First Merchants' (FRME) CEO Michael Rechin on Q2 2014 Results - Earnings Call Transcript

Jul.24.14 | About: First Merchants (FRME)

First Merchants Corporation (NASDAQ:FRME)

Q2 2014 Earnings Conference Call

July 24, 2014 14:30 ET

Executives

Michael Rechin - President and Chief Executive Officer

Mark Hardwick - Chief Financial Officer

John Martin - Chief Credit Officer

Analysts

Scott Siefers - Sandler O’Neill & Partners

Damon DelMonte - KBW

Stephen Geyen - D.A. Davidson

Daniel Cardenas - Raymond James

Brian Martin - FIG Partners

Operator

Good afternoon and welcome to the First Merchants Corporation Second Quarter 2014 Earnings Conference Call. All participants will be in listen-only mode. (Operator Instructions) Please note this event is being recorded.

We will be using user controlled slides for our webcast today. Slides maybe viewed by following the URL instructions noted in the First Merchants news release dated Thursday, July 24, 2014 or by visiting the First Merchants Corporation shareholder relations website and clicking on the webcast URL hyperlink.

During the call, management may make forward-looking statements about the company’s relative business outlook. These forward-looking statements and all other statements made during the call that do not concern historical facts are subject to risks and uncertainties that may materially affect actual results. Specific forward-looking statements include, but are not limited to, any indications regarding the financial services industry, the economy and future growth of the balance sheet or income statement.

I would now like to turn the conference over to Michael Rechin, President and CEO. Please go ahead, sir.

Michael Rechin - President and Chief Executive Officer

Thank you, Chad. Thank you all for joining this afternoon. Welcome to the earnings call and our webcast for the second quarter ending June 30, 2014. Joining me today as in the past are Mark Hardwick, our Chief Financial Officer, and John Martin, our Chief Credit Officer.

We released our second quarter results in a press release earlier today by 10 o'clock Eastern Standard Time. And our presentation speaks to material from that release. The directions that point to the webcast were also contained in the back end of that release and my comments begin on the page titled First Merchants Second Quarter 2014 Highlights at Page 4.

If you look at the top of the page, we are really pleased with progress in many areas of the company. We look forward to sharing our views of them and taking questions at the back end of the call. As contained at the top of the release, we reported earnings per share of $0.41, a 21% increase from prior period on a quarter-over-quarter basis and net income attributable to that EPS of $15.2 million. I know that our Treasurer was referencing to me earlier that absent the first quarter of 2012, it was the quarter that we had the FDIC assumption of Shelby County Bank and recognized a $9 million one-time gain. The $15.2 million in net income is the highest level ever in the history of the corporation. So, we are pleased with that. And as indicated in the last bullet point represents a return on average assets of 1.1%. So, we are gaining and hitting some of the progress targets that we had set for ourselves towards becoming a higher performing company.

Some of the income statement progress driven by loan growth, where we had nearly 3% of organic loan growth on a quarterly basis, two-thirds of which is in the C&I category. I know John Martin speaks to that at some point. And at the back end of the call, when I look forward somewhat as it relates to pipelines, I will reference similar items. And I know that our Chief Banking Officer is most pleased with the evenness of the activity across the entire company. So, all of our markets growing commercially. And for the first quarter in several quarters, some organic pickup in some of the consumer categories, you might have noticed in the release, including residential mortgage activity on the balance sheet and then the heave-hoc category. So we are pleased with that.

At a little bit of margin pressure absent the fair value accretion and yet at 3.89% of a full basis point above the like number for June quarter of last year at 3.88% and Mark will speak to that extensively in his remarks. We talked this time three months ago at the end of the first quarter about our expense levels experience through March with the hope that it would come down $2 million, it did. We had a little bit of OREO expense associated with our improving credit quality picture this journal covered. But we are trying to hit our expense targets and while I referenced in the bullet point on Page 4 that the expense target takeout for CFS had been realized. In fact the entire company of getting to the level that we think is appropriate and it reflects itself in an efficiency ratio that gets down closer to 60% level. So we are pleased with that.

So the slide is titled the second quarter and the last thing we are going to talk about at the end of the call and perhaps a couple of comment from my colleagues would reference the material covered in our press release of July 22. So two days ago we had a press release covering a definitive agreement that’s been executed, that will have Community Bancshares join our company. And we set a target for the first quarter of 2015. All of our efforts are going to be directed towards accelerating that into 2014 with the progress, the natural progress process that takes place immediately after that definitive agreement is in place and we are tremendously excited about that as well. So I am going to let Mark get into greater detail on our second quarter results and be back with you here in a few moments.

Mark Hardwick - Chief Financial Officer

Great. Thank you, Mike. If you turn to Page 6 or Slide 6, I will begin my comments there. I wanted to point out that most of my discussion is going to be a comparison between the first quarter of 2014 and the second quarter 2014. Now that we had two full months with Citizens – two full quarters with Citizens, because of the second quarter of 2013 did not include Citizens or Lakeshore Region, I think it’s difficult to try to compare the two. So if you look on Slide 6, on line 3 loans have increased on a linked basis by $106 million or nearly 3% just in end of the quarter on an annualized basis closer to 12. Through the first six months – I am sorry the investment portfolio then on line 1 increased during the quarter by $64 million as well. So we are doing a nice job of growing overall earning assets when you combine the loan totals and the investment portfolio totals.

We believe our liquidity is optimally deployed and given the current pace of loan growth we are not anticipating further increases in our bond portfolio. The allowance on line 4 totaled $68 million or 1.83% of loans and 133% of non-accrual loans. Net charge-offs totaled $1.2 million for the quarter, but we are still in a net recovery position of $497,000 year-to-date. The composition of our loan portfolio on Slide 7 is a reflective of a commercial bank balance sheet as the commercial loan categories comprised 73.5% of our portfolio. The portfolio yield for the second quarter of 2014 totaled 4.57%, down from 4.66% in the second quarter of 2013. And the two quarters obviously the Lakeshore or Citizens was not included a year ago, but we are seeing a decline from 4.66% to 4.57%. With that our fair value marks are on a normalized basis loan yields have declined from 4.61% to 4.34% during the same period.

On Slide 8, our $1.2 billion bond portfolio continues to perform well producing higher than average yields with a moderately longer duration than our peer group. Our 3.84% yield compares favorably to peer averages of approximately 2.54% with the duration of 4.3 years. The net gain in our portfolio increased back to $35.6 million during the quarter and the maturities for the remainder of the year totaled just $84 million with a yield of 3.65% and our 2015 maturities totaled $143 million with a yield of 3.01%.

Now on Slide 9, our non-maturity deposits on line 1 are up slightly over year end and last quarter and represent 76% of total deposits. Borrowings and broker deposits on line 3 and 4 have increased during the quarter and CDs on line 2 continued to decline. And the rate differential in terms of what the customer expects for CD rates in the wholesale market still remains pretty material and that’s why we are taking advantage some of – of some of the attractive features in the brokered market and Federal Home Loan Bank advances less risk of re-pricing in a rising rate environment and lower rates even in the current quarter.

Our tangible book value per share on line 10 of Slide 9 now totals 13.14%, an increase of $1.87 or nearly 17% year-over-year. Our earnings per share added $1.48 during that 12-month period reduced by our $0.23 of dividends and the remainder of the increase to $1.87 or is it still in the gap to $1.87 was a $19 million increase in other comprehensive income. So, really pleased by that transition. Based on tangible book value of ‘13/14, our current stock – when compared to our current stock price, our tangible book value multiple is just under $1.60, which is a little light of fair group and something we would like to ultimately attain is additional increases.

As I have previously mentioned, the mix of our deposits on Slide 10 continues to be strong and our total deposit expense is just 34 basis points, down from 40 basis points as of the second quarter of ‘13. And then on Slide 11, our regulatory capital ratios are all well above the OCC, in the Federal Reserve’s definition are well capitalized and continue growing nicely.

The corporation’s net interest margin on Slide 12 totaled 3.89% for the quarter and when adjusted for fair value accretion of $2.2 million totaled 3.71%. Our fair value accretion adjusted net interest margin totaled 3.84% in the second quarter of last year and has compressed by 13 basis points year-over-year. We still remain asset sensitive with $1.85 billion in assets are re-priced daily. Our net interest income simulations suggest that our net interest income should remain stable over the coming quarters. However, our new volume is averaging a spread of around 3% over the relative index. We are achieving nice loan growth. And with a mix of loan growth in our core deposits, we feel like the spread that we attained from that growth is enough to continue moving our net interest income in the proper direction and increasing quarter-over-quarter.

Total non-interest income on Slide 13 can have some volatility, through line 7, our securities gains and losses undid this quarter. Our portfolio gains were related to the liquidation of four of our six trust preferred investment pools. During the recession, we recorded OTPI and lease securities and we have been carrying them as classified assets ever since. Since we had the opportunity to sell out of our position with gains on four of those six pools, we executed the trades. We also recovered the fair market value mark, which is part of the OTPI or I am sorry other comprehensive income improvement that we recognized during the quarter that I spoke about previously. And that total was about $3 million. We are pleased that line 11 on non-interest income increased by $0.5 million over the first quarter of 2014 as service charges on deposits returned to expected levels and mortgage activity improved during the quarter.

Mike has already touched on our expense levels, but I would just highlight that our non-interest expense on Slide 14 totaled $41.2 million for the quarter, down from the first quarter total by $1.9 million. And when adjusted for OREO losses, the core level of our expenses at the bank declined by $2.7 million. Q2 of 2014 is the first full quarter post integration and we are pleased to report that our anticipated cost savings have been realized.

On Slide 15, our net interest income is aided by zero expense in our provision line item due to the fact that we have – we are in a net recovery position for the year and all of our loan categories continued – asset quality categories continued to improve. And our net income now totals $15.2 million or $0.41 for the quarter.

On Slide 16, you will notice that our EPS improved by over $0.07 second quarter of ’13 to second quarter of ’14 and $0.03 over the first quarter of 2014.

John Martin will now discuss our loan portfolio trends.

John Martin - Chief Credit Officer

Alright. Thanks Mark and good afternoon. I will be updating you on the trends in the loan portfolio on Slide 18 and then cover second quarter asset quality with an update on the progress of the work on the Citizens portfolio before closing with a look at the allowance and our fair value coverage. So please turn to Slide 18. In the second quarter we experienced strong portfolio growth on lines 1, 2, 3 in commercial and industrial, commercial real estate construction and investment real estate lending. The growth in the portfolio, the portfolio was a blended mix of new relationships what drives on existing lines and the financing of capital investments. Running out the portfolio on lines 4 through 8 we saw seasonal increases in agricultural production lending, Ag land acquisition while experiencing an uptick in residential and home equity lending. This growth combined with the strength in the commercial portfolio led to an increase of – as Mark had mentioned before $106 million or 2.9% in total loans in the quarter.

Flipping to Slide 19, on lines 1 and 2 in the Q2 2014 column we saw improvement in non-accrual loans and ORE. Non-accrual loans were down $4.4 million in the quarter and $5.1 million since the beginning of the year. This was really led by the resolution of a single loan of roughly $4 million in the quarter dropping. Then down to line 6 and 7 classified and criticized assets declined in the quarter as we continued to see improvement in the portfolio with overall levels elevated somewhat from year end inclusion of the Citizens portfolio. So on lines 9 and 10 the allowance was mostly unchanged declining by $1.2 million with the non-accrual allowance coverage which increased to 133% with the improvement in non-accruals.

And then turning to Slide 20, I would focus your attention on the last two columns starting at the top of the Q1 2014 column of $83 million which includes and kind of the beginning of the inclusion of both the addition of the CFS portfolio and highlights the improvement in asset quality since the acquisition of the portfolio. In the last column Q2 2014 we started on line 1 with $78.9 million and NPAs in 90 plus days past due. On line 2, new non-accruals continued to be relatively granular with few names greater $1 million and roughly two-thirds of the number of new non-accruals being from kind of consumer mortgages that’s in the number. In contrast on line 4 the decrease in non-accrual loans of $8.5 million that I had mentioned early included our resolution of a single borrower of roughly $4 million.

Skipping down to line 12, ORE declined by $2.5 million. The main drivers this quarter were the sale of an individual property which brought the balance down $1.3 million and an $800,000 write down on a property that had been in ORE. The property had received several offers much below the asking and reappraised it which resulted in the recognition of a decline in the value of this property. This sale and the resulting expense served to increase the ORE and credit related expenses by $800,000 on the income statement.

New ORE properties continue to be a small though with the average amount of new property coming in quarter of roughly $120,000. So with these changes during the quarter the total decline in NPA and 90 plus days past due was $6.5 million on line 16 from $78.9 million at the beginning of the quarter dropping down to $72.4 million at the end of the quarter.

So then speaking to Slide 21, on that top of the slide in the first graph with the reduction in non-accrual loans our allowance coverage on a fair value adjusted basis increased from 125% to 133% which I think really highlights the relative progress made towards improving the overall portfolio as well as efficiency of the allowance to the relative amount of non-accrual loans.

And then moving to the graph below in the second quarter, we had net charge-offs of $1.2 million, which included $1.2 million of recoveries. I would just highlight that unlike some of the more recent quarters the recoveries we had this quarter were much more granular and all under $250,000.

Turning to Slide 22, this slide continues the presentation from previous quarters and helps to support the overall allowance and mark coverage. On line 1, the allowance of $68.4 million in the far right column includes $400,000 of specific reserves allocated to the purchased portfolios. On line 2, total fair value adjustments are $43.9 million split between Shelby County Bank, the acquired portfolio there and the Citizens Bank portfolio. Fair value adjustments were down $3.3 million from $47.2 million at the end of the quarter.

And then moving down to lines 6 and 7 out to the far right column the allowance as a percentage of net loan balance is 1.83%, excuse me, on line 6 or 2.98% on line 7 or else equal. We would expect to see these coverages continue to move forward as these portfolios transition from purchased loans to allowance covered loans. So just to wrap up I would say that the originally establish marks in the purchased portfolio continues forth the work performed to original due diligence and we continue to remain focused on asset quality in the resolution and reduction of problem loans.

With respect to growth we continue to see strength in loan demands and I know Mark – Mike is going to speak to you through the portfolio and have reasons to remain optimistic through the remainder of the year. And then I know Mike, will be speaking to the Community Bank, purchase and I will be happy to answer any questions you might have on his remarks. Thanks and Mike I will turn it over to you.

Michael Rechin - President and Chief Executive Officer

Thank you, John. It’s hard for me not to offer a thought on John’s detailed coverage of the credit profile. And I think back to this time last year when we were excited about moving towards the close of Citizens now called the Lakeshore Region within our companies, it had elevated level of criticized and classifieds and non-accrual and yet when I look when I stand here in the middle of July just see that our non-performing assets as a percent of assets is identical to the level it was at June 30 of ‘13. Very pleased it not only tells me that our due diligence work was on point, it tells me equally that the management at the Lakeshore level, the Citizens Bank that have joined us knew what was going on in their profile and in a steady state economy we are able to demonstrate some ability to know what happens next with their clientele, all of that has worked our favor.

And then so when I see over a similar time period our NPAs go from $51 million in September last year to $83 million immediately post-closing and then come down 13% as they have at June 30 reflective of a safety and soundness program that runs past loan origination. So I am going to pick up with some comments that start on Page 24 and hold off on my comments about Community Bancshares for just a couple of moments. The organic growth throughout the franchise that’s refreshing for us to actually see it materialize, the commercial side we have been kind of good at. It’s the strong suit for the company that see it come across all of our franchise and in multiple lines of business particularly refreshing and a little bit of adjustment between our Chief Banking Officer and the fellow that runs our mortgage business and trying to take advantage of a slow mortgage business and maybe come up with some way to put it a little bit more in the balance sheet which we have.

And on a selective pricing and structure basis it all seems to be working for us pretty well. I referenced pipeline in my earlier comments John did a moment ago as well. While a lot of our progress in the pipeline shared with you in May made its way on to the balance sheet our pipeline is kind of replenished itself. And so I feel somewhat confident that that mid, single to high-single digit annualized growth rate how to be able to be realized in just like the activity that went on to our June 30 balance sheet across the company. The pipeline especially the commercial loans reflects that same spread across all of our key markets. In particular just to quantify things because I have in the past to our pipeline at the end of the last quarter was $274 million in credits that have been approved, reviewed by the client, in front of the clients in some form of moving towards across that number is $259 million at the end of the third quarter so, a couple of percent down, 4% down and we had 40% higher than this time last year.

So, we feel good about that. The retail bank – very strong going into the next quarter nearly twice what it was we put a lot of promotional dollars in front of our clients and perspective clients around the HELOC product. Some of it with teaser rate, most of it trying to win new clients on an overall retail basis, have a new manger and they’re running consumer business now for the last couple of quarters and we’ve seemed to see some fruit from that effort. So, we feel good about that.

The second bullet point on Page 24 refers to brand investment in our new Lakeshore region, it’s kind of a marketing point and it’s the identical point that I would have spoken to a couple of months back. Before I talked about community banks, I don’t want to rush pass, what was the critical and really attractive opportunity for us up in the Lakeshore region. So, we are just in the second full quarter post closing and completed the first quarter closed charter and so there is still a lot of freshness there and I’m so pleased with what we’re seeing there.

At this point, it is roughly 20% of our company by asset base and between the management that joined our company from there and the work we’ve been doing there welcome our new colleagues into the company, the operating cadence that we’ve been able to achieve with their talent and efforts around all new processes and yet be great in front of the clients, very, very pleased with. We can get better, but I couldn’t be more pleased kind of six months post closing there, our ability to adopt and absorb our values are critical to our sales culture makes me even more confident that as we grow into the future. We have the opportunity to be very, very good.

Regional boards I’ve touched on before. One, corporate board and yet we had regional boards in many geographies and so (indiscernible) managing our – make sure region has already assembled the regional board out of business leaders up in the Northwest part of the state, which is effectively new territory for us that give me more confidence that business leadership in that community will be hungry to learn more about our company such that they can spread our marketing message as well.

Middle of the page, I feel like we still have a little bit of room to go, we clearly aspire to have our efficiency ratio be less than 60% with the size of the company at this point it’s impossible to predict things, but we are watching all of our expense levels closely. We didn’t have a lot of noise in our second quarter numbers, we had a couple of branch related off edges that created expenses that we wouldn’t have expected, but nothing very dramatic and so all of the line items that we touched in detail in prior calls around the Lakeshore region have pretty settled in a level that are probably going to recur. So, we’re always looking for fresh ideas that are somewhat pleased with efficiency we’ve been able to attain.

Before taking questions, so our organic strategy absent community banks which I’m going to get into here in a minute is really just to sustain our progress, I mean, our folks are – these are focused on the particular community that they are servicing, trying to build in the projects that we’re fighting off as we go and anxious to see what next and what next for us starts on page 25.

I wanted to touch on there. I give you a little bit of a visual which gets a little bit better when we flip to the next page, but on 25 just on pro forma highlights on the left hand side of the page, it speaks to a company that will be the better part of $6 billion in assets when we get close with a 67% loaned asset kind of ratio and a nice risk deposit base, one it’s augmented by what we see in community bank shares and so if you take a look at page 26, you get a little bit more detail on the company itself and a math was a little bit greater definition. And what you would see is what those of you familiar with the State of Indiana would come to know that these are two companies that have great knowledge of each other. My predecessor Chuck Crow, the CEO of Community Bancshares had a long relationship as such Community and First Merchants had a long relationship, open competitors in the exact markets we overlapped in and yet we frequently shared participations. So, we have a familiarity with underwriting that makes for an easy driver of relationship capital that allowed for an easy dialogue as Chuck and their board began to think about what was next for Community. All kinds of extensive discussion about what our company felt like for the teammates that will be joining us. So, we are extremely pleased to have gotten where we are at.

So, back to 26, headquartered in Noblesville, a fairly young company at 23 years old. Chuck, one leader built a culture with the idea that they could be different than the regional banks that dominate Hamilton County and so they built a company that is nearly 24 years old has been highly successful. 10 full-service banking centers, that will be joining us in a balance sheet, the features, the bullet points directly beneath that $272 million in assets, $145 million in loans, nice deposit mix that totals $236 million. At a strong first quarter of the year, if you are familiar with the company’s history, we have looked at it since our press release as 22, you will see that as a private company, they had the luxury if you want to call it that of being patient with the evidences of the credit cycle. And so while problem assets may still be elevated by some standards, they have been working their way through them and now seeing the profitability that company resurface to the strong first quarter and a nice outlook that we are privy to at this point. A margin that we think we can help with and a fairly simple balance sheet is the last bullet points out in terms of complexities.

So, we are anxious to get started with it. And the actual guts of the transaction are laid on Page 27. These are all items that come directly out of the press release from two days ago. For the deal value of just over $46 million based on our closing price, the end of business on Monday creates some of the ratios and statistics that are evidenced here. Couple of the assumptions I would like to speak to, the first one is the cost savings. Unlike the Citizens transaction as an example, where there is a relative immediacy of expense savings around FTE involved, the level here we feel good about and it will come from a slightly different complexion in that.

If you refer of the map, you can see that there is a significant branch overlap unlike Citizens and unlike many other opportunities and that gives us an opportunity that look at a given community in this case either Hamilton or Madison County that says who has the better location and probably refine your physical properties over some period of time, I call it 12 months. So, whereas you might get a lot of expense savings should they be people related really front-end loaded post-closing in several transactions, in this one, there will be some of that, but clearly the majority of the synergy is more off of the physical assets. And we are going to be working with our retail team to get to best traffic locations for the most households and the most business convenience for our commercial banking clients.

Got some one-time expenses, which Mark Hardwick could speak to, but clearly has identified on a piece-by-piece basis and then a consistent use of our credit discipline working with Chuck Crow and his team to get inside of the files and have our entire protocol for assessing safety and soundness in the loan portfolio and in the OREO category to come up with a mark that we think is ample for the credit condition we see. Consistent with our desirables for an ad of the business would be as quick accretion is possible we are calling for accretion to EPS in the first full year, which could be in our plan 2016. It could well be 2015 in which case the accretion would be a little bit lesser, but clearly a positive story for us.

And then a tangible book value earned back inside of it about 3 and 3.25 years, minimal impact given the size of the opportunity through our capital ratio. So, it kind of works out well for us, and as I reference earlier, based on the shareholder election, this kind of footnoted at the bottom of the page. We would see that it winds up being as the consideration line item shows at the top, 31% or 32% cash if in fact the shareholder election takes full advantage of the cash that’s available.

Take a look at Page 28 a little bit more the same information and I wanted to make sure I highlighted the attractiveness of the franchise that community had built, 10-full service banking centers as I referenced. If you look at our company and there and they move off of that map which clearly shows the critical mass is being built. We get to a Hamilton County and Hamilton County is a little bit special. Perhaps on the entire Midwest, certainly special in the State of Indiana, the highest population growth in the state running 2% annually, it’s projected to grow 2% in each year over the next several years, a household – highest median household income in the State of Indiana and one that’s anticipated to rise 1.5% annually, it’s just – it’s been a particularly well led area. It’s been a magnet for job growth and as a result its unemployment rate is just about 4%, I think is the second lowest county in the state.

So, this is a plum. We’ve been growing into this county as you might know for sometime the one store at a time level going back 12 years and then through the Lincoln acquisition six years ago build some critical mass around that in terms of relationship management commercial banking tools then ultimately a few more banking centers and so we’re excited about I think you can hear my comments, equally excited about the fact that beyond the store fronts and growth demographics, that’s a key people that we met that have driven community are going to be joining us.

So, Chuck and his team are going to be assuming roles extremely similar to what they’ve been doing in the past to help us keep the momentum there, go through the change events which is a real one and keep on movement, couple of new communities that are referenced in that top section of page 28 that are communities that are going to continue to grow, Cicero, in particular and Hamilton County, Summitville and Alexandria, Madison County communities that we are not currently in. So, while there is some overlap, there is clearly some new tour for us where our name is recognized and now will be able to add convenience to that to complement what the community folks have been doing.

The financially attractive portion of page 28, I believe I covered when we are going over the transaction side and then when I think about think take a deep breath and think about the overall profile of it. We had a very though due diligence process that’s reflected the kind of company that community has built over the last 23 years, a cultural fit it’s been evidenced to me for several years and that kind of collaborative nature. It’s almost a correspondent bank type relationship as it relates to sharing credits on an opportunistic basis, retention to key focus and their company and then hopefully, the ability to couple of quarters and now to bring our experience in integration process is to the four and achieve all of our targets. On 29 and 30, I didn’t want to stop on two bonds; they reflect the additional market share muscle that is gained in the two counties we’ve been talking about.

And then on Page 31 right before we get to questions, I would just touch on the highlights that I would be happy to lead with and the one highlight that I probably should have added there was their senior management joining our team, but when I make the comment about culturally similar companies with valuable core deposit basis, it strikes me as that’s how I might describe our company. So, we like the opportunity. We’re happy that our relationship which has been a long time is able to manifest itself and our company is coming together, it’s fresh in the marketplace, we’re anxious to tell our story both on this call and then more personally to clients employees over the weeks to come.

Chad, at this point, you can open the lines for questions and we’re ready for them.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. (Operator Instructions) Our first question comes today from Scott Siefers of Sandler O’Neill & Partners.

Scott Siefers - Sandler O’Neill & Partners

Good afternoon guys.

Mark Hardwick

Hi, Scott.

Scott Siefers - Sandler O’Neill & Partners

Mark, first question is probably best for you, I was just curious if you could go into sort of the puts and takes of the adjusted margin in the second quarter it declined a little more abruptly than has been the case recently. So, just curious what caused the sequential compression that might have been a little worse than anticipated? And then I believe within your prepared remarks, you had suggested that NII should still be expected to increase quarter-over-quarter, I guess one did I hear that right? And then two, what is your outlook for the adjusted margin? So, will it be mostly kind of loan growth driven NII growth or what factored us the margin play there?

Michael Rechin

Yes, thanks Scott. The quarter-over-quarter comparison, first quarter to second is really about loan yield compression and we have been able to keep up at least so far or most recently with the loan yield compression on the deposit side and we are down to 34 basis points and it’s hard to move further. The comments that I had our net interest income simulation, we do. I think of a very thorough job of modeling out net interest income over the next 12 months every quarter. And we use all of our new loan spreads to identify what’s actually happening in terms of once you have roll-offs and then you put new loans on the books how they are priced. And the simulation is suggesting that we don’t see further compression. I mean, it’s a model and they don’t have their flaws, but it is not showing a significant level of compression. Frankly, it’s not showing any.

And I guess my confidence in terms of next quarter I believe that we will be able to continue to grow net interest income even if we have some modest net interest margin compression. So, I don’t have an exact number for you, but I feel like those are the directions, the modeling suggesting that our margin should remain fairly stable trends showing that we are having some compression and confidence that based on our asset growth that we will be able to continue to grow net interest income.

Scott Siefers - Sandler O’Neill & Partners

Okay, that’s perfect. I appreciate that. And then maybe Mike and John just curious on specifically the OREO cost in the quarter, a little more elevated. I think if I heard your comments correctly, it might have been more an isolated incident than anything more broader base. So, we keep these OREO costs elevated, but one is that the case, so can we assume that those will normalize a bit more I think you said something around $800,000 from kind of elevated OREO cost differential in the second quarter? And then the part for Mike, what’s your thought on your ability to keep the core cost base around where it is as you look forward?

John Martin

Yes. Scott, this is John. I will go first. Yes, it really when you look at our OREO expense, the ORE and other credit-related expenses may have been $1.6 million, $1.7 million pretty consistently quarter-over-quarter for the last four quarters and then we have the write-down of the one individual property. And it was one property and it was kind of a blip. I will say that when you look at what remains in ORE, it is granular. I mean, your next – I think your next largest ORE is just north of $1 million, $1.2 million, $1.3 million something like that. So, that was probably one of the largest properties in there which is the standalone and that resulted in the effect. Mike?

Michael Rechin

Well, I wasn’t going to speak to OREO if there was a follow-up question on that topic. John, I will let you take it, but I think the point directed towards me, Scott was about our overall expense levels, they stay exactly where they are at. As I said, there were $300,000 of I would consider to be not usual items in the other expense, (indiscernible) and on EEO and E&O settlement expense, but those are somewhat the knits and gnats that happened from time-to-time. I wouldn’t call them recurring. So, I would like our run rate on the largest dollar categories, the direct FTE expense, the direct premises expense, the absence of over time, those kind of things are kind of right where we want them. And yet while we are doing that, I will tell you to make sure we are going to get to where our 6/30 numbers were, we had an extensive number of profit center by profit center expense meetings that not only showed us that where our June 30 numbers will, but the level of inspection of them, I believe we’ll have some benefit as we get ready to start looking at 2015.

Scott Siefers - Sandler O’Neill & Partners

Okay, that’s perfect. And then I just so I understand clearly, it sounds like for the most part it’s going to be flat expenses, but is it – would it be correct to assume that the absolute cost base could down a little just given that elevated OREO and then they kind of an unusual items in that other expense category and other words.

Mark Hardwick

Yes.

Scott Siefers - Sandler O’Neill & Partners

If we aggregate them all, it sounds like it’s about a $1 million, so, would a better run rate be sort of $40.5 million and the $41.3 million that we saw this quarter?

Mark Hardwick

I would agree with that.

Scott Siefers - Sandler O’Neill & Partners

Okay, alright, that’s perfect. I appreciate the clarity. That’s it from my side so, thanks.

Michael Rechin

Thank you.

Operator

Our next question is from Damon DelMonte of KBW.

Damon DelMonte - KBW

Hey, good afternoon guys. How are you?

Michael Rechin

Hi, Damon. We are good. How are you?

Damon DelMonte - KBW

Great, thanks. My first question I had to deal with the growth you guys saw this quarter, C&I balance has expanded quite nicely, could you talk a little bit about what was driving that increase this quarter?

Michael Rechin

I’d like to feel like our effort and our market coverage effort now processes for pushing opportunities along to include the credit process is similar all the time. And so the prognostication of closings and winning is difficult for us. I do know that the pipeline trend that our Chief Banking Offer started probably 9 or 10 quarters ago has gotten increasingly accurate in its ability to predict the direction of the commercial side of the balance sheet in particular, may be all parts of it, but commercial in particular given it size. And so when I look at the level that it has been back into this time last year and kind of well over what is the absorption of pipeline in new balance sheet, it’s been seeing with some positive correlation and so I think we’re going to grow this quarter, what I would say if the pipeline numbers that I referenced earlier are any indication of what they’ve been in the past. But in terms of the market coverage in the actual work, this – is this your question I think might really even to the net interest margin that’s Mark was talking about earlier in that. We do spend a lot of time looking at the next opportunity that creates the loan growth in accessing the return on it by way of interest rate. So, we’re going to try to stay even sharper on that in accessing new clients in particular, but feel like nothing, no magic in the current quarter’s results other than good ability to translate pipeline loans under the balance sheet.

Damon DelMonte - KBW

Okay.

Michael Rechin

Take a little bit higher use of them from our clients.

Damon DelMonte - KBW

And with regard to the pipelines, did you say that you had – could you just go over the number again for what you said for the pipeline?

Mark Hardwick

Be happy too. On the retail side, I think I said it was nearly twice so that’s a $21.5 million number for us up from 12. On the commercial side which is the biggest line of business in terms of own production, $259 million down 4% from $274 million, but up – I know I said up 40% from a $185 million this time last year. So, the $274 million at the end of the first quarter was a highest that has ever been and so while it comes down slightly based on the last quarter and it’s still at a relatively high level for us.

Damon DelMonte - KBW

Got it, okay, that’s helpful, thanks. And then I guess with regard to the outlook for the provision, can you give us a little direction as to what we could expect for quarterly provision rate going forward, I mean if the underlying trends of the credit remained strong, I mean, I was assuming that the people are looking some provision to account for the loan growth, is that a fair assessment?

Michael Rechin

Yes, I think that’s a fair assessment, John’s chart that shows the overall level of reserve including fair value mark. I think it’s really important or trying not to be just myopic on the allowance as a percent of total loans because of all of those additional marks but as long as our net charge-offs and what currently our net recoveries remained a stable with declining asset quality trends start to justify much more provision.

Damon DelMonte - KBW

Great, okay. That’s all I have for now. I can go back into the queue if something else comes up. Thanks.

Michael Rechin

Thank you.

Operator

Our next question comes from Stephen Geyen of D.A. Davidson.

Stephen Geyen - D.A. Davidson

Good afternoon.

Michael Rechin

Hi Steve.

Stephen Geyen - D.A. Davidson

Maybe first question I know you guys can have a whole lot of accelerated accretion last quarter, was that kind of the case this quarter, I saw that I guess the fair value of accretion was $2.2 million versus $1.8 million last quarter is that right?

Michael Rechin

We were anticipating I think we gave you some guidance last quarter that we expected about $1.8 million for the quarter. And so we had a little acceleration from this pay down on the credit or two that where we added some additional, Steve.

Stephen Geyen - D.A. Davidson

Okay. So $1.8 million kind of a base level is kind of a good number to work with over near-term?

Michael Rechin

It seems like it, yes.

Stephen Geyen - D.A. Davidson

Okay. And the pipeline just maybe just one more question or a couple of questions on it. Approximately what percent or range are you comfortable with saying that those loans will be funded – fully funded?

Michael Rechin

Steve I don’t have a good answer for you on that because on the material that I have it has it by line of business and by geography, it doesn’t include structure whether it’s a term loan or evolving credit and so I am hesitant to take a shot at that one.

Stephen Geyen - D.A. Davidson

Okay. That understandable and let me see just a couple of more questions here. You had mentioned that the Lakeshore Region that the expense sales were real – are pretty much fully realized and I just wanted to make sure I understood in fact what you are saying were they realized early in 2Q or were they realized over the course of 2Q and they are fully realized are you fully in position now at the end of the quarter beginning of the third quarter moving forward?

Michael Rechin

I think they were pretty much fully realized by the end of May, so you could say that we had them through two quarters in some regards we are based on that unit alone, the Lakeshore Region alone even marginally beneath where we wanted to be because we are hoping to have a little bit of added investments into the commercial side of the bank which really hasn’t happened yet. But the absolute expense levels associated with the take outs that were part of our contemplation at the announcement were done by May.

Stephen Geyen - D.A. Davidson

Okay. Alright. Got it. And maybe last question for Mark, I think you had mentioned that you are pretty much on optimal liquidity kind of what ratios are you working with that we can kind of factor in – into our models?

Mark Hardwick

Well, there are a few things but I think those – the comments that Mike made around loan to deposit ratio they are in our press release as well. Loan to asset ratios kind of guide those number for us, but it also comes back to dispositional our excess liquidity where do we stand with availability of Federal Home Loan Bank advances, our appetite I guess for broker deposits and we feel like the current levels of our balance sheet and the current mix between loans and investments is ideal. If we were to grow on the deposits side of the balance sheet faster than you can see the bond portfolio grow, but I think based on the environment that we are in and the ways the rate environment fuels I think we are going to be working hard to keep up on the deposits side with our loan growth.

Stephen Geyen - D.A. Davidson

Got it. Okay, that’s perfect. Thanks.

Michael Rechin

Thank you.

Operator

Our next question comes from Daniel Cardenas of Raymond James.

Daniel Cardenas - Raymond James

Good afternoon everybody.

Michael Rechin

Hi Dan.

Daniel Cardenas - Raymond James

Just a quick question on competition maybe what if competition looks like in Q2 is it slowing down a little bit and what impact is that having on loan pricing in the second quarter and as you have entered into the third quarter?

Michael Rechin

Well, I don’t think it’s levying up, I think that every competitor that we have in any market we are in is recognizing that loan growth has so many positive attributes to it in terms of associated revenues whether it would be treasury management or loan fees and the introduction of other services. And so I view it being extremely competitive and so we are trying to pick our spots, make sure that the profile of a client and our risk appetite are similar, take care of our existing clients which sometimes puts pressure on your loan margin, but no, I would say it’s kind of rough out there. I think it really adds to the art of the business, which is to know where to use your balance sheet and have the ability to provide as much banking product to any given client to feel good about the return the value proposition.

Daniel Cardenas - Raymond James

Okay. And so, when you look at then, I mean what is your – maybe product per household number now and where you see that trending over the next couple of years?

Mark Hardwick

Well, that vocabulary to me seems most associated with retail banking and then you get into numbers that are like 5 and 6, but for our balance sheet which is commercial heavy, I really think of three, I think of loans, deposits and technology meaning treasury management. So, if we could get three out of all of our clients, then three would be a really magic number for us. The bonus would be the ability to use your insurance segment and your trust business to add to that, but if we were to get three with all of our commercial clients, we’d be way ahead of the game. So, it’s a smaller number than you might think, especially when you are related to the commercial side of the bank. I know I hear banks talk about 7 and 8, the great aspiration.

Daniel Cardenas - Raymond James

Yes, makes lot of sense. And just one quick question for Mike, as we think about the back half of 2014, what’s the good tax rate to assume for modeling purposes?

Michael Rechin

Yeah. We would 24 in the first quarter and 27 in the second. Of our growth in our pre-tax net income, all of that was taxed at 35. So, if you just run the same math that would have been a 26% rate and we came in at 27. I think we are a little high in the second quarter, I mean as you go through we are always trying to readjust our accruals to that time somewhere between 26% and 27%.

Daniel Cardenas - Raymond James

Okay, great. Thanks guys. Good quarter.

Michael Rechin

Thank you.

Operator

Our next question comes from Brian Martin of FIG Partners.

Brian Martin - FIG Partners

Hi, guys.

Michael Rechin

Good afternoon, Brian.

Brian Martin - FIG Partners

Just a couple of mostly as it been covered, but just John you mentioned the utilization rates sounds like they were up a little bit this quarter, was it material or was it just insignificant, what that did this quarter from a lending standpoint?

John Martin

Yes. I went back and did a little digging and it was up from 45% to 49%. We did see an uptick from the end of March to the end of June, but dollars associated with it were let’s call it $75 million. There is a lot of moving pieces going on there. You have got pay downs and term loans and the new dollars coming on from the new opportunities, but it was pretty material for the quarter.

Brian Martin - FIG Partners

Okay, that’s helpful. And just maybe two other things, the number one I guess the cost saves on the Community deal, I guess it maybe from that getting as much personnel out of there is it seems like just wondering how you get to the 40% type of level kind of targeted? And then secondly just how that plays to your goal of getting a 60% efficiency ratio, what type of timetable you think is required to kind of match it down to that level?

John Martin

Sure. We will revisit the overall efficiency target at 60% when we complete kind of all of our pro forma work. And we will talk about that the next quarter. I am sure our work will be even further along the 60% use that I referenced earlier was relative to the company as it stands today. And that’s kind of an immediate goal. If we were to get any help in the mortgage business, which is sizeable for us and remains a little bit soft or may continued headway as I have alluded to on our overall expense burden, it would get us close to that based on where we were in the second quarter.

The front half of your question spoke to a little bit more dialogue around the expense targets at Community. And I will just kind of repeat some what I shared before. We have got a couple of markets, three in particular. 3 out of 10 of the banking centers at Community are extremely local two hours. And so we are going to assess where the customer gets serviced the best without any judgment about which store whether it’s a Community store or a First Merchants banking center is best situated and picked the best situated one, pick the best customer service folks for that and then enjoy a expense savings based on the disposition of the redundant property and so, there is an FTE impact to that, but when I can trust that volume to Citizens to where we had zero overlap either commercially or in retail banking, all of the cost saved their which was lesser than 40% was really dominated by operational FTE. This will be a little bit different and the other different not just the composition of the expense savings, but the timing of this one will be a little bit less immediate based on very tangible aspect to real estate and how quickly you can move in and out of it, real nonetheless.

Mark Hardwick

The numbers – we have, we said 40% cost savings in our release, it’s about around $2.8 million, $1.8 million from the core bank, another $1 million of cost savings from optimizing the market coverage and of the 1.8 that would be from their core operations and there is a sizable component of that, that also comes just from the back office technology spend.

Brian Martin - FIG Partners

Thank you.

Michael Rechin

Hope that helps.

Operator

This concludes our question-and-answer session. I’d like to turn the conference back over to Michael Rechin for any closing remarks.

Michael Rechin - President and Chief Executive Officer

Thank you, Chad. I really have none. I appreciate your attention and the quality of the questions. I appreciate your support of the company. We look forward to talking to you in a couple of months. Have a great day.

Operator

Thank you. The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect. Take care.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!