First Merchants Corp (FRMEP) 2014 Q2 法說會逐字稿

Good afternoon and welcome to the First Merchants Corporation Second Quarter 2014 Earnings Conference Call. All participants will be in listen-only mode. (Operator Instructions) After today's presentation, there will be an opportunity to ask questions. (Operator Instructions) Please note this event is being recorded.

We will be using user controlled slides for our webcast today. Slides may be viewed by following the URL instructions noted in the First Merchants news release dated Thursday, July 24 2014 or by visiting the First Merchants Corporation 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 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.

I would now like to turn the conference over to Michael Rechin, President and CEO. Please go ahead, sir.

Thank you, Chad. Thank you all for joining this afternoon. Welcome to the earnings call and our webcast for the second quarter ending June 30, 2014. Joining me today, as in the past, are Mark Hardwick, our Chief Financial Officer and John Martin, our Chief Credit Officer.

We released our second quarter results in a press release earlier today, about 10 o'clock Eastern Standard Time and our presentation speaks the material from that release, the directions that point to the webcast were also contained at the back end of the release and my comments begin on the page titled First Merchants 2nd Quarter of 2014 Highlights, that's page 4.

At the top of the page, we're really pleased with progress in many areas of the Company and we look forward to sharing our views of them and taking questions at the back end of the call. As contained at the top of the release, we reported earnings per share of $0.41, a 21% increase from prior period on a quarter-over-quarter basis and net income attributable to that EPS of $15.2 million. I know that our Treasurer was referencing to me earlier that absent the first quarter of 2012, that was the quarter that we had the FDIC assumption of Shelby County Bank and recognized a $9 million one-time gain, that $15.2 million in net income is the highest level ever in the history of the Corporation. So we're pleased with that and as indicated in the last bullet point represents a return on average assets of 1.1%. So we're gaining and hitting some of the progress targets that we had set for ourselves towards becoming a higher-performing company.

Some of the income statement progress driven by loan growth where we had nearly 3% of organic loan growth on a quarterly basis, two-thirds of which is in the C&I category. I know, John Martin speaks to that at some point and at the backend of the call, when I look forward somewhat as it relates to the pipelines, I will reference similar items. And I know that our Chief Banking Officer is most pleased with the evenness of the activity across the entire Company. With all of our markets growing commercially and for the first quarter in several quarters some organic pickup in some of the consumer categories you might have noticed in the release including residential mortgage activity on the balance sheet and then the HELOC category. So we're pleased with that.

Had a little bit of margin pressure. Absent the fair value accretion and yet at 3.89%, a full basis point above the like number for June quarter of last year at 3.88% and Mark will speak to that extensively in his remarks.

We talked this time three months ago at the end of the first quarter about our expense levels experienced through March with the hope that it would come down $2 million with it. We had a little bit of OREO expense associated with our improving credit quality picture that John will cover, but we're trying to hit our expense targets. And while I referenced in the bullet point on page four that the expense target take- out for CFS have been realized. In fact, the entire company is getting to the level that we think is appropriate and it reflects itself in an efficiency ratio that gets down closer to 60% level. So we're pleased with that.

So the slide is titled, the second quarter and the last thing we're going to talk about at the end of the call and perhaps a couple of comments from my colleagues would reference the material covered in our press release of July 22. So two days ago, we had a press release covering a definitive agreement that's been executed that will have Community Bancshares join our company, and we set a target for the first quarter of 2015. All of our efforts are going to be directed towards accelerating that into 2014. But the progress, the natural progress -- process that takes place immediately after that definitive agreement is in place and we're tremendously excited about that as well.

So I am going to let Mark get into greater detail on our second quarter results and be back with you here in a few moments.

Great. Thank you, Mike. If you turn to page six or slide six, I'll begin my comments there. I wanted to point out that most of my discussion is going to be a comparison between the first quarter of 2014 and the second quarter of 2014. Now that we have two full months with Citizens -- our two full quarters with Citizens, because the second quarter of 2013 did not include Citizens or Lakeshore Region, I think it's difficult to try to compare the two.

So if you look on slide six, on line three loans have increased on a linked basis by $106 million or nearly 3% just in the quarter on an annualized basis, closer to 12%. Through the first six months --I'm sorry. The investment portfolios on line 1, increased during the quarter by $64 million as well. So we're doing a nice job of growing overall earning assets when you combine the loan totals and the investment portfolio totals. We believe our liquidity is optimally deployed and given the current pace of loan growth, we're not anticipating further increases in our loan portfolio. The allowance on line four totaled $68 million or 1.83% of loans and 133% of non-accrual loans.

Net charge-offs totaled $1.2 million for the quarter, but we are still in our net recovery position of $497,000 year-to-date. The composition of our loan portfolio on slide 7 is reflective of the commercial bank balance sheet as the commercial loan categories comprise 73.5% of our portfolio. The portfolio yield for the second quarter of 2014 totaled 4.57%, down from 4.66% in the second quarter of 2013 and the two quarters obviously the Lakeshore and Citizens was not included a year ago, but we're seeing a decline from 4.66% to 4.57%. Without our fair value marks or on a normalized basis, loan yields have declined from 4.61% to 4.34% during the same period.

On slide 8, 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 3.84% yield compares favorably to the peer averages of approximately 2.54% with a duration of 4.3 years.

The net gain in our portfolio increased back to $35.6 million during the quarter and the maturities for the remainder of the year totaled just $84 million with a yield of 3.64% and our 2015 maturities totaled $143 million with a yield of 3.01%.

Now on slide 9, our non-maturity deposits on line one are up slightly over year-end and last quarter and represent 76% of total deposits. Borrowings and brokered deposits on lines three and four have increased during the quarter and CDs on line two continued to decline. And the rate differential in terms of what the customer expects for CD rates in the wholesale market, still remains pretty material and that's why we're taking advantage of some of the attractive features in the brokered market and Federal Home Loan Bank advances less risk of repricing in a rising rate environment and lower rates even in the current quarter.

Our tangible book value per share on line 10 of slide 9 now totals [13.14%], an increase of [$1.87] or nearly 17% year-over-year. Our earnings per share added a $1.48 during that 12-month period reduced by our $0.23 of dividends and the remainder of the increase to a $1.87 or filling the gap to $1.87 with a $19 million increase in other comprehensive income. So really pleased by that transition. Based on tangible book value of 2013, 2014, our current stock -- when compared to our current stock price, our tangible book value multiple is just under 1.60, which is a little light of peer group and something we'd like to ultimately obtain is additional increases.

As I've previously mentioned, the mix of our deposits on slide 10 continues to be strong and our total deposit expense is just 34 basis points, down from 40 basis points as of the second quarter of 2013 and then on slide 11, our regulatory capital ratios are all well above the OCC and the Federal Reserve's definition of well capitalized and continued growing nicely. The Corporation's net interest margin on slide 12, totaled 3.89% for the quarter and when adjusted for fair value accretion of $2.2 million totaled 3.71%.

Our fair value accretion adjusted net interest margin totaled 3.84% in the second quarter of last year and has compressed by 13 basis points year-over-year. We still remain asset sensitive with $1.85 billion in assets that re-price daily. Our net interest income simulations suggest that our net interest income should remain stable over the coming quarters. However, our new volume is averaging a spread of around 3% over the relative index. We're achieving nice loan growth and with the mix of loan growth in our core deposits, we feel like the spread that we attain from that growth is enough to continue moving our net interest income in the proper direction and increasing quarter over quarter.

Total non-interest income on slide 13, can have some volatility due to line 7, our securities gains and losses and did this this quarter. Our portfolio gains were related to the liquidation of four of our six trust preferred investment pools. During the recession, we recorded OTTI on the securities and we've been carrying them as classified assets ever since. Since we had the opportunity to sell out of our position with gains on four of those six pools, we executed the trades. We also recovered the fair market value mark, which is part of the OTTI -- I am sorry, other comprehensive income improvement that we recognized during the quarter that I spoke about previously and that total was about $3 million.

We're pleased that line 11 on non-interest income increased by $0.5 million over the first quarter of 2014 as service charges on deposits returned to expected levels and mortgage activity improved during the quarter.

Mike has already touched on our expense levels, but I would just highlight that our non-interest expense on slide 14 totaled $41.2 million for the quarter, down from the first quarter total by $1.9 million. And when adjusted for OREO losses, the core level of our expenses at the Bank declined by $2.7 million. Q2 of 2014 is the first full quarter post integration and we're pleased to report that our anticipated cost savings have been realized.

On slide 15, our net interest income is aided by zero expense in our provisions line item due to the fact that we're in a net recovery position for the year and all of our loan categories -- asset quality categories continued to improve and our net income now totals $15.2 million or $0.41 for the quarter.

On slide 16, you will notice that our EPS improved by over $0.07 second quarter of 2013 to second quarter of 2014 and $0.03 over the first quarter of 2014.

John Martin will now discuss our loan portfolio trends.

All right. Thanks, Mark and good afternoon. I'll be updating you on the trends on the loan portfolio starting on slide 18 and then cover second quarter asset quality with an update on the progress of the work on the Citizens portfolio before closing with a look at the allowance and our fair value coverage.

So please turn to slide 18. In the second quarter, we experienced strong portfolio growth on lines one through three in commercial and industrial, commercial real estate construction and investment real estate lending. The growth in the portfolio was a blended mix of new relationships, withdrawals on existing lines and the financing of capital investment. Rounding out the portfolio on lines four through eight, we saw seasonal increases in agricultural production lending. ag land acquisition while experiencing an uptick in residential and home equity lending. This growth combined with the strength in the commercial portfolio led to an increase of, as Mark had mentioned before, $106 million or 2.9% in total loans in the quarter.

Flipping to slide 19, on lines one and two in the Q2 2014 column, we saw improvement in non-accrual loans and ORE. Non-accrual loans were down $4.4 million in the quarter and $5.1 million since the beginning of the year. This was really led by the resolution of a single loan of roughly $4 million in the quarter. Dropping then down to line six and seven, classified and criticized assets declined in the quarter as we continued to see improvement in the portfolio with overall levels elevated somewhat from year-end, the inclusion of the Citizens portfolio.

So on lines 9 and 10, the allowance was mostly unchanged declining by $1.2 million with the non-accrual allowance coverage which increased to 133% with the improvement in non-accruals.

Then turning to slide 20, I would focus your attention in the last two columns starting at the top of the Q1 2014 column of $83 million, which includes kind of the beginning of the inclusion of both the addition of the CFS portfolio and highlights the improvement in asset quality since the acquisition of the portfolio.

In the last column Q2 2014, we started on line one with $78.9 million in NPAs and 90-plus days past due. On line two, new non-accruals continued to be relatively granular with few names greater than $1 million and roughly two-thirds of the number of new non-accruals being from consumer mortgages, that's in the number. In contrast on line four, the decrease in non-accrual loans of $8.5 million that I mentioned early included the resolution of a single borrower of roughly $4 million.

Skipping down to line 12, ORE declined by $2.5 million. The main drivers this quarter were the sale of an individual property which brought the balance down by $1.3 million and an $800,000 write-down on a property that had been in ORE. The property had received several offers much below the asking and we reappraised it which resulted in the recognition of a decline in the value of this property. This sale and the resulting expense served to increase the ORE and credit-related expenses by $800,000 on the income statement.

New ORE properties continued to be small though with the average amount of a new property coming in at quarter of roughly $120,000. So with these changes during the quarter, the total decline in NPA and 90-plus days past due was $6.5 million on line 16, from $78.9 million at the beginning of the quarter dropping down to $72.4 million at the end of the quarter.

So, then speaking to slide 21, on the top of the slide in the first graph, with a reduction in the non-accrual loans, our allowance coverage on a fair value adjusted basis increased from 125% to 133% which I think really highlights the relative progress made towards improving the overall portfolio as well as the sufficiency of the allowance to the relative amount of non-accrual loans. And then moving to the graph below, in the second quarter we had net charge-offs of $1.2 million which included $1.2 million of recoveries. I would just highlight that unlike some of the more recent quarters the recoveries we had this quarter were much more granular and all under $250,000.

Now turning to slide 22, the slide continues the presentation from previous quarters and helps to support the overall allowance and mark coverage. On the line one, the allowance of $68.4 million in the far right column includes $400,000 of specific reserves allocated to the purchased portfolios. On line two, total fair value adjustments are $43.9 million, split between Shelby County Bank, the acquired portfolio there and the Citizens Bank portfolio.

Fair value adjustments were down $3.3 million from $47.2 million at the end of the quarter. And then moving down to line six and seven, out to the far right column, the allowance as a percentage of net loan balance is 1.83% on line six or 2.8% on line seven. All else equal, we'd expect to see these coverges continue to move forward as these portfolios transition from purchased loans to allowance covered loans.

So, just to wrap up I would say that the originally established marks and the purchased portfolio continues toward the work performed to original due diligence and we continue to remain focused on asset quality in the resolution and reduction of problem loans.

With respect to growth, we continue to see strength in loan demand, that I know Mike is going to speak to through the portfolio and have reasons to remain optimistic through the remainder of the year. And then I know Mike will be speaking to the Community Bank purchase and I'll be happy to answer any questions you might have on his remarks.

Thanks and Mike, I will turn it over to you.

Great. Thank you, John. It's hard for me not to offer a thought on John's detailed coverage of the credit profile and I think back to this time last year when we were excited about moving towards a close of Citizens now called the Lake Shore Region within our company that had a elevated level of criticized and classifieds and non-accrual and yet when I look, when I stand here in the middle of July to see that our non-performing assets as a percent of assets is identical to the level it was at June 30, 2013 very pleased that not only tells me that our due diligence work was on point. It tells me equally that management at the Lake Shore levels of Citizens Bank that have joined us knew what was going on in their profile and in a steady state economy were able to demonstrate some ability to know what happens next with their clientele. All of that has worked to our favor. And so when I see over a similar time period, our NPAs go from $51 million in September of last year to $83 million immediately post closing and then come down 13% as they have at June 30 reflective of a safety and soundness program that runs past loan origination.

So I am going to pick up with some comments that start on page 24 and hold off on my comments about Community Bancshares for just a couple of moments. The organic growth throughout the franchise that's refreshing for us to actually see it materialize. The commercial side, we have been kind of good at it. It's a strong suit for the Company, to see it come across all of our franchise in multiple lines of business particularly refreshing and a little bit of adjustment between our Chief Banking Officer and the fellow that runs our mortgage business and trying to take advantage of a slow mortgage business and maybe come up with some ways to put a little bit more on the balance sheet, which we have and on the selective pricing and structure basis, it all seems to be working for us pretty well.

I referenced pipeline in my earlier comments, John did a moment ago as well. While a lot of our progress in the pipeline shared with you in May made its way onto the balance sheet, our pipeline has kind of replenished itself. And so I feel somewhat confident that that mid-single to high-single-digit annualized growth rate ought to be able to be realized and just like the activity that went on into our June 30 balance sheet across the Company the pipeline, especially the commercial one, reflects that same spread across all of our key markets.

In particular, just to quantify things because I have in the past, for our pipeline at the end of last quarter was $274 million in credits that have been approved, reviewed by the client in front of a client in some form of moving towards a close. That number is $259 million at the end of the third quarter. So a couple of percent down, 4% down and yet 40% higher than this time last year. So we feel good about that.

The retail bank, very strong going into the next quarter, nearly twice what it was. We put a lot of promotional dollars in front of our clients and prospective clients around the HELOC product. Some of it with teaser rate, most of it trying to win new clients on an overall retail basis, have a new manager in there, running our consumer business now for the last couple of quarters and we seem to see some fruit from that effort, but we feel good about that.

The second bullet point on page 24 refers to brand investment in our new Lakeshore Region. It's kind of a marketing point and it's the identical point that I would have spoken to a couple months back. Before I talk about community banks, I don't want to rush past what was a critical and really attractive opportunity for us up in the Lakeshore Region. So we are just in the second full quarter of post closing and completed the first quarter post charter and so there's still a lot of freshness there, and I'm so pleased with what we're seeing there. At this point, it is roughly 20% of our company by asset base and between the management that joined our Company from there and the work we've been doing to welcome our new colleagues into the Company, the operating cadence that we've been able to achieve with their talent and efforts around all new processes and yet be great in front of a clients, very, very pleased with. We can get better, but I couldn't be more pleased kind of six months post closing, their ability to adopt and absorb our values are critical to our sales culture, makes me even more confident that as we grow into the future, we have the opportunity to be very, very good.

Regional boards I've touched on before, one corporate board and yet we have regional boards in many geographies and so Daryl Pomranke managing our Lakeshore Region, has already assembled a regional board out of business leaders up in the northwest part of the state, which is affectively new territory for us. That gives me more confidence that business leadership in that community will be hungry to learn more about our company such that they can spread our marketing messages well.

Middle of the page, I feel like we still have a little bit of room to go. We clearly aspire to have our efficiency ratio be less than 60% with the size of the Company. At this point, it's impossible to predict things, but we are watching all of our expense levels closely. We didn't have a lot of noise in our second quarter numbers. We had a couple of branch related off edges that created expenses that we wouldn't have expected, but nothing very dramatic and so all of that line items that we touched in detail in prior calls around the Lakeshore Region have pretty much settled in at levels that are probably going to recur, but we're always looking for fresh ideas, but somewhat pleased with the efficiency we've been able to attain.

Before taking questions, so our organic strategy absent Community Bank, which I'm going to get into here in a minute, is really just to sustain our progress. I mean, our folks are laser focused on the particular community that they are servicing, trying to build in the projects that we're fighting off as we go and anxious to see what's next. And what's next for us starts on Page 25.

All I wanted to touch on there, I'd give you a little bit of a visual, which gets a little bit better when we flip to the next page. But on 25, just some pro forma highlights on the left hand side of the page that speaks to a company that will be the better part of $6 billion in assets when we get close with a 67% loan to asset kind of ratio and a nice rich deposit base, one that's augmented by what we see at Community Bancshares.

And so if you take a look at Page 26, you get a little bit more detail on the company itself and a math with a little bit greater definition. And what you would see is what those of you familiar with the state of Indiana would come to know that these are two companies that have great knowledge of each other. My predecessor and Chuck Crow, the CEO of Community Bancshares had a long relationship as such Community and First Merchants had a long relationship, open competitors in the exact markets we overlapped in and yet we frequently shared participation. So we have a familiarity with underwriting that makes for an easy driver of relationship capital that allowed for an easy dialog as Chuck and their Board began to think about what was next for Community. All kinds of extensive discussion about what our company felt like for the teammates that would be joining us. So, we're extremely pleased to have gotten where we're at.

So back to 26, headquartered in Noblesville, a fairly young company, a 23 years old. Chuck, one leader built a culture with the idea that they could be different than the regional banks that dominate Hamilton County and so they built a company that is nearly 24 years old. It's has been highly successful. 10 full service banking centers that will be joining us in the balance sheet that features the bullet points directly beneath that $272 million in assets. $145 million in loans, nice deposit mix that totals $236 million. Had a strong first quarter of the year. If you're familiar with the company's history, we've looked at it since our press release of the 22nd. You'll see that as a private company that had the luxury, if you want to call it that, of being patient with the evidences of the credit cycle. And so, while problem assets may still be elevated by some standards, they've been working their way through them and now seeing the profitability of their company resurface with a strong first quarter and a nice outlook that we're privy to at this point. A margin that we think we can help with and a fairly simple balance sheet is the last bullet points out in terms of complexities.

So we're anxious to get started with it and the actual guts of the transaction are laid on Page 27. These are all items that come directly out of the press release from two days ago. With a deal value of just over $46 million based on our closing price, the end of business on Monday, creates some of the ratios and statistics that are evidenced here. A couple of the assumptions I'd like to speak to. The first one is the cost savings. Unlike the Citizens transaction as an example, where there is a relative immediacy of expense savings around FTE involved via the level here we feel good about and it will come from us slightly different complexion in that if you refer to the map. You can see that there is a significant branch overlap unlike Citizens and unlike many other opportunities and that gives us an opportunity to look at a given community in this case, either Hamilton or Madison County, assess who has the better location and probably refine your physical properties over some period of time, I call it 12 months.

So, whereas you might get a lot of expense savings, should they be people related really front-end loaded post closing, in several transactions and this one there will be some of that. But clearly the majority of the synergy is more off of the physical assets and we're going to be working with our retail team to get the best traffic locations for the most households and the most business convenience for our commercial banking clients.

That's some one-time expenses, which Mark Hardwick could speak to, but clearly, as identified on our piece by piece basis and then a consistent use of our credit discipline working with Chuck Crow, and his team to get inside of the files and have our entire protocol for assessing safety and soundness in the loan portfolio and in the OREO category, they come up with the mark that we think is ample for the credit condition we see.

Consistent with our desirables for an add to the business would be as quick accretion as possible or calling for accretion to EPS in the first full year, which could be in our plan 2016, it could well be 2015 in which case the accretion would be a little bit lesser, but clearly a positive story for us and then a tangible book value earn back inside of [it about 3 and 3.25 ] years. Minimal impact given the size of the opportunity to our capital ratios. So it kind of works out well for us and as I referenced earlier based on the shareholder election, that's kind of foot noted at the bottom of the page, we would see that it winds up being as the consideration line item shows at the top, 31% or 32% cash if in fact the shareholder election takes full advantage of the cash that's available.

Take a look at Page 28, a little bit more the same information. And I wanted to make sure I highlighted the attractiveness of the franchise that Community has built. 10 full service banking centers as I referenced. If you look at our Company and theirs and yet they move off of that map, which clearly shows the critical mass that's being built. You get to Hamilton County and Hamilton County is a little bit special, perhaps in the entire Midwest certainly special in the state of Indiana, the highest population growth in the state, running 2% annually, it's projected to grow 2% in each year over the next several years, a highest medium household income in the state of Indiana and one that's anticipated to rise 1.5% annually. It's been a particularly well led area, it's been a magnet for job growth and as a result, it's unemployment rate at just about 4%, I think, is the second lowest county in the state.

So this is a plum. We've been growing into this county as you might know for some time at a one store to time level going back 12 years and then through the Lincoln acquisition six years ago, built some critical mass around that in terms of relationship management, commercial banking tools and then ultimately a few more banking centers and so we're excited about that. I think you can hear it in my comments.

Equally excited about the fact that beyond the storefronts and growth demographics are that the key people that we've met that have driven community are going to be joining us. So Chuck and his team are going to be assuming roles, extremely similar to what they've been doing in the past. They help us keep the momentum there, go through the change of ends, which is a real one and keep on moving.

Couple of new communities that are referenced in that top section of Page 28, that are communities that are going to continue to grow, Cicero in particular and Hamilton County, Summitville and Alexandria, Madison County communities that we're not currently in. So, while there is some overlap, there is clearly some new turf for us where our name is recognized and now we'll be able to add convenience to that to complement what the community folks have been doing.

The financially attractive portion of Page 28, I believe I covered when we are going over the transaction slide and then when I think about take a deep breath and think about the overall profile of it in a very thorough due diligence process that reflected the kind of company that community has built over the last 23 years, a cultural fit that's been evident to me for several years and that kind of collaborative nature and almost a correspondent bank type relationship as it relates to sharing credits on an opportunistic basis, retention of key folks in their company and then hopefully the ability in a couple of quarters from now to bring our experience in integration processes to the fore and achieve all of our targets.

29 and 30, I didn't want to stop on too long. They reflect the additional market share muscle that is gained in the two counties we've been talking about.

And then on Page 31, right before the Chad, we get to questions, I would just touch on the highlights that I would have you leave with and the one highlight that I probably should have added there was, their senior management joining our team, but when I make that comment about culturally similar companies with valuable core deposit bases, it's strikes me as if how I might describe our company.

So we like the opportunity. We're happy that our relationship, which has been a long time, is able to manifest itself in our companies coming together. It's fresh in the marketplace. We're anxious to tell our story both on this call and then more personally to our clients and employees over the weeks to come.

Chad, at this point, you can open the lines for questions and we are ready for them.

(Operator Instructions) Scott Siefers, Sandler O'Neill & Partners.

Let's see, Mark, first question is probably best for you. I'm just curious if you could go into some of the puts and takes of the adjusted margin in the second quarter. It declined a little more abruptly than has been the case recently. So just curious what caused these sequential compression and it might have been a little worse than anticipated. And then I believe within your prepared remarks you had suggested that NII should still be expected to increase quarter-over-quarter. I guess one, did I hear that right and two, what is your outlook for the adjusted margin, so will it be mostly kind of loan growth driven, NII growth or what factor does the margin play there?

Yes. Thanks, Scott. The quarter over quarter comparison, first quarter to second, is really about loan yield compression and we've not been able to keep up at least so far or most recently with the loan yield compression on the deposit side and we're down to 34 basis points and it's hard to move further.

The comments that I had, our net interest income simulation, we do I think a very thorough job of modeling out net interest income over the next 12 months every quarter, and we use all of our new loan spreads to identify what's actually happening in terms of once you have roll off and then you put new loans on the books with all their price. And the simulation is suggesting that we don't see further compression. It's the model and they all have their flaws, but it is not showing a significant level of compression, frankly it's not showing any.

And I guess my confidence in terms of next quarter, I believe that we'll be able to continue to grow net interest income even if we have some modest net interest margin compression. So, I don't have an exact number for you, but I feel like those are the direction the modeling suggesting that our margin should remain fairly stable, trends showing that we're having some compression and confidence that based on our asset growth that we'll be able to continue to grow net interest income.

Okay, that's perfect and I appreciate that. And then maybe Mike and John, just curious on specifically the OREO cost in the quarter, a little more elevated. I think if I heard your comments correctly, it might have been more an isolated incident than anything more broader based, we keep these OREO cost elevated, but one is that the case. So, can we assume that those will normalize a bit more, I think you said something [like around $800,000] from kind of elevated OREO cost differential in the second quarter and then the part for Mike, what's your thought on your ability to keep the core cost base around where it is, as you look forward?

Yes, Scott. This is John. I'll go first. Yes, really, when you look at our OREO expense, the ORE and other credit-related expenses, they've been [$1.6 million, $1.7 million] pretty consistently quarter over quarter for the last four quarters and then we have the write-down of the one individual property and it was one property and it was kind of a blip. I will say that when you look at what remains in ORE, it is granular. I think your next largest ORE is just north of $1 million, [$1.2 million, $1.3 million] something like that. So, that was probably one of the largest properties in there as a stand-alone and that resulted in that effect.

Well, I wasn't going to speak to OREO, if there was a follow-up question on that topic, John, I'll let you take it. But the point directed towards me, Scott, was about our overall expense level. They all stay exactly where they're at. As I said, there were a couple, there were $300,000 of I would consider to be not usual items in the other expense (inaudible), and an EEO and E&O settlement expense. But those are some of the net, and that's happened from time to time. I wouldn't call them recurring. So I'd like our run rate on the largest dollar categories, the direct FTE expense, the direct premises expense, the absence of over time. Those kind of things are kind of right where we want them and yet while we're doing that, I'll tell you to make sure we are going to get to where our 6/30 numbers were, we had an extensive number of profit center by profit center expense meetings that not only assured us that where our June 30 numbers were, but the level of inspection of them I believe we'll have some benefit as we get ready to start looking at 2015.

Okay, that's perfect and then I just so I understand clearly, it sounds like for the most part, it's going to be flat expenses. But is it, would it be correct to assume that the absolute cost base could come down a little, just given that elevated OREO and then the kind of unusual items in that, that other expense category in another words?

Yes.

If you aggregate them all, it sounds like it's about $1 million. So what a better run rate be, sort of $40.5 million than the $41.3 million that we saw this quarter?

I would agree with that.

Okay. All right. That's, perfect and I appreciate the credit. That's it from my side. So, thanks.

Thank you.

Damon DelMonte, KBW.

My first question had to do with the growth you guys saw this quarter. C&I balances expanded quite nicely. Could you talk a little bit about what was driving that increase this quarter?

Well, I like to feel like our effort and our market coverage effort and our processes for pushing opportunities along to include the credit process is similar all the time. And so the prognostication of closings and winning is difficult for us. I do know that the pipeline trend that our Chief Banking Officer started probably 9 or 10 quarters ago has gotten increasingly accurate in its ability to predict the direction of the commercial side of the balance sheet in particular, maybe all parts of it, but commercial in particular given its size. And so when I look at the level that it has been back into this time last year and kind of roll over, what is the absorption of pipeline into balance sheet, it's been staying with some positive correlation. And so I think we're going to grow this quarter is what I would say, if the pipeline numbers that I referenced earlier, are any indication of what they've been in the past.

But in terms of the market coverage and the actual work, because this -- your question I think might relate even to the net interest margin that Mark was talking about earlier in that, we do spend a lot of time looking at that next opportunity that creates the loan growth in assessing the return on it by way of interest rates. So we're going to try and stay even sharper on that in assessing new clients in particular, but I feel like nothing, no magic in the current quarter's results other than good ability to translate pipeline loans under the balance sheet, may be a little bit higher use of them from our clients.

And with regard to the pipelines, did you say that you had -- can you just go over the numbers again for what you said for the pipeline?

I'd be happy to. On the retail side, I think I said it was nearly twice. So that's a $21.5 million number for us, up from [$12 million] on the commercial side, which is the biggest line of business in terms of loan production; it's $259 million, down 4% from $274 million, but up -- I know I said up 40% from $185 million this time last year. So the $274 million at the end of the first quarter was the highest it has ever been, and so while it comes down slightly, based on last quarter and it's still at a relatively high level for us.

Okay, that's helpful, thanks. And then I guess with regards to the outlook for the provision, can you give us a little direction as to what we can expect for the quarterly provision rate going forward, I mean if the underlying trends of the credit remained strong, I mean I would assume you'd have to be booking some provision to account for the loan growth, is that a fair assessment?

Yes, I think that's a fair assessment or John's chart that shows the overall level of reserve including fair value mark, I think is really important or trying not to be just myopic on the allowance as a percent of total loans, because of all those additional marks that no longer is our net charge-offs and what currently, our net recoveries remain stable with declining asset quality trends start to justify much more a provision.

Stephen Geyen, D.A. Davidson.

Maybe first question, I know you guys can have a whole lot of accelerated accretion, last quarter was that kind of the case, this quarter I saw that I guess with fair value accretion was $2.2 million versus $1.1 million -- $1.8 million, last quarter is that right?

We were anticipating. I think we gave some guidance last quarter that we expected about a $1.8 million per quarter. And so we had a little acceleration with paydown and the creditor to that where we've added some additional speed.

Okay. So $1.8 million kind of a base level is kind of a good number to work with over the near term?

It seems like it. Yes.

Okay. And the pipeline, just maybe just one more question or a couple of questions on it. Approximately what percent range are you comfortable with saying that those loans will be funded -- fully funded?

You know, Steve, I don't have a good answer for you on that, because on the material that I have, it has that, by line of business and by geography, it doesn't include structure whether it's a term loan or revolving credit and so I'm hesitant to take a shot at that one.

Okay. That's understandable. And let me see just a couple more questions here. You had mentioned that the Lakeshore region that the expense saves where real, are pretty much fully realized, and I just wanted to make sure I understood exactly what you are saying. Were they realized early in 2Q or they realized over the course of 2Q and they're fully realized [are you fully in] position now at the end of the quarter, beginning of the third quarter, moving forward?

I think they were pretty much fully realized by the end of May. So you could say that we had them through two quarters in some regards where based on that unit alone, the Lakeshore region alone, even marginally beneath where we wanted to be, because we are hoping to have a little bit of added investment into the commercial side of the bank, which really hasn't happened yet. But the absolute expense levels associated with the take-outs that were part of our contemplation at the announcement were done by May.

Okay. All right, got it. And maybe last question for Mark. I think you had mentioned that you're pretty much at an optimal liquidity, kind of what ratios are you working with that we can kind of factor in into our models?

Well, there are a few things. But I think, the comments that Mike made around loan to deposit ratio, they are in our press release as well, loan to asset ratios and kind of guided those numbers for us. But it also comes back to just additional or excess liquidity, where do we stand with availability of Federal Home Loan Bank advances, our appetite I guess for broker deposits and we feel like the current levels of our balance sheet and the current mix between loans and investments is ideal. If we were to grow the deposit side of the balance sheet faster than you can see the bond portfolio grow, but I think based on the environment that we're in and the way the rate environment feels, I think we're going to be working hard to keep up on the deposit side with our loan growth.

Got it. Okay, that's perfect. Thanks for your time.

Thank you.

Daniel Cardenas, Raymond James.

Just a quick question on competition, maybe what did competition look like in Q2, is it slowing down a little bit and what impact is that having on loan pricing in the second quarter and as you've entered into the third quarter?

Well, I don't think it's letting up. I think that every competitor we have in any market we're in is recognizing that loan growth has so many positive attributes to it in terms of associated revenues, whether it be treasury management, or loan fees and the introduction of other services and so I view it to be extremely competitive and so we're trying to pick our spots, make sure that the profile of the client and our risk appetite are similar, take care of our existing clients which sometimes puts pressure on the loan margin, but no, I'd say it's kind of rough out there. I think it really adds to the art of the business, which is to know where to use your balance sheet and have the ability to provide as much banking product to any given client, feel good about the return, the value proposition.

And when you look at that then what is your, maybe product per household number now and where do you see that trending over the next couple of years?

Well, that vocabulary to me seems most associated with retail banking and you get in the numbers that are like five and six, but for our balance sheet which is commercial heavy, I really think of three. I think of loans, deposits and technology, meaning treasury management. So, if we could get three out of all of our clients and three would be a really magic number for us. The bonus would be the ability to use your insurance segment and your trust business to add to that, but if we were to get three, with all of our commercial clients we'd be way ahead of the game. So, it's a smaller number than you might think especially when you're related to the commercial side of the bank. I know, I hear banks talk about seven and eight, the great aspiration.

Yes, it makes a lot of sense. And just one quick question for Mike, as we think about the back half of 2014, what's a good tax rate to assume for modeling purposes?

Yes. We were at 24% in the first quarter and 27% in the second. How far growth in our pre-tax net income, all of that was packed at 35%. So, if just run the same math, that would have been a 26% rate and we came in at 27%. I think we were a little high in the second quarter, managed to go through, we're always trying to readjust our accruals at somewhere between 26% and 27%.

Okay, great. Thanks guys, good quarter.

Thank you.

Brian Martin, FIG Partners.

Just a couple, most things have been covered, but just John, you mentioned the utilization rates sound like they were up a little bit this quarter, assuming it was material or just insignificant, what that did this quarter from a lending standpoint?

Yes, I went back and did a little digging and it was up from 45% to 49%. We did see an uptick from the end of March to the end of June. The dollars associated with that were [let's call it $75 million], there's a lot of moving pieces going on there. You've got pay downs and term loans and the new dollars coming on from the new opportunities, but it was just pretty material for the quarter.

Okay, that's helpful. And just maybe two other things, the number one, I guess the cost saves on the community deal I guess it maybe for not getting as much personnel out of there, it seems like. Just wondering how you get to the 40% type of level kind of targeted and then secondly, just how that plays to your goal of getting a 60% efficiency ratio, look at the timetable you think is required to kind of match it down to that level?

Sure. We will revisit the overall efficiency target of 60% when we complete kind of all of our pro forma work and we'll talk about that in the next quarter. I'm sure our work will be even further along the 60% use that I referenced earlier was relative to the Company as it stands today and that's kind of an immediate goal. And if we were to get any help in the mortgage business, which is sizable for us and remains a little bit soft or may continue to headway as I alluded to on our overall expense burden, it would get us close to that base than where we were in the second quarter.

The front half of your question spoke to a little bit more dialog around expense targets at community, and I'll just kind of repeat some of what I shared before. We've got a couple of markets, three in particular, three out of 10 of the banking centers at community are extremely local, two hours and so we're going to assess where the customer gets service the best without any judgment about which store, whether it's a community store, or First Merchant's banking center is best situated and pick the best-situated one, pick the best customer service folks for that and then enjoy a expense savings based on the disposition of the redundant property. And so there is an FTE impact to that, but when I contrast that, Brian, to Citizens where we had zero overlap either commercially or in retail banking, all the cost save there which was lesser than 40% was really dominated by our operational FTE.

This one is a little bit different, and the other different, not just the composition of the expense savings, but the timing of it. This one will be a little bit less immediate based on very tangible aspect to real estate and how quickly you can move in and out of it, real nonetheless.

The numbers that we have, we said 40% cost savings in our release. It's about around $2.8 million, $1.8 million from the core bank, another $1 million of cost savings from optimizing the market coverage and of the $1.8 million that would be from their core operations, there is a sizable component of that, that also comes just from the back office technology spend.

Thank you.

Hope that helps.

This concludes our question-and-answer session. I'd like to turn the conference back over to Michael Rechin for any closing remarks.

Thank you, Chad. I really have none. I appreciate your attention, the quality of the questions, appreciate your support to the Company and look forward to talking to you in a couple of months. Have a great day.

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