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Talmer Bancorp, Inc. (NASDAQ:TLMR)

Q2 2014 Earnings Call

August 7, 2014 10:00 am ET

Executives

David Provost - President & CEO

Dennis Klaeser - CFO

Analysts

Steven Alexopoulous - JPMorgan

Chris Mc Grady - KBW

John Armstrong - RBC

David Long - Raymond James

Operator

Good day, ladies and gentlemen, and welcome to Talmer Bancorp Second Quarter 2014 Earnings Conference Call. My name is Lindsey and I will be the conference call coordinator today. At this time, all participants in the call are in listen-only mode. Yesterday, the company publicly released its financial results for the second quarter of 2014.

Before we begin, I need to remind you that during this call management may make forward-looking statements about our future financial performance. You should not place undue reliance on any forward-looking statements and management has no obligation to update such statements in light of future events.

Any forward-looking statements are subject to numerous risk factors and uncertainties including those outlined in our earnings release and our annual report form 10-K for the year added December 31, 2013.

Participating in the call today from Talmer Bancorp are its President and CEO David Provost and its Chief Financial Officer Dennis Klaeser. This call is planned to be limited to 30 to 45 minutes. At the request of the company, we will open up the conference call to a question-and-answer session after management makes some prepared remarks about the results for the quarter.

Let me now turn the call over to David Provost, Chief Executive Officer of Talmer Bancorp. Mr. Provost, you may begin.

David Provost

Thanks, Lindsey. Good morning, everyone, and thank you for joining our second quarter 2014 conference call. The purpose of this call is to review our financial results as well as to give you an update on some of your key strategic initiatives. It was a very exciting quarter for us. We generated $20.6 million of net income or $0.27 per diluted average common share for the second quarter. This compared to $36.4 million of net income or $0.50 per diluted average common share for the first quarter.

We have previously discussed with your our key strategic priorities in building a strong, organic growth trajectory. The results for the second quarter are indicative of our focus on quality loan growth. Overall, our net loans grew by an annualized rate of 12.9%. Importantly, our pipeline has strengthened over the past couple of months which supports our expectation of continued strong, organic loan growth during the second half of the year.

Core operating expenses exhibited a nice trend as well with further progress in the consolidation of back office functions across our company. These and other improvements drove an increase in our tangible book value per share by $0.30 to $10.09 in the second quarter of 2014.

Our focus has always remained on compounding book value per share by increasing operating leverage through the combination of strong, organic loan growth and the further realization of synergies from current and prior acquisitions.

We are proud to note that these efforts have delivered 14.9% growth in tangible book value per share over the same period last year.

We're also pleased to announce that yesterday we entered into a definitive agreement to acquire the First of Huron Corporation. The holding company for Signature Bank headquartered in Bad Axe, Michigan. At the end of June, Signature Bank had total assets of $228 million including net loans of $172 million. The purchase price was $13.4 million or 117% of tangible book value.

The choice of cash consideration allows us to leverage our existing capital and we believe this in-market opportunity will enhance our ability to fund lending opportunities through our footprint. I'll let Dennis cover some of the relevant metrics on this deal in a moment.

Positive trends were exhibited across most areas of our income statement with increases in the net interest margin and decrease in core expenses. We are encouraged by our key fundamental trends in the recent backup in interest rates providing us with the opportunity for some upside in our initial mortgage banking expectations for the year.

Acquired loan portfolios continue to perform much better than we originally anticipated and our deposit cost remain one of the best in the industry at 20 basis points in both the first and the second quarters of 2014. It is important to keep in mind that this quarter's results include some cost synergies realized from the acquisition and integration of First Place Bank but does not reflect the utilization of any significant savings from the Talmer West acquisition that we had earlier this year.

Expenses remained elevated at Talmer West to complete the conversion and address various operational issues. Given our strong continued capital position we received many pitches from potential targets and continue to be active in exploring a variety of potential acquisition opportunities outside of yesterday's announced transaction.

As always, we will carefully evaluate every strategic opportunity in order to focus our efforts on loans that will deliver the best possible long-term returns to our shareholders and to drive franchise growth in accordance with our FDIC approved business plan. The timing on these types of opportunities, as you know, is uncertain but we believe a great deal of value can result from appropriately priced transaction. As the pricing on the Signature Bank deal shows you can be assured that we will remain disciplined and conservative in the evaluation and execution of potential strategic investments.

On a core basis our near-term focus continues to be driving quality loan growth and realizing significant operating synergies associated with the acquisition of First Place Bank, Talmer West Bank, and now Signature Bank. This includes the consolidation of back office personnel, back office processes, facilities and the wind down of third-party expenses associated with meeting regulatory compliance and system enhancements. Efforts in this area are progressing nicely with synergies from Talmer West on track to begin to benefit our results for the remainder of the year.

From an M&A standpoint, recent increases in the level of merger activities in our market area offer the potential for additional opportunities to further leverage our capital position. However, we always strive to appropriately balance risk and return and not every deal is created equal.

The effective integration of operations and cultures from previous acquisitions and our ongoing core growth provide us with substantial momentum in our pursuit of delivering a sustainable 1+% core return on assets. We are pleased with our progress to-date and are optimistic about what can be done during the remainder of the year and beyond.

With that introduction, let me turn it over to Dennis who will give you some more details about the financial results. Dennis?

Dennis Klaeser

Thanks, Dave. Our total assets were $5.6 billion at the end of June compared to $5.4 billion at the end of March. The $186 million increase was primarily due to the addition of $160 million in net total loans and $100 million growth in our securities portfolio. The transaction with First of Huron Corporation and its subsidiary Signature Bank is expected to close either in the fourth quarter or first quarter of next year.

It will add approximately $240 million in assets and features an excellent deposit base that will help replace some of the lost funding of our sale to Wisconsin locations. Our base case model assumes a $5.6% net loan mark and 35% cost saves during buy back office consolidation and some branch overlap. We believe these are conservative investments and clearly there is potential upside to these numbers.

We currently expect approximately $2.5 million of one time expenses. Assuming the deal closes later this year, we expect the deal to be a slight drag on our earnings this year, but expect it to be at least 5% accretive earnings per share in 2015. The tangible book value earn back period is expected to be less than 2.5 years and our internal rate of return is expected to be greater than 20% inclusive of the one-time cost.

Okay, now going back to our results for the second quarter. Our net total loans were $3.7 billion at the end of the second quarter, up $160 million compared to March. At Talmer Bank, net uncovered loan growth of $201 million during the quarter outpaced run-off of $33 million in net covered loan balances resulting in net growth of $168 million for the quarter or 22% growth on an annualized basis.

At Talmer West Bank, we experienced loan runoff of $52 million in the second quarter with $22 million relating to the loans previously held in portfolio that were transferred to loans held for sale as a result of the sale of the Albuquerque Branch which closed on July 18.

Our pipeline increased significantly over the past few months and we expect continued strong organic loan growth during the remainder of the year building a high quality commercial loan origination business in Northeast Ohio and Western Michigan similar to the ones we constructed in Southeast Michigan and Chicago continues to be a key strategic priority for us in order to overcome expected runoff in our acquired portfolios.

At the end of the second quarter, 12% of our loan portfolio was covered by FDIC loss sharing agreements down 40% from the end of March. The FDIC indemnification asset was $103 million down from $190 million at the end of the first quarter and is down by 40% from one year ago.

Second quarter results reflect the re-estimation of cash flows on purchase credit impaired loans for all of our acquisitions. In completing this re-estimation of cash flows GAAP accounting requires us to recognize all instances where cash flow expectations have decreased and a reduction in expected cash flow is recognized immediately through a provision for a loan loss expense whereas any improvement in cash flows is recognized in the future periods due to an increase in the accretable yield.

For the second quarter of 2014 the accounting impact of the reestimations resulted in a reduction of reported earnings even though the true economic indications of the reestimation are positive for future earnings trends. For loans where cash flow expectations decreased the net accounting impact was a reduction to our second quarter pre-tax income of $3.4 million.

In those instances where cash flow expectations improved, the total improvement was $24.5 million which will be recognized in future periods as an addition to the accretable yield.

Total liabilities increased by $161 million to $4.9 billion at June 30, 2014, compared to the end of March primarily due to increases in low cost FHLB advances partially offset by expected deposit runoff at Talmer West Bank.

Our capital ratios continue to be very strong and well in excess of our required minimums. On a consolidated basis, our tier-1 leverage ratio is over 11.5% and our risk based ratios are over 16%.

As Dave mentioned, net income for the second quarter was $20.6 million compared to $36.4 million in the prior quarter. Our first quarter 2014 net income and period and equity were increased by $3.7 million compared to what we previously reported as a result of adjustments made to the acquisition fair value certain assets at Talmer West Bank, which you'll remember closed on January 1st of this year.

For the second quarter, our net interest margin increased to 4.35% from 3.95% in the first quarter. The increases in our net interest margin in the second quarter was due to a combination of several factors, the largest being an increase in the yield on our purchase credit impaired compared loan portfolio in addition to a decline in the negative accretion rate of the FDIC indemnification asset as that balance continues to decline.

The accretable yield difference which results from the purchase accounting applied to acquired loans totaled $306 million at the end of the second quarter. The accretable yield includes both the expected coupon and a loan -- of the loans and the discount accretion. If we were to reflect only the expected coupon on the loans in our net interest margin and remove the negative accretion on the FDIC indemnification asset our net interest margin would have been 63 basis points lower in the second quarter of 2014.

This number compares to 5 basis points last quarter with the increase driven by improvements in expected cash flows on acquired loans and the decrease in the negative accretion rate on the FDIC indemnification asset.

Second quarter 2014 included a total loan loss provision benefit of $4 million for both covered and uncovered loans compared to a provision expense of $4 million in the first quarter. The net benefit in the second quarter primarily reflects the relief and allowance resulting from payments received on loans not previously anticipated, improvements in historical loss factors, and certain specifically reviewed loans where the increases in projected cash flows -- where there was increases in projected cash flows, and this was partially offset by the provision expenses result in a quarter's re-estimation of cash flows for purchased credit impaired loans.

The benefit from the reserve release on covered loans is partially offset by the negative $3.4 million of FDIC loss sharing income which basically represents refunds paid back to the FDIC or a reduction in future expected FDIC loss share claims.

Non-interest income in the second quarter totaled $14 million compared to $56 million in the first quarter. Exclusive of the bargain purchase gain recognized in the first quarter non-interest income declined by $2 million. While residential mortgage origination volumes increased in the quarter benefiting net gain and sale of loans, this benefit was mostly offset by the results of changes and the valuation of MSRs or mortgage servicing rights, which resulted in a pre-tax earnings reduction of $4.2 million in the second quarter compared to a $2.2 million drag in the first quarter.

Non-interest expenses in the second quarter totaled $54million compared to $66 million in first quarter of 2014. Excluding $837,000 of transaction and integration related expenses from the second quarter and $10.8 million of such expenses in the first quarter, non-interest expenses declined by $1.4 million. The amount of improvement in our operating efficiency is muted by the fact that commission expenses increased $1.7 million quarter-over-quarter given the substantial increase in residential mortgage loan originations in the second quarter.

We are very pleased with the substantial progress we made in improving our core operating efficiency, but we recognize that we still have a lot more to accomplish in this area.

The remainder of the year will see some additional benefit from incremental cost reductions in both our bank subsidiaries and from the sale of the Wisconsin locations. Given the strong loan growth we expect I believe we are well on pace to meet our efficiency objectives.

I also should briefly note that we had an unusually large tax benefit in the second quarter. We reported pre-tax income of $16.4 million which normally would have resulted in a tax expense of $5.6 million using an expected normal tax rate of 34%. However, during the quarter we realized $9.7 million benefit from the release of a valuation reserve on deferred tax assets associated with the First Place Bank acquisition.

During the second quarter, we engaged outside professionals to help us reassess our tax position with regards to the First Place Bank acquisition to leverage some of the knowledge that we had gained as a result of our acquisition of Talmer West Bank.

The reversal of the $9.7 million deferred tax asset valuation allowance was supported by tax opinion that we received from a nationally recognized law firm. I believe this is a one-time benefit and in future periods you should expect normal tax expenses to equal approximately 34% of our pre-tax income.

Okay, with that, now let me ask the operator to open up the call to questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question and answer session. (Operator Instructions). The first question comes from Steven Alexopoulous of J P Morgan. Please go ahead.

Steven Alexopoulous - JPMorgan

Maybe I'll start the covered loan runoff has picked up quite a bit over the prior three quarters, a little bit more than I was expecting. I know it's a volatile line item but maybe can you talk about what's driving the relatively rapid rundown of the covered loans, and do you think runoff continues in the second half at about the same pace we saw in the first half?

Dennis Klaeser

Yes, Steve, today was modestly higher than we expected. I think the runoff is primarily driven by some commercial real estate loans that paid off earlier than we were expected. And I think partly that’s a reflection of an improving economy and those credits basically paying off earlier or being refinancing the way from us.

Steven Alexopoulous - JPMorgan

What about expectations for the second half, Dennis?

Dennis Klaeser

I would expect it to be modestly lower in the second half versus the trend that you saw particularly in the second quarter, but you're right that is a number that’s a little bit difficult for us to predict.

Steven Alexopoulous - JPMorgan

Okay. And then maybe looking at the non-covered loans the growth picked up pretty nicely during the quarter, can you talk about your ability to ramp that further given all the commentary around the pipeline? Is it realistic that by the end of the year we're seeing this move up to $200 million a quarter from what we just saw? Thanks.

Dennis Klaeser

200 million is probably pushing it. It's not outside the bounds of possibilities but that’s probably pushing up to too high of expectations. As we go forward, given this very strong pipeline we have with commercial lending particularly C&I lending across our markets, we do expect the volume to pick up somewhat in the second -- in the third and fourth quarter.

In the second quarter, half or so or a little less than a half of the growth was really driven by residential loans that we put into our portfolio. As we go forward, I'm expecting that to -- the mix to change a bit and be heavily oriented towards commercial loans and we will attempt to choose to sell the larger portion of the residential loan origination particularly given the strong pickup in our commercial pipeline.

I think we talked last time about all the new lenders that we have that were just filling up at pipeline and that’s really coming to fruition especially in our Cleveland market, we have a lot of these things happening down there.

Steven Alexopoulous - JPMorgan

Okay. Then may be you can shift to the margin that combined the loan that covered 6.8% obviously was helped with the re-estimation in cash flows. How do you -- I know that’s another volatile item, but how do you think about the base rate there? And then maybe you can talk about the blend yield new loans were added to the portfolio in the quarter?

Dennis Klaeser

Yes, the base rate 4.35 in the second quarter is a bit higher than the run-rate that I would expect because with some of the improving in expected cash flows we have some loans that are paying faster than we expected and some of those loans will pay off and, therefore, their rate will come back down somewhere.

So, I think that rate is going to migrate down, exactly how much on that certainly yet, but somewhere between the rate we showed in the second quarter versus the rate we showed in the first quarter is a reasonable proxy.

The loans that were coming on the balance sheet were averaging down the margin. I think in the first quarter the average rate on new loans were just over 4% and in the second quarter the average rate was more in the range of 3.75%, 3.80%. I would expect that going forward the rate would be just a little bit higher than that because we had quite a large contribution from the residential mortgages which in general were a little bit below the average that I talked about.

Steven Alexopoulous - JPMorgan

Okay, that’s helpful. And for my final question looking at the gain on loan sales in the quarter, Dennis can you talk about the dollars and loans that were sold and what the gain on merger was? Thanks.

Dennis Klaeser

I don’t have the gain and sale margin. The dollar amount was approximately $250 million. Given our pipeline there we expect that to be relatively in the same range in third quarter and then probably seasonally coming down in the fourth quarter. I think you will be able to calculate the gain on sale and I forget the exact number, but the gain on sale has -- was quite strong and improved versus where we were in the first quarter particularly and significantly greater than what we were in the fourth quarter of last year.

Steven Alexopoulous - JPMorgan

But when you say expect a similar amount in third quarter; are you talking about the dollars of loans sold or the actual gain on sale revenue?

Dennis Klaeser

The dollar amount of loan sold probably actually picks up a little bit because rather than portfolio loans we'll be selling some. The overall origination volume of that unit is going to be roughly the same. We did put in to portfolio a little more than $100 million worth of their production but, going forward, we will be selling little bit more than that.

Operator

The next question from Chris Mc Grady from KBW. Please go ahead.

Chris Mc Grady - KBW

Hey, Dennis, on the margin, your comment to Steve before about the rate of compression next quarter being a similar to what it would expand in this quarter, let's just say kind of some 4% for the third quarter on an all-in basis?

Dennis Klaeser

I don’t want to be that specific in terms of my guidance. I would say somewhere between the rates that we had in the second quarter versus the rate that we produced in the first quarter; depends on a variety of factors.

Chris Mc Grady - KBW

Understood. The -- your efficiency comment in that everything is on track for cost saves in Talmer West, can you remind the efficiency targets that you are targeting and kind of the timeline? Just I don’t have those in front of me.

Dennis Klaeser

Last quarter we talked about by the fourth quarter getting to an approximately 70% efficiency ratio, and I believe we are trending down to that level. I did see your note that you published last night and I believe in your note you had calculated a 75% efficiency ratio for the second quarter. And I think your note, what's correct in pointing out that fundamental trend over the past three quarters we've been trending down. My calculation of the efficiency ratios is done just slightly different than yours. My internal calculation is the efficiency ratio currently more around 73% and we'll have to just talk off when exactly how you're calculating versus how we would do it from a management perspective.

Chris Mc Grady - KBW

Okay. Understood. In terms of -- last question, in terms of the size of the balance sheet you added some securities but then you have the pending transaction in Wisconsin that will kind of reduce the balance sheet size. Can you help us with the overall size of the next couple of quarters in terms of securities and cash?

Dennis Klaeser

Yes, the portfolio has -- we have reduced it modestly since the end of the quarter, and so I would expect it to be more in the lower $600 million range as we move forward. And you're exactly correct as we basically have to fund the sale of the Wisconsin branches and they'll consume some of the on balance sheet liquidity and then some of the securities portfolio which just sort of runs off; rather than replenishing, we'll just let that run off.

Chris Mc Grady - KBW

Okay. And the cash around kind of 400, is that still a target?

Dennis Klaeser

A bit lower than that, yes.

Operator

The next question comes from John Armstrong from RBC. Please go ahead.

John Armstrong - RBC

Just a couple of follow-ups. Just on the efficiency, Dennis, what are some of the big things that will be coming off the next couple of quarters? Is it just getting Talmer West cleaned up or is there anything else going on?

Dennis Klaeser

Well, first of all, our primary focus in building efficiency is fully leveraging our infrastructure. And a lot of that entails our lending teams building their pipelines, building their portfolios that they are managing and that obviously drives the revenue growth.

In the second quarter, the expansion of net interest income was primarily due to the increase in the net interest margin, not in terms of volume. If you look at the NIM table you'll see that average earning assets, in particular average loan portfolios do not really increase very much, and that’s because a lot of the growth that we had in the loan portfolio was back into the latter half of the second quarter. Now, as we move into the third quarter I think we're going to see the volume, the size of the portfolio is going to be up nicely versus where we were in the second quarter not only because the growth occurred late in the second quarter but also we're starting out the third quarter with strong origination volumes.

So, the key driver really is revenue growth. The secondary driver is beginning to realize some incremental operating efficiency from Talmer West. We thought before that we won't fully realize that until we fully merge that bank and fully integrate the systems until the first quarter of next year, but we will realize some additional synergies there.

Within Talmer Bank and Trust there is some additional incremental operating efficiencies as well on our core continuing bank. Some of that is just incremental headcount reduction more from attrition than it is from many proactive cutting of staff. Also, in the sale of Wisconsin branches we will be reducing our operating expenses by about approximately $2 million from that.

Now, I should note that the fee income will also drop by about $1 million there, but that transaction provides a nice efficiency, the efficiency pickup in and of itself.

John Armstrong - RBC

Okay. That helps. So maybe a little room on absolute expenses but it's going to be more about top-line in your mind?

Dennis Klaeser

Yes.

John Armstrong - RBC

Okay. David, maybe a question for you on the loan growth pace. You talked a little bit about acceleration in this later in the quarter, has that -- it seems like that’s held up in Q3. I just want to confirm that. And then any reason for the acceleration, is it just the new lenders or is there something else that’s happening?

David Provost

It -- first of all, it is holding up very nicely in Q3; I think we've commented on that. It takes six to eight months for our lender to really start bringing over their transactions. You can't bring them over on day one and that is really starting to happen.

We're very, very happy with the progress we're making in really all of our markets. So it's great to be in Chicago, in Metro Detroit, and Cleveland and we feel that those are really good growth engines for us.

John Armstrong - RBC

Okay, good. And then maybe, Dennis, the 5% accretion for '15 from that Bad Axe deal, that's assuming 2015 consensus. Is that the right way to look at it?

Dennis Klaeser

Yes.

Operator

The next question comes from David Long from Raymond James. Please go ahead.

David Long - Raymond James

Obviously, your pipeline is picking up here and just wanted to get a sense on the sentiment from your commercial customers. What are you directly hearing from them and then are there any industries that have stood out as far as where you're seeing potential growth?

David Provost

It's really across the board. I think we've talked earlier about Talmer's reputation in our markets as really the bank of choice. We were there when everybody else was leaving and we really have a good reputation. We get the last look at a lot of deals which gets the appropriate pricing. Customers are I think excited about the progress in the economy. We're seen to be in markets that are growing very nicely and they're participating in the recovery. We just continue to hope that it holds up as it has.

Dennis Klaeser

David mentioned Chicago, Detroit, and Cleveland, the key growth drivers. We're also seeing good growth in the Mahoning Valley Area which is the Youngstown/Warren market, so that’s contributing to growth. At this point, the central and western Michigan markets really are not contributing because we haven’t really turned the corner yet with the Talmer West acquisition but I think in future periods we see some upside there. and when we look across the composition of the loan growth it's very diversified, growth across a variety of types of lending areas. Our goal is for a third or more of it to be in the broad category of C&I lending. And we do see a lot of commercial real estate lending opportunities and we expect that to contribute to a third or little bit less than a third of the growth going forward.

David Long - Raymond James

Okay. And then what are you seeing in line utilization?

Dennis Klaeser

That would be improving. I need to do a research to get the specific numbers there but overall we see that improving as well.

Operator

(Operator Instructions). There are no questions at this time. This concludes our question and answer session. I would like to turn the conference back over to David Provost for any closing remarks.

David Provost

Thank you. We're very happy with the quarter. We appreciate everyone for participating today and look forward to talking with you next quarter.

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