Mercantile Bank Corporation Q3 2009 Earnings Call Transcript

Oct.20.09 | About: Mercantile Bank (MBWM)

Mercantile Bank Corporation (NASDAQ:MBWM)

Q3 2009 Earnings Call Transcript

October 20, 2009 10:00 am ET

Executives

Mike Price – Chairman, President and CEO

Chuck Christmas – SVP, CFO and Treasurer

Analysts

Terry McEvoy – Oppenheimer

Jason Royer – Raymond James & Associates

Eileen Rooney – KBW

Stephen Geyen – Stifel, Nicolaus

Operator

Welcome to the Mercantile Bank Corporation third quarter earnings conference call. Today's call is being recorded. 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 important factors described in the company's latest Securities and Exchange Commission filings. The company assumes no obligation to update any forward-looking statements made during this call.

If anyone does not already have a copy of the press release issued by Mercantile today, you can access it at the company's Web site, www.mercbank.com. On the conference today from Mercantile Bank Corporation, we have Mike Price, Chairman, President; and, Chief Executive Officer, and Chuck Christmas, Senior Vice President and Chief Financial Officer.

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. Price.

Mike Price

Thank you, Dana. Good morning, everyone, and welcome. The third quarter, again, was dominated by the severe economic conditions that persist. Because of our conservative recognition of potential problem loans, we again felt it prudent to aggressively enhance our loan loss provision, creating a net loss for the quarter. The large loan loss provision was the dominant story. However, Mercantile made important progress in many areas during the quarter.

Net interest margin grew again and continues to trend upward. The branch consolidation project completed during the second quarter has lowered our monthly overhead cost, and significant reductions were again made to our level of commercial real estate loans and broker deposits. Most importantly, during the very difficult economic crisis, we have taken the necessary actions to strengthen our capital ratio. While these improvements were not robust enough to counteract the increased loan loss expense, they should help us continue to improve – reprove results in the upcoming quarter.

As we have greatly expanded the amount of data in our press release, our comments this morning will be briefer than normal, leaving more time for Q&A at the end of the call. Our Chief Operating Officer, Bob Kaminski, who normally participates in these calls has the flu today. So you have Chuck Christmas and I to ask the questions. And at this time, we will turn it over to Chuck.

Chuck Christmas

Thanks, Mike. Good morning, everybody. As I typically – I'd like to give an overview of our financial condition, operating results for the third quarter of this year, as well as the first nine months of this year, highlighting the major financial condition and performance, balances and ratios.

As you saw in the release, we did record a net loss of $5.6 million during the third quarter of this year, compared to net income of $1.1 million in the third quarter of 2008. And for the first nine months of this year we recorded a net loss of $16.5 million compared to a net loss of $5.3 million in the first nine months of 2008.

As Mike indicated, our earnings performance continues to reflect a negative impact from significant provisions to the loan loss reserve, which primarily reflects the impact of State, local, and national economic struggles on the condition of our loan portfolio – loan and lease portfolio. Although in 2009, we have recorded increases in net interest income and reductions in controllable overhead costs, the significant provision expense has resulted in a loss position.

Net interest income during the third quarter of 2009 totaled $13.6 million. That's an increase of $1.8 million over the level earned in third quarter of 2008. And for the first nine months of 2009, our net interest income totals $37.8 million. That’s an increase of $4.1 million over the level earned during the first nine months of 2008. Our net interest margin during the third quarter of 2009 equaled 2.85%, up from the 2.50% margin during the second quarter of 2009, and the 2.28% margin during the first quarter of 2009. The net interest margin during the third quarter of 2008 was 2.30%.

Our yield on assets has remained virtually unchanged throughout 2009 as our strategic pricing initiatives within our commercial lending function have mitigated the negative impact of increase in the non-performing assets. Meanwhile, our cost of funds has declined by about 60 basis points as we have been able to replace higher-costing matured brokered CDs and FHLV advances at significantly lower rates. We do expect our cost to funds to continue to decline throughout the remainder of 2009 and into 2010 as well.

We have about $300 million of wholesale funds maturing during the fourth quarter at an average rate of 2.85%, and an additional $175 million at an average rate of 2.75% coming due in the first quarter of next year, and another $100 million maturing at an average rate of 2.40% in the second quarter.

To put this into perspective, current rates generally range from 0.75% to 2.50% depending on products and term. And during the just completed third quarter, the average rate on new wholesale funds we obtained averaged 1.15%. The improvement in our net interest margins has more than offset the negative impact to our net interest income resulting from a reduction in total loans and higher level of non-performing assets, and an increase in short term investments.

The increase in short term investments reflects our decision to increase on balance sheet liquidity in light of market condition. We believe that continued reduction of our cost of funds, combined with the benefit of our strategic and pricing lending initiatives on our yield on assets should provide for further notable improvements of our – in our net interest margins and net interest income during the next few quarters despite the difficulty of predicting the impact of asset quality.

The provision expense during the third quarter of 2009 totaled $11.8 million, while during the first nine months totaled $33.7 million, both significant increases from the levels of 2008. Our loan loss reserve totaled $33.4 million or 2.07% of total loans at the end of the third quarter, compared to $27.1 million or 1.46% of loans at the beginning of the year.

Non-interest expense totaled $12.5 million during the third quarter of 2009, an increase of $2 million over the level of expense a year ago. And non-interest expense totaled $35.7 million during the first nine months of this year, an increase of $4 million over the level of expense during the same time period last year. Excluding the charges associated with our branch consolidation and the FDIC special assessment primarily during the second quarter, net interest expense is $1.8 million higher during the first nine months of 2009 when compared to the same time period last year.

Branch consolidation cost totaled $1.3 million during the first nine months of this year, with all but $150,000 expense during the second quarter. However, we are already starting to see the positive impact that decision and other related decisions have made. During the third quarter of 2009, salaries, benefits, occupancy, and furniture and equipment costs totaled $6.1 million, a decrease of $0.9 million from the amount of expense during the third quarter of last year.

We have also recorded a higher cost associated with the administration and resolution of problem assets; namely legal expenses, property tax payments, and write-downs on foreclosed properties during this year than in comparison to last year. These costs totaled $2.9 million during the third quarter, and $5.0 million during the first nine months of this year, compared to $0.8 million and $2.3 million in the year-ago time period.

Our funding strategy has not changed significantly as we continue to grow local deposits and bridge any funding gap of wholesale funds, namely brokered CDs and federal loan bank advances. We have seen a significant decline during the first nine months of 2009 in wholesale funding, primarily reflecting an increase of $193 million in local deposits in sweep accounts, which along with a $243 million reduction in total loans and leases, has allowed us to reduce wholesale funds by about $380 million during the first nine months of this year.

Our average wholesale funds to total funds are approximately 58% currently compared to 71% at the beginning of the year. We remain in a well capitalized position per bank regulatory definition, with our bank's total risk base capital ratio at the end of the third quarter of 11.7%. In dollar terms, that's about $32 million above the 10.0% minimum well capitalized threshold. Our capital ratios currently exclude $10.2 million in deferred tax assets, as well $10.4 million of our loan loss reserve per the regulatory capital calculation requirement which equates to about 100 basis point off of our capital ratios.

That's my prepared remarks. Now I turn it back over to Mike for his.

Mike Price

Thank you, Chuck. And this time we'd like to answer any questions that you may have.

Question-and-Answer Session

Operator

The question-and-answer session will be conducted electronically. (Operator instructions) We'll go first to Terry McEvoy with Oppenheimer.

Terry McEvoy – Oppenheimer

Good morning.

Mike Price

Good morning, Terry.

Terry McEvoy – Oppenheimer

Local deposits, I'm guessing most of your banks within Western Michigan have had strong retail deposit growth as have you guys. Do you feel like you're getting more than your peers in that market or is it simply everyone is benefiting from just the trends we're seeing on deposits?

Chuck Christmas

Yes, Terry. This is Chuck. I don't – I certainly can't comment on what other banks are doing specifically. But I would agree with your overall generalization that the banking industry is seeing some increase in the local deposit. We're doing a lot of different initiatives and different programs here.

Primarily, as a commercial bank historically we didn’t do a lot of advertising, especially on the retail side. But one of the things that we’ve done starting almost at the beginning of this year is we really stepped up the advertising, not only our products, but also just who Mercantile is and getting out there – getting our name out there much more in the market place. Mercantile has always had relatively aggressive rates. We're never the top, but they’ve been relatively aggressive on the retail side especially.

But now, with the concerted effort to get our name out there, I think we’re just getting more bang for our buck there. But we’re doing some things, you know, we’re making concerted efforts to get more of the deposits out of our commercial lending function whether it be the business account themselves or the business owners and executives and other employees. In some cases we require an escrow deposit on commercial real estate loans.

We've got some really exciting innovations in our deposits, especially with the consumer, with some of the advances in technology that we’ve introduced. That's helped expand our local deposits as well. So we’ve kind of turned over every rock that we can and we've had great success in doing that.

Terry McEvoy – Oppenheimer

And then you mentioned your work out strategy or work out plans in the press release, and you talked about writing down loans to the market value for the collateral. Could you talk about what types of marks or write downs you’re taking on the kind of original appraised value and where you’re writing that down to?

Mike Price

Yes. Yes, this is Mike. I’ll try to answer that. It varies. It's hard to generalize, but in general I can tell you that to the original appraisal, we are seeing some of the real distraught situations, the 60% of original appraisal write downs. Some of them aren't that bad, but I would say at this point, anytime we’re getting ORE or NPAs that appear, we’re seeing probably at least down 80% of original appraisal.

What we’re seeing and what we did this last quarter is we’re well off original appraisals. In other words, original appraisals now on most of these deals are three, four, five or even older as far as age goes. But we’re constantly looking at the validations of our write downs, in other words. We had a large one this quarter for example, where we had a – we were very comfortable with the values. When we got this thing back – this particular project back a year ago and everything indicated that the values were "x", and nothing had moved though in a while, six, seven months up in this particular project.

And another land owner in the project sold a couple of lots at auction at a very significantly reduced price from what we have them at. And at that point we feel that the only way to do it is to write it down for what they were sold at auction. So we’re at sometimes second or third generation of write downs, unfortunately. But we’re seeing fewer of those things, but they still – they still pop up from time to time.

Terry McEvoy – Oppenheimer

And then just one last question, you’re yes, above the regulatory minimum requirements for your capital levels, but one might say your capital cushion is maybe a little bit light where it should be given may be a stress in your portfolio and some of the earnings losses that you’ve recorded. How do you feel looking at over the next 12 months in terms of that capital cushion and do you have some specific strategies in place to potentially increase that cushion?

Chuck Christmas

Terry, this is Chuck. Yes, I’ll check out first. One of the things you see in the – especially in the third quarter, although unfortunately, we did have the net loss, you see our cap ratios actually went up. It primarily reflects the reduction in the loan portfolio. And I think, notwithstanding the earnings performance as we go forward, obviously which is going to be driven by the provision expense, is that we do expect our loan portfolio to continue to reduce. Probably not at the pace that it has for the first nine months, but we do see some reduction.

The normal amortization of just the principal payments – monthly principal payments on term and real estate debt is probably at $8 or $9 million per month reductions. So we’ll see that. And there’s always others that would be leaving the bank for one reason or another, so we – I don't want to put too many forward-looking comments out there, but the trend that you saw on the third quarter, just looking at that quarter alone, is the trend that we do expect can happen as we go forward. As far as how much capital we're supposed to have, as far as we know the 10% is still the minimum.

But like you, we do hear from other banks – of other banks out there that – banks that are struggling with asset quality. The regulators would expect a – a little bit higher than the 10%. But on an overall basis, we're comfortable as far as where we're at. And we like the direction where it's going and the direction we think it’s going to go, just kind of through normal operations.

Mike Price

That’s just – can’t reinforce that enough, Terry. I mean, we don’t like the fact obviously, that we took a $5 million loss for the quarter. But during the same quarter, we employed enough strategies and did what we had to get that total risk based capital ratio up 20 basis points. So I don’t want to keep that theory, but we’re going to do what we got to do to keep those capital ratios as strong as we possibly can.

Terry McEvoy – Oppenheimer

Okay. Appreciate it. Thank you.

Mike Price

You're welcome.

Operator

And we’ll take our next question from Jason Royer with Raymond James & Associates

Jason Royer – Raymond James & Associates

Hi. Good morning, everybody. I just have two quick questions. In your 10-Q for the second quarter you included some cautionary comments about your deferred tax asset and can you just give us an idea of the size of the deferred-tax asset at the end of third quarter? And perhaps another, just give us an idea any risk of impairment or at least an update on the risk of impairment in the future.

Chuck Christmas

Yes. As I mentioned in our capital ratio, the bank's deferred – net deferred tax asset is about $10.2 million. It's a little bit higher on the consolidated side, but it's $10.2 million. I think it’s $10.6 million on a consolidated basis.

And as you might imagine, a lot of banks are going through a lot of discussions, a lot of analytics, not only internally, but with their auditors and their tax consultants that they employ them. And obviously, we’ve gone through that at the end of third quarter, as we do at the end of each quarter. And at this point, you’re looking at our historical numbers, as we’re required to do, but also looking at some of the analytics, some of the forecasting as we go into future periods.

Currently we feel comfortable and our partners feel comfortable that at least at this point in time, the devaluation allowance on our financial statements is not warranted. But again, as I did mention, because the FAC has different rules in regards to the deferred tax asset, we are excluding 100% all that asset in our capital calculations. At June 30th I think we excluded about 90% of the balance. So we just want for the full 100% at this point in time.

Jason Royer – Raymond James & Associates

Okay sure. And as far as the Congress extending the look back period, is that – when is that expected to run through the pipeline or is there any specific – ?

Chuck Christmas

I’m not going to put any predictions on what Congress does...

Jason Royer – Raymond James & Associates

Yes. Yes.

Chuck Christmas

...but there is a Bill that’s working its way to both the House and the Senate. Currently, we can look back two years, and then we have to look forward. The bill that’s going through their way, I understand it, is that the look back period will go back five years. Certainly, what Mercantile – like most banks, if you go back five years versus two years, it does – those three years is primarily net income which help offset the losses over the last couple of years, and certainly helps the analytics in determining whether or not you need a valuation allowance.

Jason Royer – Raymond James & Associates

Okay. Sure. And just one more quick one. Revisiting broker deposits, are there specific level that you like to reduce your broker deposits to? I know you’ve got a significant amount of wholesale funds coming due, but any specific target levels for broker deposits? Or is it just going to be on a quarter-by-quarter basis evaluating that?

Chuck Christmas

Yes. I think we don't have specific long term goals. We certainly have some internal targets that we’d like to see. But I think as you look at the trends that really started throughout most of this year, and obviously we expect them to continue. And just continue to – take a close look at the loan portfolio to determine what we want to keep and what we’d like to see go elsewhere. And again, just see the normal amortization within the loan portfolio. Certainly making every stride to continue to increase our local deposit base.

And so, with that reduction in our assets, with that hopeful increase – continued increase in local deposits, the net amount will be the reduction in the brokered CDs. So it's kind of – I won't say it's a fudge number [ph], but it's really what’s going to drive that is the reduction in assets and hopefully some further increases in local deposits.

We’re at 58% now. We expect the trend to continue to go down – go down even further. But as I mentioned before, we don't think the loan reduction in future periods will be as much in the – as we go forward in future periods. So the 71% down to the 58% is a great number, but I wouldn’t expect that number to replicate itself for the next nine months either. But we do expect that number to go down.

Mike Price

We've had – this is Mike. Just amplifying that, we’ve had $185 million increase in local deposits since the beginning of the year. Combined with the reduction in the loan portfolio as we talked about has allowed us to drop $334 million in broker deposits off our balance sheet. For $2 billion banks, that’s pretty significant. We’re pretty happy with it.

But the answer probably to your question, the same way that Chuck did, and that is, "Yes. We're constantly looking to get that number even lower, and will continue to come up with the initiatives that we need to come up with to get it down."

Jason Royer – Raymond James & Associates

Okay. Great. Thanks, guys.

Operator

(Operator instructions). We’ll go next to Eileen Rooney with KBW.

Eileen Rooney – KBW

Good morning, guys.

Chuck Christmas

Eileen.

Mike Price

Good morning.

Eileen Rooney – KBW

Most of my questions are already answered. Just in terms of the credit quality, I don't think it’s in your press release. I was just wondering what 30 to 89-day past dues look like?

Mike Price

The 30 day – 30 to 89 past dues were about $8 million at the end of the quarter. And that’s about right what they were at the end of the second quarter.

Eileen Rooney – KBW

Okay. I thought in your second quarter conference call, it sounded like you’re a little bit more optimistic on the credit quality. And then obviously, your non-performers kind of jumped up again this quarter. I was wondering – the credits that went bad this quarter, were they things that were on the watch list or maybe just a little bit more color on what happened in the third quarter?

Mike Price

Sure. Sure. I’ll be glad to try to do it. And if I found it optimistic in the second quarter, darn it, I should have done then. No. I would – I think you did pick up the right tone. I mean, we felt pretty good about things in the second quarter, that there weren’t a lot of new things coming down the pipe. And in fact, most of the stuff in the third quarter that trended in the NPAs was on the watch list.

We had very few migration from non-watch list into NPAs, but we had one or two large ones that – one especially which was a company that did some land developments that we were – we knew had been trouble for some time. But they had a related business that had been able to carry the day and provide plenty of cash flow over the last couple of years. And that really is business, took a much more drastic hit during the summer than they had projected or as we had projected. So again, we put it – at that time, we put in on the non-accrual. It was current in its payments but we felt that it belonged there.

But I’ll tell you, I mean it gets frustrating sometimes because we continue to be very aggressive and we go through spurts where we see some positive things out there. And in fact, even this quarter, I mean we did see some sales of some ORE. We’re seeing more activity on stuff that we own, and more bids. And as we’ve gone into this fourth quarter here, we've got some nice indications of some things that look like they’re starting to move. But it is still very, very challenging out there. No doubt about it.

Eileen Rooney – KBW

Okay. And what was the amount of ORE that you sold this quarter?

Mike Price

Let’s see. Let me find it here. Bob has a great list of notes here, but – I’ll see if I can find it. It is – well, we had $6.1 million in pay downs in all NPAs during the quarter, not just OREs, but – and then we wrote down another $1.6 million in ORE in looking at values during the quarter. And then we had $11 million in charge offs to the NPAs for the quarter.

Chuck Christmas

Yes. Eileen, this is Chuck. I think I’ve got that information back in my office with my cash flow information. I didn’t bring it with me this morning. So why don't you to shoot me an e-mail? I can get that to you.

Eileen Rooney – KBW

Okay. Sounds good.

Operator

And we’ll go next to Stephen Geyen with Stifel, Nicolaus.

Stephen Geyen – Stifel, Nicolaus

Yes. Most of my credit questions have been answered. Just a question on the loan portfolio. If you could provide the loan yield or what the change is quarter-to-quarter?

Chuck Christmas

You know Stephen, as I mentioned our asset yield was pretty much – it's – I look at it quarter-to-quarter, it’s virtually unchanged. So the loan yields have been pretty consistent. I don't have that right off the top of my head, though. So shoot me an e-mail too and I can get that to you. But I know it’s been extremely consistent quarter-over-quarter throughout 2009.

Stephen Geyen – Stifel, Nicolaus

Okay. Thank you.

Operator

And it appears we have no further questions at this time.

Mike Price

Okay. Well, thank you very much for your interest in our company. Things do remain challenging out there. But as Chuck and I and the press release have hopefully conveyed to you, there are a lot of positive things that are happening within our company. And we look forward to talking again with you, next quarter. I’ll end the call at this time.

Operator

Again, that does conclude today’s presentation. We thank you for your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!