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Citizens Republic Bancorp, Inc (NASDAQ:CRBC)

Q3 2011 Earnings Call

October 28, 2011 10:00 am ET

Executives

Lisa M. McNeely - Chief Financial Officer and Executive Vice President

Kristine D. Brenner - Director of Investor Relations

Mark W. Widawski - Chief Credit Officer, Executive Vice President, Chief Credit Officer of Citizens Bank and Executive Vice President of Citizens Bank

Cathleen H. Nash - Chief Executive Officer, President, Director, Chief Executive Officer of Citizens Bank and President of Citizens Bank

Analysts

John Barber - Keefe, Bruyette, & Woods, Inc., Research Division

Terence J. McEvoy - Oppenheimer & Co. Inc., Research Division

Operator

Good day, everyone, and welcome to the Citizens Republic Bancorp Third Quarter Conference Call. [Operator Instructions] Please note this call will be recorded and I'll be standing by if you should need any assistance. It is now my pleasure to turn the call over to Kristine Brenner. Please go ahead, ma'am.

Kristine D. Brenner

Thank you, good morning and welcome to the Citizens Republic Bancorp Third Quarter Conference Call. This call is being recorded and will be archived for 90 days on the Investor Relations page of our website, citizensbanking.com.

The format of the call today will be Cathy Nash, President and Chief Executive Officer, providing highlights for the quarter; Lisa McNeely, Chief Financial Officer, and Mark Widawski, Chief Credit Officer, will provide details of the quarter. Cathy Nash will then share some concluding remarks. We will then open the line up for questions from research analysts, and Brian Boike, our Treasurer, is also here to answer questions.

During this conference call, statements may be made that are not historical facts, such as those regarding Citizens' future financial and operating results, plans, objectives, expectations and intentions. Such forward-looking statements are subject to risks and uncertainties, which include, but are not limited to, those discussed in Citizens' annual and quarterly reports filed with the SEC. Forward-looking statements are not guarantees of future performance and actual results could differ materially. These forward-looking statements reflect management's judgment as of today, and we expressly disclaim any obligation to update or revise information contained in these statements in the future.

Now I'll turn the call over to our President and Chief Executive Officer, Cathy Nash. Cathy?

Cathleen H. Nash

Thank you, Christine. We are very pleased to report another quarter of profitability. Net income was $27 million, or $0.68 per common share, for the third quarter, which included a $13 million, or $0.32 a share, income tax benefit. When we look at top line revenue growth, portfolio loans grew for the first time in 3 years. Although the total portfolio balance was up modestly, C&I loans increased 13% and the indirect loan portfolio grew 2%, compared to last quarter. The strategy we put in place to prudently rebuild our loan book has been playing out as we had anticipated. We also continued to grow core deposits, which were up 4% over last quarter. While we saw anticipated seasonal growth and fund balances for the quarter, year-over-year, our core deposits are up $270 million and core deposits are now 69% of our deposit portfolio.

This quarter, we also expanded net interest margin and fee income. Our positive credit trends also continue. The multi-year emphasis on our credit portfolio and the cleanup we finished in the first quarter continues to be reflected in our improved credit trends. Now I'll turn the call over to Lisa and Mark to walk through the quarter in more detail. Lisa?

Lisa M. McNeely

Thanks, Cathy. As Cathy mentioned, we reported net income for the quarter of $27 million, which included a $13 million tax benefit. Earnings were driven by an increase in net interest margin, improvement in noninterest expenses and continued resilience in our core banking fee income. Net interest margin increased 7 basis points over last quarter to 3.63%. Compared to the third quarter of last year, margin increased 31 basis points.

Our cost of funds has significantly improved. We've decreased deposit costs by maintaining our focus on client-relationship pricing and improving our funding mix by focusing on core deposits. We have also benefited from the positive impact of lower levels of nonperforming assets and reducing excess cash. These benefits have been partially offset by lower reinvestment yields on earning assets due to lower term rates and intense competition for loans. We anticipate reinvestment rates on earning assets to continue to be pressured and negotiated at lower yields. Opportunities on the funding side that would lead to lower costs are limited.

Noninterest income was $24 million for the third quarter, a $1 million increase from last quarter. The third quarter fee income reflects the usual seasonal increase from service charges. Net gains from loans held for sale and investment securities also contributed to the increase. The fee income trend from our banking products has been resilient through the regulatory changes. Our bankers have proactively reviewed products with our existing clients, offering solutions that meet their financial needs. Our cross-sell at point-of-sale has steadily increased year-over-year. We will continue to focus our opportunities that help maintain a stable base of fee income in light of the changing regulatory environment.

Noninterest expense was $65 million, down $4 million from the second quarter, primarily due to fewer -- a few items that going forward will not impact our run rate. The regulatory changes in calculations of the FDIC assessment that resulted in a lower expense in the third quarter. We do not expect this benefit to reoccur. Also, quarter-over-quarter, salary expense was lower related to the change in the liability supporting the deferred compensation plan.

Compared to last year, noninterest expenses were down 13%. Run rate improvements are reflected in improved credit-related work-out expenses, our consistent focus on internal efficiency and vendor management. We have seen the benefits of tightly managing expenses since the beginning of the downward economic cycle. Expense management will continue to be a part of our culture. Keeping in mind that the largest drivers of the third quarter improvements do not have run rate impact, we expect additional operating expense opportunities to be modest going forward. We recorded a $13 million income tax benefit this quarter as a result of recording a receivable related to a retroactive change in a tax election for the 2010 tax year.

Taking a look at our balance sheet trends. Total portfolio loans at quarter end were $5.7 billion, representing a modest increase of $45 million from the second quarter. As Cathy mentioned, this marks the first quarter of our loan growth outpaced runoff in 3 years. The C&I portfolio grew $182 million, or 13%, compared to last quarter, and the indirect portfolio grew by $18 million, or 2%. The last several quarters we've talked about our focus to capitalize on our expertise in these lines of business. This quarter, our strong pipelines continued to result in increased loan closings. We've approved and renewed $119 million in consumer loans and $513 million in commercial loans during the third quarter. In total, this was an increase of 34% over last quarter and 49% over the third quarter of 2010.

Our continued focus on relationship banking, high-quality client service and new client acquisition led to an increase in core deposits. Our annual new client acquisition rate is 9%. Growing and retaining client relationships will continue to provide a low-cost source of funding for future loan growth.

Time deposits decreased 5% from the second quarter, reflecting our successful initiatives to reduce single-service high-cost retail CD balances. Our bankers have been successful in referring these balances to our investment center or other products which better meet both the bank's goals and the clients' needs.

As you can see from the capital table in our release, our continued positive result enhanced all of our key capital ratios. Our capital ratios remained well above the regulatory minimums and will continue to build as we report positive results. As of September 30, the valuation allowance against our deferred tax asset is estimated at $322 million. As we have said in the past, the reversal of the valuation allowance will be based on facts and circumstances that primarily focus on our sustained profitability. We continue to build a case to fully recognize our DTA as soon as possible. I'll turn it over to Mark for more highlights into credit.

Mark W. Widawski

Thank you, Lisa, and good morning. As Cathy noted, our strategy to rebuild our loan portfolio was focused on segments with favorable market dynamics and where we have demonstrated expertise. The $182 million growth in -- net growth in the C&I portfolio was primarily a result of a strong, planned origination effort in our Citizens Bank Business Finance unit, or CBBF. CBBF was formed in 2006 to finance businesses in transition. The unit originates and participates in asset-based and leveraged cash flow loans that provide industry, borrower size and geographic diversity to our C&I portfolio. CBBF provides the ability to add to the portfolio at enhanced yields while maintaining credit discipline. Since inception, CBBF's annualized loss rate is the lowest of all our asset classes. As we examine market opportunities for loan growth in 2011 and moving into 2012, we believe that originations within CBBF and indirect, deliver prudently underwritten diversified asset growth.

As we previously mentioned, we executed a geographic expansion of our indirect RV and marine lending to states contiguous to our existing indirect footprint. This activity has successfully complemented our existing strong origination and credit discipline in the business.

Loan balances in this segment peak in the third quarter as the business is seasonal. We showed increases of $18 million over the second quarter and $53 million year-over-year in indirect lending. Our growth in those 2 portfolios has performed as anticipated, as we build up the more traditional C&I pipeline. Our market teams in the branches, healthcare, core and corporate banking segments, have built their consumer and commercial loan pipelines to the highest levels since 2008. While competition for strong credits remains high, especially from a pricing perspective, our teams are winning new business with a long-term relationship, solution-focused approach without compromising underwriting standards. Our growth initiatives are supported by stable and improving credit metrics in and all asset classes.

Highlights of deposited credit trends in this quarter, total 30- to 89-day delinquencies improved to 87 basis points, the third consecutive quarter at or below 1%. All consumer asset classes saw improved near-term delinquencies, quarter-over-quarter. The improvement in commercial delinquencies reflects the stabilized credit environment and our marketing credit team's focus on diligent portfolio management such that for the first time, none of the quarter end commercial delinquencies represented market-assigned loans. All were under our Special Loans and Commercial Loan Adjustment management oversight.

Nonperforming loans were down $11 million, ending the quarter at $112 million, or 1.98% of total loans, the lowest level since -- June 2008. NPAs were down $3 million and include $12 million of NPL residential mortgage and consumer lot loans that were moved to held for sale. The quarter's inflow to commercial nonperforming totaled $24 million, flat to the second quarter and our third consecutive quarter under $30 million. The 2 largest new commercial NPL relationships are commercial real estate related, each with balances of approximately $3 million. Potential problem commercial loans, managed through our watch credit process fell for the eighth consecutive quarter with upgrades outpacing downgrades by more than 2:1. Quarterly inflows to commercial classified status, loans rated substandard or worse, were $38 million, down from $85 million in the second quarter and significantly below the 2010 quarterly average of $141 million.

Consistent with our strategy to increase the velocity of our residential NPL outflow to mitigate future ORE expense and in conjunction with an anticipated fourth quarter bulk disposition, we recorded a charge of $19 million and moved a pool of NPL residential mortgage and consumer lot loans to held for sale. This action accounted for 57% of the total quarterly net charge-offs of $33 million. Commercial net charge-offs of $6.5 million represent the lowest quarterly level since September 2007.

Our provision expense was roughly in line with the second quarter, improving our allowance coverage of NPLs to 169%. The allowance remains very strong at 3.36% of total loans. Cathy, back to you.

Cathleen H. Nash

Thank you, Mark. This quarter's results demonstrate our continued success in carrying out our strategy of prudent loan growth, maintaining that interest margin, core deposits and appropriate loan loss reserve levels and consistently delivering profits. The continued execution of our strategy will allow us to end our written agreement with our regulators. We have continuous discussions with them around this and believe we are well-positioned for this to happen, given the results we have achieved in credit quality and our consistency and profitability. Staying on our strategic course will also allow us to fully recognize the value of our deferred tax asset. We are actively working with outside tax experts to evaluate our case for bringing our DTA back. We continue to evaluate the reinstatement of our trust preferred and TARP dividends. We are considering a number of options and will examine them as we move out from under our written agreements with our regulators. We may or may not choose to catch up on dividends as we exit that agreement, depending on what makes most sense for our company at that time. And as we have stated before, we plan to repay TARP in the most shareholder-friendly way as possible. At a 5% cost of capital, we are in no rush to repay it just to get out of the program. We have seen our regulators support other banks with solid earnings capacity and credit quality, allowing them to redeem TARP in ways that resulted in less dilution to common shareholders. We believe patience results in better long-term value for our shareholders. And with those final comments, we'll open up the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first questions from Terry McEvoy with Oppenheimer.

Terence J. McEvoy - Oppenheimer & Co. Inc., Research Division

Cathy, I guess I'll start with you. Could you just talk about the positive evidence that you look at, that we can look at supporting the reversal of the devaluation allowance? Is it just 2 quarters of profitability, NPAs down over 60% over the year? Is it PPE? What would variables, do you think are the most important, again, that can help us in, determining the potential for that event?

Cathleen H. Nash

I like everything you've said in your list, Terry. I wish it was as simple as showing a set of numbers and therefore that equals an answer. It's a bit more complicated than that. We've hired outside support to help us build our case for our auditors. And really, in my view, Terry, it is the ability for us to demonstrate the continued ability for the company to perform profitably. Key to that is our ability to forecast and to meet our forecast, which we have clearly demonstrated over the last few years. Even though those forecasts were negative, our ability to meet them and understand the elements critical to our company to meet those forecasts must be demonstrated and we've done that. So I think we've got all the right pieces in place, and we're actively building that case and beginning with the meetings with our auditors now. We've set our expectations as to when we'd like it. I don't think it's realistic to think after 2 quarters of profitability we should be able to get it back, but we're building that case after that second quarter. Lisa, do you want to add anything to what I've said?

Lisa M. McNeely

Cathy, I think you've summarized it very well, and this is a primary focus for us right now. It's very important to us to restore that value so that we can begin to move forward.

Cathleen H. Nash

And harvest the tax benefit that of the DTA as well.

Terence J. McEvoy - Oppenheimer & Co. Inc., Research Division

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And a question for Lisa, in your prepared remarks, did you say that you saw limited opportunities to lower funding cost, did I hear you correctly? And then, as I just look at the time deposits, $2.3 billion came down a little bit to 1.8%. It would seem like there's an opportunity to bring that number lower and if so, could you just talk about, as we move through the fourth quarter and into next year, when you'd see opportunities to reduce those CDs?

Lisa M. McNeely

Yes, Terry, you're correct. There is limited opportunity. We will evaluate every opportunity that we can. We do want to still be competitive in our markets, but there will be limited opportunities. The time deposits will come down. We actually have a very nice, smooth maturity pace for the CDs. There aren't a lot of lumpy bumps anymore. We've managed through those. So, again, that kind of leads to our limited ability to continue to find opportunities to bring the funding cost down.

Cathleen H. Nash

Yes, Terry, It's Cathy. I think a good example is January, we've got $100 million maturing in our CD portfolio. About $50 million of that is priced at over 4%. Of that $50 million, half of those clients are single service. So if we kind of do that math, half of that money we would quite happily let go. The other half being relationship client we would give them a market competitive rate, but we certainly won't be repricing them anywhere near the -- bigger shock they see when they come off of 4%. So we see opportunity on the CD side, but we don't have chunks of $500 million, $600 million, $700 million, returning at a time. We have really smoothed that portfolio out. So we're going to keep steadily working at it.

Terence J. McEvoy - Oppenheimer & Co. Inc., Research Division

And then just a last question for Mark. The bulk residential sale in the fourth quarter. Could you just talk about the marks on that sale versus the large one that happened, was it the third quarter of last year or the ones last year?

Mark W. Widawski

Right. What we've seen in terms of pricing is what we expected. It has not firmed up. Our marks are below where they were last year. We're into the selling process and the offering memorandum is out. So we have our sights on finishing that up in December. We will continue to take a look at that portfolio. The interesting thing on the residential side is the near-term delinquencies at, I believe, 1.36% of the portfolio, are down from where they where when we came out of those other sales. So we are taking the risk out of it appropriately. In terms of pricing, going forward, the economic indications are out there that there is some firming in the residential market. We'll take a look at that in combination with hopefully a quicker selling process to maybe realize better value to discrete sales.

Operator

And we'll take our next question from John Barber with KBW.

John Barber - Keefe, Bruyette, & Woods, Inc., Research Division

My first question is related to your C&I growth this quarter. Was that all organic and end-market? And also, was it related more to new relationships or to the distinct customers?

Cathleen H. Nash

It was primarily organic. It was a mix of end-market, I'd say 80% end-market, 75% end-market, I don't remember the number.

Mark W. Widawski

Yes, no, I think the thought process there, John, is that our CBBF grew in terms of the diversification they can provide, includes going outside of the geography a bit. I was involved with that group directly from inception. And what that gives us an ability to do is front-end load our growth cycle here with some transactional opportunities. As asset-based lending and event-type business opportunities through mergers or acquisitions present themselves in the leverage space, they are able to go outside of our footprint a little bit. So it may be a little more skewed towards 50-50, Cathy.

Cathleen H. Nash

Yes. And the last part of your question was new or existing, and it's primarily new.

Mark W. Widawski

Yes. Our usage on the lines of credit has been stable. We haven't seen an increase there yet. We're still seeing some degree of reticence from our customers to commit their balance sheet to long-term fixed-asset or real estate financing.

John Barber - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. And Mark, you mentioned that you're seeing high-level of competition from pricing perspective. Is it mostly from community banks or other large regional?

Mark W. Widawski

It's both, depending on the segment.

Cathleen H. Nash

Yes. And also depending on the markets. John. In some our markets, smaller community banks are getting a little price crazy. And other part of our footprint, the large regional seem to be reaching a bit, both in terms of price and covenants. We've been pretty clear, we will compete where it makes sense on price, but we are not willing to change our credit standards or our risk appetite just to "get a deal." We see some of the larger regionals dipping a little bit more into that space than we would.

John Barber - Keefe, Bruyette, & Woods, Inc., Research Division

All right. And then I guess, Lisa, you said that your valuation allowance came from DTA. I think you said it was $322 million this quarter, and that's up from $293 million at the end of the year. Maybe at a high level, could you just talk about what drove the increase?

Lisa M. McNeely

Yes. So as we worked through and we've realized losses and charge-offs, that kind of builds and drives through the deferred tax asset as we -- and then as we reverse that, we'll begin to harvest those benefits in future years.

Cathleen H. Nash

So I think, John, the biggest driver from the end of last year was, you'll remember, it does seem like a distant memory, but the large amount work we still did in the first quarter of 2011 went through the DTA as well. So, while the last 2 quarters have felt very strong and comfortable, remember, we had a lot of cleanup work we filled in the first quarter this year.

Lisa M. McNeely

Right. I'll reconfirm the number, but I think at the end of the second quarter, we were at $315 million. So you can see that the large part of it, as Cathy noted, was related to the first part of the year.

John Barber - Keefe, Bruyette, & Woods, Inc., Research Division

All right. And last question was how should we think about the provision relative to net charge-offs going forward? I guess given your level of reserves as a percentage of loans, it's still very high and the coverage ratio's over 1x.

Lisa M. McNeely

Right. So as we talked about before, we're looking to bring that down modestly as we work through the rest of the cycle. And I think the last 2 quarters you've kind of seen a pattern there that will continue to trend in that direction.

Cathleen H. Nash

Yes. And because we run a historical model, John, that will naturally decline because the model will show, given the cleanup work we did, that the necessity for the reserve and that level of provisioning simply doesn't exist. So we're going to let that, if you will, flow through our model versus some active oversight to change it arbitrarily. And we think that's a better course of action for us, and quite frankly, makes more sense for our company and for our regulators.

Cathleen H. Nash

We thank you for your questions and your participation in the call today. The results we've shown in the quarter are a good indicator of the path the bank is on in executing our strategies. And we're going to continue to focus on top line revenue growth as we look to build our case for recognizing our deferred tax asset and then for shareholder-friendly TARP repayment options. And I believe with that, we'll end the call. As usual, for any follow-up questions, please let us know. Thank you.

Operator

This concludes today's conference. You may now disconnect, and enjoy the rest of your day.

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