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Mercantile Bank (NASDAQ:MBWM)

Q4 2010 Earnings Call

January 18, 2011 10:00 am ET

Executives

Robert Kaminski - Chief Operating Officer, Executive Vice President, Secretary, President of Mercantile Bank of Michigan, Chief Operating Officer Mercantile Bank of Michigan and Secretary of Mercantile Bank of West Michigan

Charles Christmas - Chief Financial Officer, Principal Accounting Officer, Senior Vice President, Treasurer, Chief Financial Officer of the Bank, Senior Vice President of Bank and Treasurer of Bank

Michael Price - Chairman, Chief Executive Officer, President, Chairman of Mercantile Bank of Michigan and Chief Executive Officer of Mercantile Bank of Michigan

Analysts

Stephen Geyen

Eileen Rooney - Keefe, Bruyette, & Woods, Inc.

David Long - Raymond James & Associates

Operator

: Welcome to the Mercantile Corporation Fourth Quarter Earnings Conference Call. [Operator Instructions].

Before we begin today's call, we'd like to remind everyone that this call may involve certain forward-looking statements such as projections of revenue, earnings and capital structure, as well as statements on the plans and objectives of the company or its management; statements on economic performance and statements regarding underlying assumptions of the company's business. The company's actual results could differ materially from any forward-looking statements made today due to important factors described in the company's latest Securities and Exchange Commission filings. This company assumes no obligation to update any forward-looking statements made during this call. If anyone does not already have a copy of the press release issued by Mercantile today, you can access it at the company's website, www.mercbank.com.

On the conference today from Mercantile Bank Corporation, we have Mike Price, Chairman, President and Chief Executive Officer; Bob Kaminski, Executive Vice President and Chief Operating Officer; and Chuck Christmas, Senior Vice President and Chief Financial Officer. We will begin the call with management prepared remarks and then open the call up to questions.

At this point, I would like to turn the call over to Mr. Price. Please begin, sir.

Michael Price

:

Thank you, and good morning, everyone, and welcome. Fourth quarter of 2010 demonstrated many of the same attributes and trends that the third quarter exhibited. The decline of the volume of non-performing assets, which started with a large reduction during last quarter, continued. The net interest spread, which was 2.40% two years ago, increased to 3.36% and appears to be poised to remain steady for 2011. Non-bad debt overhead expense remains well-controlled, and overall, we appear to be well-poised to take advantage of the modest economic recovery we are experiencing.

We continue to be very conservative in writing down collateral values and in treatment of problem loans. This caused us to post a quarterly loss. However, the pretax loss was much improved from the previous quarter, and all indications are that our strategy of grinding through this very deep recession, with our focus on aggressive problem loan resolution and maintaining our well-capitalized status, is starting to pay off.

As usual, Chuck Christmas will cover the financials, and then we'll have Bob Kaminski cover the dynamics of our loan portfolio. We will all remain available for questions at the end of the presentation.

At this time, I'll turn it over to Chuck.

Charles Christmas

:

Thanks, Mike, and good morning, everybody. This morning, we announced that we recorded a net loss of $5.3 million during the fourth quarter of 2010 compared to a net loss of $36.4 million during the fourth quarter of 2009 and a net loss of $14.6 million for all of 2010 compared to a net loss of $52.9 million during all of 2009.

On a pretax basis, which we believe provides a more accurate comparison of our operating results given the change in our tax position, our net loss during the fourth quarter of 2010 was $3 million compared to a net loss of $20.7 million during the fourth quarter of last year. And our net loss for all of 2010 was $13.4 million compared to a net loss of $46.6 million for all of 2009.

While we are, of course, disappointed anytime we have to report a net loss, we are encouraged with the significant improvement in our operating results, as well as the continued improvement in many key areas of our financial condition and performance. Our financial performance during 2010, like that throughout 2009 and 2008, was impacted by a significant provision expense and bad debt cost. Unfortunately, continued state, regional and national economic struggles have negatively impacted some of our borrowers' cash flows and underlying collateral values, leading to increased non-performing assets, higher loan charge-offs and increased credit risk within our loan portfolio when compared to historical norms.

From the time we sensed economic weakness over two years ago, we have been working with our borrowers to develop constructive dialogue, which has strengthened our relationships and enhanced our ability to resolve complex issues. With the environment for the banking industry likely to remain stressed until economic conditions improve, credit quality will continue to be our major concern. We will be relentlessly vigilant in identification and administration of problem assets. Unfortunately, provision expense, as well as non-performing asset administration and resolution costs will likely remain higher than historical norms, dampening future earnings performance.

But during the fourth quarter of 2010, we saw a continuation of the very positive trends we reported for the first three quarters of 2010 and throughout most of 2009 as well, and I'd like to touch on some of them. Despite a reduction in our total earning assets, an improved net interest margin has provided substantial support to net interest income. Net interest income during the fourth quarter of 2010 was $200,000 or 1% higher than the fourth quarter of 2009. And during all of 2010, our net interest income was $5 million or 10% higher than during all of 2009.

Our net interest margin during all of 2010 was 3.31% compared to 2.62% during last year, an improvement of 69 basis points or 26%. The improvement is primarily due to a significant decline in our cost of funds, but also reflects a relatively stable yield on assets, resulting from the many strategic initiatives we have successfully implemented within the commercial loan function.

Overhead cost reduction strategies have been realized. Salaries and benefits, occupancy and furniture and equipment costs have declined $0.5 million or 8% during the fourth quarter of 2010 compared to the fourth quarter of 2009, and are down $3 million or almost 12% during all of 2010 when compared to 2009. Non-performing asset administration and resolution costs increased $0.7 million during the fourth quarter of 2010 when compared to the fourth quarter of the previous year and were up $3.6 million during all of 2010 when compared to all of 2009. Valuation write-down on and net loss on sale of foreclosed properties totaled $4.4 million, property tax payments aggregated to $2.2 million and legal expenses totaled $2.1 million during 2010.

We've remained a well-capitalized banking organization. As of year-end 2010, our bank's total risk-based capital ratio was 12.5% and in dollars, was $34.6 million higher than the 10% minimum required to be categorized as well-capitalized. At year-end 2009, our bank's total risk-based capital ratio was 11.1%, and the surplus was about $18.5 million.

Local deposit and sweep accounts are up $103 million during all of 2010 and are up $317 million since the end of 2008. Combined with the reduction in our loan portfolio, we have been able to reduce our level of wholesale funds by $830 million in the last couple of years. As a percent of total funds, wholesale funds have declined from 71% at the end of 2008 to 40% at the end of 2010. Our loan loss reserve was $45.4 million at year-end 2010 or almost 3.6% of total loans and leases. At year-end 2009, the loan loss reserve equaled 3.1% of total loans and leases.

Provisions to the reserve totaled $6.8 million during the fourth quarter of 2010, a substantial decline from the $25.3 million we expensed during the fourth quarter of 2009. For all of 2010, provision expense totaled $31.8 million or 46% less than the $59 million we expensed during all of 2009.

Those are my prepared remarks, and I'll now turn the call over to Bob.

Robert Kaminski

:

Thank you, Chuck. My comments this morning will focus on the company's asset quality and will be an amplification of the very detailed information presented in the press release.

During the fourth quarter, we saw a continuation of the non-performing asset reductions that started in the second quarter. In March, NPAs totaled $117,557,000 and dropped to $110,533,000 in the second quarter, further dropped to $92,397,000 in the third quarter and concluded the year at $86,119,000.

The $6.3 million net decrease in NPAs during the fourth quarter is reconciled as follows: Principal payments were $7.2 million, sale proceeds were $5.3 million, loans returning to performing status were $1 million, charge-offs totaled $4.7 million and valuation write-downs totaled $1.7 million, with some of which more than offset NPA additions of $13.6 million.

Additionally, $4.8 million of the non-performing assets at December 31 consisted of restructured but accruing loans, where the bank is working with distressed borrowers to provide relief with some loan modifications. Most of the reductions in NPAs during the fourth quarter came from decreases in the non-owner occupied commercial real estate category.

Net charge-offs for the fourth quarter totaled $5.3 million, and for all of 2010, $34.3 million. Of the losses in the fourth quarter, approximately 45% were previously reserved and recognized from an income statement standpoint. Of the $5.3 million in fourth quarter losses, the majority, at $2.6 million, was from the commercial real estate non-owner occupied category, $976,000 was commercial real estate owner-occupied, $819,000 was commercial and industrial and $485,000 was residential construction and development.

Provision expense for the quarter was $6.8 million, with the major allocations as follows: $2.5 million was for impairments and general allocations for C&I; $1.9 million was for commercial real estate owner-occupied and $1.6 million was for commercial real estate non-owner occupied.

Loans delinquent 30 to 89 days performed well at $1.1 million compared to $1.3 million at the end of the third quarter and continued in a nice trend that started in mid-2010. The bank continued to drive down commercial real estate concentrations, with a reduction in outstandings and commitment totaling about $170 million for all 2010, including approximately $120 million in the construction, development and non-owner occupied categories.

That concludes my prepared comments, and I'll be happy to answer questions during the Q&A. Mike?

Michael Price

:

Thank you, Bob, and thank you, Chuck. And at this time, we'd like to take any questions that you might have for us.

Question-and-Answer Session

Operator

: [Operator Instructions] Our first question is from Eileen Rooney of KBW.

Eileen Rooney - Keefe, Bruyette, & Woods, Inc.

:

I had a question on the timing of the FHLB prepayments that you had. I'm just wondering when that came off.

Charles Christmas

:

This is Chuck. Most of that came off in October, with a little bit more in early November. So it all happened in the first half of the quarter. Obviously, with that, we got a reduction in interest expense along with the $1 million prepayment. The net impact to our income statement for the fourth quarter was about $400,000.

Eileen Rooney - Keefe, Bruyette, & Woods, Inc.

:

Do you have monthly margins? I'm just wondering where, say December margin was.

Charles Christmas

:

The December margin was up a little bit. One of the things that we, I'll say, struggled with and started at the end of the third quarter and continued for most of the fourth quarter was with the continued reduction of loan portfolio, including some larger payoffs, and with some really, really strong local deposit growth. We ended up with a pretty high level of Fed Funds. You saw that with our September 30 actual balance sheet. Fed Funds averaged about $103 million or so during the quarter, which put a pretty big impact not only in our margin, but our Tier 1 leverage capital ratio as well. You saw that by the time we got to the end of the quarter, we were around $50 million. $50 million is kind of our goal, give or take. And so we got there. So our December margin was certainly higher than what it was, say, in October and November, but on an overall basis, without those excess Fed Funds, the margins for the fourth quarter would have been closer to about 3.5% or 3.45%, somewhere in that range.

Eileen Rooney - Keefe, Bruyette, & Woods, Inc.

:

Just one question on the OREO properties. How many actual properties did you sell this quarter?

Robert Kaminski

:

Off the top of my head, I don't have an exact number. But I'd say December was a very busy month for us. We had probably 10 properties that closed during the latter half of December. And so there was significant movement there as you saw by the reduction in the ORE overall balance. And it was really a mixture of some small properties and some bigger properties. So we're really pleased to see that across all spectrum of the ORE category, there was some activity not only on the size of the property, but the type of property as well.

Eileen Rooney - Keefe, Bruyette, & Woods, Inc.

:

On the DTA, Chuck, could you give us just a little bit of how you expect that to play out when you guys turn profitable, when we should expect the valuation allowance to come back on and just what the moving pieces will be there?

Charles Christmas

:

Yes, it's a great question, and we obviously look forward to getting there. And timing is obviously very difficult to predict with any great certainty. As we talk with our auditors, and we kind of look prior-year to the ground as far as the expectations, and the interesting thing is when you talk to the auditors and it's not their fault, they say there's lots of guidance on when you need to set up the valuation allowance but there's very little, if any, guidance on when to reverse it. And I think we're all hoping for a little more guidance and least expectations. We're afraid of what the answer might be. Certainly, we need to get back to a profitable standpoint, and it's not just one quarter that's going to make a difference. It needs to be consistent profitability and obviously, not just bottom line numbers, but all the trends, all the fundamental trends and looking at those things. Obviously, one year is not -- if you look at just one actual year of performance by itself it's not going to get rid of the valuation [ph]. We're going to certainly have to look out with projections. And so any type of projections we put out there, say, for the next three to five years to try to support reversing that valuation allowance is going to come with some scrutiny as it certainly should. But certainly, making money, getting back to a profitable standpoint on a consistent basis and having some strong metrics, especially in regards to asset quality, certainly, levels and trends on both are going to play out. If we have a good 2011, we're hopeful, maybe by the end of this year, we can certainly have some meaningful discussions amongst ourselves, along with our auditors, in regards to reversing that valuation allowance. But I would think it's going to be more of a year-end discussion at the earliest possible point in time than any earlier than that.

Operator

: Operator Instructions] We have a question from David Long of Raymond James.

David Long - Raymond James & Associates

:

Looking at the tax line, can you maybe just walk me through the tax line? It seems like there were some moving parts there. I just want to better understand how we came up with the number for the quarter and then also how should we think about this looking out to 2011.

Charles Christmas

:

This is Chuck. It's a great question. The tax line is totally reflective of the changing market value, unrealized gain and loss on our available for sale securities portfolio. The way that FASB has written a comprehensive income/loss rules that obviously, in normal times, the FAS 115 adjustment as I'll call, goes directly to our capital accounts. In the event that you have a 100% valuation allowance against your deferred tax asset and you also report a pretax operating loss, you have to show that change in unrealized gain or loss on your available for sale securities right on your income statement in that line item. We were able to record a benefit in the first three quarters because of the drop in interest rates, which meant that the unrealized gain in our securities portfolio was increasing, certainly with the very strong increase in medium and long-term rates that we saw in the first quarter, kind of did a big reversal on that. So as we had to go and put again that change in the unrealized gain which had a significant reduction, that went into that line item. So you can see on a net basis, you got -- for the whole year, it was almost zero. But certainly, some lumpiness on a quarterly basis. I guess this is kind of a good preview of what fair value accounting can potentially do to an income statement. As far as going forward, as I mentioned, if you have a valuation allowance against your DTA on 100% and reporting a pretax operating loss, you're going to have to continue to show that change in unrealized gains. If anything, for the month rates haven't changed too much, so far, hopefully, if we can show a pretax operating income, it won't be an issue that line item would be zero. If we show an operating loss, then obviously, whatever the change in that valuation would be shown in that line item whether it be up or down.

David Long - Raymond James & Associates

:

Looking at the sale proceeds in the quarter, I think it was about $5.3 million. With those proceeds, what was tied into the net charge-off for the valuation write-downs from those sales?

Michael Price

:

If I understand your question correctly, the total sale proceeds from the ORE properties during the quarter, how much related to valuation write-downs?

David Long - Raymond James & Associates

:

Yes, I'm just trying to figure out what additional write-downs were taken in the quarter from where they were marked at the end of the third quarter.

Michael Price

:

On the valuation write-downs, most of the valuation write-downs that we took were assessments of properties that remain in ORE and ones that we either through updated valuations, appraisals, whatever, and we decided that it was prudent to take additional reductions in those totals. The encouraging thing that we're seeing is that on the sales of the properties that occurred during the quarter, we had a fair number of gains, we had a few losses, and overall, I think if you netted those out, we're pretty well right on in terms of the values that we had in the properties at the time of sale. So that's something that has been a continuing trend from the last quarter, and the numbers of gains that we're seeing is certainly increasing. The activity in the properties is increasing. The interest in properties has been increasing. And so the combination of all that, reflected with the nice reduction that we saw in the overall OREO category for the quarter. But the valuation write-down, that was primarily focused in our properties that remain there, and we decided to take some additional write-downs on those values.

Operator

: Our next question is from Stephen Geyen of Stifel, Nicolaus.

Stephen Geyen

:

You mentioned the modest economic recovery, and I'm just curious when you think that might translate into some kind of maybe stable loans or some kind of growth.

Michael Price

:

This is Mike. I think we're starting to see some nascent signs of that type of activity starting. I mean, I think Chuck has mentioned it in a few of our previous calls that we've seen a marked reduction in our lines of credit, our C&I customers, for example, since this crisis started a few years ago. We're starting to see a little bit of expansion of lines of credit, and we're starting to see our customers use them a little bit more. We're starting to see some requests for additional equipment and that type of thing, inventory buildup. So we would expect and hope that we would see probably a couple of quarters down the road a slowdown of the reduction in loan volume or loan balances. But it's a hard thing to put your finger on because we are also, at the same time, taking strategic opportunities to find higher-risk commercial real estate to have move out of the bank. And so sometimes, we get some nice new volume in, we say, "Hey, that's great." But then we get an opportunity, maybe somebody can refinance that in the high-risk category, CRE, and we go ahead and have them move that. So to use a cliché, there's certainly is lots of moving parts, but we would expect in our budgeting that the rate of decline of loans will start to slow down probably a couple of quarters down the road here.

Stephen Geyen

:

And the decline in NPAs is certainly an asset. Just curious if there's any change in the additions to NPAs, say, from a year ago as far as loans or the size of loans, the types of loans or size?

Robert Kaminski

:

If you look at the additions to NPAs this time last year on a quarterly basis, it was a much greater number. I think what you had was -- this quarter was a continuation of the relative level that we saw during the third quarter. And in terms of the size, you had a couple larger ones in there that represented that number, and the rest of them are consisted of smaller ones. I think in most cases, encouraging for us to see are the ones that deteriorated or ones that we had identified as potential problem loans, potential NPAs, and we were continuing to work and again, taking the conservative approach for loans on non-accrual status when we deemed it appropriate, and that settled in that $13 million for the quarter. But a much greater year ago -- much higher numbers a year ago on a quarterly basis going into that bucket.

Stephen Geyen

:

Have the downgrades like with the other ratings, has that subsided as well?

Robert Kaminski

:

It has. I think if you look at the bank's problem loan list, encouraging to see for the latter half of 2010 on a monthly basis the number of upgrades in terms of credits coming off the watch list were outnumbering the loans going onto the watch list. And that is the trend that again encouraging to see and is continuing to be reflected in the NPA total as well.

Stephen Geyen

:

And a question for Chuck, with the changes in the quarter, I'm just curious how the balance sheet is positioned for, I guess, what rates might do. It's certainly debatable how rates are going to react to any improvement in the economy, whether we're going to get an upward shift in the yield curve or short end up or the long end up. But just curious how the balance sheet has changed -- or given the change in the balance sheet, what kind of your expectations are and what might happen to the margins, say, if rates should increase.

Charles Christmas

:

Well, it's obviously a great question, and we'll spend certainly a lot of time on it, like everybody else does and obviously -- and you've got to spell it out exactly. There's a tremendous amount of different scenarios, and we got to look at it in more of a broad sense to answer your question. I think one of the things that we've certainly seen on our funding side, which gives us a lot more flexibility, is that we have obviously a lot less CDs and we have a lot more non-maturing deposits. And one of the things that's always impacted us -- and this is certainly greater when rates are going down is well over half of our loan portfolio was tied to prime or LIBOR. So rates would go down. When rates went down, those repriced immediately. We had a lot of short -- even some short-term CDs on our books, obviously we had to wait for the maturity. Now we've got a lot more non-maturing deposits, so a lot more flexibility in those environments. So from a funding standpoint, that helps. On our current CDs, especially -- we still have, certainly, brokered deposits on our books. We continue to extend the maturities on those, especially the multimillion dollar-deals that we're doing. They're generally three- and four-year deals. Kind of going back in time, our average used to be at 12 months. So we're trying to extend the duration of those. Yes, it's a little bit costly up front, but certainly, rates are incredibly low right now. And at some point, rates will obviously go up, so if we extend a little bit, that will certainly help us. On the asset side, one of the things -- the biggest item that's facing us is that as a reminder, we de-linked the Mercantile prime, which a vast majority of our commercial loans are tied to, from the Wall Street Journal Prime back in October 2008. Wall Street Journal Prime obviously is 3.25%. Our prime is 4.5%. So relinking those rates is certainly something that's up towards the top of our list when rates do start going up. How that plays out by itself, relinking those rates, as is with every banks, we've got floors on many of our floating rate loans. Every bank has done that. So how the floors that are out there in existence, how they interplay with re-marrying the Mercantile prime with the Wall Street Journal Prime is certainly something that we'll keep an eye on and see how it goes its course. But from an interest income standpoint, the increase in interest rate environment on the short-term rates that interplay is going to be most important and certainly something that we're keeping our eye on and certainly part of the reason why we're extending the duration of our wholesale funding program.

Stephen Geyen

:

So you mentioned the possible linking down the road. Do rates need to increase 100, 125 basis points before they come off the floors?

Charles Christmas

:

We're certainly looking at -- there's a lot of different arms and legs in this whole scenario. And one of the things that we're doing quite frankly is as we're moving forward, especially with lines of credit, renewal season coming up, we're looking at existing relationships, especially the stronger relationships. And as we go forward, putting customers back on the Wall Street Journal prime versus the Mercantile prime is something that we're considering doing and doing in selected cases. On an overall basis, when the Wall Street Journal prime starts moving upwards, it's likely that you won't see the Mercantile prime move until the Wall Street Journal prime catches up. I mean, that's kind of what we're looking at right now. But certainly in between there, there's a lot of things that we can do and a lot of things that we're looking at in relation to our relationships with credits on a one-by-one basis.

Operator

: Thank you. And I'm showing no further questions at this time. I would like to turn the call over to management for any closing remarks.

Michael Price

:

Thank you, Tyrone. Thank you, all, for your interest in our company. It's always disappointing to report a loss quarter, and we certainly know that this recession has been a long and difficult one. But we do continue to see some very promising signs. And as we head into 2011 and look forward, we see some pretty positive things coming down the road. So at this point, we will end the call, but willing to talk to anybody that would like to follow up by e-mail or a phone call to any one of the three of us. Thank you.

Operator

: Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Have a wonderful day.

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