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Independent Bank Corporation (NASDAQ:IBCP)

Q2 2014 Earnings Conference Call

July 28, 2014 11:00 a.m. ET

Executives

Brad Kessel – President and Chief Executive Officer

Robert Shuster – Executive Vice President and Chief Financial Officer

Analysts

Rick D'Auteuil – Columbia Management

Damon DelMonte – Keefe, Bruyette & Woods

Operator

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

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

Brad Kessel

Good morning. Thank you for joining Independent Bank Corporation's conference call and webcast to discuss the company’s financial results for the second quarter of 2014. I am Brad Kessel, President and CEO of Independent Bank and joining me is Rob Shuster, Executive Vice President and Chief Financial Officer.

Before we begin today’s call, it is my responsibility to direct you to the cautionary note regarding forward-looking statements. This is Slide 2 in our presentation. If anyone does not already have a copy of the press release issued by Independent today, you can access it at the company’s website. We will begin today’s call with our prepared remarks and then open the call up to questions.

Beginning with the financial summary slide, Page 4, we are pleased to report for the second quarter of 2014 net income of $6.1 million or $0.26 per diluted share. On an income before tax basis, we are reporting $7.9 million as compared to $6.9 million for the same quarter last year. This represents a $1 million or 14.5% year-over-year increase. For the six months ended June 30, the company is reporting net income applicable to common stock of $9.2 million or $0.39 per diluted share, compared to $66.9 million or $2.90 per diluted share in the prior year period.

Recall the second quarter and year-to-date results -- 2013 results, included income tax benefit of $57.6 million associated with the reversal of substantially all of the company’s deferred tax asset valuation allowance in June of 2013.

Turning to the financial highlights slide, Page 5, we remain optimistic about the company’s prospects for long term earnings growth. This past year we saw net interest income up slightly on a linked-quarter basis. Non-interest expenses also on a quarterly basis have been reduced by $5.2 million or 18.7% as compared to the same quarter one year ago.

Our balance sheet continues to be strong, with net loan growth for the quarter. Our growth is being driven by commercial loan growth of $12.2 million or 7.6% annualized and consumer installment loan growth of $12.9 million or 27.4% annualized. Our tangible common equity ratio increased to 10.68% and our tangible book value per share increased to $10.47. On July 22, 2014 our Board of Directors declared a $0.06 per dividend payable on August 15 to shareholders of record as of August 5.

Our footprint shown on the core banking market slide Page 6, includes significant market presence and opportunity to gain market share in attractive Michigan markets. For the second quarter of 2014, Michigan market conditions continued to improve as compared to the same period one year ago, evidenced by a reduced unemployment rate, net job growth and appreciation in real estate values, both residential and commercial. Commercial vacancy rates continue to improve for industrial, retail and office space.

Moving to the deposit franchise slide, Page 7, we continue to emphasize growth in our core deposit base. We have $1.9 billion in total deposits as of June 30 2014, up $92 million or 5.1% since June 30, 2013. $1.5 billion or 79% of our $1.9 billion in deposits are transaction accounts. For the second quarter of 2014, our cost of deposits was 26 basis points, down 2 basis points for the quarter. Consistent with industry trends, we are seeing increased transaction volumes through our electronic channels, and decreased foot traffic in our branches. Accordingly, we continue to review our staffing models, and branch profitability model. We continue to invest in our associates to position them as trusted financial advisors inside and outside the branch and we continue to invest in the self-service channels as that is what many of our clients and prospective clients are now demanding.

Our loan composition in historical yield on the loan portfolio is shown on Slide 8. Total portfolio loans accrued to $1.4 billion as of June 30, 2014. For the second quarter, in addition to the commercial and consumer portfolio growth, we originated $65.4 million of residential mortgages, and saw $47 million in mortgages generating $1.5 million in net gains. The 8 basis point decline in yield from the first quarter to the second quarter was evidence of the continued low rate environment and competitive pricing for loans that we see in our markets. Our associates continue to execute on our strategies to grow our loan portfolios, targeting the commercial small business and consumer markets. We also continue to be well-positioned in our markets, with a very experienced team of residential mortgage originators to support in-market purchase mortgage needs of salable and non-salable products.

As you can see on the overview slide Page 9, we outline what we believed to be the keys in executing to improve our efficiency ratio and grow earnings. While there does exist improvement opportunity on the cost side, a majority of the improvement now needs to come from revenue growth, and while our balance sheet is set up very defensively for realizing interest rates, our revenue growth strategies continue to be led by our commercial line of business. For the first half of the year, we had new commercial commitments of $94 million with $73 million in funded new loans. Of this new business, C&I lending accounted for the largest portion of $55 million. In terms of where the growth is taking place, we have very good balance between our East Michigan and our West Michigan regions, followed by our central region. The quality of our portfolio continues to improve and is now very strong with watch credits under 10%, early stage delinquencies at $0.7 million or 11 basis points and commercial non-accruals at $5.1 million or 78 basis points. Our commercial pipeline is solid and we feel good about achieving our targeted growth rate.

Our retail banking business continues to gather momentum. This past quarter, we saw across the board improvement in branch network originations, and very strong originations by our indirect lending group. The indirect group is very seasoned and has been with the bank for some time. This past quarter, the group generated $18.5 million in new bookings, principally a combination of recreational vehicle and marine lending. Our mortgage business for the first six months of 2014 was challenging as this unit worked through an extremely difficult winter, generally higher interest rates compared to the first half of last year, competitive pressures and a significant number of new regulations. That said, we expect improvement in this position having increased the number of originators, the addition of two new loan production offices, an increase in demand for construction loans, and finally having received approval for [JMA] securitization. This will assist in an improved net margin on a portion of our loan sales while allowing us to retain the servicing for this customer base.

Finally, as mentioned, we continue to work on reducing our expenses. For delivery channel optimization efforts, this includes investment in new technologies, further branch rationalization and work flow process improvement enterprise-wide.

I would now like to turn the presentation over to Rob Shuster to share a few comments and our financials, credit quality and management outlook. Rob.

Robert Shuster

Thanks, Brad and good morning everyone. I am starting at page 10 of our presentation.

Our net interest income totaled $18.5 million during the second quarter of 2014, a decrease of $1 million from the year ago period, but an increase of $0.1 million on a linked quarter basis. Our net interest margin was 3.74% during the second quarter of 2014 compared to 4.16% in the year ago period and 3.79% in the first quarter of 2014. The year over year decrease from the net interest margin primarily reflects the change in asset mix as higher yielding loans decreased and lower yielding investment securities increased. The linked quarter increase in net interest income is primarily due to growth in average interest earning asset, including loans. Average interest earning assets were $2.01 billion in the second quarter of 2014 compared to $1.9 billion in the year ago quarter and $1.99 billion in the first quarter of 2014. We will comment more specifically on our outlook for net interest income for the remainder of 2014 later in this presentation.

Moving on to page 11, noninterest income totaled $10.1 million in the second quarter of 2014 as compared to $13 million in the year ago quarter and $9 million in the first quarter of 2014. The most significant change was the $1.7 million year-over-year quarterly decline in gains on mortgage loans. In addition, mortgage loans servicing was $1.5 million lower as the second quarter of 2014 included a $0.2 million impairment charge on capitalized mortgage servicing rates compared to a $1.7 million recovery in the year ago quarter. However, overall total noninterest income in the second quarter was within our expected range albeit at the lower end. As we previously reported, we did sign a new debit card brand agreement in January of 2014. We expect this to add about $1 million of net interchange revenues annually and we substantially completed the conversion of our debit card base in June and July.

As detailed on Page 12, our noninterest expense declined $22.6 million in the second quarter of 2014 as compared to $27.7 million in the year ago quarter. Many expense categories were lower in 2014, primarily reflecting our cost reduction initiatives. In particular, year-over-year quarterly credit related expenses declined by $4 million.

Investments securities available for sale increased by approximately $56 million since the beginning of 2014, reflecting in part funds provided from the year-to-date increase in deposits. However, during the second quarter of 2014 investment securities available for sale declined by $5 million due primarily to the combination of loan growth and the seasonal decline in total deposits during the second quarter.

Page 13 provides an overview of our investments at June 30, 2014. 50% of the portfolio was variable rate and much of the fixed rate portion of the portfolio is in maturities of five years or less. The estimated average duration of the portfolio is about two years.

Page 14 provides data on nonperforming loans, other real estate nonperforming assets and early stage delinquencies. We continue to make progress on improving asset quality. Nonperforming loans declined by $3.5 million or 17% during the second quarter of 2014. ORE was relatively unchanged at $18.1 million as of June 30, 2014. However, subsequent to quarter end, in July 2014 we sold our single largest ORE property which had a book balance of about $5.5 million for nearly one third of our total ORE balance. We recorded a gain on this sale of $405,000 in July of 2014. In addition total 30 day to 89 day delinquencies declined to $9.9 million or 0.7% of portfolio loans at June 30 which is the lowest level in several years.

Moving on to Page 15, we recorded a credit provision for loan losses of $1.8 million in the second quarter of 2014 compared to a credit provision of $2.1 million in the year ago quarter. Loan net charge-offs declined to $0.4 million in the second quarter of 2014 or 0.12% annualized of averaged portfolio loans. And were $1.9 million or 0.54% of average portfolio loans in the year ago quarter. Other credit related costs such as loan and collection and net gain or loss on ORE were significantly better in the second quarter of 2014 as compared to the year ago quarter. Finally the allowance for loan losses totaled $28.2 million or 2.05% of portfolio loans at June 30.

Page 16 provides some additional asset quality data, including information on new loan defaults and unclassified assets which declined by approximately $3 million in the second quarter of 2014. Page 17 provides information on our TDR portfolio that totaled $118.4 million at June 30, 2014, a decline of about 9.5% on an annualized basis since the end of 2013. Specific reserves allocated to the TDR portfolio were $13.1 million or about 11.1% of the total balances at June 30. Importantly, nearly 89% of the TDR portfolio was current as of June 30.

Finally on Page 18 we provide some details on our outlook for the remainder of 2014. In January 2014 we outlined our expectation for low single digit overall loan growth during the year. Second quarter 2014 actual results were somewhat better than our expectations. As we outlined in our April 2014 call, we expected a seasonal pickup in consumer lending volume and continued growth in commercial lending, thus leading to our forecast of low single digit overall loan growth by the end of the year. Both of these occurred leading to growth in net total portfolio loans of $17 million or 5% annualized in the second quarter of ’14 and we are now up about $3 million since the end of 2013.

We indicated in our April 2014 Earnings Conference Call that we were optimistic that we could hold net interest income steady, or increase it from the first quarter of 2014. This in fact did occur in the second quarter. We also believe that the extended period of net interest margin compression caused by near zero borrowing short term interest rates is likely nearing an end. We continue to expect generally steady improvement in asset quality during the remainder of 2014. The performance of the TDR portfolio, though we have a significant amount of allocated specific reserves, as well as loan net charge-offs, loan default volumes and our watch credit levels, will be the primary factors impacting our 2014 provision levels for the last half of the year.

Moving on to non-interest income, we anticipate for the last half of 2014 that total quarterly levels will remain between $10 million to $11 million. In January 2014, we forecast non-interest expenses to be in a range of $22.5 million to $23.5 million per quarter during the year. Actual second quarter 2014 non-interest expenses of $22.6 million were just above the low end of the range. We continue to expect non-interest expenses to be at or near the low end of the aforementioned range for the last half of 2014.

Finally, we expect income taxes to equal 31% to 32% of pretax income during the last half of 2014, with the primary permanent differences being interest income on tax exempt securities and earnings on our bank owned life insurance. As mentioned in our earnings release, we did record $0.7 million of income tax credits in the second quarter of ’14, which reduced our effective tax rate below that expected range.

That concludes my prepared remarks, and I would now like to turn the call back over to Brad.

Brad Kessel

Very good. Thank you, Rob. As we look ahead, we’ll continue to execute on strategies and initiatives to improve earnings, and increase long-term shareholder total return. Our focus areas continue to be on organic growth, increasing revenue through retaining and cross selling, existing customers and acquiring new customers, controlling costs, utilizing enterprise-wide risk management best practices, retaining, developing and attracting an engaged workforce, and providing our customers legendary and exceptional service.

At this point in time, we’d now like to open it up for questions.

Question and Answer Session

Operator

(Operator Instructions) We have a question from Rick D’Auteuil from Columbia Management. Please go ahead.

Rick D'Auteuil – Columbia Management

Just -- so one thing we had talked about when you visited and I think as you did the offering last year were some thoughts and targets on efficiency ratio. Can you talk about your progress toward your targets and -- without the non-interest expense coming down in a more material way, I’d like to hear your thoughts on your expectation to achieve those targets.

Robert Shuster

We are at about 78%, maybe just below in the second quarter and – so that’s moving I guess in the right direction. Longer term, we want to move it towards 75% as we move through the balance of this year with our long term goal of moving it towards the 65% level. I think as Brad referenced in his comments, we do feel we need a little bit more balance coming from the revenue side and I think there’s a couple of things there. The primary driver there would be loan growth in starting to build our net interest income. Certainly if we had a bump up in interest rates, that could accelerate that progress. The loan growth piece, given our outlook for low single digit loan growth, is likely to take a little bit more time without the bump in interest rates. We do feel there’s a couple of categories in the noninterest income, mainly gains on loan sales and interchange where we could get some modest increases.

And in addition we did have, not that it’s a huge number, but a $0.2 million of impairment charges on mortgage servicing rights and we feel a more I guess normalized number for that would be $500,000 to $600,000 of positive income per quarter. So we can get some boost there. And then we think longer term there’s still progress to be made on the expense side. But we feel to get to the 65% long term goal from where we are at today, more of it is going to have to come through the revenue side. We went from $3.5 billion in assets some time ago to $2.2 billion. Some of that was due to the branch sale that we had at the end of 2012, but a lot of it was due to the deleveraging of the balance sheet. We do we feel we have the infrastructure to support a larger balance sheet certainly the capital as well and that’s what our longer term targets are.

Rick D'Auteuil – Columbia Management

So you don’t have -- I guess you are saying short term expect the noninterest expense to be slightly below the $22.5 million a quarter, but on the longer term you don’t expect that needle to move very much on the downside anyway?

Brad Kessel

I guess Rick, I’d jump in there. On the expense side, I think the two categories as Rob mentioned that still have room are loan and collection and we’ve made a lot of progress there. I think the other category obviously is our largest expense and that’s salaries and benefits. And today we continue to have a large number FTEs for an institution our size, including our service portfolio. So I think that’s the area that will -- that does have some opportunity. I think in terms of capitalizing on the opportunity, we have a couple of things in the works.

Number one is we have contracted with a third party that’s helping us with what I call workflow or process flow throughout the organization and essentially trying to minimize the number of handoffs, eliminate paper and as we flow chart today the way work runs through our system and then flow chart a more optimized process of it running through our system, I think out of that we are going to find that some work today that we're doing just as it’s needed. I think there’s some pretty good upside there. I also think that today we have 70 branches and our peak we had 106. We sold off 21. We consolidated another 15 and we probably have some room for further branch consolidations and or sales. We are not I guess just set or comfortable with the $22.5 million run rate. We are going to continue to whittle away at it.

Operator

(Operator Instructions) Our next question is Damon DelMonte, KBW. Please go ahead.

Damon DelMonte – Keefe, Bruyette & Woods

Just wondering if you could talk a little bit on the loan growth, maybe some of the -- go into a little bit more detail on some of the initiatives on the commercial side that's going to be the biggest drivers of growth in the coming quarters.

Brad Kessel

Sure, I think we have now the right team in place. We have 21 business bankers spread across our markets essentially, and I outlined on this, east Michigan, west Michigan and central Michigan. And overseeing those business bankers we have three group managers and two of them have been with us for some time and then the third is an add here in west Michigan within the last 18 months. And I think what we’ve seen here over the last six months in particular is finally starting to ramp it up here in the west Michigan region. I think before that there was probably untapped demand simply because we were still coming out of I think our prior period of healing the balance sheet and we didn’t necessarily have all the people in place.

So now that the people have been in place for I think enough time to make a difference -- and we’re getting a lot of looks in all our markets and it’s a nice mix. What I like is that it’s a mix in product. It’s a mix in geography and it’s very granular. As an example this past quarter I think our largest onboarding was probably just around the $10 million mark and after that there’s probably another 35 credits that are over the $500,000 mark. So, a lot of just solid, good sized credits. And then within the new business we’ve seen this past quarter it was probably more slanted new to new customers as opposed to new to existing customers. But -- so that’s some of the, I guess facts behind what we are seeing. And I guess I’ll leave it at that.

Damon DelMonte – Keefe, Bruyette & Woods

Okay, that's helpful. Thank you. And then just with respect to the margin, I take it from the commentary you'll probably see a little bit more pressure on the margin, but can you quantify your estimate for maybe on a quarterly basis? Are we talking just a couple basis points similar to kind of what we saw this last quarter? Or are we looking at something a little bit greater than that?

Robert Shuster

No, I think that’s fair, Damon. I said in my comments that we believe we are coming likely to an end of compression caused by the near zero short term interest rate environment. Absent an unexpected adverse shift in loan mix, our modeling seems to or indicates that we really have pretty much come to the end of the downward margin compression. So perhaps we get a basis point or two additional, but we really feel it’s flattening out at that point.

Operator

Having no further questions, this concludes our question and answer session. I would like to turn the conference back over to Brad Kessel for any closing remarks.

Brad Kessel

In closing, 2014 is a very special year for us at Independent Bank as we mark 150 years of serving in our Michigan communities. I’m very proud of our associates and to be a part of a company that has such a long history. On behalf of Independent Bank I would like to thank you for joining us on today’s call. Have a great day.

Operator

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

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