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First Interstate Bancsystem Inc. (NASDAQ:FIBK)

Q2 2014 Earnings Conference Call

July 22, 2014 11:00 am ET

Executives

Marcy Mutch - IR

Edward Garding - President and CEO

Kevin P. Riley - EVP and CFO

Robert M. Cerkovnik - SVP and Chief Credit Officer

Analysts

Jeff Rulis - D.A. Davidson

Brett Rabatin - Sterne Agee

Jacquelynne Chimera - Keefe, Bruyette & Woods

Brad Milsaps - Sandler O'Neill

Operator

Good day everyone and welcome to the First Interstate Second Quarter 2014 Earnings Conference Call. All participants will be in a listen-only mode. (Operator Instructions) After today’s presentation, there will be an opportunity to ask questions. (Operator Instructions) Please also note that today's event is being recorded. I would now like to turn the conference call over to Ms. Marcy Mutch, Investor Relations officer. Please go ahead.

Marcy Mutch

Thanks Jamie. Good morning. Thank you for joining us for our second quarter earnings conference call. As we begin, I’d like to direct all listeners to the cautionary note regarding forward-looking statements and factors that could affect future results in our most recently filed forms 10-K and 10-Q. Relevant factors that would cause actual results to differ materially from any forward-looking statements are listed in the earnings release and in our SEC filings. The Company does not intend to correct or update any of the forward-looking statements made today.

Joining us from management this morning are Ed Garding, our Chief Executive Officer; and Kevin Riley, our Chief Financial Officer, along with other members of our management team.

At this time, I'll turn the call over to Ed Garding. Ed?

Edward Garding

Thanks, Marcy. Good morning and thanks again to all of you for joining us on the call. Yesterday, we were pleased to report earnings of $21.1 million or $0.47 per share. This was another stable quarter of earnings, complemented by strong loan growth and continued improvement in asset quality.

I'd like to start with loan growth. We indicated in April that we were beginning to see an increase in loan demand, so it was great to have that translate into loan growth in every major loan category this quarter. This quarter, total loans grew $142 million or 3.2% over last quarter, and total loans are up about 5% over June 30 of last year. The growth was spread across our footprint with the three strongest markets being Billings, Montana; Casper, Wyoming and Bozeman, Montana.

Construction real estate grew 2% or $6 million from linked quarter. Within that portfolio, construction on commercial projects increased $11 million and land acquisition and development decreased by $5 million for the $6 million increase. We are still continuing to make new residential development loans, but as we've said before, one of our lessons learned during the last recession was to limit our focus to real estate developers with a strong proven track record. We've learned that you just have to respect the profession of real estate developer.

First mortgage residential loans were up $26 million from the first quarter. We continue to retain 5-year to 15-year adjustable rate mortgages, 10-year conventional mortgages, along with a few jumbos. Indirect consumer loans grew $31 million or a 6.4% increase from the first quarter. We really need to give credit to our indirect lending team. This quarter represented the highest volume level in our history and exceeded the next highest quarter by 15%. This level of performance represents the relationship our lenders have with the auto and RV dealers across our footprint, aided by the fact that we have exceptional turnaround time in funding these loans. On top of that, through May of this year, our loss rate is only 2 basis points on these loans. I'm very pleased with the performance of this portfolio.

Ag loan growth of $22 million, a 20% increase from the first quarter, was predictable as this portfolio typically increases during the spring as farmers and ranchers start utilizing their operating lines. We anticipate this portfolio will remain fairly constant through the third quarter and then experience the normal seasonal decline in the fourth quarter.

Commercial loans were up 3% quarter over quarter or $20 million. This growth is not specific to a particular industry or region. The average size of the new loan in this portfolio was less than $100,000 this quarter which we view as good news because it gives us diversity and some feedback that we are serving small business. Headed into the third quarter, we continue to see strong loan demand and are well on track to see loan growth meet our goal for this year.

We also continue to see steady improvement in our credit quality. Non-performing loans decreased $9 million or just over 10%. With the minimal level of net charge-offs this quarter, this decrease was mainly the result of paydowns, payoffs and upgrades of loan balances. We are happy with the pace of the decline and are making substantial strides toward achieving our non-performing asset-to-total asset goal of 1%.

Sales of other real estate this quarter were modest compared to prior quarters. Inflows approximated outflows resulting in a very small decline in the balance of other real estate. We continue to see steady sales of residential lots at small gains from some of the land acquisition and development properties we hold. We also do not anticipate further significant valuation adjustments on the properties. Our current strategy is to remain diligent as we work out selling the rest of this inventory.

Increased loan growth and improved credit quality can be attributed to the healthy economies we are enjoying here in the Northwest. With unemployment rates below 5% across our footprint, we would consider ourselves at near full employment. It appears the summer tourism season is off to a strong start. Yellowstone Park recreational visits are up 7% through June. Pleasure is about breakeven with last year. With the exception of wheat, commodity prices are up across the board. As of June 30, natural gas and coal prices were up over 20% from a year ago and oil was up 9%. Cattle prices were up almost 26%. So the largest contributors to our economy, energy, agriculture and tourism are all doing very well, which is helping to drive the uptick we are seeing in loan demand both from consumers and our commercial customers.

I'd like to turn this over to Kevin for a little more detail behind the numbers and then I'll wrap up with an update regarding our pending merger. Go ahead, Kevin.

Kevin P. Riley

Thanks, Ed, and good morning everyone. I'd like to start off by reviewing the balance sheet. As Ed has indicated, loan growth was just over 3% for the quarter and almost 4% year-to-date. Deposits grew at approximately 1% for the quarter and also on a year-to-date basis. The primary driver of the increase was our non-interest-bearing deposits which were up about 5% for the quarter. This resulted in an improved deposit mix and a lower deposit cost. With loan growth outpacing deposit growth, we had a loan-deposit ratio of 72.9% as of June 30, a 210 basis point increase from that of last year.

The investment portfolio declined slightly again this quarter but still represents 27% of our total assets. We've been very successful in continuing to shorten our duration in the portfolio which declined to 3.1 years this quarter from 3.4 years as of March 31. We continue to work at insulating our balance sheet to sensitivity from interest rate movements. We know at some point rates will eventually rise, and if and when this occurs we're positioning ourselves to be ready.

To reiterate what we've said in the past, we think our customers are patiently waiting for opportunities to earn better rates on their money. When rates are moving, we believe they're going to demand higher interest rates, but for now the continued shift to short-term deposit has allowed our cost of funds to continue to decline slightly to 27 basis points.

Capital remains strong with our tangible capital ratio increasing to 8.72% and total risk-based capital at 16.69%. As part of our capital management strategy, we continue to look for the right opportunity to repurchase our shares. This resulted in over 225,000 shares of stock being repurchased this quarter at an average price of around $24.91. Even considering the impact of the stock buyback, tangible book value grew $0.34 per share for the quarter.

As you can see, our operations continue to generate a significant amount of capital and we are highly focused on efficiently managing our capital position. We are returning capital to our shareholders through a strong dividend and the ongoing share repurchase program, while also investing in the business to support organic growth and the acquisition growth. We believe this formula of balanced capital management will continue to optimize our level of returns and to create value for our shareholders.

We recently received re4ulatory approval and we'll consummate the Mountain West acquisition at the end of this month. While this will result in a temporary decline in our capital ratios, we anticipate the enter-back period on our capital of less than three years. At the anticipated earnings lever however, the actual tangible book value per share should return to its current level within two months.

Moving to the income statement, while core income was stable quarter to quarter, pre-tax pre-provision income was up $2.5 million or about 9%. We were pleased to see our net interest income increase on a linked quarter basis. This increase is mainly attributable to loan growth and one additional accrual day and the recovery of interest on nonaccrual loans.

The net interest margin increased to 3.54%, a 2 basis point improvement over last quarter. This improvement was however the result of two factors, increased loan growth and recovery of interest. Omitting the impact of interest recovery on a quarter to quarter comparison, the net interest margin would have declined 3 basis points from the prior quarter.

As for our outlook for our net interest margin, we don't believe this quarter improvement is indicative of an upward trend. Continued loan growth will help maintain our margin as the ratio of loans to deposits increase. We also anticipate purchase accounting on acquired loans from Mountain West will create a little noise in our net interest margin over next several quarters.

For the fourth consecutive quarter, we've had a negative provision. The $2 million reversal this quarter was a result of the declines in criticized loans along with continued improvement in our economic indicators and our historical loss rates. Going forward, depending on how quickly non-performing loans continue to decline and our level of new loan growth, we may continue to be in the position that will be required to release reserves. However, we are conservative in our current outlook and we believe we may even have a small provision during next two quarters.

Non-interest income was up $2.5 million or 10% from last quarter. Higher volumes of debit and credit card transactions resulted in higher fee income. Income from origination and the sale of home loans increased 37% over the first quarter, where 76% of this production was purchase activity while 24% was refinance activity.

As of June 30, the volume of production was in line with our goals for the year. We believe that third quarter will look a lot like this quarter and then will probably slow down again as winter approaches. There's still a shortage of builders to keep up with the demand in our area, particularly in the starter home market.

Wealth management continues to grow. Revenues were up 3.5% quarter over quarter. Assets under management this quarter grew $73 million or 6.7% on an annualized basis. Core non-interest expense was in line with our expectations of approximately $55.5 million per quarter. However salary and wages increased this quarter as a result of an additional day, commissions paid to mortgage originators and an increase in incentive compensation accrual. Continued improvement in the levels of health insurance claims led to a decrease in our employee benefits and really nothing else that stands out within our core non-interest expense.

To-date we've incurred about $600,000 in merger-related expenses. We've disclosed earlier that we anticipate one-time deal cost to be approximately $7.2 million. At this point, we're optimistic that this may be a little high. We stated in the past that we thought all of our cost base would be realized by the end of third quarter. With regulatory delays, we had to push back our bank conversion six weeks. So we now believe that they'll all be realized by the end of the year.

To wrap things up, I'd like to say we continue to be bullish on the future, higher levels of loan growth, improving asset quality and a successful integration of Mountain West acquisition will lead to higher returns for our shareholders. So with that, I'd like to turn the call back over to Ed.

Edward Garding

Thanks Kevin. Kevin just mentioned the Mountain West acquisition and I'd like to wrap up by providing you with an update on that transaction. We received the necessary regulatory approvals and will close on July 31. Following that, as we indicated in a press release last week, we anticipate the bank merger will occur in mid-October. Because of the 100% market overlap and the proximity of the Mountain West locations to existing First Interstate branches, we'll be consolidating eight of their locations into our branches. So now our focus is on our combined customers.

We are striving to ensure that our integration efforts don't have a negative impact on the banking experience of our customers in any way. We are excited about the possibilities created through the combination of our two companies and are honored to have Mountain West become part of the First Interstate organization. They've worked hard to create a strong franchise and are a recognized leader in our shared communities. We believe the combined organization will be stronger and will enable us to better serve all our customers.

So with that, I'll open up for questions, but before I do that, I have found out that we had the wrong telephone number posted for this call. I'm not sure how that happened but some of you may have had to join late. So don't feel bad about asking me to go back to the beginning if there is something you want to know, and for those of you that did join us, thank you for persevering and figuring out what the phone number actually was. So, now do we have any questions out there?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Jeff Rulis from D.A. Davidson. Please go ahead with your question.

Jeff Rulis - D.A. Davidson

Just a follow-up on your branch closure announcement. Any expected financial impact either near-term cost or long-term savings that you could quantify?

Edward Garding

I think the best to say is that it will be a wash because we have appraised all of those buildings and there's a lot of interest from people who would like to buy them, and so it would appear that we're going to be able to sell those buildings very near if not above what we booked them for. And fortunately in most cases we will build to sell them to non-financial institutions so that we're not helping a competitor come into the market.

Jeff Rulis - D.A. Davidson

Okay. And do you have updated balances on the loan and deposit balances from Mountain West as of June 30?

Edward Garding

Yes, and I think I'll ask Bob Cerkovnik to give us the ballpark numbers. Would you, Bob?

Robert M. Cerkovnik

In our earnings release, we've talked about there's roughly about $623 million in total assets and loans are right around $380 million and deposits are about $520 million.

Jeff Rulis - D.A. Davidson

$520 million, okay. And then just one last one I guess on, Ed, you talked about your loan growth goal and it sounds pretty positive in terms of the loan pipeline I guess coupling together what you're seeing from or hearing from Mountain West but also just the legacy business, maybe if you could remind us what that goal was or quantify what you see for the year?

Edward Garding

I'm going to say between 4% and 5%. We're all looking at each other and saying, what was our goal, and I think that the stretched goal would've been in the 5% range and I'd say the stretched goal that was in January and now we're feeling pretty optimistic about hitting that number.

Jeff Rulis - D.A. Davidson

Great. Okay, I'll step back, thank you.

Operator

Our next question comes from Brett Rabatin from Sterne Agee. Please go ahead with your question.

Brett Rabatin - Sterne Agee

Wanted to first ask, just there's been a whole a commentary this quarter from banks bigger than you guys about regulatory cost and I know you're not going to be $10 billion post Mountain West, but was just curious on efficiency I guess one is are there going to be any new do you think levels of investment you'll have to make as you approach $10 billion, and then just secondly, you've gotten a lot of issues over the past year, should we see anything else aside from Mountain West potentially having a positive impact on the efficiency ratio?

Edward Garding

I'm taking a minute to think about how to answer all of that, Brett, but I think I would start with the $10 billion subject, and there's just no question that there are increased regulatory and reporting costs when you approach and exceed that threshold and the cost is enormous. But that said, we also think that with that growth you move your non-interest and your interest income up to the point where you achieve critical mass, and so in a sense that will net out.

We have experienced a higher cost of doing business because of some of the provisions of Dodd-Frank becoming active over the last year. The best example I could give you is that in mortgage lending, it just flat takes more people to do the same amount of volume as you previously did to stay up with the regulatory requirements, but that's just the nature of the game. But again, if you continue to grow, I think you can grow into that.

In regards to efficiencies with Mountain West, with that acquisition, this is the first in-market acquisition we've ever done. We've always gone outside of our market even if it's just a little bit outside. So this is our first in-market acquisition and we think that we are going to create some tremendous efficiencies by gaining a lot of new customers without adding a lot of new expense.

Brett Rabatin - Sterne Agee

Okay, thanks for the color around that. The other thing I guess I was curious about was just thinking about your loan generation in terms of rate compared to the present portfolio, any thoughts around what new generation is coming in at and sort of thinking about the margin going forward? Aside from Mountain West, any changes in interest rates?

Edward Garding

I'm not sure I'm understanding the question, but in general new loans are going on the books at an average of around 5%. As we stated, we saw a 2 basis point increase in the net margin and that was driven not just by loan growth or loan interest rate, it was driven somewhat by interest recoveries from previous losses too, but nevertheless we're gratified to see that that margin is holding and we don't see that dropping off significantly in future quarters. Does that answer your question?

Brett Rabatin - Sterne Agee

Yes, that's exactly what I was looking for. Thanks for all the color.

Operator

Our next question comes from Jackie Chimera from KBW. Please go ahead with your question.

Jacquelynne Chimera - Keefe, Bruyette & Woods

Looking to the loan growth, and you had really good loan growth in the quarter, was part of that related to loans that may have been delayed from first quarter just due to the weather and everything?

Edward Garding

Yes, definitely. The construction industry, whether it was commercial highway even or mostly the homebuilders, they were very stagnant during that tough winter weather and that's not always the case. These days they have the technology to build 12 months a year but this was a tougher winter than we had experienced in some time and you could just feel it and see it open up as springtime came around. So I'd have to say, yes. Now that said, we don't think it's a one-time event because we're seeing development in both residential and commercial ramp up, and so we're feeling pretty good about third quarter loan growth too.

Jacquelynne Chimera - Keefe, Bruyette & Woods

So to make sure that I heard you correctly in the prepared remarks, did you say that the average size of new bookings in the commercial portfolio was around $100,000?

Edward Garding

No, just the average size of new commercial loans, that does not include commercial real estate.

Jacquelynne Chimera - Keefe, Bruyette & Woods

So just the straight commercial portfolio?

Edward Garding

Correct.

Jacquelynne Chimera - Keefe, Bruyette & Woods

Okay. So did you take on a lot more customers this quarter then, because just looking at it, with $100,000 versus the substantial quirk you had in the quarter, that's kind of where I'm going with that, am I thinking about it properly?

Edward Garding

I wish I could say a whole lot of new customers, but no, a modest number of new customers and an awful lot of business owners with renewed confidence in the future that are either expanding or building inventory and those kinds of things.

Jacquelynne Chimera - Keefe, Bruyette & Woods

Okay, so it sounds like increasing line utilization, consumer confidence is building, that sort of thing.

Edward Garding

That is correct.

Jacquelynne Chimera - Keefe, Bruyette & Woods

Okay. And then just one last quick one. Given that you've had some nice interest recoveries over the past couple of quarters, is there still a sizable pool for that left?

Edward Garding

Bob Cerkovnik, would you address that?

Robert M. Cerkovnik

Good question, Jackie. We don't see a significant pool out there but it comes, we are working hard on collecting that interest on those non-performing loans as our non-performing loan balance comes down. We will see some of it, but to that level I really can't give you a real strong answer in that regard.

Jacquelynne Chimera - Keefe, Bruyette & Woods

Okay, so it will just continue to fluctuate over the next couple of quarters?

Robert M. Cerkovnik

Yes.

Jacquelynne Chimera - Keefe, Bruyette & Woods

Okay. Great. Thank you all for the color.

Operator

Our next question comes from Brad Milsaps from Sandler O'Neill. Please go ahead with your question.

Brad Milsaps - Sandler O'Neill

Kevin, sorry if I missed this, but just curious, what drove the decision to be maybe a little more aggressive with the buyback this quarter relative to other quarters and how do you kind of feel about that going forward maybe weighted against pursuing other acquisition opportunities that might be out there?

Kevin P. Riley

We really probably highlighted the reason why we bought back is our stock price dropped to a level we believe that it's a good return to the shareholders at that price. We have a kind of a price target and we are onto that price target. So we acquired shares during that time.

Brad Milsaps - Sandler O'Neill

Got it, okay. And then in terms of M&A going forward, can you guys just talk about that maybe once you get Mountain West closed and converted, I mean is there something you would maybe begin to pursue again in early 2015 or what are you thinking there?

Edward Garding

Mostly I'm thinking that we wanted to do a good job of integration with the Mountain West people and the Mountain West customers before we think seriously about the next acquisition. And so I certainly wouldn't expect to do any hunting in the next couple of quarters.

Brad Milsaps - Sandler O'Neill

Okay, great, fair enough. Thank you.

Operator

We do have a follow-up question from Brett Rabatin from Sterne Agee. Please go ahead with your question.

Brett Rabatin - Sterne Agee

I just wanted to ask about capital pro forma correlated to the share repurchase question and if you're not going to be maybe not doing an acquisition until next year, and you focus on the Mountain West integration, where do you guys focus on at this point in terms of the most important capital ratio, now the regulators have been all done, but what's your primary capital ratio? And then kind of maybe if you can just give us an idea of a target ratio or a number you wouldn't go below?

Edward Garding

I'm going to have Kevin give you the specifics, but I would say that our thoughts along capital are to have a little more than the regulators want us to have and a little less than the investment community thinks we should have. There's a fine line there. But Kevin, would you be more specific than that?

Kevin P. Riley

Bret, you know there's a number of ways to look at capital. So the biggest thing of the driver, we're trying to look at our capital management as one. I agree with Ed, we want to keep substantial amount of capital around most ratios, but I think what we're trying to focus on is keeping our tangible book value per share increasing, and return on equity I think that we want to continue to drive a higher return on total equity and we do have aspirations of increasing from where we're at. So we're trying to manage capital appropriately, one to keep the tangible book value per share growing as well as return on equity, and again, with that also drive earnings per share growth. So we're always going to keep adequate capital ratios but we're trying to drive that return with good capital to our shareholders.

Brett Rabatin - Sterne Agee

Okay, I appreciate the color.

Operator

And we do have another follow-up question from Jeff Rulis from D.A. Davidson.

Jeff Rulis - D.A. Davidson

Kevin, you mentioned some noise on the margin with Mountain West. What in specifics does that mean, I guess up or down, is the expectation?

Kevin P. Riley

We had a regional model when we did the regional marks on the various loans, deposits as well as investments and borrowings in account with the margin. The final numbers when we go through purchase accounting will post that mortgage. So we will say noise is that as you know in purchase accounting you amortize some of your marks in, you re-price your investment portfolio and deposits. So we believe it might have a slight positive aspect, but at this juncture, since we haven't gone through all purchase accounting, we don't know what that impact might be.

Jeff Rulis - D.A. Davidson

Great, thank you. And then just one quick one on mortgage sale gains, I guess what have you seen so far in Q3 and what do you expect the trend on the fee income line from mortgage?

Edward Garding

We think the third quarter is going to be very similar to second quarter in total volume.

Jeff Rulis - D.A. Davidson

And then perhaps it taper into Q4.

Edward Garding

Yes.

Jeff Rulis - D.A. Davidson

Okay, fair enough. Thanks.

Operator

Gentlemen, at this time, I'm showing no additional questions. I'd like to turn the conference call back over for any closing remarks.

Edward Garding

I would make a closing remark which is just kind of an anecdote about the economy because I didn't mention anything about the Bakken oil field and that still is having an impact especially on Eastern Montana but in many cases all across our footprint over in northern South Dakota and even Casper, Wyoming where there's a lot of oil industry people. But the story I would tell is here in Billings where we're very bullish about the economy in Billings.

We did have a hailstorm early this summer that did about $900 million dollars worth of damage to homes and buildings here in Billings which is causing a lot of rebuilding so to speak, and one of our leading house builders in town who has been very busy is building a house right next to me and it has sat idle for quite a while. I know the house is sold, because I know the buyer and I asked the builder when I saw him in the bank, what's going on, why don't you get that finished, and he said, I can't find roofers. He said, I cannot get the roof completed because I can't find the roofers. And interestingly, I said I could talk my son into trying to help you out but it would have to be just at certain times because he's making a fortune driving a gravel truck over in the Bakken in North Dakota and he's parked his roofing tools in my garage.

But that type of story you hear a lot, kind of a combination of a lot of building going on and people taking the opportunity to make money over in that oilfield. With that, I think we'll conclude. Thank you everyone for joining us.

Operator

Ladies and gentlemen, that does conclude today's conference call with you. Thank you for attending. You may now disconnect your telephone lines.

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