First Merchants Corp (FRME) 2007 Q4 法說會逐字稿

Hello and welcome to the First Merchants Corporation fourth quarter 2007 earnings call. All participants will be in a listen-only mode. There will be an opportunity for you to ask questions at the end of today's presentation. (OPERATOR INSTRUCTIONS) Please note this conference is being recorded.

Before we begin, please note during the call, management may make forward-looking statements about the Company's relative business outlook. These forward-looking statements and all other statements made during the call that do not concern historical facts are subject to risks and uncertainties that may materially affect actual results. Specific looking statements include, but are not limited to, any indications regarding the financial services industry, the economy and future growth of the balance sheet or income statement.

Now I would like to turn the conference over to Michael Rechin.

Thank you, Joe. Welcome, everyone, to our fourth-quarter and full-year earnings conference call. Joining me today are Mark Hardwick, our Chief Financial Officer, and Dave Spade, Chief Credit Officer. We will host a question-and-answer session following our prepared comments.

As our release states, we concluded 2007 with a strong fourth quarter and positive momentum in our operating and financial performance. Several factors came together for us in the quarter, resulting in earnings of $9.3 million, or $0.51 a share, a 21% increase over our earnings in the fourth quarter of 2006.

While growing earning assets and improved net interest margin were significant drivers in our fourth quarter earnings lift, I thought I would start my remarks by commenting on the activities we completed in the year that yield a more-efficient and higher-performing company. During the first half of 2007, we merged several bank charterers in central Indiana, which has proven to offer the managerial, regulatory and compliance efficiencies we had identified. The reduced costs and operational synergies began to reflect themselves in the fourth quarter and the associated branding opportunity in the marketplace is clearly taking hold. Our associates worked tirelessly on our changes and our customer experience remained strong, allowing us to grow operating revenues and add customers uninterrupted.

The FDIC results reported midsummer reflect deposit share growth in nearly every market in which we operated. Also in the second-quarter we refinanced our trust preferred securities at opportunistic time and rate. Based on the capital markets turbulence we've experienced, that transaction and its attractive terms would not have been available to us from July through the current period. Our fourth quarter interest expense reflects the 200-basis-point benefit of that refinancing.

Earlier I referenced earning asset growth continuing through the year. As we have discussed in earlier calls, our growth has been strongest in our metro markets of Indianapolis, Columbus, and Muncie. Earnings assets grew by $85 million, $70 million and $40 million, respectively, in 2007. While the growth in the fourth quarter totals appear slower, it is offset by a mortgage transaction that Mark will cover in his remarks.

Our disciplined calling continues and our relationship orientation has been effective despite the competitiveness of the markets. While our loan growth is somewhat concentrated, our non-interest income gains are much more broad-based, driven by common processes implemented for specific banking center product bundling and our fee-for-service activity. You can see in our statement that our overall non-interest income grew 17% year-over-year. I think I feel even better that when you net out the entirety of our other income category, it still grew greater than 14%.

I will share two thoughts on our credit philosophy and a few thoughts on 2008 before asking Mark and Dave to speak more specifically to our financial statements. Our loan portfolio continues to be very granular, both by borrower and by market concentration. With a legal lending limit in excess of $50 million, we have no single or related borrower exposure in excess of 50% of our limit. On a separate note, our incentive plans now common throughout the Company proactively address relationship manager accountability and risk detection. 100% of a banker's incentives are risk-based upon managerial review.

In regard to 2008, our expectation is for a year-long continuation of the current conditions or worse. We intend to operate our community bank relationship model and be close to our customers while protecting our capital. We intend to emphasize more information reporting, technology and convenient products to meet the commercial and consumer customer needs. Lastly, we will be opportunistic in adding management talent that builds our capability for the long-term.

During 2007, as I have referenced, we have committed to various financial strategies that we feel optimize our balance sheet growth and maximize capital utilization. Listen as Mark highlights those in his comments.

Thank you, Mike. I would like to thank all of our interested shareholders for joining us today.

As Mike mentioned, we are pleased with our results for 2007 and I will report on the details in the release as well as several strategies that are proving successful in today's operating environment. The Corporation's assets reached a record level of $3.782 billion as of December 31, 2007, an increase of 6.4% over year-end 2006. Total loans and investments, the Corporation's primary earning assets, increased by $169 million, or 5.3%. During 2007, management strategically reduced several earning asset categories with a view towards higher performance capital maximization. Investment securities were reduced by $15 million due to low bond yields vis-a-vis the wholesale borrowing cost. Individual loans for households and personal expenditures, as detailed on the last page of our press release, were reduced during the year by nearly $36 million as management strategically reduced its indirect lending function, our lowest-yielding loan category.

In the fourth quarter of 2007, management also sold $27 million of seasoned long-duration, conforming mortgage loans yielding 6% to Freddie Mac in an attempt to keep our portfolio variable in nature. This strategy still looks good today post the Fed's 75 basis point reduction in the Fed funds rate, as the mortgage market is driven by treasury rates and the five-year treasury was just 3.29 at the end of the year.

Several balance sheet strategies have allowed our earnings to be stable, given today's economic environment, including not owning collateralized debt obligations in our bond portfolio. Having sold our credit card portfolio in 2007 increased the stability of our earnings and selling the majority of our one to four-family residential real estate loans upon origination into the secondary market with very limited recourse creates a stability that we are looking through in the credit quality of our balance sheet.

Total deposits increased during the year by 3.4%. Deposit growth is trailing loan growth. To keep up the pace, we are enhancing our sales team and our sales efforts around our cash management product offering in 2008.

Total stockholders equity increased by $12.6 million during 2007 as the Corporation used earnings of $31.6 million to pay dividends of $6.9 million and $12.8 million to repurchase 500 -- 565,000 shares in the open market. It has been the desire of management to use the Corporation's share repurchase program to capitalize on market conditions. We have an additional 485,000 shares authorized by the First Merchants Corporation Board of Directors for repurchase.

Net interest margins declined 16 basis points in 2007, however fourth-quarter net interest margin improved consistent with management's communication in prior calls regarding our performance in a falling rate environment by expanding from 3.52% in the third quarter to 3.66% in the fourth quarter. We also communicated that margin expansion would occur for the first 100 basis point decrease from our current level at time of 5.25% -- of a 525 Fed funds rate.

Yesterday's announcement by the Federal Reserve should result in compression throughout the industry as deposit rates begin to find their lowest level possible. First Merchants did adjust deposit rates downward yesterday to mitigate reduced interest income derived from our $544 million variable rate prime indexed assets. One of our mitigating factors deployed to reduce compression derived from our interest rate sensitivity model and lessons learned in 2003 and 2004 when the prime rate equaled 4% was the purchase of $250 million of notional prime-based floors in August of 2006. One of the floors with a term of three years is $100 million in notional dollar with a strike rate of 7%. Given yesterday's 75 basis point decline, that floor is now in the money by 50 basis points.

Loan loss provisions for the year increased $2.2 million, or 36%, in 2007 based on the Corporation's continued evaluation of the allowance for loan loss calculation, our most significant accounting estimate. Net charge-offs increased by $1.9 million during 2007 and non-performing loans increased by $11.1 million. All changes to specific reserves are included in the allowance for loan loss calculations. Dave Spade will add significant color to our non-performing loans and non-performing assets, as well as the granularity of our loan portfolio, as mentioned by Mike, in just a moment.

Non-interest income, or total other income, increased in 2007 by $5.9 million, or 17.2%. All reported line items increased by a minimum of 9.8% to a high of 59.7%, reflecting the Corporation's focus on fee-for-service business. Our trust company, our insurance agency, our mortgage teams and the branch network that drives our service charges on deposit products are to be commended for a great 2007.

Non-interest expense, or total other expense, increased by $6.1 million in 2007. Non-recurring expenses as detailed in the earnings release related to our trust preferred refinance and the expenses associated with our rebranding effort and corresponding data conversions of five bank charters totaled $2.9 million. Our core operating expenses increased just $3.2 million, or 3.4%.

The end result is a 5.5% year-over-year increase in earnings per share and a 21% increase in the fourth quarter earnings per share and good momentum despite a difficult operating environment. Our culture statement reads that we are a team of associates who expect superior results from our company and ourselves. We intend to keep finding new ways to offset the strong headwinds that our industry is currently facing with great people building great, repeatable processes, producing more satisfied customers who can allow us to meet you, your, the shareholders', expectations.

Dave Spade will now provide the desired detailed of our credit quality beyond what is visible in the press release.

Thank you, Mark. First Merchants Corporation, along with all its banking affiliates, continues to focus on the troubled loans with goals and strategies to move the trends downward on non-performing assets through aggressive collections and potential loan sales. I'll highlight a few items that reflect our activities during the fourth quarter.

While average loan outstandings increased by $38 million, the total non-performing assets decreased by $555,000. Total non-performing plus 90-day delinquencies showed a very slight improvement of $109,000 from the period ending 9/30 '07 through the period ending 12/31 '07.

Total non-performing assets as a percentage of actual loans decreased from 1.12% on September 30, 2007, to 1.1% as of December 31, 2007. Total nonperforming assets to total assets declined for the second straight quarter, moving down slightly to 0.84% during the fourth quarter. Other real estate owned and other repossessed assets increased by $492,000 from the end of the third quarter as one particular commercial credit moved from a non-accrual asset category to the other real estate through foreclosure.

Net charge-offs represented 24 basis points on average year-to-date loans outstanding for 2007 and that compared to 0.9%, or 19 basis points, for the previous year.

I will do a little portfolio breakdown at this point to give you an idea of where our commercial loans and commercial real estate loans stand. The first item you see on the press release is the $165.4 million in construction and land development loans, which are down $4 million year-over-year from the period ending 12/31 '06. Total commercial real estate loans of $947 million are really broken down by these categories -- $104.6 million in multi-family properties with five or more units; $715.8 million secured by non-farm, non-residential properties; and $126.8 million secured by farmland.

The top three loan categories, as Mike talked about the granularity, include lessors of non-residential buildings representing 8.43% of total loans at First Merchants Corporation. Second category is development and land subdivision loans representing 3.23% of total loans at First Merchants Corporation. And medical professionals and professional services represent 1.48% of total loans at First Merchants Corporation. Again, those all totaled $947.2 million as of 12/31 '07.

Let me speak, then, to the residential consumer-type properties. Let me just point out the first category, first real estate mortgages on one to four family properties represent $598.7 million and the rest would represent loans for second mortgage, lines of credit, loans held for sale and other revolving facilities. Total residential mortgages, one to four family dwellings, had balances of $744.6 million at the end of December 2007. Agricultural loans and production loans to farmers increased year-over-year by $14.2 million. Trends for agricultural loans have been favorable relative to the improving credit grades and delinquency status in the FMC portfolio.

Let me, then, share with you some information concerning our past due loans by category and would make those comparisons to past due loans from the 9/30 '07 Federal Reserve statistical release that was provided after the last quarter and compare those numbers to the First Merchants Corporation past due loans. Commercial loans at First Merchants Corporation were 79 basis points of total commercial loans outstanding, compared to 1.24% for all the banks in the Federal Reserve release. Installment loans represented 2.14% past due at First Merchants Corporation, compared to 3.22% in the statistical release. And mortgage loans were 2.39% past due at First Merchants Corporation, compared to the national average of 2.71%.

Total past due loans at First Merchants Corporation 30 days or more past due were $33.098 million. That represented 1.17% of First Merchants Corporation total loans that were 30 days or more past due.

Finally, want to talk a little bit about the residential real estate market. And although the state of Indiana has seen significant issues with delinquency rates compared to many other states, First Merchants Corporation has fared much better. Subprime delinquencies were reported at 16.7% for adjustable-rate mortgage products in the subprime category and 10.7% of fixed-rate products in the subprime category. Prime loan delinquencies -- and those are loans that were booked as performing credits -- have past due adjustable-rate mortgage figures of 3.7% past due, while the fixed-rate loans were reported at 1.8% past due. We would compare all of those numbers favorably to the performance at First Merchants Corporation, where all of our residential fixed and adjustable-rate mortgages are 2.71%.

And my final comments would reflect the charge-offs. As I mentioned earlier, our total charge-offs at First Merchants Corporation were 24 basis points. By comparison, commercial and industrial loans represented a 25-basis-point charge-off compared to the national average of 48 basis points. Agricultural production loans represented 22 basis point charge-offs for First Merchants Corporation during 2007, compared to a lower number at the Federal Reserve statistical release at 9 basis points. Consumer loans, however, were 44 basis points of charge-off compared to the national average of 2.48%. And commercial real estate compared favorably at 12 basis points, compared to the national average of 11 basis points. And finally, the residential real estate charge-off percentage at First Merchants Corporation was 30 basis points, compared to all banks in the Federal Reserve statistical release of 26 basis points.

Dave, I appreciate the depth of your comments and the metrics associated we feel are appropriate given the climate that we are in. I don't think that even speaks to the scrutiny that our bankers and our credit folks along with our relationship managers are spending, staying close to the customer, as I referenced in my remarks. We presented more information than we typically have given the climate and at this point, Joe, would be glad to take questions, should there be any.

(OPERATOR INSTRUCTIONS) Our next question is from Brian Martin.

Just a couple little things here. Maybe a first question for Dave, the non-performings in the quarter were, on balance, were relatively flat. I guess I'm just wondering if you can provide a little color as far as what was inbound or outbound that -- is it kind of as it appears, so there wasn't much change in the quarter? Can you just give a little color of kind of what was coming in versus what was going out?

Yes, thanks for the question. We did have one development loan that represented over $2.1 million that went into a non-performing category. We had some residential real estate loans that also went to that category. We think we've got resolution on several of those already. Nothing dramatic or substantial in any particular name. A lot of it is driven by year-end performance on their financial statements and we will make those adjustments and evaluations as we receive the year-end numbers.

There's nothing remarkable that stands out other than the one development loan.

Okay.

One going off, by the way, was a credit in our Anderson market and that was $2 million. I think I had alluded to that possibility happening in the last conference call.

Right, okay. You talked about the 30-day bucket being kind of that 1.17%. How does that stand relative to last quarter? I don't recall that number, if you have it off the top of your head. If not, I can --

I don't. I think it is pretty much on par with where it was at. Dollar-wise it might have been higher by $450,000. That was my recollection, but I just don't --

Okay, that's fine. No material change is kind of what I was getting at. Then you talked about the granularity of the portfolio. I am just wondering on the non-performing side if you can just give a little color given that seems to be the biggest concern in the market these days. Some of the larger credits within your portfolio, I think you talked about legal lending limit being $50 million and half of that being maybe the largest single creditor relationship you guys have. Can you just give a little color as far as the larger credits in the portfolio, where they may be as far as component or category?

Are you talking about non-performing?

In both categories, that's kind of what I was looking at is in the non-performings, where are the largest and then also in the performing loans.

Okay, in non-performing assets, our largest one is commercial real estate project in Delaware County. We think there's excellent value. We've had appraisals that would justify our current book balance. We've got a reserve on that.

How many dollars, Dave?

Dollars? Okay, it is about $6.2 million. The other, larger non-performing asset in that area was also a residential land development and that is in the Indianapolis market. We think it is properly valued today on our books and we've taken a reserve of $400,000.

And that one's worth -- that one's value is at least -- and the non-performings is how much? Is that a similar type of level, $6 million?

That's a $2.1 million.

So those are the two largest, the $6 million and the $2 million?

Those would be the two largest.

How about just as far as the -- in the performing loans? Just where you have the largest exposure?

Yes, total largest borrower is a contractor-type C&I loan that relates to overhead power and tree removal. Worked for a lot of the national electrical companies around the country and it's been a good performing asset for us, very good performing and long-term customer. Next largest would be a metal manufacturing processing company actually in Muncie, Indiana. They do a lot of work for guys and production work for large auto manufacturers.

Sizewise, those are in what type of range?

The first when I mentioned is probably in the range of $24 million to $25 million, a lot of letters of credit to support some of their insurance requirements, and the other is about $6.7 million.

Okay, then just the last two, the residential exposure, I thought you guys said was about $165 million at quarter end?

That was -- $165 million was land development.

Right, the land development. Can you just give a little color as far as how that's performing, maybe I missed it in your remarks. If I did, I apologize, but just as far as how comfortable you feel about the quality of that portfolio at this point?

There's only three in there that we have concern that are nonperforming. Those are two of the ones I mentioned earlier, commercial development that was approximately $6.2 million in Delaware County and $2.1 million in Marion County, Indianapolis area. And the third one would be a bit smaller loan, just less than $2 million in the Lafayette area. Other than that, my analysis of performing payments and so forth seems to be rather strong in terms of the loans being current and the assets being properly valued.

Okay, lastly if you could give a little color on your outlook on the loan pipeline and just kind of growth expectations in '08?

Brian, it's Mike. We track our pipeline defined to be commercial credits in excess of $0.25 million that we would anticipate closing in the next 60 days where we have approved the credit extension. And so we have tracked that now on a consistent definition basis for about 15 months and we are just over $100 million, down slightly from December. But actually at a level that is, absent December, as high as it has been all the way back to the first quarter of last year. Although in actuality, the trend is somewhat flat. We had a little bit of a lull into the $60 million to $70 million range in the early fall and it kind of rebuild its way up closer to $100 million, as I shared.

Okay.

(OPERATOR INSTRUCTIONS) David Scharf, FTN Midwest Securities.

I just wanted to follow-up on some of Mark's comments regarding the net interest margin, given the floor and the 75 basis point move, and I know you had mentioned that you are more neutral-positioned than anything else, but given the 75 basis point cut, when should we start to expect that to flow through the cost of funds side? Can you also give us just some current pricing also relative to maybe a month ago or a little further away?

I can. As we look at the impact of that, the Fed change in our prime-based loans, the impact financially on an annualized basis is right at $4 million. And we have about $1.2 billion in non-maturity deposits and we're targeting a reduction of those categories between 10 and 15 basis points, where we think we can continue to squeeze a little more interest expense or reduce our interest expense in those categories. The prime-based floor will make up for $500,000 and then of the remaining $1.5 billion of CD dollars, we would need to obtain about a 16-basis-point reduction to continue at our same 3.66 level.

I would not say that that is insurmountable. The CD portfolio will take some time to reprice or manage our way through, as 33% of that portfolio reprices in the next three months and then another 19% the following quarter.

The CD pricing, I am optimistic of what I am seeing on the brokered CD market given this latest move. Our average cost of CDs is around a 4.55. Our brokered money is around a 5.25 today at the end of December. We were seeing a lot more reasonable kind of four, 4.25, 4.35-type brokered CD deposits, which hopefully are reflective of where the market will continue to move and our competitors continue to move. I think the credit crunch obviously has caused the large banks to have some liquidity issues and I think throughout our footprint, the retail CD market has been priced higher than what would normally be reasonable vis-a-vis a spread over treasury or spread to Fed funds. So I was optimistic to see the brokered CD market start to move and hopeful that the competitors, our larger competitors, will start to bring those CD rates down given this latest movement.

So still it is around a 4.5% range for retail CDs? Or at least from your competitors and some of the larger banks?

Yes, and it has -- before this move it has been a little bit higher. We're waiting to see all the changes that work their way through the system, but the brokered market reacted immediately and we were seeing some reduced rates in the brokered market, which gives us a few more alternatives where we can be -- we can allow some of the hot money, public-type dollars where we're bidding market CD rates to roll out as we replace them with brokered deposits. So I'm hopeful that that trend in that alternative funding source allows the retail market to start to reduce its unreasonably high rate.

I have mentioned this before, but do you expect the agricultural sector, given the commodity prices being so high as they are, to either start jetting out a little more loan volume or, probably more importantly for you all, to start seeing some core funding coming into the bank?

The ag sector has been a plus for us and we'd look for another strong '08 out of it. You are right, the grain prices have really added some health to a longtime client list, both on the East and West hand sides of the state for us, flowed in some in from a deferred equipment purchases that were put off when prices weren't as robust.

Despite that, we're still being cautious relative to the land values that we're willing to lend in too, but, yes, it has been a positive for us and I don't know that we will see a lot of lift in our funding out of that, but we clearly are relationship-oriented there and probably have the most comprehensive effort in ag for Indiana banks, in my opinion.

Okay, what about as far as future de novo branches in '08 or '09 as far as expansion areas you'd like to go into and can you kind of give us an idea of some of the investment dollars you're going to be spending?

We actually have for '08 a slower year in terms of new banking center building being done, but we're evaluating deeper penetration into any of the markets where we've gained share, for instance Indianapolis, the Fort Wayne market, where we have some commercial exposure, has been good to us. Lafayette, we will be refurbishing some of our branch system there. And we're going to look at that selectively, but do not have as many openings planned for '08 as we did even in '07.

Okay, so all else equal, the operating expense should -- the velocity of growth should slow down?

Correct.

Well, I'll pop off here, guys. Thanks so much for your time.

Sir, that concludes our question and answers.

I appreciate it, Joe. We look forward to chatting at the end of the first quarter come mid-April and look forward to our progression of results. Thank you.