Mercantile Bank Corp (MBWM) 2010 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 session at the end of the presentation. (Operator Instructions).

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 underlying assumptions of the Company's business.

The Company's actual results could differ materially from any forward-looking statements made today due to important factors described in the Company's latest Securities and Exchange Commission filings. The Company assumes no obligations to update forward-looking statements made during this call.

If anyone does not already have a press release issued by Mercantile today, you can access it by the Company's website, www.mercbank.com. On the conference today from Mercantile Bank Corporation we have Mike Price, Chairman and President and Chief Executive Officer; Bob Kaminski, Executive Vice President and Chief Operating Officer; Chuck Christmas, Senior Vice President and Chief Financial Officer. We will begin today's call with management's prepared remarks, then open up the call to questions.

At this point, I will turn the call over to Mr. Price. Please begin.

Thank you, and good morning, everyone, and welcome. While our income statement continued to show distress of elevated provisioning and bad debt expense, our third-quarter results had some very positive important trends. The improvement in past due in nonperforming loans that initially surfaced in the second quarter picked up tremendous momentum. Nonperforming loans and ORE were down significantly for the quarter and since we have painfully learned that the level of nonperformers is a good indicator of future credit costs, this reduction is a very positive sign for the quarters ahead.

Bob Kaminski will detail the dynamics of our loan portfolio and the provision for loan loss during his comments, but at this time I'm going to turn it over to our CFO, Chuck Christmas.

Thanks, Mike. Good morning, everybody. This morning we announced that we recorded a net loss of $5.7 million during the third quarter of 2010 compared to a net loss of $5.6 million during the third quarter of 2009 and a net loss of $9.3 million during the first nine months of 2010 compared to a net loss of $16.5 million during the first nine months of 2009.

On a pretax basis which we believe provides a more accurate comparison of our operating results given the change in our tax position over the last couple of years, our net loss during the third quarter of 2001 was $6.1 million compared to a net loss of $9 million during the third quarter of 2009. And our net loss during the first nine months of 2010 was $10.4 million compared to a net loss of $25.9 million during the same time period in 2009. While we are of course disappointed any time we have to report a net loss, we are encouraged with the significant improvement in our operating results as well as the continued improvement in many key areas of our financial condition and performance.

Our financial performance during 2010 like that throughout 2009 and 2008 has been impacted by a significant provision expense. Unfortunately continued state, regional, and national economic struggles had negatively impacted some of our borrowers' cash flows and underlying collateral values, leading to increased nonperforming assets, higher loan charge-offs, and increased overall credit risk within our loan portfolio when compared to historical norms.

From the time we sensed economic weakness over two years ago, we have been working with our borrowers to develop constructive dialogue which has strengthened our relationships and enhanced our ability to resolve complex issues. With the environment for the banking industry likely to remain stressed until economic conditions improve, credit quality will continue to be our major concern. We will remain relentlessly vigilant in the identification and administration of problem assets.

Unfortunately, provision expense as well as nonperforming asset administration resolution costs will likely remain higher than historical levels, dampening future earnings performance. But during the third quarter of 2010, we saw the continuation of the very positive trends we have reported for the first and second quarters of 2010 and throughout 2009 as well. And I would like to touch on some of them with you this morning.

Despite a reduction in our total earning assets, an improved net interest margin has provided for increased net interest income. Net interest income during the third quarter of 2010 was $400,000 higher or 3% than the third quarter of 2009 and during the first nine months of 2010, our net interest income was $4.8 million or 13% higher than during the first nine months of 2009.

Our net interest margin during the third quarter of 2010 was 3.33% compared to 2.85% during the third quarter of 2009, an improvement of 48 basis points or 17%. The improvement is primarily due to the significant decline in our cost of funds. While we expect further reductions in our cost of funds in future periods, it will likely be at a much slower pace than during the past couple of years.

Also contributing to our improved net interest margin has been a very stable yield on assets. The loan pricings initiatives that we have undertaken within the commercial loan function have almost completely mitigated the negative impact of higher levels of nonaccrual loans.

Overhead cost reduction strategies are becoming realized. Salaries and benefits, occupancy, and furniture and equipment costs declined $400,000 or 7% during the third quarter of 2010 compared to the third quarter of 2009, and are down $2.5 million or almost 13% during the first nine months of 2010 when compared to the same time period in 2009.

Nonperforming asset administration resolution costs totaled $2.9 million during the third quarter of 2010, unchanged from the third quarter of last year. However, the cost during the first nine months of this year totaled $7.9 million, compared to $5.0 million during the first nine months of last year. During the first nine months of this year, valuation write-downs on and net loss on the sale of foreclosed properties totaled $3.1 million; property tax payments aggregated to $1.7 million; and legal expenses totaled $1.6 million.

We remain a well-capitalized banking organization and our regulatory ratios have increased throughout 2010. As of the end of the third quarter, our bank's total risk-based capital ratio was 12% and in dollars was $30 million higher than the 10% minimum required to be categorized as well capitalized. At the beginning of the year, our bank's total risk-based capital ratio was 11.1% and the surplus was about $18.5 million.

Local deposit and sweep accounts are up $94 million during the first nine months of 2010 and are up over $300 million since the end of 2008. Combined with the reduction in our loan portfolio, we have been able to reduce our level of wholesale funds by $646 million since the end of 2008. As a percent of total funds, wholesale funds have declined from 71% at the end of 2008 to 47% at the end of the third quarter of this year.

Our loan loss reserve was $43.9 million as of September 30, 2010, down $3.9 million from the beginning of the quarter. However, the reduction primarily reflects the charging off of almost $11 million in specific reserves that were created through provision expense in prior periods. At the end of the third quarter, only 14% of loan loss reserve was comprised of specific reserves, compared to about 35% at the end of the second quarter.

While the reserve coverage ratio declined slightly during the third quarter from 3.38% to 3.30%, this quarter's ending balance represents a substantial increase in general allocations. Provisions to the reserve totaled $10.4 million during the third quarter of this year, an increase from the $6.2 million expensed during the second quarter of this year but a decline from the $11.8 million provided during the third quarter of last year.

Approximately $3.8 million of the current quarter provision reflects the net impact of changes made to reserve allocation factors for accruing loans and leases and an additional $2 million due to the return of almost $8 million of nonaccrual loans back to performing status and into the pooled application factors.

Those are my prepared remarks. I will now turn the call over to Bob.

Thank you, Chuck. My portion of the call will be dedicated to the Company's asset quality and will be an amplification of the very detailed information presented in the press release today.

Mercantile experienced some nice reductions in net nonperforming assets during the third quarter, the second consecutive quarter of NPA decreases. In March 2010, nonperforming assets totaled $117.557 million and dropped to $110.553 million at June 30 and as we are pleased to report this morning that as of September 30, NPAs have been reduced to $92.397 million. This continues the theme that we were witnessing at the end of the second quarter with some signs of stabilization in the portfolio.

The $18 million net reduction in NPAs during the third quarter is broken down as follows. Principal payments of $5.4 million; sales proceeds of $1.2 million; loans upgraded and returned to performing status of $7.9 million; plus loan charge-offs of $12.8 million; and valuation write-downs of $1.6 million, more than offset $10.9 million in nonperforming loan additions.

It should be noted that the $92 million in nonperforming assets includes $5.9 million in restructured but accruing loans where the bank is working with distressed borrowers to provide relief with some loan modifications. Most of the NPA productions came from decreases in the various commercial real estate and residential land development and construction categories.

Net loan charge-offs during the quarter totaled $14.3 million compared to $8.6 million in the second quarter and $6.2 million in the first quarter. Of the third-quarter losses, over 75% of the charge-offs -- over 75% of the charge-offs were previously reserved and recognized efficiencies from an income statement standpoint.

Some additional details on the third-quarter charge-offs, $6.8 million was attributable to commercial real estate non-owner occupied; $2.2 million for commercial real estate owner-occupied; $2.1 million for residential land development; $1.5 million for commercial and industrial; at $1.2 million for residential owner-occupied rental.

Provision expense for the quarter totaled $10.4 million. Major allocations were as follows, $2.6 million was for commercial real estate non-owner occupied; $2.7 million was for multifamily residential; $1 million was for land development; and $3.8 million was for general pool allocations to bolster the reserve. Loans delinquent 30 to 89 days totaled $1.3 million at September 30. This continues a nice trend of modest and even minimal delinquencies outside of nonperforming loans in the portfolio.

As we have discussed in prior calls, one of our strategic initiatives is to reduce exposure in our portfolio to commercial real estate. Year to date in 2010, we have reduced CRE by $122 million in outstandings and commitments, including $87 million in land and real estate development and not owner-occupied commercial real estate.

That concludes my prepared comments. I will be happy to answer any questions in the Q&A and I will turn it back over to Mike.

Thank you, Bob, and thank you, Chuck, for your presentations. At this time, we would like to open up the phone lines for any questions.

(Operator Instructions) Stephen Geyen, Stifel Nicolaus.

Good morning, guys. Certainly the decline in non-accruals and NPAs was nice to see. Could you talk a bit about the changes made to the reserve allocation factors in the quarter?

This is Bob. As we continue to do every quarter, we look at our reserve, analyze the various components of it, look at the various quantitative and qualitative environmental factors that we see based on the wide landscape of things that go into the reserve calculation. And we felt that it was prudent to pump some additional funds in there to bolster the reserve based on some of the things we are seeing. And as you can see, we were able to add $3.8 million, as I mentioned, into to the general reserves for the quarter.

That certainly bodes well for future quarters, as we have loans that may develop into problems. There's already a hefty reserve allocated against them and will cause us to have less specific reserves in the future as loans may tend to fall down into rating categories that already have a large block of reserve plugged in against them.

I guess could you just give a little bit more color on the commercial real estate? Any thoughts on stability of the commercial real estate values over the last couple quarters or so?

Based on our valuations that we have seen in terms of ORE that we have sold and also with appraisals that have come in, our carrying values have been holding up very, very well. I think we've taken an aggressive approach, as we always have, on valuations of both impaired loans from a real estate standpoint but also just looking at valuations as we do general collateral analyses on performing loans. While the values are very, very low, we have seen some stabilization there and that is something that we hadn't seen in certainly 2009. So from that standpoint, it is an encouraging sign.

Okay, maybe a question for Chuck. End of period loans, certainly it's difficult growing from almost any bank out there today. Where do you think that might go over the next quarter or two?

I'll let Mike and Bob trip on that one, too. They are a bit closer to the loan portfolio than I am. But certainly we would very likely see a continued decline for some of the same reasons that we have seen over the last really year, year and a half, or two years. We still don't have much new requests coming from existing customers to buy equipment.

I think our C&I segment of the portfolio is doing very well, but we don't really see a lot of growth coming from that segment. But certainly a solidification in their financial performance, but again they are not coming and asking for equipment loans. We don't really see a huge increase in our line usages as well.

Okay, thank you. I guess, Mike, if you have any comments?

No. I think Chuck answered the last question very well as far as the overall again situation, Stephen. The thing we are very happy to see is a 16% reduction in non-performers. This is really the first time in two years we have been able to see a real, tangible shift in what's going on and we were, as you know, a little optimistic last quarter when we though we saw the crest.

We're much more optimistic now that we are seeing the drop. And as I said in my opening comments, we have learned the hard way that your level of non-performers kind of predicts where your credit costs are going to be for the next few quarters. So it's really nice to see it come down.

Okay, thank you.

(Operator Instructions) Terry McEvoy, Oppenheimer.

Good morning. It was nice to see the additions to NPAs down again to $11 million. Could you just comment on those inflows? Is there any theme among your borrowing base? Is it just customers who have held on this long and are just unfortunately rolling into or moving into NPA status?

I will let Bob add any color to the comments, Terry. This is Mike. But you kind of hit the nail on the head. A lot of the stuff that we saw roll into nonperformers this quarter, if not all of it -- it might have been all of it -- was stuff that we really already were aware of. It was on the watch list. [A lot of people are geared towards] who had been just going to the hip pocket so to speak, making the payments, struggling along and they just kind of gave out because of a prolonged assault on their liquidity, if you will. And so we felt it prudent to move it in nonperformers.

Our lending staff continues to do a very good job of identification of loans that are experiencing some distress, taking what we feel is a very conservative approach to loss -- to loan -- problem loan identification. And as we see, as Mike said, some customers who are continuing to see distress and cash flow becomes very tight, loans gets [pulled] up to nonperforming status.

Returns to performing status, the $8 million, and then I go up to the table above there, nonperforming assets. The biggest drop was in that land development -- excuse me -- construction bucket. Was that where you saw the biggest return to performing status or was it somewhere else in the portfolio?

Loans returned to performing status were commercial real estate loans and what you have sometimes is you have loans shifting between buckets. You have what was a construction loan, it tends to move towards other normal performing real estate status categories as they flip out of construction stages into occupancy stages. I think that's where that loan or those loans continue to be having the biggest impact is loans that were in a development and construction bucket and a nonperforming state simultaneously moved to occupied real estate performing status during the quarter.

I did pull up the deposit market share in Kent County, where you guys are number four. And as I look at the three ahead of you and the one behind you, all four of those banks making money or expected to make money this quarter. Two out of those four have repaid TARP.

How -- I just a question on the competitive landscape, still losing money unfortunately and still having TARP. Does that have any significant impact on how you conduct your business and how your customers or potential customers view you as a bank or potentially a new bank to do business with?

No, I don't think that it has been a significant issue because most of our customers and most of the people out there in our market understand that it's a very difficult environment especially for community banks like us who try to build their communities by financing a lot of real estate. That was a big part of what community banks did and still have on their books.

They are very happy that we have TARP. They are very happy that our capital ratios have remained in the well-capitalized status because that's a very, very important part as far as the safety aspect of it. And I think there was a little political I guess smoke when TARP first came out, but now that people understand better what TARP is, they are very glad. We have very, very strong well-capitalized ratios.

This is Chuck. If I could just add to that, we spend a lot of time talking with our depositors not only about the deposit offerings that we offer and we offer a lot of robust deposit offerings, but also about our financial condition. The three of us are more than happy to sit down and talk with these depositors, big, medium, or small size, and let them know and understand the condition of the bank and what we are trying to accomplish.

But we've also spent a lot of time especially over the last couple of years of adding a lot to our menu of deposit products and whether it's an Internet banking product or new products that we are offering, we spend a lot of time on that and I think our customers really appreciate the delivery that we are able to provide them.

I think the proof is in the pudding. We can talk about these issues and try to observe lots of different attitudes out there. But at the end of the day I think Chuck mentioned earlier in his comments, our local deposits are up substantially over the last year or so and I think that's really probably the best way to gauge what our customers and what our potential customers think about the bank.

Okay, I appreciate the insight. Thank you.

John Barber, KBW.

I had to hop on the call a little bit late, so I apologize if you already covered this, but can you talk about what drove the increase in non-owner occupied CRE net charge-offs this quarter?

As we mentioned in the comments, John, we had a total 75% of the charge-offs for the quarter were previously reserved. In the course of a loan workout, a lot of those specific reserves against the commercial real estate became time to be charged off based on the developments of the overall direction of the workout. And what we saw is the end result. So the timing of it was such that it was prudent to take those losses now. But from an income statement standpoint, they had been previously reserved and recognized from an income statement standpoint in prior quarters.

Okay, thanks. And on the margin, I'm just curious what happened to loan and security yields this quarter.

What was that? Sorry, I couldn't hear the whole question.

Just wondering on the linked quarter basis what happened to loan and security yields this quarter?

The loan yields continue to be extremely stable and the security yields, it's a really good question because we're starting to get a little bit of compression on the securities with the calls that we've been getting and will likely continue to get with rates coming down like they have throughout the summer and into early fall here. We are getting quite a bit of volume of calls. We put a lot of our -- over 50% of our portfolio are callable government agencies, primarily a Federal Homeland Bank and Federal Farm Credit Bank, and they are certain taking the opportunity of low rate environment to go ahead and call and reinvest at much lower rates.

So we do have collateral requirements, so most of the items that we get called, we do have to put the money back to work to continue to provide the collateral. Certainly our yield is being impacted by that. But again, obviously the securities portfolio is a relatively small part of our total assets, too.

Thanks for the color. Thank you.

Greg Dodgson, Royal Securities.

Good morning. I was looking at the margin relative to Fed Funds sold. It appears that the question before, you know, are you guys doing very much banking? It seems like a poor allocation of money to me.

Greg, this is Chuck. One of the things that happened is we have been keeping and will likely continue to keep our Fed Funds around $50 million to $60 million. We think that's prudent to do given the state of the economy and the banking industry as well. Obviously where we are at almost $150 million at the end of the quarter is well above that.

The reason for that -- and it actually kind of goes back to a question earlier -- is we had just been getting a tremendous amount of local deposit growth and with those monies coming in and also getting some paydowns on some loans, you saw loans came down quite a bit there in the third quarter. It takes a little bit of time to put that money back to work. So when we get the cash and we invest that on an overnight basis to Fed Funds, and then certainly what we try to do primarily is get rid of our wholesale funding. Our wholesale funding is primarily fixed-rate instruments, so we have to wait for the maturities to come up. They do come up and then we go ahead and release them whether they are broker deposits or Federal Home Loan Bank advances.

In fact, already this quarter earlier this month, we did prepay $40 million of FHLB advances to start reducing that Fed Funds balance and certainly we expect that balance to be much closer to the $50 million or $60 million later here in the quarter and by the quarter end.

Are you pursuing this new SBA thing at all? Huntington has done -- is doing a marvelous job in that area.

Well, we are continuing to look at that program as well as other SBA programs, as we've done a very good job over the years of utilizing the SBA tool to place various borrowers that made sense, we place in SBA loans. So we will certainly look at that and use that as a potential mechanism to place borrowers that warrant that in that program.

It was signed into law last month and it's quite a deal. The government is really helping small community banks with this SBA loan program.

Yes, Greg, I will point out -- and again, I agree with you. I think Huntington has done a good job with SBA lending but I will refer you back to I believe it was last week's Business Journal that points out that Mercantile was the number one SBA lender in this marketplace during the last year. So we agree with you. SBA is a good program and we use it a lot, and we will continue to use it when it is the right situation.

Thank you.

[Eric Reboulet], individual investor.

Good morning. Just a couple of questions. One, would you be able to provide a little bit of color about migration and special mention in substandard categories of the loan portfolio?

And then the second question I had was, given that you had a little bit more elevated level of charge-offs in the commercial real estate category, is that going to portend next quarter that the ORE bucket is going to be up? Or in fact are you breaking any loans up into like an A/B type status where you still have a nonperforming piece but as you mentioned before, there was some element that had returned to performing in the TDR status?

This is Bob. To answer your question on migration, Mercantile Bank has performed migration analysis for some time and it becomes one of the tools that we continue to utilize in the determination of the adequacy of our reserve. A lot of moving parts to migration analysis and the one that tends to change from quarter-to-quarter certainly and we make adjustments to that as appropriate. It's not a simple calculation. It's certainly one that as I said has many facets and one that we use to gauge the movement of loans between the various loan rating categories, as you alluded to.

With respect to ORE, as you can see by the numbers, we have actually had reductions in the overall ORE level over the last couple of quarters. But with that, there have been a lot of loans that have came into ORE and a lot of sold pieces of assets that have gone out of there. I think our staff has done a good job of working with borrowers on properties that are even in foreclosure to try to affect sales of those properties so they maybe never make it to the ORE bucket.

Loans that's do make it to foreclosure -- through their foreclosure process many times have buyers that are waiting at the end of the redemption period to be able to complete those sales. So -- but it's really -- it's a case-by-case basis. You have some properties that are a little bit harder to sell, maybe spending a little bit longer time in the ORE bucket. And others that are more attractive from a purchaser standpoint in this environment, have a tendency to spend a lot less time in those categories. But each loan, each property is taken on a case-by-case basis.

This is Mike. I appreciate the granularity of the question and I don't know that we would be prepared with a number right at our fingertips to talk to you about the substandard and special mention granularity. But I will go back to some of the more general questions we gave you -- or comments we gave you at the beginning of this and that is we are very happy to report that nonperformers in total are down. Watch list totals are down and past dues are down. That has been a trends now that we've seen for two quarters in a row. And I'm almost ready to say two quarters does make a trend, but if we see it again this quarter, which no reason to believe we won't see a continuation of improvement, then we are going to be even more optimistic that we are getting on the right side of this crisis.

What is also good to see is not only have we had loans that been taken off the nonperforming list because of nonperformance, we had loans that are just on the watch list that have never made it to nonperforming status are also being upgraded to show that I think we are taking the right approach in our grading of loans and being somewhat conservative in putting loans on a watch list for monitoring purposes. As the loans have been improving, they get upgraded.

No, I think you answered the question with just your last comments on the watch list trends. I think that probably speaks well enough. One last thing for Chuck. Just in terms of the wholesale deposit costs versus sort of your local retail area, what are you looking at differential wise there?

Eric, on a CD basis, we are probably 75 to 100 basis points above the brokered market. And I think that generally speaking the brokered market and the local CD market historically has been about the same, maybe a little bit of a premium to local deposits. I think the reasons why the wide disparity is on both sides of it. One is the regulators do not like brokered deposits. Certainly this bank hears about it from regulators and in talking with other banks and reading I am sure some of the same articles you do, regulators do not like brokered deposits. And so banks are shying away from it.

Certainly many banks are strengthening their balance sheets, as we are, and certainly letting brokered deposits run off. Then you got on the investor side, which mostly deposits are coming out of the retail brokerage. A lot of investors are certainly skittish to getting back in the stock market. So what you have is just a tremendous amount of supply potential investable funds, but not very many banks out there that want that, which obviously is impacting the price.

Going back to the comments that the regulators don't like brokered deposits, well, if they don't like brokered deposits, you can certainly shrink to get rid of some of them. But you can also replace them with local deposits, so you got the same banks that are trying to reduce their brokered deposit reliance are out there also trying to increase their local deposit gathering activities, which certainly therefore increases the rates.

So I think that wide gap we are seeing now is for those two primary reasons and who knows what the future is going to be and how the regulators deal with brokered deposits going forward?

Okay, but you are seeing a little bit of pressure then from sort of the core retail side of the deposit base given that competition?

Yes, I think pressure meaning higher prices or --?

Yes (multiple speakers)

Yes, definitely.

Okay, thanks a lot.

You are welcome.

Thank you, sir. I'm showing no further questions or comments at this time. I would like to turn the call over to Mr. Price for any closing remarks.

Thank you very much and if you have any additional questions, please feel free to give any one of the three of us a call. We appreciate your interest in our Company.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Have a wonderful day.