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Susquehanna Bancshares Inc. (NASDAQ:SUSQ)

Q1 2014 Earnings Conference Call

April 24, 2014 11:00 AM ET

Executives

Jason Weber – Director, IR

Bill Reuter – Chairman and CEO

Mike Harrington – EVP, CFO and Treasurer

Analysts

Chris McGratty – KBW Investments

Matthew Clark – Credit Suisse

Preeti Dixit – JP Morgan

Matthew Kelley – Sterne, Agee

Operator

Good morning, and welcome to Susquehanna Bancshares First Quarter 2014 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) Thank you. Mr. Weber, you may begin your conference call.

Jason Weber

Thank you, Brendon. Good morning, and welcome everyone. I am Jason Weber and I serve as Vice President and Director of Investor Relations at Susquehanna Bancshares. Our press release containing 2014 first quarter financial results was made available yesterday after the market closed. You can find this and other financial releases in the Investor Relations section of our website at www.susquehanna.net.

Certain statements made during this conference call may be considered to be forward-looking statements. In particular, certain statements made on this call may include forward-looking statements relating to customer relationship strategies, 2014 performance, deposit and loan volume, growth and mix; fee income activities and revenues; capital management, and the impact of purchase accounting benefit on financial results.

Such statements are not guarantees of future performance and are subject to certain risks and uncertainties. Factors that may cause actual results to differ materially from expectations are detailed in the press release and our SEC filings. We encourage you to refer to such filings including the Form 8-K filed yesterday containing our earnings release and our most recent Form 10-K for a complete discussion of forward-looking statements.

Forward-looking statements speak only as of the date they are made. We do not intend to update publicly any forward-looking statements to reflect circumstances or events that may occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events, except as required by law.

Participants in today’s call will be Bill Reuter, Chairman and Chief Executive Officer; Mike Harrington, Executive Vice President, Chief Financial Officer and Treasurer; Mike Quick, Executive Vice President and Chief Corporate Credit Officer.

Now I’ll turn the call over to Bill Reuter.

Bill Reuter

Thank you, Jason and good morning everyone. And thank you for joining us. Our first quarter results show progress on certain key initiatives for this year, as well as areas where we need to improve our performance going forward. As other banks in the region have noted, factors impacting the quarter include the ongoing competitive business environment and the winter weather that caused a slowdown in business activity. These factors had a wide ranging affect on various areas of our operations.

The weather endangers travel conditions, reduced traffic in our branches, affected the level of business activity of our customers and delayed some loan closings. We also felt the winter storms seasons impact on the expense side as we spent nearly $2 million on store removal during – towards the season. Both the weather and the competitive lending environment contributed to a slowdown in loan originations which decreased from the prior quarter. Mike will provide some additional color on this but total loans and leases were essentially flat on a linked quarter basis. However, the commercial pipeline has remained stable and with the weather slowdown from the January and February behind us, we saw some beginning signs of some pickup in March.

In managing the loan portfolio, one aspect we’re focusing on is an improvement in the mix of loans. To that end, we saw growth in commercial loans for both – from both, the prior quarter and from the first quarter 2013. I should note that we’ve also achieved good year-over-year growth from our small ticket commercial finance line of business adding higher quality yielding assets to the mix. We also achieved growth in consumer and leases. As mentioned in the past quarters, we continue to increase our auto loans and leases as we’ve expanded into markets.

Data [ph] quality remains largely stable, on a linked quarter basis we saw a slight uptick in non-performing assets but net charge-offs decreased and TDRs also declined. First and foremost, among our objective this year is to increase deposits as we discussed on last quarter’s call. Total deposits increased $210 million or 1.6% from December 31 and $388 million or about 3.1% year-over-year. The pace of deposit growth accelerated over the levels reported in January both on a linked quarter and on year-over-year basis. It’s important to note that we’re able to achieve this level of growth without an increase on the cost of deposits.

Comparing deposits at the end of the quarter for the same period a year ago, there was a solid increase in relationship banking products, including interest-bearing checking and saving accounts, as well as our CD portfolio. The number of business checking accounts was up 2.8% year-over-year while balances in business checking accounts achieved a strong 11.4% increase compared to March 31, 2013. In consumer checking we saw a positive trend in March when our average daily new and closed account numbers were at the strongest level in more than two years and balances were up 5% year-over-year. We also continued to receive strong interest and convenient services such as online and mobile banking. As of March 31 for example, mobile banking uses were up 72% from the same time last year.

This is a good time really the performance of our Stellar Checking with Smart Rewards, the new checking account product we launched a year ago. Of the 70,610 Stellar Checking Accounts about 30% are customers who are new to the bank. We’re seeing that both, new and existing Stellar Checking Account holders are also bringing additional deposits to the bank. The total relationships they have with such account have grown by $181 million over the last 13 months. In addition the rewards associated with this account provide an incentive for activities that generate recurring fee income such as debit-card interchange fees. Stellar Checking customers have shown good retention with 93% of accounts opened since March 2013 still active.

The competitive banking environment continue to put pressure on the margin, partly due to repricing within our existing loan portfolio. We’re working to strike up the right balance between meeting customer demand and profitability. Our approach to pricing involves reviewing the overall customer relationship. Consistent with our strategy, we’ve strived to maintain stronger customer relationships and the related revenue they produce for the bank. Mike will provide additional information on our margins later on in the call.

Non-interest income decreased on a linked quarter basis and was essentially flat year-over-year. This area was also impacted by harsh winter weather. For example, as commercial loan closings declined, related capital market fees also decreased. We did an effective job of managing expenses while still investing in new talent to help grow our organization and enhance operations with need to [ph] build out our team of bankers focused on developing relationships with customers and generating loans as well as non-interest income.

In addition to new commercial lenders, we’ve added residential mortgage bankers and financial consultants and are working in line of business to better penetrate markets. We appointed two experienced members of our team to serve as divisional CEOs in Pennsylvania; one leading our Central Pennsylvania, market of Lancaster, York and Harrisburg, and the other leading the northern tier of our Pennsylvania market ranging from State College East to Lehigh Valley. We also hired a veteran banker to fill the new role of Chief Retail Officer. He will be responsible for further developing our overall retail strategy, collaborating with the leadership at our regions to bring greater consistency and productivity to our sales efforts.

Now I’d like to turn the call over to Mike Harrington for review of our first quarter results.

Mike Harrington

Thank you, Bill and good morning everyone. As Bill mentioned in his opening remarks, we got up to a slow start in 2014. For the normal levels of customer activity do impart to the weather. In addition, slow economic growth along with low interest rates remain headwinds to our business.

Despite these challenges we were able to execute on our strategic plan by growing C&I loans while de-emphasizing other loan categories such as residential loans that we portfolio. Also consistent with our strategy, strategic plan, we saw an increase in deposits. With that in mind, I’ll review some of our key financial results for the first quarter of 2014.

Net income for the first quarter was $37.2 million or $0.20 per diluted share compared to $41.3 million or $0.22 per diluted share for the prior quarter. Return on average assets and average tangible equity for the quarter finished at 0.82% and 11.08% respectively compared to 0.89% and 12.49% respectively for the prior quarter. Net interest income decreased $2.6 million or 1.8% linked quarter. The decline was attributable to 90 days in the quarter compared to 92 days in the prior quarter. Average earnings assets were up slightly while net interest margin increased 1 basis point to 3.61% for the 3.60% in the prior quarter.

The net interest margin excluding purchase accounting was down 5 basis points to 3.40% compared to 3.45% in the prior quarter. While we mentioned last quarter that the net interest margin should start to stabilize, we in fact experienced a higher than expected level of repricing in our existing loan book, a result of increased competition in the markets we serve. Newer rates, new originations coming on that lower rate on existing loan book, and less commercial loan mix as expected also had a modest negative impact.

On a positive note, new loan spreads and yields were up linked quarter. We are cautiously optimistic that by year end we will reach a point where new loan yields near the existing loan book, with a specific timing of when we reach that point it will be a function of the competitive market, interest rate environment, and our origination mix for the remainder for the year.

Expected purchase accounting benefit to continue into future periods or caution at the timing of the recognition of this benefit will be subject to fluctuations as evidenced in this quarter. As I mentioned above certain challenges this quarter which will lower the normal level of customer activity, as a result, we did see a drop in loan originations and commitments linked quarter which line utilization remained generally the same. Line utilization was 43% for commercial lines and 52% for consumer lines.

Loans and leases ended the quarter at $13.6 billion, essentially flat from the prior quarter. Consistent with our strategic plan, we saw a pickup in C&I lending in the first quarter which was up 0.7% or 2.8% annualized. Total deposits ended the quarter at $13.1 billion, an increase of 1.6% or 6.5% annualized. Deposit growth continues to be a top priority for us in 2014 and beyond. Our goal is to drive the loan to deposit ratio to just below 100% in 2014. Achieving this goal will increase the value of our deposit franchise which improving the liquidity and interest rate risk profile of the bank. To that end, the loan and deposit ratio ended the first quarter at 103.8% compared to a 105.5% in the prior quarter.

Turning to credit quality. The loan loss provision was $6 million for the quarter while net charge-offs were $9.5 million, which was the lowest levels of net charge-offs since the third quarter of 2008. As a result, the allowance for loan losses declined to 1.14% of loans from 1.16% in the prior quarter while the coverage ratio remained healthy at 142% of non-accrual loans and leases.

Non-interest income decreased to $42.1 million compared to $50.7 million for the prior quarter. The prior quarter end included a gain on sale of branch properties of approximately $5 million and an incentive payment of approximately $1.5 million from our payment network provider. The remaining decline in non-interest income was due to softer performance in our other fee businesses. For example, our capital markets business revenue is down due to weaker commercial loan closings that we saw in less swap income. Additionally, other income was down as we had approximately $1 million less in gain on sale of non-mortgage loans and leases, primarily SBA loans.

Non-interest expense decreased to $123 million compared to $135.7 million in the prior quarter. Our fourth quarter included branch consolidation cost of $6.6 million and approximately $3 million of additional incentive compensation expense due to a stronger than anticipated fourth quarter, particularly in commercial loan growth. Most of the expense categories had linked quarter declines, particularly salary employee benefits and FTIC expenses. Occupancy expenses were up $2 million, due primarily to slow renewal expenses during the quarter.

The effective tax rate for the quarter was 30% compared to 26% linked quarter. The tax rate was lower in the fourth quarter primarily due to a reduction in expense of approximately $4 million as a sale leaseback transaction enabled Susquehanna to realize deferred tax asset which was previously subject to evaluation allowance.

Turning to capital. Our capital ratios continue to build and exceed our internal targets and those required to be considered both capitalized under the current regulatory requirements with the tier 1 common ratio of 10.84%., tier 1 risk weighted capital ratio of 11.95%, total risk weighted capital ratio of 13.23%, and a leverage ratio of 9.72% each as of March 31, 2014. In the final form of capital, we expect to provide more guidance on the capital management, much received feedback from our submission from the Federal Reserve which we don’t expect until the second half of 2014.

I will conclude my remarks with a few comments about our expectations for the next quarter. First, an interest margin and net interest income. We may see our margin excluding purchase accounting to climb slightly as we experience similar competitive pressures in our existing loan book, on the core known basis that equates to a range of 3.40% to 3.36%. With regards to purchase accounting, we believe 15 basis points is a loan lease level of accretion. As we mentioned in the prior quarters, we expect the provision to trend in line with the last four quarters annualized. We expect non-interest income to be up from the prior quarter as capital markets rebound and we get a lift from the mortgage business as we enter the spring home buying season.

We expect non-interest expenses to be up for the quarter as normal, inflation factors such as annualized merit increases begin to fully impact the salary and benefits line item.

Now I would like to turn the call over to Bill for his closing remarks.

Bill Reuter

Thank you, Mike. With the first quarter and the weather issues behind us we need to focus on several key areas going forward in 2014. First, effectively managing expenses on increasing efficiency is always a top priority, particularly in this challenging revenue environment. Second, we’re working to build on momentum with established and deposit growth. Third, we’re continuing the rebalancing of our loan portfolio by growing C&I lending and de-emphasizing less strategic lines of business.

And finally we must capitalize on opportunities for non-interest income by cross-selling existing customer base and developing prospects into new relationship. Our key members are collectively focused on implementing our strategic objectives to further enhance the service we offer to customers and results we provide to shareholders.

I look forward to working with them to tackle these challenges as 2014 unfolds. Thank you for your attention. We’ll now open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) And we’ll go first to Chris McGratty with KBW Investments.

Chris McGratty – KBW Investments

Good morning guys. Mike, on the CD growth in the quarter, what were the – how far did you guys go in terms of term and what were the rates you guys are paying them in new CDs?

Mike Harrington

We have two terms that we’re using to attract new CDs, let’s say a five-year term and an 18-month term. So the five-year term is placed around 2% and the 18-month terms in the 1.20% range.

Bill Reuter

Chris, I want to point out to you however that there – that’s not what I consider a money renting situation, in order to get those rates you have to have your core checking account, or just open a core checking accounts.

Mike Harrington

And the only thing I’ll add to that is, it’s not that the expense was flat so what we experience is we had our existing CDs renew at our rack rates, so that offset the cost of the acquisition on the new CDs.

Chris McGratty – KBW Investments

Okay. Mike, on the purchase accounting, I think at year end you had about $46 million or so, correct me if I’m wrong, of purchase accounting accretibly you have left [ph], what is that number at year end and what is the – what’s left in terms of the credit market?

Mike Harrington

As the credit market numbers – credit market, that total is – I don’t have that in front of me, the loan market is $35 million, total. So that would be the credit market.

Chris McGratty – KBW Investments

Okay. And then…

Mike Harrington

No, I don’t have the number right in front of me, the accretion mark, for the purchase impaired.

Chris McGratty – KBW Investments

Right. But I guess my question is, if we take a step back and as the year plays out and as we get in the 15 – the majority of this should have been – should burn off over the next six quarters.

Mike Harrington

Our estimates right now, we expect the credit, the total accretion from purchase accounting to go well into 2015, at least in the middle of 2015. For this year, and the reason I pointed out that the 15 basis points of normalized as we expect that 15, that’s what we’re assuming when we look at our forecast that all stand at 14 basis points to 15 basis points and just a percent of that total margin.

Chris McGratty – KBW Investments

Okay. Just a last one, on the comments on the balance sheet, maybe I missed it. Mike, is the expectation for earning assets basically be flat for the rest of the year?

Mike Harrington

Yes, it is.

Chris McGratty – KBW Investments

Thanks.

Mike Harrington

Yes, what we’re doing is we’re retaining the loan side. So, and just to clarify Chris, the total market is $35 million, that includes the credit piece as well. Okay, so…

Chris McGratty – KBW Investments

So $35 million is both credit and non-credit and not accretively [ph] yield in credit market, okay.

Mike Harrington

And then just to answer your question, so what we’re doing so is rotating the asset side, and so higher yielding assets. And then we’re also rotating the funding side swapping borrowings for deposits but don’t expect a lot of growth, last quarter I said that would be below our growth rate last year which was 2.4% and we really don’t expect it to be much more than – between 0% and 1% probably.

Chris McGratty – KBW Investments

Thanks.

Mike Harrington

This is the one – let me clarify one thing that’s – I think it’s really an important concept that everybody understand, how important is this change of mix of loan portfolio is. We – as an example, we expect about 80% of our mortgage production to be sold in the secondary market, that was probably around 60% last year. Obviously the loans that were booked in that portfolio or loans like COA loans which we book for own account. So we want to push more one to four one year arms and five year arms into the secondary market. Our gut tells that it’s not a great time to book those anyway, and as you see that portfolio start to pay down, it’s going to be replaced by an increased emphasis on C&I lending, I mean our C&I loans right now are going on the books of that – sort of around 4.70% or better, as opposed to our one year arm that’s probably around 2.80%. And then on top of that we’re picking up some good steam in our small ticket commercial loan operation. There you know we saw – we’re experiencing about a 32% increase in the volumes and we’re well north of 6% in yield in that portfolio. So we are – that’s some of the things we’re doing to rebalance the mix of the portfolio which ends up protecting our yield and increasing our yield overall and the company on our loan portfolio.

Chris McGratty – KBW Investments

Got it, thanks a lot.

Operator

We’ll go next to Matthew Clark with Credit Suisse.

Matthew Clark – Credit Suisse

Very good morning guys.

Bill Reuter

Hi, Matt.

Matthew Clark – Credit Suisse

As we think about the balance sheet, going beyond this year, you’ve got a remix going on the asset side, you’ve got a loan to deposit ratio that you want to get down to a hundred by the end of this year. But I guess what could be still – maybe even a more difficult deposit gather environment next year, I guess can you talk about whether that were going to be in this kind of steady state on the asset side or even – sorry, in the loan book, even beyond this year or just more muted growth going forward?

Bill Reuter

Well, we’ve messaged from an ultimate goal around line of deposit is into the mid 90s. So we’re going to continue to try to drive deposit growth, I mean we’re being preemptive in doing that now, we want to try to get ahead of that and build momentum in deposit gathering to the extent we do that and we get start to drive that ratio down then we’ll be able to grow incrementally as we bring in more deposits. And I’ll talk about – maybe Mike will also chip in here, but – for instance, the investment portfolio, we’re not growing the investment portfolio right now, it’s slightly shrinking slightly because the yields are just not there, so if the rate environment changes then what would be back in the business of increase in the investment portfolio but that’s not on the cards right now based on the product rate that we’re in.

Matthew Clark – Credit Suisse

So we have any…

Bill Reuter

I think that the company is really focused on deposit generation from a relationship banking standpoint, whether it’s our cash management people or retail people or our commercial people, all across the board we’re focused on deposit generation as it relates to the core relationship. Again, we’re not emphasize not necessarily money renting but the relationship banking, so we were – despite the bad weather we were very optimistic of even our first quarter results as we grew about 1.6% and we’ve got good mix of business from the first quarter, we expect that momentum can continue to increase. That [indiscernible] had more flexibility as we move forward in terms of increasing the loan portfolio and again helping to change the mix.

Matthew Clark – Credit Suisse

Great. And with that deposit growth, I guess for the balance of the year after – you know, you could start here. Are there any promotions plan at all?

Bill Reuter

We’re running them not until…

Mike Harrington

Yes, there are. I mean many but we have a number of promotions from – in the marketing department. And I think one of our core strategies is having brought a new retail, we have a new position in the company for the Chief Retail Deposit Officer, I think he moved a lot of good thoughts from the table and he’s already implemented some of them and I think you’ll see deposit momentum continue throughout the year. I would also tell you that lot of our short-term incentives are realigned with deposit generation at same time with more weight towards deposit generation and for instance in 2000 and 2013 [ph].

Matthew Clark – Credit Suisse

Okay. And then just a housekeeping item, the tax rate going forward has been down a little bit?

Mike Harrington

It’s about 30%, good number to use.

Matthew Clark – Credit Suisse

Okay, thanks.

Operator

We’ll next go to Preeti Dixit with JP Morgan.

Preeti Dixit – JP Morgan

Hi, good morning everyone. You mentioned the reduction in the SBA gains this quarter, can we expect other income to look more like the average last year or what’s a good run rate for that line item?

Bill Reuter

Yes, I think you’ll see it rebound from the 42-ish number that we reported this quarter. And I would – if you’re trying to think about it on a full year basis, I would expect – you should expect us to get back to what we were doing last year. The timing of that – whether or not that’s in the second quarter or third, I can’t really comment on it right now but – to certainly see that suppose the activities like SBA lending should definitely rebound off the soft quarter we had.

Preeti Dixit – JP Morgan

Okay, that’s helpful. And I appreciate your comments on waiting for DFAS but can you just help us think about your philosophy with regard to buybacks given the pressure on the shares here, maybe help us think about where you look to get more active relative to potential book value. I hope you have an authorization in place?

Bill Reuter

We don’t have an authorization in place right now and I would – this is Bill Reuter’s take, and then I would tell you that as we proceed with looking at DFAS results, we at the same time will be formulating it a new capital plan with pretty much everything on the table, from increased dividends to special dividends, to buybacks or a combinations there, what we’ve got pretty much everything on the table. So, but again as Mike indicated in his comments, we expect that to be a second half occurrence.

Preeti Dixit – JP Morgan

Okay. And in terms of total payout, I know in the past with regard to the dividend you’ve talked about 30%, maybe if you could help us think about your total payout time?

Bill Reuter

No, I don’t think – I think we’re going to – we’ll revisit the total payout thought process as prior capital plan.

Preeti Dixit – JP Morgan

Okay, great. I appreciate that color, thanks.

Operator

(Operator Instructions) We’ll go next to Matthew Kelley with Sterne, Agee.

Matthew Kelley – Sterne, Agee

Hi, I was wondering if the pace of the securities book reduction will be maintained, down about 4%, in the fourth quarter 3%, is that the same type of level we’ll see over the next couple of quarters.

Mike Harrington

Matt, I mean the reason that – and Bill alluded to this a few minutes ago, the reason we’re not reinvesting is because as the shreds [ph] dropped in the quarter, they are just still low right now, I just really don’t want to be buying the security. So instead of maintaining the size of that balance sheet, we’re just using those proceeds and paying off borrowings. So, to the extent that the interest rate environment changes and maybe it moves up a little bit, airway [ph] might get back into the market, that’s what you’ve seen us, if you look at our balances over the last four quarters, it bounced around a little bit and that’s the reason for that; when rates move up, we’ve got a certain – totally look for the full reinvestment, right now we’re just not comfortable buying three four-year assets with 1.80% [ph] handle on them.

Matthew Kelley – Sterne, Agee

Okay. And has there been a change in your assessment rate or were there any onetime factors in the FTI sheet or fee insurance expense, or…

Mike Harrington

I think what happened – we have to make an estimate, and then we actually get the invoice. So, I mean sometimes it’s not as precise as it could be, so – you saw this, a good run rate if that’s what you’re looking for in FTI sheets, it’s about $5.5 million.

Matthew Kelley – Sterne, Agee

Okay.

Mike Harrington

So it’s a little high. In Q4 this number was low because we’re reversing some of that and over.

Matthew Kelley – Sterne, Agee

Got it. And then, just beyond the loan and deposit ratio, as you look at your capital management and liquidity management plans in light of the DFAS results in longer term, what else beyond just getting into the mid 90s on a loan to deposit ratio that you’re targeting for changes in your liquidity profile compared to what we’ve seen historically?

Mike Harrington

If the combination of the loan to deposit ratio will drive a few things and one of that will be less reliance on non-core funding and wholesale funding, so that’s the other – you will see us have less reliance on that on a go forward basis, that’s prior to the other primary key risk indicator that we’re looking at.

Matthew Kelley – Sterne, Agee

Got you. Okay, thank you.

Operator

(Operator Instructions) We’ll go to John Loraine with McQuerry Capital [ph].

Unidentified Analyst

Hi, guys. Just a quick one for me, I know you guys have consolidated some branches to some say lease backs [ph] and some different things. Do you think there is more wood chop [ph] in terms of getting OpEx out of the system that way and how do you kind of balance that against the adoption that you have in mobile and obviously, the focus on deposit generation here?

Mike Harrington

That’s a great question. Listen, when we bought [indiscernible] two years ago, I think we consolidated or they were close, about 25, 26 branches. This past October we did another 10 to 15 branches. So I think we’re pretty satisfied with the core branch system that we have. Now I would say that always forget to us watching trends in the branch system like any bank does. You know, I don’t think you should be looking for another branch consolidation on assets in near future. I think we’re very satisfied with the branch system we have. I think any additional closing of branches would have a net negative result on deposit generation, to be quite frank with you. So we’re happy with the branch system. What I say subject to, we obviously are continuing to look at trends in foot traffic and branches. We look at trends in terms of how our mobile activities are affecting our own loan activities are affected branch traffic, so we’ll continue to monitor that, certainly not for the short-term are we considering branch consolidation.

Unidentified Analyst

Got it, thanks very much.

Operator

(Operator Instructions) And it appears we have no additional questions in our queue. I would like to turn the call back over to Mr. Reuter for any additional or closing remarks.

Bill Reuter

Yes, thank you for your questions this morning. We hope you can join us for our next quarterly conference call on Thursday, July 24, 2014 at 11:00 AM Eastern Time. It will be available via our webcast on our website www.susquehanna.net. Thank you for your interest in Susquehanna Bancshares.

Operator

And that does conclude today’s call. Thank you all for your participation.

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