Mary Beth Weisenburger – SVP, IR
William Small – Chairman, President and CEO
Don Hileman – EVP and CFO
Jim Rohrs – President and CEO, First Federal Bank
John Barber – KBW
Don Verges – Verges Capital
First Defiance Financial Corporation (FDEF) Q1 2011 Earnings Call Transcript April 26, 2011 11:00 AM ET
Good morning and welcome to the First Defiance Financial Corp’s 2011 First Quarter Earnings Conference Call and webcast. All participants will be in listen-only mode. (Operator instructions) After today’s presentation there will be an opportunity to ask questions. (Operator instructions)
Please note this event is being recorded. I would now like to turn the conference over to Ms. Mary Beth Weisenburger, Senior Vice President. Please go ahead ma’am.
Mary Beth Weisenburger
Thank you. Good morning everyone and thank you for joining us for today’s first quarter 2011 conference call. This call is also being webcast and the audio replay will be available at the First Defiance website at fdef.com.
Providing commentary this morning will be Bill Small, Chairman, President and CEO of First Defiance, and Don Hileman, Executive Vice President and Chief Financial Officer. Following their prepared comments on the Company’s strategy and performance they will be available to take your questions.
Before we begin, I’d like to remind you that during the conference call today, including during the question-and-answer period, you may hear forward-looking statements related to future financial results and business operations for First Defiance Financial Corp. Actual results may differ materially from current management forecasts and projections as a result of factors over which the Company has no control.
Information on these risk factors and additional information on forward-looking statements are included in the news release and in the Company’s reports on file with the Securities and Exchange Commission.
And now I’ll turn the call over to Mr. Small for his comments.
William Small, President
Thank you, Mary Beth. Good morning and thank you for joining us for the First Defiance Financial Corp. conference call to review the 2011 first quarter. Last night, we issued our earnings release reporting the first quarter 2011 results and this morning we would like to discuss that release, and look forward into the balance of 2011. At the conclusion of our presentation, we will answer any questions you might have.
Joining me on the call this morning to give more detail on the financial performance for the first quarter is, CFO, Don Hileman. Also with us this morning to answer up questions is Jim Rohrs, President and CEO of First Federal Bank.
First quarter 2011 net income on a GAAP basis was $2.7 million or $0.25 per diluted common share. This compares to net income of $1.5 million and $0.12 per diluted common share in the 2010 first quarter. The 2011 first quarter earning results are an encouraging start to the year.
These improved results are a direct reflection of better asset quality performance during the quarter and the bank’s ability to maintain its net interest margin. The primary driver on asset quality was a significantly lower provision expense in the first quarter of 2011 compared to last year’s first quarter. This helped to offset reduction of non-interest income and an increase in non-interest expense.
Credit quality has been the most significant factor impacting earnings over the past couple of years and while we are still seeing a degree of stress on certain credits, overall, we saw marked improvement in the maturity of the loan portfolio. Reduction in classified loans and other real estate-owned, along with stabilizing values contributed to the lower provisions.
The stabilization of property values resulted in fewer and less severe write-downs of previously identified problem assets. We are also encouraged by the reduction in non-performing assets for the second consecutive quarter, lower delinquencies, and reduction in troubled debt restructure.
Net charge-offs were also a factor in the improved earnings as they were down compared to both the linked quarter and the first quarter 2010. We anticipate the level of charge-offs s will be choppy over the next several quarters as more of the problem assets work through this system. However we are confident that we’ve adequately reserved for these assets.
Loan balances dropped again during the first three months of 2011 in virtually all loan categories, both normal amortization and pay downs and lines of credit contributed to the reduction as loan demand remains soft through most of the quarter. We did start to see a pickup in borrowing requests in the latter part of the quarter and several significant commitments on the commercial side are waiting to be closed and funded.
Residential mortgage funding is well off the pace till the last half of 2010, but it is at more normal historic levels. One positive on the residential side is we are seeing a significantly higher percentage of purchases, rather than the refinancing loans that were more prevalent in 2010.
Even with the drop in loan balances, net interest income for the quarter was up slightly over the first quarter 2010 results. Net interest margin was also up four basis points over the first quarter 2010 and flat with the linked quarter. Pricing discipline on both loans and deposits along with the change in the deposit mix were positive contributors to the margin performance.
Non-interest-bearing deposit average balances were up 20%, compared to March 31, 2010. Non-interest income was down in the first quarter of 2011 as lower mortgage income and reduced fee income caused by recent regulatory changes and changes in consumers’ management of their checking accounts were not offset by increases in insurance and wealth management revenue.
The increase in insurance revenue over first quarter 2010 was positively impacted by increases in contingent revenue as well as the increased production resulting from the May 2010 acquisition of the group benefits business from a local agency. Non-interest expense was basically flat with the linked quarter, but up compared to the first quarter 2010. The primary difference year-over-year was in compensation related categories.
I will now ask Don Hileman to give you the financial details for the quarter, before I wrap up with an overview and a look at what we see developing for the balance of 2011. Don?
Donald P. Hileman
Thank you, Bill and good morning everyone. The first quarter saw stronger profitability and progress in improving asset quality metrics, as well as higher net interest income. Net income was $2.7 million or $0.25 per share, compared with $1.5 million or $0.12 per share in the first quarter of 2010.
The improvement in profitability was driven by an improvement in credit quality and corresponding impact on the provision for loan losses. Credit related expenses still remain significant with a total $1.4 million in the first quarter of 2011, compared with $1.3 million in the first quarter of 2010 in our linked quarter basis.
Our markets are persistently showing the effects of the difficult economic environment. We are pleased with the trend of reducing unemployment rates in our market area, but meaningful economic growth is slow and developing. We are encouraged with the overall trend assuming and getting improved economic activity, however we’ll be irregular and take time to solve the developed with an extended ramp up period well into 2011. We are pleased with the first quarter results and three opportunities to improve further.
I will begin with a discussion of the credit quality. Our provision expense totaled $2.8 million down from $6.9 million a year ago and down from $5.7 on a linked quarter basis. Our allowance for loan loss increased to $40.8 million from $39 million on March 31, 2010. The loss percentage increased to 2.77% from 2.47% a year ago.
The change in the percentage is driven primarily by the lower average loan outstanding. The overall reserve remained basically flat on a linked quarter basis. The first quarter provision was $282,000 less than charge-offs for the quarter. The overall reserve levels consistent with our anticipation of higher near term charge-off as we continue to work through problem credits.
Annualized net charges-offs were 85 basis points for the first quarter of 2011, compared with 114 basis points in the first quarter of 2010, and 158 basis points in the fourth quarter of 2010. Of the total charge-offs 68% related to commercial real estate loans, 16% residential, 6% from equity and consumer and 10% commercial loans. While the total commercial real estate charge-offs 68% or $1.6 million was due to credit relationships.
As we see improvements in our asset quality trends as well as in the economy, we’ll be more confident that assets quality trends have turned the corner towards steady improvement. OREO balance declined on a linked quarterly basis and ended the first quarter at $9.2 million. The OREO balance is made up of $7.2 million of commercial real estate and $1.9 million of residential real estate.
We also had additions of $1.8 million in the first quarter of 2011 offset by sales of $1.6 million and valuation adjustments of $573,000. We continue to be active in seeking potential buyers of these properties that are encouraged with the recent activity. We have more buyers of OREO properties and we expect to see some stabilization of values in the near term.
On March 31, our allowance for loan loss is represented a 2.77% of total loans outstanding, up from 2.7%, on a linked-quarter basis and represents 89.53% of our non-performing loans. The allowance of non-performing assets was 74.56% at March 31, 2011, up slightly from 73.05% at March 31, 2010.
Non-performing assets ended the quarter at $54.7 million, or 2.65% of assets, down from 2.78% of total assets on a linked-quarter basis and up slightly from $53.4 million or 2.59% of total assets at March 31, 2010.
Total non-performing loans decreased to $45.6 million from $47 million on a linked-quarter basis and were up from $40.6 million in the first quarter of 2010. Restructured loans decreased to $1.4 million from last quarter. Restructured loans are considered non-performing because of the changes in the original terms granted to borrowers. It is important to note that these loans are still accruing.
Total classified loans increased $5.2million to $131.9 million at March 31, 2011 from $126.7 million at March 31, 2010 and decreased $1.2 million from $133.1 million at December 31, 2010. We are encourage with the near term trend and we continue to expect improvements in our overall risk profile throughout 2011.
Total delinquency rate was 3.2% at March 31, 2011, down from 3.36% at March 31, 2010 and down from 3.4% on a linked-quarter basis. The delinquency rate for loans 90 days past due or on non-accrual increased to 2.6% this quarter, up from 2.68% in the fourth quarter of 2010 and up from 2.1% at March 31, 2010.
We are not satisfied with the overall levels of 90-day delinquencies, whoever of the total non-accrual loans of $41 million, $12.4 million or 30% are 90 days past due. We are very pleased the improvement in the 30 day and 9 day level of delinquencies. The 30 day and 9 days past due decreased 67% from 20 million a year ago to 6.6 million in the first quarter of 2011, a decreased on a linked quarter basis from $11.1 million in the fourth quarter of 2010. This improvement helps to signal improved credit quality trends as we work through the current problem credits.
Mortgage banking was down in the first quarter impacted by rising rates and seasonal patterns. We’ve seen a tapering off of applications over the last several months. Overall, mortgage banking income in the quarter was $1.3 million, compared to $1.8 million in the first quarter of 2010 and $2.7 million on a linked quarter basis.
We had a gain on sale income of $726,000 in the first quarter of 2011, compared with $1.2 million in the first quarter 2010 and $1.8 million in the fourth quarter of 2010. We also reported a positive valuation adjustment to mortgage servicing rights of $171,000 in the first quarter of 2011, compared with positive valuation adjustments of $321,000 in the first quarter of 2010 and positive valuation adjustments of $1.1 million on a linked quarter basis.
The positive valuation adjustment in the first quarter reflects the steady change in the level of marking interest rates over the last several quarters that effectively assumed prepayment speed of the underlying collateral.
At March 31, 2011, First Defiance had $1.3 billion of loan service for others. The mortgage servicing rights associated with those loans had a fair value of $9.6 million or 76 basis points of the outstanding loan balance service. Total impaired reserves, which are available for recapture in future periods, totaled $953,000 at quarter end.
In the first quarter we recorded charges of $2,000 for other than temporary impairments, compared with first quarter 2010 charges of $70,000. This fact reflects a more stable economic environment that relates to our investments and trust preferred collateralized debt obligations.
Management realizes the probability is low that we will have any significant OTTI charges in the future. The stability of marketplace and the continuing analysis of the current portfolio assist us in making this conclusion.
Turning to the other operating results, our net interest income was $17.2 million for the quarter, compared to $17.1 million for the first quarter of 2010, and $17.8 million on a linked quarter basis. For the quarter our margin was 3.89%, which was 4 basis points increase from the first quarter of 2010 and flat on a linked quarter basis.
We have been successful in lowering cost of funds to offset the decline in asset yields. We have seen more aggressive competitive pricing pressure and the downward re-pricing of variable REIT loans based on the current yield curve. The continued high level of liquidity has also impacted the margin as we have seen an increase in overnight deposits which were $207 million at the end of the quarter.
We have selectively increased the securities portfolio in order to deploy lower yielding overnight deposits into securities on the short to intermediate term and of the yield curve. We will continue to the strategy over the next quarter until loan demand picks up. We have been staying in the four or five year weighted average life range.
Even with the give up in the yield associated with the higher liquidity level, we believe our liquidity position continues to be important and gives us added flexibility in the overall liability pricing. We place a strong emphasis on non-interest-bearing deposit accounts and saw the balances grow this quarter. Non-interest-bearing deposits represent 14% of total deposits.
We are focusing on pricing opportunities to maintain and expand the margin. We are particularly focused on asset pricing discipline and the challenges of maintaining asset yields. Our cost of funds declined 10 basis points on a linked quarter basis, with the yield on assets declining 10 basis points as well. Non-interest income was $5.9 million for the first quarter, down from $6.8 million in the first quarter of 2010.
The income declined to $2.6 million in the first quarter of 2011 from $2.9 million on a linked-quarter basis and from $3.2 million in the first quarter of 2010. The decline in fee income is directly attributable to the downward trend in net NSF fee income, as a result of new regulations. Net NSF fee income was $1.2 million for the first quarter of 2011, compared with $1.6 million for the fourth quarter of 2010, and $1.8 million in the first quarter of 2010.
Insurance revenue was $1.7 million in the first quarter of 2011, up from $1.3 million on a linked quarter basis and up from $1.3 million in the first quarter of 2010. The year-over-year insurance revenue increase is driven by an increase in contingent income in 2011 to $329,000 from $91,000 in the first quarter of 2010, and the acquisitions of a group benefits business line in the second quarter of 2010. This acquisition added approximately $210,000 in quarterly revenue. Non-interest income also included loss on the sale of OREO of $311,000 in the first quarter of 2011.
Overall, non-interest expense increased to $16.6 million this quarter, compared to $14.4 million in the first quarter of 2010 and was basically flat on a linked quarter basis. The first quarter compensation and benefits expenses increased to $7.8 million from $7.2 million on a linked quarter basis and from $6.5 million in the first quarter of 2010.
The increases in compensation and benefit expense over the first quarter of 2010 is due to the company freezing pay in 2010, coupled with no bonus accrual in the first quarter of 2010 based on the company not meeting certain performance targets. The company also had the additional compensation cost of about $100,000 in the first quarter of 2011 associated with the May 2010 acquisition of the group benefits business line. Healthcare costs also increased 18$0,000 over the first quarter of 2010.
Our total FTE level was consistently around 500 throughout the year. We believe we are close to the optimal staffing level necessary to maintain our quality, customer service culture, our customers’ desire and expect from First Defiance.
FDIC insurance expense decreased $133,000 in the first quarter of 2011, compared to the first quarter 2010. Our non-interest expense increased to $4.1 million in the first quarter from $3.3 million in the first quarter of 2010 and declined from $4.4 million on a linked quarter basis. Increases in expenses over the prior year were primarily due to secondary market buyback losses of $228,000 and auditing and examination services of $168,000.
On a linked quarter, other non-interest expense declined $308,000, primarily due to approximately $800,000 of core conversion related expenses in the fourth quarter of 2010 and a decrease in real estate-owned expenses of $54,000. These decreases were offset by the aforementioned secondary market buyback losses and additional non-run rate charges of $248,000 in the first quarter of 2011.
Finally, as a three quarter trend of certain significant expenses, real estate-owned expenses were $718,000 in the first quarter of 2011, compared to $772,000 in the fourth quarter of 2010 and $798,000 during the first quarter of 2010. Credit and collection expenses were $193,000 in the first quarter of 2011, compared to $162,000 in the fourth quarter of 2010 and $349,000 in the first quarter of 2010.
Secondary market buyback losses were $228,000 in the first quarter of 2011, compared to no losses in the fourth and first quarters of 2010. We saw the balance sheet remained relatively flat from the first quarter of 2010 with total assets of $2.06 billion at March 31, 2011.
On the asset side, cash and equivalents grew $81 million over the year up to $235 million at March 31, 2011. Securities grew $32 million over the year to $180 million. Gross loan balances declined to $105 million year-over-year and declined $48 million on a linked quarter basis.
Loan activity in general continues to be weak, but we are seeing some signs of an increasing commercial loan pipeline. We continue to be prudent on our new loan activities, we’ve been very disciplined in our underwriting and have not focused on growth at the expense of taking on greater credit risk or lower rates to increase loan volumes. We’ve been intent on making sure our service levels have not suffered as a result of increased levels of loan workouts. We have been able to develop strong new relationships with good commercial clients.
Total deposits declined $8 million from March 2010, but increased $17 million on a linked quarter basis. We are pleased with the mix of deposits, as we have seen a growth in non-interest bearing accounts. Non-interest bearing deposits increased to $219 million at March 31, up from $187 million at March 31, 2010.
We continue to focus on growth in non-interest bearing balances in correlation with an overall strategy and efforts to reduce our cost of funds in this interest rate environment. As mentioned previously, we completed a common stock offering in March of this year and increased shareholders’ equity by $20 million.
Total shareholders’ equity at March 31, 2011 was $263 million up from $236 million at March 31, 2010. Our capital position remains strong, our shareholders’ equity to assets improving to 12.76% at March 31, 2011 from 11.45% at March 31, 2010. The Bank’s risk-based capital ratio was strong at approximately 14.8%. We believe that we are on target to repay our CPP investment in the latter part of 2013 without additional equity offering.
The Board continually assesses our involvement in these programs. We recently implied to the Small Business Lending Fund in order to give us a possible alternative of refinancing our CPP investment. At the present time, we have not made a final determination as to our course of action. That completes my overview for the quarter and I’ll turn the call back to Bill.
William J. Small
Thank you, Don. As we progress through 2011, we are aware that there are still challenges to a sustained economic recovery. Our three primary focuses remain asset quality, expense control, and core deposit growth. We have made significant strides in all three of these areas in recent quarters and we must continue with this effort to meet the challenges and return to higher levels of profitability.
We are hoping that recent indications as stronger loan demand continue to build and reverse the recent trend of declining balances. The overall economic climate throughout our market area shows indications of strengthening. Commercial clients were showing improving cash flows and stronger balance sheets as 2010 wound down and we are seeing these validated in year-end audited statements.
Many are also reporting significant pick up in work orders and in some cases new hiring. Most of our commercial clients are keeping a cautious eye on oil prices and the impact this is having on fuel, fertilizer and other petroleum-based products. We look for overall loan demand to slowly pick up as the economy improves.
As stated previously, we already saw indications of this uptick late in the first quarter, and we anticipate this will continue. Pricing on both loans and deposits will be critical on maintaining our margin, especially as the Fed continues to work at keeping interest rates down.
Unemployment continues to run slightly above the national rate throughout our market area and this may continue to stress some of our customers. However, we are pleased to see some improvement in the employment data and the additional consumer confidence that this seems to bring with it.
Don mentioned our common stock offering completed at the end of the first quarter with gross proceeds of slightly over $21 million. This additional capital creates liquidity at the holding company and an independent source of capital that will give us more future flexibility without needing to upstream capital from the bank. We are keeping a cautious eye on the regulatory and legislative scene, as regulators are now working on developing the regulations that will implement the Dodd-Frank Act.
There is still many unanswered questions regarding this legislation and our industry is working hard to help shape the final regulations to have the least damaging effects to banks and their customers. Our mission is to be a community bank that provides a complete line of financial services with a relationship-oriented approach on a profitable basis.
The staff we have throughout this organization understands the importance of relationship banking and the importance of delivering on that mission. I thank them for their diligence and loyalty, and I thank you for joining us this morning on the call. And now, we would be happy to take your questions.
(Operator instructions). Our first question comes from John Barber of KBW.
John Barber – KBW
Good morning everyone.
Good morning John.
John Barber – KBW
I think, you said classified loans are down 1.2 million linked-quarter. I was just hoping, if you can talk about any trends you’re seeing and your expectations going forward for classified loans.
I’ll let Jim Rohrs, our President of the Bank answer on that John.
We project the three quarters out through the end of the year what credits we think will come off of our classified list and we’ve got about $20 million that we think could come off by the end of the current quarter. Now, that’s going to be offset somewhat by the potential for other credits to potentially be downgraded back into the classified, but we’re hopeful to have probably somewhere around the $12 million to $15 million reductions in classified in the next quarter, and then that trend hopefully continuing for the balance of the year.
Maybe not in such great numbers we have a fairly large number coming off in the second quarter because of companies with calendar fiscal year-ends where we get their CPA prepared financial statements in the second quarter and based on interim financials and preliminary year-end statements we already have, we have strong reasonable we believe that that will be upgrade because of improving cash flows.
John Barber – KBW
Next question was related to the $228,000 rep and warranty charge you took this quarter. I was just wondering what triggered the repurchase?
It is a request they have been more aggressive in looking at issues and forcing buybacks and we had in previous quarters than just not on a comparative, but it was a little bit more of a demand from them to repay. Take it our pattern and the issues that was the total John.
That’s something I think John, you’ll see that many in the industry are facing as particularly Fannie Mae and Freddie Mac are reviewing these loans very, very closely and many banks have faced this issue and as Don said, we’ve had it some of other quarters just not in the linked quarter or the first quarter of 2010.
John Barber – KBW
Can you talk about the upcoming change in regulators, if you expect there’ll be any changes to how you guys run your business on a day-to-day level and then any actions that you’ve taken to help with that transition?
Yeah, we’ve been in contact, the OCC will become our primary regulator at the Bank and the Federal Reserve will be our primary regulator at the holding company as the OTS is phased out as of July 21. We have been in contact with both those agencies. In fact, OCC the Deputy Comptroller out of the Chicago region heads up the Chicago region and his Assistant Deputy Comptroller that works out of the Cleveland Office, which will be the office that will primarily be responsible for our examination.
Both of those are coming for an on-site visit at our invitation. They are going to be here next Monday. So that, got a chance to meet our management team. Don and I both have been to OCC outreach meetings that the Fed has also attended. I don’t see any significant change in our approach to our business plan as a result of that. We are feeling that our business plan, the way it’s structured right now at the bank has been very much a commercial bank strategy for a number of years and a strategy that’s obviously the OCC is very familiar with.
At the holding company level, obviously, we’ll be entering a new era there with the Fed regulation. But I think the in part the liquidity and the independent capital, the parent that was created through the recent stock offering, I think puts us in good shape there. So there is obviously you are always a little bit anxious when there is a change, but I think we’re properly prepared for it.
John Barber – KBW
That’s all I had. Thank you very much.
(Operator instructions). Our next question comes from Don Verges from Verges Capital. Please go ahead.
Don Verges – Verges Capital
Yes, could you comment on dividend policy going forward and how you are thinking about that?
As I’m sure with most of our listeners are aware, we have we suspended our dividend in the fourth quarter of 2009. We continue to assess it on a quarter-by-quarter basis as we’ve gone through the economic cycle that we’ve been in. We’ve just felt that it was prudent to preserve as much capital at, especially at the bank as possible. We do continue to assess it. We certainly are encouraged by the improvements that we are starting to see in the economy and our Board will continue to evaluate based on current economic conditions and economic forecast and regulatory environment and make decisions based on that. Obviously, we are hoping to get back to paying a dividend sometime in the not too distant future.
Don Verges – Verges Capital
You’re welcome. Thank you.
(Operator instructions). I’m showing no further questions at this time. So we are going to conclude our question and answer session. I would like to turn the conference back over to Mary Beth Weisenburger for any closing remarks.
Mary Beth Weisenburger
We just like to thank everyone for their participation today and this concludes our call. Thank you.
The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect your lines.
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