First Merchants Corp (FRMEP) 2006 Q3 法說會逐字稿

Welcome to the First Merchants Corp. third-quarter earnings conference call. At this time, all participates are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

During the call, we may make forward-looking statements about our 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.

It is now my pleasure to introduce your host, Mr. Michael Cox, Chief Executive Officer of First Merchants Corp. Thank you, Mr. Cox. You may begin.

Thank you, Doug. Good afternoon, everyone. Thank you for dialing into our third-quarter release call. With me again today are Mike Rechin, Executive Vice President and Chief Operating Officer, and Mark Hardwick, Executive Vice President and Chief Financial Officer.

I hope all of you have received our earnings release that went out this morning, about 9AM this morning, and I believe has been picked up by the wire services. If you received it, you know from that release that our third-quarter EPS came in at $0.42 versus $0.44 for the same quarter a year ago, down $0.02 or 4.5%.

Of a positive note, the third quarter was up from $0.39 in the second quarter of this year or a 7.6% improvement. Year to date, we are at $1.22, flat with the same period in 2005.

Looking over my notes from last quarter's call, I predicted at that time that we thought margin compression had about run its course. And I obviously was wrong. Or Mark was -- I am going to blame Mark for that. In any event, we were wrong because we experienced another 14 basis point compression in the third quarter, down to 366 from 380 in the second quarter. And the second quarter, incidentally, a year ago, was at 4%, so we have had a 34 basis point compression from a year ago.

Year to date, our margin stands at 378 versus 396 a year ago, and the reason we are going to talk about margin a good deal, as I think all of our competitors and fellow banks in the industry are doing, is because it has such a significant impact on our reported results.

With our balance sheet size, and I think this is somewhat of a mathematical coincidence, but at our current balance sheet size and shares outstanding of 18.345, roughly, each basis point equates to $0.01 a share for us on an annualized basis. So a year-over-year decline from second quarter '05 to second quarter '06, decline of 34 basis points, equates to $0.085 per share, a significant number for us.

I am not sure exactly what that means. Maybe it is just a little math frustration we go through internally. But it does work out to that equation.

Our balance sheet growth continues to encourage. Net loans were up 8.1% quarter over quarter. More specifically, in the third quarter we saw continued growth of $49 million in loans and $77 million in earning assets. So the balance sheet continues to expand at a nice pace.

Total deposits for the same period were up 9.3%, so our funding sources are also fairly robust. However, we are, as all in our industry are, we are seeing a continued upward shift into the higher-paying and higher-cost category deposits.

Net charge-offs were the lowest in a long time at 7 basis points for the quarter on an annualized basis, and total nonperforming assets declined quarter over quarter to 87 basis points. So we are encouraged at the asset quality numbers.

Our cost containment measures continue to be effective, even as we invest in new talent and facilities in our strongest markets. Mike Rechin will say more about that in a few minutes. Our noninterest expense is up a modest 2.8% for the quarter and only 1.3% year to date. So again, I think our cost management measures are becoming very effective.

From an operations perspective, we have now essentially completed our relocation of our combined ops and tech, compliance, risk management and audit center. And we are beginning to see some improving efficiencies from that initiative. For instance, most of our examination and audit engagement activity now take place in that single centralized facility as opposed to happening at eight different banks throughout the state and into Ohio.

Economy-wise, we are continuing to see slow improvement in our coverage area. I think the auto industry shocks have mostly abated and have proven to be manageable, up until this point at least, and we think they will continue so. And obviously, a lot of the growth that we are seeing is coming out of our metro markets, which are very competitive, but are continuing to provide very good growth for us.

So with that as an overview, I would like to turn it over to Mark for a little more detailed comparison of the year-over-year analysis, and then to Mike Rechin for some comments on credit quality and growth initiatives that we are working on. Mark?

Thank you, Mike. Ladies and gentlemen, we appreciate your interest in our call this afternoon. As it relates to our balance sheet, our total assets reached a record $3.472 billion at quarter end, an increase of $233 million or 7.2% over the third quarter of 2005.

Total loans increased 8.1% or $198 million, as Mike mentioned. And the breakdown of that loan growth comes in a variety of loan categories. Our commercial real estate is leading our growth initiatives as we -- as that category increased by $116 million during the last four quarters. Commercial and industrial loans have also increased by $21 million during the period. Individual loans for household and personal expenditures improved by $28 million, while agricultural production and residential real estate increased by $10 million each.

The total investment securities and bank-owned life insurance also increased by $31 million and $20 million, respectively. And our Fed funds sold declined by $16 million to round out the overall increase in the earning asset categories.

Net interest margin -- for the bank analysts that are on the call, this topic of net interest margin deserves little introduction this earnings season, as most of the releases we have read have had a significant amount of discussion pertaining to the margin. But it does require us to give the same amount of time and energy to our discussion and how it impacts our balance sheet and income statement.

Our year-to-date average earning assets totaled $3.037 billion in 2006 and $2.891 billion in 2005. That results in an average increase of $146 million or 5%. The year-to-date net interest margin on a fully taxable equivalent basis totaled 378, a decline of 18 basis points as the Corporation's yield on earning assets during the year improved 72 basis points and the cost of supporting liabilities increased 90 basis points.

As discussed in our news release, our rate variance -- and this is the first time I have really covered a rate and volume variance discussion in any of our releases, but it is a way that we use internally and I think the industry assesses the overall improvement of net interest margin from a volume perspective or a rate perspective. And in our case, we have had a $4.2 million decline in our rate variance during the year, or just under $0.136 per share, given the math that Mike discussed. If you tax-adjust the $4.2 million and then divide it by our shares outstanding for the nine months this year, that has had almost $0.14 of negative impact to our earnings per share.

For First Merchants -- I guess, however, related to our peer banks and the industry averages, we believe that our balance sheet has performed well and that it is positioned for any upward slope in the yield curve. Our increases in earning assets year over year have managed to neutralize the reductions in margin as net income during the year declined by $24,000. And that neutralization is really the volume variance -- as we have been able to grow the balance sheet, we have been able to neutralize the negative impact of the margin compression.

Moving on, the loan loss provision for the year equals -- or the loan loss provisioning that hits our income statement has totaled 26 basis points for the year, down $1.396 million from this time last year. Nonperforming loans totaled 87 basis points. Net charge-offs for the year totaled 17 basis points. And the allowance for loan losses is at 1.02% at period end. Noninterest income declined $745,000 as gains from the sale of loans declined by $668,000 year over year, and our non-interest expenses increased 1.3% during the year.

Earnings per share again totaled 122, equal to the prior-year total of 122. Management expects to finish the year well, even in the face of the margin headwinds in our industry.

And now, Mike Rechin will give you some insight on credit quality and our ongoing growth initiatives.

Thank you, Mark. Our credit quality, which Mike Cox alluded to earlier, remains stable at a satisfactory level. Our quarter-end nonperforming asset total of $22.9 million or 87 basis points is down approximately $1 million from June 30.

During the quarter, we did see, however, an increase in nonaccrual loans as a component of the nonperforming mix, and the earnings drag from that increase in nonaccrual loans was responsible for 3 basis points decline in the net interest margin for the quarter ended 9/30. Our 10 largest nonperforming assets total $9.3 million, with three of those 10 being greater than or equal to $1 million.

As a percent of our portfolio, our criticized assets grew modestly to 7.05%, up from 6.5% at June 30, and likewise, our classified assets grew modestly to 3.45% from 3.05% at June 30. All told, we are aggressively continuing to manage assets of less than satisfactory condition and do not foresee imminent issues out of the management of those assets.

As Mark and Mike covered earlier, our balance sheet continued its third-quarter trend of growing in both loans and deposits. Our loan growth and client acquisition is strongest in Columbus, Ohio, and Indianapolis, although all markets reported positive loan growth for the quarter.

We recently received FDIC data that reflects our year-over-year deposit activity. We were pleased to see that the data shows net growth of $84 million, led by increases in First Merchants Bank, reflecting our efforts in the Muncie and Indianapolis markets, and our Lafayette Bank.

We also are encouraged in the recent upward movement in service charges, which grew $220,000 or 7.7% above the second-quarter level of $2.8 million. Although our noninterest income level for the current year remains below the same period in 2005, the most recent quarter reverses the trend of declining fee income.

I would offer three additional thoughts as we look forward to executing in the fourth quarter and into 2007. Namely, we are looking closely at the earning asset mix that we have been building in the balance sheet, reflecting both on the adequacy of the pricing relative to the risk in the assets and the magnitude of the relationships that we serve. We are going to take a harder look at exactly how it is we are growing it. The C&I growth we have seen has been satisfactory. We are examining all of the other line of business activity as well.

Effective the first of the year, we will be launching new incentive plans which will move away from geographic plans built by each of our units more towards line of business thought, built out of the best-of-class work that emanates from some of our existing banks and spread that across to share the culture and to accelerate our growth.

And then lastly, towards that same point, we added six new revenue banking officers in the last quarter and have three more scheduled to join us here before year end, essentially covering the mortgage and commercial lines of business.

At this point, the three of us are available to take questions.

(Operator Instructions). Kenneth James, FTN Midwest.

I apologize, I missed most of the prepared remarks, but I obviously have one question. I apologize if you covered this area, but I wanted to talk about the margin. I know you probably covered it, but just to get a kind of a feel on the deposit pricing side and what is going on there, and given where the Fed has stopped, if you think rates on the funding cost side are getting ready to level off, or if you still see a little upward pressure there here in the fourth quarter.

As I mentioned earlier, I forecast at the end of the second quarter that we thought they would level off and they did not. Our funding costs continue to rise in the third quarter. I am getting a little squeamish at guessing right now, to tell you the truth, but I have to believe we are flattening out in margin. As you know, we are at 366 at the end of the third. I am thinking most of the damage has been done at this point, at least in terms of that related to the curve, to the shape of the curve.

With regard to margin pressure brought about as a result of competition -- remains to be seen. I am hoping in our metro markets, at least, we are seeing some tempering of the deposit pricing and deposit chasing. So I am hoping for some mitigation on the competitive side as well. Mike and Mark might have a view of that as well. I hope we are not too contrary. Mark, you guys --

Mike, I see the deposit costs in terms of our need to match markets, retain customers, has leveled some as the growth on the asset side of the balance sheet in loans comes increasingly from markets such as Columbus and Indianapolis. There's pressure on loan pricing as well, not unexpected as we move from the lower middle market into the middle market and the professional services that we've targeted. We do feel like there is an opportunity to grow share with our service model and we'll need to compete and be competitive with pricing that is indicative of the competitive of those two particular markets.

Then kind of touching on loan growth here, it's pretty good clip here year to date, pretty solid, really, the last two quarters. Is this something that we can expect to see sustained? Is that kind of the outlook?

We hope so. We are monitoring our pipeline very carefully and the pipeline continues to be at about its highest point all year. We track that on a basis of those credits expected to close within 60 days. And there can be some slippage of that number, we all know. But we are getting a lot more precision in our forecasting, so the pipeline would tell us that the growth rate's going to continue at a high-single-digit level.

Mike is correct. The precision with which we manage that continues to get more consistent usage. We cannot very accurately forecast, but as described, we track commitments where the bank has issued a legal commitment and have won the customer mandate. The area of that that is tougher is in the construction area, where we are a prominent player.

But overall, we would expect our lending activities to grow. As I mentioned in my last couple of remarks, we're looking at the relationship orientation of our credit relationships to make sure that if our funding is going to continue to escalate or stay at a high level, if we are extracting as much out of the wallets of our customer relationships as need be, and so there are certain pockets of lending that we may look to analyze further from a profitability standpoint.

And then looking at the expense -- thinking about expenses, is there anything, any catalysts coming down the pike here that are going to drive expenses higher beyond kind of the 2 to 3% growth rate that we have been seeing here for the last few quarters, or are we expecting this run rate to kind of continue?

I think the run rate is going to continue about where it is, at a pretty modest level, under the level of our equity and cost of living adjustments on salaries beginning in the first of next year. Our overall growth in expense is below our salary growth, so we're continuing to extract costs out of other operations. And I think we've got some more to go there. At least the early indications on our '07 budget would say that.

And then quickly, one question on credit -- the slight uptick in nonperforming loans, was that just a migration from the 90-day past-due category last quarter? And if you provided color on it, I apologize.

I did not cover that. There is some migration. I referenced in the prior two quarter reports a particular asset in our Lafayette Bank that we were looking to exit, and we did not exit it, but found a really suitable restructuring that removed it from the list. Of the balance of the nonaccrual increase that you refer to, actually 3 of the $4 million increase came from the 90-day; the other one was not on the list at 6/30.

Okay, so it was a handful -- a granular increase? That is not all one loan there?

Correct.

Kenneth, as you missed some of the comments, there was also the statement that as we move loans into nonaccrual, we did have to reverse some interest income during the third quarter, as you would any quarter where loans go in nonaccrual. But it was about $210,000 for the quarter as you're assessing the margin.

Okay, so it was maybe a little bit higher than 366 on a core basis?

Yes.

Brian Martin, Howe Barnes.

Just wondering on these new staff additions that you brought aboard this quarter, if you can give a little color on -- you talked about the mortgage and commercial side. What markets are these people going to be in? A little help there.

Be happy to, Brian. They really come from a relatively broad spread of the Corporation, specifically two in our Lafayette Bank, one a senior commercial banker in our UCNB unit, which covers the Richmond/Winchester/Liberty markets, a banker in our Indianapolis office, one in our insurance business, and one in Frances Slocum, which is in Wabash, Indiana, that last being a mortgage banker also.

And how about -- you talked about most of the growth coming from the Columbus and Indy market. If you can give us an idea of where your footings are in those markets at this point?

Brian, we cannot hear you very well.

I just wanted to get an idea of where -- with most of the growth coming from Columbus and Indy, if you could give a little idea of how much your footings are in those two markets at this point.

Sure. Do you want to cover Indianapolis?

Yes, I think I can cover both of the markets without having the numbers specifically in front of me. But I'll start with the Columbus bank. The Columbus bank, in total asset size, went over $0.5 billion earlier this year. As you may know, it is not a hub of retail activity. Their deposit gathering is by courier, carrying out their mission as a business bank in the greater Columbus market with a health-care orientation. And roughly a year ago, maybe closer to 18 months ago, they began an entrance into Cincinnati. And so the Cincinnati results, albeit new, would be included in those Columbus numbers.

The total footings as of September 30 for our Columbus bank are $513 million with a loan portfolio of about $434 million.

Indianapolis office does have the benefit of some Hamilton County retail locations, so they originate consumer loans and commercial. The commercial team has been in place for the better part of three years, really only spruced up in terms of people investment in the last 12 months, and that number is right around $115 million in commercial activity. That does not speak to the retail activity.

And how about just one last question, and that was on the deposit side of the balance sheet -- the growth this quarter was mostly on the CD side, and I'm just wondering if you can elaborate as far as any strategy I guess you are employing to help mitigate there -- is that just going to continue that trend with where rates are and what people are demanding, or just kind of what you guys are thinking there?

This is Mark. The one comment I would have on the margin discussion that maybe was not covered by Mike and Mike, as we are growing the loan portfolio with some success, we are funding a little more of our deposit side of the balance sheet or our finding side with wholesale dollars or brokered CDs, which is costing us a little more on the margin than just our overall cost of supporting liabilities.

So we do see some continuation of that. We are obviously working to bring the deposit relationships with the commercial loans that we put on the books and we're having some success with our public funds across the state of Indiana. Those are a couple of categories.

The other area, Brian, that we're spending a lot of time on is just mining our database relative to stand-alone products in the retail side of the bank, those households where we have not successfully won multiple products and where we do not have primary checking account activity.

How big are these wholesale deposits at this point, Mark? Can you give us an idea of at quarter end how much they were versus let's say second quarter?

From a brokered CD, I can give you those numbers. We are about $298 million in total brokered CDs. As far as the public fund money, I do not have that in front of me.

How about the brokered CDs last quarter? How much of the growth this quarter was broken CDs? Was it all brokered CDs, or--?

I do not have that. A year ago, it was 220. I'm sorry -- yes, $220 million a year ago. I do not have last quarter's number.

Jon Arfstrom, RBC Capital Markets.

In your prepared comments, you talked about looking at your earning asset mix and some of the price and risk balances. Can you give us a little more detail on what exactly you are doing there?

The primary activity is on the retail side of the house in our direct and indirect lending and trying to assess the profitability on a household basis or a total all-in customer basis between those two categories.

I just wanted to make sure that you were not talking about some of the other commercial categories, and I wanted to make sure there wasn't anything I'd missed there.

It is not really commercially driven, Jon.

Mike Cox, you talked a little bit about the auto industry maybe troughing or being washed out. Can you give us why you think that and maybe what else you can give us to support that comment?

I think I based that, Jon, primarily on my beliefs that most of the bad news is out at this point, and we have assessed it pretty diligently in our markets. As you know, Anderson, Indiana, had at one time a huge General Motors concentration. That has been whittled away over the years to the point where now it is not terribly significant. The Lafayette market has actually seen some positive news on the auto front with the Toyota activity there.

Looking at our other markets, and we've talked to our bank CEOs to try and identify the third-tier suppliers to the audio industry that may not have had the second shoe fall, and there really aren't any that we are banking of any significance.

So I think the impact on us directly is going to be minimal. And I think most of the bad news is out and in the press. So that has become more of a psychological damper than anything else in this part of the state. But in terms of actual economic impact to our banks, it is pretty minimal.

Good, that is helpful. And then can you comment a little bit on your ag portfolio? My sense is that is reasonably healthy and you're showing good growth there, but can you just give us a little more color on that?

The ag portfolio, John, is pretty healthy. In our Company, it is most prominent in our Lafayette Bank and First National Bank in Portland, a seasonal business, as you might guess, and we are currently evaluating what role, if any, we're going to take in the alternative energy sector of that ag business, which seems to be proliferating to a pretty large magnitude in the state of Indiana.

That would be stock loans on ethanol production, things like that?

Yes, either considering exposure to any of the projects directly, to any of the farm community that would sell their outputs into them, or stock loans by way of equity investment, yes.

And then the last question on the new hires -- you are saying six of them are in the quarterly run rate and three of them will come on in the fourth quarter? Did I hear that correctly?

You did. I am not sure I said that they were in the run rate. They started their employment with us -- the joined the team during the quarter, a couple of them right towards the end of the quarter.

But yes, their productivity, at least for the third-quarter adds, should begin to show up in the fourth quarter. And I would think that the folks we're hoping to add here this quarter would be into that run rate by the first quarter of next year.

(Operator Instructions). Gentlemen, there are no further questions in the queue. Do you have any closing remarks?

Thank you, Doug, and again, we appreciate all of our call-ins today and the continued interest in our Company. Without violating Reg FD, I think we could comfortably say that we do feel the sales are starting to get some strong breeze in them, and I think this fourth quarter is going to look pretty good for us.

So with that, we thank all of you for your interest and look forward to talking to you early next year. Thank you very much.

Ladies and gentlemen, this does conclude today's conference. Thank you for your participation. You may disconnect your lines at this time.