Financial Institutions Inc (FISI) 2022 Q2 法說會逐字稿

Hello, everyone, and welcome to the Financial Institutions, Inc. Second Quarter 2022 Earnings Call. My name is Charlie, and I'll be coordinating the call today. You will have the opportunity to ask a question at the end of the presentation. (Operator Instructions)

I'll now hand over to your host, Shelly Doran, Director of Investor Relations to begin. Shelly, please go ahead.

Thank you for joining us for today's call. Providing prepared comments will be President and CEO, Marty Birmingham; and CFO, Jack Plants. Chief Community Banking Officer, Justin Bigham, and Director of Financial Planning and Analysis, Mike Grover, will join us for Q&A.

Today's prepared comments and Q&A will include forward-looking statements. Actual results may differ materially from forward-looking statements, due to a variety of risks, uncertainties, and other factors. We refer you to yesterday's earnings release and investor presentation, as well as historical SEC filings available on our Investor Relations website for a safe harbor description and a detailed discussion of the risk factors relating to forward-looking statements.

We'll also discuss certain non-GAAP financial measures intended to supplement, and not substitute for, comparable GAAP measures. Reconciliations of these measures to GAAP financial measures were provided in the earnings release filed as an exhibit to Form 8-K.

Please note that this call includes information that may only be accurate as of today's date, July 29, 2022.

I'll now turn the call over to President and CEO, Marty Birmingham.

Thank you, Shelly. Good morning, everyone, and thank you for joining us today. During the second quarter, our operating performance reflected the hard work of our entire team and yielded with very solid results, including net income available to common shareholders of $15.3 million, or $0.99 per diluted share. Results are up from the linked first quarter, but down from the year-ago period, when we recorded a sizable benefit for credit losses of $4.6 million. Having returned to a more normalized loan loss provisioning environment this year, after 2 years that were significantly impacted by the pandemic, we recorded a provision of $563,000 in the most recent quarter, which was positively impacted by a $2 million commercial loan recovery.

In addition, our second quarter 2022 results were impacted by $1.3 million of nonrecurring restructuring charges related to locations that were closed and consolidated as part of our 2020 retail bank network optimization. We've made significant progress on liquidating most of these properties, and this charge reflects a fair market value adjustment, based on existing purchase offers and current market conditions. Excluding these nonrecurring charges, adjusted pretax, pre-provision income was $21.3 million, which was $594,000 higher than the first quarter of 2022 and $361,000 higher than the second quarter of 2021.

The second quarter was a productive one for our company, as we delivered organic loan growth, maintained strong asset quality, and took steps to position our company for continued success in an evolving economy. We are making important progress on our digital transformation, which I'll touch on in more detail in my concluding remarks.

Total loans were up an annualized 3.3% from March 31, even as Paycheck Protection Program loans continue to wind down, as expected. We also sold about $31 million of indirect loans during the period. We were afforded the opportunity to sell this small pool of indirect loans, given the strong demand and growth we've experienced in this line of business in recent years. We will continue to evaluate future opportunities to sell indirect production as we manage our balance sheet and remix the loan composition with growth in other loan portfolios, namely commercial. Excluding PPP loans and the indirect portfolio sale, total loans grew more than 9% on an annualized basis.

On the commercial side, excluding the impact of PPP loans, we grew our commercial business portfolio 5.7% on an annualized basis from March 31, while commercial mortgage was up 3.7% annualized. I note that a fair amount of that growth came late in the second quarter, so we'll see the full benefit of that loan production and net interest income during the third quarter. Contributing to these results was strong performance out of the gate from our new Mid-Atlantic team that serves the Baltimore and Washington, D.C., region. Since joining 5 Star Bank in February, they have brought on approximately $24 million in outstandings as of June 30 and have built an ample pipeline to support future growth. Clearly, our community banking approach is resonating with customers in this market, and we believe it will continue to be a competitive advantage moving forward.

Looking ahead, we remain focused on partnering with high-quality commercial sponsors in our markets. Commercial real estate demand continues unabated, even amid the current interest rate environment, as developers in our Upstate New York markets continue to advance projects.

Turning to residential lending, balances were relatively flat from March 31. First mortgage volumes continue to trend lower, but we have seen increases in home equity volumes. Like much of the nation, residential lending opportunities in our markets have been impacted by higher interest rates, inflationary pressures, low housing stock, and changes in buyer appetite. As we manage through these challenges, we continue to focus on driving operational efficiencies and recruiting top-tier talent to support this key line of business and maximize opportunities for growth moving forward.

Consumer Indirect continues to be a core competency and growth engine for our company, up nearly 13% annualized from March 31, even with the sale of a portion of the loans late in the quarter. We continue to benefit from high auto valuations and a robust network of more than 500 franchise new auto dealerships. We remain focused on rate and our unwavering approach to credit discipline. Our prudent approach to credit transcends all lending categories and results in continued strong and stable credit quality metrics, including nonperforming loans of $6.5 million, or 17 basis points of total loans, and net recoveries of $1 million, or 11 basis points of average loans. Our allowance for credit losses to total loans measured 113 basis points at quarter end, up 3 basis points from March 31.

Our insurance and wealth management businesses achieved solid results in the second quarter and first half of 2022. Jack will provide additional details on their performance during his remarks, but overall, we believe these fee-based businesses remain well positioned to support revenue growth and profitability. Client retention in our insurance business has been very strong, and we believe new business development and cross-sell opportunities of our robust product offering are durable, bolstered by 2 acquisitions in 2021 that expanded our Upstate New York presence and enhanced the employee benefits business.

On the wealth management side, there is no doubt that the first half of 2022 has been challenging throughout the industry, and we did experience a market-driven decline in assets under management. Year to date, our investment advisory income is up about 5% from the first half of 2021, and our teams at Courier Capital and HNP Capital are closely engaged with clients to provide steady guidance and counsel amid historic pressures.

It's now my pleasure to turn the call over to Jack for additional details on our financial results and an update on 2022 guidance. Jack?

Thank you, Marty. Good morning, everyone. I'll begin by providing commentary on performance in key areas, with comparisons to the first quarter of 2022. Net interest income was $41.6 million, up $2 million from the linked quarter, as a result of higher average interest-earning assets and a higher interest rate environment. Just over $23 million and approximately $25 million of PPP loans were forgiven in the second and first quarters of 2022, respectively, with related fee accretion of $756,000 in the second quarter, as compared to $971,000 in the first quarter. Less than $1 million of 2020 vintage loans and $8.7 million of 2021 vintage loans remained on the balance sheet at quarter end.

NIM, on a fully taxable equivalent basis, was 319 basis points for the second quarter of 2022, up 8 basis points from the linked quarter and 13 basis points from the second quarter of 2021. Our margin has improved as a result of the rising interest rate environment, along with lower levels of federal reserve interest-earning cash this year as compared to 2021.

Investment securities were down because of the impact of rising interest rates on the market value of the portfolio and the deployment of portfolio cash flow to fund loan originations during the second quarter. As a reminder, our investment securities portfolio is primarily comprised of mortgage-backed securities with intermediate durations. These securities provide ongoing cash flow and have historically generated incremental yield over federal reserve balances. Cash flow from the portfolio allows for reinvestment into loans or additional investment securities.

Our cost of funds was 28 basis points in the current quarter, up 6 basis points from the linked quarter. The increase was primarily driven by the impact of higher rates on wholesale borrowings and reciprocal deposits. Noninterest income of $11.4 million was up modestly from the linked quarter's $11.3 million.

Revenue categories with the largest changes quarter-over-quarter were as follows: Gains on sale of loans of $828,000 were up significantly from the net loss of $91,000 reported in the linked quarter and included $586,000 associated with the sale of indirect loans that Marty mentioned earlier. Insurance income was $863,000 lower, primarily as a result of contingent revenue received in the first quarter each year. And income from limited partnerships was $553,000 lower based on performance of underlying investments in the current quarter. Noninterest expense was $2.8 million higher than the linked quarter, primarily as a result of $1.3 million of restructuring charges, higher equipment costs associated with technology, and the relocation of our regional administrative office in the Buffalo area, along with higher salaries and employee benefits.

Income tax expense was $3.9 million in the quarter, representing an effective tax rate of 19.8%, compared to $3.4 million and an effective tax rate of 18.7% in the first quarter of 2022. The Accumulated other comprehensive loss increased by $32.6 million in the quarter, driven by the unrealized loss position of our available-for-sale securities portfolio. Intermediate maturities of the treasury curve negatively impacted the market valuation of our investment portfolio due to its 5-year duration. We continue to believe these unrealized losses are temporary in nature. given the high quality of our agency mortgage-backed securities that are implicitly and explicitly guaranteed by the U.S. government. The unrealized loss position does not impact our forward earnings metrics, as we expect the securities to mature in a terminal of the value equivalent to par. As these securities roll down the curve, we continue to redeploy cash flow into the loan portfolio for current coupon bonds. As you'll see outlined in our investor presentation, the unrealized loss position negatively impacted the year-to-date TCE ratio by 157 basis points, intangible common book value per share by $5.64. We continue to expect these metrics to return to more normalized levels over time, given the high quality of our investment portfolio.

I'll now take a few minutes to provide our current outlook for 2022 in key areas. We continue to expect mid- to high single-digit growth in our total loan portfolio for the full year, with commercial and indirect loan categories driving this growth. This guidance assumes the forgiveness or repayment of the majority of the outstanding $9 million of PPP loans during the remainder of 2022.

We continue to plan for a low single-digit growth in nonpublic deposits. We are focused on attracting new consumer and commercial deposit accounts and expect the positive impact of these new accounts to be partially offset by an expected decline in the average balance per account. In the first half of 2022, reciprocal and public deposits have declined due to the current interest rate environment, as customers have looked to alternatives like U.S. Treasuries to generate more yield. For the second half of 2022, we are projecting balances to be relatively flat, absent typical seasonality in the public deposit portfolio.

We are increasing the range for full year NIM to 310 to 320 basis points, excluding the impact of PPP activity. The noise in NIM relative to PPP forgiveness will be muted for the remainder of the year, since the majority of PPP has been forgiven or repaid, although we are continuing to guide on full-year NIM, excluding PPP. NIM guidance reflects the increase in the Fed funds rate that occurred earlier this week. In the past, we have guided on NIM using a spot rate forecast. However, we have recalibrated our forecast based upon expectations of continued FOMC rate hikes through year-end.

We continue to expect a higher investment securities portfolio due to the carryover from our 2021 excess liquidity position as we deploy liquidity from the investment portfolio into loans. Guidance also reflects an increase to expectations for deposit betas, given the current rate environment, with a range of 0% to 55% from non-maturity deposits. As a reminder, our NIM fluctuates from quarter to quarter due to the seasonality of public deposits and its impact on both our earning asset and funding mix. In quarters where our average public deposit balances are higher due to seasonal inflows, the second and fourth quarters, our earning asset yields are lower, given the short-term duration of the deposits and limited opportunities to invest the funds.

Our balance sheet sensitivity remains relatively neutral. We saw a modest level of NIM compression in the first quarter, as expected, with a lower level of PPP revenue. However, the higher rate environment positively impacted loan margins in the second quarter, and we expect NIM to expand modestly throughout the remainder of the year if the current rate environment persists.

Approximately 32% of our loan portfolio, excluding PPP, is indexed to variable interest rates. We are lowering our projections for noninterest income to a low single-digit decrease compared to the prior year, excluding gains on investment securities and limited partnership income, as they are difficult to forecast. Our current outlook reflects continued pressure on mortgage banking revenue as a result of lower refinance activity and tightening of gain on sale spreads due to the interest rate environment, pressure on wealth management fees related to a market-driven decrease in value of assets under management, and a reduction in card interchange income as inflation impact consumer spending behaviors.

We are tightening the full year noninterest expense range to $126 million to $128 million, excluding the restructuring charge, which aligns with our original quarterly guidance of $31 million to $32 million annualized. You can now expect the second half of 2022 to be between $32 million to $33 million per quarter, as an expense plan in the first half of the year has been pushed to the second half of 2022, coupled with the current wage and inflation pressures.

Our spend in 2022 includes investments in strategic initiatives, including further enhancements to our new customer relationship management solution, digital banking, and banking as a service. We expect these investments to begin producing incremental revenue in 2022. However, full benefits are likely to be realized over the coming years.

Our expectations for efficiency ratio remain the same, within a range of 59% to 60% for the year, excluding the impact of the second quarter restructuring charges. 2022 efficiency ratio is impacted by upfront costs associated with our aforementioned investments and strategic initiatives that we expect to recoup in later periods, driving our expectation for improvement in the future efficiency ratio.

We continue to anticipate that the 2022 effective tax rate will fall within a range of 19% to 20%. Guidance includes the impact of the amortization of tax credit investments placed in service in recent years. We continue to evaluate tax credit opportunities, and our effective tax rate would be positively impacted by taking advantage of further investments.

We expect quarterly net charge-offs for the second half of 2022 to be within our annual historical range of 35 to 40 basis points. Net charge-off activity has been benign in the first half of the year, including the second quarter commercial recovery. Therefore, we expect our full year net charge-off rate to range from 15 to 20 basis points.

Our overall focus includes executing on strategic initiatives that will improve profitability and operating leverage over time. We believe that achieving results in line with the guidance provided will drive these outcomes. In June, we announced a new stock repurchase program for up to 5% of outstanding common shares, replacing the previous program completed during the first quarter. We believe a stock buyback program is an important part of our capital markets tool kit. No shares have been purchased to date under the new program.

That concludes my prepared remarks. I'll now turn the call back to Marty. Marty?

Thank you, Jack. Our digital transformation continues to build momentum as we deliver meaningful and differentiated customer experiences. Whether it's launching our open payments network, building digitally focused solutions for our consumers and small businesses, or sourcing complementary fintech partnerships, we are extending the reach of our banking products and services. Traditionally, this would have been challenging for a bank of our size. However, ongoing investments in the platform and solid partnerships are delivering benefits across customer acquisition and retention, operational efficiencies, and further revenue opportunities through Banking as a Service, or BaaS.

In a complementary way, we are building our digital capabilities on the foundation of a well-established community bank and reaching a broader expanse of consumers and small businesses than ever before. We see disruptive opportunities in digital payments, small businesses, artificial intelligence and machine learning, and digital currency. During our last quarterly call, I spoke about several efforts and initiatives underway, and I'd like to provide a brief update today.

CHUCK, our open payments hub, went live earlier this month. CHUCK allows customers to send and receive payments of any kind and on any platform. This unique approach helps us to lean into customer preferences and grow digital banking engagement, while honoring and enabling customer choice. We are working with partners Numerated, Autobooks, and Q2, among others, to create a digitally focused solution for small businesses. At 5 Star Bank, we view small business banking as table stakes. However, we recognize that much like consumers, small businesses are becoming digital first in their approach to banking. This digital small business hub will strengthen existing relationships and efficiently position us for expansion beyond our current footprint.

As part of our efforts to improve operational efficiency, lower customer friction points, and enhance the associate experience, 5 Star Bank has been working with Zest AI to provide data-driven credit decisioning using artificial intelligence. The program is undergoing extensive testing, and we anticipate a phased pilot approach to roll out through 2022.

Our BaaS pipeline is beginning to translate into success, and we anticipate it growing through 2022 into 2023. We have several BaaS partnerships that have entered the onboarding and testing phases and are expected to go live later this year.

Lastly, we continue to collaborate with our regulators on our exciting efforts to offer Bitcoin to consumers in partnership with NYDIG. We don't anticipate any issues and have been responsive to the information requests to date.

I remain very pleased with the exceptional efforts of our teams to support our customers and communities while building long-term value for shareholders. And before opening up the line for questions, I would like to take a moment to acknowledge a colleague who will be retiring in September. Shelly Doran, who have served as Director of Investor and External Relations for Financial Institutions and 5 Star Bank since 2016 has been instrumental in helping to build out our IR program and enhance our company's reputation among investors, customers, and our communities. We will miss her positive attitude and exceptional mind, and we are grateful for her efforts over the years and wish her well in a much deserved retirement.

Assuming Shelly's role by Kate Croft. Kate brings more than 10 years of experience in investor relations and corporate communications, most recently working at a national consulting agency where she supported about a dozen financial service client relationships, including banks with assets ranging from $800 million to more than $150 billion, and a wealth management firm with more than $16 billion in assets under management. Kate has been working closely with Shelley since joining us in June, and we look forward to introducing her to many of you in the coming weeks and months.

Operator, this concludes my prepared remarks, and we are ready to open the call for questions.

(Operator Instructions) Our first question comes from Alex Twerdahl of Piper Sandler.

First off, I wanted to ask about the indirect auto sales you did this quarter. I remember it's a business line that you guys kind of started to get into a decade, maybe even a little bit more than that ago, and then the rate and the whole market changed on you. Is this something that's now kind of a renewed effort to kind of get into having the gain on sale from indirect loans be a more consistent revenue stream in the future?

Alex, this is Jack. As you may recall, over the last couple of years, we've had a lot of demand in the indirect space, particularly throughout the pandemic, and it's certainly a line item on our balance sheet that's grown. We view this as an option to execute on some capital market relationships we have to remix the balance sheet modestly and take some gains, so it's opportunistic. But it's certainly a viable option, should we need to further remix that balance sheet in future periods.

Okay. And then, I noticed that the ACL ticked a little bit higher this quarter. I was wondering if you could kind of just kind of give us an update on what you're seeing in your markets and sort of the drivers of that metric.

So, credit continues to be very stable, in our experience, across our markets and certainly in our portfolio as we see it. As we've shared before, the primary driver is the national unemployment rate, which seems counterintuitive, given all the volatility that seems to be working its way through the economic outlook as we speak. So, we have been thoughtfully thinking about qualitative factors as well and taking the actions that we did this quarter relative to the provision that we took. And as well, we were -- our provision was influenced by a final resolution of a credit that we had to work out that provided a recovery for us.

Yes. Alex, this is Jack. I would say that our current coverage ratio of 113 basis points aligns with our pre-pandemic CECL day 1 level, and so it's something that we're certainly comfortable with.

Great. And I just want to make sure I understand your NIM guide, Jack. I think you said 310 basis points to 320 basis points, excluding PPP. First half of this year, we're right around 310 basis points, I think; correct me if I'm wrong. So, sort of the difference from here, the difference between the 310 basis points and 320 basis points, is that pretty much dependent on deposits, where if you had a 55% deposit beta that you'd be closer to 310 basis points and a 0% deposit beta closer to 320 basis points? Is that the right way to think about it?

No. We've modeled in the forward curve for the rate hike that occurred yesterday, and then for the expectations for future hikes in September, November, and December. We conservatively modeled in 0% to 55% for non-maturity deposit betas, which is a mix of stress betas versus what we traditionally would see from a management standpoint, just given the magnitude of fed hikes that have occurred this year and are expected to continue to occur. So, just from a conservative standpoint, we feel there's opportunity for us to modestly expand to approach that 320-basis points level by year end.

Okay. So, but the 0% to 55% deposit beta, that's kind of certain deposits are a 55% beta in certain are a 0%? Is that -- I'm a little bit confused by that comment.

Yes, that's correct. So, some of the higher-balance money market accounts have more of a 55% beta, whereas demand is 0%.

Again, you're emphasizing that that is a conservative…

Yes, correct. And that's a conservative approach that we've established.

As compared to our actual experience.

Yes. And I know that the municipal deposits and certain public deposits may be a little bit higher beta right now and starting to see fees and pressure. But in kind of your core deposit, are you seeing much pressure so far, a lot of competitive pressure on deposits in your markets?

Not on the core portfolio at this point.

Our next question comes from Marla Backer of Fidelity.

So, I have a couple of questions, and I was hoping we could get a little bit more color on the Banking as a Service at staff initiative terms of, you talked about a lot of a lot of customers, potential customers, in testing mode at this point. Have you converted any customers yet to going live, or it's still early days for that?

Generally, it's still early days, Marla. And I would say that what we're doing in Banking as a Service is a natural extension of the experience that we've all lived through in the last couple of years. With digital adoption soaring across all customer segments, our own experience of upgrading our own digital platform, working with our allied labs consortium that ultimately has allowed us to produce CHUCK and go live with CHUCK, we continue to kind of extend our banking platform into services and collaborative partnerships with technology companies. And we mentioned the work that we're doing with Numerated and others. That's in the small business space. That is an outgrowth of our work that we did during the pandemic with the PPP program and automating that process. So, we're taking a series of incremental steps that, at this point in time, the investments are approximately equal to -- the expenses are equal to the revenue, so it's a breakeven as we speak today. But the opportunity we see as being quite enormous in terms of the small bets, the array of small bets, if you will, that we are exploring.

Marla, this is Jack. I would suggest you're referring…

And then…

Sorry, Marla, I just want to point you to the investor presentation. We do have some slides in there that outline the phased approach we're taking, where we have a couple that are in integration and onboarding and one that in testing, and we have the number that are expected to go live later this year.

Okay. Great. And obviously, digital is a big factor here. It's part of what's supporting this initiative and others. Given that we are seeing these changes and you did close a number of branches in 20 -- over the past several quarters, do you think that that strategy will also continue? Have you identified any further potential branches for either closure or downsizing?

A couple of comments that I would offer is that this is why we have really embraced the opportunity to have -- to drive exceptional digital experiences for our customers. And while we're doing that, there's meaningful and substantive opportunity to drive efficiencies into the core banking operation. And as I said in my comments, it also honors our customers' ability to be empowered to choose how they want to deal with us. And branches are a big -- in-person, personalized service is a big part of our reason for being. But as you're pointing out, strategically, that is a challenge that we need to continue to work on and think about in terms of optimization.

Justin is here. You want to comment as our Chief Banking Officer with responsibility for our retail network?

Yes, Marla, we don't have any consolidations planned at this time. But obviously, we have very detailed information about each one of our branch's geography, the markets that they're in, the customers that they serve, and we do monitor that regularly. And should something present itself, we would certainly consider it, but at this time, we don't have any plans for more consolidations.

Okay. And then one last question, or topic: the Mid-Atlantic team. When they came in, my understanding is they came in with a pipeline of business or conversations they had been having. So, is some of what you're seeing there, they're converting some of that pipeline into actual business now? Can you give us some sense of how their conversations are going in terms of sourcing new business under their new 5 Star or Financial Institutions umbrella?

It's -- the team has been very active. They've got a very strong following. They've been operating in the market for a number of years, and in terms of a number of years together working as a team. So, Marla, in the -- they've developed a pipeline of approximately $100 million, and they closed about $24 million in the second quarter. So, our loan guidance does include the impact of the team that Jack articulated, and I would just say we are very pleased and excited by the strong start that they have gotten off to here.

(Operator Instructions) Our next question comes from Damon DelMonte from KBW.

This is Matt [Renk] filling in for Damon. I just had a follow-up to the Banking as a Service line of questioning. What types of clients are these new -- are the 4 customers in the pipeline currently? Are they fintechs? Are they more nonbanks on the wealth side? What types of fee-based lines of businesses are they selecting? Is it all that's listed on the slide? And then, maybe if you could just give some outlook into 2023 of like, what do you expect these 4 to bring in in revenues?

Well, as I said, we are exploring a number of opportunities, and each is slightly different. And so, I would say that the partnerships in total could drive positive -- have positive impact on our fee revenue as well as deposits and interest income for the company.

Yes, Matt, this is Jack. And I just want to add color as to the impact on 2022. So these fintech relationship (technical difficulty) are modeled to essentially break even in the first year for us, so our guidance indicates that any revenue offsets expense. We do expect them to ramp up in 2023 and 2024 as the relationships grow, so the larger impact from a P&L standpoint will be seen when we provide guidance on 2023 at the end of this year.

Okay. And when you say break even in the first year, so we've onboarded by the end of 2023, the outlook for 2023 is it doesn't generate a profit, correct?

It depends on the stage of the deal and the deal itself, but generally speaking, it depends on the -- also the speed at which they ramp up. From a conservative standpoint, they're breakeven in year 1, and then with pretty high upward trajectory from a profitability standpoint after that.

Okay. And do you think that speed will pick up as you guys onboard more people, or is that just kind of the normal time it takes to complete one of these deals?

Yes. In our experience, we're going at a natural pace. We want to make sure that we get it right. And as we finalize and push forward, we think the opportunity is very significant.

(Operator Instructions) At this time, we currently have no further questions. Therefore, this concludes today's call. But before that, I'll hand over to Marty Birmingham for any closing remarks.

Thank you, operator, for your help this morning. I want to thank everyone for their participation, and we look forward to building on the conversation at the end of the third quarter.

Ladies and gentlemen, this concludes today's call. You may now disconnect your lines, and have a lovely day.