Mercantile Bank Corp (MBWM) 2004 Q3 法說會逐字稿

Welcome to the Mercantile Bank Corporation third quarter earnings conference call. There will be a question and answer period at the end of the presentation. If you have a question at that time, please press star, 1, on your touch-tone telephone. Before we begin today's call, I would like to remind everyone that this call may involve certain forward-looking statements, such as projections of revenue, earnings and capital structure, as well as statements on the plans and objectives of the Company or its management, statements on economic performance, and statements regarding the underlying assumptions of the Company's business. The Company's actual results could differ materially from any forward-looking statements made today due to several important factors described in the Company's latest securities and exchange commission filings. The Company assumes no obligation to update any forward-looking statements made during this call. If anyone does not already have a copy of the press release issued by Mercantile today, you can access it at the Company's website, www.mercbank.com. On the conference today from Mercantile Bank Corporation we have Gerry Johnson, Chairman and Chief Executive Officer, Mike Price, President and Chief Operating Officer, Chuck Christmas, Chief Financial Officer, and Bob Kaminski, Executive Vice President. We will begin the call with management's prepared remarks, and then open the call up to questions. At this point, I would like to turn the call over to Mr. Johnson.

Thank you very much, and thank all of you for your interest in Mercantile Bank Corporation, for joining us this morning. If have you had a chance to read our press release, we think you will note that we enjoyed another outstanding quarter of earning and asset growth. We're also making good progress, as Mike and Bob will mention, on our new corporate headquarters and our banking facility in Holland. One item that we did accomplish this past quarter, and it was a new instance for us, as far as our capital is concerned, is that we refinanced our $16 million standalone trust preferred securities with a 16 million pooled trust preferred. And a number of you, especially the analysts, 6 to 12 months ago when we discussed the standalone, we had indicated that we did not have a huge interest in looking at it, just because of the rate structure and costs. Since that time, however, as many of you know, LIBOR has come in almost 100 basis points. However, the LIBOR has -- the spread to LIBOR has come in almost 100 basis points over what it was 6 to 12 months ago. There is no longer any underwriting spread that is charged by all of the pools, and we talked to representatives of all of the pools. So we have a spread that has come in around 100 basis points. We have eliminated the underwriting discount, as well as other issuance costs and ongoing annual maintenance fees, and other than some legal fees, there are not a lot of other additional costs attached to that. So we made a very conscious decision that refinancing the 16 million made sense.

If you compare our current rate, although obviously it's floating and is subject to going up as LIBOR increases, but our current rate of 4.06% compares very favorable with our prior coupon of 960. I think it's important to note also, that even if short-term rates do rise, our balance sheet is extremely well positioned to mitigate any impact of that. I think when we did our standalone, floating rate loans as a percentage of our portfolio, were 30-plus percent. Today they are 75% or so of our portfolio. So we're in great shape to handle any increases in short-term rates with this new $16 million offering that we just closed. So that really is kind of the thought process that went into our decision to do this, even though it resulted in incurring an $840,000 or so pretax charge. We think with the disparate rate structure here, that we can recover fairly quickly. With that, I will turn our remarks over to Chuck Christmas, and go from there.

Thank you, Gerry. And good morning to everybody. What I would like to do today is give you an overview of Mercantile's financial condition and operating results for the third quarter of 2004, as well as year-to-date 2004. I will highlight the major financial condition performance balances and ratios, but one of the things you'll see, is that the underlying theme of Mercantile's financial numbers continue to reflect a successful implementation of our strategy, that being a concentration on business lending, strong asset growth led by growth of our commercial loan portfolio, high asset quality, and controlled overhead costs. Our financial results also continue to reflect our visits to the capital markets and the significant provision expense necessitated by our strong loan growth. In addition, our third quarter earnings results were impacted by the one-time write off of issuance costs associated with the 1999 issuance of trust preferred securities, which as Gerry mentioned, were redeemed last month in September. The $845,000 one-time charge equates to about 548,000 on an after-tax basis. As part of my presentation, I will be giving numbers on a GAAP basis, as well as an adjusted basis, as we did in the press release.

With overall earnings performance, our GAAP net income for the third quarter of this year was $3.1 million. That's an increase of 900,000 or almost 40% over the 2.2 million we made in third quarter of last year. On a year-to-date basis, we made $9.2 million in the first 9 months of this year. That's an increase of 2.2 million, or 32% over the $7 million we made in the first 9 months of last year. On a diluted earnings per share basis, our third quarter earnings per share are 43 cents, an increase of 16% over the 37 cents that we made in the third quarter of last year. Net increase of 16% is despite average shares being up about 1.4 million, or 23%, again, related to our common stock issuance back in the third quarter of last year. On a year-to-date basis, we made $1.26. That's an increase of 6%, despite an increase of 25% average shares outstanding over the $1.19 that we made in the first 9 months of last year. On an adjusted basis, again eliminating the one time charge, our net income for the third quarter was $3.6 million. That's an increase of 1.4 million, or 64% over the 2.2 million we made in the third quarter of last year. And on a year-to-date basis, our adjusted net income is 9.8 million, an increase of 2.8 million, or almost 40%, again over the 7 million we made in the first 9 months of last year.

And on a diluted earnings per share basis, third quarter came in at 50 cents a share. That's an increase of 35%, again despite the 23% increase in average shares outstanding, over the 37 cents we made last year. And on a year-to-date basis we made $1.34. That's an increase of 12%, again despite a 25% increase in average shares outstanding, over the $1.19 that we made in the first 9 months of last year. Our strong increases in net income continue to be achieved due to strong growth in net interest income resulting from earning asset growth, which has more than offset the growth in overhead costs and a significant loan loss provision expense due to continued strong loan growth. With net interest income, our overall profitability continues to be driven by the strong asset growth, which is translated into increased net interest income, further supported by slightly increasing net interest margin. In the third quarter of this year, our net interest income totalled 10.8 million. That's an increase of 2.8 million, or 35% over the 8 million we made in the third quarter of last year. And for the first 9 months of this year, our net interest income is 30.3 million. That's an increase of 8 million, or 36% over the 22.3 million we made in the first 9 months of last year.

Our earning assets at the end of the third quarter totalled $1.4 billion. That's up 311 million, or 28% from where we were a year ago. Loans are up $280 million during the last 12 months, or 90% of the growth in our earning assets. Our net interest margin for the third quarter is 3.23%, up 4 basis points from the 3.19% we made in the third quarter of last year. And on a year-to-date basis our margin is 3.24% compared to 3.20% in the first 9 months of last year. Overall, we continue to have a very steady net interest margin. In fact, over the last 9 quarters, our margin has been in a range of only 10 basis points.

Looking forward with regards to our net interest margin, as in the past we don't provide specific guidance, but as in the past, our main issues continue to be our loan yield, any action or inaction by the Federal Reserve, and our wholesale funding rates. Our new loans -- with our new loans, a vast majority of borrowers continue to elect floating rate over fixed rate, which is resulted in our portfolio, as Gerry has already mentioned briefly, that large preponderance of our loans are floating rate, almost 80% as we stand today. The 80% compares to 74%, where we were at the beginning of this year. And as we mentioned, 4 years ago, it was only 35%. The level of loans that are at floors has declined with the interest rate increases that we've seen over the last 3 months. For example, at the June 30th increase by the Federal Reserve, about 32% of our floating rate loans were at their floors, and did not reprice. However, with this last increase in September, only 14% of the loans -- floating rate loans did not reprice. So with regards to potential and likely future increases, well under 10, if not under 5% of our loans, will not reprice. So a large preponderance of our floating rate loans are now fully indexed and will enjoy increased interest rates if the Fed does decide to increase interest rates, like many believe they will.

Our cost of wholesale funds have increased as market rates have increased, which for the wholesale funding portfolio -- market rates started at about May. That has resulted in an increasing interest costs of our wholesale funding costs, but as you can see from our net interest margin, has been more than mitigated by the increased rates on our loan portfolio. At September 30th, our overall average rate of our wholesale funds was 2.42%. That's up 14 basis points from where we were at the end of the second quarter. Recent increases in interest rates will certainly result in increased costs of wholesale funds. And to put that in perspective, for the remainder of this year, or for the fourth quarter, we have about $165 million maturing at an overall cost of 185. And for all of 2005, we have about 500 million maturing, at a weighted average cost of 2.25. To put it in further perspective, the current 12-month rate is about 2.60%, but it's also important to note that that 2.60% does take into account the market's expectations of future Fed increases. As we've already discussed briefly, a large preponderance of our loan portfolio is tied to prime, and should offset any increases in our wholesale funding portfolio.

With regards to our loan loss provision, we have expensed $1.2 million during the third quarter of this year. That's a decrease of 200,000 or 13% from what we did in the third quarter of last year. If you remember, last year third quarter was our biggest loan growth quarter ever of over $100 million in loan growth. And, while we had very strong loan growth again in this quarter, it wasn't to the degree that we had a year ago. On a year-to-date basis, our provision expense is 3.7 million. That's an increase of 800,000 or 29% from what we had to expense in the first 9 months of last year. That's due to a combination of loan growth during the period, as well as a higher net chargeoff number during this year. With regard to the fee income, in the third quarter of this year we earned $1.1 million, about $100,000 higher from the third quarter of last year. And on a year-to-date basis, we're at 3.2 million, about $100,000 lower than what we made last year, but you can see it's very, very close year-over-year. We've had increases in virtually all non-mortgage related activities, which to a large degree has offset the decline in mortgage related fees. Some of the bigger changes and growth in our fee income include service charges on deposit accounts, which is up almost 80,000 year-to-date over year-to-date. Letter of credit fees are up about 240,000 year-to-date over year-to-date, which is primarily the result of an accounting change. Our payroll and brokerages combined has increased about 80,000 year-to-date over year-to-date. And as I mentioned we certainly have, I'm sure all banks, have seen a decline in mortgage loan related fees, we've had a decline this year of 515,000 over what we had earned in the first 9 months of last year.

As you also saw in our press release, we did have some gains on the sale of some loans during the third quarter, as well as the second quarter. We did sell -- as we did in the second quarter, during the third quarter we did sell some SBA guaranteed loans, netting us a gain of $135,000 in the third quarter, bringing that up to 175,000 on year-to-date basis. Again, that is related to the sale of SBA guaranteed loans. With regards to non-interest expense, and I'll do both GAAP and adjusted numbers here. First of all , on GAAP third quarter, non-interest expense totalled 6.4 million. That's an increase of 1.6 million, or 35% over third quarter last year. And on a year-to-date basis, and also on a GAAP basis, we've had to expense 17 million, an increase of 3.8 million, or 29%, compared to the first 9 months of last year. Our efficiency -- our GAAP efficiency ratio on year-to-date basis is about 50.5%, a slight improvement from the 51.3% in the first 9 months of last year. However, certainly on an adjusted basis, those numbers improve quite dramatically. On an adjusted basis, our overhead costs total 5.6 million, an increase of 800,000 or 17% over the third quarter of last year. However, that $800,000 compares very favorable to the fact that net revenue, during the same time period, is up almost $3 million. And on a year-to-date basis, our adjusted overhead costs are 16.1 million, a $3 million increase over what we did in the first 9 months of last year. However, our net revenue is up almost 8 million, or over 2-and-a-half times the growth in our overhead costs. Our adjusted year-to-date efficiency ratio is a little over 48%, a 6% improvement over the 51.3% ratio we had in the first 9 months of last year.

With regards to the growth in overhead costs, of the $3 million increase in the adjusted year-to-date number, 2.1 million or about 70% is related to salaries and benefits. A large part of that is the fact that we continue to increase our staff. We've gone from 156 full time equivalents 12 months ago, to 190 at the end of the third quarter of this year. That's a 22% increase. Other overhead costs also -- are also up due our increased asset base. Now switching over to the balance sheet, total assets at the end of the third quarter total $1.47 billion. That's an increase of 96 million or 28% on an annualized basis. And loans are up 67 million for the quarter or 22% on an annualized basis. In the last 12 months, our assets have increased 320 million or 28%, and loans [inaudible] have increased 280 million, or 29%. Again, there are no major changes in our asset structure. Our funding strategy has not changed. We continue to grow local deposits and bridge the funding gap of wholesale funds comprised of brokerage CDs and Federal home loan bank advances. We continue to have very strong local deposit growth this year, with local deposits up $77 million, or on an actual basis, 25%. Our wholesale funds are also up 193 million, or about 28%, but you can see on a percentage basis, very similar to our growth in local deposits. In fact, our wholesale funds to total funds are 66% at the end of the third quarter, up slightly from the 65% we were at the beginning of the year. With regard to capital, we continue to be in a well-capitalized position per bank regulatory definition, with our total risk based capital ratio of 12.2%. That is my prepared remarks. I'll be certainly happy to answer any questions during the question and answer session. But for now, I'll turn it over to Mike for his comments.

Thanks, Chuck. Good morning, everyone. At the risk of sounding like a broken record, the song remains the same here at Mercantile. Growth across the board on the balance sheet and loans and deposits, combined with outstanding credit quality continues to be the case. During the third quarter, the Bank's assets grew by $96 million of loans increasing by 67 million. Over the past 12 months, total assets at the Bank have grown by $320 million. As Chuck alluded to a little earlier, we are especially happy with the growth of our non-interest bearing deposits this year. Through the first 9 months of the year, they are up 46% over year end 2003 balances. While we have seen the mortgage refi boom come somewhat to an end, we have been able to withstand the reduction of mortgage fee income by increasing the level of other non-interest income. Through 9 months of this year, we're only slightly behind last year's record, non-interest income totals. Net loan charge offs were $467,000 for the quarter, or 15 basis points of average loans. Non-performing assets were reduced by nearly $750,000 through the quarter, and total less than $3 million at this point. Growth for the fourth quarter continues to look good, as we continue to bring some very nice new relationships into the bank. That's the end of my prepared remarks at this time. And I'll turn it over to Bob Kaminski.

Thanks, Mike. I have just a brief update on Mercantile's 2 construction projects. We're pleased to report that Mercantile's new Holland Lakeshore office is nearly complete and we anticipate moving into this new facility by the end of this month. As you recall this, is a 30,000 square foot facility on the south side of the city of Holland, less than a mile from the temporary office that we've maintained for the past year and a half. Momentum continues to be strong in the Holland market for Mercantile, as loan and deposit growth and new customer opportunities continue to increase. Work also continues on the construction on Mercantile's new downtown Grand Rapids main office, at Leonard Street and US 131. It is anticipated that this 60,000 square foot facility will be completed and occupied in the spring of 2005. That is the end of my comments. With that, I turn it back over to Gerry.

Thanks, Bob. And with that, we would open up the session for questions.

At this time, I would like to remind everyone, in order to ask a question, please press star, then the number 1, on your telephone keypad. We will pause for just a moment to compile the Q&A roster. Your first question comes from the line of Steve Covington, Stifel Nicolaus and Company.

Good morning, guys. Congratulations on another great quarter.

Thanks, Steve.

Good morning.

Can you give me an idea, was the growth during the quarter, was it relatively balanced on a monthly basis, Mike, or was it--

Yeah, it was -- unlike some of our other quarters where we seem to put a lot of growth on right at the end, this quarter had some pretty good balance to it. So they were pretty evenly divided across the 3 months.

Okay. Thanks. And then from a competitive standpoint, can you give us an idea of anything, any new developments within the market, including has the economy continued to stabilize and firm up, and how is it looking going forward?

Yeah, from a competitor's standpoint, really not a lot of change or really much change at all during the quarter. Continues to be a very competitive landscape out there. Has been since we started the bank, and we anticipate it always being competitive going forward. The economy in west Michigan continues to take baby steps forward, and they get, you know, somewhat more stable and better than what it was. As many of you know, we continue to have kind of an interesting situation in west Michigan. Many, many of our customers and their business lines are doing very, very well. But office furniture and those companies related to that continue to struggle a little bit, although we are starting to see some recovery in that particular industry. So we're very positive looking forward, especially looking at how our asset quality has held very, very firm through some pretty difficult times for a couple industries in our market.

Okay. Just quickly, your asset quality remains, obviously very strong. Looks like you did have an REO go into -- repossessed asset during the quarter. Can you give us an idea, what that is and was the chargeoff related to that?

Yeah. There has been no chargeoff related to that particular piece of real estate, and it is one loan, and we did take it into ORE last quarter at the end of the quarter. We have some interest in having someone purchase it at this time. Although, you know, we still do have it, but we don't expect to have it for a long time. We do have an appraisal on the property that indicates we're in very good shape, as far as loan to value, and that's why we haven't taken any writedown on it.

Good. And then lastly, this is the -- you had some, obviously had some gains on the sale of SBA loans. Can you give us an idea on, I guess growth in that business for you? Is this an ongoing focus for the Company, kind of a new focus, the SBA lending?.

We've always made SBA loans since we started the Bank as a commercial lending oriented bank and one that's very dedicated to helping new businesses get started. The SBA from time to time is a great vehicle for us to get loans out there. So we watch the market. The market changes a lot on what the appetite is for the purchasing the guaranteed portions into the secondary market. And when we think the opportunity is right and we have some inventory to sell, we'll sell those out into the secondary market. But nothing really changing as far as our focus goes or it being a new issue. We just happened last quarter, especially we had some fairly sizable ones that we got booked and the market was pretty favorable. So we sold them.

Okay. Thanks, guys, and again, congratulations.

Thanks, Steve.

Your next question comes from the line of Brad Vander Ploeg with Raymond James.

Good morning, Brad.

Good morning. Great quarter.

Thank you.

Also from me. And a couple quick questions. Chuck, you mentioned the wholesale funding that is maturing. I think you said for the remainder of the year, is 165 million, is that right?

That is correct.

At 185. I'm just, I'm wondering, you know, if that needs to reprice up, you know, 70 or 75 basis points immediately, if I should think of that as a risk to the margin. It looks like that costs you incrementally a couple hundred grand in the fourth quarter by itself. And I know some of the loans are probably going to ratchet up a little bit with the recent Fed rate hikes. But, you know, just how I should think about that?

I think we can -- and that's a very good point. I think if you draw some of the numbers though, is that our margin during the quarter was actually on an improving trend. As you know, with the wholesale funds being tied to LIBOR and treasury, as I mentioned we've really started to see those rates increase in May. We didn't see the Fed start increasing rates, which obviously our loans are based on prime, until the very, very end of June or the first of July. So what you saw, actually -- obviously we reported our margin for the quarter. It actually was improving by a basis point or two through each of the months. So I think that even if the Fed doesn't raise rates in the fourth quarter, although we are going to have repricing on our wholesale funding, I think you would see that our margin would actually hold fairly steady, just because of the timing issues.

Okay. Fair enough. And then Mike, just a follow-up on loan demand. How about utilization rates? You track that, I'm sure, if you're comfortable sharing that, or maybe just anecdotally or add some color to that. Are people on the commercial side getting more optimistic, drawing down lines, or is it mostly new business that accounts for your growth?

Yeah, it's a good question. We're still seeing the majority of our growth coming from new relationships into the Bank, which we're very comfortable with and very happy with. We see more of that than really we have, you know, someone who has had a $2 million line of credit, and really hasn't needed it because of activity, helps them start to ratchet up to, you know, full usage. So we're very optimistic that we can continue to bring good, strong relationships, new relationships into the Bank, and as the economy does recover here, we'll probably see increases in utilization as well. But, you know, it's been a very steady, as you know, drum beat since we've opened the doors here, as far as loan growth goes, and fourth quarter doesn't look to be a whole lot different.

Do you have any sense that we're turning the corner there? I know in some geographies in the southeast in particular, it sounds like demand is increasing, even on the existing relationship side. Are you getting any sense from your existing relationships that that might be about to happen here as well?

Well, one of the things that we've kind of had a bifurcated economy here over the last couple of years, and a lot of our customers who have been in industries that have not really felt any of the recession at all, have been pretty strong utilizers of their credit facilities right along. And ones that have, we've either not wanted to lend to in some of the office furniture-related or transportation-related industries, they are just now starting to get back. So we aren't seeing it here at this bank as [inaudible] we've got all these really great customers that just haven't borrowed. Most of our really great customers have just kind of sailed through the economy and the handful of industries that have really taken a beating, have really taken a beating, and we've either not lent to those industries or, you know, we're just now starting to see a little bit of recovery there. But that's not going to be a real big part of our growth. Our growth really continues to be, you know, generated on bringing in these new relationships and sticking real strong with the strong customers that we have.

Okay. Thanks. And just finally on the expansion plans, can you tell me just how the expenses are going to be layered into the income statement? Are you incurring those as you go or will you have those coming in as those facilities begin being used?

This is Chuck. We're not going to see, you know, any significant increase in costs, although there certainly will be. The facility, you know, we're not really hiring any additional people because of our moves. All the people that are moving to those facilities already work for us, so from a salary and benefits standpoint, really there is nothing there as far as increased costs. The facility that we're leaving in Holland -- or in Grand Rapids, excuse me, is currently leased. And when we compared the lease expense-- oh, and another thing, I should back up. We also pay for the parking of our folks, and we have a relatively parking lot at our existing downtown facility. So between the lease for the facility and the lease on the parking, you compare that to what the depreciation cost is going to be at our new facility, and it's not a very significant increase. It's obviously a bigger building, so from a utilities and maintenance and those type of costs, there's certainly going to be some increases there. But when you look at the overall overhead cost structure, you're not going see any really significant increases there at all.

Okay. Very good. Great quarter. Thanks, guys.

Thanks, Brian.

Once again, I would like to remind everyone, in order to ask a question, please press star, then the number 1, on your telephone keypad. Your next question comes from the line of Kevin Reevey with Ryan Beck.

Good morning. Congratulations on a very impressive quarter.

Thank you, Kevin.

My first question is for you, Chuck. You mentioned that excluding the charge, your net income is $3.6 million for the quarter. But when I divide that by your shares outstanding, I'm getting 49 cents as a core number versus 50 cents. I was just curious where the discrepancy comes from.

I guess I can't answer that because I don't have that discrepancy with regards to the numbers that we reported.

Okay. Then we'll--

I'll have to check on that.

Our auditors also review these numbers as well.

You know, obviously with 3.6 million, we're using very specific numbers and not the rounded numbers.

Okay. I'll revisit that. And then my second question's related to your increase in service charges. Is that driven more by increases in your deposit accounts or was it by increased pricing?

I would say this year the majority of it has been increase in the number of accounts that we've been able to open and bring on. We had some pricing adjustments at the end of 2003, but really it's the volume that's been driving that.

And then I guess going forward, do you think that the continued growth will be more from increased accounts versus pricing?

Well, we continually, you know, shop the markets to see what our competitors are doing out there, pricing-wise. And our plan has always been to be competitive, but if we have opportunities to increase pricing, we will. I would expect that the end of this year we may see some opportunities to increase some pricing, but when you're growing at the rate that we're growing, 20-30% in assets, it probably will always at least at this rate of growth, be driven more by the number of new customers that we can bring in and new accounts that we can open up. But we certainly will take advantage of any price increases that we can.

Great. Thank you.

You bet. Thank you, Kevin.

Your next question comes from the line of Brad Ness with FBR.

Hey, guys, how are you doing?.

Hi, Brad.

Hi, Brad.

A few questions here. It looks like you guys increased your investment securities portfolio a little bit from the second quarter. Could you just describe your rationale for that?

Those are junk bonds, Brad.

Brad this, is Chuck.

Just kidding.

Chuck just hit me. I'm sorry.

The-- our policy is to keep the investment portfolio between 10 and 12%. And historically we've kept it at 10%. One of the things, and I think what you're seeing is, we went from about 9% of total assets at the end of June to back up to about 10% at the end of September. We had quite a bit of, you know, when rates had kind of dipped on the mortgage side, back in late spring, actually mid-- early to mid spring, we had a lot of principal reduction on our mortgage back portfolio. And instead of reinvesting those proceeds into new securities, which I thought and the Mercantile team thought, was at relatively low interest rates, we decided to put those funds -- drop it back in the loan portfolio and then wait until rates had increased to what we thought more appropriate levels before we started reinvesting proceeds in the investment portfolio. So what you saw by the end of the second quarter, was that our investment portfolio had dropped down to 9%. We built that back up during the third quarter, back up to the 10%, and like I say, historically, that's where we've kept it. And I don't see any need for any changes to that program.

Brad, this is Gerry. As Chuck and I discussed, that there just wasn't anything to buy that gave you any kind of yield at all.

Right.

And Chuck, I think very appropriately, waited until there was some yield back in the curve that we could take advantage of.

Okay. Appreciate it. On the non-interest expense side, on a core basis, it looks-- I'm calculating link to quarter increase of around 3.1%. And that looks to be the lowest increase, you know, in several years. Would you-- is there anything unique in this quarter that lowered expenses, on maybe some non-recurring stuff, you know, that was netted out in there? Or do you think just as the Company matures that, you know, maybe we should expect lower expense growth going forward?

I think part of that, and I'll let Chuck and Gerry jump in after my comments, but I know one of the things that we didn't do this quarter that we had done last year at this time, for example, is we didn't find anyone at a high salary level, especially on the lending side, that we added to the staff. We're very judicious before we bring people at that salary level on, and we had planned to do that, but we don't bring them on unless they fit the Mercantile culture and what we want, and we just didn't -- really, the last couple quarters haven't found anybody. We're still looking and will continue to look, but I know that's part of it. I can't think, to answer your question specifically, anything unusual that added to it. I think it's a little bit of what you said. As we get bigger, the percentage number becomes, you know, the denominator gets bigger obviously, so that gives us some help there. I don't know, Chuck, if you or Gerry had any comment.

Brad, this is Chuck. I think Mike hit it right on. It's timing, when you're comparing quarter-over-quarter, year-to-date, year-to-date, most of it's just timing with regards to hiring additional staff. Certainly from an overall overhead structure, or cost structure, this quarter there wasn't any, you know, accruals that we haven't done in the past, or have done in the past and didn't do this quarter. So I think most of it's just related to the staffing.

Most of the hiring we did do, or plan to do for '04, we did early on too, in the first -- especially the first quarter and a little bit of the second.

Right. Appreciate it. Last question here, with your reserve to loan ratio, I'm calculating 136 as of the end of third quarter, and that compares to 139 at year end. Do you see this ratio continue to decrease over time?

The ratio is directly proportion national to our formula that we need to keep, that is directly proportional to the health of the loan portfolio. And we, in looking at it, drives it down to 136 because the portfolio has continued to get healthier during the first few quarters. So I guess the answer would be, if I were to guess short-term, or estimate, I don't want to use the word guess, but estimate short-term, 136 could probably be a good number, might even drop to 135 because we aren't seeing any big degradations to the credit quality. But as always, it's hard, to you know, foresee too far, too many quarters out there because, again, we could have 1 or 2 large credits downgrade a little bit and necessitate that we move back up towards 137.

Brad, this is Gerry. I would add to what Mike said, in that we have a pretty conservative risk weighting for all categories of loans, whether they be in the best category or the worst. And that's why you tend to see our loan loss reserve a little higher across the board than many of our peers. That being said, we don't sit and target 138, 136 or 140. Really the formula and its risk weight components really drive where we end up at the end of each month.

Okay. I appreciate it, guys.

You bet.

Your next question comes from the line of Barry Mendel with Mendel Money Management.

Great quarter, guys.

Thank you.

I'm sorry if I -- if you said this already, because I was got on the call a little late. But I see your efficiency ratio on an adjusted basis was down to 46.37, which is as low as I can remember it. Where do you think you can get to in terms of that ratio, or is this as low as it can get?

This is Mike. We were very pleased to see that number come in that low. And you're right, it is the lowest that we've ever had in our strategic plan, you know, calls us for to drive it down if we can, maybe to 45% level. But we're always very cognizant of not letting customer service suffer, or any other areas of our operation suffer. So, I would expect over the next couple of quarters, that we linger in that 46-47%, because again, we are always looking for great people to hire. And if we drift up a little bit because of that, and it takes them awhile to bring the income in, we may in fact do that. We certainly like the progression of where we started 6 and a half years ago with the efficiency ratio, and how that's continually working its way down. I think it validates our business model of trying to keep the number of locations down, trying to keep staff level down, hiring excellent people who tend to be able to do more than the average employee, and utilizing alternative delivery methods. And also, obviously as a commercial lending bank, by and large, having larger loans so that we are more efficient there as well. So very excited about that, and look forward to at least holding the line, but not driving it so low that our customers would notice a change in our excellent service quality.

Okay. In terms of your loans, I assume that you're pretty much -- the next Fed rate increase will affect all of your variable rate loans now?

I would say at least 95%, if not, you know, a little bit higher than that. I know we have a few more that still need another 25 to 50, but I would say at least 95, if not 97% will go up.

Okay.

In the next increase.

All right. And the Federal Home Loan, you're up to 120 million there. What rate are you paying on that versus your, say, CD rates, and how high can you go there?

As-- I haven't run the numbers as of September. We're still going through and crunching our collateral position, but I believe at the end of June, our line would have been about either 160 or 180 million. I can't remember exactly which number it was. So, we certainly have some room for additional borrowings there. With regards to the rates, we primarily do bullet advances, one, two, and three-year fixed rate deals. Those rates are very, very similar to doing a one, two, and three-year fixed rate CD. And we do all fixed rate CDs. So, there's not really, maybe 5, perhaps 10 basis points on occasion, difference between the rates. But when you look at the cost of Federal Home Loan Bank advances versus broker CDs, it's very, very similar.

And broker CDs, are they still 65% of your funding or something like that?

Our wholesale -- broker plus the Federal Home Loan Bank advances, which we entitled our wholesale funds. It was 66% at the end of the third quarter.

Okay. And another question would be, since you haven't been hiring in the last couple quarters highly compensated people, which to me means loan officers who could bring business in. If that continues for some period of time, is that going to affect your loan growth at some point?

It could possibly, yeah, although we continually are amazed by the number of referrals we're getting from our existing customer base, and as our reputation and our, you know, our name gets out there even more and more, it's been real gratifying. We certainly have capacity with, because we've hired so many good people in the last 6 and a half years, we have capacity to continue to develop loan growth quite a while. But it's always one of our challenges, is to make sure that we continue to hire the type of people we want and so we can continue the level of growth, without falling prey to let's just get somebody in here that doesn't fit the Mercantile way. That's very important to us. So we have work to do there yet, but we'll continue to do it.

Okay, and lastly, I assume you're going review the dividend again in January?

What was the question? I'm sorry.

I assume you're going review the dividend again in January.

We review it every year.

Okay. All right. Thank you very much.

Thank you.

Thanks, Barry.

Your next question comes from the line of Frank VanderHoff with Kent King Securities.

Hi, Gerry and Chuck.

Good morning, Frank.

First of all, congratulations on a great quarter.

Thank you.

Super job. Easy question. What's the analyst estimate for the fourth quarter earnings?

I believe the current consensus is 55 cents.

Okay, and then you may have answered this question, but on an ongoing basis, the savings on your preferred, if the rate stays currently where it is, how much does that add per quarter to your earnings per share?

You know, Frank, this is Chuck. I didn't actually do that calculation, because when we were going through our analysis, we made the assumption that rates were going to increase. We rely on several economists that work for major banking firms to kind of put our own consensus together. And everyone had predicted and still continues to predict, that the Fed is going to be relatively aggressive will their interest rate increases throughout the rest of this year and throughout most, if not all of next year. When we looked at their increases, which were at least 25 basis points a quarter, it was going to take us slightly over a year to recoup that initial writedown. I'm sorry I can't answer your question directly right away. But, again, we're looking at about 12-month recovery period, assuming increases in LIBOR.

That would be a savings of about 200,000 a quarter then, is that correct?

Yeah, Frank, this is Gerry. If you just take the current difference, which obviously will diminish a little bit as LIBOR goes up, that's about 554 basis points. And if you take that times the 16 million, divide that by 4, you come up with about 221,000.

Okay. Thank you. And the last question is, is you're about you're about a billion and a half in assets. With your current capital the way it's structured, approximately how much loan growth or asset growth can you have before you need more equity?

That's always a good question, Frank. I think our current capital structure will support probably an additional 300, 250 to $300 million from where we stand today.

Okay. About another year's worth at this rate?

Plus obviously, additional net income will help that as well.

Yeah. Thank you.

Thanks, Frank.

You have a follow-up question from the line of Brad Vander Ploeg with Raymond James.

No follow ups allowed, Brad.

I'm sorry. I'm done then. (laughter) It just occurred me as you were talking about capital and the trust preferred, you'll have that savings benefit in the fourth quarter and obviously ongoing, Chuck. But then, with the additional 16 million that will get layered on in the fourth quarter, is it correct to think of that as essentially offsetting all of the benefit that you'll be getting in the fourth quarter as you move into 2005? I mean, it pushes out the time where you would need further common equity, but the savings would basically be washed out by the additional expense of the new trust preferred?

I think mathematically, I think-- I see what you're saying. Yeah, obviously if there is a double layer in the amount of trust preferred, that would so to speak, eat into the cost. But obviously from a longer-term perspective, that would be additional capital that we would be able to leverage going forward.

Absolutely.

I would say, Brad, we really, we can't talk a lot about the transaction. I think we do mention in our press release that we did file a form 8-K on September 22nd. That's about the extent that we can discuss the transaction. I'm sorry.

Understood. And then just one final thing, not mentioning any names, but there is another community bank that's attempting to make a push into the Grand Rapids market, and having been up there recently, I've noticed a couple new offices of theirs going up. I'm just curious if, if any others have made any headway in this market, if you're concerned at all that that might increase competition, might eat into growth, or if their focus is different enough that that's not going have a major impact.

I think we have built the bank to withstand intense competition. I think the day we started the bank, we knew there was going to be intense competition and it hasn't, hasn't let us down. Without mentioning any names, there's a lot of good banks out there that we compete against every single day. I'm always amazed at how many of them survive in this market, given the size of the market and the number of banks. But we're very confident that our business model is the right one, that our service level is very strong and will continue to carry the day. And 6 and a half years into this thing we call Mercantile Bank, we couldn't be happier with our success. Competition doesn't scare us. It keeps us sharp, and it keeps us on top of our game. But I don't expect that it would really make any difference to what we have seen as our growth pattern. Banks come and go as far as, you know, some of them get really aggressive with pricing, and some of them take their hands off the wheel as far as loan structuring, and some will try all crazy things to get deals away from us. But as always, we are really built to win deals on relationships, and not by the size of our competition or the cost of what they are coming in with, or that type of thing. So, you know, we're not being ignorant of the fact that they are out there. We know it's out there and we know it's very competitive, but I don't expect it to really change from a competitive standpoint over the next couple of years.

All right. Very good. Thanks.

Thanks, Brad.

At this time there, are no further questions. Are there any closing remarks?

Once again, we would like to thank everybody for dialing in to our teleconference today, and for your interest in Mercantile Bank Corporation. If you do think of additional questions that you have subsequent to the call, please give one of the four of us a call and we will try to answer it as best we can. Again, thank you very much. That concludes the teleconference.

Thank you. This concludes today's Mercantile Bank Corporation third quarter earnings conference call. You may now disconnect.