First Commonwealth Financial's (FCF) CEO Mike Price on Q2 2014 Results - Earnings Call Transcript

Jul.23.14 | About: First Commonwealth (FCF)

First Commonwealth Financial Corporation (NYSE:FCF)

Q2 2014 Earnings Conference Call

July 23, 2014 14:00 ET

Executives

Rich Stimel - Vice President, Corporate Communications

Mike Price - President and Chief Executive Officer

Jim Reske - Executive Vice President and Chief Financial Officer

Bob Emmerich - Chief Credit Officer

Mark Lopushansky - Chief Treasury Officer

Analysts

Bob Ramsay - FBR Capital Markets

Collyn Gilbert – KBW

Matthew Breese - Sterne Agee

John Moran – Macquarie

Operator

Good day, ladies and gentlemen, and welcome to the First Commonwealth Financial Second Quarter 2014 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct the question-and-answer session and instructions will follow at that time. (Operator Instructions)

I would now like to introduce your host for today’s conference, Mr. Rich Stimel. You may begin.

Rich Stimel - Vice President, Corporate Communications

Thank you. As a reminder, a copy of today’s earnings release can be accessed by logging on to fcbanking.com and selecting the Investor Relations link at the top of the page. We have also included a slide presentation on our Investor Relations page with supplemental financial information that will be referenced throughout today’s call.

With me in the room today are Mike Price, President and CEO of First Commonwealth Financial Corporation and Jim Reske, Executive Vice President and Chief Financial Officer. After brief comments from management, we will open the call to your questions. For that portion of the call we’ll be joined by Bob Emmerich, our Chief Credit Officer and Mark Lopushansky, our Chief Treasury Officer.

Before we begin, I’d like to caution listeners that this conference call will contain forward-looking statements about First Commonwealth, its business, strategies, and prospects. Please refer to our forward-looking statements disclaimer on Page 2 of the slide presentation for a description of the risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements.

And now, I’d like to turn the call over to Mike Price.

Mike Price - President and Chief Executive Officer

Hey, thanks Rich and welcome everyone. First, I would like to welcome Jim Reske, our new CFO, who is with us this afternoon for his inaugural earnings call with First Commonwealth. He joined us in early May after the retirement of Bob Rout. He will provide some commentary on our second quarter financial performance in a few minutes.

Second quarter earnings of $0.13 per share are the same as the first quarter. This includes a $2.6 million second quarter charge associated with our core conversion, which we have named operation excellence. I would like to give some additional time to operation excellence this afternoon given the strategic importance to the company. In the fourth quarter of 2013, we shared that this project would require $10 million to $12 million investment and result in some $6 million to $8 million of annual savings, which would begin to accrue in the fourth quarter of this year. The project has unfolded as we have hoped and we are slated for our conversion in August.

Besides the financial benefits, this will enable better solutions for our clients, better integration of our systems, and improved speed to market with products and services. As you think about the financial impact the last several quarters, the charges associated with this project have totaled $4.6 million in the fourth quarter of 2013, $2.4 million in the first quarter of 2014, $2.6 million here in the second quarter of 2014, and another final charge in the third quarter of approximately $2 million for $11.6 million total.

Starting in the fourth quarter of 2014, we will expect to realize the financial savings we have outlined of at least $1.5 million per quarter. Having these one-time charges in our rear-view mirror coupled with realizing the savings outlined in the fourth quarter, it will have a palpable impact on our core earnings and our ROA. This is an exciting time in our company. We began this IT journey two years ago and have been thoroughly engaged with the majority of our employees the last eight months. The task has been monumental. We have completed four tests and two mock conversions over six separate weekends over the last two quarters. This is the IT and operational platform that will run this company for years to come and we have laid a solid foundation for our future.

Now, on to some other important items. First, since the fourth quarter of last year, we have invested in de novo mortgage as well. We took our first purchase money mortgage loan application this month and that’s the first one in almost 10 year. This was the core offering for any community bank. As I have shared we do not have any dilutions about mortgage and the current mortgage outlook. However, a mortgage offering will bring a younger credit worthy consumer household to our bank. These same households will tend to have a checking account, a debit card and other services. This will be good business and fill a gapping hole in our product offering. We expect mortgage to yield approximately $6 million in 2015 fee income, which after roughly $4 million in associated expense would add about $2 million to the bank’s pretax income.

Second, we were pleased to see $82 million of growth in period end loan balances in the second quarter with $23.8 million in new loan outstanding balances coming from our new Cleveland office alone. However, a good portion of these loans came on to the balance sheet towards the end of the quarter and so the second quarter net interest income did not receive the full benefit of this growth. As you can see from Page 7 of our supplemental earnings presentation roughly half of the second quarter’s loan growth was in C&I, with the remainder fairly evenly split between commercial real estate and auto loans.

Third, I want to give some brief color and coverage to expenses. Despite the linked quarter optics, we believe our core second quarter expenses are below the $40 million figure we had previously discussed, when adjusted for $2.6 million in conversion related charges and certainly the $700 million – or $700,000 write down of an OREO property. This obviously precedes the realization of the savings in conjunction with operation excellence.

Fourth, credit metrics improved in the second quarter with non-performing loans falling by $9.9 million to $46 million or 1.07% of total loans. This is the lowest level of non-performers since 2006. Provision expense was flat with the prior quarter. Charge-offs of $7.1 million were elevated by a $5.8 million write-down on an oil and gas servicing company. Most of that write-down was covered by a specific reserve assessed in the first quarter. That charge-off contributed to a decrease in the ratio of total reserves to total loans. But the ratio of general reserves to non-impaired loans stood at 1.04%, which was relatively unchanged from last quarter’s 1.05%.

In closing we have made a transformative investment in our IP and operations infrastructure that will be a foundation for years to come. This will make us both more efficient and easier to do business with. Over the last 12 months we have also made a transformative investment in a mortgage offering to serve a loyal customer base and capture younger credit worthy households. And then lastly, our asset quality continues to improve and we believe that our credit function will provide a source of strategic advantage for our company.

With that I will turn it over to Jim Reske. Jim?

Jim Reske - Executive Vice President and Chief Financial Officer

Thanks Mike. First of all since this is my first earnings call with the company, let me say how happy I am to be joining First Commonwealth at such a strategic time especially with the IT conversion, the new mortgage initiative and expansion into new markets such as Cleveland. It’s certainly very exciting time for the company and I am delighted to be part of it. Let’s start with a few broad statements about the company’s second quarter performance and then provide some detail that I hope will be helpful to you.

Overall, the company’s financial performance in the second quarter could be characterized as one of stability when compared to the previous quarter and strong improvement when compared to the same quarter a year ago. Earnings per share came in at $0.13 in the second quarter unchanged from the prior quarter and up strongly from $0.06 a share a year ago. In comparing the second quarter to the linked quarter a few things standout. Loan balance has experienced solid growth, credit quality continued to improve, fee income expanded and expenses on an adjusted basis remained under control. First half performance as a whole is particularly impressive in light of the $5 million headwind of one-time expenditures related to our IT conversion.

Now let me take each element of the income statement in turn. First of all, net interest income came in at $46.2 million in the second quarter, which is down by about $300,000 from the first quarter, a decrease of less than 1%. Net interest margin did contract somewhat over this period from 3.3% to 3.26%. However, approximately 10 basis points at the first quarter’s margin were due to prepayment penalties compared with four basis points in the second quarter.

Like most banks, our loans continue to re-price lower in the current rate environment. On the funding side, we continue to benefit from the growth in average non-interest bearing deposits which were up by nearly $100 million in the second quarter of 2014 from where they were a year ago. Over the same period, average time deposits were down by roughly the same amount, bringing the total cost of deposits down four basis points to 0.30% for the second quarter.

On a linked quarter basis, total deposits were down $187 million or $106 million of that decline is in broker deposits, as we consciously shifted to cheaper, short-term borrowings. Overall, the bank remains a very well-positioned for a rise in rates, which I’ll return to in a moment. As Mike shared, we were pleased to see in $2 million of growth in period end loan balances in the second quarter. However, average loan balances are relatively flat, as a good portion of these loans came out of the balance sheet toward the end of the quarter, and so second quarter net interest income did not received the full benefit of this growth.

Non-interest income came in at $70 million in the second quarter. However, to be fair, in order to properly understand the change from the prior quarter, the one-time gain of $1.2 billion in the sale of our registered investment advisory business in the first quarter should be taken into account, as should a $2 million gain on the sale of a single OREO property in the second quarter.

Beyond those items, we did experience an increase in number of fee income categories in the second quarter. Deposit service fees were up $300,000, insurance and retail brokerage commissions were up $200,000 and interchange income was up $200,000. Swap fee income which is contained in the other income line also increased by $400,000 in the second quarter. As Mike mentioned, we re-entered the mortgage business in July, we understand the mortgage refi industry has experienced a downturn in the current rate environment, but they are still upside for us and being able to do purchase money mortgages for our customers.

We expect this business will begin to make a contribution of approximately $0.5 million of fee income in the fourth quarter of this year, but because we continue to invest in that business, the bottom-line impact to net income will be negligible in the fourth quarter. We continue to expect that we will sell most of our fixed loan production in the secondary market.

Turning to non-interest expense, the one-time expenditures related to our IT conversion are the biggest story by far. These expenses totaled $2.6 million in the second quarter, up $200,000 in the first quarter. As Mike described, the first quarter also benefited from a $900,000 insurance recovery while conversely, the second quarter is impacted by a write-down of $700,000 related to single REO property. By way of note, at June 30th, REO balances were down to $7.8 million with only two properties valued at over $1 million.

Nevertheless, taking all these items into account, on an operating basis, second quarter non-interest expense remained relatively in line with the linked quarter, below our previously announced target of $40 million per quarter, and well below last year’s level.

We continue to expect that our IT conversion will result in expense reductions of at least $1.5 million per quarter beginning with the fourth quarter of 2014. However, before we get there, we are still incurring expenses related to the conversion, which we expect to come in approximately $2 million in the third quarter. In addition, our continued investment in the mortgage business will result in about $600,000 in expense in the third quarter before we start to see positive net income from fees in the fourth quarter.

In other news, our effective tax rate was 28.4% in the second quarter compared with 28.3% in the first quarter and our stock buyback program continues at $17.4 million of our $25 million authorization remaining as of June 30, 2014. We have changed our approach slightly to purchase shares more aggressively on price dips, while still pursuing a goal of completing the repurchased program by the end of this year.

Finally, there is no mention of our interest rate risk methodology in the earnings release, but it will come up in the 10-Q is wanted to mention it here. With the help of a third party, we have done a close examination on the stickiness for a lack of a better word of our demand in saving deposit base. We found that they are “stickier” than we had previously contemplated, meaning that they are less likely to run off in the raising rate environment. As such, the weighted average duration of our deposit base has increased. This means in the upcoming 10-Q, you will see that our interest rate risk calculations show that we are more asset sensitive than was the case in the first quarter and it’s a direct result of this change in our methodology.

With that, we’ll take any questions you may have.

Mike Price - President and Chief Executive Officer

Operator, questions?

Question-and-Answer Session

Operator

(Operator Instructions) And I am showing our first question comes from the line of Bob Ramsay from FBR Capital Markets. Your line is now open.

Bob Ramsay - FBR Capital Markets

Hey, good afternoon, guys.

Mike Price

Hey, Bob.

Bob Ramsay - FBR Capital Markets

Hey, really a nice quarter for loan growth, it’s nice to see on an end period basis, those balances are moving higher. I know it’s something you guys have been focused on for a long time. You highlighted the contribution from the Cleveland commercial business center, is something $20 million, $25 million a quarter, is that a good run rate out of that office or was there anything sort of unusually strong this quarter or sort of what’s the expectation from that branch?

Mike Price

Well, I think we got off to a really strong start. The $23.8 million is really with probably in excess of $70 million of approvals. So, those are just beginning to fund. We will continue to monitor that kind of pipeline, but it continues to look pretty strong and it’s pretty split between commercial real estate and C&I.

Bob Ramsay - FBR Capital Markets

Okay, great. And then in the growth that you saw in the rest of the portfolio, was it more sort of some of the – I guess less of a drag from loan sales and loan run-off this quarter or was it stronger originations or what was sort of in the rest of the book the factors in the growth?

Jim Reske

Yes. I wish I could say that run-offs had – and our episodic de-risking had come to close, but it hasn’t and we probably there was another creditor too that were a little larger, that we had a pretty good production quarter probably in excess of quarter $0.25 billion of loan production and that was pretty equally split between commercial real estate and C&I.

Bob Ramsay - FBR Capital Markets

Okay. And then so I guess you are doing a little more production and do you have the sense that borrowers are little more confident and is this something that you expect to continue?

Mike Price

I wouldn’t go there yet. I was just looking at the spreads and I think I have shared some of these spreads before. I don’t know that I need to do that, but I am looking at ‘12, ‘13 and ‘14 and there continues to be downward pressure on these spreads for the quality credits. I mean, it’s really that simple. And that obviously you see that in the margin.

Bob Ramsay - FBR Capital Markets

Yes, okay. Shifting to fee income, I know you guys highlighted that strong interchange income was one of the factors this quarter, what is driving that? Has there been any sort of push to I guess get people spending on debit cards, to your debit cards or is it – yes, I am just curious for any color there?

Mike Price

Yes. It’s really just the continued growth in consumer households and the interchange associated with that. It kind of seems paradoxical given the leakage in our deposits, particularly on the savings and the time deposit side. But on the time side, the bulk of that, I think it was $133 million downdraft, with seeders and we have gotten pretty stiff when it comes to promo rates. We haven’t done a promo rate I think now for almost a year. And everybody hangs a rate. Now, part of that was our margin and honestly part of it was just we have this conversion, and it just makes the product mapping less complicated when we get to the conversion here in August. So, that was a little bit of the thought process as well. So, we have kind of driven out a lot of the households that just come in and shop rates. There is really – there is not really a lot of vehicles for them other than some exception pricing that could happen on a discrete basis, branch-by-branch, but that’s pretty rare.

So, the benefit is you see it in the rate, in the downdraft in the funding cost, but we are somewhat pleased that households continue to grow and you can see that obviously in the deposit service charges and not just the interchange. So, it just we are growing households, but we are losing that kind of single service rate shopper. Now, in fairness that single-service rate shopper will become important to us at some point and we will want to bring them back into the house and we will begin to experiment with some promo rates, I am sure on the other side of the conversion, Bob.

Bob Ramsay - FBR Capital Markets

Okay. Last question and I’ll hop back out, but it looks like most of the margin compression this quarter really related to the drop in prepayment fees that were really strong last quarter. Do you guys think you’re getting closer to a trough in the margin?

Mike Price

I’ve kind of had that perspective before, so I’ll stop short of reiterating that. So, I just focus on the strategy, but it’s still downward pressure on C&I side of the business.

Bob Ramsay - FBR Capital Markets

Okay, great, thank you guys.

Operator

Our next question comes from the line of Collyn Gilbert from KBW. Your line is now open.

Collyn Gilbert – KBW

Thanks, good afternoon guys.

Mike Price

Hi, Collyn.

Collyn Gilbert – KBW

Just want to ask about the net charge-off that came in this quarter. It – I presume that that was somewhat unexpected, just wanted to kind of better understand the circumstances around that and then also to – if you guys could provide any color on the direction of the reserve.

Mike Price

Yeah, I have Bob Emmerich with us and I’ll turn to Bob for that question.

Bob Emmerich

Yes, Collyn, that was an oil services company that was heard by – obviously by the decline in gas prices and the reduction in drilling activity. On top of that, both the CEO and the CFO became ill very close to each other within about six months of each other and let the company so there was a vacuum in leadership with the company while the market was going down. And so they – that really hampered them being able to work their way through it in terms of that one specific credit that we – where we took the charge off is.

Collyn Gilbert – KBW

Okay, okay.

Bob Emmerich

And we took a specific reserve in the first quarter and then charged through here in the second quarter.

Mike Price

Yes.

Bob Emmerich

And then in terms of the direction of the reserve, the reserve as you know has been going down for the last few quarters and down from last quarter, where it was at 128, and a lot of this has been in reduction in specific reserves or impaired loans and that was really the reduction of this quarter was really from that one large charge-off because where we took this specific reserve in the first quarter. And as Mike mentioned in this comments earlier the reserve – the general reserve for the non-impaired loans has been pretty consistent at 105 down to 104.

Collyn Gilbert – KBW

Okay, okay, that’s helpful. And then just on the loan growth, Mike, I know you said it was fairly evenly split between CRE and C&I, and Cleveland had been driving a lot of that. Was there any – anything in there that was out of market or were other loan participations or with all of this in-market originated, and you guys carried the bulk of the projects?

Mike Price

I’m looking at the most right now, Collyn and I’d say, I mean if you’re just including Ohio as an adjacent state, I would say that the vast majority of this is either Western PA or Ohio and particularly Northern Ohio or Central Ohio and we’ve got a pretty good total than Ohio right now. I think we have a $238 million of the loans and about $80 million of that is C&I and the remainder of it is commercial real-estate, and some nice projects in Columbus. So, I think that’s the bulk of it. As you know, we have done some SNCs and some participations in the past, and there are few of those in here, as well.

Collyn Gilbert – KBW

Okay, okay, that’s helpful. And I think you may have just covered it, and I apologize. With the – your outlook for the NIM, or more specifically on kind of the loan yield trajectory, how are you guys thinking about that from here? Assuming we don’t see any kind of change in rates and certainly not for the rest of this year.

Jim Reske

Yes, Collyn, this is Jim Reske. I think we’re seeing is something that we see a lot of other bank experiencing which is that the new loans coming on are at slightly lower rates in the loans that are loan off and so, we expect that to continue for a little while here until rates eventually rise.

Collyn Gilbert – KBW

Okay, okay and anything more to do on the funding side in terms of cost reduction, or are you kind of bottoming there.

Jim Reske

Your total cost of funds is down in the 0.30 level, getting closer the cost of borrowing overnights, it’s hard to see that getting a lot lower than it is now.

Collyn Gilbert - KBW

Okay, okay, good, that was all I had, thanks guys.

Mike Price

Thank you.

Operator

And our next question comes from the line of Matthew Breese from Sterne Agee. Your line is now open.

Matthew Breese - Sterne Agee

Good afternoon guys.

Mike Price

Hi, Matt.

Matthew Breese – Sterne Agee

I just wanted to drill a little bit down into non-interest income, specifically the gain on sale of assets line. Given how much credit quality has improved. Should we expect that line item to dwindle quite a bit over the next few quarters?

Jim Reske

Yeah, this is Jim Reske, yes, actually, we did actually provide in the supplemental presentation, some non-GAAP disclosures that will help you with that. But, yes, some of that was just a recovery of an REO property of $2 million gain on sale in the second quarter. The other part of that and if you’re looking at back of the supplement, it’s really start seeing the quarter-by-quarter and it’s stated in a first half basis. So, you see gain on sales assets of $3.7 million, $2.3 million of that covering ROE I just mentioned that $1.2 million of the gain on the sale of our first investment advisory business that we saw in the first quarter so, if you’re adjusting and looking at adjustments to make those would probably be proper adjustments.

Matthew Breese – Sterne Agee

Right. So I mean, all things aside, we shouldn’t expect much of a contribution from that line item going forward?

Jim Reske

No, I wish we could sell – a gain of piece of OREO property recorded for $2 million, but probably not that happen again.

Matthew Breese – Sterne Agee

Okay. And then turning to the swap side of things, what would be a more realistic run rate on swap income, versus that of what you put on the books this quarter?

Jim Reske

Yeah, the swap income is up nicely and I really – and saying those numbers in my prepared remarks, they want to overstate the case. I think these items like the swap income and some of the other items as well are moving in the right direction, fee incomes going up, it’s all positive, but they’re really, relatively minor of variances. So, I wouldn’t put too much attention on that as a growth trend, swap income of 400,000 are increased in the first quarter which is healthy, it’s good, some of them might actually come down a little bit. I think there is expectations may be to do little less swap activity going forward so that might come down there.

Matthew Breese – Sterne Agee

And then on the overall expense side, Mike, you noted a $1.5 million per quarter reduction in overall expenses. So, as we think about that and this quarter’s operating expenses, should we just basically subtract $1.5 million from this quarter’s run rate and that will be the new expenses, post-conversion?

Mike Price

I think we’ve been taking there to the $40 million number less than $1.5 million over the last few quarters I think that’s fair.

Matthew Breese – Sterne Agee

Okay, okay, that’s all I had. Thank you.

Mike Price

Thank you.

Operator

(Operator Instructions) And we have a question from John Moran from Macquarie. Your line is now open.

John Moran – Macquarie

Hey, guys.

Mike Price

Hey, John.

John Moran – Macquarie

Hey, I just want to circle back on this mix, real quick. Is the result of the annual review incorporated in this print, or are you guys still – is that kind of ongoing?

Mike Price

It’s in the print.

John Moran – Macquarie

It is in this print, okay, great. The next question – just if I’m looking at this wrong, flag me here, but as I look at the kind of year-on-year growth, create a lot of that has been driven out of commercial. And then if we tease it out in dollar terms, right you are up year-on-year about $110 million in the total commercial portfolio. The SNCs are up $107 million, so it’s kind of 97% of that growth, if I’m thinking about it right. And I guess what I’m driving at here is, SNCs – and I appreciate that more of these are being done in footprint, but SNCs was part of what drove a whole lot of credit sins of the past. So maybe it’s a question for Bob sort of what’s changed and can you give an update on the company’s approach to how we should think about this business, or how you guys think about this business?

Bob Emmerich

Yeah, in comparison to how things were in the past, I think there are a lot different than they were in the past. I think we’re a lot more selective about who we have as an agent bank and also a lot of the transactions I’d really classify as club deals where we know a bank reasonably well and we share in exposure there and rather than a broad syndication. And we are doing that both on the C&I side and also on the real estate side. And we have had a situation here maybe it was in the first quarter where there was a large real estate transaction here in the City of Pittsburgh. And we were trying to win the agency and we didn’t win it, another bank here locally won it. And we ended up splitting the deal. And so we do have a fair number of either participation in loans or syndication of loans that kind of fall into that category as well. And in addition to just being more careful about the agent banks and the kind of transactions we are getting into, as you know we have also been more careful about the size of the credits we got into and trying to make the – keep the portfolio very granular.

Mike Price

And John this is Mike let me just add to Bob’s comments I think if you looked at – if you track ($1.25 billion) of credit costs over four years that came out of that ’04 to ’07 timeframe, the vast majority, underscore the word vast probably 85% would be come out of the construction portfolio and participations in speculative development lending. And we are not doing participations in speculative development lending. So now you are talking about a C&I credit that quite frankly preformed pretty well through the cycle and it wasn’t the credit that kind of it is the back side. The other thing I would say is that we underwrite all of these loans and we are not buying these loans in the aftermarket. And a good portion of these loans we have other relations with them in terms of either deposits or a cash management, a branch in their corporate headquarters you name it and so just a little different. Again speculative development and participations that’s what hurt this company and these aren’t those types of deals.

John Moran – Macquarie

Got it. That’s actually really helpful. If I could just do quick follow-ups on that, one I guess back to Bob, how large was that CRE credit that you referenced in Pittsburgh that came-in in the first quarter, were you guys were trying to be agent and it ended up, it sounds like you kind of got second place?

Bob Emmerich

I think the total credit was probably around $40 million something like that.

John Moran – Macquarie

Okay. And then maybe just a second quick follow-up to Mike, you mentioned that you guys have another relationship of some sort with a whole lot of these guys, do you know offhand what the percentage would be where either it’s a deposit relationship or some other kind of product relationship versus just a physical branch in the building?

Mike Price

I think the fact that they are in our backyard, I am going to speculate it’s probably a third to a half, but I will get back to you on that.

John Moran – Macquarie

Okay. So a third to a half that you guys would have some sort of other relationship with, I mean do you know or have handy and I think you guys used to disclose this but how many you were actually lead on?

Mike Price

The number where we would be a lead on would just be a handful and there is probably about 70 credits or so would be in this bucket.

John Moran – Macquarie

Got it. I really appreciate all the detail. Thanks very much guys.

Operator

At this time I am showing no further question. I would like to now turn it back over to management for any further remarks.

Mike Price - President and Chief Executive Officer

We appreciate your interest in our company, your questions and we invite your questions at anytime and either Jim or I will be helpful and suspect we will get to see a lot of you before our next earnings call. So thank you.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect.

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