First Merchants Corp (FRME) 2008 Q2 法說會逐字稿

Hello, and welcome to the First Merchants second quarter earnings conference call. All participants will be in listen-only mode. There will be an opportunity for you to 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 effect 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 Michael Rechin. Mr. Rechin?

Thank you, Amy. Good afternoon. Welcome, to everyone that's taking time out of their afternoon to listen in on our earnings conference call for our second fiscal quarter, the six months ending June 30, 2008. Joining me today are Mark Hardwick, our Chief Financial Officer, and Dave Spade, Chief Credit Officer. We're available for a question and answer session following our prepared comments.

I would like to begin with a few thoughts on our financial results, and then ask Mark to provide additional detail with his remarks that follow. As our release states, one released earlier today, our second quarter earnings per share grew year-over-year by 5.9% to $0.36 per share, and net income for the quarter totaled $6.5 million. For the first six months of the year, our earnings per share totaled $0.81 versus the $0.76 in the prior year, a gain of 6.5%. A driver of our earnings growth is our revenue growth, driven by an expanding net interest margin that produced $4.6 million of incremental net interest income, year to date. Our bankers are focused and managing our business, and getting a fair price from employing our capital, and proactive in liability pricing through the rate reductions announced by the federal reserve earlier this year. We're balancing the competitive market pressures and deposit pricing, with the overriding strategy to build deposits in funding our loan growth.

I'm pleased to report that our total deposits were up 2% in the quarter, and up nearly 5.5% from the second quarter of last year. As importantly, non-interest bearing demand deposits are up 11% from the prior year, reflecting our emphasis on the lower middle markets, small business, and retail. We're advancing our credit processes around common underwriting practices, and risk identification for new opportunities and our seasoned portfolio.

Let me return a moment to our earnings. Our revenue and net interest income gains were offset largely by the need to increase our provisioning in the quarter. While our charge-offs for the first six months were high, we used the second quarter provision to build our loan loss reserve by 7 basis points over the level of last June. During the quarter, we completed a rigorous evaluation of our commercial portfolio, in particular, real estate development, and made many appropriate grading changes and value adjustments based on fresh appraisals. While we're disappointed in the direction and level of our nonperforming assets, we feel our measurement of impairment is very current, and reflective of an environment that we expect to remain weak. Dave Spade will follow Mark with a discussion of our overall credit quality and portfolio activity.

Our plan for 2008 is to remain active in managing credit, and our overall expense levels. We're pleased that our efficiency ratio has continued to decline. The efficiency ratio measured 58% in the second quarter, continuing a trend that began with our organizational changes last year. As stated earlier in my remarks, and as you'll hear from Mark and Dave, we recognize the environment we're operating in, and really prioritize managing through this credit cycle in a manner that positions First Merchants well for the future. We find our customers and prospects and employees are looking for affirmation that our bank is active, and very much open for business. I assure you that our activity levels in regards to customer calling, deposit-gathering, the winning of new households, and commercial accounts, remains robust. At this point, I would also Mark to probe deeper into our financials.

Thank you, Mike. I would like to thank all of our interested shareholders for joining us today. As Mike mentioned, we are off to a solid start in 2008. The corporation's assets reached a record $3,822 billion as of June 30, 2008, an increase of 4.2% over this time last year. Total loans and investments the corporation's primary earning assets, increased by $142 million, or 4.3%. As investments decline, $71 million, and total loans increased by $213 million.

Of that $213 million increase in total loans, commercial and industrial loans increased by $225 million. Commercial and farm real estate increased by $59 million, and agricultural production loans increased by $22 million. Individual loans for household and personal expenditures declined by $45 million, as the corporation strategically exited the indirect lending business, due to a lack of customer relationships and low yield. The corporation has additionally reduced its exposure to residential real estate for similar spread-related reasons, by reducing outstandings by $50 million, and is focusing all of its mortgage efforts around the origination of fee for service business.

Total deposits increased during the past year by 5.2%, the combination of investment portfolio run-off and deposit growth, allowed borrowings to decline by $1 million year-over-year, reducing our dependency on wholesale funds. Total stockholders equity increased by 20 million from June 30, 2007 to June 30 of 2008, despite the repurchase of 458,000 shares totaling $10 million, and the payout of nearly $16.8 million in dividends. First Merchants remains confident in its ability to produce the net income sufficient to maintain adequate capital levels, our dividend payout, and a growing balance sheet.

Net interest income as a primary driver of First Merchants Corporation's earnings. For the quarter, net interest income improved by $4.6 million, or 16.5%, as net interest margin expanded by 35 basis points to 3.85%. As we discussed in our last call, the corporation received $5,216 million in connection with the termination of its three interest rate floor agreement. The three interest rate floors, which add aggregate notional amounts of $250 million, and strike rates ranging from 6% to 7% were purchased on August 1, 2006 for $553,000. The contractual maturity of the floors was through August 1, 2009. The pretax gains of $4,662 million are to accrete into earnings over the remaining 16 months of the original contract. In March, the corporation recorded $236,000 of the gain, in net interest income, and $277,000 into other income. During the second quarter, the corporation recorded $561,000 to net interest income, leaving the remaining $3.6 million gain to be recognized over the next 13 months.

Loan loss provisions for the quarter increased by $5.4 million to $7.1 million, based on the corporation's continued evaluation of the allowance for loan loss calculation, our most significant accounting estimate. Net charge-offs totaled $4.6 million, or 61 basis points on an annualized basis for the second quarter. The net effect of the allowance for loan losses was an increase to 1.05% of loans outstanding. Specific reserves at quarter end declined by $100,000 from the same period last year, while general historical and environmental factors accounted for the $4 million increase in the total allowance for loan losses, period to period. Dave Spade will add color to our NPLs and our NPAs, as well as the granularity of our loan portfolio in just a moment.

Non-interest income remains strong, increasing 5.8%, and total expenses decreased $1.3 million as the efficiency ratio improved to 58.24% for the quarter. The end result is a 5.9% quarter over quarter increase in earnings per share, and a 6.6% year to date improvement, respectable, given the environment. Dave Spade will now cover our credit quality.

Thank you, Mark. As Mark and Mike mentioned, we continue to operate in a challenging economic and credit environment, although volatility in certain regions of the country remains high, the Midwest is not immune to the larger economic issues facing housing and real estate markets. Allow me to highlight some more significant change in our credit portfolio during the second quarter.

As of June 30, 2008, First Merchants Corporation continued to see increases in the nonperforming asset totals, primarily in two additional commercial industrial loans, that represent $10.1 million in outstanding balances. In line with our last market call on April 22, the remaining loan exposure for one particular Indianapolis-based residential land developer, was also moved to the other real estate-owned classification, as three properties were deeded to the bank during that second quarter. Finally, one residential land development credit from our Lafayette market was deeded to the bank during the second quarter, representing the only other major addition to the nonperforming asset category. With those changes referenced in these remarks, the other real estate-owned and repossessed asset classification balances moved to $17.5 million, as compared to $7.4 million at the end of the first quarter of 2008.

Non-accrued loans increased by $6.9 million, while the 90-day over past due delinquent loans fell by $1.5 million. The affiliate banks of FMC have an active marketing plan through auction companies, and direct sales opportunities, to reduce the other real estate own totals. Annualized net charge-offs year to date, to average loans outstanding, stood at 0.61% as of the end of the second quarter compared to 0.12% for the same period one year ago. These performance numbers reflect the challenging stage of the economic cycle effecting the corporation. By comparison, annualized net charge-offs as a percentage of average total loans outstanding, represented 0.24% at December 31, 2007.

Total residential mortgage loan delinquencies at First Merchants Corporation as a percentage of total mortgage loans outstanding, increased to 2.31% compared to the first quarter delinquency of 1.9%. Total commercial loan delinquencies over 30 days past due were 0.93% of total commercial loans outstanding, which compared favorably to the first quarter past due report of 1.06%. Except non-accrual balances, total First Merchants Corporation loan delinquencies declined from 1.3% of outstanding loans during the first quarter, to 1.17% at June 30, 2008.

The seasonally adjusted delinquencies for residential mortgages provided for all banks, as presented in the latest release by the Federal Reserve stood at 3.68%, while commercial loan delinquencies during the same time frame represented 1.41% of total C&I loans outstanding for all banks. By comparison, FMC continues to perform favorably in the control of delinquencies, as compared to the composite totals for all banks in the United States.

Construction and land development loans as defined by the OCC were $181.6 million as of June 30, 2008. Those loans represented 52.2% of capital, and 6% of total loans at FMC at the end of the second quarter. Multifamily loans of $102,800 million represented 29.6% of capital, and 3.4% of total loans. Finally, investment commercial real estate and (inaudible) family loan balances of $386 million represented 111% of capital, and 12.8% of total loans. Overall, the total commercial real estate including land development, nonowner-occupied property, and multifamily loans, represent 27.6% of total loans at First Merchants Corporation.

There continues to be a balance of components within the commercial real estate portfolio, and we continue to pay particular attention to our asset mix, as we review new opportunities, and move to grow the commercial portfolio.

Thanks, Dave. It's Mike Rechin again, and we'll open up for questions in a moment. I would just add that while some of the credit statistics you see in our industry, and some of the deterioration we've had in our portfolio portray a duller environment, I'm pretty pleased with our asset mix.

Some of the changes that Mark referred to earlier in terms of strategic exits from indirect and such are beginning to play into our margin, and while our balance sheet clearly has risk in it in a lending emphasis, I look at it absent some of the ingredients that some of our peers are deeper in. For instance, home equity lending, which is less than 5% of our earning assets and the credit card business, which appears to gather more scrutiny, which is not in our balance sheet at all. So at this point, we would be happy to take any questions from those on the phone.

(OPERATOR INSTRUCTIONS). Our first question comes from David Scharf at FTN Midwest Securities.

Hello, guys. Thanks for taking my call.

Hello, David.

Hello. I was wondering if we could just kind of dive into a little more of what was going on with the nonperforming loans and what was in that. Maybe I misunderstood you, but what was in that, about $7 million on the quarter increase on P&Ls, and also what came out of OREO? I understood what went into it, but what came out of it?

Loans coming out of OREO would be some pay downs of some of our development loans, where we had taken ownership. I can speak to the Lafayette credit that I mentioned that had some particular sales. In fact, had those lot sales at retail prices.

We had some other sales of residential-type properties. In fact, this year we've had at least six loans that we were outbid at, at sheriff's sale, so a small number on that side, but particular interest in the Lafayette project.

Okay, so mainly Lafayette, C and D?

Yes.

Okay, and then what was led to the increase in the nonperforming loans?

Could you repeat the question?

Yes, I think I heard you.

I apologize. The link quarter increase in NPLs, non-accruals?

Yes, it came from two particular C&I credits.

That was the 10 million?

Up to 10 million, right.

I misunderstood that. So the residential land from Lafayette was also in the non-accruals?

We took it into other real estate-owned.

Okay. I misunderstood. How is the, how is the sale process going as far as from when it gets to you all selling the property, relative to the original value, meaning like if you appraised it, what sort of write-down is occurring?

On the residential types, we've had fairly conservative appraisals. We've had write-downs of probably less than 10%.

Okay. Is that a fair gauge, 10% to 15%?

A general statement, but the ones I could think of off the top of my head, haven't been additional adjustments downward from the appraised values, after we've taken it into other real estate-owned.

David, I think we're assessing those really case by case. The benefit of the fresh appraisal, it is written, underwritten off of market conditions, arm's length valuations, that help us to better understand what is, as you have probably seen, a significant amount of non-bank activity, in trying to take advantage of distressed assets. So we're assessing those, and probably through the balance of the year, we'll take advantage of a deeper market for properties as we get more comfortable with what their actual worth is.

Okay. And what are the-- as far as loan categories, what are the other portion of the nonperforming loans about? Looks like about one third of it is the C&I that you mentioned. What would the other two-thirds be?

In non accruals?

Yes.

Let me refer back to a couple of my notes here. Non-accruals, I'm sorry, thanks for bearing with me here.

Sure.

One to four-family residential properties, approximately 10.5 million. Loans secured with owner-occupied, non-farm properties, 7.6 million. Loans for C&I, 8.4 million. Those are some of the biggest categories.

Okay.

They break down from there.

Okay. Well, I'll take a step back here for now. Thanks for answering my questions.

Yes, thank you.

Thanks, David.

Our next question comes from Brian Martin of Howe Barnes.

Hello, guys.

Hello, Brian, good afternoon.

Maybe I didn't write it down fast enough when David was talking, but the construction development portfolio, how big is that at this point? Can you quantify what that number was, or maybe I just didn't hear you?

It was about 182 million.

Okay, and of the 182, how much is nonperforming at second quarter?

Yes. Let me refer to a couple other notes I've got here.

Okay.

Bear with me a moment please. I'm just adding up a couple of things. Probably about, out of that total, probably about-- including non-accrual?

Yes.

It would be about 15 to 16 million. That's just quick addition here. I'm sorry.

Okay. All right, and, you know, I guess as far as just couple other items, on the loan side, the strong growth in the C&I book at this point, given that you've seen a little bit of weakness in a couple of credits this quarter, can you just talk a little bit about your outlook on that growth going forward? Are you slowing it down a little bit, or is this just capitalizing other banks, kind of withdrawing in the market, or just trying to understand, what your outlook on that growth is, and the opportunities you're seeing in the market?

I'll take that, Brian. It's Mike.

Okay.

Yeah, it has been, as you look at some of the information provided, kind of the dominant growth engine of the commercial loan category overall, and I would characterize us as one of the banks, that we looked at our leverage parameters around C&I lending, cash flow leverage in particular, pretty mindful of our fresh underwriting, as being, I think pretty commensurate with conditions of the time. We've had some issues, as you note, with some of our seasoned work, that might have been underwritten in earlier time periods. What we're really focused on now is, better structure, first and foremost, better pricing to compensate us for the risk we are taking.

I would look-- part of your question was a little bit of a forward look. I would think that our loan growth should plug along at a, in my mind, conservative mid single-digit annualized rate, that would account for both the new volume, netted by the shrinkage, I think you'll continue to see in our indirect book.

Okay. So it would still continue to be at a pretty-- double-digit type of clip in the C&I book going forward?

I think it will be, because you referred in your question to something that's hard for us to ignore, and that is the opportunistic growth that's available, based on a number of the regional competitors that we have really backing away from the market. And our parameter there beyond loan structure, that I referenced earlier, is just to do it in the context of full relationship banking, and to make sure that we're partaking in the deposit opportunity, and the fee opportunity.

Okay, and to that end, have you guys added-- with some of these other banks withdrawing from the market, any news on this quarter as far as taking talent from other markets? I thought last quarter, the quarter before, you kind of talked about the Indianapolis market, might being an opportunity. Have you seen any additions in that market?

Yeah, our net numbers are not up dramatically, but in the places that we're seeing continued growth, Indianapolis being one, in this past quarter we would have added relationship managers in Cincinnati, Ohio, in Columbus, and Indianapolis, and Lafayette, for that matter. Yet our net numbers shouldn't grow that high. We're mindful of the expense of those folks, and are continuing to look at the efficiency and the quality of the folks on the field.

Okay. All right. How about maybe a question for Mark on the margin, just kind of, where you're positioned, versus what you've repriced on the deposit side, kind of how you feel at the margin at this point?

We feel great about the margin in today's rate environment. Actually we feel pretty good about the margin in a modest movement upward or downward, really either direction. We still think we have a little room on the deposit side if rates were to decline. It doesn't look like that's where we're headed. If rates are to move up, we have the historical kind of proven capacity to lag our deposit rate, and to have our $500 million plus in prime rate loans price upward.

We've actually been selling this year pretty successfully, some interest rate swap arrangements with some of our larger commercial borrowers moving out of-- allowing the borrower to have a fixed rate loan, and that would be floating on our books, which allows us to have a little more rate movement in the upside. So within some reasonable range, the 100-basis point movement to 150 up, we feel really good that we would be able to maintain our margin or slightly expand. So, at least where we are today, we feel like we have a pretty strong net interest income engine running in the company, that is allowing us to offset some of the additional provisioning that we've seen this year.

Okay. How about just going back to credit for a minute, maybe Dave, did you talk about the, of the-- you talked about the breakdown of the non-accruals. Can you talk about, maybe the two largest credits in there? How-- top credits, how big in size we're talking about?

Are you talking OREO, or non-accrual?

I guess maybe just both separately, which in each is a significant size? You talked earlier about kind of the granularity. Just trying to get a sense for what the profile of that, the nonperformers are.

Yes, one is a fairly recent one that's C&I credit, and it's in our Anderson market. There is some cash associated with that. We haven't recognized yet.

Size wise, that was how big?

Size wise, that's about 4 million.

4 million, okay.

And then the other credit is another C&I credit in the Indianapolis market. In fact, there are a couple of apparently written offers. That's about 6 million roughly.

Okay.

A couple of letters of intent rather, not offers, but letters of intent to acquire that company. And if those are successful, we would be paid in full.

Okay.

Those are the non-accruals. And the largest other real estate would be, credit that I've mentioned in the past. In Delaware County, it's a commercial development and we have some level of activity at this point in time, have provided an offer, and a counteroffer back to a buyer, for about 40% of that. And that dollar figure is roughly on our books, as roughly at about 5.9 book balance on that, today.

Okay.

And the other largest OREO property that we have, would be the developer that I've mentioned in Indianapolis, that's roughly 6 million.

Okay. So I mean two credits for about 12 million are in OREO, and two credits at about 10 million, is that right?

That's correct.

Okay. How about-- do you guys by chance have the regulatory capital levels at quarter end?

Didn't bring that with me.

Was there much change, Mark, do you recall? Or I can get it from you after the call if that's easier.

I can get that to you after the call. I mean our standard capital plan is, with all of our banks, and then the corporate borrowings, et cetera, we've had very little fluctuation. We have no negative movement downward in the tangible capital, or the regulatory capital, but I don't have the number in front of me.

All right. I think that's it. Thanks, guys.

Thanks, Brian.

(OPERATOR INSTRUCTIONS) At this time, we show no further questions.

Well, thank you, Amy, and thanks again to all of our listeners and participants today. We look forward to sharing an update on our third quarter results come mid-October. Thank you.

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