First Merchants Corp (FRMEP) 2017 Q2 法說會逐字稿

Good day, and welcome to the First Merchants Corporation Second Quarter 2017 Earnings Conference Call. (Operator Instructions) 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 27, 2017, or by visiting the First Merchants Corporation shareholder relations website and clicking on the webcast URL hyperlink.

The corporation may make forward-looking statements about its relative business outlook. These forward-looking statements and all other statements made during this meeting 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. Please refer to our press releases, Form 10-Qs and 10-Ks concerning factors that could cause actual results to differ materially from any forward-looking statements. Please note, this conference is being recorded.

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

Great. Thanks, Allison. Welcome, everyone, to our earnings conference call and webcast for the second quarter ending June 30, 2017. Joining me in the room today are Mark Hardwick, our Chief Operating Officer and CFO; and John Martin, our Chief Credit Officer.

Now we released our earnings in a press release approximately 10:00 a.m. Eastern Daylight Savings Time this morning, and the presentation you're about to hear speaks to the material from that release. The directions, as Allison pointed out that point to the webcast, were also contained at the back end of that release, and my comments begin on Page 3, a slide titled Second Quarter 2017 Financial Highlights.

So I feel like we really posted a strong quarter, and a couple of the bullet points cover that, including earnings per share of $0.57, a 16.3% increase over the second quarter of last year, or $24.1 million in net income, a 20.6% increase over the second quarter of 2016. The earnings composition, as Mark will cover later, would be inclusive of approximately 50 days of operations of the Arlington Bank within the First Merchants numbers and then the expenses associated that Mark will detail in a little bit.

Our mix of organic growth and mergers and acquisition, working well for us as our total assets of $7.8 billion, grew by 13% over second quarter of 2016. Our organic loan growth in the quarter of $114 million annualized is at 8.6% growth rate, whereas our similar deposit growth of $129 million, a 9.2% annualized growth rate, with great similarity there. The current loan yields and deposit costs we've had are proving to be net positive to our core net interest margin, producing new highs in net interest income. Mark will elaborate on each of those in the next couple of minutes.

Page 4. Some of the performance highlights that come out of those results. That would include high-performance ratios relative to return on average assets and return on average equity, a 9.3% increase over last year's second quarter in tangible book value per share up to $16.97, and efficiency ratio now for a couple of quarters consecutively, well beneath 55%. And then some of the nonspecific financial highlights would include 2 closings, roughly 60 days apart: the successful completion of the Arlington Bank acquisition on May 19 of this year; and then roughly 2 months later, much more recently, the July 14 closing of the acquisition of Independent Alliance Bank. So we're really pleased on a bunch of fronts and hope to cover some of the material behind that deeper in this morning's press release.

I'm going to start with some of Mark's comments.

If you turn to Slide 6, I'll start my comments there. Our total assets reached $7.8 billion, an increase of $593 million or an annualized 16.4% over year-end 2016. Really, line 3, loans is where most of the growth came from, and it increased $473 million since year-end, which includes $224 million of loans from the acquisition of the Arlington Bank. When normalized for acquisitions, organic loan growth totaled 9.4% year-to-date or 10.5% in the first quarter and 8.9% in the second quarter of 2017. We've got a couple of different numbers that you'll hear. $224 million was the number I used for loans related to the Arlington Bank, and the press release has $232 million, and the difference is really $8 million of loans held for sale that came over at the time of purchase that have since been sold into the secondary market.

The composition of our $5.6 billion loan portfolio on Slide 7 continues to be reflective of the commercial bank, and it continues to produce strong loan yields. The portfolio yield for the second quarter of 2017 totaled 4.65% compared to an annual loan yield of 2016 of 4.58%.

On Slide 8. Our $1.3 billion bond portfolio continues to perform well, producing higher-than-average yields with a moderately longer duration than our peer group. Our 3.85% yield is actually about 8 basis points better than a year ago and continues to compare favorably to peer averages of approximately 2.61%. Our average life continues to be 5.3 years. The net unrealized gain in the portfolio totals $35.2 million, and maturities for the remainder of 2017 total $72 million with the yield of $329 million. 2018 maturities total $136 million with a yield of $331 million, and 2019 maturities total $162 million with a yield of $381 million.

Now on Slide 9. Non-maturity deposits on line 1 represent 78% of total deposits and grew by $296 million or an annualized 13.4% over year-end 2016. Customer time deposits also increased $128 million or an annualized 34.3% over year-end. On a combined basis, when adjusted for the Arlington Bank totals of $253 million, lines 1 and 2 grew by 6.6% annualized since year-end. Also, on line 7, common equity increased by $106 million over the first quarter of 2017, reflecting the purchase of the Arlington Bank through a 100% stock transaction. The additional shares of just over $2 million at approximately $40 per share accounted for nearly $83 million of the $106 million increase, with $13 million coming from retained earnings and $7 million coming from the exercise of stock options during the quarter.

As I previously mentioned, the mix of our deposits on Slide 10 remains strong, and our total deposit expense is now 45 basis points.

Our regulatory capital ratios on Slide 11 are above the regulatory definition of well capitalized in our internal targets. We believe the strength of our 9.68% tangible common equity ratio and our 14.1% total risk-based capital ratio will continue to provide optimal capital flexibility into the future.

The corporation's net interest margin on Slide 12 totaled 3.95% for the quarter, and when adjusted for fair value accretion of $2.3 million, totaled 3.81%. Net interest income on a fully taxable equivalent basis totaled $67.2 million during the quarter and continues to be the driver of our operating income. On a linked basis, when compared to the second quarter -- when comparing the second quarter to the first quarter of '17, our fair value accretion adjusted net interest margin increased by 9 basis points due to recent fed fund increases.

Total noninterest income on Slide 13 improved by $3.5 million on a linked basis. $2.2 million of the increase was the result of several life insurance claims during the quarter. And I would just say, as a point of reference for all of your models, our 6-quarter average of life insurance is about $1.4 million.

Noninterest expense on Slide 14 totaled $47.3 million for the quarter, an increase of $4.2 million when compared to the first quarter of 2017. Of the increase, M&A or onetime expenses accounted for $2.5 million, and about $650,000 of that was salary and benefits and another $1.6 million related to professional services and data processing providers.

Now on Slide 15, our net income for the second quarter of 2017 totaled $24.1 million and EPS totaled $0.57 per share. Including our acquisition expenses of $2.5 million, our efficiency ratio totaled 53.61%, following a 52.61% efficiency ratio in the first quarter of '17.

On Slide 16, we highlight our growth and earnings per share, dividends and tangible book value per share. But more importantly, the day 1 dilution from our acquisitions totaled $0.13 per share versus our anticipated $0.16 per share and is embedded in the current 16.97% total that you see on line 3.

Slide 17 highlights our historical growth rates in tangible book value per share and dividends. Our forward dividend yield totals $179 million, and our price to tangible book value now totals to 237%, and our compound annual growth rate of our tangible book value per share for the last 6.5 years is 9.86%.

Thanks for your attention, and now John Martin will discuss our loan portfolio composition and related asset quality trends.

All right. Thanks, Mark, and good afternoon. Beginning on Slide 19, I'll be updating the trends in the loan portfolio, review a summary and reconciliation of our asset quality, discuss provisioning fair value and allowance coverage, and then end with a few portfolio highlights.

So on Slide 19 for the quarter, we grew loans before the addition of the Arlington portfolio by $114 million. I'm going to start on the third column from the right and work my way, the increase in line 11 represents the organic quarterly growth of 2.16% for the quarter. Starting at the top and working down the slide, the growth was driven by increases in commercial and industrial loans on line 1 of $28 million, construction loans on line 2 of $81 million, residential mortgage loans of $11 million on line 7 and public finance of $30 million on line 9.

As mentioned on prior calls, we continue to build a dynamic construction lending pipeline. Where our construction lending on line 2 and non-owner occupied real estate on line 3 are driven by project funding during the construction phase, moving to either the permanent market or into the bank's portfolio at completion. We expect to see the CRE portfolio continue to ebb and flow, as we have in the past, while trending positively as projects fund, stabilize and move both to the permanent market and into the bank's portfolio.

So finishing out on lines 12 and 13, we continue to remain below the regulatory real estate concentration guidelines of 100% of construction loans and 300% of investment real estate loans to capital.

Turning to asset quality on Slide 20. Overall, asset quality remained stable in the quarter. On line 1 in the linked quarter, excluding the Arlington portfolio, nonaccrual loans declined $1.8 million while other real estate loans -- or other real estate increased $3.6 million, renegotiated loans fell $500,000 and 90 days past due increased $100,000. The increase in ORE was driven by an acquired loan unrelated to the Arlington portfolio that had been identified and marked at acquisition.

During the quarter, we reached a settlement with the borrower to take the property securing the loan, which resulted in the increase in ORE and, as I'll highlight on a later slide, decreased fair value adjustments. Overall though, total NPAs and 90-day delinquent loans increased modestly by $1.4 million on line 5, remaining at 70 basis points of total loans and ORE.

While both classified and criticized assets on line 7 and 8 fell with improvements in the portfolio by $30.6 million and $60.3 million, respectively.

Turning to Slide 21, which reconciles the quarterly migration of nonperforming assets. In the fourth column to the right of this slide titled Q2 '17 that excludes Arlington, we began the quarter with $37.2 million and added $8.7 million of new nonaccruals. The new nonaccruals included the transfer of the marked loan I just mentioned a moment ago of $6.2 million, while on line 4, the $6.8 million transferred to OREO includes that number as well. We had $1.4 million of gross charge-offs in the quarter on line 5, which netted to the $1.8 million decrease in nonaccrual loans on line 6.

Dropping down to line 7, we added $6.2 million -- we added the $6.2 million property plus an additional $600,000 in OREO, totaling $6.8 million. Then on lines 8 and 9, we sold and wrote down $2.8 million and $400,000, respectively. So the change for the quarter after the -- after restructured and 90-days past due ended the quarter increasing $1.4 million before the addition of the Arlington portfolio.

Now turning to Slide 22. The allowance on line 1 grew with the growth of loans in the non-purchased portfolio, which now stands for the quarter at 1.25% of loans and 1.45% of non-purchased loans. The fair value adjustments on line 5 declined $900,000 from $30.6 million to $29.7 million. The reduction in fair value adjustments included the $4.45 million offset in the credit mark associated with the previously discussed loan moving to OREO, $2.3 million of fair value accretion for the quarter and the addition of $6.6 million of a new fair value adjustment for the Arlington Bank portfolio. The balance of the difference then is the remaining offset credit adjustment in the quarter. These changes result on line 12 and the allowance and fair value adjustment to total loan balances plus fair value adjustments to 1.77%.

So turning to our summarizing on Slide 23. I'd just conclude by saying a couple of things here that the portfolio growth rates are in line with our earlier communicated expectations as we continue to find opportunities in both the C&I and investment real estate areas, with continued regulatory concentration headroom. We experienced reductions in criticized and classified assets in the quarter, and asset quality remains stable with nonperforming assets at 70 basis points of loans and ORE. And so finally, the economy appears to continue to improve in our higher-growth areas, with recently announced unemployment rates in Indianapolis under 3% and Columbus under 4%, which should help with continued portfolio improvements that in turn results in provision expense of that primarily supports loan growth rather than issues related to asset quality. Thanks for your attention.

I'll turn the call back over to Mike Rechin.

Thanks, John. I'm going to have some closing comments on Page 25, and then we'll open up the phones for questions. On 25, underneath the caption of Looking Forward, are several bodies of thought, starting with driving to gain the synergies and market expansion that the Arlington Bank and Independent Alliance Bank acquisitions bring to us.

That starts with what's right in front of us, which are integrations planned for the third quarter and then the fourth quarter for IAB. And so Mark made some comments relative towards Arlington. And so at this point, we are finding the acquisition assumptions from a financial standpoint to be holding up really well. We're finding exactly what our work had identified. We're also finding that the human capital in terms of community, understanding and expertise is what we thought it to be. Arlington, as an example of -- really, in a tight geography, that brings further penetration for the First Merchants' brand, along with the mortgage origination expertise that we're already seeing show up in our short results in the second quarter during the time of Arlington and in our pipeline as well.

Lastly, the press release, in regard to both companies, Arlington Bank and Independent Alliance Bank, providing some of what I called leadership team additions as we look for senior people from each of those companies to bring their managerial strength inside First Merchants, and our results have really been off to a great start. But the technical integration, which includes a lot of people, is well underway. Our broadcasting internally is to have that be a clear focus to produce, again, what have been successful integrations over the last several companies that have joined us. Kind of job one here while we're taking care of our client base.

Next bullet point talks about winning in all of our markets. We continue to benefit from a growing marketplace that allows for the organic growth we've achieved. It allows our clients to grow and then with aggressive calling efforts, growing our market share as well. And we think that superior and excellent service allows us to bring our technology investments to the benefit of our clients. And so the vendors that we use in review for their capabilities as they grow, we try and take those out to our clients.

The next bullet point talks about expanding some specialty businesses, and our expansion in those to date, whether it's asset based, sponsor or public finance, have been organic. And yet we look at opportunities to grow those through acquisition if that were to come about.

Understanding our client preference obviously moves us towards digital channels, and so we continue to refine our traditional retail structure around what our clients prefer. And so we've -- it's been one of the drivers of our efficiency ratio continuing to move down. And then lastly, as I mentioned on the last couple of calls, our investment continues to grow around the expectations that would come to First Merchants when we come to that crossing the $10 billion threshold.

So I feel like we're able to move on all of those initiatives and produce the kind of results you heard earlier today. We're anxious to get after the next couple of quarters through the back half of 2017.

And at this point, Allison, I'm happy to take questions.

(Operator Instructions) And our first question will come from Scott Siefers with Sandler O'Neill.

Mark, I was hoping you could talk about the core margin progression for just a moment. Up 9 basis points was really good performance and better than I was expecting. I think in the past, you've suggested that each rate hike might be, I think, 3 or 4, 3 to 5 -- worst, 3 to 5 basis points to the margin. What were the sort of the puts and takes as you saw them? And were there any nuances in Arlington's portfolio that would have caused that core to drift up in there?

There's really nothing related to Arlington. We had a nice increase in the fed funds rate that happened in December that we were anticipating seeing flow all the way through our income statement in the first quarter. And I know I mentioned that February always kind of holds down the quarter. So we saw nice increases in January and March. And so I was pretty confident the second quarter would be strong, especially with another fed fund increase that happened in the March. So it was good to see it come to fruition and be able to prove what we thought would happen all the way through the end of the quarter. So we have such a variable-rate balance sheet that we expect to be asset sensitive, and that's proving to be the case. I know just listening to other calls where folks are talking about deposit pricing, we see some pressure on the higher end. The larger the balance, the kind of more pricing power they have. And so we're seeing some increases there, but not outside of our models or what we've been anticipating as we've looked at interest rate simulations in the past.

Okay. That's helpful. And just as we look forward, if the fed kind of, say, pauses for just a little while here, what would be your expectation for the core margins? Is there more follow-through that could take place and allow to expand in the absence of further rate hikes? Or would we just sort of hold steady at this quarter's 3.81%-ish level?

Well, I think the core with the June increase gives us a little bit of -- might be a little bit of expansion. Like I said, there's a little bit of pressure on deposits on the larger end-of-the-balance spectrum. And the more the curve inverts, the more difficult it will be to -- the closer it comes inversion, the harder it is to play the yield-curve game. But I would think that this June increase, that we could expect to see a few basis points into the third quarter.

Our next question will come from Kevin Reevey of D.A. Davidson.

So first question, just again on the margin. How asset sensitive is IAB relative to your balance sheet? And do you think, with the addition of IAB, would that change your asset sensitivity meaningfully in any way?

We're not really anticipating any meaningful change there. Their balance sheet is very similar, commercially oriented with an incredibly strong low-cost deposit base. So I think the deposit base is where the strength of margin comes from. And then they've worked hard to stay asset-sensitive. So I don't know that it improves our position, but we're not expecting it to hurt it either.

And then on the organic loan growth on the C&I and commercial real estate, where was the growth coming from geographically? Was it more from Muncie or was it Indianapolis?

Yes, I can field that question, Kevin. Much of the growth was coming from Indianapolis and the Ohio region. While the other markets did see -- experience some expansion, those were really the 2 most significant drivers.

And then my last question. If you think about crossing the $10 billion threshold, I guess, first, what's your timing and how far along are you in the planning process to actually, eventually, cross that threshold?

Well, the planning process -- Kevin, it's Mike answering. The planning process around the actual proactive activities that a bank would be required, whether it's DFAST or AML, BSA procedures, cyber security, vendor management and such, we're pretty far along. Obviously, DFAST and making sure the stress testing protocol is an extension of what we're already doing. The timing, which speaks to the rest of your question, on an organic basis would probably be a 2019 event. And so absent a meaningful acquisition, it's a 2019. We want to be prepared to meet expectations well short of that. We obviously, from a calendar standpoint, could accelerate our work on any of these, but we'll be ready for it when it comes. I feel like the work has been divided, and the managerial tasks assigned. But on an organic basis, to answer your question, would be 2019.

Our next question will come from Erik Zwick of Stephens Inc.

Maybe first, just looking at the increase in C&I loans in the quarter. Curious if you could provide any color, whether you're seeing new customer growth or if it's higher line utilization? Or what's driving the growth there?

I would -- I'll field this one, I guess. I think the most significant driver is coming from both -- it's really not additional draws on existing lines as much as it is new names that we're seeing across our specialty finance as well as new credit extended to existing borrowers. So new projects would be the 2 areas that, I think, as I'm sitting and seeing through loan committees, seem to be the areas where the most expansions occurred.

And then could you provide an update on the scheduled timeline for the integrations and system conversions of the 2 deals that have recently closed as well as the related costs that are still to be incurred?

The -- I mentioned earlier, the quarter -- the Arlington acquisition's integration would be this quarter, and Independent Alliance Bank, middle of the fourth quarter as we currently have them scheduled. And all of our routine leading up to that in terms of preparedness would signify that those timeless are going to hold in place.

And as far as any costs remaining for those actions, those activities?

Yes, the onetime costs related to the Arlington Bank have really already been accrued. But because the IAB closed in July, those are all expenses that will be recognized in the third quarter.

Okay. And then finally, just on M&A activity, we've seen a few deals in the region in the past couple weeks. Just curious for an update on the pace of your discussions today, what sellers are -- kind of how you would gauge sellers' asking prices and then your appetite to take on a deal at this point?

Well, I think a quarter or 2 ago, we had talked about needing to make sure all of our resources were aligned against the 2 that we had announced. And there's somewhat a same -- similar feeling on my part. These integrations need to go well to get the returns we expect out of them that speaks to the value we transacted. Having said that, we will be in 2018 quickly, and we'll obviously have the ability to look at new opportunities. I feel like the pricing, even on the most recent ones, is within a fairly tight band for what we've seen for 1.5 years now. So we'll be looking to grow the company, probably consistent in the manner that we've talked about on all prior calls.

Our next question will come from Damon DelMonte with KBW.

So my first question is relating to the margin. Thanks for the good color on that earlier, Mark. Do you guys have an approximation on fair value accretion, given that the Arlington deal just closed during last quarter and the IALB just closed early in the third quarter?

I have to go back and look at the IAB impact. But the kind of the core run rate that we see right now, even with the addition of Arlington, is $2.75 million. So that's what we're anticipating. I could dig through my notes and make sure I -- or I can get back to you on what I'm anticipating with Arlington -- or I'm sorry, with Independent Alliance. Sorry.

Okay. That would be helpful. And then as it relates to kind of your organic growth outlook for the back half of the year, pretty decent growth this quarter. Do you think that based on your pipeline, something in the high single-digit range is achievable?

I do think that, Damon, we've got 2 quarters in a row now that are both at the really high end of the previously articulated 6% to 8% range. So we're really at the high end of that each of the first 2 quarters. And the pipeline would suggest we're going to be at the high end of that, at least through the balance of this quarter, maybe into next. The pipeline in our mortgage business is up because it's a little stronger right now, coupled with Arlington's strength in it. Retail -- consumer lending, which is not a big part of our growth, is also up. And then the driver of our organic growth from a total loan perspective is commercial. And between the structured finance business that John spoke to, sponsor finance and the traditional C&I and real estate, it's kind of up throughout the company. Our pipeline is $470 million, a little north of that, which is about 10% higher than it was at the -- at our last call. And it's also considerably up over last year. So the economy is really doing relatively well, and we're the beneficiary of that.

Okay, great. And then just lastly, the -- and I apologize if I missed this part, but the construction and development loan growth this quarter, any color on what drove that from $337 million to $418 million?

I missed -- I couldn't hear your question.

The composition of the construction increases.

Yes.

Yes, the -- I would say that the -- where the growth is coming is out of the multifamily and multifamily student housing section as well as senior living. We continue to see strong demand for those projects, and that is a lot of where the growth is coming from.

Our next question will come from Peyton Green with Piper Jaffray.

My question was also on the construction and development. And I was wondering, Mike, it's been certainly a good part of growth over the first couple quarters. But I was wondering, in your kind of pipeline outlook, is it expected that, that continues to grow? Or do you start to see payoffs and pay downs that might limit that growth and you have to get the growth from the other areas?

Well, they are offsets. And this is all part of the year when the construction activity is at its peak. And so we would expect it to remain fairly strong throughout the third quarter for certain. John referenced earlier that the stabilized properties find their way to the secondary markets. And so those typically are the offsets to either new projects or funding of existing projects. I still view it as a growth category, probably more pronounced in this quarter than it would be going forward, but it'll continue to grow.

And I think I would just add, this is John, that when you look at the availability under existing construction loans, the projects, as Mike points out, still through the balance of the season will continue to draw. So between that and even as they do draw and move into the portfolio for like a mini-perm, it's reasonable to expect that we'll continue to see some growth there.

Our next question will come from Brian Martin with FIG Partners.

Just a couple things from me, 2 housekeeping. And that was the tax rate was a little bit lower this quarter, Mark. Just kind of wondering, any thoughts on that? Or just how to think about that going forward?

Yes, we had a higher-than-normal BOLI income during the quarter. Our average, like I said, over the last 6 quarters, has been about $1.4 million, and that income is all tax-free. So if you apply a 35% tax rate, that's kind of a more -- 35% tax rate to the difference, that's a more normalized level for us.

Okay. And I guess, is that kind of the run rate, I guess, you think about using that less, the $1.4 million, I guess, would be a little bit lower than that?

Yes, I think that's a good number. We had a similar amount last quarter of extraordinary tax savings related to the -- to our RSAs and the new accounting pronouncement around RSAs. So the 2 quarters in a row was a really kind of unique tax position, but last quarter was $770,000 and this quarter was a little bit less than that.

Okay, perfect. And then just on the expense front, can you just remind us how much of the contribution from -- in expenses this quarter was from Arlington and just kind of any outlook on kind of how the expenses play out here?

Well, we closed Arlington in mid-July, so -- I'm sorry, mid-June. Let me get it right, mid-May. I'll get it right eventually. And so we had $326,000 of expense for the quarter related to Arlington Bank.

Okay. All right. And then the -- just the comment you made, Mark, on the funding cost kind of being just at the upper end right now, I guess, is there any indication that you're starting to see any pressure beyond that? Or is it still, I mean, I guess, we've heard more consumers are looking for higher rates. I mean, not that that's unusual, but the -- I mean, is it any -- is it getting more prevalent or not necessarily, it doesn't sound like that's the case?

No, not on the non-maturity deposit side. There's a little bit of pressure with CD rates, as you would expect and as we've modeled, a little bit of pressure with larger balances. We've got balances, call it between $50 million and $100 million, there's some pricing power that the depositor has. And so those are more volatile deposits or we're happen to be more aggressive. But the deposit made is on all of just the core retail customer base, are incredibly low.

Ladies and gentlemen, this will conclude our question-and-answer session. I would like to turn the conference back over to Mr. Michael Rechin for any closing remarks.

Thanks, Allison. My only remark would be to share appreciation from the management for people's interest and questions. We look forward to continuing our strong performance into the next quarter and speaking about it in about 90 days. Have a great day.

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