Financial Institutions Inc (FISI) 2021 Q2 法說會逐字稿

Good day, and welcome to the Financial Institutions, Inc. Second Quarter Earnings Conference Call. (Operator Instructions) After today's presentation, there will be an opportunity to ask questions. (Operator Instructions) Please note, today's event is being recorded.

I'd now like to turn the conference over to Shelly J. Doran, Director of Investor and External Communications. Please go ahead, ma'am.

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 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 a Form 8-K. Please note that this call includes information that may only be acted as of today's date, July 30, 2021.

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

Thank you, Shelly. Good morning, and welcome to our second quarter 2021 earnings call. It was another strong quarter for our company. Net income of $20.2 million or $1.25 per diluted share was the second highest in company history. Net income was down slightly from the first quarter's $20.7 million or $1.27 per share and significantly higher than second quarter 2020 net income of $11.1 million or $0.67 per share.

We once again benefited from a positive provision in the quarter, experienced growth in our wealth management and insurance businesses and continue to contain expenses despite critical investments being made in technology and people.

Pre-tax pre-provision income for the quarter was $21 million, a $3.1 million decrease from the first quarter of 2021 and a $3.7 million increase from the second quarter of 2020.

I want to thank my fellow associates for their dedication in serving our clients across all business lines. They are delivering strong outcomes for our customers, communities and shareholders.

It was an eventful and successful quarter for our retail branch team. During the month of June, we opened 2 new Five Star Bank branches in the City of Buffalo. Buffalo has long been a focus for company growth. With these openings, we have grown our presence in the greater Buffalo area to 6 branches. While still early, both branches have received warm welcomes in their respective neighborhoods.

The new branches are located in areas undergoing significant redevelopment and revitalization, and we look forward to contributing to the positive momentum. We also look forward to delivering our unique style of community banking to our new neighbors.

On Monday, we are relocating our existing Five Star Bank branch in the City of Elmira. The new branch in a newly constructed building is about 1,600 feet from the existing branch. This relocation is exciting for our Elmira customers and our associates, and will result in a more efficient footprint and annual costs savings for the company.

All 3 new branches are designed to serve as financial solution centers with no teller lines and no barriers between associates and customers. They feature a blend of technology, including interactive teller machines as well as the comfort of working directly with our certified personal bankers.

The new design requires less staff and provides a cost effective, lower square footage approach to aligning services with shifting customer needs and preferences. This includes advancements in financial technology that enable consumers to bank from virtually anywhere anytime.

The new branch openings and Elmira branch relocation are a continuation of our retail branch evolution. You will recall that in 2020, we consolidated a 11 branches in suburban communities with overlapping areas into 5 full-service financial solution centers and closed one additional branch.

We have a fundamental responsibility to our customers and communities to adapt our approach as market conditions change, influencing our brand strategy.

I'll now turn the call over to Jack, so he can provide additional details on results and guidance. Jack?

Thank you, Marty. Good morning, everyone. I'd like to begin today by providing commentary on key areas, along with comparisons to the first quarter of 2021. Net interest income for the quarter was $37.7 million, a slight decrease from the linked quarter, despite an increase in average interest-earning assets.

The decrease was primarily driven by lower PPP fee accretion. Approximately $95 million and $87 million of PPP loans were forgiven in the second and first quarters of 2021, respectively, with related fee accretion of $1.5 million in the second quarter as compared to $2.9 million in the first quarter.

PPP loan fees are paid at varying rates. Lower balance loans paid a higher percentage rate fee than larger loans and we experienced forgiveness of a higher percentage of the larger loans in the second quarter.

Net interest margin was 3.06%, 23 basis points lower than the linked quarter. Our excess liquidity position exacerbated this quarter due to the seasonal impact of public deposits, resulted in approximately 12 basis points of NIM compression from the linked quarter.

The previously mentioned lower PPP loan fee recognition in the quarter negatively impacted NIM by about 11 basis points. We do, however, continue to experience stability in the margins of our core balance sheet as reflected in the stable credit spreads on new originations as compared to the prior quarter and prior year.

Provision for credit losses was a benefit of $4.6 million in the quarter compared to a benefit of $2 million in the linked quarter. Continued improvement in the national unemployment forecast, positive trends in qualitative factors, and lower net charge-offs resulted in the second consecutive quarterly release of credit loss reserves.

Net recoveries were $394,000 in the quarter as compared to charge-offs of $887,000 in the linked quarter. The second quarter benefited from commercial-related net recoveries of $294,000 and indirect net recoveries of $426,000.

Our indirect business experienced a lower level of repossessions. In addition, we had a lower loss per unit due to the recent increase in used car prices. Because of these factors, the allowance for credit losses decreased by $3.5 million in the quarter down to $46.4 million.

As we've previously discussed, in the fourth quarter of 2020, we identified the specific customers and industries we believe to be most at risk because of pandemic. We moved these loans -- about 20 loans totaling $127 million to criticized assets and set aside a specific reserve of $4.7 million.

The specific reserve increased by $2.4 million in the first quarter to $7.1 million and decreased by about $200,000 at $6.9 million as of June 30. Approximately $112 million of these loans remain in the criticized or classified asset class at quarter end.

We are optimistic that these credits will normalize post pandemic. And while we have seen improvement in the performance indicators of several of these credits, we do not plan to release specific reserves until the credits return to normal paying status.

The allowance for credit losses on loans to total loans was 128 basis points at quarter end, down 8 basis points from March 31. If you exclude PPP loans, the ratio increases to 134 basis points, a decrease of 13 basis points from the end of the first quarter.

Credit metrics continue to be strong with a total nonperforming loan to total loan ratio of 18 basis points and an allowance for credit losses to loans to non-performing loans of 699% at June 30.

Noninterest income of $10.2 million was $2.8 million lower than the first quarter of 2021. First quarter noninterest income was exceptionally strong, and during the quarterly call, we indicated that we expected fees from both interest rate swaps and mortgage banking to moderate. Key drivers of the second quarter decline were associated with fee income areas that tend to fluctuate quarter-to-quarter and are difficult to forecast.

Income from derivative instruments was down $2.5 million because of a significantly lower level of interest rate swap transactions executed in the quarter, combined with the negative impact of lower long term interest rates on the fair market value of borrower facing trades. And income from limited partnerships was down $617,000 based on the activity and performance of underlying investments.

Noninterest expense was $26.9 million, an increase of $204,000 from the linked quarter. Computer and data processing expense of $3.5 million was $339,000 higher than the first quarter of 2021 due to the investments in technology. The largest decrease in expense was professional services down $292,000 from the first quarter due to the timing and level of consulting expenses, including audit fees.

Income tax expense was $5.4 million in the quarter, representing an effective tax rate of 21.1%. The effective tax rates in 2021 have been higher than the previous year because of higher pre-tax earnings.

Moving on to the balance sheet. Total loans decreased $22 million or 0.6% from March 31, 2021. Commercial business decreased 10.5%, commercial mortgage increased 3%, residential real estate loans were down 1.9% and consumer indirect was up 4.8%. You will recall that PPP loans are included in the commercial business loans. Excluding PPP loans, the commercial business portfolio decreased 0.4% and total loans increased 1.8%.

Total deposits at quarter end were $57 million lower than at March 31 due to the seasonality of public deposits, partially offset by growth in the nonpublic and reciprocal deposit portfolios. Our excess liquidity position continues to put pressure on net interest margin, through both our excess federal reserve balance and additions to the securities portfolio.

During the second quarter, we continue to expand our investment portfolio to benefit interest income by deploying excess liquidity into investment classes with a risk-adjusted yield profile that exceeds the interest on excess reserves.

We remain cautious of extending the overall portfolio duration. However, we're mindful of striking an appropriate balance between increasing net interest income and mitigating the impact of excess cash balance on net interest margin.

Our average federal reserve balance was $126 million higher during the quarter, largely due to the seasonal inflows of public deposits. Overall, the inflows of public deposits have been higher and retained longer and then we'd experienced historically, which resulted in a higher average FRB balance.

We experienced improvement in our TCE ratio during the quarter from 7.13% to 7.58%. Total assets declined slightly given the seasonal outflow of public deposits at the end of the quarter, which compared to the seasonal inflow of public deposits at the end of the first quarter.

Conversely, our tangible common equity increased, primarily a result of our strong second quarter earnings. We remain very comfortable with our capital position, given that much of the asset growth we've experienced in the past year was due to shorter-term PPP loans and excess liquidity.

In addition, our asset growth has been concentrated in very low risk-weighted assets. Therefore, our regulatory capital ratios remain comfortably above well capitalized minimums.

I'll now provide an update on our 2021 outlook in key areas. We continue to expect mid-single digit growth in our total loan portfolio, excluding the impact of PPP loans. All loan categories are expected to contribute to the increase, with the largest contributions from the commercial real estate and indirect portfolios, as experienced in the first half of the year.

Our original PPP assumptions included approximately $125 million to $175 million of 2021 originations. Actual originations for the first 6 months totaled $107 million, and we expect no further originations as the SBA is no longer accepting applications.

We experienced approximately $17 million, $87 million and $96 million of forgiveness and payoffs of the 2020 vintage of PPP loans in Q4 2020, Q1 2021 and Q2 2021, respectively. We continue to estimate that 90% of the first wave of loans will be forgiven in 2021. We have not included any forgiveness on the second wave of loans in our assumptions as we believe most forgiveness will occur very late in 2021 and into 2022.

We continue to anticipate mid-single digit growth in nonpublic deposits. While deposit balances remain elevated in the low interest rate environment, we have seen growth moderate, largely due to a change in the deposit behavior of PPP customers. Guidance includes the 2 new Five Star Bank branches that we opened in Buffalo.

We experienced stronger-than-expected growth in the first half of the year for both reciprocal and public deposits and are now projecting double-digit growth in these areas for the year. We are reducing full year NIM guidance by 5 basis points to a range of 305 to 310 basis points, excluding the impacts of PPP loans.

The reduction reflects our expectation for continued compression from excess liquidity and carrying higher balances, interest-bearing cash and investment securities. It also reflects lower yields on interest-earning assets as loans and securities repriced, which will be partially offset by lower deposit funding costs.

The noise in our NIM related to PPP forgiveness and new originations will be muted in the second half of 2021 as compared to the first half. However, we are continuing to guide NIM, excluding the impact of this activity.

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 deposits and limited opportunities to invest the funds. Our NIM guidance remains highly dependent on the overall rate environment.

We are increasing full year noninterest income guidance to high single to low double-digit growth, excluding gains on investment securities, given our strong noninterest income performance year-to-date. As previously mentioned, this category includes revenue that is difficult to forecast, such as swap fees and limited partnership income, so we are providing a wider range of guidance. We continue to anticipate an increase in noninterest expense in the low to mid-single-digit range for 2021.

Noninterest expense is expected to range from $27 million to $29 million per quarter. Expense savings from our enterprise standardization program are offsetting the cost of important investments we are making in people and technology to improve relationships with our customers and enhance future profitability.

We are lowering our 2021 efficiency ratio guidance to a range of 56% to 57% for the full year, given the strong results posted in the first 6 months. We continue to expect that the effective tax rate for 2021 will be within a range of 20% to 21%, given earnings results in Q1 and Q2. This guidance reflects the impact of the amortization of tax credit investments placed in service in recent years.

We will continue to evaluate tax credit prospects, and our effective tax rate would be positively impacted by taking advantage of further investment opportunities.

Given our low level of net charge-offs in Q1 and net recoveries in Q2, we are revising full year guidance to a range of 20 basis points to 30 basis points, a 10-basis point reduction to the low and high-end of this range previously provided. Our focus remains on improved profitability and operating leverage.

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

Thank you, Jack. I would like to close with a few governance and organizational updates. In mid-June, we announced that Susan Holliday was elected Chair of the Board of Directors. Susan has been a member of our Board since 2002 and most recently served as Vice Chair. She is past Chair of the Management Development and Compensation Committee and most recently served as Chair of the Nominating and Governance Committee.

Susan was the owner, President and Publisher of the Rochester Business Journal from 1988 to 2016 and is currently the CEO of Dumbwaiter Design. Her community involvement is extensive, and she serves on numerous nonprofit Boards.

I've known Susan for many years, and I'm very pleased that she is now serving in this critical role. She brings strong integrity, acquisitiveness, willingness to challenge and a collaborative approach to the role of Chair. I want to take a moment to thank former Board Chair, Bob Latella for his dedicated service. We have benefited greatly from Bob's leadership and are grateful that he has agreed to remain on the Board.

At the June annual meeting of shareholders, 2 new directors were elected. Mauricio Riveros and Mark Zupan. Mauricio and Mark are exceptional additions, and they bring diverse work and life experiences, representing incremental skills, experience in market knowledge and will benefit our organization.

Our Board of Directors is committed to diversity and inclusion and through thoughtful succession planning and refreshment has achieved the following levels of diversity and tenure. 5 new directors have been added to the Board over the past 5 years. Gender and ethnic diversity has strengthened.

50% of the Board's 10 independent directors represent diverse groups, with 3 women, each of whom hold key Board leadership positions and 2 directors who belong to a racial or ethnic minority group, one of whom holds a key Board leadership position.

Board tenure is balanced with 5 members between 0 years and 5 years, 3 members between 6 years and 10 years and 3 members with tenure of more than 10 years.

Advancing diversity and inclusion is an area of focus for management as well. Last September, we established a Diversity And Inclusion Advisory Council to evaluate company practices and provide learning opportunities to educate, build inclusion acumen and foster a sensor belonging.

The counsels comprised of associates from diverse personal and professional backgrounds across our geographic footprint. I serve as sponsor for the counsel and continue to be inspired by the passion of its members. Our work here is critical and will be ongoing.

The company continues to take a thoughtful and prioritized approach in returning our associates to the office. Currently, 70% of our workforce has returned to primary office location and 100% of our client-facing associates returned to primary locations earlier this month.

We remain mindful of the COVID variants and are following, not only state and federal guidelines, but also maintaining many of the safeguards we successfully instituted throughout the pandemic, including continued social distancing, active vaccination tracking and hybrid working arrangements.

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

Thank you. We'll now begin the question-and-answer session. (Operator Instructions) Today's first question comes from Damon DelMonte with KBW.

So I just had a question on the outlook on net charge-offs that was provided. You guys said 20 to 30 basis points for the full year. If you kind of look at what you've done in the first half of the year, that kind of implies upwards of 35 basis points of net charge-offs in the back half of the year. So, I guess, my question is, do you feel that with where the reserve level is today, 134 on ex-PPP loans, that you'll need to cover those expected charge-offs? Or are you able to let the reserve run down from here?

Hey, Damon, this is Jack. So from a NCO level, we're expecting that guidance to revert back to what we've seen historically. But from an allowance standpoint, looking at that pool of specific reserves we have from the COVID deferrals, there's about $7 million still there and as those stabilized when they come off their deferral. And we expect to have some release of those reserves. So from an overall allowance standpoint, I would expect that to migrate back down to historic levels.

So you think you need like another quarter or 2 on that pool of loans to have comfort where you could begin to release those specific reserves?

Yes. I mean the passage of time hasn't been long enough to establish a trend there. They're coming off deferral in the fourth quarter and couple of them are coming off in the first quarter of 2022.

Yes. Just to read forward Damon, it's Marty. We -- our approach in terms of providing relief and the COVID bridges that we've talked about previously, basically run through the end of the year. The idea there was that based on regulatory conversations and guidance, we were providing relief through the end of the pandemic -- expected, anticipated. And when we get to that period of time, that would be when we would consider removing them from the categories that you guys are talking about.

And then I guess just a quick question on the core margin outlook. Just to make sure I understand this correctly. Jack, you're saying like, discontinued excess liquidity and the repricing of loans at lower than legacy portfolio yield is going to kind of cause the core margin to grind down a little bit lower for at least another couple of quarters?

Yes. There's just cash flow coming off the -- our core portfolio that we're reinvesting at current market yields. Credit spread has been holding up very well, which is a positive trend for us. And then the excess liquidity is really what's weighing on the margin. Thanks Damon.

And our next question comes from Marla Backer with Sidoti.

A couple of questions. First of all, you're talking about excess liquidity, and I'm thinking that, that's something that other financial institutions operating into your markets are also clearly experiencing. What are you seeing in terms of pricing in some of your key products as a result of that?

Well, as I mentioned earlier, from a pricing standpoint, we've only really guided on credit spreads and our credit spreads have been very stable relative to the prior year.

And switching topics in terms of the Elmira branch relocation. Is this a model if you find that it's successful with the Elmira branch, is it a model that you're thinking you might replicate with other older branches?

So basically, that's in my prepared comments. We were talk -- I want to make sure we emphasize it. We are well aware of the opportunity and the responsibility to make sure that we are operating our branch network in the most efficient and effective manner. Efficient for the company and effective for our customers and the markets we're serving.

So the short answer is, yes. This can serve as a model for us as we go forward. Our financial solution centers, in general, have served as kind of our modern approach, and they've evolved or in our third version in terms of size and how we configure them and application of technology and the levels of staffing. But at the end of the day, specific to Elmira, was an opportunity where we were working together, and we've reduced the annual lease expense in a significant way in this specific location as well as being able to apply more flexibility and efficiency to how we deliver the branch in the actual location where we're operating.

So in terms of achieving cost savings, you're talking about a combination of reducing the footprint of the branch as well as reducing staff levels at branches that you open going forward? Is that the right way to think about it?

Staff, its footprint, and in this case, since we didn't own it, it's annual lease expense. It's a meaningful savings.

And then the last question I have is, your new community banking unit is fairly new. Can you give us any color on if you're seeing -- what kind of benefits you're seeing from that structure at this point?

So I'll ask Justin respond, but before I do. I'll say that I'm very pleased with the overall organizational approach that we are operating under right now in terms of leadership of our community bank, our commercial bank, our administrative functions and our risk functions as well as our human capital. And, obviously, Jack is participating in this call. So Justin?

Hi, Marla. Its Justin. Things are progressing really well with the new structure. Obviously, it takes time to sort of adjust and start developing strategy and thinking through the changes and thoughtful approach to how we want to conduct our community banking. And I think in the coming quarter -- couple of quarters, you'll start to see -- externally start to see some things that are changes as to how we're thinking about the community bank and how we're thinking about our own value proposition in the future. So I look forward in the future to providing more information on that as we get into the next couple of quarters.

(Operator Instructions) Our next question comes from Bryce Rowe, Hovde Group.

I wanted to kind of follow-up on one of Damon's questions there about the specific reserves against the COVID sensitive loans. So Jack, you noted a drop from $127 million to $112 million, was curious, if that was kind of normal schedule in terms of loans coming off of deferral? Or did they come off early?

Hey, Bryce, this is Jack. Yes, those were 2 loans that we saw stability in their performance. So they came off the deferral program early and returned to normal payment status.

And are there prospects for the balance -- the $112 million balance for that to happen earlier than the Q4-Q1 time line that you have set out at this point?

Yes, there is potential for those loans to come off we'll see then return to normal payment status. We monitored them very closely. We stay very closely credit on them. The determination at this point in time is, we just want to see trends and stability. We feel optimistic about them. So that we expect that they are moving in the right direction at this point in time.

I wanted to ask about the PPP program. Jack, I kind of missed what you said about the forgiveness for round one. Can you just tell us what the respective balances are for round one and round 2 as a of the end of the second quarter?

At the end of the quarter we had about $172 million in total PPP loans outstanding. $70 million of that was related to the 2020 round one vintage and $107 million related to 2021 vintage.

And then remaining fees tied to PPP, you can certainly break it out as 1.0 and 2.0, but just total remaining fees would be helpful?

Yes. I can break it out. We have $1 million remaining on the 1.0 vintage and $4.7 million on 2.0 vintage.

And then wanted to ask about -- you obviously highlighted excess liquidity. It's obviously something we've seen throughout the industry. You all have grown the bond portfolio by, let's call it, $100 million a quarter for the last 3 quarters or 4 quarters. Is that kind of the plan at this point? Or is it more trying to understand what the flows are going to be, and that will kind of dictate the bond purchases or the new bond purchases?

So we're trying to strike an appropriate balance between growing net interest income and managing net interest margin. And having that excess cash, sitting with the Fed is obviously been weighing on both metrics. So we've been very particular about choosing the bonds we want to purchase and growing the portfolio in a methodical way that doesn't put an undue extension of duration to the portfolio, but provides the ability to lean on the portfolio for liquidity purposes in the future as we get through this excess federal reserve balance.

And then one last one from me. You noted the recoveries on the indirect side, lower repossessions and higher values. It certainly feels like the higher value side of used cars or cars will continue here. Do you have a sense from a kind of a repossession perspective if that might continue to? Or was this more of an anomaly here in the quarter?

Yes. The trends we've been seeing with our repo rates are at historic lows. But what's really driving that is that the average loss per vehicle is down significantly, and that's coupled with the increase in used car prices, but we expect the reversion to normal levels over time.

And our next question comes from Alex Twerdahl with Piper Sandler.

I just want to ask, I think over the last couple of years, the indirect portfolio had been sort of shrinking as a percentage of the overall pie, maybe more supplementary than anything else. Just curious, just given all the liquidity out there and certainly, the strength in indirect auto, the car market recently, if the thought process around that portfolio has changed. And maybe it can be actually a bigger percentage of the pie from here?

So the thought process really hasn't over the long term. But, clearly, it's been a very important capability -- strategic capability that we can -- have relied on, Alex, in this period of time with excess liquidity rolling through the system, certainly, our balance sheet as well as the market dynamics that we're all well aware of in terms of how robust that business line has been.

Just the reason we're so comfortable continuing to engage in the short term is because our program is probably now in its 16th year, and it's been very consistent, as you know, focused on fundamentally strong credit. And certainly, the stability of our credit performance really does speak for itself. So we remain very comfortable with it and glad we had that capability over the course of the last 18 months.

And then I'm just curious what you're seeing out there from an M&A perspective, not just whole bank, but also some of the fee-based businesses that you guys have bolted on over the past couple of years. If there's going to be some opportunities to do some more of those types of transactions later this year?

Well, we remain open to those opportunities and are interested in continuing to bolster our fee-based business platforms. And we're very excited by the progress that's being made with our Landmark acquisition. That was a modest acquisition in terms of impact, in terms of earnings dilution and accretion. But it was very important for us in terms of driving our Rochester presence as well as the market knowledge that the principles have brought to us. And so as those other opportunities surface, we'll be open to them and consider them whether they support our wealth or insurance operations.

And then just for the whole bank acquisition, it's something you guys had talked about in the past. It's been a while since any of landed for you guys. But just given the outlook on the market and the prospects were down earnings in 2022 everywhere, we've certainly seen a lot of transactions. I'm just curious if you think that's something that you guys would participate in and what the criteria would be?

These are possibilities. And the criteria is probably the same that you hear across these conversations. We want to be very sensitive to dilution, accretion and earn back periods. And while we're well aware of what's happening in the outlook in terms of merger of equals being, I guess, more enthusiastically appreciated by the market. We're open to possibilities, but we're also sensitive to making sure that the financial impact makes sense for shareholders.

Ladies and gentlemen, this concludes the question-and-answer session. I'd like to turn the conference back over to the management team for any final remarks.

Thank you, Rocco. I want to thank all who participated in the call this morning. We look forward to continuing to build on our communication with investors in the future. Thank you.

This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines. And have a wonderful day.