First Merchants Corp (FRMEP) 2011 Q2 法說會逐字稿

Good afternoon, and welcome to the First Merchants Corporation second quarter 2011 earnings conference call and webcast. (Operator Instructions). I would now like to turn the conference over to Michael C. Rechin, President and Chief Executive Officer. Please go ahead, sir.

Thank you, Jill. Welcome, everyone to our earnings conference call and webcast for the second quarter, ending June 30, 2011. Joining me today are Mark Hardwick, our Chief Financial Officer, and John Martin, our Chief Credit Officer. We released our earnings in a press release around 11 AM Eastern daylight savings time, our presentation speaks to material from that release.

The directions that point to the webcast were also contained at the back end that have release, and my comments begin on page four, slide titled "Second quarter 2011 Highlights." The second quarter First Merchants earned just earned under $4.5 million or $0.18 per fully diluted share.

The results continue to trend profitability with sound underlying fundamentals. On a year-over-year basis, we produced $9 million positive swing in core pre-tax earnings. A market execution remains strong in terms of managing the customer experience, maximizing the margin opportunity available to us, and addressing the muted, yet building credit demand. Our Credit Administration Team continues to lead our work and reducing the risk in our portfolio and related cost. We're pleased to see results from many current initiatives, which I'll comment on toward the end of today's presentation. At this time I would like to ask Mark to share more insight on our results for the quarter.

Thanks, Mike. Over the last year, First Merchant's has stabilized the balance sheet in terms of loan balances, and credit metric, strengthened it's capital position and produced consecutive quarters of core profitable. Earnings per share for the last quarter totaled $0.2, $0.10, $0.17 and now $0.18, or $12.3 million in net income available to common share holders over the past year, with $9 million coming from the past two quarters. On slide six, our loan-to-asset ratio now totals 67%, and loan-to-deposit ratio totals 87%. Consistent with many high performing peer banks.

Loan declines are stabilizing, liquidity is fully deployed and the balance sheet is producing strong and increasing net interest income. The composition of our loan portfolio on slide seven, is diversified by type, granular by size, and allows for pricing power. Our Community Bank balance sheet produced a 5.51% yield on loans for the quarter, down just 5 basis points from the first quarter of 2011. On slide eight, our $938 million bond portfolio continues to perform well, producing higher than average yields, with a moderately longer duration than our peer group.

Our 4.8% yield, compares favorably to peer averages of approximately 349 and duration remains just a year longer at four and a half years. Now let's look at the right side of the balance sheet on slide nine. Non-maturity deposits remain stable despite lower interest expense, and are reflective of the core value of the Corporation. Broker deposits and borrowings on lines three and four, are stabilizing as we are beginning to extend liabilities rather than simply paying down maturities. Common equity continues to increase through retention of earnings and book value per share total $9.74.

The mix of our deposits on slide ten continues to improve and our total deposit expense is now below 1%. Our least expensive categories, demand in savings, now total 68% of total deposits. All regulatory capital ratio on slide 11, are well above the OCC and Federal Reserve's definition of well capitalized, and are also exceed the (inaudible) three proposed targets as well. As mentioned in our press release, net interest income on slide 12, has now grown again for the first time since the third quarter of 2009. Considering our more conservitive asset mix of loans and investments, we're pleased by the growth in this category for the quarter.

Our net interest margin totalled 3.99%. The highest level since the fourth quarter of 2005, when it reached 4.03%. Non-interest income on slide 13, always reflects some volatility due to line six, securities, gains and losses, however when normalized for the bond portfolio activities as reflected on line nine, the quarter and total was somewhat of a disappointment. Our insurance commissions for the quarter were down due to a one adjustment, totalling $557,000.00. The core line of business, being our insurance agency, continues to exceed prior year commission income and will return to more historical pace next quarter.

Mortgage production is seasonal and somewhat unpredictable due to interest rate volatility, however our current pipeline is up 76% over this time last quarter. Our March 31 pipeline was just under $14 million, and as of June 30, 2011, the pipeline total $24.5 million. On a positive note, service charges on deposit accounts increased for the first time since the implementation of Reg E, as overdraft fees increased, and service charges waivers on commercial checking accounts were reduced by nearly 250 accounts. Total non-interest expense on slide 14, totaled $34.4 million for the second quarter of 2011, up $500,000 from the first quarter of 2011.

Salary and benefits increased by $1.4 million as health insurance increased $1.1 million, due to an unusually volatile claims experience. We changed carriers at the end of the fourth quarter. In the first quarter was unusually low. Our average expense has been $1.5 million over the last six quarters, last quarter was $760,000. This quarter we were at $1.8 million.

Please turn to slide 15. Our pre-tax pre-provision run rate. It remains strong averaging $17 million for the first two quarters. The reduction and provision expense produced $4.5 million bottom line in each quarter of 2011. Our credit expense, both highlighted here in terms of provision and the exclusions that we make for ORE and credit related expenses, totaled $0.21 for the quarter.

So we are continuing to make progress in credit, and allowing that additional income to flow through to our bottom line. Based on our S&L Database and peer research that we perform, we believe our margins, our efficiency, our MPA levels, our allowance levels and capital levels and the growth market coverage, commands a higher price than the current 95%. Now John Martin, our Chief Credit Officer will discuss our improving asset quality trends and allowance for loan loss coverage ratios.

Thanks, Mark, and good afternoon, everyone. I will start my presentation on slide 17,v where I will begin by reviewing some of the portfolio highlights, before walking through portfolio detail. I'll conclude my remarks with some high level observations and a review of our allowance coverage before turning the program back over to Mike Rechin for his remarks. Please turn to slide 17,

Our key credit metrics continue to show improvement in the quarter, both criticized and classified substandard assets, which include those graded substandard or worse, continue to improve while impaired loans decline to $8.5 million for the quarter to $108.3 million. Our non-accruel and non-performing assets remain mostly unchanged for the quarter, as the non-accruel inflows were offset by loan restructures, pay downs and charge offs. Ninety plus day delinquency improved for the quarter, down $230,000, while we continue to work on two matured loans that were in the 30- to 89day past due category, and are in process of resolution at quarter end.

One of these has subsequently been resolved, with the other currently in late stage negotiation, with expected resolution later in the quarter. Turn to slide 18 and I'll begin walking through some of the portfolio details. As shown in the non-accrual trends, there was a $12.3 million increase in commercial and industrial non-accrual loans. During the quarter we moved three larger relationships to non-accrual totaling $11 million. The largest of which was a $6.5 million under performing retail grocery operation.

While all three borrowers are paying in accordance with their original contractual terms, due to financial performance, collateral deficiency and probability of potential loss, these relationships were moved to non-accrual and are appropriately reserved. Offsetting the increase in CNI non-accruals, was approximately $10 million reduction in non-accruals was an approximately $10 million in non-accruals under the commercial mortgage category. This movement highlights that while we continue to experience inflows in non-accruals, we continue to see improvement in the resolution of troubled loans, mortgage loans as well. In particular and where appropriate, we continue to use a B Note Restructure, which allows us to work with troubled customers and expedite resolution.

I think it's important to highlight that the A Note, while remains on the books, and remains as and an accruing loan after the performance was established, the B note is charged off. This is increased for the quarter and is highlighted on slide 22, and I'll cover that later in my NPA reconciliation.

Now please turn to slide 19. Other real estate owned continued to decline for the third consecutive quarter down from $17 million to $15.4 million and off of a high of $21.5 million at the end of the third quarter of 2010. Reduction came from all categories, with one to four family homes representing nearly half of the change.

We continue to make progress selling these properties, although we expect ORE to fluctuate for the remained of the year as we work through commercial real estate secured non-accrual assets where restructure is not possible. Please turn to slide 20. As just mentioned, loan delinquency trends continue to remain stable with 90-plus days past due declining, and 30 to 89 day delinquency affected by the (inaudible) relationships.

Excluding the impact of these names, 30 to 89 day delinquency would have been more inline with Q1 rates at .79% of total loans, now please turn to slide 21 which shows the current and historical quarterly annualized net charge off. For the quarter, and in the Commercial and Industrial category, we realized a $6 million recovery on an individual charge off that occurred in the second and fourth quarters of 2009. Unanticipated in proof performance by the Customer allowed us to recognize a recovery with the payoff of previously charged off balances.

While we continue to have residual exposure to the borrow, performance is such that no additional loss is expected and remaining notes continue to perform under the original contractual terms. Next, moving to the Commercial Mortgage Category, we resolved a number of troubled commercial real estate relationships in the quarter that resulted in elevated charge off results. We charged off B notes on restructures and took new and incremental marks with the resolution of specific troubled names.

I will now walk through the non-performing asset reconciliation on slide 22. We started the quarter with a $107.6 million in non-performing assets and 90 days plus past due. We reduced non-accrual loans by $100,000 with inflows of $26.7 million.

This trend continues to be choppy with inflows of $15.5 million in Q3, 2010, $27.4 million in Q4, 2010, and $11.7 million in the first quarter. Moving down the slide, we had payoffs to accrual and to restructure of $8.3 million and gross charge offs of $16.9 million. We had a net decrease in ORE of $1.6 million, by adding $1.6 million in new RE, selling $1.6 million and writing down $1.6 million. Movement in ORE is equally fluctuating as we evaluate and balance the restructure of troubled loans, against liquidation through foreclosure and ORE. And finally 90 plus days past due decreased $500,000 and restructured $4.1 million.

Again that $4.1 million is restructures on the A note, B note, the remaining balance on the A note after the B note has been charged off. The A note is expected to perform as a result of the resize of the entire relationship the borrower down to the expected level that the customer can then return and continue to pay based on their existing cash flow. Please turn to slide 23.

On this slide of highlighted are classified and criticized assets. These metrics are indicators of loans with potential and well defined weaknesses in a customer's financial performance. The percentage change in these results from Q2, 2010, to Q2, 2011, show the directional consistency between the improvement of these credit metrics and the reduction of the allowance.

While the allowance declined 11% year-over-year, the trend and asset quality improved at a higher rate with criticized and classified assets declining 18.6% and 17.4% respectively. These speak to losses and not accruals. While this is expected to be somewhat choppy, should continue to moderate in coming periods. Finally on slide 24, continuing from the discussion around the moderation of losses, I've highlighted the charge offs and provisions and allowance.

As we follow our allowance methodology and with the reduction in criticized and classified loans, we reduce the allowance by $3.8 million in light of the improvement. Despite the reduction we continue to maintain an 88% coverage of non-accrual loans and believe our methodology provides for future losses. I'll turn the presentation back over to Mike Rechin for his remarks.

Thanks, John. Page 26 is intended to capsulize our emphasis for the balance of the year, and given John's most recent coverage of credit quality, I'll start with the last bullet point. It was the an active quarter, with a lot of work load producing outcomes with our clients. Our hope is, and our outlook is, that non-accrual inflows uneven as John depicted, should really move down based on what we know today, as should the overall direction of our credit statistics as criticized and classifieds have done several quarters in a row now reducing the risk in the portfolio and it's intended cost.

Speaking to the balance of the page, which I view as an investment page, our plan is to lead the growth of our more established markets and then more deeply penetrate our growth markets. As the page suggests, more formerly segmenting our commercial banking business to support the small business community, we've added a business banking segment Managers to bridge business owners needing commercial services.

In addition we added five middle market managers in Indianapolis and Columbus, Ohio and we should be productive in market coverage and balance sheet growth shortly there after. In addition we have opportunistically added bankers in LaFayette and Wabash, amongst other markets to upgrade our presence in places where we enjoy sizable shares. Overall through the balance of the credit cycle we aim to transition what had been inwardly focused bankers to market-serving, revenue-producing bankers without a large increase in overall employees..

Mark referenced our mortgage line of business. We have invested there to take advantage of what we view as a great opportunity to balance the production that comes out of our banking center driven current mortgage origination team, and about this time of our last earnings call, late April we had effected a lift out from a larger mortgage operation, and that time's team's pipeline is beginning to augment our team with our re-fi as a market as a whole. Given the recovery we continue to witness, albeit slow, we're confident about our direction.

Consistent with our 2011 plan, we look to reverse the direction of our loan portfolio before year end. Our loan pipeline that Mark highlighted as it relates to mortgage gives us reason to be optimistic about our near-term opportunity. For instance, our overall loan pipeline, including those loans that would be sold through the secondary markets was up about 20% to its current state of $240 million and the on balance sheet piece of that is effectively retail and commercial, makes up the majority of it, also up $40 million with that overall captioning. Pipeline, as you know, is a little bit difficult to assess because it takes equal parts bank commitment and ultimate closings, but the figures are significantly higher than they've been throughout this year, and accounts for the market coverage emphasis we've placed throughout 2011.

So in summary, people investment coupled with our technology investment highlighted on our page, we're introducing significantly more functionality and flexibility with our commercial and retail customers. We look to have our 3,000 commercial customers who utilize account analysis take advantage of some of that technology for which we will get paid as the year rolls out, and then our 107,000 households taking advantage of mobile banking, e statement, and mobile application banking all of which kind of rolled out at this time.

I referenced in the last call the $1 million plus investment we've made in online banking, much of that foundational work took place in May and then the functionality taking place as we speak to include the August roll out for all of our customers of e statement and mobile banking as employees and customers have been testing for better than a month now. At this point I would like to turn the call over to questions we might have on any of the aspects of the results we shared.

Jill, if you can do that, we're ready to go.

Thank you, sir. We will now begin the question and answer session. The first question is from Scott Siefers with Sandler O'Neil. Please go ahead.

Good afternoon, guys. I just wanted to start with credit. I appreciate all the color you gave in combination of choppiness but expectations for improving trends going forward. I guess Mike or John, maybe you could give your thoughts on sort of the pace or magnitude of improvement. I think given the elevated inflows into any perspective you might have on how quickly or forcefully we could get that aggregate NPA number down would be helpful.

I don't think I can give details that would project forward third and fourth or even in the next year. I think it does speak to the choppiness that you're seeing as some of the older substandard assets or classified assests that are rolling into non-accrual. We have folks who are improving and being able to effect that number. There are some that are not. I don't have a projection as to necessarily--

Scott, what I would add, this is Mike. John referenced, we kind of thought it was worth while to emphasize what I consider to be restructuring practices that John applied that yield in our mind conservative portrayal of our portfolio risk. So if you think about what exits are, I would expect as Mike comments covered, I think a lesser amount of inflows going forward based on what we see today. I'm standing right next to John, which always makes me anxious when I get too predictive, but that's what we see.

We see an overall loan portfolio that is reviving itself. I referenced the TDRs because while it is a modest piece of the overall MPA caption, it is a piece that you can pretty predictably, based on established cash flows, assume would move out of that category over a two-quarter period of time. So I would agree with John that we don't forecast that all that well. I think the directional correctness of the criticized and classifieds should continue as well.

That's what we really focus on in terms of our best internal predictor in credit costs. Our credit costs for first and second quarter were approximately $9 million per quarter. When you couple provisioning and OREO expense, we expect that to reduce.

Okay, that's perfect, thank you. To switch gears a little bit, Mark, when you X out all the noise in the line fee income line item, you're sort of somewhere in the $10.8 million range. Is that something that is sustainable? You mentioned the strength of the mortgage pipeline, which should be helpful, but do you see any pressures elsewhere that would preclude you from keeping things in that $10.5 million to $11 million range.

You're speaking specifically to non-interest income.

Yes.

If you normalize for the noise, the $550,000 on the insurance side, and with the improvements in the mortgage area, I would agree with you. That feels like the right place to us. And it's consistent with where we've been the last couple of years as well. Some movement by categories but over all a pretty consistent trend.

Okay, perfect. Then the last question, Mike, I know you made some new hires and you're looking to get the loan portfolio moving upward by the end of the year, I wonder if you could speak to price pressures that you are seeing or how aggressively you're competing on price on new originations, particularly on the commercial side.

Well, the quantitative piece is best seen in our loan yield and we only lost five basis points quarter to quarter. Clearly the people investment and the healthiest markets we cover as you might guess would be the most competitive. We're picking our spots, and we're price competitive where we win 100% of the relationship. We're selective around risk profile and really trying to effectively work with clients.

Clients are anxious about changing banks at this point in time. We're having our best successes in terms of conversions that I feel would account for what I feel like is an improved pipeline are people who know how we think and know our bankers. If you factor in the people we're adding, they are not junior folks. They are people who are market-smart, who will allow us to make what I call credit risk adjusted credit decisions that we feel good about, clearly there will be coupon pressure on fresh underwriting, but I don't feel like it's going to erode into the kind of yields you've seen to date.

Okay, perfect. Thank you very much.

Thank you.

The next question comes from Stephen Geyen of Stifel Nicolaus.

How are you doing today.

Well, thank you.

Good. Just a couple of questions, starting on page 21, you talked about the charge-offs and primarily the C&I portion. Curious what the recovery portion was and what that charge off number might have looked like without the recovery.

Well, the original charge off.

Your charge offs on 22, the 16.9, and what's the net?

Well, it is that difference. This is Mike. I think if you correlate 21 and 22, I think that the recovery number was a $7 million kind of number gross.

Yes.

Well, on the particular name it was $6.1 million, $6 million. In aggregate it was $7.4 million is the total. Our net charge-offs were 9.4. Is that the question that you are asking?

Yes. I think we're getting to the right spot specifically on the C&I portion, the 2 Q.

The second quarter, John, while you're flipped to that page. If you're looking at what were the negative charge-offs in that period, that's because the largest recovery that John referenced, the $6.1 million was the C&I name that off offset any charge-offs that would have taken place in that category.

That's what I was looking for. I might have missed that. Then the last question, you had mentioned that you're moving to the E-Statement and mobile banking later this year. Any thoughts on the improvement.

We approached it conservatively where we were trying to build an ROI for the project, based on its cost that focused exclusively on paper saved. It's $1.7 million over a three-year period of time was the cost side of it. And I might have with me here what the raw paper save is. If I don't have it with me, I'll get back to you.

We built into our analysis virtually no new revenue knowing that we will have a start date for new fees that start up after the successful implementation of it at the customer level. I'll have to follow back up with you. It's a paper-based and mail savings that I think you're looking for, and I can follow up with you on that.

That would be great, thank you.

The next question is from Brian Martin of FIG Partners.

Hey, guys, nice quarter. Mike or John, can you just talk a little bit about the inflows being a little bit lumpy when you look at them over the last couple of quarters. Is there any similarity on what is coming in that portfolio?

Is it commercial real estate? Is it commercial construction? What is the make up of it as it comes into it this quarter.

The top largest, Brian, the top largest that I mentioned earlier was the retail supermarket, $6.4 million. The next one down was the commercial real estate $3.2 million. And then it goes to a retail government contractor. That was $2.7 million.

Then the next one down is commercial real estate at $2 million. Then we had a land subdivision at $2 million.

Okay. And Mike, you talked about these numbers going down over time, I guess how should we think of a normalized level as to where that inflow number goes to. I realize that it's lumpy, but when you look at last quarter being $12 million, $11 and change, is that a more normalized number, or would you expect to see it lower.

That's a tough one, but I think $12 million. If you had to choose between the two, I would clearly tell you 12. What John covered in his remarks that I'll repeat is that the majority of the inflows, and the three large ones that John spoke of, are all current in their payment. What I think John has taken a finer pen to is just assessing secondary sources of repayment.

So if you take a look at John's page 23, the gap between non-accrual loans and impaired loans continues to narrow as we look, you know, when we have a client that has protracted weakness over a period of time, even with current pay, whether that be interest or interest and principle, when we identify a clear gap in secondary source of repayment, that's when John has chosen in many instances to move them to non-accrual despite its payment status. That does not necessarily speak to your question, but I think it's a good overall caption of what his strategy and our strategy as a bank has been. And then trying to circle back to your specific question, I think a lower eight-figure number, a $10 million, $12 million, a $15 million is clearly more predictive of where our inflow should be based on where the portfolio is sized.

That's helpful. Then the OREO costs and where appraisals are shaking out these days. Can you give any color on what pricing you're seeing on these appraisals as they come in, and we expect continued write downs in that policy portfolio for a period of time here.

Brian, I think anything that is the older the appraisal, the greater the risk in the change in the valley. I would say that if you take it by category, commercial real estate, It depends on the type. You're going to see reductions there.

Land subdivision, I'll tell that you on land loans and the values getting back to just plain land is buoyed at some point by agriculture when you get to that point, but I would say we're probably down some percentage over last quarter. So the commercial real estate, lower 10%, 20%, I don't know. And on the land year-over-year, it's probably held relatively constant because many of the levels that we had last year are probably in line with what we're seeing this year.

Okay, and just the last two. Can you talk a little bit about just the follow-up on SBOS and your thoughts, if you had new word or how you're thinking about that topic.

Sure, this is Mike, and then Mark might have a comment, but I think I know we discussed last fall that we had applied, which we did, all along that schedule continue to feel the purpose of that program fits our sweet spot as a community bank really well. And as such, you heard our comments about the formalization of that segment. We would fully expect with or without the SBLF that the client sizing of $50 million in credit exposure speaks really well to where we add the most value in the market.

We continue to look forward to programs roll outs. We don't have anything to report at this time, but based on the funding parameters of it, it would likely have played its way through by the time we next hold a call like this one. So we continue to like the program.

Okay, and then lastly, a question for Mark, have you set up a little bit of noise on the run rates, they are a little bit lower. Is that the way we should look at it.

I felt it was $300,000 above what would be a normal run rate on the expense levels based on where health insurance came in this quarter.

Okay, all right. Thanks very much, you guys.

Thank you, Brian.

Thank you, showing no further questions, this concludes our question and answer session. I would like to turn the conference back over to Mr. Rechin for closing remarks.

I have very few. I appreciate you hosting the call. I appreciate all those who patched in to listen. Mark, John and myself are available for any follow up questions that you have. We look forward to speaking with you again in a couple months to review the third quarter. Have a great day.

The conference has concluded. You may now disconnect your lines.