First Security Group, Inc. Q3 2008 Earnings Call Transcript

Oct.21.08 | About: First Security (FSGI)

First Security Group, Inc. (NASDAQ:FSGI)

Q3 2008 Earnings Call Transcript

October 21, 2008 3:00 pm ET

Executives

Rodger Holley – Chairman and CEO

Dave Haynes – Senior Corporate Credit Officer and SVP

Chip Lusk – CFO, EVP and Secretary

Barry Ritchie [ph] – Senior Corporate Lender and SVP

Lloyd Montgomery – President and COO

Analysts

Charlie Ernst – Sandler O'Neill Asset Management

Michael Rose – Raymond James

Sam Caldwell – KBW

Operator

Welcome to First Security Group, Inc. third quarter earnings conference call. There will be a question-and-answer period 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 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 filing. 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 First Security today, you can access it at the company's Web site www.fsgbank.com.

On the conference call today from First Security Group, Inc. we have Rodger B. Holley,

Chairman and Chief Executive Officer, Lloyd L. Monty” Montgomery, Chief Operating Officer and President, William L. “Chip” Lusk, Chief Financial Officer and Executive Vice President, Barry Ritchie [ph], Senior Corporate Lender and Senior Vice President and David R. Haynes, Senior Corporate Credit Officer and Senior 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. Holley.

Rodger Holley

Good afternoon, everyone. Thank you for joining us. Today, we announced our financial results for the third quarter. And I would like to highlight some of the results.

Net income of $826,000, diluted earnings per share of $5 billion. Total assets of $1.282 billion at quarter-end. Total loans $1.17 billion, a modest increase of $10.8 million from the second quarter 2008. Total deposits $976.5 million at quarter-end compared to $950.5 million at the end of the second quarter 2008.

Net charge-offs for the quarter were $2.5 million, 0.98% on a quarterly annualized basis. And the allowance for loan and lease losses was increased to 1.31%, from 1.18% at the end of the second quarter. For the third quarter provision expense was $3.96 million compared to $1.95 million in the second quarter, and $1.18 million of the first quarter. Given the additional credit costs that we and many others in the industry are facing we are pleased with this quarter's results.

I would like to spend a few minutes on the subject of asset quality and then allow Dave Haynes to elaborate further.

In response to the downturn of the national economy, and some slowing locally, the frequency of our credit monitoring have increased. We are taking a proactive aggressive step and managing through credit issues when they arise.

Our third quarter charge-off rate was decidedly larger than we had planned. One relationship accounted for nearly three quarters of the total for this quarter. We had maintained a longstanding relationship with this account. However, the borrowers business saw a quick and pronounced downturn and was unable to refinance and/or sell several real estate related projects due in part to the overall tightening of the credit market. We maintain a relationship with this account and we are aggressively pursuing collection of the charge-off.

Regarding our regional economy, as you may know, we are headquartered in Chattanooga, Tennessee and operating communities along I-75 corridor between Dalton, Georgia, Nashville, Tennessee and along asset I-40 corridor based in Nashville, Tennessee, and this region we did face many of the same economic issues that are affecting most of the U.S. such as slower housing sales, higher gas and diesel prices, and inflationary pressure. However, we are fortunate in that this area has and continues to see positive growth trend.

Without the highs and lows of some market, as you might recall from last quarter's call Volkswagen Group of America announced on July 15 it would build the U.S. automotive production facility on the 1350 acre mega site 12 miles Northeast of Downtown, Chattanooga, and adjacent I-75. This manufacturing plant will bring about 2,000 direct jobs and up to 10,000 related jobs to the area. Hiring has begun and site work is well underway on the new facility which is scheduled to begin production in year 2011.

Because of this economic development in our core regions, we feel the impact of the economic downturn will not be as severe regionally as in other areas. Our analysis of our asset quality indicates that we are running about 90 days behind other areas. And with this economic development we feel we may come out of the downturn ahead of other wages. However, we won't be realistic about our economy.

Our customers are conscious, they are tightening their belts and demonstrating a wait and see attitude. This attitude is reflected in our loan and lease pipeline. Presently, our pipeline is running about half of previous quarter end level or about $45 million.

The loans and leases making up this total are evenly split over all major loan categories. We too are conscious, and we too are tightening our belts. Also, we feel this pipeline is very reflective of our aggressive stands on lending an asset quality. We are not spreading to grow loans, and we have been careful with the type, term and structure of the loans and leases that we did make.

I will now turn it over to Dave Haynes who will discuss the bank asset quality in some detail.

Dave Haynes

Net charge-offs for the third quarter were $2.5 million or 0.98% on a quarterly annualized basis as compared with the second quarter net charge-offs of $1.405 million. The annualized year-to-date net charge-offs through September 30th is 0.63%. As Rodger mentioned, one borrower accounted for 74% of net charge-offs for this quarter.

Total non-performing assets were $15.6 million at the end of the third quarter, up $2.6 million from the linked quarter. The majority of the increase was caused by the addition of $2.5 million and remaining loans placed on non-accrual and not charged off from the one borrower previously mentioned. Non-accrual loans and leases totaled 8.773 million at quarter-end, an increase of 1.928 million from the linked quarter.

Other real estate owned was $5.561 million at the end of the third quarter, up $956,000 from the linked quarter while we possess assets were $1.293 million, down $246,000 from the second quarter.

The classified loans and leases increased by $18.226 million from the second quarter and totaled $54.824 million at quarter-end. Provision for [ph] loans and leases are 50% of Tier 1 capital and 5.4% of total loans and leases. The special mention risk rate grade category has increased to $21.9 million, primarily as a result of CRE, C&D loan downgrade. The special mention loans and leases represent over 2% of total loans and leases.

In the third quarter we provided an additional $3.96 million for loan losses, $1.95 million over the linked quarter and $3.4 million over the prior year quarter. The increase provision was necessary due to the increased stress that is in place on our borrowers. This provision increases our allowance to 1.31% of total loans at quarter-end. The allowance for loan and lease losses to non-performing assets stands at 85.33% at the end of the third quarter. The allowance for loan and lease losses to non-accrual loans is 152% at September 30, 2008.

Total CRE and C&D loans net of owner occupied loans was $275 million as of September 30th which represents a slight increase from $271 million reported from the linked quarter. These groups of loans are 224% of risk-based capital. C&D loans continue to decline and are presently $165 million which is a 135% of risk-based capital as compared to 143% from the linked quarter. We are continuing our effort to identify problem loans early and to seek problem loans strategy to minimize losses.

I will now turn it over to Chip Lusk to discuss our financial performance for the quarter.

Chip Lusk

Thanks, Dave. My comments will touch on the income statement and the net interest margin, but we will focus on our liquidity and capital positions. On a quarter over linked quarter basis our net interest spread improved by $280,000 as our end market CDAR continue to reprice down at a faster pace than our earning asset.

Cost of funding and market retail CD decreased 33 basis points and the cost of funding end market jumbo CD decreased 32 basis points. Overall, our cost of funding decreased 19 basis points to 3.08% whereas our yield on earning assets was down 14 basis points to 6.67%. Our net interest margin expanded by 1 basis point in the third quarter. We do expected to come under pressure again from the Fed's recent 50 basis point rate cut as well as from our plans to enhance our liquidity. Speaking of which we target and maintain our liquidity ratio of 12% non-pledged liquid assets to end market deposit and short-term LIBOR. Short-term meaning one year less.

In addition, we maintain sufficient unused contingent funding sources to adequately meet our short-term needs in the event of a severe credit and liquidity crisis. Looking back to the latter half of 2007 and the first half of 2008 we allowed our overnight borrowing position to increase over $100 million in order to arrive the yield curve down and offset some of our asset sensitivity. Our overnight borrowings are based on Federal funds rate not on LIBOR.

In light of some recent large bank failures we decided to enhance our liquidity, our reducing our exposure to overnight funding and target a cash neutral funding position. Liquidity enhancement and protection strategy we have evaluated over the past six months and adopted over the past few months include Number one, brokered money market which are priced to target fed funds rate plus 50 basis points. Number two, we are cyclical in one way buy CDARS or Certificate of Deposit Account Registry Service through Promontory Interfinancial network and number three, the reserve cash management suite to replace our collateralized commercial repurchase agreement. Paying off our overnight borrowings with these strategy and traditional brokerage CDs will negatively affect our margins, but it will provide us with stability and strength until the national credit and liquidity crisis subside.

As for our contingent funding sources, include $137.3 million of collateralized borrowing capacity, FHLD [ph], $69.2 million of potential repurchase agreement using currently unpledged investment securities. $78 million of unsecured Federal fund lines of credit and the Federal Reserve's discount window to which we have not yet applied but plans to do so as an abundance of caution.

Now, I want to circle back to our liquid assets. Our investment portfolio was $134 million at quarter-end and performing well. We did not hold any Fannie Mae or Freddie Mac common or preferred stock or sub-debt. But we did hold $14 million of AAA Senior unsecured debt which we sold one week prior to the treasury taking the agencies into conservatorship.

We sold the bonds due to the uncertainty of the treasury's role and their lack of communication regarding their willingness to assume the agencies obligation. As a result of the transaction we booked $146,000 pretax gain on the sale which we believed a non-interest income.

Comparing a third quarter with the linked second quarter noninterest income increased by $61,000 or 2%. Excluding the gain on sale of investments non-interest income was down $85,000 or 2.8% due primarily to $78,000 decline in mortgage origination income.

As for noninterest expense, we cut our expenses by $558,000 or 5.4% on a quarter-over-linked quarter basis. On a year-to-date – year-over-year basis total noninterest expenses are down $935,000 or 3% while at the same time FDIC insurance premiums are up $318,000 or 224% due to the higher deposit insurance premium imposed on the industry.

Based on our calculation of a new and recently released FDIC insurance rate, including the 10 basis points for non-interest bearing DDAs our premiums will increase by approximately $810,000 in 2009.

Turning now to shareholders equity. For the 12th consecutive quarter, we paid our cash dividend. This was our 8th consecutive quarter at 5/10th per share. At quarter-end, our shares outstanding were unchanged from the linked quarter-end. However, our ESOP purchased 71,000 shares during the quarter which along with the lower stock price increased our weighted average diluted shares outstanding of $78,000.

Over the next several weeks, we will continue to evaluate the benefits and costs of the one-time opportunity to participate in the TARP capital purchase program regardless of our decision we take some comfort in our tangible equity ratio which remains solid at 9.5%.

I will turn it back to Rodger.

Rodger Holley

In closing, I would like to review some of our fundamentals. We are $1.3 billion bank with 39 locations, operating east Tennessee, northern Georgia. Our NPAs to total assets 1.22%. Our allowance for loan and lease losses now stands at 1.31% of loans. We have a firm hand on our operating expenses and as others are we are tightening our belts.

We paid a cash dividend for 12 consecutive quarters. We remain profitable. Until recently, capital was king [ph], and we are well capitalized at 9.5% to tangible capital ratio.

Now, liquidity is king. Chip and his staff done a great job of structuring our balance sheet so we can call in liquidity on short notes. This is critical. We have the ability to borrow over $200 million in collateralized assets.

Finally, that single large charge-off this quarter cost us $0.07 per share. And the additional $5.7 million in provision expense in 2008, above the 2007 provision expense cost us $0.23 per share. Fundamentally, we remain sound. Fundamentally, strong, and position to win. We are now available for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Charlie Ernst with Sandler O'Neill Asset Management.

Charlie Ernst – Sandler O'Neill Asset Management

Good afternoon, guys.

Barry Ritchie

Hi, Charlie.

Charlie Ernst – Sandler O'Neill Asset Management

Can you add just a little bit of color on the salaries line as to why that was down so much linked quarter?

Barry Ritchie

Charlie, we reversed some accrual on the incentive compensation, and that's one reason. The other reason is that the mortgage originations were down and so was the commission on mortgage on those mortgages.

Charlie Ernst – Sandler O'Neill Asset Management

Okay, and how big was the accrual I guess?

Lloyd Montgomery

It's $500,000.

Charlie Ernst – Sandler O'Neill Asset Management

500. Okay. And can you just add a little bit of color just observations that you have about your market and kind of how the economy is progressing in the market?

Lloyd Montgomery

Charlie, this is Monty. The economy is in our primary market which was the Chattanooga, Knoxville remain stable. I mean there has been some softness particularly in the residential real estate area, but we have not seen that softness in our C&I customers. They have been able to – sales were held up pretty strong – not strong, held pretty flat. We haven't seen any real decrease in sales revenues of our C&I customers. So all in all, while it's soft has been more favorable in other areas of country. And I think that partly result of we got good diversification in the economies of Chattanooga and Knoxville.

Charlie Ernst – Sandler O'Neill Asset Management

And a little bit more color on the real estate pricing. What's happening with home values?

Chip Lusk

What we have seen – first stage of the softness was an extension of the sale cycle, and what we have seen is that some other builders have tried to maintain their prices. And during the softness we have is the softness has continued we have seen some a decline in there some were, but not greater 5%, by 5% range. And my comment on our philosophy on how we are managing, approaching our (inaudible) that is related to the residential market.

Charlie Ernst – Sandler O'Neill Asset Management

That will be great.

Dave Haynes

Yes. Charlie, this is David Haynes. When we reevaluate the OREO property on annual basis, as Monty pointed out, we are seeing anywhere around 5% I think the highest that seen is the 10% decrease and we are taking those in the OREO now we are looking at our cost to hold, trying to factor in the market conditions with the prolonged sales cycle and actually taking those losses to the reserve before we place them in the OREO. So as we have been selling OREO property we have been very close to getting what our basis or the property.

Charlie Ernst – Sandler O'Neill Asset Management

Okay, great. Thanks a lot, guys.

Dave Haynes

That percent – Charlie, just to say, that average about 92% about what we have on the book.

Charlie Ernst – Sandler O'Neill Asset Management

All right.

Operator

Your next question comes from Michael Rose with Raymond James.

Michael Rose – Raymond James

Hi, good afternoon. Could you talk a little bit about – can you give some more color on the margin and what the impact of future rate cuts might have on the margin going forward?

Chip Lusk

Michael, based on our – Michael, this is Chip. Based on our projections we can see another decline of 25 basis points in the margin. Two things happening there. One is rate cuts have just happened and another is as I discussed transitioning from the overnight borrowing position to term liabilities, is going to cost us probably about 7 basis points is what we are estimating, 7 basis points more an additional expense and we give up about 18 basis points on the assets because of the rate cut. So overall, looking like about 25 basis points.

Michael Rose – Raymond James

Okay. I guess secondarily what was the impact of the higher nonperforming assets in terms of basis point on the margin this quarter?

Chip Lusk

Michael, I don’t have that answer, but I can circle back to you. I don't have it on my finger tip.

Michael Rose – Raymond James

Okay. Switching gears a little bit, can you talk about the CDARS program a little bit? When I look at your brokered deposit line, I mean, how much of that growth is related to the utilization of the CDARS program?

Chip Lusk

At the end of the quarter, the CDARS program – actually we implemented that on October 1st, and so we brought our first deposit then in the first week of October so to zero at quarter-end.

Michael Rose – Raymond James

And I guess finally can you discuss trends in 30-day, 9-day past due loans?

Dave Haynes

Sure. Our past due loans excluding nonaccrual have jumped from the prior quarter end, we were at 1.18%, it's the quarter-end September 30th it jumped to 2.16% and we have seen an increase in the 90-day past dues as well. And generally, that's a point that we do place it on nonaccrual when they begin the foreclosure process that were increase in non-accrual probably 90%, very high percent are secured by real estate. That the past dues have increased as well as the classified loan and special mention those trend lines are probably at the highest level we have had in quite some time.

Michael Rose – Raymond James

Okay, great. Thank you.

Operator

Your next question comes from Sam Caldwell with KBW.

Sam Caldwell – KBW

Good afternoon, gentlemen. Thanks for taking my call.

Rodger Holley

Hi, Sam.

Sam Caldwell – KBW

I just wanted to ask about the leasing portfolio and how that's performing in you mentioned that the past due, can you walk through that, how much of that increases is in that leasing portfolio?

Lloyd Montgomery

Sam, this is Monty. I will start out, and then Dave can add on here. First of all, the leasing portfolio has declined in absolute dollars as well as a percentage. One time the hire would have been probably 9% of the total portfolio, and now at the end of September it's down about 3, 3.5%. A lot of that is reflective of the type of lessee that both those companies target. If you remember one is heavier weighted in transportation, the other has the little more balance and the type of equipment it leases and while it has a heavy weighting in transportation, also has a heavy weighting and construction equipment, and both of those industry's trucking because of the higher price of fuel, and again, the profile typical – lessee profile on those leasing companies would be a smaller owner-managed business that is less well capitalized than you would have been – larger trucking companies would be so they are typically the first hit by a decrease in the shipment of freight and an increase in the price of fuel, so originations in those portfolios, Sam, are way down, and that's contributing to the fact that those portfolios are trending downward in absolute terms as well. Outstanding leases combined for both companies $33 million, at one point it was up in the $55 million range. So given the economic conditions, the profile of the typical lessee in those two companies we see net portfolio to continue to decline.

Dave Haynes

As regarding past dues, the over 90 days past due at the end of the quarter were $2 million – about $2.200 million. Of that 530,000 is attributed to leasing companies. So that's lowered than what it has been in the past. And as I mentioned in the comments, the repossessions were down for the quarter about $246,000 and our Repos are pretty much consist of the two leasing companies that we own, the bank side of that of our repossessed that generally less than $50,000.

Sam Caldwell – KBW

Okay, great. Thank you.

Operator

(Operator instructions) At this time, you have no further questions.

Rodger Holley

I like to thank everyone for joining us on this call today. We look forward to talking with you at the end of next quarter. Thank you. Good bye.

Operator

This concludes today's conference call. You may now disconnect.

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