First Merchants Corp (FRME) 2008 Q1 法說會逐字稿

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

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 forward-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. (OPERATOR INSTRUCTIONS) Please note this conference is being recorded.

Now I would like to turn the conference over to Mr. Mike Rechin. Mr. Rechin?

Thank you. Welcome to our earnings conference call for our first fiscal quarter. The three months ending March 31, 2008. Joining me today are Mark Hardwick, Chief Financial Officer; and David Spade, our Chief Credit Officer. We will host a question and answer session immediately following our prepared comments. I thought I'd begin with a few high level comments on our financial results and then ask Mark to provide detail with his remarks that follow.

As our release dates earnings per share grew just over 7% to $0.45 per share and net income totaled $8.1 million. A key driver in our earnings growth was the strong net interest margin we experienced. The bankers in all of our markets have been proactive in managing our Company through the series of rate reductions announced by the Federal Reserve since year end. We're balancing the competitive market pressures and deposit pricing with an overriding strategy to build deposits in funding our loan growth. In regard to loans, we see new originations in this environment as a time to get the pricing and structure in today's higher risk climate. We're advancing corporate credit around common underwriting practices and risk identification for our new opportunities and our seasoned portfolio. To deliver these common processes are driven locally and supported corporately, much in the manner of the improvements we made during 2007 in streamlining our operating model.

I'll return to those earnings for a moment. Our revenue we're pleased with net interest income and noninterest income grew enough such that the increase in our loan loss provision driven by weakness in the economy and somewhat in our portfolio did not negate our ability to grow net earnings. David Spade joining me will follow Mark with a discussion of our credit quality and portfolio activity. Our noninterest income grew on virtually every line item and 7% in total on a quarter over quarter basis.

We have seen a deceleration in the rate of service charge growth as our customer counts remain strong and growing but overall transactions have slowed. Our insurance and trust units continue to grow and our mortgage business enjoyed a higher fee quarter as originations reflect greater share being returned to the banks and First Merchants Corporation and a resurgence of refi activity based on lowered rates.

During the quarter we made additional investments in our management team, salesforce and infrastructure. We added senior managers to our cash management business, and Corporate credit function, and several seasoned commercial and grants relationship managers all around the Company. In an 8-K released in January, we announced that Mike Stewart joined as Chief Banking Officer. Mike was with us for the majority of the quarter and is accelerating the use of these common processes and go to market strategies. Mike works directly with our bank CEOs and supports our local bank growth strategies in driving higher revenue from all of our customer relationships. In addition, Mike coordinates his effort with our credit function as we proactively work on new opportunities and sharpening our repayment strategies and tactics in these rapidly changing times.

As 2008 progresses, we'll continue to be opportunistic as it relates to talent available in the market but we're keenly aware of our overall expense levels. We were pleased as a team that our efficiency ratio was below 60% for the first time in recent years. As stated in our release, we have the people, products, and processes of a stronger Company than we were a year ago. We're optimistic about our opportunities around the franchise but are keenly focused on asset quality. We do not expect any help from the economy so our efforts are directed clearly at having live and timely discussions as a foundation to all our commercial and consumer relationships. Mark, at this point, I'd ask you to provide some additional detail on our first quarter financials.

Thank you, Mike. I'd like to thank all of our interested shareholders for joining us today. As Mike mentioned, we're off to a solid start in 2008. The Corporation's assets reached a record $3.760 billion as of March 31, 2008, an increase of 6% over the first quarter of 2007. Total loans and investments, the Corporation's primary earning assets increased by $157 million or 4.9% as investments declined by $50 million and loans increased by $207 million. Of the $207 million increase in total loans, commercial and industrial loans increased by $167 million commercial and farm real estate increased by $55 million and agricultural production loans increased by $26 million.

Individual loans for household and personal expenditures declined by $36 million as the Corporation strategically exited the indirect lending business due to lack of customer relationship and low yield. The Corporation has additionally focused at reducing its exposure to residential real estate for similar spread-related reasons by reducing outstandings by $27 million. And is actually focusing its mortgage effort around fee for service business. Total deposits increased during the year by 4.7%. Deposits are currently growing at a slower pace than loans resulting in a 15.5% increase in borrowings. Total stockholders equity increased by $20 million from March 31, 2007, to March 31, 2008, despite the repurchase of 518,000 shares for $11.5 million and the payout of nearly $17 million in dividends.

It has been the desire of management to use the Corporation's share repurchase program to capitalize on market conditions. We currently have an additional 390,000 shares that are approved by the First Merchants' Corporation Board of Directors for repurchase. It is not the intention of management to repurchase shares at the current price level. Net interest income is the primary driver of the Corporation's earnings. For the quarter, net interest income improved by $3.7 million to 13.8% as net interest margin expanded by 24 basis points to 3.74%.

Management positioned the balance sheet to perform well in the following rate environment in the face of having $522 million in prime based variable rate loans in the portfolio. Borrowings and CD maturities were strategically short in duration, and as the Fed rate declines, management aggressively lowered all nonmaturity deposits as well. In addition, on March 19, of this year, First Merchants received $5.2 million in connection with the termination of its three interest rate floor agreements. The three interest rate floors, which had an aggregate notional amount of $250 million and strike rates ranging from 6 to 7% were purchased in August of 2006 for $553,000. The contractual maturity of the floors ended on August of 2009.

The pretax gain of $4.7 million will accrete into earnings over the remaining 16 months of the original contract. In March, the Corporation created $236,000 of the gains to net interest income. The $236,000 plus the $106,000 that we earned on the floors prior to the sale improved net interest margin during the quarter by 6 basis points. As our 8-K details, if the principal amount of the originally hedged loans falls below the notional amount of determinant floors, then the accretion to income could be accelerated, and in fact was accelerated in the month of March by $277,000. That additional $277,000 is reflected in our income statement under other income. It is not included in the net interest margin calculation.

Loan loss provisions for the quarter increased by $2.2 million or 139% to $3.8 million based on the Corporation's continued evaluation of the allowance for loan loss calculation, our most significant accounting estimate. Net chargeoffs totaled $3 million or 41 basis points. The net effect of the allowance for loan losses was a slight increase to 0.99% of total loans outstanding. Specific reserves at quarter end declined by $128,000 from year end. David Spade will add color on the NPL and NPA numbers as well as the granularity of our loan portfolio in just a moment.

Noninterest income remains strong as Mike mentioned increasing by 7.4% and total expenses increased by $2.1 million as the Corporation's efficiency ratio improved to 59.74% for the quarter. The end result is a 7.1% quarter over quarter increase in earnings per share. Dave Spade will now cover our credit quality beyond what's visible in the press release.

Thank you, Mark. As of March 31, 2008, First Merchants Corporation had seen a slight increase in nonperforming assets in the same period ending December 31, 2007. A lot of that was due to reclassification of two primary commercial relationships to a nonaccrual status. Although the aggressive collection activity on troubled loans continues, weaknesses in new home sales has resulted in a decrease in development lot sales for one particular borrower and the associated loan of $2.2 million was reclassified as nonaccrual during the first quarter. The other loan represented a 1.8 million C&I service credit in our portfolio.

As net loans increased by $60 million during the first quarter, the total nonaccruing loans OREO in 90-day plus past due loans increased by $4.6 million. Total nonperforming assets as a percentage of total assets plus OREO increased from 84 basis points at year end to 93 basis points during the first quarter. Net chargeoffs year-to-date represented 10 basis points of average loans outstanding as of March 31, 2008. That compared to 24 basis points in the fourth quarter of 2007. During the quarter, First Merchants Corporation charged off loans for specific reserves had already been established.

Other real estate owned increased by $4.7 million during the quarter primarily due to a foreclosure action on a specific commercial development. Two loans associated with that borrower were transferred from the nonaccrual category to OREO status after the foreclosure sale. The move to OREO follows a judgement where the bank now controls the sale in an effort -- in a location that's really deemed attractive to the bank. 90 day plus past due loans increased by $1.4 million while nonaccrual loans fell by $1.6 million during the first quarter of 2008. This partially offset the increase in the commercial OREO just mentioned.

Our delinquency trends continue to be favorable compared to all banks in the United States as listed by the Federal Reserve Bank release, as to statistical releases provided by the Federal Reserve for chargeoffs and delinquencies for all banks. I use the comparison of our current quarter's information to the fourth quarter 2007 which is the most recent database used for comparison purposes. In all commercial loans including term loans, lines of credit, commercial real estate, our delinquency was 1.7% compared to all the banks in the Federal Reserve Bank release of 1.35. Consumer loans at First Merchants Corporation represented 2.17% delinquency compared to the industry at 3.22%. Residential mortgages in FMCs portfolio represented 1.9% past due. Again, these are over 30 days compared to the industry averages of 3.09%. And finally, our line of credit unsecured open end facilities represented 1.43% delinquency compared to the industry average of 2.65%.

Let me move on to chargeoffs for the first quarter 2008 and again, I'll compare those to the fourth quarter information provided by the Federal Reserve Bank. First Merchants Corporation had 25 basis points in chargeoffs for commercial and industrial loans compared to the industry average of 82 basis points. Agricultural production losses at First Merchants were 2 basis points compared to the industry of 6. Consumer loan losses and chargeoffs for the first quarter were 9% at First Merchants Corporation while it was a rather large 278 basis points for all banks in the country. Commercial real estate 4 basis point chargeoff compared to the industry average of 35 and residential real estate chargeoffs were 8 basis points compared to the industry average of 47 basis points.

The Mortgage Bankers Association details for the fourth quarter 2007 reflect continuing issues with the residential mortgage delinquencies as 7.38% of all loans in the North Central region were 30 or more days past due. That compares again to the delinquency rate of First Merchants Corporation of 1.9%. Within the state of Indiana, the 30-day past due rate was 8.35% of all loans while the prime rate or prime loans, I guess the quality credits within that portfolio were 4.53% past due and the subprime past due rates were well over 19%. First Merchants Corporation performance indicates that current and historical disciplined underwriting and the standards that we have in place have for both fixed and adjustable rate loans have been exemplary.

At this point, if you could open up the lines, we'd be prepared to conduct a question and answer session.

(OPERATOR INSTRUCTIONS) Our first question comes from Brian Martin of Howe Barnes.

Good afternoon.

Good afternoon, Brian, how are you?

Good thanks. Just a couple questions. One, the expense growth in the quarter, I guess just wondering if you can -- it was a little bit higher than I was looking for. Just curious if you can give a little bit of color. It looked like -- as to what was driving that, I guess, sustainability of this pace if that's pretty realistic and--J?

Yes. I'll take a swing at it and Mark, feel free to add. Kind of two pieces that jump out at us. One of them very intentional relative to people investment and then that's clearly some related expense associated with credit quality. As it relates to the salary line item, we would have reflected in that much of the managerial and relationship manager investment I alluded to in my remarks, it's somewhat broad based. I probably highlighted five or six specific functions or individuals by name and it's probably twice that number. We had some other fill-in, I thought, really attractive opportunities to bring people on to our team.

The credit-related piece would be, I think, reflected in the statement and kind of what is other expense and some of the credit costs outside of loan loss provision are captured in there to include our OREO repossession expense, which was about $180,000, actually $190,000 year-over-year higher associated with softness there. Legal and other professional expenses again, associated with aggressive collection strategies, up $290,000. Then we have some of the people recruitment costs as well whether they be up front work or in at least two cases recruiter help.

Okay. the staff changes you alluded to, Mike, what -- can you give some -- can you quantify, maybe how many people you have at it and maybe just what at a producer level versus maybe at an operational level?

I don't have a specific number in front of me, Brian, as I say that, but I know that we went into the year with about 12 revenue positions we were looking to fill and we filled half of those. That would be at the relationship manager level.

Okay.

As you can imagine, the more costly in terms of expense as you look at it in that context, our investment in senior managers would be lesser in terms of individuals, but higher in terms of the dollars represented by it.

Okay. The relationship managers, what -- were these pretty experienced people and maybe what -- you alluded to earlier maybe across the market, across all of the markets or was it more Indianapolis, more--?

Actually, we will look to continue to be aggressive when conditions merit, but in the first quarter what you actually see is some Columbus, Ohio and Lafayette, from a revenue perspective, but I would look for those two markets as well as Indianapolis to continue to get some of our attention.

Okay. How about just on the -- you talked about on the deposit side, being -- having less there and more in borrowings. Mark mentioned that. I guess, can you give -- is that an intentional strategy I guess I assume at this point? And what is the pricing looking at on the deposit side?

Well, it's -- Mark will have a thought but I'll tell you, it's a tight wire in my opinion. We really want to maximize our leadership position in a lot of the communities we're in. Some of the larger banks as you're aware have liquidity issues that have had them in our mind propping up their deposit rates in an effort to deal with their own issues and we, accordingly then need to respond. We're pleased that as we look at the customer acquisition we've had on the commercial side of the Company, we had hoped that one of the attendant byproducts would be demand deposits. As you look at our balance sheet, you can see that we've done a nice job in keeping our demand deposits growing.

Okay. I guess, if these regional banks are having the liquidity issues, I guess if that trend continues, is your expectations, you continue to rely on borrowings in the short run here or?

Well, it's a couple of things. One, we're trying to stay extremely sensitive to the margin aspects and we have been able to lower interest-bearing deposit rates from a year ago around the 374 down to 291 as of the month of March. And our CD portfolio continues to reprice down. It's moved from a 502. The CDs over 100,000 which is about 400 million in deposits down to a 397. So we're continuing to allow the CD portfolios to price.

The real strategies that we have from a deposit growth perspective, our goal is not to be deposited on the borrowings and broker deposits, and the activity levels where we're putting a significant amount of effort are in the areas of cash management. We really have made some people investments in the area of cash management and we have every expectation that we'll be able to grow those commercial demand deposits and then lower interest bearing type of accounts to allow us to continue to grow the balance sheet and yet continue the growth with the type of spreads and margins that we target.

Okay. So I mean, the sustainability of the margin, I guess with, it sounds like it was close to a 368 kind of a, I guess core margin with the -- is that where you guys see the margin stabilizing here?

It is at current levels. With the Fed funds rate remaining at the 225, we expect to see it normalize in this range, the 360s and then we're getting the nice accretion into the income statement over the next 15 months that we have remaining on the interest rate floor on the sale of the floors.

Okay. All right. Just, maybe a question for Dave on the credit front. I guess I missed the comments about what the -- your first comments I couldn't hear them that well but the one residential builder, it sounded like you mentioned the -- I guess, would you mind just repeating what you said in your opening comments, Dave as far as--?

Sure.

I thought you talked about two credits and I didn't get that.

Two credits we had, one was a development borrower in the Indianapolis market that we have moved to a nonaccrual status and the other one was a about $1.8 million C&I credits and service Company and we've moved them as well to a nonaccrual status.

Okay. As far as that developer goes, is that -- I don't recall your development exposure here, but I guess is there any other concerns within that segment of the portfolio on the developer side as you're seeing stress at this point or--?

That developer represents about a $6.5 million total exposure to the bank. He's still selling properties within those developments, but the slowness of that takedown and the resulting issues with some other banks that do the construction piece within that have seen some troubled issues. So we decided to take that to a nonaccrual based upon things that may happen in the future with them. In terms of our overall portfolio, we have probably close to $79 million in outstanding loans to developers today. We would consider 23% of those as special mention or substandard.

Okay.

Around the entire portfolio, I think what we're doing is just more aggressively getting fresh appraisals on which to base our judgment.

Okay. Just given your comments as far as kind of the weakness in the economy and kind of hearing a little bit more about your delinquency translate, can you give any thoughts as far as the chargeoffs being up a little bit this quarter but the delinquency trends favorable relative to I guess it would appear at least the fourth quarter level? Is that your expectations going forward, based on the delinquency trends, the chargeoffs are stable to down, I guess over the balance of the year here? I guess can you give any color as far as your expectations, your outlook on the credit cost front? Maybe not quantifying it just as much as just a general trend or how you feel about things right now?

Brian this is Mark Hardwick. That number really is driven obviously every quarter by the great job that our Company does at reviewing the special assets list, the watch list meetings, going through problem loan updates and identifying cash flow and collateral deficiencies that really drive the specific reserves. And at this point in time, given where the economy is, it really is a quarter by quarter situation that we continue to monitor very closely. We feel great about how we ended the quarter being able to step up to some of the specific reserve issues that we do have and the nonperforming asset category and yet still produce the 7% increase in earnings. But for next quarter, I think we just have to continue staying very close to our borrowers, understanding if they're having any change of condition in their cash flow or if there's deterioration in their collateral value. I'm not real sure how to give you a great answer as far as go forward or what to expect from an earnings perspective for the remaining part of the year other than to just say that we're staying very close to the issues that we have in the nonperforming portfolio.

How about just the comments in the press release about adding to the allowance at this point or just building to the reserve levels. I guess, what's the thought process there just, I guess can you give any thoughts on that comment?

We just would like to marginally continue to add basis points to the reserve. We'd like to see it over, transitioning into some level over 1% as we move forward and it's a reflection, I think the statement is clearly just a reflection of the state of the current economy and some of the deterioration that we're seeing in cash flows and collateral values.

Okay. All right. That's all for me, guys. Thanks a lot.

Thanks, Brian.

(OPERATOR INSTRUCTIONS) We have a question from David Scharf of FTN Midwest Securities.

Just one quick question. Mark, if you could just walk through what you expect the quarterly benefit to be from the swap sale? Is it about $1 million?

Well, it's fairly close. I mean it really is going to amortize on essentially a straight line basis between now and the end of July of next year.

Just so I understand that should go into the interest income?

It should go into interest income. As we apply FAS 133, the portion that went into other income or noninterest income this quarter, the $277,000 is something that we'll have to run the calculation every quarter to look at the overall loan pools that we have associated with the floors, and we have to continue looking at the effectiveness and ineffectiveness of that hedge. We have since the time we put the floors in place, we have aggressively been building in loan floors in our actual contract or the note that we have with our borrowers.

Okay.

That's helped our earnings this last month by about $35,000. But it's causing some of the loans to be excluded from the pool. So as we continue repricing and renewing notes, we have to continue looking at the effectiveness. So there's some probability, some likelihood that we'll see some acceleration of that amortization as we move through the remaining, I guess, five quarters or so that may push some of the gain into other income as we move through the remainder of this year and the first quarter of next year. So at this stage, it looks like a straight line amortization but it is dependent on that effectiveness test that we'll have to do at the end of each quarter.

Cool. Thanks for your time, guys.

Thank you.

(OPERATOR INSTRUCTIONS) And it seems we show no further questions. Would you like to make any closing remarks?

I don't think so. I would appreciate everyone's continued interest in support of First Merchants Corporation. We look forward to sharing an update come July about our second quarter's activity and look forward to speaking with you then.

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