Executives
William J. Reuter - Chairman and Chief Executive Officer
Drew K. Hostetter - Chief Financial Officer, Executive Vice President
Michael M. Quick - EVP and Chief Corporate Credit Officer
Abe Koser – Vice President, Investor Relations
Analysts
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
David Darst - FTN Midwest Securities
Thomas Alonso - Fox-Pitt Kelton
Analyst - Keefe, Bruyette & Woods, Inc.
Susquehanna Bancshares, Inc. (SUSQ) Q3 2008 Earnings Call October 23, 2008 11:00 AM ET
Operator
Good morning and welcome to Susquehanna Bancshares third quarter 2008 earnings conference call. Today's call is being recorded. At this time participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator instructions)
Mr. Koser you may now begin your conference call.
Abe Koser
Thank you, good morning and welcome everyone. I am Abe Koser, Vice President, Investor Relations of Susquehanna Bancshares. By now, you should have all received a copy of our third quarter 2008 earnings release which we made available yesterday. If anyone still needs a copy, please call us at 717-625-6311 and we will fax it to you. Our financial releases are also posted in the Investor Relations section of our web site at www.susquehanna.net.
Before we begin, I'd like to remind you that during the course of our call, management may make projections and other forward-looking statements regarding events or the future financial performance of Susquehanna. We do want to caution you that these forward-looking statements may differ materially from actual results due to a number of risks and uncertainties.
For a more detailed description of the factors that may affect Susquehanna's operating results we refer you to our filings with the Securities and Exchange Commission including our Annual Report on Form 10-K for the year-ended December 31, 2007 and our quarterly report on Form 10-Q for the quarter-ended June 30, 2008. Susquehanna assumes no obligation to update the forward-looking statements made during the call.
Now I'll turn the meeting over to your host, William J. Reuter, Chairman and Chief Executive Officer.
William J. Reuter
Thank you, Abe, and good morning, everyone. Thank you for joining us for our review of the third quarter 2008 results. Also participating in today's call will be Drew K. Hostetter, Executive Vice President and Chief Financial Officer, and Michael M. Quick, Executive Vice President and Chief Corporate Credit Officer.
As you all know, this has been a period of unprecedented economic challenge and volatility in the financial service industry. Although Susquehanna did not engage in sub prime lending activity, it has hampered some bank’s performance. We have experienced some impact from the turmoil in the broader markets. This led to a number of charges that affected our third quarter results.
Net income for the third quarter was $6.4 million or $0.07 per share compared to $19.9 million or $0.38 per share for the third quarter last year. For the first nine months of 2008, that income was $63.6 million or $0.74 per share compared to $50.4 million or $0.97 per share during the same period in 2007. Results from the third quarter include the impact of four items which together reduced earnings by $0.22 per share. Excluding the impact of these charges, that income for the third quarter would have been $0.29 per share. We believe this shows the stability of our core operations especially in light of the currently highly competitive and volatile banking environment.
I would like to review the charges and impact to our third quarter results all of which were previously disclosed at SEC filings. First we took a $2.5 million dollar pre-tax charge for costs related to the consolidation of our three bank subsidiaries into a single charter. This consolidation occurred on October 10. It is expected to generate annual savings of approximately $20 million in 2009.
Second, we had a pre-tax loss of $6.5 million due to an interest rate swap loss. We had engaged in interest rate swap agreements in preparation for a planned securitization of the vehicle leases during the third quarter. However, when it became clear in the third quarter that there was no well-run market for this type of securitization, we terminated the planned sale and the related interest rate swap agreements. Due to declining interest rates, the fair value of the agreements was under water and we needed to reduce our pre-tax income accordingly. However, we expect that this loss would be more than offset by net interest income that will earn on 350 million of vehicle leases over the next two years.
Third, our Board of Directors committed up to $2.1 million to mitigate the potential losses of Valley Forge Asset and Management customers who helped position in the primary fund. As you know, Valley Forge Asset and Management is one of our wholly-owned wealth management subsidiaries. Some of their customers have holdings in the primary fund, a money market mutual fund managed by the reserve. The fund’s net asset value dropped below a $1.00 to $0.97 per share as of September 16, 2008. Valley Forge Asset Management initiated a redemption request for its clients’ assets invested in the fund. However, at this point, no redemption has occurred. It is our understanding that the primary fund will be liquidated with the proceeds paid to its shareholders.
Our best estimate at this time is that investors will be paid approximately $0.97 on a $1.00.Money market mutual funds have straightforwardly been considered very safe investment vehicles maintaining a consistent net asset value of a $1.00 per share. Given this history, our Board agreed that it would be appropriate to commit up to $2.1 million to mitigate the potential loss our customers could realize on their investment. We believe this will be, is in the best interest of our Company because it will help to reinforce the relationships and trusts we have built up with these customers over the years.
Finally, we have reported a pre-tax investment security impairment charge of $17.5 million related to two synthetic corporate collateralized debt obligations. These two securities had a par value of $10 million each and they each had 100 underlining reference companies. Through August 31, 2008, there were no credit events such as bankruptcies, conservatorships, or receiverships related to any of the reference companies. However, given the significant development that affected the market since August 31, there were a number of recent credit events that reduced the fair value of both securities. One was reduced to 12.5% of par and the other to 12% of par. As a result, we anticipate that both securities will receive a below investment grade rating by the rating agencies. Consequently, Susquehanna recorded a $17.5 million pre-tax impairment charge at September 30, 2008. I would like to point out that these are the only two securities of this type in our $2 billion investment portfolio.
Now, I would like to go over a few highlights of our third quarter results. Excluding the impact of the November 2007 acquisition of Community Banks, net loans and leases grew 17% from September 30, 2007. Total deposits excluding Community Banks increased 5% from last year. Interest margin for the third quarter decreased four basis points to 3.6% compared to 3.64% for the third quarter of 2007. During the third quarter, we continued to closely monitor credit borrowing as we have throughout the year. Net charge-offs as a percent of average loans and leases for the quarter were 35 basis points compared to 39 basis points for the third quarter of 2007.
We saw a 19% increase in non-performing assets during the quarter which was primarily caused by an increase in non-accruals of $17.6 million. This was due to a weakening in the real estate market in the Baltimore-Washington MSA. The increase was centered in six residential real estate projects and two assisted living facilities. We are optimistic that we will be able to resolve two of the stressed residential real estate projects during the fourth quarter. Due to the weakness that we have seen in the real estate market, the bank increased its provision for the quarter to $17.7 million after net charge-offs of $8.2 million, the reserve balance increased by 9.9% to $105.6 million. This raised the ratio of allowance to net loans and leases to 1.12%. Non-performing assets as a percentage of net loans, leases and other real estate owned was 1.15%.
We have seen a challenging environment in the housing market throughout our footprint. Over the last year, the only metropolitan areas with positive value increases had been Retting, Harrisburg, Carlyle, Lancaster, Philadelphia and York Hanover. The Baltimore-Washington MSAs saw values decrease between 5.75% and 9.14% year-over-year. However, we are working diligently to resolve issues created by the weakening housing market. For example in Ocean City, Maryland, a condominium project, we had an outstanding loan balance of $17 million at this time last year. Twenty one units had been sold by October 31, 2008 representing about 1.31 units sold per month. At the end of October, we expect this balance to be around $7.5 million with fourteen units to be sold.
Now turning to our Wealth Management business, assets under management and administration increased 13% from September 30, 2007 to $6.4 billion in this year’s third quarter. Wealth Management business income for the quarter was $11.1 million, an increase of 37% compared to third quarter 2007. Commission income from property and housing insurance business was $2.6 million up 3% when compared to third quarter in 2007.
I will now turn the call over the Drew for a review of our results on a quarter to quarter basis.
Drew K. Hostetter
Thank you Bill. In my presentation, I want to focus on third quarter results for 2008 and our 2008 financial targets. Debt interest income increased $2.2 billion dollars or 2% from the second quarter due to an increase on average earning assets of $308 million offset by a decline in the net interest margin of 6 basis points. The decline in margin was due primarily to competitive pricing in our market area or deposits.
Non-interest income decreased $26.8 million or 60% from the second quarter due primarily to the $17.5 million impairment charge and the $6.5 million interest rate swap loss recorded in the third quarter of 2008. Non-interest expense increased $5.5 million or 6% from the second quarter due primarily to the $2.5 million consolidation charges and $2.1 million primary fund charge recorded in the third quarter of 2008.
Our updated financial targets for 2008 are as follows: FTE margin, 3.64%. Loan growth 9%, deposit growth 4%, non-interest income growth 21%, non-interest expense growth 32% and the tax rate 26%. These financial goals include no securitization activity in 2008.
I will now turn the conference call back to Bill for his closing remarks.
William J. Reuter
Thank you Drew. I am sure you are all familiar with the unprecedented changes that have engulfed our industry in recent weeks. There are a number of factors I would like to mention that are designed to help us navigate this challenging environment.
First, Susquehanna has maintained good liquidity. It remains well capitalized. We have a liquidity plan that is monitored closely by executive management. Our regulatory capital ratios at September 30 were leverage ratio of 7.5%, Q1 risk based capital of 8.63% and total risk base capital of 10.86%.
Second, the recent consolidation of our banks into a single charter was planned and initiated months before the recent economic crisis and now appear particularly well timed. Combining our franchises provide our customers with a single network of more than 230 branches in the Mid-Atlantic region where they can complete any banking transaction. It positions us to provide more flexible convenient service to customers at the same time it increases our internal efficiencies through some staff reduction and by eliminating inter-affiliate transactions. The result is a projected $20 million in annual expense reductions beginning in 2009 which will make us a more streamlined player in today’s competitive environment. This consolidation was a result of a concerted effort of many of our employees and I would like to thank them for their hard work and dedication throughout the process.
Third, we have enhanced our efforts to communicate with all of our employees and our customers about Susquehanna’s safety and soundness. We have built a record of more than 100 years of service to our communities through good and bad economic cycles. We are a well capitalized institution. We do not pursue sub prime mortgage lending and we believe that this a strong selling point for customers seeking a safe haven for their deposits. In addition, we have recently expanded our use of the certificate of deposit account registry service, commonly called CDARS. This program gives our customers the ability obtain FDIC insurance coverage on multi-million dollar deposits.
The bottom line is that times of turmoil create not only challenges but also opportunities. The changes we have seen in recent weeks will, no doubt, cause some competitor customers to seek out new, stable financial service partners. We are working to engage all of our employees to act on these opportunities to meet customer needs and to further grow our customer base and market share. The unprecedented economic environment we faced over the last few weeks gives us reason to reassess our position in this industry.
Let us plan ahead of the year with a position of strength. We had just completed the largest merger in our Company’s history. We have a legacy of conservative lending practices and strong credit quality. We have the privilege of serving stable markets in the Mid-Atlantic region that were somewhat insulated from the extreme real estate market volatility seen in other parts of the country.
During this challenging year, we have worked to better integrate our operations to improve efficiency. We have continued to show strong loan growth while diligently while diligently monitoring our portfolio for troubled credits. We have worked to serve as a source or device and a reassurance to customers by strengthening existing relationships and build new ones. We have done this with a single objective: to position Susquehanna Bancshares to weather the current economic storm and to emerge into even a stronger Company.
At this point I would like to open the call for your questions and comments.
Question-and-Answer Session
Operator
Thank you. (Operator instructions) Your first question is from David Darst from FTN Midwest.
David Darst - FTN Midwest Securities Corp.
Bill have you given us any statistics in the past on how the construction portfolio is allocated among your three markets?
William J. Reuter
David, we have not. You mean such thing in Maryland and New Jersey?
David Darst - FTN Midwest Securities Corp.
It sounds like your Pennsylvania market the real estate values are holding up well.
William J. Reuter
I would say Pennsylvania and Southern New Jersey are all holding up well. I think. Maryland is the cherry somewhat but not nearly as bad as all other constructions in the country.
David Darst - FTN Midwest Securities Corp.
Michael, do you have any information that will...
Michael M. Quick
Would you like to know what, how much we have in each state?
David Darst - FTN Midwest Securities
Yes, so I guess Maryland would be the first.
Michael M. Quick
Okay we have in Maryland $869 million of which $368 million is in investment properties, $500 million and change is in LAD Construction, $102 million is one to four family constructions, $72 million is commercial, $14 million is multi-family and approximately $283 million is of land.
David Darst - FTN Midwest Securities
Okay. Thank you and then regarding your deposit close and the decline in core deposit. Were most of those you accounts moving into CDs that is safe in the bank or did you actually see an outflow of core deposits?
William J. Reuter
David, that was about 50/50 and in the demand area, one of the biggest, you know, we have actually seen the increase in accounts in our demand area versus the average balance that is continuing to drop because of the economy.
David Darst - FTN Midwest Securities
Okay, thank you.
William J. Reuter
And David, that makes kind of sense because, what we look at most closely is how many net new accounts we are generating and our net new accounts are net new are actually up but the average balances are down and if you are paying more for gasoline and you are paying more for healthcare and paying more for food that would make sense if the average balance would be down somewhat.
Operator
Thank you. Your next question is from Steve Moss with Janney Montgomery Scott.
Steve Moss - Janney Montgomery Scott
Okay, good morning guys. I just, with regards to the asset quality, what were delinquencies at the end of the quarter?
William J. Reuter
At the end September 30?
Steve Moss - Janney Montgomery Scott
Yes.
Michael M. Quick
Do you want 90-day or you want the other categories?
Steve Moss -Janney Montgomery Scott
Other categories please
Drew K. Hostetter
Look at that four year cycle.
Michael M. Quick
Thirty to 59 days was approximately a little over 40 basis points, 60 to 89 days was approximately about 37 basis points, over 90 days was approximately 20 basis points and this is for accruing and our total accruing loan was 0.95%.
Steve Moss - Janney Montgomery Scott
Okay and with regard to the loans that were on non-performing status this quarter that you mentioned on the six residential construction projects and two assisted living facilities?
William J. Reuter
Yes, will you give a little more color?
Steve Moss - Janney Montgomery Scott
I assumed they are all in Maryland sites?
William J. Reuter
They were all in Maryland, right?
Michael M. Quick
No, one was not.
William J. Reuter
One was not.
Michael M. Quick
There was assisted living which is an existing facility which was located and still operating, located just north of the Maryland Blue Ridge area of Pennsylvania. The other assisted living facility was a construction project. We had the land loan on it. There is a construction halfway behind us which did not get the funding. We will probably have to foreclose to take them out but the project is 65% that they do have significant dollars in behind us.
Steve Moss - Janney Montgomery Scott
How large is that project?
William J. Reuter
I think a million and a half dollars.
Michael M. Quick
Yes, our position is a million and a half. There is about $6 million behind it and that adds up 55% to leave.
Drew K. Hostetter
Yes, we are based on current appraisals. We think there is probably $4 or $5 million in equity behind this in the project.
Steve Moss - Janney Montgomery Scott
And then with, how big are the two loans you expect to resolve this quarter?
Michael M. Quick
One is in the $7 to $8 million range and the other is in the $4 million range, $4.5 million range.
Steve Moss - Janney Montgomery Scott
Okay, thank you very much.
Operator
(Operator instructions) Your next question is from Collyn Gilbert of Stifel Nicolaus.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
Good morning, gentlemen. Just first, a question on, I think I saw this anywhere, but the drop in other income during the quarter, I am thinking that maybe that $6.5 million swap loss came out of that line?
Michael M. Quick
That is correct.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
Okay was there anything else in there?
Michael M. Quick
Two other things, when a customer wants a fixed rate loan today, we swap it to floating or livewire basis and those fees in the third quarter about a $1 million less than they were on the second quarter.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
Okay. And is that just because activity was less?
Michael M. Quick
Yes.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
Okay. And then Mike, maybe on, when you just comment, we are talking a little bit about the construction portfolio in Maryland. Could you, of the segments that you just broke out? Can you give some of the asset quality statistics on some of those segments? Do you have that in that kind of detail?
Michael M. Quick
Just bear with me one second. I can answer that question for you.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
And even if it is helpful to just speak in general terms about, stresses, I guess the assumption would be that the investment properties of that $368 million are going to be under the most stress.
Michael M. Quick
Not necessarily a lot of those are already occupied properties, where people have to keep, where the owner has a piece of it, a doctor or a lawyer, and then the rescue runs out. I do not have it broken down by Maryland, I can get that for you off the, I can call you back with that. But I can tell you, of our total portfolio of commercial loan. When I looked at the LAD, the past due was about 1.99% of the total portfolio. One-to-four-family was about 2.3%, owner occupied was about 0.88%, and TNI was 1.32%. Multi family construction, we did not have any delinquency. Commercial construction, we had 0.08%, nothing in farmland. In the non-accruals, TNI we had 0.94% or approximately $12 million. Owner occupied in non-accrual we had about $9.4 million. CRE permanent we had $7.2 million and in LAD, we had about $48 million in non-accrual.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
Okay.
Michael M. Quick
If you quote about $76 million in differentials, there is about $ 3 million in our commercial leasing company and the rest is residential and consumer loans.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
Okay. Is there any particular area of Maryland where you are seeing stress? I mean Eastern Shore versus some of the Western parts of it?
Michael M. Quick
I would say is that the stress is probably in the quarter between Baltimore and Washington and, we decided that quarter, more so towards the Virginia side.
William J. Reuter
We do not have very much exposure on the Eastern Shore.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
Okay, that is helpful. And then finally, Drew could you run through some of the statistics on Hann, in terms of originations, kind of activity going on there and then maybe speak of the bigger picture strategic plan with what you are intending to do with Hann and the capital needs that that might require.
Drew K. Hostetter
Okay, first, the production for the month of, for the quarter was, for the third quarter was 3,295 units up from 2,979 in the previous quarter and total dollars was $77 million up from $76 million in the prior quarter, so volumes have hung in there pretty well and that is mostly because the competition is going. We are still being very selective about the type of cars that we are originating. We are still originating mostly foreign cars. So even though Chrysler, Ford and GM do not have a leasing arm anymore, those particular types of cars we are not doing much business in.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
Okay.
Drew K. Hostetter
Profitability-wise for the year, we project Hann’s going to be down. Our original projection was $4.5 million and they tap on the auto leasing business. We project that to be about $1.7 million now instead and two reasons for that. One maintains a lot of cash; they are kind of a cash cow for us. They have about $75 million in cash throughout the year. Some are up $75 to $100 million and the overnight rate was budgeted at the beginning of the year and obviously that has come down. So half-out, half-out loss relates to interest income on our cash position. Second thing is because the decline in the auto industry has also affected residual values; therefore we are touching more cars than we did last year. We touched about 65% of the cars that we originated last year. We are touching about 70% this year because of the decline in residuals. That has created extra expense on the back end for us. And that is about the other half of that decline in pre-tax income. Capital wise, it does not take any capital at all, it has $150 million deferred cash liability on its books and its assets are less than $150 million. It does not require any capital at all.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
But for you guys to now, I mean you are going to obviously need to be funding any new originations in, whatever it is that, your portfolio onto your balance sheet and you are just saying that that will not create additional strains?
Drew K. Hostetter
No. No it will not. That mobile production will, what we are doing is we have increased our pricing on our loan areas so our growth in our commercial and commercial real estate areas are slowing down a little bit because of our increased pricing and as a result, we believe, I think our raise last time was 10% for the year. I think it is going to be down to 9% even including the Hann leases in there. So, we believe we have enough liquidity without any concerns to continuing the take the Hann production onto our books.
William J. Reuter
Plus our balance sheet is much larger than what it was this time last year.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
Okay, alright and just given the thought down on the auto and I hear what you are saying but there is no strategic plan to change the way that that relationship has been with Hann? Or they do not have any plans to shift the business at all or scale back or…?
Drew K. Hostetter
We used to do about $450 million in production a year. This year will be probably around 275; we expect it to be going forward in the 250 to 275 range column and the reason that we have to price our products to make sense for us and because we are priced at that serve particular levels that has cut the volume back even in the past couple of years and we always continue to look strategically at alternative options for the auto leasing business.
Collyn Bement Gilbert - Stifel Nicolaus & Company, Inc.
Okay. Okay. Thanks.
Operator
Thank you. Your next question is from [Ted Rossinas] for KBW.
Analyst - Keefe, Bruyette & Woods, Inc.
Just a few questions on the deposit side. First in the quarter, how much of the increase in prime over 100,000 were related to broker and CDs?
Michael M. Quick
About all of it.
Analyst - Keefe, Bruyette & Woods, Inc.
About all of it? Then I guess staying on that front too. Can you maybe update us, as far as since quarter end, what you are seeing in trends on deposits?
Michael M. Quick
This quarter end?
Analyst - Keefe, Bruyette & Woods, Inc.
Yes.
Michael M. Quick
They have been fairly stable since quarter end.
Analyst - Keefe, Bruyette & Woods, Inc.
I guess, that works and then the last question regarding the margin going forward I guess in light of the steady easing and kind of a mix shift we saw this quarter, I think you said 364 for year end, if I caught that correctly.
Michael M. Quick
That is correct.
Analyst - Keefe, Bruyette & Woods, Inc.
You have maybe any comments about what you see that doing maybe through 2009 or just maybe in general?
Michael M. Quick
Now that is a tough prediction but where we are right now. What we are seeing right now is that we are getting increased pricing on the loan side but that is being more than offset by, because of deposit competition, what we have to price our deposits to keep our deposit levels up. Though we believe our margin in the fourth quarter will be somewhere in around 358 or about 2 basis point declines. One of the things we will have to see here is what the Wells Fargo does with Wachovia, because Wachovia was the one who is killing us in the market here. They were 25 to 50 basis points higher than anybody else on deposit cost. So we are hoping that some of that competition will go away here in the near future with the acquisition by Wells.
Analyst - Keefe, Bruyette & Woods, Inc.
Okay and then maybe just one quick follow up. The average rate in market now, is it still well above four or is it hovering around 4% on the CD side?
Michael M. Quick
On the CD side between 4 and 4.5 in our market. Now, Wachovia is even above that.
Analyst - Keefe, Bruyette & Woods, Inc.
Okay. That is it. All the other questions I have are already answered. Thanks guys.
Operator
Your next question is from Tom Alonzo with Fox Pitt Kelton
Thomas Alonso - Fox-Pitt Kelton
Good morning guys. Real quick because I was interrupted, can you just give what your estimate for the tax rate was again?
Michael M. Quick
Twenty six percent
Thomas Alonso - Fox-Pitt Kelton
Okay and then the capital ratios you went through? I think you said Q1 one was 863? Is that right?
Michael M. Quick
Yes I have got them right here. Q1 one was 863, leverage was750 and total capital was 1086.
Thomas Alonso - Fox-Pitt Kelton
Great. Okay. That was, maybe just on that, I mean, I assume you guys are taking a look at this hard but just any kind of thoughts you might have on that.
Michael M. Quick:
We are on exploratory stages on it. We are intrigued by certain aspects of it. Clearly we are well capitalized and if we could access some additional capital it would be great to have more of a buffer, more of a buffer from a capital standpoint. As you saw we are going into loan side 17% so we are growing along side 17%, it would be well worth it for us to be able for a few more dollars out especially at a time where it looks like margins might be getting a little better. So, yes, we are intrigued by it. We certainly have made commitments but we are studying it very hard right now.
Thomas Alonso - Fox-Pitt Kelton
Okay thanks.
Operator
(Operator instructions) And it appears that there are no further questions at this time. Mr. Reuter I would like to turn the conference back over to you for any additional or closing remarks.
William J. Reuter
Well thank you for dialing in. I would like to remind you that our next quarter conference call will be held on Thursday, January 29, 2009, 11 am Eastern Time. Thank you for your time today and for your continuing interest in Susquehanna Bancshares.
Operator
This does conclude this teleconference. You may now disconnect and have a great day.
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