First Merchants Corp (FRME) 2014 Q1 法說會逐字稿

Good afternoon and welcome to the First Merchants Corporation first quarter 2014 earnings conference call. (Operator Instructions)

We will be using user-controlled slides for our webcast today. Slide may be viewed by following the URL instructions noted in the First Merchants news release dated Thursday, April 24, 2014. Or by visiting the First Merchants Cooperation shareholder relations website and clicking on the webcast URL hyperlink.

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 risk 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.

Please also note that today's presentation is being recorded. I would now like to turn the conference over to Mr. Michael Rechin, president and CEO. Mr. Rechin, the floor is yours, sir.

Thank you, Mike. Welcome, everyone. All of our listeners today. And welcome to our earnings conference call and webcast for the first quarter ended March 31, 2014.

Joining me today are Mark Hardwick, our Chief Financial Officer; and John Martin, our Chief Credit Officer. Our remarks will be focused on our earnings release which came out earlier today, about 10.00 Eastern Daylight Savings Time. And our presentation speaks to material from that release.

The directions that point to the webcast were also contained at the back end of that release. And my comments will begin on Page fi-- 3, a slide titled First Merchants 2014 Highlights.

So the top bullet point covers the release. First Merchants Corporation reporting first quarter 2014 net income of $13.6 million, compared to $11 million during the same period of 2013.

The earnings net income increased 24%, a like number to the number of shares increase such that earnings per share totaled 38%, equaling the first quarter of 2013. A busy quarter for us. We're pleased to talk about it today.

And on the second bullet point of this slide, somewhat the signature accomplishment was the successful completion of our integration of CFS Bancorp. And from a vocabulary point of view you may hear through the comments today from my colleagues and myself terms of Citizens, CFS, or the Lakeshore Region. And we'll just ask at this point to recall that they all are effectively the same thing, as we've renamed Citizens within First Merchants to Lakeshore Region.

So the best and quickest integration of a company into First Merchants in the acquisitive history that we've had. Roughly 100 days from legal close on November the 13th we moved to bring that franchise, their clients, and employees fully onto our systems the week of February the 24th.

Went very well and so you'll hear repeatedly some of the accomplishments, the challenges, the expenses, and where we expect that all to move forward for us.

Mark will in detail talk about the expense levels which were probably a little higher in the first quarter than what we had anticipated. And some portion of that was due to expenses associated with the integration. Mark has detail that he'll share momentarily.

Net interest margin we're pleased came in just under 4% at 3.97% in the underlying net interest margin absent any fair value accretion really at a healthy and steady level throughout the entire business.

And we look forward to the same kind of future as we not only continue to value exchange with our customers but continue to watch the purchase accounting flow through the income statement in the several quarters going forward.

Our non-interest income growth really pleasing to us in every category, absent the mortgage business. And I think like many institutions we saw a soft fourth quarter of 2013 kind of plan for that into the early part of 2014.

And whether it's the appetite of the home buyer, the absence of refinancing, or just the difficulty in getting around through the first three months of the calendar year, a softer mortgage business.

And in one of Mark's slides you'll see the line item categories for the non-interest income portions of our income statement.

Asset quality continues to go very well. An overall net recovery, an increase in our loan loss reserve, each of which, coupled with other characteristics, allowed us to have zero provision expense for the quarter. And we like the look of the asset quality on a going forward basis.

Non-interest expense, including the integration and weather-related expenses, did push our overall operating expenses higher than we had forecast. And we feel good about the normalization of those that we not only saw in March as a stand-alone month. But what we would expect to see in the remaining three quarters of this year.

And we'll cover some of those specific items on a go-forward basis. Roughly $1.4 million of Citizens-related expenses.

And then a full conversion of our employee benefits plan from a PPO plan through the last couple years, including 2013, to a high deductible HSA-attached plan available to all of our employees. That's referenced in the release.

And the one-time expense portion of that, just under $700,000, was the Company's decision to provide our employees with some early seeding to affect that transition.

When I couple many of those thoughts relative to the Citizens acquisition itself, four from critical perspectives in our minds the things have gone exceedingly well. Led by credit.

I thought that when we took on the portfolio going in from where Citizens had been, I thought our upfront due diligence, our work with the Citizens relationship managers and their credit function, all produced a pretty solid understanding on our part that reflected itself in the closing.

We continue to feel good about the credit perspective as they've joined our company. The management view extremely strong. I think we talked about in each of the last two calls of 2013 the welcoming aspect of qualified commercial trained executive level management from Citizens that were leading that company over the last couple years into our company.

That's worked exceedingly well. Such that our need to supply talent geographically into that marketplace has been right on our original plan. Which is at a modest level. The expenses I spoke to earlier kind of got through the integration with a little bit more expense than we thought.

The March numbers reflect that we're on target in the overall target that we shared with you at the end of June following the definitive agreement being signed in May about a 30% total expense saved will be realized through this year.

And if those three items go well, then we hope that over time, knowing that four months does not a value make. But the price will prove to be really prudent for our shareholders.

Then lastly, at the bottom of the page, not really a first quarter event. But something more recent was last week's decision on the part of our board of directors to increase our common dividend from $0.05 to $0.08 a quarter was announced on April the 18th.

And reflects the growing level of capital that we have and free cash flow at the current levels of profitability. So at this point, Mark's going to jump in and speak with more detail around our first quarter results. Mark?

Thank you, Mike. I'm starting on Slide 5 where loans on Line 3 increased year over year by 26%. $140 million or 5% of the increase was the result of organic [calling] efforts. And $597 million, or 21% of the increase resulted from our acquisition of CFS Bancorp in November of last year.

The investment portfolio on Line 1 increased by $280 million, now totaling $1.2 billion as deposits exceeded loans in our merger by approximately $350 million.

The allowance on Line 4 totaled $70 million, up from year end. And first quarter of 2013. As we experience net recoveries in the quarter of $1.7 million. And the allowance now totals 1.92% of total loans and 125% of non-accrual loans.

The composition of our loan portfolio on Slide 6 is reflective of a commercial bank balance sheet with community granularity. And it continues to produce very good loan yields. The portfolio yield for the first quarter of 2014 was 4.67%.

On Slide 7, our $1.2 billion bond portfolio continues to perform well, producing higher than average yields with a moderately longer duration than our peer group. Our 3.87% yield compares favorably to peers of 2.6%. And our duration remains just under a year longer at 4.4 years.

The net unrealized gain in the portfolio totals $20.8 million. And maturities for the remainder of the year total $114 million, with a yield of 3.45%. And in 2015, our maturities are $128 million with a yield of 3.07%.

Now on Slide 8, non-maturity deposits on Line 1 increased by 31% year over year and represent 76% of total deposits. Of the year over year increase, $45 million originated through organic growth initiatives. And $722 million was due to the acquisition of CFS.

And our changeable common equity continues to grow nicely. On the bottom of the page, now totaling $12.63 per share, an increase of $1.39 year over year, or more than 12%.

As previously mentioned, the mix of our deposits on Slide 9 continues to improve. And our total deposit expense is now just 31 basis points, down from 46 basis points at this time last year.

All regulatory capital ratios on Slide 10 are well above the OCC and the Federal Reserve's definition of well capitalized. And all Basel III minimums as well as our internal targets.

The Corporation's net interest margin on Slide 11 totaled 3.97% for the quarter. And when adjusted for fair value accretion of $1.8 million, totaled 3.83%. Net interest income totaled $47.8 million during the quarter and continues to be the driver of our operating income.

Total non-interest income on Slide 12 can have some volatility due to Line 7, securities, gains and losses. Line 6, gains from the sales of mortgage loans, is the only line item that has declined since the acquisition.

Mortgage volumes for the quarter were weak but have begun to improve in late March and early April as the weather has improved. Non-interest expense on Slide 13 totaled $43.1 million for the quarter, an increase of $8.4 million over the prior year.

Of the increase, $1.4 million was related to non-recurring expenses as part of the acquisition. And $682,000 was a result of seeding the HSA accounts, as Mike mentioned previously. And also another $669,000 was due to unusually high amounts of snow removal in the first quarter.

Of the $1.4 million in non-recurring expenses related to the acquisition, it's really split. It's primarily salary and benefit expense. And then our expenses related to paying [Pfizer] prior to the conversion of their core system.

Now, if you turn to Slide 14, our net income totaled $13.6 million for the quarter, or $0.38 per share. The performance for the quarter was aided by the absence of provision expense through net recoveries, as mentioned previously.

(Coughs) Excuse me. We're looking forward to the second quarter of 2014 to fully realize the earnings strength of our CFS acquisition. Q4 of 2013 and Q1 of 2014 included significant amounts of one-time expenses associated with the February 24th completion of our data and platform integration.

John Martin will now discuss our satisfying asset quality trends.

Thanks, Mark. And good afternoon. I'll be updating you on the trends in the loan portfolio starting on Slide 17. And then cover first quarter the asset quality with an update on the progress of the Citizens portfolio before closing with a look at the allowance and fair value coverage.

So please turn to Slide 17. In the first quarter, we experienced mixed trends in the portfolio, resulting from three primary drivers. First, on Line 1, there was an uptick in demand for C&I lending in the first quarter, which resulted in a roughly $26 million increase in C&I loans.

Second, on Line 2, there were several larger construction projects that paid off and were placed in the secondary market after construction. These expected payoffs were fueled by borrowers taking advantage of less restrictive secondary market underwriting and conditions for loans coming out of construction.

And third, the seasonal timing of payoffs of 2013 agricultural production lines prior to draws on 2014 production lines. So then looking forward, I am encouraged by the C&I production and pipeline that Mike will highlight in his remarks. As well as the unfunded commitments for new construction projects headed into the spring. And the coming seasonal draws on agricultural production lines.

So overall, while the portfolio is down somewhat in the quarter, the above factors should help to grow the portfolio for the remainder of the year.

Now, turning to Slide 18, on Lines 1 through 3 in the linked quarter, we saw improvement in non-accruals for ORE and renegotiated loans.

Note that on Line 5, the percentage of NPAs to loans and ORE stands at 2.1%, which is below year-end 2012, having absorbed the CFS portfolio with markedly higher levels of non-performing assets.

On Lines 6 and 7 we saw an increase in both classified and criticized loans, driven by a $17.5 million agricultural relationship in the legacy portfolio. While full repayment is expected, the issues experienced by the borrower drove the downgrade.

The remaining increase is attributable primarily to downgrades stemming from review of new information around borrowers from the CFS portfolio.

Despite the downgrades, I continue to feel good about the work that was performed and our understanding of the purchased portfolio. As well as our strategies to reduce troubled assets.

Jumping down to Lines 9 and 10, the allowance increased modestly in the linked quarter by $1.7 million. The allowance model was driven by the increase in criticized assets in the legacy portfolio, as well as a $200,000 bump in specific reserves.

Turning to Slide 19, in the first quarter asset quality continued its positive trend. I would focus your attention on the last two columns, which both included the addition of the CFS portfolio and provides the greatest comparison for the quarter.

In the last column, Q1 2014, we started on Line 1 with $83 million and NPAs in 90+ days past due. On Line 2, new non-accruals, we're granular with only one name greater than $1 million.

The inflow in non-accruals included a higher proportion of consumer mortgage non-accruals this quarter, while on Line 4, non-accruals which moved out of the category were more lumpy with $4.4 million, representing the top four names.

Skipping down to Line 12, ORE declined by $1.1 million. This was driven by the sale of an individual property that netted roughly $950,000 which originated from the original CFS other real estate portfolio.

New ORE were granular this quarter and averaged just $80,000. And then finally on Line 17, (sic - see Slide19, "Line 15") there were two large restructured AB notes that seasoned and moved out of the category for a total NPA change of $4.1 million on Line 15, resulting in an ending NPA in 90+ days past due of $78.9 million.

So briefly, moving to Slide 20, on the top of the slide in the first graph you can see with the reduction in the non-accrual loans and the $1.7 million increase in the allowance, our allowance coverage on a fair value adjusted basis increased from 120% to 125%, moving in the right direction.

Moving to the charge-offs in the graph below, in the first quarter we had two large [V Note] recoveries totaling roughly $1.7 million that drove this category while all other charge-offs in the quarter were less than $250,000.

So turn to Slide 21. This continues the presentation from last quarter and highlights the coverage with the fair value included to help demonstrate overall allowance coverage. On Line 1, the allowance of $69.6 million in the far right total column includes $400,000 of specific reserves allocated to the purchased portfolio.

One Line 2, total fair value adjustments are $47.2 million, split between Shelby County Bank acquired portfolio and the Citizens Bank portfolio. Fair value adjustments are down $2.2 million from $49.4 million at year end.

So skipping down to Line 6 and 7, out to the far right total column, the allowance as a percentage of net loan balance is 1.92% on Line 6, or 3.19 [per seven] on Line 7. All else equal, we would expect to see these coverages move lower as these portfolios transition from purchased loans to allowance-covered loans with an allowance coverage moving towards 2% over time.

So to wrap up, I would just say that I continue to feel good about the work the due diligence team performed on the CFS portfolio and our analysis of the portfolio and the strategies that the team have developed around the troubled spots in the portfolio.

And while the loan growth was mixed for the quarter, we continue to see strength in the pipeline. And reason to remain optimistic for the remainder of the year. Thanks for your attention. And now let me turn the call back over to Mike for his comments.

Thank you, John Martin. I'm on Page 23. Going to briefly revisit our First Merchant strategy. It's a consistent strategy. We've used it in these slides in the past.

Coverage of the market segment's most important to us and the lines of business that our management runs through. The only other comment I have on the page would be that with the Lakeshore or Citizens business being fairly new to us, we look to introduce the trust business and the insurance business. They're the bottom two bullet points on Slide 23.

Capabilities that we've had in First Merchants that Citizens previously had not offered. And so at this stage, we're making sure that our bankers that are the glue to the clients understand the needs for those product lines.

And then we're going to train to the product knowledge with the full intention of growing the run rate of those two important fee lines within the overall mix of our revenue stream.

Also mentioned in our trust company we had great leadership over there for the better part of the last decade. And a retirement of that leader where we've replaced [Terry Magget], that leader, with a new executive from inside the Company. So we fully anticipate our speed of that business to stay the same or accelerate.

Moving to Page 24 on the tactic overview, as I think forward we're optimistic. In the top bullet point about intensifying revenue generating, we're going to do what we do. Which is stick to our sales management protocol, win new clients, take care of our existing clients.

But primarily what it means is taking pipelines, particularly on the earning asset side, and moving them onto the balance sheet. And I think we've got some history that shows that it's not an even line. But one that also shows that pipelines have had a high run rate into our balance sheet.

And so we would expect the increased numbers I'm going to share here in a minute to help us out moving forward. Our level of activity, pipeline measurement, that is, is up in every line of business.

From our smallest lending business in retail up 25% over the prior year and the highest level since we've started measuring this more rigorously a couple years ago. So retail is up.

All of the different aspects of our commercial banking business, which is our largest line of business on the lending side, is up 85% in dollars from the beginning of the first quarter of this year to about $274 million. It's up 20% on a year over year basis from the end of the first quarter of last year.

So we're encouraged by that kind of geographically from all around the Company. As you know, we've put a lot of resources into Central Indiana and Central Ohio. So we're seeing pickups there.

And for the first time we're beginning to track and measure new business activity out of the Lakeshore Region. So we've made progress not only in the data integration but in the behavioral and sales tracking as well.

Pleased with that. So that is a pipeline as we've defined in these calls in the past where we have credit approved in front of the clients. And on its way into the documentation process.

A related but different pipeline of earlier stage where we're using proposals is also up materially. It's up 15% from the end of the year. And materially higher at 30% than it was at year end.

So all the indications are that our clients are doing well after a little bit of an early season slumber. And that our bankers are in front of them hearing what their needs are.

Other bullet points in that top section on Page 24 would include putting our marketing dollars to having them shift away from raw introduction of the First Merchants' name in the Lakeshore Region towards a deeper understanding of what our capabilities are.

That marketing process is really buoyed by the fact that it's the same bankers in front of the clients on the front line. Whether it's the retail bank or the commercial bank, including the executive level that I cited earlier where we've gotten great understanding of our business mission and execution with their teams.

And messaging, much like the prior page where we talk about the strategy. The messaging of our plan internally and externally continues to go well. And I feel like we've generated through people being magnetized by that a stronger roster of bankers as we look at the rest of 2014.

Second, middle of the page talks about increased efficiency. And a couple of thoughts. One is we need to see that March actual carry-over of operating expenses through the remaining three quarters.

And for reasons I think that Mark laid out very well, there's some very clear couple million dollars' worth of non-recurring numbers. So I think we'll have a good story for you come August when we talk about the June quarter.

And then the pipeline that I didn't mention explicitly in my earlier remarks was around the mortgage business. And so we talked about the softness of it. We have found a way to track exactly what's taking place there both in refi business and in the purchase business.

And the purchase business is helping us because while our units are down and close activity, the actual dollars associated with the mortgages that are closing have risen. Nonetheless, we have to keep an eye on where it goes forward.

And so our pipeline in that business is up 27% going into the second quarter from where it was at the beginning of the year. We're pleased by that. It's still beneath the level of a year ago.

So we still think the overall condition of the market is a little bit softer but materially stronger than what we saw in either the fourth quarter of last year. Or the quarter most recently completed. The one that we're prioritizing.

I'm going to drop down to the last item before we take questions, Mike. And that would just be we've watched the marketplace, as measured by releases of other M&A activity, begin to warm up.

And we would expect that to happen to us. We've had some opportunities to consider. And I would just tell you that our discipline in measuring growth opportunities will be constant.

I feel like we've been responsible in that activity not only understanding our own ability to digest and assimilate and then execute. But also one that gets back to our shareholders. So we are willing to pay for value if it is clearly additive to our franchise. But only for value that will get to our shareholder in a very responsible period of time.

So hopefully over the course of the next year or two we'll be able the continue to work on that. And have a machine in place and the talent to work with it.

At this point, Mike, we can go to the questions, should you have any in the queue.

Yes, sir. We will now begin the question and answer session. (Operator Instructions) Scott Siefers, Sandler O'Neill & Partners. Please go ahead.

Let's see. Mark, maybe first question, most appropriate for you just on cost. So if you back out the direct one-time costs and then some of the noise, like the snow removal, HSA seeding, et cetera. Looks like you're at a run rate expense base of about $40.3 million.

Just given that you now have the CFS cost savings officially in the numbers from March, do you think that $40.3 million number is one that you can improve upon in the second quarter? Or will there be just normal investments that'll kind of keep it flattish? How are you thinking about that dynamic?

Well, I think that's the right number to look at going forward. To think that we're going to push it lower than that through the quarter really isn't an expectation. We're obviously looking for opportunities around every corner. But I think that assessment of $40.3 million is good for the quarter.

Okay. Great. And then just on the margin, you held a core number in there very well. So I would be curious to hear about your thoughts on how well you can hold the core going forward.

And then you guys have kind of reintroduced PAAs, or purchase accounting adjustments into the equation with the CFS deal now closing. Is what we saw this quarter a good proxy for what we can expect going forward in terms of the fair value contribution?

The overall question, the margin numbers, no, we -- I felt great about the quarter. That's two quarters in a row where we've been at a 3.83% margin, if you take out fair value accounting.

The volatility of the number related to the accretion going forward is one we're still trying to get our arms around. We had early kind of -- I guess it adds to interest income when we purchased the Shelby County portfolio.

And we're not seeing that kind of movement through interest income to date. Although you can tell by the charts that John has in his presentation just how much is still pent up in the portfolio that we expect to see some of that come through the income statement on a go-forward basis.

The bond portfolio will continue to perform at its current levels. The loan yields, the small amount of attrition that we're seeing in the core portfolio in terms of attrition, in terms of yield really has leveled out. And I think is very manageable.

So net, if you take out the fair value accretion, I would think that we see a modest amount of compression. One or two basis points. But nothing more than that.

Okay. That's perfect and helpful. I appreciate that. And then, Mike, just wanted to ask you about loan growth. Just make sure I understand the way you're characterizing things correctly.

So the point to point this quarter was perhaps a little weaker. But your comments on the pipeline and including what John had added as well, it all sounds very, very optimistic about the remainder of the year.

So I think in the past you've talked about kind of a mid-single digit organic type of growth rate. Correct me if I'm wrong. But is that something you still feel will hold true? In other words, do you get some catch up from the softness in the first quarter? Or does the softer first quarter impact what you think you guys are going to be capable of doing for the full year?

No, our expectation, Scott, I -- thanks for the question. No, our [expation] is that there is no give up. And that we would expect overall growth in the second quarter. And that mid-single digit growth rate on a year over year basis from the fourth quarter last year through the end of 2014 holds.

We're kind of encouraged and would like to see that increase that I cited earlier just to carry through as it has earlier quarter. So, no, that -- our expectation would remain the same.

Okay. That's perfect. I think that does it for me. So thank you.

Thank you, Scott.

Stephen Geyen, D.A. Davidson.

Maybe just a couple questions on the security portfolio. Just curious what kind of cash flows you're expecting there. If there's any kind of readjustments ahead. Or if that's behind you now.

And what the reinvestment rate. And if you think the majority of the cash flows are going to be generating -- are going to be able to put the work in growing loans?

Yes. We, as I mentioned in my comments, we have in the bond portfolio -- I'm looking for them again real quickly.

We have $114 million that will mature this year to 3.45%. But we're not getting quite 3.45% on the reinvestment rate. But given the size of the portfolio at $1.2 million, we feel really good about being able to maintain current levels.

And then next year we have $128 million that will mature at a 3.07%. And we're definitely replacing the 3.07%, so we shouldn't see any decline. So 3.45% we're not quite getting 3.45% with current reinvestment rates.

We did do a $50 million small leverage transaction that may have been noticeable by using broker deposits and putting some bonds in the portfolio. And we're in the process of doing another one about the same size.

(whispering) 200 basis points.

Yes. Where we have a little over 200 basis points of spread. And it's -- you asked about the liquidity or any maneuvering related to CFS. And we did sell their entire portfolio prior to close. Or they did, technically.

And so they were sitting in cash at closing. And then we reinvested those dollars. That has all happened. And it is all -- we had that completed by the end of the quarter. And then because of the added liquidity from the acquisition, we decided to add another $100 million into the bond portfolio that we felt was prudent and made sense, based on the overall structure of the balance sheet.

Okay. And maybe a question for you, Mark. If you -- you kind of gave us some really nice color on the pipeline. And just kind of outlook of what you're seeing maybe for the second quarter and the rest of 2014.

Do you see -- is it across the geography? Or is it weighted in any particular area?

Yes, Steve, it's Mike. For this particular point in time, it's heavy. It's in our Greater Indianapolis business. Maybe even a little bit more pronounced than it has been in a couple periods before.

I referenced that the Lakeshore begins to pitch in. And given the size and depth of that marketplace we would look for not only some contribution from there, which I'm pleased by.

Because there's a lot of transition there and there have been some assets there from the legacy loan quality issues that we will be curious to see what kind of net growth we can achieve there, knowing that we've got a little bit of improvement when you do affect through the balance of the year.

But the sales force up there is in tune and led. And so I would expect them to be a net contributor. But, no, outside of that we're getting it somewhat from everywhere.

John Martin referenced that agribusiness has been a little bit off of its normal seasonality. So we expect that to pitch in as well.

Okay. (inaudible) And maybe just a couple questions for John. John, on Page 21 you noted the reserves and fair value adjustment to gross. And just can you get -- real quickly just give me what the numbers were that went into that. The 3.19%.

It's just the math above. It's the allowance, it's the $69.6 million and the fair value adjustments in total divided by your gross line. Or balance (technical difficulty).

Okay. Just wanted to make sure. I didn't do the numbers while you were talking. And then second question is on Page 19.

You'd mentioned that consumers contributed to new non-accruals. Just curious if there's any -- were there any seasonality to that or any commonality in the type of credits?

No. I went back, actually, and did a little bit of analysis as to what was driving that. And we've taken a slightly different approach in the consumer portfolio as it related to what would be bankrupt fraud and deceased.

And it drove a couple of million dollars' worth of increased non-accruals for the quarter. Essentially, yes, taking them to and letting them stay in non-accrual, particularly in the deceased category where we have a deceased borrower. Until we have the -- and I'm not going to use the term right.

But decedent's family reaffirm on the property. We had a number of those that we backed up. And made adjustments to in the quarter. So that did impact the number somewhat.

Okay. Great. Thanks for your time today.

Thank you, Steve.

Michael [Prados], KBW

I thought I'd start just on the provision expense. It's come down quite a bit the last couple of years and you guys posted the zero dollar provision this quarter.

Was that more a function just of the slower EOP loan growth this quarter? Or is that a rate that you guys think you can replicate going forward over balance of the year?

Well, I think the way I'd respond to that is obviously the provision's going to be driven by your charge-offs and the asset quality of the portfolio.

I think in the quarter we had net recovery position. And we booked a zero provision. I don't know as that we'll have net recoveries every quarter to be able to do that. But I think that's what you're seeing in the current quarter.

So it certainly is down from other years. But then on the other hand our asset qualities improved significantly. So --

Michael, this is Mark. We want the reserve to be directionally consistent with all of the trends in the portfolio. And this particular quarter we had a little bit of a mix in a lot of the numbers improving.

And our classifieds were up slightly. And the fact that we had a net recovery you said -- it's taking a zero provision at least for this quarter was the right answer. (multiple speakers) So we'll evaluate it next quarter and see where we stand.

All right. Thanks. And then on the dividend raise, can you -- I can't remember if you guys have ever said anything publicly about this. But can you remind us about how you're thinking about the dividend just in the context of payout.

And if you guys have a target payout ratio that you guys are hoping to reach. Or if you think about it in a different way like on yield or anything like that?

Well, in terms of what they equate to today, Michael, you can do the math. And it gets us closer to -- based on today's stock price roughly a 1.5% dividend yield. And a payout ratio just over 20%.

I think that we don't have a stated dividend policy. But we're clearly mindful of what the investment community looks for out of a bank such as First Merchants.

And I think that something in the mid-high 20s over some period of time should our earning continue and grow at a rate as they have over the last several quarters would certainly be something that's possible.

Where we try and balance where our capital levels are with cash at the parent company for M&A use, should that be the case. It's multiple variables that go into it but pleased to have the flexibility to consider increases as earnings sustain themselves.

Okay. All right, thanks. And then just one last for me. With the Citizens deal now integrated, can you guys just update us on how you taken our chances to see what the balance sheet looks like combined.

And just on how you guys view rate sensitivity within your balance sheet. And whether you are positioned as you would like to be today. Or working to reposition yourselves for something else. And any color there would be great. Thanks.

Yes, we had gone through that entire analysis and part of selling their bond portfolio and reinvesting we had looked at exactly where we stood from an interest sensitivity perspective.

And we're still extremely asset-sensitive. We have $1.6 billion that re-prices every month. And almost all of it is daily because it's the loan portfolio that's primarily driving it.

And with that much in variable rate loans, it allows us to be -- well, on the other side, let me say. With that much in variable rate loans and the amount of transactions, or non-maturity deposits that we have, the strength of that deposit base in a rising rate environment is a good formula for growing net interest income.

So that is the reason that when we reinvest their bond portfolio and then also with this small leveraged transaction, the two that we've done, we thought we could go out a little further on the curve in the bond portfolio because in a rising rate environment the loans perform so well.

And how much of your loan portfolio is variable again? Sorry, if you disclosed that already, I must've missed them.

Yes, I have it here. $1.6 billion of our total assets were priced on a monthly basis. And most of that is daily because it's driven by the loan portfolio. (multiple speakers)

Okay. That's good to know.

Split pretty evenly between LIBOR and prime-based.

Okay. Perfect. Thank you very much, guys.

You're welcome.

Brian Martin, FIG Partners. Please go ahead.

Two of my questions are already answered. But one, and maybe John already covered this. But just the classified assets in the quarter, that increase from year end to first quarter, can you just -- if you already mentioned it, John, what was driving that? Any trends you're seeing there?

Yes. So I did. As I mentioned a little bit earlier, there was one large name there that was $17.1 -- or $17.5 million that went to substandard. And that made up a large portion.

The rest of it came out of just new information that we got out of the CFS portfolio. So it's not a trend, it's just kind of what came out in the first quarter.

Okay. And was that -- what type of credit was that? I mean, was it a real estate? Was it C&I?

Sure. It was an ag production. Ag-related credit.

Okay. All right. That's all I have, then. Thanks very much. Nice quarter, you guys.

Thank you, Brian.

Daniel Cardenas, Raymond James.

Just a couple quick questions here. On the second leverages transactions that you guys were talking about, has that occurred already? Or is that expected to take place sometime in the near future?

That's -- we're working on it. The funding actually should be finalized this week. And then we'll put the dollars to work.

Okay. And it's roughly the same size as the first?

Yes. It's right at $50 million.

Okay.

It's not a big needle mover but it's more about optimizing the balance sheet.

Gotcha. Gotcha. And then as I look at the tax rate this quarter, is that a good -- I mean, it looks like it was up on a sequential quarter basis. Is that a good run rate to use going forward?

Yes. I mean, that's our -- there wasn't anything extraordinary in the number this quarter. So I think it's a good estimate.

And then last question. Just given your size at roughly $5.5 billion and I have to imagine you're probably getting a lot of folks wanting to talk to you. How much bigger can you grow without having to make significant infrastructure investments?

Well, that -- good question. It covers a lot of asset classes. Management being one, technology being another one, physical capacity for our operation center.

So in inverse order that -- our operation center could allow us to grow probably another 20% from where we are now without a significant investment. We were fortunate managerially at the Lakeshore opportunity to be able to take advantage of an incumbent management team that was already changing a thrift culture into a commercial bank.

So we're just trying to fortify that and accelerate what we're doing. And then technology, we are -- I think we've been fortunate to have chosen a handful of key vendors that serve our asset size.

You know, kind of $5 billion to $20 billion. That have plenty of product wherewithal that our customer mix uses. So I don't see in the near term, certainly between $5 billion and $10 billion of material need for infrastructure or overhead expansion.

Okay. Great. All right, thanks a lot, guys. Good quarter.

Thank you.

Well, at this time, we're showing no further questions. We'll go ahead and conclude our question and answer session. At this time, I'd like to hand the conference back over to management for any closing remarks. Gentlemen?

Thank you, Mike. This is Mike Rechin. I have no remaining remarks. Flattered by the questions and the attendance today. Look forward to talking to you mid-summer about our second quarter end of June. Talk to you then. Have a great day.

And we thank you, sir, and to the rest of the management team for your time. The conference call is now concluded. We thank you all for attending today's presentation. At this time, you may disconnect your lines. Thank you and take care, everyone.