would be in the CRE loans, and then you said more of a 40% decline in the A&D bucket?

Yes. If you look at the A&D, it's probably even more than that. When you look at the last 12 months, we averaged the appraisals, and it's about 32% over the last 12 months, and then about 63% from its peak, which we consider to be that 2006-2007.

Okay, in that particular category, do you think you will be more aggressive in trying to move some of those to OREO, or charging those down more kind of aggressively with where the market may be now versus then?

Very much so. Most of our A&D book -- if it's got problems, we put those in different categories. If it's a good piece of property and we think over the long term, if we hold it, it will pay out better for us, we will look at that. But if we just think it's a property that is not going to move and the market is saying it's going to take some time, then yes, we will probably look to blow that out as much as possible. But again, our reserves and stuff that we have allocated for those problem credits -- and as Lyle mentioned in his opening statements, we do want to work with our borrowers for as long as we possibly can, and their ability to carry is always factored in.

(Operator instructions) Matthew Clark, KBW.

Just want to clarify -- you guys have talked to the construction portfolio, there's pretty good detail. We see the outstandings of 564, we've got the breakdown in three buckets with related non-accruals. But I guess the ongoing comment about commercial real estate and the fact that there's $75 million of non-accruals in that bucket -- can you remind us, I guess, how much you might have that -- I'm assuming part of those non-accruals relate to construction. I'm just not 100% sure if there's some construction within commercial real estate that we should try to isolate and think about.

No, that is not correct. We look at -- okay.

It's not? So it's pure, it's traditional commercial real estate?

Right.

Okay, that's all, thank you.

Jeff Rulis, D.A. Davidson.

I had some questions about -- I guess, if you look into 2011, Terry, you made some comments on the margin. If you could broadly speak about margin trends in the loan pipeline for the next year, I guess, whether you are budgeting for further compression, and I guess if you could speak to any changes in the -- if we could see some net growth next year, I guess, what would be your comments there?

Yes, Jeff, that would be great. From a budgetary viewpoint, we are budgeting a slight increase in loans. But, obviously, based on our most recent quarterly trend, we have not had a growth but a net decline. So, as Lyle indicated, we have some optimism that we have a positive outlook on the underlying economies. And so we are hopeful -- I wouldn't say it's all pipeline, but we were hopeful that we will resume back to some growth in 2011 of loans, although it will be quite modest.

A reminder that some of our decline of loans is attributable to a couple of areas. One, the sale of the student loan portfolio in third quarter 2010; that would not be reoccurring, so that's behind us. And also, if you step back and look at over the last 12 months or look at Q3 of 2009, that for the most part our decline in loans is attributable to the construction portfolio. So, although we have a net reduction in loans, I think we can understand from a macro viewpoint that it has been relatively flat and we would be hopeful to at least be flat, if not grow a couple of percent in loans over the next year.

As it relates -- you had asked also about the net interest margin application. And I think, as rates and quantitative easing that occurs, to the extent that the yield curve continues to flatten closer to zero across the board, that that has some negative implications t-o our margin. We don't see the margin free-falling, and we've tried to disclose some unusual reversals of accrued interest in the third quarter that we don't think will be of that magnitude in future quarters. So certainly some pressure against margins, to the extent rates just stay low here. But not seeing those two free-fall but perhaps come down a few basis points.

(Operator instructions). We have no further questions, so this will conclude the question-and-answer session for today. I'd like to turn the conference back over to Mr. Lyle Knight for any closing remarks.

Well, thank you, and thank you again for joining us this morning. I hope you can sense by the comments from management that we are bullish regarding our general market space. We are not seeing the enthusiasm yet from our borrowers which will drive up demand, but everyone feels that we are on a long-term, modest growth cycle that will carry us into the near-term.

With that, we thank you again for joining us, and we'll sign off.

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