Midwestone Financial Group Inc (IOWA) (MOFG) 2016 Q3 法說會逐字稿

Good day and welcome to the MidWestOne third-quarter 2016 earnings conference call.

(Operator Instructions)

Please note this event is being recorded. I would now like to turn the conference over to Charlie Funk President and CEO. Please go ahead.

Thank you very much Carie. Good morning everybody and thank you for joining us on the call. As I always do, I want to give the forward-looking statement which simply says the presentation contains forward-looking statements relating to the financial condition, results of operations, and business of MidWestOne Financial Group. Forward-looking statements generally include words such as believes, expects, anticipates, and other similar expressions.

Actual results could differ materially from those indicated and among the important factors that could cause actual results to differ materially are interest rates, changes in the mix of the Company's business, competitive pressures, general economic conditions, and risk factors detailed in the Company's periodic reports and registration statements filed with the SEC. MOFG undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances after the date of this presentation.

With that I will get started and talk quite a bit about the third quarter and then at the end of my prepared remarks maybe give a little bit of guidance for the fourth quarter and for 2017. Even though it may be limited, there will be some guidance.

There is no doubt, and I indicated this in my opening commentary, in the earnings release that we were disappointed with the third-quarter earnings per share. That said I think there are a lot of reasons for optimism in our Company which I will cover in these remarks.

We had one-time items that actually offset each other even though they may not have been reported that way. During the quarter, we of course had the sale of our Davenport office which was offset by two items that were somewhat extraordinary.

We had a roughly $200,000 wire loss at the beginning of the quarter that we recognized during the quarter which simply came as a result of employees not following proper policies and procedures. So we endured that, and we also had a $400,000 writedown on OREO and that was as a result of a development loan that was made, I believe, in 2010.

The appraisal came in, we took the writedown, and when you put those things together they essentially offset each other. As we indicated we lost a little over $30 million in loans when we sold the Davenport office. We replaced about $10 million of the $30 million as of the end of the third quarter and today, as we near the end of October, we have probably replaced another $7 million to $10 million depending on the day.

We are in the process of replacing those loans. I think the exciting thing, and we talked at length in the last earnings call about how the pipeline have gotten sparse. We have a very, what I would call, robust pipeline of loans well in excess of expected pay downs.

The trick is to get the loans closed. They have been for the most part approved and in November and December I would think we should see very good months in terms of getting these loans closed. The question always comes where these loans coming from? The answer is not much different than it has been in prior quarters.

The Twin Cities market, especially the closer you get to Minneapolis and its suburbs, Minneapolis St. Paul and its suburbs, continues to be very strong. The Iowa city market has seen good activity as well, with one large construction loan that has been approved and will come on over time.

If you look toward year end, it's always a guessing game because you don't always anticipate pay downs. But I will give you a range of $2.170 billion to $2.190 billion in terms of where we think we should be at December 31. But again that is affected by how quickly these loans close and also the related pay downs that we can't always predict.

One other thing that I commented on, Katie can comment in more detail if you like, but the accretion income that we have been receiving, especially in the third quarter and will continue on in the fourth quarter, has been a little bit less than it would have otherwise have been because of the impact of writing down the FDIC receivable more perhaps than we had anticipated. The good news is that the accretion should become more of a tailwind as we get into 2017 and the FDIC receivable is essentially written off.

In terms of deposits. Deposits have been okay. We've talked at length about our treasury management focus. And we've talked about that for roughly 18 months. There is a good pipeline of anticipated deposits that we think are going to continue to come on. We have had a couple of large deposit payoffs and you get this with large deposit customers.

In one case the customer changed its investment strategy and moved a large sum out of the bank. And then we had another large customer this week that moved money. But again these things are just in the ebb and flow of business and I think the most important thing is that there are lots of calls being made we think that deposit generation will be easier and better than it has been in the past.

You talk about noninterest income. Our wealth management unit is down year to year. Most of that is in the brokerage area. I think many of you know that we clear through LPL, so we get good market data and industry data from LPL.

And it's interesting to me, that even though the stock market is having a reasonably good year this year, that bank brokerage commissions are down throughout the industry. And it would appear to me based on the data I have seen, that ours are down about the same amount that other banks brokerage commissions are down.

We've hired one broker for the Twin Cities footprint and we are hopeful in the next six months that we will be able to hire more in that footprint. But at this point in time we don't have signed agreements in place.

That leaves our trust and insurance units and wealth management and their results are relatively flat with a year ago and we have been crystal clear with all three of these units that we need growth in top-line revenues and that will be a focus as we move into 2017.

Mortgage had a good quarter. The fourth quarter is starting well. We typically get a slow down as we approach the holidays. The MSR writedowns continue to be an issue that drag on that business. That is just part of the business you're in if you're going to service mortgage loan portfolio's.

But we are hopeful at this level of interest rates that it will be a positive adjustment for the fourth quarter although we really can't estimate that because we don't know what the interest rates will be as of quarter progresses.

On expenses, I think it's a good story on expenses. We've talked ad nauseam about the need to reduce expenses and I would tell you that we are probably a little ahead of our schedule. And the salary numbers should continue to come down as time goes by. Katie can talk more in detail about that if you would like in the Q&A.

We are also beginning, it took a while but we are beginning to see some of the data processing savings come into the income statement as the contracts get signed and the savings become realized. We have talked about the consultants that we hired. And yesterday we actually had the final meeting and it was a very good meeting.

It's really too soon to talk about the opportunities that we think we have in 2017. But I am more than confident, I am certain that there will be more progress that comes to the bottom line as a result of these recommendations. I thought that they did a very good job, as did our employees, in working with them.

I think when all is said and done the biggest positive will be hard to measure. But there are a lot of processes that we had both at Central Bank, which when it merged with MidWestOne was $1.2 billion and at MidWestOne which was $1.7 billion when we merged. And when you have a $3 billion bank, you need different processes. You also have to have the ability to scale going forward and I think there is going to be a lot of refinement there that will only make us a better and more efficient Company.

A few words about asset quality. Very stable. You see that the net charge-offs, 8 basis points that is very good. We have talked at length for the last four to five quarters, about a large loan that is on nine accrual. It's an Iowa City area loan. I think it's fair to say it's a little closer to resolution but I wouldn't want to predict resolution in the fourth quarter but we are moving down a path there but as with all of these things it's hard to predict when you could actually get that wrapped up.

The crop report which plays into our agricultural loan portfolio is -- the crop report is incredible. For those of you who are familiar with the work-bin buster, this is probably a bin-buster crop if there ever was one. We are hearing throughout our footprint, probably the worst we hear is average yields but in many cases they are seeing all-time highs in terms of yields. And even throwing out in portions of fields 300 bushels an acre which, 10 years ago, 200 bushels was a very good harvest.

That doesn't totally make up for the low crop prices. But it helps because there is more crops to sell. I think our borrowers do get a little bit of a break in terms of most of them are seeing very good yields.

We always say this on the third-quarter call, and the questions will come, how many downgrades do you see on all of that? Well the next 90 days we will begin the renewal season. We're going to try to expedite the renewal season as much as we can with our borrowers so that we can get a good idea of just where they stand.

I don't think there's any question we will see some credit downgrades. But I think we will have a much better idea of what this means for our income statement by January when we host that earnings call. Be assured we are proactive and that I don't think that there's much of an income statement impact for the foreseeable future.

But as I have said many times, the longer this goes on the more stress it causes and inevitably you may see some charge-offs. We have reserved quite aggressively for our ag portfolio within our loan loss reserve and, at this point in time, I think it fairly states with the credit quality is. But it will be interesting to see as we go through the renewal season just how many credits are downgraded.

A word about capital. I think capital is fine. Think we are on target in terms of our projections, we should be over 8% tangible common which has been our goal by the end of the year. I would remind everybody that we do analyze the dividend at our January Board Meeting and I think probably there is a good prospect for an increase.

What it is I don't know. We really haven't given too much thought to that just yet. In terms of M&A there is certainly nothing eminent but there have been discussions and I would characterize most of them as preliminary discussions at this point. But more and more you are seeing banks that are in the $100 million to $1 billion range just wondering what their long-term future is with the incredible amount of regulation we have.

I think the longer this low interest rate environment goes on that has an effect on it as well. The growth, as I said, in quarter four and in 2017 and I think really has to come mainly from Iowa City and the Twin Cities. I feel good about our prospects there. I also think we have to understand that roughly a quarter, 20% to 25% of our footprint are in rural markets.

And the rural markets if they are not in recession they are in very slow economies because if they are driven by agriculture the people in agriculture are not spending the money. They don't have the discretionary income to spend that they've had in prior years. So, to expect much growth out of that part of our footprint is probably not realistic.

But again we are very fortunate to be in Iowa City and to be in the Twin Cities because those economies are very strong. I think, one other thing that is not financial but it's very clear to me and I think it's clear to everyone on our Senior Management Team, that with each month that passes that we are working more and more as one team.

The morale is better. And I think, as much as anything, that adds to my confidence level because companies can't succeed with poor morale and I don't sense that there is much evidence of poor morale at this point in our footprint and that makes me feel very good.

In terms of 2017. A couple of words when talking about 2017. In retrospect, as I look back, we did not do a very good job of budgeting in 2016. In some ways that's understandable. And I think as we look back to a year ago, when everything was coming together with the merger of the banks, we just missed a few things in our budget, but I'm very confident and certain that we have learned from our mistakes.

We have focused little more effort on 2017 earlier than we have in past years, because people have been asking and I appreciate that. And the only other thing I would say about 2017 is that as I look at the estimates that are out there, I am confident that the estimates that are out there are accurate.

I think this is the first quarter in three or four quarters on this call that I could speak with a real sense of optimism. But I feel like that there will be progress made in the fourth-quarter 2016 and I think 2017 becomes a pretty good year and I feel good about our ability to lay out what has been projected for us. The only thing I would say in concluding is that as disappointed as we were our return on tangible equity was over 12% and I think we have the ability to do better than that.

And I am also encouraged that the efficiency is coming down. I think the efficiency has come down primarily because of the past expense reductions and current expense reductions that we have been able to enact. I think to get our efficiency below 60%, and to sustain that, that revenue growth has to come in a little bit more than it did this year and again I think that we should be able to do that.

In terms of our margin, our margin is -- those of you who follow our income statement know it bounces around a little bit because the amount of the intangibles and the amortization and the discount accretion that comes in. So we look at our core margin and pay a lot of attention to that. And I think that the best we can come up with right now is probably 1 to 2 basis points a quarter of narrowing in the core margin because our loan portfolio tends to just come down a basis point or two a quarter and it looks like, to us, that our cost of funds has probably bottomed out a little bit. There may be a little bit of opportunity there. We will get rid of some high-cost federal home loan bank borrowings that mature as we go on.

But by and large I think our cost of funds is probably pretty much it bottom. If we could keep it around these levels that will more than likely be a good achievement. So, with that, I think that is all I have to offer this morning in the prepared remarks and Carie, I would turn it back over to you for the Q&A.

We do have in the room Katie Lorenson our Chief Financial Officer and Kent Jehle, our Chief Credit Officer available to answer questions. So, Carie, I will turn it back to you.

(Operator Instructions)

Our first question comes from Jeff Rulis of D.A. Davidson. Please go ahead.

Thank you. Good morning.

The morning.

Question on the -- honing in on the costs. First of all the $200,000 in merger costs was that centered in any one line item or items? Just trying to map where that would come out of.

I believe that was in the data processing. This is Katie, Jeff. That was in the data processing line item for the most part.

Okay great. So if you back that out and you get to a low $20 million, call it a $20.2 million-or-something run rate and then expectations of further improvement. Could you talk about one, is that run rate de-anticipate to some modest improvement as we roll into 2017? And ultimately where you're cutting a bone or where it stops from that basis.

Sure. Yes, I will take that one. We do anticipate further reductions in that non-interest expense line item. As you recall our cost save goal is to get that to about $19 million per quarter. And we do look for, again, further decreases in Q4 and then continue drops in 2017 to get us to that goal.

And so the goal is to maybe hit that $19 million at Q4 of next year?

No, I would say that, just to be very clear, the $19 million is excluding the amortization expense and we anticipate hitting that goal in Q4 of this year. Or coming close to it and then getting there for sure in 2017.

Okay. Got you. And then maybe just circling back on that margin. What was the core margin if your reported was [3.72%]?

The core margin for the quarter was [3.61%]. The purchase accounting for the quarter was about $800,000.

And what was the purchase accounting -- so if you had 11 basis points this quarter what was that in Q2?

In Q2 the core margin was [3.69%]. With purchase accounting of about $1 million.

Great. Okay. That is helpful. And then just one last one on the tax rate. Any commentary about how you closed the year and maybe into 2017 any estimates there?

Yes we are seeing the tax rates increase from where it was with the historical MidWestOne financial growth and of course we have a historical tax credits in the prior year. So that does appear that, that is going to be closer to the 30% range. Which is a couple basis points higher than it had been in the past.

Okay. Thank you.

(Operator Instructions)

Our next question comes from Andrew Liesch from Sandler O'Neill. Please go ahead.

Hey guys. Everyone.

Good morning.

A question on your efficiency ratio targets. It seems like some of that is going to be from lower expenses but also higher revenue. Is that correct?

Yes.

And on the revenue side I'm just curious what you think is going to be driving that? Is that going to be better fee income, loan growth, a better margin next year because of less writedown because of the receivable? If you can just give some direction there.

I think, Andrew, it's all of the above. We have been writing down the FDIC receivable or amortizing that receivable. And most of that amortization does relate to improved credit quality.

So that means more accretion will be used for future income than it will be used for absorbing credit losses. So that certainly impacts the efficiency ratio going forward.

And then we do look, as Charlie alluded to in his opening comments, additional top line revenue growth from our wealth management mortgage trust. And then again that non-interest expense is continuing to come down in 2017 will all attribute to dropping that ratio to our goal.

We have to see -- I just would just add, we have to make sure that we returned a little bit more balance sheet growth and I think the growth on the balance sheet will contribute to that as well. Again we do have a little bit of a headwind as I said because of our locations that are located primarily in rural Iowa that its not realistic to expect growth. Where we are just trying to maintain and make sure we keep credit quality. But we do think that Iowa City, the Twin Cities, and to a little lesser extent Cedar Falls, Waterloo can help us in terms of the revenue growth. It's offset(technical difficulty) that in rural Iowa.

Okay great. Thanks. That's my only question.

Our next question comes from Daniel Cardenas of Raymond James. Please go ahead.

Good morning guys.

Good morning.

Maybe just a quick question on what line utilization look like this quarter versus last quarter.

Yes, Dan, this is Kent. I can answer that. The line utilization was up in the third quarter primarily driven on construction side as we continue through the construction season.

I will add though as we look into the fourth quarter we are starting to see that turn the other direction on ag as we get into the harvest season we are seeing obviously current year operating loans of portion of those being paid back as our clients are selling grain right out of the fields and paying down their debts. So we look at that -- the gain we picked up in the third quarter we are starting to see that erode in the fourth quarter and won't lean on that for our loan growth as we look at the fourth quarter.

And maybe just a quick question on the ag portfolio. A while back you guys stress tested that portfolio and I think you indicated that you felt there were losses, they would be coming at the lower end of your range. You still feel that way given where commodity prices and yields are shaking out right now? Or is there a change in your overall concern about the portfolio?

Kent again I will answer that it get as well. I would say we are still are in the same position. When we look at how it was stressed prior.

As Charlie alluded to the yields are coming in very strong and actually when you look at the yields in Iowa they are above the national average and the average is around the surrounding states. Again that gives us the commodities to move forward with. The key is going to be the marketing as we go through the rest of the season.

As we only saw about 15% of the current year's crop price prior to going into the harvest season. So we are subject to the current market prices we see today but again we will be working closely with our clients to get their take on how they're going to market the grain over the upcoming months and into next year. The good news is, again, we were ahead of the game when it comes to the yields and what we have to sell we just need to work through marketing piece.

That makes sense. And then as you look at loan growth in the Twin Cities and Iowa City, which market, and I'm sure they are both very competitive, but are the yields coming out of the Twin Cities substantially lower than what we are seeing in Iowa City?

I would say they are very comparable. I think the nature of the competition is a little bit different, but I think where it all falls out, but I don't see a whole lot of difference.

The only other thing I would add to that, Dan, is we've talked in the past, we did dip under 4% on our commercial real estate rates at [3 3/4%]. That did get us back in the game on quite a few conversations and is part of what's driving the pipeline that we are experiencing right now. And that is for both markets, as Charlie is alluding to.

We just approved a nice loan yesterday. It was a variable-rate loan and it was priced at 3.5% variable, more or less, and we thought that was pretty good terms to get the variability.

It's out there and you just have to make sure that you don't compromise too much on terms. Because there is still whole bunch of compromising on terms going on, at least we see that at our loan presentations that we hear from our commercial bankers.

All right. And then just a couple more questions here. As we think about the margin, and thank you for the guidance that you gave, have you priced in any rate hike for 2017 in that margin assumption?

No. We typically don't. But our Treasurer, Jim Cantrell, would tell you that a rate hike is a good thing for our Company. So, we probably would get a little bit of a boost there, I think as many banks would if they were to raise rates.

Okay. And then last question, how should we be thinking about your provision expense going forward?

That is a great question. I will look to our Chief Credit Officer.

Well, there is two components to that, and I will have Katie add to this as well. For our existing portfolio, how we traditionally look at it, we would look at that comparable to what we have in the past, so no real changes. But obviously the purchase accounting aspect of that does come into play, so with that I will defer to Katie to look at what the all-in number would be as we look forward.

Thank you. And I think based on what we are seeing as far as projecting out what we can with new renewals and such, I think the provision would stay at about the same pace as it has been the past few quarters.

Dan the only thing I would qualify is, obviously if we have a hiccup on the credit side, that we would need to identify and realize the impairment that would come into play. And the only thing I would share that we do have one credit in the 30 to 89 day category that we're watching very closely to see where we sort out with that one. And that will occur in this quarter if there's anything that's going to be needed above and beyond what we normally look at. But again, obviously we always got to mention if there's anything that would come up as a surprise that we would need to deal with.

Okay. Great. Thank you, guys.

Thank you Dan.

Our next question comes from Brian Martin of FIG Partners. Please go ahead.

Good morning.

Good morning Brian.

Maybe just a couple things here, Charlie it seemed like last quarter you were fairly bullish, if you will, on loan growth and the momentum that you had. And I realize you have the Davenport sale this quarter, but we've also heard from your competitors that there has been a little bit of a slowdown of C&I demand in some of the markets. Just trying to get a sense for, have you guys changed or have maybe different thoughts on the growth outlook on a net basis going forward as you look at 2017?

It sounds like the pipelines are strong, should carry a good fourth quarter based on the range you gave. But how you think about 2017 at this point, and is there anything with ag being a little bit slower now, maybe some C&I slowdown? Are you seeing that and does that temper your outlook on loan growth for next year?

There is still a lot that is out there and there is a lot of calling efforts, and I think that we typically don't project 6%, 7%, 8% loan growth. As a Company, and I think we've been pretty consistent in the past that we just expect 4% to 5%. I think given the markets we're in, some markets will be over that and some markets will be under that, but I'm still in the 4% to 5% range for loans and maybe 3% to 4% for deposits, I think that is a realistic expectation.

Again, I think if there is one surprise, good surprise for us, I think it's that our Treasury management area could come in ahead of what we think and produce higher deposit growth. So we probably would say the same things every fall when we talk about the next year, but we've never been one to forecast double-digit loan growth. But I think we should be able to deliver 4% to 5%.

Perfect, that's helpful. I know you mentioned some of the nonrecurring items that were in that other line in fee income, but when you guys look at the current quarter as a core run rate for fee income and you net out some of those items, is it what the reported number was -- the [5.7%, 5.6%] type of number? Is that a clean number as you guys look at it, or was there something I am missing in there?

Brian, this is Katie. No, I think you're right. The [5.6%, 5.7%] because we did have Davenport gain offset by the other real estate loss, but then also in there is the MSR writedown, and that was about $200,000 for the quarter. In that [5.5%, 5.6%, 5.7%] range should be a run rate going forward.

Okay. Perfect. Then maybe one more for you, Katie. In the press release, when you spell out the accretion income, you talk about it being, I thought you said $800,000 or so this quarter.

And in the release I know there's -- some of that tax that you talk about a $600,000 number. The differential, did I miss that in the text? Is there also something that talks the other piece of to get to the $800,000?

Sorry, there's $600,000 is the loan interest income, and then there is $200,000 which is coming to the end of the deposit mark to market, that is positive impact on the interest expense. So those two combined are the purchase accounting entries that are entering into the net interest income and net interest margin.

Okay perfect. And then that $200,000 the you are getting on the deposit side, do you also talk about that in the release? Maybe I just missed it.

I think we did not talk about that in the release. Next quarter I think that is going to be less than $100,000, and then that is the end of the deposit mark to market for purchase accounting.

I got you. Okay, that's perfect. And then maybe just the last thing is, your -- can you guys remind me where your CRE concentration levels are today, relative to the 300% and 100% guidance? Where do you stand on that?

Brian, this is Kent. We are under 250%, closer to 225% of the capital number when you look at that category.

Okay, and I guess just a way to think about this is you're comfortable with that. Your intent is to not to go over those limits, so what kind of the bigger picture thought as you look forward?

I would put a range that we would be in the 225% to 275% range. Again, the regulatory threshold is 300%, and I would see us staying certainly under the 300% as we look at things today.

Okay, perfect. Okay, and I think that's it. You guys said that the tax rate, you're thinking 30% is a good run rate to use going forward?

It is unless we buy more municipal bonds.

Right.

Okay. And the cost savings, Charlie, just to be clear, the numbers that you guys are talking about on the expense side, I think it was $20 million number depending on how you guys do the -- how you handle the amortization expense. The consultants that you've brought in to make some changes or at least give you suggestions, the $20 million number, the target that you've got out there, does that include or exclude their recommendations? I assume it's got nothing of their recommendations in that number right now, so that we could think about it, expenses could potentially be better if you implement some of their recommendations, or --?

Yes, Brian, thank you for asking that question because that was in might remarks and I skipped right over it. That does not include anything from these recommendations. So anything that we would get there would be over and above.

Because we didn't know what to expect, and as I said I'm still trying to get my arms around the whole thing, so I can't really offer any guidance on that number. Just know that we didn't put that in our forecast for 2017 yet.

Okay, yes, that's all I was wondering. And then just maybe for the amortization of intangibles, Katie, do you know ballpark, is this run rate of [970], does that tail off a bit in 2017, or does it stay at this level for a bit? So we're thinking about managing to the numbers you're talking about on the expense side.

It does tail off in 2017. I think the number for 2017 is about $3.2 million and in 2016 it will end up closer to $4 million.

$3.2 million for full year 2017?

Right, and it declines every quarter.

Yes, okay, I got you. I appreciate you guys taking the questions. Thanks.

Thanks, Brian.

This concludes the question and answer session. I would now like to turn the conference back over to Charlie Funk for any closing remarks.

I'd just say thank you for everyone who joined us on the call. If anyone has any follow-up questions, please call either Katie or myself and we will be happy to try to assist. Hope everybody has a great day and a good weekend.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect your lines. Have a great day.