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United Community Banks, Inc. (NASDAQ:UCBI)

Q2 2014 Earnings Conference Call

July 24, 2014 11:00 AM ET

Executives

Jimmy Tallent - President and CEO

Lynn Harton - COO

Rex Schuette - EVP and CFO

Analysts

Jefferson Harralson - KWB

Brad Milsaps - Sandler O'Neill

Michael Rose - Raymond James

Jennifer Demba - SunTrust Robinson

Christopher Marinac - FIG Partners

Operator

Good morning and welcome to United Community Banks Second Quarter Conference Call. Hosting the call today are President and Chief Executive Officer, Jimmy Tallent; Chief Operating Officer, Lynn Harton; Chief Financial Officer, Rex Schuette; and Chief Risk Officer, David Shearrow.

United's presentation today includes references to core pre-tax, pre-credit earnings, and other non-GAAP financial information. For each of these non-GAAP financial measures, United has provided reconciliation to GAAP in the financial highlights section of the news release and at the end of the investor presentation. Both are included on the Web site at ucbi.com. Copies of today's earnings release and investor presentation for the second quarter were filed this morning on Form 8-K with the SEC, and a replay of this call will be available on the Company's Investor Relations page at ucbi.com.

Please be aware that during this call, forward-looking statements may be made by United Community Banks. Any forward-looking statement should be considered in light of risks and uncertainties described on Page 4 of the Company's Form 10-K and other information provided by the Company in its filings with the SEC, and included on its Web site.

At this time, we will begin the conference call with Jimmy Tallent.

Jimmy Tallent

Good morning and thank you for joining us for our second quarter conference call. We had a solid second quarter; and overall, I'm very pleased with our results. We saw revenue bounce back after the expected seasonal dip in the first quarter. This increase in revenue along with the elimination of the last of our preferred stock dividends allowed us to achieve an 8% increase in earnings per share over the first quarter. I'll talk more in a moment about the drivers of our second quarter results, but let me begin with some of the highlights.

We earned net income of $16.4 million or $0.27 per share. This is up $0.02 or 8% from the first quarter. Our return on assets increased to 88 basis points, moving us closer to our target of 1%, and our return on equity was 9%. We were able to hold our margin flat and took actions that should allow us to maintain or improve this level. Our efficiency ratio improved to 58.6%. We increased loans by $54 million or 5% annualized, just under half of the increase resulted from our acquisition of Business Carolina, Incorporated, a specialty SBA lender. This transaction closed late in the quarter.

We increased core transaction deposits by $52 million or 6% annualized. Compared to a year ago, we are up $303 million or 9%. Our provision for credit losses was $2.2 million, net charge-offs were $4.2 million, and the allowance ratio was 1.66%. Non-performing assets were $24 million or 32 basis points of assets. That is down over 20% from the first quarter, and all of our capital ratios strengthened during the quarter.

Now, I'll share some details and our outlook for the rest of the year. As you can see on Page 12 of the investor presentation, core pre-tax, pre-credit earnings were $28.8 million, up $1.4 million from the first quarter, and up $1.8 from a year ago. The increase from the first quarter was due to higher net interest revenue and fee revenue, which were partially offset by higher expenses. We were able to hold our net interest margin level with the first quarter at 3.21%, which was better than we anticipated during our last call. During the second quarter, we executed certain balance sheet restructuring and hedging actions that will allow us to maintain our margin at or above this level going forward. This in turn will allow us to improve our earnings run rate through balance sheet growth.

Our growing core transaction deposit balances and our mix of loans and securities over time have improved our overall interest rate risk and sensitivity. These improvements have allowed us to restructure and reduce our securities portfolio, wholesale borrowings, and several forward starting hedges that were put in place several years ago that were beginning to become effective, but were no longer necessary.

At quarter end, we remain asset sensitive with a 200 basis point ramp in interest rates over the next year increasing net interest revenue by 2.3%. During the second quarter, we deleveraged and restructured our securities portfolio by selling low yielding floating rate CMOs as well as fixed rate corporate bonds that had been swapped to floating. The $4.4 million of gains from these security sales were used to offset $4.4 million of charges from the repayment of a $44 million structured repurchase agreement, which was at an interest rate of 4%.

Our investment portfolio remains very conservatively positioned in regards to interest rate risk. At the end of the second quarter, 31% of our securities portfolio was floating rate loans. That compares with 39% at the end of the first quarter. Additionally, the effective duration of the securities portfolio at quarter end was 2.6 years, compared to 2.8 years last quarter, and three years at the end of 2013. The combined effect of the hedge reductions, restructuring of our securities portfolio, and the repayment of the high cost repurchase agreement, will benefit net interest revenue and margin going forward. In this current rate environment, we expect our margin to continue at or slightly above the 3.21% level for the remainder of 2014. In the second quarter, we grew loans by $54 million or 5% annualized. As I mentioned earlier, half of the increase came from our acquisition in South Carolina of an SBA lending company that will strengthen SBA and USDA lending across our footprint.

Let me take a moment to update you on our SBA business strategy. I'm very excited about the tremendous growth and fee revenue opportunities for United. As we discussed last quarter, we have significantly expanded our SBA, USDA lending capabilities with the addition of Rich Bradshaw to lead that team and our specialized lending group. Our build out of this business is progressing at a rapid pace, even faster than originally planned. Our upfront expenses are running higher as a result, but we should also see revenue grow at a faster pace in the coming quarters. Rich has already assembled an outstanding team of SBA lending specialist, underwriters and closers to grow the business within and more importantly beyond our existing footprint. As part of the business plan, we sold the guaranteed portion of SBA loans this quarter for a gain of $744,000, which was included in other fee revenue. We expect these sales and gains to continue around that level through 2014.

Looking further at loan growth, our new loan production was $357 million in the second quarter shown on Page 20 of our investor presentation. Production was strong in nearly every category. The acquisition of the SBA business unit added $26 million to our loan production totals, with $22 million in owner-occupied commercial real estate and $4 million in C&I. Geographically, these loans are included in the totals for South Carolina.

Last quarter, I reported that our C&I production of $75 million was the strongest we had seen to-date. I am pleased to report that this record has already been surpassed with second quarter production topping the first quarter by a fairly wide margin. We generated $115 million in new C&I loans and increased outstanding balances by $59 million. Although our production in the other commercial categories equaled or exceeded the first quarter, several large CRE loan pay-offs decreased our income producing CRE loans outstanding by $25.5 million from the first quarter. On the residential construction side, we saw some seasonal increase in production, but higher than normal payoff resulting in a $16 million reduction and outstanding balances. One particular payoff from the sale of our home building company accounted for half of that decrease.

Production in our residential mortgage and home equity lines of credit was up slightly from the first quarter. Geographically, our strongest loan production activity was in South Carolina and Atlanta. While we also had solid production in North Georgia, payoff activities again more than offset production and reduced loan balances by $29.7 million from the first quarter.

You'll find the trends on core fee revenue on page 12 of our investor presentation. Second quarter core fee revenue was $13.9 million, up $2 million from the first quarter, with increases in every category. Interchange fees were up $445,000 on strong transaction volume. Mortgage fees were up $523,000 after a slow first quarter. We closed $69 million in mortgage loans in the second quarter, compared to $46 million in the first quarter and $95 million a year ago. New loan purchases accounted for about 68% of second quarter mortgage production, compared with 66% last quarter, 49% a year ago. We saw a mass increase in customer swap fees of $414,000 in the second quarter. That total was up $357,000 from the first quarter, but down about $74,000 from a year ago.

As I noted earlier, our SBA lending business produced $744,000 in gains from loan sales in the second quarter. We sold approximately $6 million in balances. With our new focus on growing the SBA business, we expect to have sales and related gains each quarter going forward while retaining servicing on sold loans.

We continue to focus on growing fee revenue sources and expect to make further progress in this area. In last quarter's call, I mentioned that we added new leadership in treasury management services. Under this leadership, we are leveraging our diverse customer base and high customer satisfaction scores to grow merchant services, which will begin to produce results in the third quarter.

Let's turn now to core operating expenses presented on Page 13 of the investor presentation. Core operating expenses are up $1.4 million from the first quarter. About $600,000 of that increase was one timers, which I will cover in just a moment. We remain focused on controlling expenses while at the same time, making strategic investments in key personnel to drive revenue growth.

While direct salary costs were up on a linked quarter basis, total salaries and employee benefits cost of $24 million were down $223,000 from the first quarter. The decrease was driven by lower payroll taxes. We do expect to see some increase in staff cost in the third quarter as we continue to ramp up the SBA business and add other revenue producers.

Advertising and public relations expense is up $513,000 from the first quarter, reflecting the cost of new product initiatives and refreshing our branded marketing materials as well as our annual Customer Appreciation Day. Since much of the increase was related to non-recurring items, we would expect these expense categories to come down in the third quarter. Professional fees were up $745,000 from the first quarter, mostly reflecting consulting and legal fees from various internal initiatives, including the acquisition of the SBA business unit.

As I mentioned earlier, most of the $600,000 increase in the other expense category resulted from non-recurring items. This includes a $375,000 charge from the consolidation and sale of one of our branch facilities, which will be closing in third quarter, a $100,000 write down of our loss share indemnification asset and severance cost of $83,000.

Our loss sharing agreement with the FDIC for commercial loans from our 2009 acquisition of Southern Community Bank expired in June on the five-year anniversary of the acquisition. Our effective tax rate for the quarter was 37%, which is equal to the effective rate for the first quarter. We expect our effective tax rate to remain in this range for the rest of the year.

Before we open the call for your questions, I want to make a couple of closing comments. In the second quarter, we took steps to stabilize our net interest margin. We also continue to invest in new businesses where we see outstanding growth opportunities. This combination will drive earnings growth in the quarters and years to come. I'm especially delighted with the progress and outlook for our SBA business. We are positioning ourselves to become a top performer in this business nationwide.

We are already bearing much of the cost and now we look forward to the revenue growth. We had a slight uptick in the expenses in the second quarter, mostly as a result of our continued investment in revenue producers and some one-time items. Even so, we continue to improve operating efficiency. As reflected in our lower efficiency ratio of 58.6%, our people have done an outstanding job of controlling costs.

Our efficiency ratio remains consistently within the same range as before the financial crisis. I'm very proud of the dedication of our bankers, who continue to perform with commitment and discipline day-in and day-out. Even more impressive about this team is the steady improvement in our industry-leading customer satisfaction scores. In the second quarter, JD Power announced that we earned their award for the highest customer satisfaction in the Southeastern United States and nationwide, we came in second, missing the top spot by just two points. We believe this competitive distinction, combined with our business strategies and ongoing progress, speaks very well for the future of this organization. I'm very excited about the opportunities ahead for us.

Now, Lynn, Rex, David, and I will be pleased to answer any questions. (Operator Instructions)

Question-And-Answer Session

Operator

Our first question comes from Jefferson Harralson from KBW. Your line is now open. Please proceed with your question.

Jefferson Harralson - KWB

I was hoping to dig into the SBA business. From selling $6 million of loans, it sounds like you may have originated about $8 million. How fast do you expect that to ramp up? Where can it get to? Is there some non-competes in place that's going to keep that flat for the rest of the year, or I guess I'll stop there, and just let you guys answer from here.

Jimmy Tallent

Lynn?

Lynn Harton

Sure, Jefferson. To give you a sense of the scale of what we're doing in SBA, if you go back 120 days ago, we had one producer in 2.5 FTEs in the support role. So today, as we sit today, we've got 12 producers, 12 people on the support side in terms of credit closing et cetera, and only nine of those came from the acquisition of BCI. We're very proud of this team. We've obviously got to give them a little bit of time to ramp up production. But by the fourth quarter, we would expect in the range of $30 million in production in Q4.

Jefferson Harralson - KWB

And now I'll ask on the overall loan growth, the origination in the production is very strong obviously. It's not all getting to the bottom line. You guys had sort of guided to upper single digit loan growth three quarters ago, and it seems like the capacity is still there to do that, but pay-downs are getting in the way. Can you talk about the potential to take this overall loan growth rate up to high single digit or it's just the pay-downs are too high to get there in the near term?

Lynn Harton

You've hit that right on the head. The positives -- monthly productions are on a steady upward trend ever since February. Our Senior Credit Committee approvals are up 12% quarter-over-quarter. Now that doesn't translate directly into growth. We don't close every deal we approve, but still that's a good indicator. Our C&I business is strong, up $59 million. Only 40% of that came from our specialty groups and 60% came of our community banks, which I think is another great marker for the future in terms of the business there.

Our income property group is strong. We don't break that out separately, but it was up $18 million for the quarter and we're actively recruiting for another producer in Atlanta in that business. But as you said, the payoffs have been more than we expected. A couple of examples -- we had two stabilized hotels, $15 million. They were sold. The owner hadn't planned to sell, but the offers were too good to pass up. We've had two construction projects that we expected to hold through stabilization that sold at the end of construction again because of the cap rates. And on the C&I side even, we had three fairly large borrowers sell the business to national Operators that we didn't expect. So that's really the delta. We feel very good about production and the direction, momentum and certainly SBA. And it's just going to turn on the pay-down side, what happens in the third quarter.

Operator

Our next question comes from the line of Brad Milsaps with Sandler O'Neill. Your line is now open. Please proceed with your question.

Brad Milsaps - Sandler O'Neill

Just wanted to see if you guys could talk about capital plans, the TC ratio well above 9.5% now. Just curious what your thoughts are, maybe potential for M&A versus maybe buying back the stock versus organic growth? Just any additional color there would be greatly appreciated.

Jimmy Tallent

Brad, this is Jimmy. Of course, when we look at our capital management, there are several factors that we feel we must take into consideration. We're pleased that capital is growing at a very nice pace, earnings plus the DTA recapture. As you know, we reinstituted our cash dividend to our common shareholders at the first of the month, which basically represents 10%, 11% of earnings. I'm sure over time that that will probably increase. But there is other factors that we strongly consider as we look at the overall capital management. First, the amount of capital that we will need to support the organic growth of the Company, capital that would be needed possibly in acquisitions, stock buybacks maybe at some point. So, we factor in a number of these components when we think of capital management.

Brad Milsaps - Sandler O'Neill

Sure. Any thoughts on just kind of the M&A environment in general? Obviously, your own share price into consideration, seller expectations, how are you guys kind of seeing the market at this point?

Jimmy Tallent

Well, certainly Brad, there's a significant amount of conversations going on. We believe that M&A will certainly play a role in our future growth. Our strategy really has not changed. We still look within our four states that we operate in. Today, we would be biased toward expansion into metro markets. The size would probably be $300 million to $1 billion range, would probably be in our wheelhouse, could be in new markets, could be fill-ins, could be markets that we need to add both. So yes, we continue to survey and strategize as well as have conversations with potential partners.

Brad Milsaps - Sandler O'Neill

Great. And then just one final question maybe for Rex, sorry, if I missed it, but with the pay downs this quarter, were there any prepayment fees or loan fees that would have been out of the ordinary that helps you guys out this quarter?

Rex Schuette

No, not. There wasn't a significant amount of fees related to any of the pre-payments that came through that helped in the loan interest income line that comes in there. So it wasn't a significant amount all related to that.

Operator

Our next question comes from the line of Michael Rose with Raymond James. Your line is now open please proceed with your question.

Michael Rose - Raymond James

Got one for Rex, obviously there's a little bit of balance sheet restructuring this quarter. Are there other opportunities there, and how should we think about those opportunities?

Rex Schuette

As Jimmy indicated, I think we had a great opportunity to sell off some securities in combination with some low yielding securities, mixed in there to get a gain to repay down about $44 million of our structured repo. There's still $6 million of that outstanding. We are still looking at that later this year. If there is an opportunity, we would definitely proceed to do that also.

And again in our parent company, we do have some TruPS there. There's about $50 million, averaging about 9.3% sitting on that side also at the same time. But I think we look at this on a very active basis each month and quarter going through ALCO, looking at opportunities and continue to look for further opportunities where we can leverage. Again, I think the best part about that transaction is again, we were able to deleverage the security portfolio at the same time, reducing it by $120 million and still retain our interest revenue. So, we'll continue to look, but there is nothing immediate out there other than those two items.

Michael Rose - Raymond James

Okay. And maybe a couple of questions on the loan side for Lynn, outside of the SBA group that you picked up this quarter, what do trends look like in South Carolina? Maybe if you can update us then too on the healthcare efforts up in Nashville. And then when can we expect to see the decline in balances in North Georgia begin to level off? Thanks.

Lynn Harton

Yes, sure. So, we feel very good about the trends in South Carolina. All those businesses are going well. Healthcare continues to grow. It's probably a little slower, and that's -- than we anticipated at the beginning of the year, and that's really about our choice. That's the one area where we've seen credit terms get stretched beyond our tolerance. We've got an outstanding team there. Again they're continuing to grow, but it's probably going to be a little slower than we anticipated. And in terms of North Georgia, the production is continuing, the growth is really driven by lot and land payoffs. So, we think we're pretty close to a bottoming in that trend at this point.

Operator

Our next question comes from the line of Jennifer Demba with SunTrust Robinson. Your line is now open. Please proceed with your question.

Jennifer Demba - SunTrust Robinson

Question on the North Georgia, Western North Carolina economy; I think everybody is pretty familiar with what's gone on in Atlanta in the last couple of years. But could you talk about the economy up there and what's changed in the last six months to 12 months?

Jimmy Tallent

I'll give you just a quick overview; and Lynn, if you would add on too. I think, what I have seen, Jennifer, is stabilization in the real estate. In some of the very rural markets, it's still on the lending side, it's still slow. In some of those pockets, that would have a larger city. And within that rural market, we've begun to see some growth, but again, it's slow. I think tourism has increased. I think second homes and retirement homes, we see some increase there out of Florida, as well as out of the Northern states. So, I would -- I guess, the way I would size it is that the stabilization seems to be apparent and it's a slow growth at this point. Lynn, any...?

Lynn Harton

Yes. I completely agree. The economies are clearly better there. Our C&I business in both markets is actually already flat to slightly up. It's just that that – both markets were historically driven by real estate and that continues to pay down and that's not necessarily a bad thing. We are seeing more construction loans, good construction loans that we're participating in. But so, again, clearly the economy is better, our customer relationships are strong, but we have excellent fee income growth in both of those markets and continue to feel really good about our position there.

Jennifer Demba - SunTrust Robinson

And I have a follow-up on operating expenses. In terms of the outlook for next year, Jimmy, it sounds like it might be hard to get some net reduction that your investments will offset that. Is that a fair expectation if we look at 2014 expenses -- 2015 expenses versus 2014?

Jimmy Tallent

Jennifer, let me just kind of give you a little color as to my view on that and certainly it's baked into the efficiency ratio. And if you go back a year ago and look at it then and look at it today from 69% to 58%, tremendous improvement. Our people have done what I believe to be a fabulous job there. I don't know, if we have put a stake in the sand and said the efficiency ratio needs to be x. Certainly, we want to continue to drive that lower. But I think we're at that point now, where the revenue growth because of the reduction of the cost, investment in new revenue producers, we should see the revenue begin to move in an upward trajectory.

I think second quarter was very much the proof of our strategy. When you take out those one-time expenses, you basically see revenue up about $2.8 million, you see expense up $900,000. So that's really, I guess the way I would look at it. We expect that to continue as we go forward. And the investments in revenue generation hopefully will actually start paying off; and that in itself will have to drive the efficiency ratio even down further.

Operator

Our next question comes from the line of Christopher Marinac with FIG Partners. Your line is open. Please proceed with your question.

Christopher Marinac - FIG Partners

I think, Lynn may have mentioned this at the tail end of his remarks few minutes ago. But in North Georgia, you still are seeing pay downs, and that's influencing these numbers, but the North Georgia does seem to have an acceleration of new loan growth. I just want you to expand on that for a minute.

Lynn Harton

Yes, you're right on track. We are seeing good production in North Georgia. And so again, we're not sure exactly when it bottoms out and turns, but we continue to feel good about the activity of the teams in this market.

Christopher Marinac - FIG Partners

Great. And then can you talk a little bit about new loan pricing and sort of just kind of loan yields, and sort of how that is – just new loans that are coming onboard?

Rex Schuette

Sure, I think as you see in the our rates earned and paid in the press release, we dropped down 2 basis points on our loan yield, overall loan yield from 4.46% to 4.44%. That's probably the smallest drop, Chris, we've had in probably six or seven quarters on a linked basis. Some of that again is driven in the mix that both Jimmy and Lynn talked about. We did see, a new and renewed loan pricing come down a little bit in Q2 versus Q1 overall. But again, still up high enough to keep our overall loan yield in the 4.46%-4.44% range. So, we do see pricing that continues every quarter, but again I think we're looking to try and maintain it where we can maintain it, but the pricing pressure will continue. So we'll see that come down a little bit each quarter, but not to the lengths I think that we've had in prior quarters, over 10 basis point to 15 basis point drop.

Christopher Marinac - FIG Partners

And Jimmy, just I guess from big picture perspective for – potential acquisitions that are out there, how does pricing feel to you in terms of what the seller expectations are and has that varied at all in terms of last year has unfolded?

Jimmy Tallent

Well certainly, Chris, the pricing has increased, expectation has increased. But I still think the general dynamics of consolidation and probably the reasons for consideration are as strong as ever. Certainly, we have gotten a number of calls and certainly have initiated a number of calls our self. But yes, I think we will see pricing continue to maybe strengthen for a period of time. But you still have an economy and a market that's hypercompetitive, loan growth is still challenged, cost of operation which would include compliance and so forth, is very tough, probably somewhat of a board of directors and maybe even managements that are either tired or feel like hooking their wagon to another company I think is really what will ultimately drive that. So, yes, I think pricing will continue to strengthen, but I think there will be lots of opportunities over the quarters ahead.

Christopher Marinac - FIG Partners

And just one last quick one: the SBA production that you had, is that included in the new loans funded we see on Slide 20?

Rex Schuette

It is.

Jimmy Tallent

Yes.

Operator

Thank you. And with that, I'm not showing any further questions in the queue. I would like to turn the call back over to Mr. Jimmy Tallent for any closing remarks.

Jimmy Tallent

Thank you, Operator. And thank all of you for your questions today and your interest in United Community Banks. I do want to recognize, once again, our team of United Bankers and the fabulous job that you all continue to do day-in and day-out, and just say thank you for that. Thanks for being on the call today. We hope all of you have a great day, and we look forward to talking with you next quarter.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Have a good day, everyone.

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