First Merchants Corp (FRMEP) 2006 Q4 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the First Merchants Corporation 2006 earnings conference call. At this time, all participants 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 Corporation. Thank you, Mr. Cox, you may begin.

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

I hope that you have all received our earnings release that went out yesterday at 10 AM announcing pretty solid results for the year, as well as a separate release that was sent out today at 12 noon focusing on our 2007 strategic initiatives.

By now, you may have read that I have decided that the time is right for me to retire. I have chosen the date of April 24 of this year, coinciding with our Corporation's annual meeting and allowing time for a smooth CEO transition.

Yesterday, I am pleased to announce, the Board of Directors elected Mike Rechin as our new CEO. When Mike joined us in October 2005, he brought new energy and a fresh perspective, which serves us well. His substantial leadership abilities have been keenly observed by our staff and our corporate Board. I look forward to Mike's expanded leadership role in First Merchants.

I am proud of the progress we have made as a Company to build a common infrastructure, including products and systems. This is a positive step toward higher performance for us that will take advantage of a stronger brand presence and increased efficiencies.

To begin, today is a very important day in the history of our Company. We're communicating to our employees that four of First Merchants Corporation's separately chartered banks will be combined under the First Merchants Bank name. They are Frances Slocum Bank, Decatur Bank & Trust, First National Bank, and United Communities National Bank.

In addition, the Hamilton County offices of First Merchants Bank will combine with Madison Community Bank and create the newly-formed First Merchants Bank of Central Indiana. Lafayette Bank & Trust Company and Commerce National Bank in Columbus, Ohio, will retain their names, charters, and leadership.

As a result of these changes, First Merchants Corporation will now have four bank charters -- First Merchants Bank, First Merchants Bank of Central Indiana, Lafayette Bank & Trust Company, and Commerce National Bank.

This process began back in September of the past year at an off-site planning retreat with a team of the Corporation's and banks' executives. It continued with an off-site retreat with our corporate Board of Directors in October. During these discussions, we reassessed our vision, mission, and core values, and we also assessed our structure as a Corporation within the current business climate.

There is great news. First Merchants Corporation more than doubled its assets and earnings in the last five years and is now the third-largest Indiana-based bank holding company. For that, our staff of professionals should be congratulated.

But there are challenges. Changes in the banking environment during this period, including legislation such as Graham-Leach-Bliley dealing with customer privacy issues, and Sarbanes-Oxley having to do with public accounting reform, have made each of our banks separate SEC registrants by proxy. The result is a large increase in costs and time devoted to compliance issues for all of us. It is very difficult, expensive, and inefficient to have eight separate charters. We need to simplify our structure.

I am proud of First Merchants Corporation, which will soon include four bank charters as well as First Merchants Trust Company and First Merchants Insurance Services. Each of these companies is strong and profitable and has the potential to achieve even more. Higher performance is our collective goal as a group of nearly 1,200 talented employees.

Mark will now address our 2006 results; and then Michael Rechin will speak to some of the tactical plans we have developed to support our 2007 strategic initiatives. We will follow that with an open Q&A session. Mark?

Thank you, Mike. Ladies and gentlemen, we appreciate you joining our call this afternoon. The Corporation's total assets reached a record $3.555 billion at year-end, an increase of $318 million or 9.8% over 12/31/2005.

Total loans increased 9.6% or $235 million. Commercial real estate loans continued to lead our growth initiatives as this category increased $127 million or 17.2% over last year. Commercial and industrial loans have also increased by $76 million during the year. Loans for individual household personal expenditures improved by $23 million.

Total investment securities and Bank Owned Life Insurance increased by $31 million and $21 million, respectively. Total deposits increased during the year by $368 million or 15.4%.

We are pleased with this growth but we feel like a couple of items deserve to be singled out. Borrowings declined $67 million as the Corporation transitioned to purchase agreements not requiring collateral to deposits. So at some level, this represents a reclassification of customer balances versus organic growth. Additionally, brokered CDs increased $62 million during the year; and it is not representative of banker activity. Net of these two items, core deposits did increase $239 million or 10%, of which we are very proud.

Net interest margin, again during the quarter and for the year, requires a significant amount of discussion and analysis. Our year-to-date average earning assets totaled $3.073 billion at year-end, or the average at year-end 2006; and $2.891 billion in 2005, an increase of $182 million or 6%.

Year-to-date net interest margin on a fully taxable equivalent basis totaled 3.71%, a decline of 26 basis points as the Corporation's yield on earning assets during the year improved by 66 basis points and the cost of supporting liabilities increased by 92 basis points.

As discussed in our earnings release, the Corporation's rate variance resulted in reduced pretax income of $8 million or $0.26 per share.

As stated in our last couple of conference calls, 1 basis point does equate in our Corporation to 1 penny per share. This compression is the result of the inverted yield curve, competition, and growing the balance sheet on the margin. Many banks in the industry have announced and deployed bond portfolio restructurings during 2006. Our portfolio has an average life of just under three years, and a restructuring would provide very little lift in earnings.

Our margin has compressed in 2006; however, compared to banks that have not restructured their bond portfolios, we remain very respectable and above peer. We continue to believe that we're well positioned for an upward slope in the yield curve.

Our strong year-over-year improvements in earning assets offset just under $7 million of this year's rate variance, producing a decline in net interest income of $1,034,000.

The loan-loss provision for the year-end equaled 23 basis points, down $2,096,000 from last year's 34 basis points. Nonperforming loans totaled 87 basis points at year-end, and net charge-offs totaled just 19 basis points during the year.

Non-interest income also declined by $104,000 as gains from the sale of mortgage loans declined $731,000. One-time gains in 2005 for extraordinary items totaled $711,000. Non-interest expense increased just 2.2% during the year, despite $833,000 of FASB 123 expense related to the expensing of stock options, and investment in sales talent throughout our footprint of over $1 million.

Earnings per share totaled 1.64 or $1.64 for the year, a $0.01 improvement over 2005.

Relative to the business of the combination of five bank charters into one, we are excited about the focus on branding, greater customer service, sales, and efficiency. The cost associated with our bank combinations will be just over $1 million in 2007, while the benefits in 2008 are expected to reach a minimum of $1.5 million.

We are confident that operationally we are prepared to execute this strategy with minimal customer impact. All platforms throughout the five combining banks are currently standardized, therefore significantly reducing our risk of employee or customer disruption.

Additionally, we are in varied stages of implementation on several tax strategies aimed at reducing our overall tax burden. This relief should help offset most of the after-tax impact of bank combination expense during 2007. Now Mike Rechin will cover the market specifics related to our 2007 initiatives.

Thank you, Mark, and good afternoon, everyone. I would like to share a few thoughts on our 2006 results to complement what Mark shared, and then speak to the release of earlier today.

In regard to credit quality, it remained pretty stable over the second half of the year at what we believe to be an acceptable level. We have some work to do. We had a $1.3 million increase in our nonaccrual loans, offset by a like amount of reduction in our 90-day past due. The overall level of nonaccruals put downward pressure on our net interest margin of 3 to 4 basis points.

Our largest 10 nonperformers totaled just under just $9 million, with only three of them having exposures of $1 million or more. Our criticized and our classified asset levels both reduced modestly over the fourth quarter, criticized moving from just over 7% to 6.77%; and our classified assets also improved, down to 3.18% from the prior-year quarter's 3.45%.

So we feel that credit quality is holding up pretty well. We actively pursue strategies for collection against all of our underperforming exposures.

We had a release you may have seen last week that recognized the addition of Dave Spade in a new capacity in our Company as Chief Accounting Officer, which we view as a real proactive way to stay out ahead of our credit risk as the balance sheet grew 9%, as Mark spoke to, and as we put incentive plans in place that are intended to have that continue on a go-forward basis.

In regard to the balance sheet, we are pleased not only with the amount of the loan growth but the broadbased nature of it, across all of the banks in our franchise, and look to that to continue. We clarified our view of sales management, maintaining our focus on closely-held businesses and supporting our branch structure throughout the franchise.

The deposit gathering that Mark referred to is very satisfying to us. Introduced a new sweep product last year that really enabled that transition of some of our repo based borrowings into our deposit product. Deposit gathering is forefront in all of our measures as we recognize the funding cost associated with growing the loan side of the balance sheet.

Our Columbus bank in particular, along with its Cincinnati office, continued with their Bank for Business approach; had our strongest 2006 earnings performance amongst our banking units. Other of them, to include Lafayette and Indianapolis, performed well, also.

The banks that we will combine to be the First Merchants Bank also continued their high market shares in all of the markets contiguous to Muncie. That bank is positioned to really lever the strength of all of the employees in there, to include a renewed emphasis on the agri business that is indigenous to this part of the state.

I would like to pause and just share some thoughts on our release of earlier today. I would like to begin by recognizing Mike Cox for his outstanding leadership of this Company. Mike, thank you for your contributions over the years and especially your vision for our 2000 initiatives that we have announced today. During 2007, First Merchants Corporation will become even better known as a Company reaching for higher performance, and you have laid the groundwork for this to occur.

Our structure change will have a long-term and very positive impact on the Company. Merging five banks into one sounds daunting, but we're not doing all the work at one time. In so many ways, we are one bank already, as Mark alluded to.

Over the past five years, through diligent effort and nearly $16 million of capital expenditures, we have moved to centralize departments for operations, human resources, marketing, risk management, and finance. Reducing the number of charters and names is simply the next step in a journey to increased efficiency and higher levels of performance.

Also wanted to share some news about our leadership structure. The following support structure as identified in the release takes place immediately. Jim Meinerding, currently President and CEO of United Communities National Bank, will become CEO of the newly-combined First Merchants Bank serving East Central Indiana and Butler County, Ohio.

Mike Baker will become President and CEO of First Merchants Bank of Central Indiana. The structures and leadership at Lafayette Bank & Trust and at Commerce National Bank remained unchanged, Tony Albrecht at LBT and John Romelfanger at Commerce National Bank. Bob Bell, Ron Kerby, Steve Bailey, and Jack Demaree, as Regional Presidents, continue their focus on serving their customers, growing new relationships, and providing greater profit contributions to the Corporation.

Our local bank boards support and have approved this new structure. A single new First Merchants Bank Board, comprised of members of the five existing boards, will preserve and reflect each of our respective markets.

Four strong charters allows us to build our brand in our four served regions. Each bank will be able to expand its market position and focus on their customers' needs. We're confident that these structural changes lead to increased efficiencies and improve our performance, and we continue to look for new ways to improve our performance for our shareholders.

At this point, any of the three of us are available for questions on any of the portions of those remarks.

(OPERATOR INSTRUCTIONS) Kenneth James with FTN Midwest Securities.

First of all, congratulations on your retirement, Mr. Cox; and Mr. Rechin, congratulations to you as well. I have enjoyed working with Mr. Cox. I look forward to working with Mr. Rechin in the future.

Thank you.

Thank you.

The first question is in regards to the charter consolidation plan. You reference $1 million of expenses. Do you expect that that will be kind of distributed throughout the year, maybe so we don't even really notice it? Or is it going to come in the form of a lump charge or two? How do you see that playing out?

That charge will be distributed throughout the year. Our timing of the actual combinations will primarily be the third and fourth quarters of 2007. So we do anticipate really no expenses in the first quarter related to that charge, and then pretty evenly spread out over the next three quarters.

Okay. I am curious, when you kind of modeled this out or looked at it, and thinking about the increased efficiencies, do you have an idea or a target of where you would like the efficiency ratio to be, ultimately, maybe when this is completed? That has always kind of been in the low 60s. I was wondering if maybe there is a kind of new goal there or target level we could look for.

This is Mike. We have an internal target number there of 55%. It has been in our strategic plan benchmarks now for a couple years. As you know, we are having trouble breaking through 60 and heading lower. We spend a lot of time analyzing that to determine whether it is a numerator or denominator problem.

We think, frankly, it is more of a revenue issue than it is a cost management issue. If we could get some cooperation on the margin side, and not be so severely affecting revenue, that efficiency ratio would come down pretty abruptly.

But on the cost management side, we're pretty pleased with how we're handling that. Our total non-interest expenses in 2006 were only up 2.2%, including salary adjustments across the board and all the other overhead that goes with it.

We constantly monitor staffing levels and headcount. While we have been growing the Company by a factor of 2 times, our headcounts hasn't changed at all. Essentially been flat for the last five years. So I think if we can begin to get some help on the revenue side, that efficiency ratio is going to take care of itself.

Okay. Since you mentioned the margin, maybe we could go there for a second. The increase in funding cost this quarter, wasn't dramatic, but it's a little bit more than I have seen maybe from some other banks in the area. Can you touch on kind of what was the drivers of the compression this quarter, and then kind of your outlook here, going into the first half of the year?

You know, we are deploying a number of different strategies. We have one new account that we are using in a number of markets with tiered deposit rates that looks very much like a money market account. That is winning some business. We are kind of in the middle of our peer -- or not our peer, but our competitors in our remaining markets as it relates to CD pricing.

With a Fed funds rate of 5.25%, to have an overall cost of our supporting liabilities in the 3-53 range, we feel like that is starting to get to the top end or the high end of the range of our overall deposit cost. So do anticipate that to continue to stabilize, given the current interest rate environment.

Okay. So do you think kind of customer mix shift, if you will, from lower-cost to higher-cost deposits has run its course, and deposit rates have topped out? So if the Fed kind of stays on hold here, do you think asset yields and funding costs have pretty much hit where they will stay?

We have -- from a budgetary perspective, we anticipate being in the 3-55, 3-60 range for the year of 2007. So based on all of our models, we do think that we are close to the end of the rate compression.

I think the pricing up of our existing liabilities has predominantly run its course, as you allude. Our remaining exposure, in my mind, is that if our loan growth were to continue to outstrip our deposit gathering, our incremental funding continues to be rich from a pricing standpoint.

Okay, thank you.

Brian Martin with Howe Barnes.

I will echo Ken's congratulations to both of you guys. I guess maybe to that, Mike's last comment, just kind of following up on that, the likelihood that loan growth might outstrip deposit growth, but I guess can you give -- you talked about the Columbus market and Lafayette being I guess the best of the bunch for last year. Just can you give a little color on your expectations on the loan side for this coming year?

And then maybe also talk a little bit about -- I guess I was assuming that strength you were referring to was more on the loan side and not the deposit side. But maybe you could also give us a little bit of color of the improvements or the mix shift on the deposit -- because it looks pretty good this quarter -- what markets that was driven by.

Sure, in regard to the loan demand, we are not going to be altering our approach to any of our core markets based on the ownership of the customers that we have been winning that comprise the majority of the loan growth.

There are some categories of loan growth, as other banks have looked, we're also assessing some of the areas like indirect lending where we don't feel like we have the ability to sell multiple products nor win deposits that might become less attractive to us as we go forward. We're pretty confident that that might be the case. We would act on that if in fact the loan growth numbers continue to put pricing pressure on their funding.

In regard to particularly strong deposit markets, they have all participated in what are already standardized promotions at the retail banking level and been successful in going back to win incremental deposits from customers that already think about this as their bank. Lafayette Bank & Trust had a particularly strong 2006 relative to deposit gathering out of their own organic efforts.

Okay. Just maybe I didn't get everything on the loan side of the equation. But I mean somewhere in a mid type of single digit, mid to high single digit loan growth, does that seem like a reasonable place to start on the loan side?

I don't know how the pipeline stands at this point relative to maybe a year ago. I guess it seems like a lot of banks are giving us a little bit of color that maybe it is a little bit slower than it was a year ago.

Our tracking of that pipeline -- that is a good question. Our tracking of pipeline from a common definition standpoint really gathered integrity in terms of comfort with the number, really earlier in 2006. So it's tough for me to give you a great feel for January over January.

But I would tell you that through the year, from the time that we really adopted a common methodology for assessing commercial pipeline, that we had a significant buildup into the third quarter, much of which was closed in the fourth quarter. It is back to a level that was late summer-ish, which we still feel good about; but it's beneath where it was a quarter ago. I am comfortable that the balance sheet reflects the pipeline transitioning to closed loans.

Okay, all right. Maybe just one more housekeeping item. That was within the other income line in the quarter you had a reasonably -- I guess, a jump in the net gains on fees of sale and loans. Was there anything nonrecurring in that line item? Or was that maybe just a higher run rate? (indiscernible) you're not sure what that is, per se.

The net gains from the sale of loans?

Yes, I mean it was a little bit higher over the last three quarters.

The answer to that really is that is an accurate reflection quarter-over-quarter of the specific activity happening in that line item or that category. During, really, one of the more important parts of the year, obviously the summer season, we were low as it relates to total originators. We have made some advancements in the fourth quarter of hiring new originators and generating higher volumes.

Okay, so that number might be more of a sustainable level then, going forward?

We hope so. As Mark said, we're disappointed in our performance on that particular line item. Coincident with the midyear number of effective originators, we also were really getting the kinks out of some new software for our processing side that we have gotten some --gained some experience with this, such that our processing will be more consistent and then more centralized.

Okay. Then just lastly on the credit front, maybe, it sounds as though things are going pretty well, I guess. The level of losses incurred for the year, I guess, is it fair to think at this point that there is not any real likelihood that those go materially higher? Is that the outlook or the expectation at this point? That this level, given that credit appears to be pretty stable, that that is a pretty good trend line?

Our tracking of our loan quality is the best that it has been in the Corporation's history. I think our diligence related to loan grading, the assessment of loss in specific credits, is as well defined as it has ever been.

The specific reserves in our allowance for loan loss totaled $4.7 million. That is every anticipated loss and any of our watchlist credits that we are evaluating. So we feel very good about the specific identifications and the trend that has been occurring in that specific line item. And that is published every quarter in our 10-Q.

Well, okay. That is all I needed. I appreciate it, guys. Thanks.

I might comment before you leave us, you are looking at the linked-quarter-to-quarter report in our release, and that is very observant of you. There is another item there worth pointing out, and that is the trend on service charges on deposits.

We are currently trending at a level that is 3 to $400,000 higher per quarter than it was back last year. The result -- or the cause of that is the introduction of our overdraft protection product on our debit card, which really became effective about midyear '06 and is providing some substantial boost in service charges. So we are not sure where it's going to flatten out; but we are looking for that to provide nice comparisons year-over-year going forward.

Okay. One thing I didn't ask, that you guys commented on, but I just didn't write it down, was the margin in the quarter. The reversal of interest. What was the reversal of interest? You said it was a couple basis points on the margin? Is that what you guys said?

3 to 4.

And the size of that credit was -- ? Did you guys give that?

It was not one credit, it is the collective drag of the level of our nonaccrual loans. It was not one credit specific.

Okay, okay. That's it. I appreciate it, guys.

Jon Arfstrom with RBC Capital Markets.

Mark, can you talk a little bit, to the extent you can, about the tax strategies? About the tax rate in the fourth quarter and whether or not you expect that to pop back up in the first quarter?

We have a couple of different things we are doing. One is a re-evaluation of our entire BOLI platform throughout the Company. Our BOLI assets. We are actively engaged in a 1035 exchange, which should improve the performance of the yield of that category.

Then the second is a strategy to try to transition some of our assets or a larger percentage of our assets into our Nevada subsidiary. So as we move forward with that strategy, look for appropriate Board approvals, and the deployment, we feel strongly that that will help the year of 2007 and hopefully beyond, depending on what kind of tax law may be passed.

So those are the primary items that we are looking at. We did have a bit of a decrease in the fourth quarter. We had an assessment of our overall tax position and decided that we had some additional room to reduce the overall accruals. So I would anticipate that that percentage, at least in the first quarter as we are moving through some of these strategies, would bump back up a little more to our traditional level.

Okay. Good, that's helpful. On the changes in your charters, where do the expense saves come from?

The expense saves that we have identified and that we have mentioned in this call really are 100% structured around a more efficient backroom operation in our Corporation. Some of the benefits that could come at the bank level, our expectations are to make sure that we are deploying those dollars back into the revenue generation position.

Okay. Does the charter change do anything to the way you manage the balance sheet? Does it allow for you to hold less securities? Or can you change your earning asset mix at all?

Yes, one of the best -- or one of the nice things that I think this will create, one is it will allow us to move more of our investment portfolio into our Nevada subsidiary for a tax-advantaged return and really better portfolio management.

The secondary item as we do have situations periodically, given the separate charters, where we have liquidity that is invested in bonds when a sister bank may have really a borrowing need. That can inflate the balance sheet slightly at a real minimal spread. So it's an item that we will be evaluating. It should give us the opportunity to just ensure that the deployment of all those borrowings and investments are maximized.

Okay. Just a couple more here for either of the Mikes. But in terms of the multi charter approach, I know it has been a while since you had an acquisition. But does consolidating the charters change the way you look at acquisitions? Does it make you less attractive to an acquisition partner? Or does it -- kind of dual strategy where you still have some charters out there -- allow you to go either direction on that, on a potential M&A target?

We have talked about that a lot internally, and it's an excellent question. We don't think that it will impact us dramatically going forward. We're still going to be a multi charter company with four charters, and they now bear some regional justification, some regional geographic justification. We plan to continue that mode of operation.

We now have those four charters positioned in specific identifiable regions through the state. We are eliminating some charter overlap or market confusion overlap, particularly in the greater Indianapolis, Hamilton County market. This should serve us very well from a customer and a branding perspective.

In the future, if we have acquisition opportunities, and sort of using Commerce National as an example, if it is in a clearly distinct market area with a presence fully established, I would see no reason why we wouldn't want to maintain that charter. We still believe in the value brought about as a result of boards of directors made up of local prominent businesspeople; and we are maintaining that to the fullest extent we can.

You may know that there is a government, a federal regulation governing the size of national bank boards, and we are going to stretch that to the outer limit in configuring the new First Merchants Bank Board because we believe we have an awful lot of good statesman in our market and we want to preserve that feel.

I think we still have a good story to tell potential partners going forward. As you have heard us say before, it is not the talk, it is the walk. I think we are doing it, and we are going to be pleased with the outcome of these changes.

Good, that's helpful. Just one last question. I know it is not a large piece of the loan portfolio, but can you talk a little bit about the health of the real estate construction portfolio. It has been down the last couple of quarters, which I think most analysts like to see. But can you talk a little bit about your appetite in that business as well?

Sure. I don't have numbers in front of me to refer to directly, but the health of it has really held up well. We have seen some slower absorption in some of the residential development. We're keeping a close eye on that. Most of our construction activity in the C&I is for owners; so we really shouldn't expect to see much softness there.

But we are heavily engaged in the local real estate communities in terms of trying to assess the sale activity that gives rise to lot takedowns across all of our builder customers and at this point feel good about the credit caliber of the portfolio.

Okay, great. That's helpful. Thanks, guys.

(OPERATOR INSTRUCTIONS) Gentlemen, there are no further questions at this time.

Thank you, Doug. We appreciate your facilitating the call. As a closing remarks, I would just say to all of you, and we have a very large number of callers today, we appreciate very much your interest in First Merchants Corporation, your support over the years, and we look forward to providing continued growth to our shareholders both in the form of EPS growth and, we hope, stock price growth.

I think you're going to like what you see from Mike Rechin's leadership. He's a tremendous leader and coach for our people. I can only look to brighter things in the future. So thank you very much for being with us, and we will talk to you next quarter.

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