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UMB Financial Corporation (NASDAQ:UMBF)

Q4 2013 Earnings Conference Call

January 29, 2014 09:30 ET

Executives

Abby Wendel - Director, Investor Relations

Mariner Kemper - Chairman and Chief Executive Officer

Peter deSilva - President and Chief Operating Officer

Mike Hagedorn - Chief Financial Officer

Analysts

Herman Chan - Wells Fargo Securities

Chris McGratty - KBW

John Rodis - FIG Partners

Peyton Green - Sterne Agee

Tyler Stafford - Stephens

Operator

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the UMB Financial Fourth Quarter and Year End 2013 Financial Results Conference Call. During this presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions) This conference is being recorded today, January 29, 2014.

I would now like to turn the conference over to Abby Wendel, Director of Investor Relations. Please go ahead, ma’am.

Abby Wendel - Director, Investor Relations

Thank you. Good morning, everyone and thank you for joining us for our conference call and webcast regarding our fourth quarter and full year 2013 financial results. Before we begin, let me remind you that our comments in this conference call contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements rely on a number of assumptions concerning future events and are subject to risks and uncertainties, which could cause actual results to differ materially from those indicated in our statements made during this call.

While management of UMB believes our assumptions are reasonable, UMB cautions that material changes in interest rates, the equity markets, general economic conditions as they relate to the company’s loan and fee-based customers, competition in the financial services industry, the ability to integrate acquisitions and other risks and uncertainties, which are detailed in our filings with the Securities and Exchange Commission may cause actual results to differ materially from those discussed in this call.

UMB has no duty to update such statements and undertakes no obligation to update or supplement forward-looking statements that become untrue because of new information, future events or otherwise. By now, we hope most of you on the call who are listening via webcast have had a chance to review our earnings release, which was issued yesterday afternoon. If not, you will find it on our website at umb.com. Also we have again published some supporting slides on our website that contains some of the drivers and metrics we will discuss today to make it a bit easier for you to follow along and to review afterwards. A link to the slides can be found at umb.com in the about UMB section or in the Investors section under Presentations.

On the call today are Mariner Kemper, Chairman and Chief Executive Officer; Peter deSilva, President and Chief Operating Officer; and Mike Hagedorn, our Chief Financial Officer. The agenda for today’s call is as follows: Mariner will provide high level commentary on our results and Mike will review the details of our financials. Then Peter will review key income business drivers. Following that, we will be happy to answer your questions.

Now, I will turn the call over to Mariner Kemper.

Mariner Kemper - Chairman and Chief Executive Officer

Thank you, Abby. Welcome everyone and thank you for joining us. For the fourth quarter, we reported record total revenue of $221.5 million, an increase of 16.9% compared to the fourth quarter of 2012. Net income for the quarter was $34.7 million or $0.77 per diluted share. On a full year basis, we achieved record revenue and record net income.

For 2013, net income increased 9.2% to $134 million or $3.20 per diluted share on revenue of $825.1 million. For the quarter, non-interest income increased 24.1% to $135.6 million, which is a 61.2% of total revenue. For the full year, non-interest income was $491.8 million, an increase of 7.4% and represented nearly 60% of total revenue. Institutional Investment Management, 26.4% growth, led the increase in non-interest income.

Also included in the quarter’s results were $13 million of unrealized gains and market adjustments to Prairie Capital investments and a $7.6 million expense related to contingent consideration liability for acquisition of Reams Asset Management. The increase in our earn-out liabilities in the quarter is directly correlated to the success of our acquisitions. Later in the call, Peter will discuss our results by business segments to give you clear pictures of the components that makeup UMBF’s business model.

Getting back to the income statement, fourth quarter net interest income increased 7.1% to $85.9 million compared to the fourth quarter of 2012 driven primarily by loan growth. On a full year basis, net interest income increased 4.1% compared to prior year. Net interest margin remains under pressure, but our near $1 billion average loan growth this year offsets the declining average loan yields as illustrated on our press release.

I am pleased to report a 19.2% average loan increase for the quarter making this the 15th consecutive quarter of year-over-year loan growth, the past eight of which were double digit percentage increases. For the year average net loans were up $970 million to $6.2 billion or 18.5%. I am incredibly proud of our team accomplishing fantastic loan growth in this environment. As of December 31 as stated, net loans were $6.4 billion in 2013 and $5.6 billion in 2012, an increase of 14.8%. Compared to the industry there are 1723 regulated depositaries that had reported year end quarter results of January 27 reported a median increase in loan balances of 3.8%.

Five major points contributed to recent loan growth at UMB. First, not long ago, we changed our approach to sales incentive compensation practices to ensure we acquire and retain the best business development proceeds. Second, our low overall cost of funds of 0.10%, allow us to meet the best pricing and competitive situations for high quality credit. Third, we are in four cities with MSAs as big or bigger than Kansas City, but have a fraction of the market. We have upgraded our teams in most of these regional markets and a slight market share improved – and even slight market share improvement would have a significant impact on our loan volume as a company. Fourth, historically UMB wouldn’t make a real estate loan to a company that didn’t move their entire banking relationship. In more recent periods we will make loans for these companies on their real estate or equipment without requiring a move of the entire relationship. And we are doing this without changing our underwriting standards. And finally, we have had success expanding small business and private banking loan channel. Over the past year private wealth management has $76.8 million in new mortgage loans and for the fourth quarter small business increased average loans by $30.4 million compared to the fourth quarter last year.

Credit quality is incredibly important to us and as I mentioned on – about our underwriting standards we have not changed those at all. A strong loan book is something you come to expect from UMB. And with fourth quarter net charge-offs of 0.26% of average loans, the non-performing loans at 0.47% of average loans our reputation for quality credit endures. Looking more closely at loan growth drivers, C&I loans were up $427.8 million or 14.9% to $3.3 billion as of December 31, 2013 compared to December 31, 2012. For the same time period commercial real estate loans were up $266.3 million or $18.6 million to $1.7 billion.

Commitments at December 31 had increased by nearly 10.5% over the prior year and our utilization rate was at 29.9% compared to 28.4% at the same point a year ago although utilization rates remain behind historical averages. We are seeing growth across our footprint as our lenders bringing a new business. Kansas City, St. Louis and Colorado continued to provide the larger dollar volume in the new loans and fastest region – growing regions are Arizona, St. Louis and Oklahoma. Our Dallas office reached $68.1 million in loans as of December 31, 2013. We are looking forward to expanding our Dallas market.

Another topic I have spent a fair amount of time talking about on previous conference calls is expense growth and operating leverage. Although non-interest expense increased 7.9% for the fourth quarter and 5.7% for the year, I am pleased to report that expenses in our bank segment decreased 1.5% for the fourth quarter of 2013 compared to the fourth last year. For the full year the reduction was 1.4% compared with 2012. Total expense growth for both the fourth quarter and the year came largely from expenses in our non-bank segment. The increase is higher than I would have liked as we were aiming for a sub 5% growth rate for the year. But as a growth company we are comfortable of making investments in certain areas that have both attractive margins and momentum. For the full year of 2013 expenses included $11.3 million charge for increasing the contingent consideration liability related to three of our recent acquisitions, $6.9 million of which were recorded in the fourth quarter.

In 2012 the expenses related to contingent consideration liability was $6.1 million. The net increase to expense related to these acquisitions year-over-year was $5.2 million. As we think about 2004 - 2004 - as we think about 2014 keep these things in mind. As we’ve shown you in the past in investor presentations, we’ve been successful slowing the rates of expense growth. We remain committed to keeping operating expenses at that level or lower. Because of M&A activity and future investments, we could see additional volatility in both the earn-out and income of the company. The timing of income and expenses may not always be in the same period. The good news is that these are all strategic investments that are part of the company’s future. For the full year of 2013 our efficiency ratio was 72.8% improved slightly from 74% in 2012.

With that I’ll turn over the conference call to Mike Hagedorn who will walk you through our financial results in more detail. Mike?

Mike Hagedorn - Chief Financial Officer

Thanks, Mariner and welcome everyone. End of period earning assets were $15.7 billion. Average earning assets were $14 billion for the year, an increase of 13% compared to 2012 and $14.5 billion for the quarter, a 12.7% increase compared to the fourth quarter 2012. The average balance in our securities available for sale investment portfolio for the quarter increased 2.2% compared to the fourth quarter 2012 but declined 0.2% from the third quarter 2013 denoting a slight change in our earning asset mix.

The fourth quarter average yield on securities was 1.97%, an increase of one basis point from the fourth quarter last year and a decrease of two basis points from the third quarter of 2013. As you’ll see in our slides accompanying the call, activity during the fourth quarter include the roll-off of $308 million in portfolio securities at an average yield of 2.04%. In turn we purchased $355 million of securities at an average yield of 0.64%.

The average life is now 47.55 months down from 49.39 months last quarter. The average life in the fourth quarter of 2012 was 39.95 months. Duration for the fourth quarter came in at 44.12 months shortened from 46.31 months in the third quarter of this year. Our bias is towards shortening and shrinking the investment portfolio and putting more deposits to working loans. In previous years we have (pre-bought) in the portfolio in anticipation of the seasonal and flex of public fund deposits. Instead during the fourth quarter of 2013, we left more in fed funds at the Federal Reserve in preparation to fund the exit of a large depositor which I’ll discuss in a moment.

Over the next three months $398 million of investments with an average yield of 1.71% were cash flow and over the next 12 months $1.1 billion of investments with an average yield of 1.94% were cash flow. Additionally 66% of our total loan portfolio is expected to reprice or mature in the next 12 months. Allowance for loan losses is $74.8 million and allowance as a percent of total loans is now 1.15% compared to 1.26% a year ago.

Although allowance as a percent of loans has decreased, we believe this level is appropriate given the high quality of our loan portfolio and the history of charge-offs. Our coverage ratio is just under 2.5 times the amount of non-performing loans, while the median industry allowance reported for the third quarter would have covered three quarters of non-performing loans according to data on the 400 publicly traded banks reported through S&L. We remain well capitalized with Tier 1 leverage and total risk-based capital ratios of 13.61%, 8.41% and 14.43% respectively.

Looking at the liability side of the balance sheet, average deposits for the quarter increased 14.6% to $12.7 billion for the fourth quarter compared to the same period last year. Average non-interest bearing deposits were 38.6% of our total deposits, which put us in the top 6% of the industry according to SNL Financial. Our high percentage of free funds is a competitive advantage and is reflected in our low cost of funds.

Our overall interest bearing cost of funds was 14 basis points for the fourth quarter versus 23 basis points a year ago. If you factor in free funds, this brings our overall cost of funds down to just 10 basis points for the quarter. For the year, those costs were 17 and 11 basis points respectively. The increase in deposits was primarily driven by institutional clients that leaves sizable deposits on balance sheet. The large depositor disclosed last September remains on balance sheet with increased deposit since the announcement.

The expected departure date of these funds is now mid first quarter of 2014. Public funds remained a substantial part of our business typically resulting in seasonal and total deposits beginning in the fourth quarter and usually peaking in the first quarter. We haven’t seen substantial changes to public funds this year. The level of these deposits is similar to what we have seen in prior years. The short-term nature of public fund inflows combined with the anticipated large depositor outflow are the primary reasons for the increase in the interest-bearing due from banks from $720.5 million on December 31, 2012 to $2.1 billion on December 31, 2013.

Moving to other financial highlights, return on average assets was 0.89% for the quarter, up from 0.60% in the fourth quarter of 2012. For the full year of 2013, return on average assets declined from 0.92% in 2012 to 0.89% in 2013. Return on average equity for the fourth quarter was 9.08% compared to 6.47% a year ago. For the full year, return on average equity was 10.02%.

Turning to the income statement for the fourth quarter 2013, net interest income increased 7.1% to $85.9 million compared to the fourth quarter of 2012. On a linked-quarter basis, net interest income was flat. Fourth quarter average earning asset balances increased 12.7% year-over-year, however, overall yield was 2.6%, down 18 basis points from 2.78% for the fourth quarter 2012. Compared to the fourth quarter 2012, average net interest margin for the quarter decreased 13 basis points to 2.51%. As a reminder, net interest margin is negatively impacted this time of the year when public fund deposits come on balance sheet due to a more narrow spread. For the year ended December 31, 2013, net interest income was up 4.1% to $333.3 million compared to $320.1 million in 2012.

Average net interest margin for the year decreased 20 basis points to 2.55%. Provision expense did not change from 2012 to 2013 and was $17.5 million for the year. As we have discussed in several prior quarter’s conference calls, our provision expense is a reflection of our consistent methodology, which considers the inherent risk in our loan portfolio as well as other qualitative factors. As Mariner mentioned, non-interest income increased 24.1% to a $135.6 million comparing favorably to $109.3 million for the fourth quarter of 2012.

Two major components drove the improvement. First, we recorded $13 million in unrealized gains in market adjustments to Prairie Capital Investments. The second major component is the increase in trust and securities processing, which increased 22.9%. Our Institutional Investment Management segment led the increase in this category with revenue growth of 36.8% for the fourth quarter 2013 compared to the fourth quarter 2012. Peter will provide additional detail behind the improvement in this section of the call.

For the year, total non-interest income increased 7.4% compared to 2012. Details can be found in year-to-date section of our press release. For the fourth quarter, non-interest expense increased 7.9% or $12.5 million compared to the fourth quarter 2012 to $170.4 million. Expenses for the fourth quarter included $6.9 million related to the contingent consideration and liability for two past acquisitions. As we have mentioned in prior earnings calls, an increase to expense in the short run indicates that the expected future performance of these acquisitions will be better than what it is today. In other words, we take the expense in the current period and exchange for the long-term positive impact we expect these businesses to generate. Additionally, as you saw in the press release, higher salaries and wages coupled with an increase in commissions and bonuses with the majority of the increase combined with the adjustment.

For the full year 2013, expenses were up 5.7% compared to 2012. This $33.7 million increase was due primarily to higher salary and benefit expense of $19.8 million. Other non-interest expense increased $3.7 million or 11.4% driven largely by a full year adjustment of $11.3 million in contingent liabilities related to our earn-out agreements versus an adjustment of $6.1 million in 2012 as Mariner mentioned in his remarks.

As part of our quarterly earnings release process, we continue to include segment information in the slide deck accompanying the press release. We have covered the major items attributable to the changes in financial results for the segments earlier in the call and we will be happy to take any specific questions during the Q&A session this morning.

With that, I will hand the call over to Peter for more detail regarding the drivers behind the segment results.

Peter deSilva - President and Chief Operating Officer

Thanks, Mike and good morning everyone. As Mariner mentioned earlier, non-interest income represented 61.2% of revenue for the quarter. As a comparison, the industry medium level of non-interest income to total revenue in the third quarter was 18.6% according to SNL Financial. As a reminder, the income at UMB is generated primarily by our asset management, asset servicing and payments businesses. To provide additional context to our results, I would like to discuss the primary drivers of fee income and highlight some of the developments in each of our operating segments. Much of the data I will cover is included in the supporting slides on our website.

Let me begin with Institutional Investment Management, which is comprised of Scout Investments, equity and fixed income mutual funds and separately managed investment accounts. Revenues in this segment are driven by average mutual fund and separately managed account assets, the mix of those assets, net flows and finally equity and fixed income market performance. Solid performance in net flows combined to contribute to another good quarter for Scout. Assets under management at the end of the year were $31.2 billion, an increase of 32.4% compared to year end 2012. Scout fixed income mutual funds closed the year with assets of $2.8 billion and Scout equity mutual funds with assets of $12.6 billion. Coincidentally, Scout fixed income separate accounts also totaled $12.6 billion and Scout equity separate accounts totaled $3.2 billion in assets under management.

If you look at flows separated by equity and fixed income strategies across all Scout products, including the Scout funds and separately managed accounts. Page 5 of the supporting materials shows the drivers of the change in assets under management, including both net flows and market impact. As of December 31, 2013, assets in Scout equity strategies increased by $709.6 million compared to September 30, 2013. Components of this increase included $106.7 million in net outflows for the Scout equity mutual funds, $13.6 million in net outflows from Scout separately managed equity accounts and a positive impact of $829.9 million due to the overall increase in equity markets.

For the year, assets under management in Scout equity strategies increased $4.5 billion compared to assets under management as of December 31, 2012. Components for the full year include net equity fund inflows of $468.8 million led by the Mid Cap and International Funds. Net equity separately managed account inflows of $1.7 billion, but again by the Mid Cap strategy and positive market impact of $2.4 billion. Assets in Scout’s fixed income strategies increased by $1.1 billion from September 30, 2013 to December 31, 2013. Included in this increase was a $799 million increase in net flows into Scout fixed income mutual funds led once again by the Scout unconstrained bond fund, $253.2 million in net flows into Scout’s fixed income separately managed accounts and a net positive market impact of $86.8 million across all of our fixed income products during the quarter.

For the year, assets in Scout’s fixed income strategies increased $3.1 billion compared to assets under management of December 31, 2012. Components driving the increases included $1.9 billion in fixed income mutual fund net flows, $1.3 billion in fixed income separately managed account net inflows and negative market impact of $58.7 million for the full year. Part of our strategy for Scout is to have a diversified product mix. As of December 31, 2013, six of our strategies had more than $2 billion in AUM contrasted with only four strategies that had at least $2 billion on AUM at December 31, 2012.

Our asset servicing segment comprised of UMB Fund Services ended the year with $191 billion in total assets under administration, an increase of 22.4% compared to $156 billion a year ago. Non-interest income in our asset servicing segment is based on a variety of factors depending on client agreements including basis points on assets administered, transaction fees, or poor account fees. Drivers include new business, growth in the number of funds and shareholders we service, transaction volumes in our clients’ funds and their accounts and overall asset valuations.

Page 10 of the supporting materials shows metrics for some of our various services within UMB Fund Services. In fund accounting and administration, 40 new funds were added over the past year and assets under administration stood at $63 billion at quarter end, an increase of nearly 42.9% compared to the same quarter a year ago. The fourth quarter non-interest income increased 12% compared to the fourth quarter of 2012 and increased 6.7% on a full year basis. Pre-tax profit margin for the year improved to 12.4% from 11.2% in 2012. As a reminder, the final earn-out payment associated with our acquisition of JD Clark & Company occurred in April 2013.

In our Payment Solution segment, there are a number of important business drivers, including overall credit and debit card purchase volume and the resulting card interchange, HSA deposits, FSA and HSA accounts and ACH wire and check transaction volumes. We grouped card purchase volume into four major categories: commercial credit, consumer credit, consumer debit, and healthcare debit.

For the fourth quarter, purchase volume across our suite of interchange generating card products increased 18.4% to $1.6 billion when compared to the fourth quarter of 2012. For the full year, card purchase volume totaled $6.8 billion, an increase of 16.8% compared to 2012. For the quarter, interchange revenue was $15.9 million, an increase of 1.6% compared to the fourth quarter last year. For the full year 2013, interchange revenue was $66 million, an increase of 6.6% compared to 2012.

Commercial credit card purchase volumes continue to grow increasing 5.1% for the fourth quarter when compared to a year ago. Spending by our commercial credit card clients represented 18.6% of total cards spending for the quarter and continues to provide the largest portion of our interchange revenue representing 45.2% of our interchange dollars both for the quarter and for the year.

Moving on to healthcare services, customer deposits and assets in our custody accounts stood at $642.4 million at year end, an increase of 49.2% compared to 2012. The number of flexible spending arrangements in health savings accounts surpassed $4 million for the very first time representing a 32.7% increase from a year ago. We had another strong quarter in this area with purchase volume of $649.2 million in the quarter, an increase of 54% over the same period last year. For the year, purchase volume in our healthcare business increased 41.7% compared to 2012 and represented 43.6% of total card purchase volume for the year.

Interchange revenue from healthcare card purchases in the fourth quarter was 19.3% greater than interchange in the fourth quarter 2012 increasing from $1.8 million to $2.1 million. For the year, it increased 32.8% to $10.3 million. Healthcare services continues to be a reliable, strategic and low cost source of deposits and a growing source of revenue from several streams, account and transaction fees, card interchange, net interest margin, and investment management fees.

The final segment I’ll cover today is our Bank represented by commercial banking, consumer banking and private wealth and institutional asset management. Mariner covered our commercial banking highlights and the very strong loan growth there. Home equity lines and credit balances decreased by 0.5 percentage point to $551.9 million when compared to December 2012. Since 2009, home equity commitments have increased 39.2% and outstanding balances by 28.5%. Portfolio utilization was 45.4% at year end. Assets under management in Prairie Capital Management, private wealth management and institutional asset management stood at $10.2 billion at December 31, an increase of 16% from a year ago. Comprising the $10.2 billion is $7.3 billion in assets under management within private wealth and institutional asset management and $2.9 billion in assets managed by Prairie Capital Management.

Our private banking teams exceeded $325 million on average loans for the fourth quarter, a 36% increase compared to the fourth quarter of last year. We are very pleased with this year-over-year performance.

With that, I will conclude our prepared remarks and turn it to over to the call operator who will open up the line for your questions.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will begin the question-and-answer session. (Operator Instructions) Our first question is from the line of Herman Chan with Wells Fargo Securities. Please go ahead.

Herman Chan - Wells Fargo Securities

Thanks. Realizing the bank continues to invest in the fee income components, can you talk about the general expense trajectory as we head into 2014 and should we expect the Bank to aim for another 5% expense growth?

Mariner Kemper

Yes, hi. This is Mariner, Herman. Thanks for the question. We, as we have done in the past, I hope you have had a chance to look at our investor presentations from the past. We have a slide that has detailed our, what we have been able to do over the past few years in reducing expense, the grade of expense growth? And from ‘11 to ‘12, we brought that down to 4.7% – 4.9%. And it is our intention, it is our plan to continue to keep our core expenses at that level or better as we look forward.

Herman Chan - Wells Fargo Securities

I understood. And can you give some color on the loan growth front in the quarter? From a period end standpoint, it looks like commercial loan growth was pretty strong? What were some of the offsets as you look into the fourth quarter and the period balances?

Mariner Kemper

So what happened in fourth quarter with our loan growth really was simple. A lot of the expected pipeline growth from the fourth quarter moved into the first quarter. So we did have some of what was expected to close in the fourth quarter has moved into the first quarter. What I can tell you about the first quarter is that the pipeline remains as strong as we said that the fourth quarter was supposed to be. And so we expect a decent pipeline in the first quarter.

Herman Chan - Wells Fargo Securities

Understood. Thank you very much.

Operator

Our next question is from Chris McGratty with KBW. Please go ahead.

Chris McGratty - KBW

In your prepared remarks, I am wondering if you can offer a little more color on the expenses, if we adjust for the $7 million earn-out, it looks the fourth quarter expenses were $163 million, $164 million understanding that there were lot of performance hurdles that were achieved and paid, but I guess the question is the expense level that the Street was all looking forward, this came in quite a bit higher. Can you help us at all, Mike, I know you have guidance, but I think we would all appreciate a little bit of color on where the expenses may go over the next few quarters?

Mariner Kemper

Yes. So once you back out the almost $7 million adjustment for the earn-outs, you got to keep your eyes on two other things, it’s going to be salary and benefits. And a lot of the compensation expense increase is related to the performance of fee income businesses. So you are going to have an increase there as well. And then also we will keep your eyes on processing fees as we continue to add more business we are going to pay additional fees to third-party processors. And those two alone are the places where you probably are going to see the most movement and you did see that in the fourth quarter.

Chris McGratty - KBW

Okay. So I guess aside from these line items, should we expect more of a migration back to the low 150s, the mid 150s and as we saw last year or should we be assuming that the performance continues in this level expenses will remain?

Mariner Kemper

I apologize to do this to you, but I guess I would point to the answer I gave, Herman, which is we expect – we were shooting for the kind of expense growth without adjustments of the kind of what we were doing from ‘11 to ‘12.

Chris McGratty - KBW

Okay.

Mariner Kemper

Expense growth, right, so we are not going to be bringing down our expenses to some previous periods where we are a growth company and you are going to see expense growth.

Chris McGratty - KBW

Okay. And then one for you, Mike, I think in the K or the Q, you talk about the proportion of the securities that are pledged, I think it’s around 70%, can you just elaborate a little bit more on the impact for your margin in kind of a different rate scenario, how should we thinking about this dynamic?

Mike Hagedorn

So you are worried about us having, I am not sure I understand the question correctly is the question more around whether we have enough pledgeable securities to continue to bring on those kinds of deposits or is it something else I am not sure I understand it.

Chris McGratty - KBW

I am actually looking for, yes, I guess from that perspective, but also will your – I mean, you got a reasonably low security yield and reasonably a 250 margin. I am wondering if the kind of the underwater, the ball under the water is kind of the spring from the margin perspective, if you will, you will get the full benefit when rates go up?

Mike Hagedorn

Well, I think there is two things. So I understand I think you are getting at two things to consider. When you look at the margin in the fourth quarter and this will be true to probably a little lesser extent in the first quarter of 2014, it’s negatively impacted. We are talking about just margin here, not net interest income, because of the thin spread that we have for all those public fund deposits. So that’s not an ongoing run rate, if you will. You guys, those people that are familiar with our company know that they have to account for that in the fourth quarter and the first quarter. So that’s one issue.

The second issue is as I have talked about in my prepared remarks, specifically we do have a bias towards at least if we can’t shrink the portfolio, we are certainly trying to do that with loans, but if we couldn’t do that, we are certainly shortening the duration. That comes with the cost and that cost shows up in the yield on the reinvestments that we are making each month in the investment portfolio. And that’s something we have been talking about and doing for quite some time, it’s not new.

Mariner Kemper

Yes. I might add on your expense question too is that it’s important for investors to understand we have introduced volatility into our income statement with the investments that we have made in Prairie Capital as well as the other acquisitions we have made. And those investments are strategic and ongoing and will likely introduce additional volatility in the future. We have to keep that in mind.

Chris McGratty - KBW

Okay, great. Just one last one, the large depositor, I think I may have missed it in your prepared remarks, the large deposit relationship that was supposed to exit the Bank at the end of the year, did that fully occur?

Mariner Kemper

No, it’s now expected to occur sometime in the middle of the first quarter this year.

Chris McGratty - KBW

And that’s $1 billion right.

Mariner Kemper

Yes, plus, billion plus.

Chris McGratty - KBW

Okay. And a thought on the replacing the funds is still grow other sources of interest bearing deposits and potentially some borrowings?

Mariner Kemper

I doubt that we probably in the borrowing group, it’s probably going to be mostly attributable to growth in efforts that we have to replace it, but…

Mike Hagedorn

We are a deposits underwriting, which means where we pick up deposits all across our corporation and that’s pretty much the strategy.

Chris McGratty - KBW

Alright, thanks a lot.

Mariner Kemper

Yes.

Operator

Our next question is from John Rodis with FIG Partners. Please go ahead.

John Rodis - FIG Partners

Good morning, guys.

Mariner Kemper

Good morning, John.

John Rodis - FIG Partners

Quick question maybe for you, Mariner, just sort of back to loan growth or I guess the fact that loans were sort of flat linked quarter, I know you talked about some carryover from the fourth quarter into the first quarter, could you maybe talk a little bit about the nature of the pay-downs in maturities during the quarter?

Mariner Kemper

Sure, yes. We had a couple of transactions took place in the fourth quarter, a couple of our larger borrowers that sold in one way. So it’s kind of typical stuff, but this happens now and then, just happened to have a couple of them in the fourth quarter.

John Rodis - FIG Partners

Okay, okay. And then I guess the gains that you had the 13 or so million in gains you had from Prairie Capital, I noticed you said they were unrealized gains, do you expect to realize them at some point or what sort of the distinction there, what are your thoughts?

Mike Hagedorn

Yeah, obviously in this kind of investment where we’re serving is the general partner or fund at some point, these things have an end days. So yes we do expect to at some point in the future realize cash into the company. Keep in mind as we said these are not – these are unrealized and they are not cash, at some point.

Mariner Kemper

But we do not control that.

Mike Hagedorn

That’s correct, we do not.

Mariner Kemper

Unknown date and unknown value in the future.

Mike Hagedorn

Yes. And it could move the other direction. So, to be fair the adjustments this time are up based upon the valuation estimates, but the valuation estimate in future periods could be different.

Mariner Kemper

And we do not control that event either.

Mike Hagedorn

Correct.

John Rodis - FIG Partners

Okay, fair enough. And I hate to do this again, but back to the expenses, the salary line item just to get specific on salaries were up $5 million linked quarter. Given Mariner sort of what you’re saying up 3% to 5% growth going forward. Is that $85 million or $88 million to $89 million sort of a new run rate to use going forward given the level of I guess earn-out and so forth you talked about with the recent acquisitions?

Mariner Kemper

I’m going to refer you to – we have a pretty good page and hopefully this answers your question, Page 4 in the slide deck. It’s actually not in our side, sorry. Can you ask the question again?

John Rodis - FIG Partners

Yes, I guess I was just trying to I guess drill down again on expenses and if you looked at the linked quarter increase in salary expense it went from roughly $84 million to call it $89 million on a linked quarter basis. So, is that $89 million sort of a new run rate going forward or are there some year end incentive comp and so forth that would cause this sort of drop back down in the first quarter?

Mariner Kemper

Well as just Mike said earlier incentive comp is a variable, an ongoing variable based on the success mostly of our non-bank businesses.

John Rodis - FIG Partners

Okay.

Mariner Kemper

So to the extent that those continue to be successful we will continue to have elevated incentive comp, yes.

John Rodis - FIG Partners

Okay. But - so just on expenses so I guess back to a prior question is the right way just sort of look at is to take the 170 back out the $6 million or $7 million adjustment for the earn-out sort of annualize that and assume you’re going to grow low single digits off of that. Is that sort of - am I hearing you correctly?

Mariner Kemper

Well we can’t – we have to let you I guess to do that without because we don’t give guidance if at all I guess that all we can do for you.

Mike Hagedorn

The other thing I would add is you should look at the seasonality of the quarters that’s one thing because obviously as the year goes on you get a better picture for the performance of incentives in particular in fee-based businesses. So, I mean you are on the right track with what we provide to you but.

Mariner Kemper

And fourth quarter is usually a little higher for us anyway; there is some elevated expenses in the fourth quarter of every year so if you look in prior periods you will see that also.

John Rodis - FIG Partners

Okay, that’s fair enough. And Mariner just maybe like to hear your thoughts on the M&A environment you sort of give your update every quarter, so like to hear your thoughts there?

Mariner Kemper

Yes, sure. So, I’d say it’s not a lot new so what I said in the previous period is we have re-engaged our M&A group. We’re active in both looking for bank deals and then non-bank deals in our main areas. We have - all I can say is we like to find a deal that is matches with the kind of company we are and gives us scale and penetrate on the bank side we penetrate further deeper into one of the – our major markets. And the other opportunity is outside the bank, we don’t have any product gap, so they were clearly would be bolt-on or scaling type opportunities. So nothing to report, we are active and we’d very much like to do a deal, do a transaction.

John Rodis - FIG Partners

Okay, fair enough. Thanks guys.

Operator

Our next question is from Peyton Green with Sterne Agee. Please go ahead.

Peyton Green - Sterne Agee

Yes, good morning. I was wondering if you could talk a little bit about the payments business profitability. And maybe what our credit card charge-offs in the fourth quarter versus a year ago and what were they for 2013 versus 2012 I mean the overall charge-off where it seems quite good. And I was just wondering why there would be more provisions in that business?

Mariner Kemper

That’s the allocation.

Peyton Green - Sterne Agee

It is an allocation. It’s something that we have actually been looking at recently. It’s based on believe it or not more balances than actually a history of charge-offs, but yes it is something that we are looking at. Keep in mind even if we were to change the allocation of provision through the card business, it’s likely that we may allocate that back into the commercial sides, I don’t know it would change the provision for the company in total?

Mariner Kemper

Yes, if you look at Slide 11, which was maybe where you are looking, Peyton, you will see the allocation increase from $8.2 million to $12.3 million for the card segment for the full year of last year and might try we have been taking a look at that and making sure without that allocation to the card segment is right. Our charge-offs continue to look great, superior to industry averages, which were I think they are 45 basis points last year and we don’t see any change, 26 basis points. We don’t see any concerns with that portfolio. It’s still clean as a whistle. The real answer is there won’t be any change for the totals within allocation or within the mix.

Peyton Green - Sterne Agee

No, but I mean I guess just looking at the pre-tax margin of 12% down from 25%, I mean that just seems like the Bank’s profitability is overstated versus the Payment Solutions business, but maybe I guess I am thinking about it wrong, but credit cards were flat year-over-year even commitments were only up slightly, I don’t know?

Mariner Kemper

(Indiscernible)

Peyton Green - Sterne Agee

Okay. And then on the interchange, I mean for the volume to be up like it was, the non-interest income was roughly flat, what’s the nature, because I mean I guess all else equal 5% increase in commercial product sort of generated the like increase in the interchange and it doesn’t seem like it is. And certainly, the other side the FSA, HAS, trust-wide fees just don’t seem to be adding much to the pie even though the volume is going up, can you talk a little bit about that?

Mariner Kemper

Sure. So if you are talking about mix and you are exactly, you are exactly correct. The interchange – the highest interchange we have for any interchange producing product is commercial credit and so growth there is a very positive, very positive contributor. The lowest we have is healthcare. And as you know, we have arrangements with a lot of our institutional partners and that holds down the debit interchange and that’s been running in the mid 30s, 30 basis points versus a little, about 150 basis points for the commercial card interchange. So we are seeing nice growth in bulk, but when you look at interchange dollars, certainly the overweight and the interchange being generated by healthcare is compressing the overall growth in the interchange dollars.

Peyton Green - Sterne Agee

But the volume is the answer, right and that’s the short-term problem with the success we are having with healthcare and expect that with healthcare should outpace over time in dollar volume the margin compression there?

Mike Hagedorn

Yes, actually to scale business with about 20% of the GDP in the United States in the healthcare space.

Mariner Kemper

And we are having very, very good success, but it will be a lower interchange revenue generating line item, healthcare will be.

Peyton Green - Sterne Agee

Well, I guess, I mean how many years will you stomach up like 16% to 25% of the increase from the expense side versus what nominal increase in the revenue side, maybe that’s a better way to ask the question?

Mariner Kemper

You are talking about payments generally or healthcare specifically?

Peyton Green - Sterne Agee

Yes, just the Payments Solutions business, I mean if I am looking at year-over-year, revenue was up about 2% in the fourth quarter, it was up maybe 6% or 7% year-over-year, but expenses were up 16% and 25%. I am just wondering what’s the outlook for the next couple of years? Was there a large investment stomached in ‘13 that that won’t be as noticeable in ‘14 and ‘15?

Mariner Kemper

And you hit it it’s an investment technically…

Mike Hagedorn

We had a number of things going on. One, as you may recall, we reported in prior periods that we acquired the book of business from First Data Resources that added a significant amount of expense starting in 2013 as we acquired that book in December of 2012, that’s one element of it and we have corresponding revenues associated with that obviously. Secondly, we have got a little expense heavy and we did a reduction in force, a little bit in the light-weighted part of 2013 to try to right-size some of the expenses. Third, you talked a little about the difference in interchange between healthcare in our commercial and consumer credit cards. Fourth, we haven’t been doing portfolio acquisitions in the last three years and we did some very successful portfolio acquisitions in the prior periods. And so all taken together, you are right we won’t tolerate 25% expense growth which we experienced from ‘12 to ‘13 non-interest expenses. You notice the three months was only 16% and there are some severance costs in there in side. So we are beginning to right size the expense load for the revenue that we expect from this area.

Mariner Kemper

It wasn’t actually a reduction in force just for cleaning up some areas of the organization and bringing people together. We ended up fortunate of being smaller, but we didn’t do a reduction in force actually.

Peyton Green - Sterne Agee

Okay. And then on the asset servicing business, I presumed $1.1 billion in deposits that will rollout in the first quarter, while the net interest income would flow through that servicing business, is that right?

Mike Hagedorn

Correct, that’s correct. You had net interest income move from a $1.8 million in 2012 to $2.4 million roughly in 2013 and some of that will move on in 2014.

Peyton Green - Sterne Agee

Okay. And then that business, I mean, would you expect that the profit margin on the asset servicing business to improve, I mean, certainly you had a very strong asset under administration improvement year-over-year. Should we expect, I mean, more lift in the pre-tax margin in ‘14?

Mariner Kemper

The pre-tax margin is we have ended up at 12% as we noted in 2013. And based upon sales activity and sales growth that we are seeing, yes, I do think that the margin should improve in 2014.

Peyton Green - Sterne Agee

Okay. And then I mean I guess in terms of the bond portfolio buying $355 million worth of bonds, I mean, part of this, forget the expenses, I mean you are growing, you’ve had good revenue growth over the years, but some of it’s an inefficient allocation or generation of revenue I guess. And I mean buying bonds that yields 64 basis points in the time period where rates have effectively increased to 100 basis points to 130 basis points, I don’t know that just doesn’t seem to add up with adding a lot of variable rate loans at the margin too. I mean, we bought asset backed product that yielded 1 to 1.5 and how long whether you buy stuff that yields 50 basis points or 65 basis points?

Mariner Kemper

Peyton, this is one of your favorite questions?

Peyton Green - Sterne Agee

Well, it’s your best opportunity to earn more money in short run, so.

Mariner Kemper

And part of the answer is there is a whole lot of moving parts. It’s not as simple as that, but Mike, you want to take it?

Mike Hagedorn

Well, there is a couple of things in there. You talked about adding variable loans. Actually, if you look back to early 2013, 75% of the portfolio priced in 12 months, we are now down to 66%. So we are putting actually more duration risk if you will into the loan book, not less.

Mariner Kemper

Intentionally.

Mike Hagedorn

Intentionally.

Mariner Kemper

We have talked about that thing in the last quarter or so.

Mike Hagedorn

Correct.

Mariner Kemper

And the intention to remix on the loan side up from variable and put some fixed rate loans on and we have had some success doing that.

Mike Hagedorn

And the second part is obviously we are concerned whether you look at average life for duration as your measurement of how much we would play in a rising rate environment. Now, just to be clear about what is a rising rate environment, the reference you made to 100 basis points up is not the cash flows we are buying. Those are 10-year in our cash flows. We are talking about five years and then maybe even three years and that’s where the yield is. So if we are going to continue to run a portfolio with an average life that we talked about going down, not up, we are obviously going to be buying lower yields, lower average life securities for some period of time, not forever.

Mariner Kemper

We have to pay attention, Peyton, obviously to potential unrealized losses, right, in the future and future period and that has a lot to do with our buying also to make sure that we don’t put undue risk in the organization.

Mike Hagedorn

Yes, Mariner has made a great point that our sensitivity to market risk is something that we watch very closely. And obviously unrealized losses and what that can do to your intangible capital is something that we are considering in those investment decisions as well.

Mariner Kemper

Right. There is lot of moving parts, lot of things to consider. And what we love to do it is higher yields ourselves, but if you are trying to keep within five years as Mike said, your options are very limited.

Peyton Green - Sterne Agee

Okay. And I guess from a production capacity, Mariner, on the loan growth side, you mentioned that the pipeline really slipped from what you would have thought would have funded in the fourth quarter to what will happen in the first quarter. Do you feel like you are constrained at all or do you feel like the capacity is still really good?

Mariner Kemper

I would say that – so, I have been giving – been able to give you a look over the last year or so on a quarterly basis is to what the pipeline looks like. And going into the first quarter, we feel as good about the coming quarter as we did during last year’s outlook. Does that make sense?

Peyton Green - Sterne Agee

Okay. So I mean you feel really good about the volume, naturally the growth rate will slow, because you have got a bigger denominator, but you still feel really good about the volume?

Mariner Kemper

Yes I mean that’s a decent outlook in the first quarter.

Peyton Green - Sterne Agee

Okay. And then maybe the notion of trying to drive operating leverage and get paid back for all the investments that you made I mean I know I guess kind of thinking I mean what’s an acceptable decline I guess in the expense growth rate I mean I guess if we just take reported numbers and assume it all events out over time, the expense growth rate flowed from about 6.5% down about 5.7%. What’s – what do you think the right I mean when would you expect a bigger pay-off or more I guess the utilization of the productive capacity versus what you have to kind of pay?

Mariner Kemper

We’re aiming for it sounds assuming things – a lot of things movement doesn’t take place around the edges. We would like – we’re aiming to what we did from 11 to 12 or thereabout. And if you can refer back to the investor deck I mean that’s a separate 4.9% number and again that is not I’m not giving guidance on that, that’s a – the desired outcome and a range around that. That makes sense. That would be a range.

Mike Hagedorn

Yes, my only thing to add to that would be to make sure that you’re accounting for the fact that the earn-out liabilities have variability up or down obviously as we talked about an increase in those liabilities i.e. an increase in the current period expense is a indicator of the strength that we expect to get from the cash flows of those investments in future periods. I know it doesn’t feel right to take the expense upfront but that is in fact what it means. So, don’t discount that and that number can be significant from time-to-time.

Operator

And our next question is from Tyler Stafford from Stephens. Please go ahead.

Tyler Stafford - Stephens

Hey good morning guys.

Mariner Kemper

Good morning, Tyler.

Tyler Stafford - Stephens

Good morning. Just a follow-up question on the $13 million unrealized gain from Prairie. In the press release you pointed out $14.7 million of earnings from alternative investments. Can you help me understand what that $1.7 million difference is between the $14.7 million and the $13 from Prairie?

Mike Hagedorn

Yes, so the $13 million is specific to one investment. We have considerably more than one investment with Prairie. And so there is adjustments on all the other things they do as well, obviously big difference in valuation between the two.

Tyler Stafford - Stephens

Okay. And do you have a like a apples-to-apples comparison what that would have been in 3Q?

Mike Hagedorn

For just the one investment or..

Tyler Stafford - Stephens

Just kind of X I think there was $3.9 million of Prairie related gains, just kind of X that?

Mike Hagedorn

Yes, you got it Tyler that’s a $3.9 million.

Tyler Stafford - Stephens

Okay. Just $3.9 million, okay.

Mariner Kemper

Yes.

Tyler Stafford - Stephens

And then switching over to the (indiscernible) quickly, how far away do you feel you are from seeing maybe an inflection point in the loan yields?

Mariner Kemper

That’s a great question. We do feel like that’s starting to moderate and as we mentioned the remixing is starting to take place so we should start to feel that level out both because I think at a competitive level that’s starting to flow and then also for us in particular remixing should contribute as well.

Tyler Stafford - Stephens

Okay, thanks. All my other questions have been answered.

Operator

Our next question is from John Rodis with FIG Partners. Please go ahead.

John Rodis - FIG Partners

Hi guys. Just a follow-up question on the Peyton’s on the asset servicing business, I know initially you said the one large depositor that was leaving will remain a servicing client. Is that still the case?

Mike Hagedorn

Yes, in the…

Mariner Kemper

Very much so they are very happy with the relationship.

John Rodis - FIG Partners

Okay. And then Mike just your comment on the higher earn-out and then taking the expense upfront for future, better future cash flows. So is that I guess those better future cash flows would flow through the trust and securities processing line item. Is that correct?

Mike Hagedorn

No, we are talking about net interest margin.

Mariner Kemper

No, no, he is asking about where that would flow through sort of taking the adjustments and then where was the future period?

Mariner Kemper

Oh, you are talking about the….

John Rodis - FIG Partners

The earn-out?

Mariner Kemper

The earn-out, yes, for the most part, it would be in that line, correct. Sorry, I misunderstood your question.

John Rodis - FIG Partners

Okay, thanks guys.

Operator

And our next question is from the line of Peyton Green. Please go ahead.

Peyton Green - Sterne Agee

Yes. Just a follow-up on the Institutional Investment Management business, I mean, over time operating leverage has been quite substantial due to the Reams acquisition, which has been a great one, but is the thought and maybe I just want to make sure I understand, the earn-out on that rolls in December of ‘15 is that correct?

Mariner Kemper

Yes.

Peyton Green - Sterne Agee

Okay. And then Prairie would roll in July or August of ‘15 also?

Mariner Kemper

Correct.

Mike Hagedorn

Yes.

Peyton Green - Sterne Agee

Okay. So if you had such success on the unconstrained bond fund, but yet there were still fee and expense waivers in place say for ‘13 and ‘14, but they would roll in ‘15, I guess that would significantly affect your outlook for profitability for Reams in the potential earn-out. Is that the right way to think about it?

Mariner Kemper

Yes, correct.

Peyton Green - Sterne Agee

Okay. So there is – I guess there is really a year gap between what you would expect the operating leverage to be all else equal in ‘15 versus ‘14 due to the unconstrained bond fund, is that fair?

Mariner Kemper

Yes, I think that’s a good way to think about it.

Peyton Green - Sterne Agee

Absolutely true.

Mariner Kemper

We do have the fee caps in place today.

Peyton Green - Sterne Agee

And so when you announced Reams, I think the original cash piece was about $45 million and the earn-out was estimated about $33 million, what’s the earn-out estimated today?

Mike Hagedorn

I don’t know the number off the top of my head in total for the future periods, not sure that we made that public. We can get back. We will look into that and see…

Mariner Kemper

What we have disclosed that’s going to get out the current results on that one. I think we are just doing that period by period, so…

Peyton Green – Sterne Agee

Yes, this goes back to what it was about. So, I guess, I mean, the basic point though is that earn-out is no longer 33, it’s substantially higher?

Mike Hagedorn

Well, it’s going to be, yes, I mean, it’s performed better than model that’s your question.

Peyton Green - Sterne Agee

Yes.

Mariner Kemper

Yes, that sounds like that’s your question, it has performed better than model.

Peyton Green - Sterne Agee

And the earn-out from those are cash not stock, is that right?

Mike Hagedorn

Correct.

Mariner Kemper

Correct.

Peyton Green - Sterne Agee

Okay. Alright, thanks for clarifying that.

Mariner Kemper

Okay.

Operator

And our next question is from Chris McGratty with KBW. Please go ahead.

Chris McGratty - KBW

Just unclear Mike on the expenses, apology, the 3% to 5% and Mariner, you spoke about that’s off an adjusted – adjust for the full earn-out liability, correct?

Mike Hagedorn

That is correct. For the full earn-out liability and I would say also for those things that are seasonal in nature that always occur in the fourth quarter. So what are those things? Marketing and maybe some business development tends to always be higher in the fourth quarter than the previous three. We bought a little bit of equipment in the fourth quarter and had higher expenses of about $1 million as a result. So there is always some seasonality in the fourth quarter.

Mariner Kemper

Right. And just to be clear, I didn’t use the word 3%.

Chris McGratty – KBW

Alright, thank you.

Mariner Kemper

Yes, thanks Chris.

Operator

And there are no questions at this time. Please continue with any closing statements.

Abby Wendel - Director, Investor Relations

Thank you very much for your interest in UMB. This call can be accessed via replay at our website beginning in about two hours and it will run through February 6. And always you can contact UMB Investor Relations with any follow-up questions by calling 816-860-1685. Again, we appreciate your interest this time.

Operator

Ladies and gentlemen, that does conclude the conference call for today. Thank you for your participation. You may now disconnect.

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