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Mercantile Bank Corporation (NASDAQ:MBWM)

Q3 2010 Earnings Call Transcript

October 19, 2010 10:00 am ET

Executives

Mike Price – President and CEO

Chuck Christmas – CFO, SVP

Bob Kaminski – COO, EVP, Secretary; President

Analysts

Stephen Geyen – Stifel Nicolaus

Terry McEvoy – Oppenheimer & Co.

John Barber – Keefe, Bruyette & Woods

Greg Dodgson – Royal Securities

Eric Reboulet [ph]

Operator

Welcome to the Mercantile Bank Corporation third quarter earnings conference call. There will be a question and answer session 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 of objectives of the company or its management, statements on economic performance and statements regarding 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 obligations to update forward looking statements made during this call. If anyone does not already have a press release issued by Mercantile today, you can access it by the Company’s website, www.mercbank.com

On the conference, today from Mercantile Bank Corporation we have Mike Price, Chairman and President and Chief Executive Officer, Bob Kaminski, Executive Vice President and Chief Operating Officer, Chuck Christmas, Senior Vice President and Chief Financial Officer.

We will begin today's call with management's prepared remarks and open up the call for questions. At this point, I will turn the call over to Mr. Price to begin. Please begin.

Mike Price

Thank you, and good morning everyone and welcome. And while our income statement continued to show distress of elevated provisioning and bad debt expense, our third quarter results had some very positive important trends. The improvement in past due in non-performing loans that initially surfaced in the second quarter picked up tremendous momentum. Non-performing loans and ORE were down significantly for the quarter and since we have painfully learned that the level of nonperformers is a good indicator of future credit costs, this reduction is a very positive sign for the quarters ahead. Bob Kaminski will detail the dynamics of our loan portfolio and the provision for loan-loss during his comments but at this time I'm going to turn it over to our CFO, Chuck Christmas.

Chuck Christmas

Thanks Mike. Good morning everybody. This morning we announced that we recorded a net loss of $5.7 million during the third quarter of 2010 compared to a net loss of $5.6 million during the third quarter of 2009 and a net loss of $9.3 million during the first nine months of 2010 compared to a net loss of $16.5 million during the first nine months in 2009. On a pre-tax basis which we believe provides a more accurate comparison of our operating results given the change in our tax position over the last couple of years, our net loss from the third quarter of 2001 was $6.1 million compared to a net loss of $9 million during the third quarter of 2009 and our net loss from the first nine months of 2010 was $10.4 million compared to a net loss of $25.9 million during the same time period in 2009.

While we are of course disappointed any time we have to report a net loss, we are encouraged with the significant improvement in our operating results as well as the continued improvement in many key areas of our financial condition and performance. Our financial performance during 2010 like that throughout 2009 and 2008 has been impacted by a significant provision expense. Unfortunately, continued state, regional, and national economic struggles have negatively impacted some of our borrowers' cash flows and underlying collateral values, leading to increased non-performing assets, higher loan charge-offs, and increased overall credit risk within our loan portfolio when compared to historical norms.

From the time we sensed economic weakness over two years ago, we have been working with our borrowers to develop constructive dialog, which has strengthened our relationships and enhanced our ability to resolve complex issues. With the environment for the banking industry likely to remain stressed until economic conditions improve, credit quality will continue to be our major concern. We will remain relentlessly vigilant in the identification and administration of problem assets.

Unfortunately, provision expense as well as nonperforming asset administration resolution costs will likely remain higher than historical levels, dampening future earnings performance. But during the third quarter of 2010, we saw the continuation of the very positive trends we have reported for the first and second quarters of 2010 and throughout 2009 as well, and I'd like to touch on some of them with you this morning.

Despite a reduction in our total earning assets, an improved net interest margin has provided for increased net interest income. Net interest income during the third quarter of 2010 was $400,000 higher or 3 percent than the third quarter of 2009 and during the first nine months of 2010 our net interest income was $4.8 million or 13 percent higher than during the first nine months of 2009. Our net interest margin during the third quarter of 2010 was 3.33 percent compared to 2.85 percent during the third quarter of 2009, an improvement of 48 basis point or 17 percent. The improvement is primarily due to the significant decline in our cost of funds. While we expect further reductions in our cost of funds in future periods it will likely be at a much slower pace than during the past couple of years.

Also contributing to our improved net interest margin has been a very stable yield on assets. The loan pricing initiatives that we have undertaken within the commercial loan function have almost completely mitigated the negative impact of higher levels of non-accrual loans. Overhead cost reduction strategies are becoming realized. Salaries and benefits, occupancy, and furniture and equipment costs declined $400,000 or 7 percent during the third quarter of 2010 compared to the third quarter of 2009 and are down $2.5 million or almost 13 percent during first nine months of 2010 when compared to the same time period in 2009.

Nonperforming asset administration and resolution costs totaled $2.9 million during the third quarter of 2010, unchanged from the third quarter of last year. However the cost during the first nine months of this year totaled $7.9 million compared to $5.0 million during the first nine months of last year. During the first nine months of this year, the valuation write downs on and net loss from the sale of foreclosed properties totaled $3.1 million. Property tax payments aggregated to $1.7 million and legal expenses totaled $1.6 million.

We remain a well-capitalized banking organization and our regulatory ratios have increased throughout 2010. As of the end of the third quarter our banks' total risk-based capital ratio was 12 percent and in dollars was $30 million higher than the 10 percent minimum required to be categorized as well-capitalized. At the beginning of the year our banks' total risk-based capital ratio was 11.1 percent and the surplus was about $18.5 million.

Local deposit and sweep accounts are up $94 million during the first nine months of 2010 and are up over $300 million since the end of 2008. Combined with the reduction in our loan portfolio, we have been able to reduce our level of wholesale funds by $646 million since the end of 2008. As a percent of total funds, wholesale funds have declined from 71% at the end of 2008 to 47% at the end of the third quarter of this year. Our loan loss reserve was $43.9 million as of September 30, 2010, down $3.9 million from the beginning of the quarter. However, the reduction primarily reflects the charging off of almost $11 million in specific reserves that were created through provision expense in prior periods. At the end of the third quarter only 14 percent loan loss reserve was comprised of specific reserves compared to about 35 percent at the end of the second quarter.

While the reserve coverage ratio declined slightly during the third quarter from 3.38 percent to 3.30 percent, this quarter's ending balance represents a substantial increase in general allocations. Provisions to the reserve totaled $7.4 million during the third quarter of this year, an increase from the $6.2 million expense during the second quarter of this year but a decline from the $11.8 million provided during the third quarter of last year. Approximately $3.8 million of the current quarter provision reflects the net impact of changes made through reserve allocations factors for … loans and leases and an additional $2 million to the tune of almost $8 million of non- accrual loans back to performing status and into the pool of allocation factors. Those are my prepared remarks; I will now turn the call over to Bob.

Bob Kaminski

Thank you Chuck. My portion of the call will be dedicated for the company’s quality and will be an amplification of the very detailed information presented in the press release today. Mercantile experienced some nice reductions in net non-performing assets during the third quarter, the second consecutive quarter of NPA decreases. In March 2010, non-performing assets totaled $117,557,000 and dropped to $110,553,000 at June 30. As we are pleased to report this morning, that as of September 30, NPAs have been reduced to $92,397,000. This continues to seem that we are witnessing at the end of the second quarter with some signs of stabilization in the portfolio. The $18 million net reduction in NPAs during the third quarter is broken down as follows

Principal payments of $5.4 million, sale proceeds of $1.2 million, loans upgraded and returned to performing status of $7.9 million plus loan charge-offs of $12.8 million and valuation write-downs of $1.6 million more than offset $10.9 million in non-performing loan additions.

It should be noted that the $92 million non-performing assets includes $5.9 million in restructured but accruing loans where the bank is working with the distressed borrowers to provide relief with some loan modifications. Most of the NPA reductions came from decreases in the various commercial real estate and residential land development and construction categories. Net loan charge-offs during the quarter totaled $14.3 million compared to $8.6 million in the second quarter and $6.2 million in the first quarter. Out of the third quarter losses, over 75 percent of the charge-offs were previously reserved and recognized efficiencies from an income statement standpoint. Some additional details on the third quarter charge-offs, $6.8 million was attributable to commercial real estate non-owner occupied, $2.2 million for commercial real estate owner-occupied, $2.1 million for residential land development, $1.5 million for commercial and industrial and $1.2 million for residential owner-occupied rental.

Provision expense for the quarter totaled $10.4 million. Major allocations were as follows

$2.6 million was for commercial real estate non-owner occupied, $2.7 million was for multi-family residential, $1 million was for land development and $3.8 million was for general pool allocations to bolster the reserve. Loans delinquent 30 to 89 days hold $1.3 million at September 30. This continues a nice trend of modest and even minimal delinquencies outside of non-performing loans in the portfolio. As we have discussed in prior calls, one of our strategic initiatives is to reduce exposure in our portfolio to commercial real estates. Year-to-date in 2010 we have reduced CRE by $122 million in outstanding in commitments including $87 million in land and real estate development and non-owner occupied commercial real estate.

That concludes my prepared comments. I will be happy to answer any questions in the Q&A and I will turn it back over to Mike.

Mike Price

Thank you Bob and thank you Chuck for your presentations and at this time we would like to open up the phone lines for any questions.

Question-and-Answer Session

Operator

(Operator instructions) We have a question from Steve Geyen of Stifel Nicolaus. Your line is open.

Stephen Geyen – Stifel Nicolaus

Good morning, guys. Certainly the decline in non-accruals and NPAs was nice to see. Could you talk a bit about the changes made to the reserve allocation factors in the quarter?

Bob Kaminski

Well as you can take this is Bob. As we continue to do every quarter we look at our reserve, analyze the various components of it look at the various quantitative and qualitative environmental factors that we see based on the wide landscape of things that wonder the reserve calculation and so we felt it prudent to move it some additional funds in their to bolster their reserve based on some of the things we are seeing and as you can see to add $3.8 million as I mentioned into the general reserves for the quarter. That certainly boards well for future quarter's as we have loans that may develop into problems there are already a happy reserve that LK and against them and will cause us to have lot specific reserves in the future as well may tend up to fall down into rating categories already have a large block of reserve something against them.

Stephen Geyen – Stifel Nicolaus

I guess could you just give a little bit more color on the commercial real estate? Any thoughts on stability of the commercial real estate values over the last couple quarters or so?

Bob Kaminski

Based on our valuations that we have seen in terms of ORE that we have sold and also with appraisals that have come in our caraways have been hold up very, very well. We are taking an aggressive approach as we always have on valuations of Mercantile loans or from real estate standpoint and also just looking at evaluations as we do general clatter analysis on performing loans and while the values are very, very low, we have seen some stabilization there and that's something that we haven't seen in 2009. So at that standpoint it is an encouraging sign.

Stephen Geyen – Stifel Nicolaus

Okay, maybe a question for Chuck. End of period loans, certainly it's difficult growing from almost any bank out there today. Where do you think that might go over the next quarter or two?

Chuck Christmas

Mike in the (Inaudible) because of the loan portfolio IM, but certainly we would very likely see a continued decline for some of the same reason that we have seen over last nearly year, year and a half or two years. We still don't have much new request coming from existing customers to buy equipment, I think our C&I segment of the portfolio is doing very well, but we don't really see a lot of growth coming from that segment. But certainly a solidification in their financial performance, but then again they are not coming and asking for equipment loans. We don't really see a huge increase in our line usage, usages as well.

Stephen Geyen – Stifel Nicolaus

Okay, thank you. I guess, Mike, if you have any comments?

Mike Price

No. I think Chuck answered the last question very well as far as the overall again situation, Stephen, the thing we are very happy to see is a 16% reduction in non-performers. This is really our first time in two years we have able to see a real tangible shift in what's going on and as you know little optimistic last quarter when we saw the crash. We are much more optimistic now we are seeing drop in the as I said in my opening comments, that we have learned the hard way that the level of non-performers kind of predict where your credit costs are going to be for the next two quarters. So it's really nice to see it come down.

Stephen Geyen – Stifel Nicolaus

Okay, thank you.

Operator

Thank you and again (Operator instructions). You have a question from Terry McEvoy of Oppenheimer. Your line is open.

Terry McEvoy – Oppenheimer & Co

Good morning.

Mike Price

Good morning Terry.

Terry McEvoy – Oppenheimer & Co

It was nice to see the additions to NPAs down again to $11 million. Could you just comment on those inflows? Is there any theme among your borrowing base? Is it just customers who have held on this long and are just unfortunately rolling into or moving into NPA status?

Mike Price

I will let Bob add any color to the comments, Terry. This is Mike. But you kind of hit the nail on the head. A lot of the stuff that we saw roll into non-performers this quarter if not all of it might then all of it, the stuff that we really already were aware of. It was on the watch list. A lot of people had guarantors who had been just going to the hip pocket so to speak, making the payments, struggling along and they just kind of gave out because of a prolonged assault on their liquidity if you will. And so we felt that it prudent to non-performers.

Bob Kaminski

There are, our lending staff continues to do a very good job of identification of loans that are experiencing some distress taking what we feel is a very conservative approach to loss – to loan – problem loan identification. And as we see as Mike said some customers who are continuing to see distress and cash flow becomes very tight, loans gets pulled up to the nonperforming status.

Terry McEvoy – Oppenheimer & Co

Returns to performing status, the $8 million, and then I go up to the table above there, nonperforming assets. The biggest drop was in that land development – excuse me – construction bucket. Was that where you saw the biggest return to performing status or was it somewhere else in the portfolio?

Chuck Christmas

Loans returned to existing performing status were commercial real estate loans and what you have sometimes is you have loans shifting between buckets, you have a construction loan, it tends to move towards other normal performing real estate status categories as they flip out of construction stages into occupancy stages, I think that’s where that loan, those loans continue to be having the biggest impact is loans that were in a development and construction bucket and non-performing state simultaneously move to occupied real estate performing status during the quarter.

Terry McEvoy – Oppenheimer & Co

Last night I did pull up the deposit market share in Kent County, where you guys are number four. And as I look at the three ahead of you and the one behind you, all four of those banks making money or expected to make money this quarter. Two out of those four have repaid TARP. How – I just a question on the competitive landscape, still losing money unfortunately and still having TARP. Does that have any significant impact on how you conduct your business and how your customers or potential customers view you as a bank or potentially a new bank to do business with?

Mike Price

No I don't think that, it's been a significant issue because most of our customers and most of the people out there in our market understand that it's a very difficult environment especially for community banks like us who try to build their communities by financing a lot of real estate, that was a big part of what community banks did and still have on their books. We are very happy that we have TARP. We are very happy that our capital ratios have remained in a well capitalized status because, that is a very, very important part as far as the safety aspect of it and I think there was a little political, I guess smoke when TARP first came out but now the people understand better what TARP is, they are very glad we have very, very strong well capitalized ratios.

Chuck Christmas

And with respect to what Mike said. We spend a lot of time talking with our depositors, not only bulk, the deposit offerings that we offer and we offer lot of robust deposit offerings but also about our financial conditions. Three of us are more than happy to sit down and talk with these depositors. Big, medium or small sized and unless they know and understand the condition of the bank and what we are trying to accomplish but we have also spent a lot of time especially in the last couple of years of adding a lot to our menu of deposit products and whether it is an Internet banking product or new products that we are offering. We spend a lot of time on that and I think our customers really appreciate the delivery that we are able to provide them.

Mike Price

I think the proof is in the pudding and the reason we can talk about these issues and try to observe lots of different attitudes out there. But at the end of the day I think Chuck mentioned earlier in his comments that our local deposits are up substantially over the last year so and I think that is really probably the best way to gauge what our potential customers think about the bank.

Terry McEvoy – Oppenheimer & Co

Okay, I appreciate the insight. Thank you.

Operator

Thank you. Our next question is from John Barber of KBW. The line is open sir.

John Barber – Keefe, Bruyette & Woods

I had to hop on the call a little bit late, so I apologize if you already covered this, but can you talk about what drove the increase in non-owner occupied CRE net charge-offs this quarter?

Bob Kaminski

As we mentioned in the comments John, we had a total of 75% on the charge-offs for the quarter were previously reserved as the course of the loan workout allow those specific reserves against the commercial real estate became time to be charged off based on the developments of the overall direction of the workout. We saw the end result. So the timing it was such that it was proven to take both losses now but from an income statement standpoint. They had been previously reserved and recognized from an income statement standpoint in prior quarters.

John Barber – Keefe, Bruyette & Woods

Okay, thanks. And on the margin, I'm just curious what happened to loan and security yields this quarter.

Bob Kaminski

What was that said. I couldn't hear the whole question.

John Barber – Keefe, Bruyette & Woods

Oh, sorry. Just wondering on the linked quarter basis what happened to loan and security yields this quarter?

Chuck Christmas

The non-yields continue to be extremely stable and the security yields, it's a good question, because we're starting to get a little bit of compression in the securities with the call that we have been getting and will likely continue to get with rates coming down like they have throughout the summer and the early fall here. We are getting quite a bit of volume of calls. We put a line-up of over 50% of our portfolio are callable government agencies primarily a Federal Homeland Bank and Federal Farm Credit Bank and they are certainly taking the opportunity to lower rate environment to go ahead and call and reinvest in much lower rates so we do have our collateral requirements so most of the items that we get calls, we do have to put the money back to work to continue to divide the collateral and certainly how the yield is being impacted by that. But again obviously the skittish portfolio is relatively small part of our total assets too.

John Barber – Keefe, Bruyette & Woods

Thanks for the color. Thank you.

Operator

Thank you. Our next question is from Greg Dodgson of Royal securities. Your line is open.

Greg Dodgson – Royal Securities

Good morning. I was looking at the margin relative to Fed Funds sold. It appears that the question before, you know, are you guys doing very much banking? It seems like a poor allocation of money to me.

Chuck Christmas

Yes Greg. This is Chuck. You know one thing that happened is, we have been keeping and will likely continue to keep our Fed funds around $50 million to $60 million. We think that is prudent to do given the state of the economy and the banking industry is well, obviously where we are at almost $150 million at the end of the quarter is well above that. The reason for that and actually kind of goes back for a question earlier, is we have just been gaining a tremendous amount of local deposit growth and with those moneys coming in and also getting some pay-downs on some loans.

You saw our loans came down quite a bit during the third quarter. It takes a little bit of time to put that money back to work. So when we get the cash in, we invest that on overnight basis to Fed funds and assuming what we try to do primarily is get rid of our wholesale funding. Our wholesale funding is primarily fixed-rate instruments. So we have to wait for the maturities to come up. They do come up and then we go ahead and we release to one of the broker deposits of Federal Home Loan Bank advances. In fact already this quarter earlier this month, we did prepay about, we did prepay $40 million of FHLB advances to start reducing that Fed funds balance and certainly we expect that, that balance to be much closer to the $50 million or $60 million later here in the quarter and by the quarter end.

Greg Dodgson – Royal Securities

Are you pursuing this new SBA thing at all? Huntington has done – is doing a marvelous job in that area.

Chuck Christmas

Well, we are continuing to look at that program as well as other SBA programs as we have done a very good job over the years of utilizing the SBA tool to place various borrowers that make sense to the equation of SBA loans. So we will certainly look at that and use that as a potential mechanism to place borrowers that want that in that program.

Greg Dodgson – Royal Securities

It was signed into law last month and it's quite a deal. The government is really helping small community banks with this SBA loan program.

Mike Price

Yes Greg I'll point out and again I agree with you. I think Huntington has done a good job with SBA lending but I will refer you back to I believe it was last week's business journal that points out that Mercantile was the number one SBA lender in this marketplace during the last year. So, we agree with the SBA, as a good program and we use it a lot and we will continue to use it when it is the right situation.

Greg Dodgson – Royal Securities

Thank you

Operator

Thank you. Our next question is from Eric Reboulet of Individual Investor. Your line is opened sir.

Eric Reboulet

Hi good morning. How are you?

Mike Price

Good Morning.

Eric Reboulet

I just had a couple of questions. One, would you be able to provide a little bit of color about migration and special mention in substandard categories of the loan portfolio? And then the second question I had was, given that you had a little bit more elevated level of charge-offs in the commercial real estate category, is that going to portend next quarter that the ORE bucket is going to be up? Or in fact are you breaking any loans up into like an A/B type status where you still have a nonperforming piece but as you mentioned before, there was some element that had returned to performing in the TDR status?

Bob Kaminski

This is Bob. To answer the question of migration, Mercantile Bank has performed migration analysis for some time and becomes one of the tools that we continue to utilize in the determination of the adequacy of our reserve. While moving parts to migration analysis and the one that tends to change from quarter to quarter certainly and we make adjustments to that as appropriate. It's not a simple calculation. It’s certainly one that has many facets and the one that we used to gauge the moving of loans between various loan rating categories as you alluded to. With respect to ORE as you can see by the numbers we have actually have reductions in the overall or a level over the last couple of quarters?

But with that, there have been lot of loans have came into or in lot of sold the piece of assets that have gone out there. I think our staff have done a good job of working with borrowers on properties that were even in foreclosure to try to effect sales of those properties so that they may be never make into the ORE bucket. Loans that do make into foreclosure due to foreclosure process many times have buyers that are waiting at the end of the redemption period to complete those sale. So it’s really page by page basis. You have some properties that are little bit hard to sell, may be spending little bit of longer time in the ORE buckets and others that are more attractive for purchasing standpoint this environment have tending to spend a lot less time in those categories but each of all these properties take by page by page basis.

Mike Price

(Inaudible) I appreciate the granularity of the question and I don't know that we will be prepared with the number of line-up finger tips to talk to you about the sub- standard and special mentioned granularity but I will go back to some of the more general questions we gave – comments we gave you at the beginning of this and that is what we are very happy to report that nonperformers has been (Inaudible) down watchless totals are down and past dues are down and that's been the trend now that we have seen for two quarters and overall and I almost ready to say two quarters does make the trend but if we see it again this quarter which no reason to believe we won't see continuation of improvement then we are going to be even more optimistic that we are winning on the right side of this crisis.

Bob Kaminski

Then what’s also good to see is that not only that we have loans that have been taken off from that nonperforming list because of performance. We had loans that are just on the watch and have never made to nonperforming so that is also being upgraded to show that I think we are taking the right approach in our grading of loans and being some for monitoring purposes and that the loans have been improving as they get upgraded.

Eric Reboulet

No, I think you answered the question with just your last comments on the watch list trends. I think that probably speaks well enough. One last thing for Chuck. Just in terms of the wholesale deposit costs versus sort of your local retail area, what are you looking at differential wise there?

Chuck Christmas

On a CD basis were probably 75 to 100 basis points above the brokered market and I think that generally speaking the brokered markets and the local CD market historically has been about the same maybe a little bit of a premium to local deposits and I think the reasons why the parity is on both sides, is that one is the regulators do not like broker deposits. Certainly this Bank hears about it from regulators and talking about other banks and I am sure as some of the same brokers you do, regulators do not like broker deposits and so banks are shying away from this, many banks are strengthening the balance sheet as we are and certainly letting broker deposits run off. And then you got on the investor’s side which most of these deposits are coming from the retail brokerage lot of investors are certainly skittish to getting back in the stock market.

So what you have is the tremendous amount of supply of potential investible funds but not very many banks out there that want that which obviously is impacting the prize. Going back to the comment as the regulators don't like broker deposits well if they don't like broker deposits, you can certainly shrink to get rid of some of them. But you can also replace some of the local deposits so you got the same banks that are trying to reduce their broker deposit reliance are out there also trying to increase their local deposit gathering activities, which certainly therefore increase in the rates. So I think that wide gap we are seeing now is for those two primary reasons and who knows what the future is going to be and how the regulators deal with broker deposit going forward.

Eric Reboulet

Okay, but you are seeing a little bit of pressure then from sort of the core retail side of the deposit base given that competition?

Chuck Christmas

Yes, I think pressure meaning higher prices or Eric. Yes, definitely.

Eric Reboulet

Okay, alright thanks a lot.

Chuck Christmas

You welcome.

Operator

Thank you sir. I'm sorry, no further questions or comments at this time. I would like to turn the call over to Mr. Price for any closing remarks.

Mike Price

Thank you very much, and if you have any additional questions please feel free to any one on the three of us a call and we appreciate your interest in our company.

Operator

Ladies and gentlemen thank you for your participation in today's conference this concludes the program. You may now disconnect, have a wonderful day.

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