First Defiance Financial's (FDEF) CEO Don Hileman on Q1 2016 Results - Earnings Call Transcript

| About: First Defiance (FDEF)

First Defiance Financial Corp. (NASDAQ:FDEF)

Q1 2016 Earnings Conference Call

April 19, 2016 11:00 AM ET

Executives

Tera Murphy - VP

Don Hileman - President and CEO

Kevin Thompson - EVP and CFO

Analysts

Christopher Marinac - FIG Partners

Damon DelMonte - KBW

Daniel Cardenas - Raymond James

Operator

Good morning and welcome to the First Defiance First Quarter 2016 Earnings Conference Call. 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 Tera Murphy, Vice President with First Defiance Financial Corporation. Please go ahead.

Tera Murphy

Thank you. Good morning, everyone and thank you for joining us for today’s 2016 First Quarter Earnings 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 Don Hileman, President and CEO of First Defiance; and Kevin Thompson, 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 would 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 forecast 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 will turn the call over to Mr. Hileman for his comments.

Don Hileman

Thank you. Good morning and welcome to First Defiance Financial Corporation’s first quarter conference call. Last night we issued our 2016 first quarter earnings release and now we would like to discuss that release and give you a look into the remainder of 2016. At the conclusion of our remarks 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 quarter is our CFO, Kevin Thompson.

We are very pleased with the continued momentum developed in the latter part of 2015. First quarter 2016 net income on a GAAP basis was $7.1 million or $0.78 per diluted common share compared to $6.6 million or $0.69 per diluted common share in the first quarter of ‘15. Our overall core performance this quarter was very strong creating a good start to the year. We experienced solid year-over-year and linked quarter annualized loan growth of 8.3% and 5.1% respectively.

Our loan growth percentage this quarter was down from the strong 9% annualized level in the fourth quarter. However, first quarter loan growth tends to be seasonally weaker. So we are pleased with the overall growth. Our ability to grow our loan portfolio is a key strategic piece of our plan. The lending environment is very competitive with rate and structure pressures relating to terms and conditions. All institutions are looking for loan growth and we are seeing more competition from large financial institutions for larger deals.

In some cases we are seeing very aggressive rates and loosening of terms and conditions. It was encouraging to us to see contributions from across our entire footprint despite this environment and we ended the first quarter with a solid pipeline, which was up from year end. Our Columbus, Ohio LPL has grown to about $90 million of outstandings and stronger contributions are expected going forward. We also saw stronger than expected growth in the Toledo market, which was offset somewhat by declines in the Fort Wayne market related to the payoff of a large credit in the quarter.

Overall growth in the Fort Wayne market is still expected this year. This coupled with more overall confidence from segments of our clients concerning economic stability and the economic environment leads us to believe we have positioned ourselves for a continued disciplined loan growth during the remainder of 2016. We are also very pleased with our margin improvement this quarter over the fourth quarter of ‘15, which we feel is a reflection of our disciplined approach to both asset and liability pricing.

Loan portfolio growth contributed to the improved earning asset mix increasing our net interest income. The growth in both our net interest income and our non-interest income revenues on a quarterly basis as a result of contributions from our core business strategies. We are also pleased with our resilient net interest income growth this quarter of 5.5% over the first quarter of ‘15.

We expect the interest rate environment to be relatively stable at the current levels in the short-term, but anticipate an increase in market rates in the second half of this year. We’re continuing to measure our interest rate risk position and are managing toward a neutral to slightly positive position.

Growth on the deposit side of the balance sheet was strong this quarter, growing 7.6% on a linked quarter basis and 5.6% year-over-year. On a linked quarter basis we were able to increase our overall margin to 3.8% from 3.7%. We are very satisfied with this quarterly improvement in today’s environment.

Non-interest income driven primarily by service fees, trust income and other income was offset by a decline in mortgage banking revenue. While down year-over-year mortgage banking revenues increased on a linked quarter basis. Non-interest income grew 4.3% year-over-year. Total non-interest expense decreased slightly from the fourth quarter of ‘15 and increased 2.2% on a year-over-year basis.

The credit quality metrics showed continued overall improvement this quarter from the first quarter of ‘15. Non-performing assets declined approximately $6.3 million or 25% year-over-year. Non-performing loans decreased approximately $1 million or 5% year-over-year to $17.7 million. Approximately 60% of the non-performing loans are continuing to make payments. We also had a decrease of $8.3 million or 42% in restructured loans.

We are satisfied with the level of 30 days, 90 days delinquencies at 0.14% of loans for the first quarter of ‘16 the same level as the first quarter of 2015. Overall, we expect to see stable to improving asset quality terms across the board. We will continue to focus on asset quality through reducing the non-performing and classified asset levels in the future leading to improvements in our non-performing asset ratio.

Regarding our capital management plans, we brought back approximately 168,000 shares of our stock in the first quarter. We are also delighted to announce a 2016 second quarter dividend of $0.22, representing a 10% increase and an annual dividend yield of approximately 2.3%. We anticipate a continuation of the balance dividend and stock buyback reflecting our strong earnings trend and are focused on the utilization of capital.

I will now ask Kevin Thompson to provide additional financial details for the quarter before I conclude with an overview. Kevin?

Kevin Thompson

Thank you, Don, and good morning, everyone. As Don stated, net income for the first quarter was $7.1 million or $0.78 per diluted share. This compares to prior year results of $6.6 million or $0.69 in the first quarter of 2015. It’s always encouraging to start the year with strong results and we are very pleased with our first quarter financial performance results as well as our outlook for 2016.

Starting with growth, our loan and deposit balances both had solid increases in the first quarter, which was a nice continuation after our very strong fourth quarter. Total loans finished the quarter up $22.8 million from year end and up $140.4 million or 8.3% from a year ago. First quarter average balances increased $63.7 million on a linked quarter basis keeping our earning asset mix strong and profitable.

On the deposit side, we saw balances increase $35 million in the quarter and $98.5 million or 5.6% from a year ago and average deposit balances grew $11.9 million in the first quarter of 2016. Over the past year, we have generally seen our loan growth outpace our deposit growth and have relied a bit more on borrowings to grow our balance sheet. While these sources are a bit more expensive this has been tempered by a favorable mix in our deposit growth.

Over the past year, our $98.5 million of deposit growth includes $55.1 million of growth in non-interest bearing demand balances. Overall, our strong growing balance sheet has continued to generate strong growth and earnings.

Turning to the income statement, our net interest income was $19.2 million for the first quarter of 2016, up from $19 million in the linked quarter and up $1 million from $18.2 million in the first quarter of last year. The increase over the prior year was despite the last year’s benefit of $264,000 of recovered interest. Our margin this quarter was 3.80%, down 8 basis points from 3.88% in the first quarter of last year, which again benefited from the recovered interest, which was about 5 basis point effect. But our margin was up 3 basis points from last quarter.

On a linked quarter basis, our yield on earning assets was up 6 basis points as our loan portfolio yield held steady at 4.34%, but our mix improved. Our cost of interest bearing liabilities was up 3 basis points on a linked quarter basis impacted both by rate and mix. While our earning asset mix has kept our margin strong and steady as we continue to grow our balance sheet, our interest rate risk position is basically neutral and well balanced for our expectation of a cautious but determined Fed.

Our non-interest income was $8.6 million in the first quarter of 2016, up from $7.7 million in the linked quarter and up from $8.3 million in the first quarter of 2015. The first quarter of 2016 includes $131,000 of securities gains plus $317,000 of net gains on the sale of OREO. While the first quarter last year included only $67,000 of net OREO gains.

Furthermore the first quarter is generally when we receive our contingent insurance commissions, which totaled $799,000 this year versus $967,000 a year ago. So excluding these non-core and seasonal items our net interest income was up year-over-year about $143,000 or 2%. Service fees, trust income and our core insurance commissions were all up while mortgage banking declined versus the first quarter of last year. Regarding mortgage banking revenues for the first quarter of 2016 were $1.5 million, up $74,000 from the linked quarter, but down 236,000 from the first quarter of 2015.

The first quarter mortgage banking originations were $51.1 million compared to $56.3 million last quarter and $52.7 million in the first quarter of 2015. Gain on sale income was $994,000 in the first quarter of 2016 compared to $836,000 on a linked quarter basis and $1.3 million in the first quarter of last year. In addition, the first quarter included a negative valuation adjustment to the mortgage servicing rights of $21,000 compared to positive adjustments of $75,000 last quarter and $26,000 in the first quarter of 2015.

At March 31, 2016 First Defiance had $1.3 billion in loan service for others. The mortgage servicing rights associated with those loans had a fair value of $9.2 million or 73 basis points of the outstanding loan balances serviced. Total impairment reserves, which were available for recapture in future periods totaled 666,000 at quarter end.

As for the non-interest expense, first quarter expenses totaled $17.3 million, even with $17.3 million in the linked quarter, but up from $16.9 million in the first quarter of 2015. The increase was primarily in compensation and benefits expense, which in the first quarter 2016 was up $1.3 million from last year, mainly due to higher cost for health benefit plans, incentive compensation, merit increases and new staff to expand and support our growth strategies.

Other non-interest expense was $2.9 million in the first quarter of 2016, down from $3.6 million in the same quarter last year, mainly due to reductions in OREO write-downs which totaled $522,000 in the first quarter of last year and only $53,000 in the first quarter of 2016. Regarding provision expense, the first quarter of 2016 totaled $364,000 compared to $43,000 last quarter and $120,000 in the first quarter of last year. The first quarter of 2016 included net charge-offs of 2 basis points compared with net recoveries of 3 basis points last quarter and net recoveries of 10 basis points in the first quarter a year ago.

Our allowance for loan loss at March 31, 2016 was $25.7 million or 1.41% of total loans versus $25.3 million or 1.50% at March 31st last year. The change in the allowance ratio reflects the credit quality improvements achieved during the past year such that the allowance coverage of nonperforming loans has increased to 145% at year end, up from 135% at March 31, 2015. We expect the allowance to loans percentage to continue to reflect strengthening asset quality.

As for the asset quality numbers, nonperforming loans increased slightly this quarter to $17.7 million from $16.3 million on a linked quarter basis, but was down from $18.7 million at March 31, 2015. Our OREO balance decreased this quarter to $1.1 million from $1.3 million last quarter and from $6.4 million in the first quarter last year.

Overall nonperforming assets ended the quarter at $18.8 million or 0.80% of total assets, down from $25.1 million or 1.14% of total assets at March 31, 2015. Our troubled debt restructured loans this quarter were $11.3 million, up $106,000 from last quarter, but down considerably from $19.6 million.

Looking at our capital position, total period end stockholders’ equity finished the quarter at $280.4 million, up just slightly from $280.2 million at March 31, 2015. During the quarter we repurchased 167,746 shares leaving approximately 377,500 shares remaining under our current repurchase authorization.

Our capital position remains strong with quarter end shareholders equity to assets of 12.06%, although down from 12.84% last year. The total risk-based capital ratio is approximately 13% at quarter end March 31, 2016. Our healthy capital position continues to support our growth strategies as well as enhance shareholder value through share repurchases and dividends.

So on summary, we have a strong balance sheet, solid profitability and good momentum. That completes my financial review and now I will turn the call back over to Don.

Don Hileman

Thank you, Kevin. I’m very pleased with the core results in the first quarter of 2016 and the important progress we have made position First Defiance for success the remainder of 2016. We continue to focus on several key areas that we believe important to improving financial performance and greater shareholder value. These areas include core balance sheet growth with a focus on loan growth and deposit growth, overall revenue growth, expense control and improved asset quality.

We look to continue to making steady progress in all of these areas throughout 2016. We are off to a good start with the first quarter asset growth of 3% on a linked quarter basis with solid growth in both loans and deposits this quarter. Overall revenues grew 4% in the first quarter of ‘16. We do believe improvements in loan demand aided by further improvements in the economic environment will carry throughout 2016.

As we have discussed we have looked to strategically grow our overall position in the metro markets of Fort Wayne, Indiana, Toledo, Ohio and increase loan production in Columbus, Ohio. We are seeing strong activity in these areas.

As I mentioned previously, some additional expense was added to the quarter and we expect some degree of additional expense in ‘16 as reflected in Kevin’s comments concerning the compensation and benefits expense. We still believe a growth rate in the high single-digits is appropriate for the remainder of the year.

While the lending environment remains very competitive as previously noted, we feel we can realize loan growth without making significant concessions in rate and other terms through a strong process relationship building and quality client focused service despite seeing declines in offering rates from some competitors. We understand it will be challenging to drive growth in loans and maintain yield management until market rates move higher. We’re very focused on relationship management pricing and believe our delivery and service model is effective and is contributing to the strong margin performance.

We continually look to enhance our electronic and mobile capabilities giving our customers more choices on how they bank with us and are responding to their requests unveiled during our research. We’re seeing a changing pattern in transactions and service on the retail side driven by our customers. The shift in customer demographics will also have an impact on our business model. We spent both time and resources to gain understanding of the needs of our current clients and potential clients as new client relationships are essential to us.

We are looking to better understand the needs and behaviors of millennial as the market research indicate this is an increasingly important segment of the population. This group is distinct in their needs and the use of banking products and services and we must be prepared to serve this generation. We are pleased with the increases in the activity in both electronic and mobile transactions including online account opening, mobile deposits, electronic payments and the use of mobile wallet features.

The digital delivery environment is changing at an accelerated pace and we’re committed to providing our clients both retail and business a quality choice of products and services. In constant with this we are taking a closer look at how our customers interact with us both inside and outside the branch. As banking behaviors of our clients change we’ll focus on adopting our service and sales model for a more convenient better banking experience for all our customers.

We will continue to focus on growth in our insurance and wealth management revenues as part of our strategic plan. We believe these revenue sources help in our ability to grow revenue in an environment with added pressure on MSF and other deposit fees. We were pleased with the -- by the continued improvement in credit quality reflected by low charge-offs in overall lower non-performing assets.

We are committed to continuing to improving our results relatively to our peer group in this area. We are also very pleased by our recent performance and look to constantly drive our performance through initiative that will help us obtaining our goal being a consistently high performing community bank. We understand the headwinds and challenges ahead including economic, regulatory and operational factors.

We are also working diligent to address the growing issues of cyber security and provide our clients important information to protect their financial information. We believe we can accomplish our goals through a balanced approach and a long-term focus on a shareholder value. We remain confident in our strategy and in the people we have dedicated to executing this.

We feel that the performance of the organization reflects our focus on shareholder value and at the same time our commitment to being a strong community partner in the areas we serve. Not only by donating funds and employee volunteer hours, but by creating valuable partnerships with community organizations such as the Toledo Public Schools and the Toledo Zoo to provide educational opportunities by bringing zoo animals into the elementary schools.

We also very committed to providing financial wellness and additional educational opportunities to the public through our footprint. We remain strongly committed with our customers and our shareholders and we appreciate the trust you have placed on us as we work to make First Defiance a company to be proud of.

Thank you for your interest in the First Defiance Financial and we thank you for joining us this morning.

We will now be happy to answer any of your questions.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. [Operator Instructions]. Our first question this morning comes from Christopher Marinac of FIG Partners. Please go ahead.

Christopher Marinac

Thanks, good morning. Don and Kevin I want to ask a little bit about your thoughts regarding adding mergers to the bank going forward. Is this something that is possible in the future and I think more importantly is just can you give us a band I guess about what price expectations may be among sellers? And is there a sort of updated tolerance in terms of how much dilution you will or won’t accept on any given transaction?

Don Hileman

Well, thanks for the nice simple question there, Chris. I think it’s definitely one of our things that we consider. When we look at the environment, I believe the M&A activity is going to increase a little bit. We still think it’s important that we match up the culture both of First Defiance with any potential acquisition client. And so we’re I guess fairly selective in that part of it because I think that’s key to the execution. As part of our expectations on where we might be from a pricing standpoint, I think we look at a lot of factors I don’t know if we have one, but I think as far as our buyback and intangible buyback. Those are all factors, but I don’t think at this point we have anything that’s really specific. We’re looking to make sure it would be an accretive transaction.

Christopher Marinac

Okay, great. Thanks for that, appreciate it. From the standpoint I guess this current quarter, does the margin get stronger if we see one or two more additional Fed hikes or would that sort to be a challenge. I know you mentioned in the remarks about moving towards neutral. So just curious I guess is that more of a timing issue that happens right away maybe a negative, but if it happens later in the year, it could be either non-event or a slight positive?

Kevin Thompson

Yeah. Chris, I actually I think we really are pretty neutral. Our numbers indicate we maybe have a slightly positive bias to a rise in rates. But I wouldn’t look for any kind of windfall impact on our numbers. And in terms of timing, I don’t know that that’s going to make a significant difference. I think though as we look ahead, with the Fed we think moving on a very measured basis, we think that’s probably a pretty good environment for us to operate in as opposed to any significant and swifter movements if you will by the Fed. That could be a little more perhaps volatile impact. But if the Fed moves as we expect with maybe one or two more increases over the remainder of the year. We think again we’re pretty neutral to that impact with maybe a slight benefit.

Christopher Marinac

Okay. Thanks, Kevin, appreciate that. And just as last question since you mentioned the cyber topic in the earlier remarks, is cyber covered within your existing budget this year or are there additional spending you have? And then I guess to what extent is some of your plan sort of go part and parcel with your main systems vendors?

Don Hileman

Yeah. That’s a good question. It is and we look at it from two perspectives. My comments were related to more what we are trying to do to execute our clients and help them navigate cyber security. We have a lot of businesses and small business clients and how do we provide them the best information for them to make informed decisions to protect them themselves.

We also have a decent amount of spend in our operating budget for enhancements if you will to our core systems and ancillary systems to protect us as best we can. We feel real comfortable with our core system provider and their ability to provide additional protections from a cyber-security standpoint. But we continually focus on that because I think we all realize that’s a big issue for us today and this will continue to be an issue going forward.

Christopher Marinac

Sounds good, guys. Thanks again for all the background here.

Kevin Thompson

Sure.

Don Hileman

Thank you. Appreciate it.

Operator

Our next question comes from Damon DelMonte of KBW. Please go ahead.

Damon DelMonte

Hey, good morning, guys. How are you doing?

Don Hileman

Good morning, Damon.

Damon DelMonte

My first question just relates to expenses and the outlook there, I think you had mentioned that there might be some higher expenses in ‘16 related to competition cost. Is that correct?

Kevin Thompson

That’s correct. I mean we are investing in our growth strategies and we are obviously reflecting some elevated expenses versus a year ago and we expect that trend to continue.

Damon DelMonte

Okay. So, as you look for like a quarterly run rate, I think last quarter you were talking maybe something in the $17.5 million to $18 million range. Is that still a reasonable expectation for the remainder of the year?

Kevin Thompson

Yeah. I would think $18 million might be pushing it. But I think $17.5 million probably isn’t a bad number.

Damon DelMonte

Okay, great. And then the $317,000 in the OREO gain that you had this quarter, was that captured in the other non-interest income line?

Kevin Thompson

That is correct.

Damon DelMonte

Okay. And then, do you know what the average price was that you bought back the share this quarter at?

Kevin Thompson

I don’t right off the top of my head. But my estimate would be about $38.

Damon DelMonte

Okay, great. And then I guess lastly with respect to the provision expense with the outlook for continued positive growth in the loan portfolio, should we kind of look at the quarterly run rate and provision to be something similar to this quarter’s level?

Kevin Thompson

I think that’s probably a reasonable expectation. Our asset quality again kind of little bit stable or steady if you will from fourth quarter to first quarter here. But we are still working hard and expect some continued improvements over the remainder of the year and our allowance ratio is quite strong. So we think with our continued work there that we would expect to keep provision in check despite our growth.

Damon DelMonte

Okay. Great. So that’s all I had, thanks very much.

Kevin Thompson

Sure.

Don Hileman

Thank you.

Operator

[Operator Instructions] Our next question comes from Daniel Cardenas of Raymond James. Please go ahead.

Daniel Cardenas

Hey, good morning, guys.

Kevin Thompson

Good morning, Dan.

Don Hileman

Good morning, Dan.

Daniel Cardenas

Maybe some quick comments on competitive factors, what are you seeing out there in terms of your large and small competitors in terms of structural weakness if any, I know pricing is very intense. And is that causing you to perhaps to tighten your credit underwriting standards? And then if that’s the case, do you still think you can hit some high single-digit loan growth numbers given all of that?

Don Hileman

We still do, we still think we can generate those numbers with our current underwriting standards, which we think are pretty -- we will service well. The structural issues we’re seeing some compression in margin on variable rate loans, we’re seeing still some very aggressive fixed rate, longer kind of fixed rate on commercial deals from the rate standpoint we’re still trying to target what we think is the right rate on a standard durational basis, the longer terms and that’s very hard to compete and in some cases we don’t want to compete with that.

From a structure standpoint I think it goes back to I think we’ve said previously in the call that couple of years ago we were getting lot more personal guarantees on small business or business loans and now that’s harder to get. And a lot of these are going to be project specific guarantees rather than more global guarantees, we still ask us, still try to get it but our percentage is probably a little lower on that. And there is some other things that relate to the strength of the global position versus the project that are little harder to get than they were a few years ago.

Daniel Cardenas

And then just is that kind of across the board are you seeing the big banks and small banks to do it and what impact are credit unions having on loan growth if any?

Don Hileman

It’s pretty much across the board. I think we’ve already said if the smaller bank want some loan growth they will go and structure it to get it. So it’s not I wish I could say this one competitor is our biggest problem and that we have to deal with and figure out that, but it seems to be across the board on different things. Our credit unions are getting to be more of a competitor especially on the commercial side, and then we still see our market still very strong competition on some deals from firm credit as well.

Daniel Cardenas

And then as you look at your footprint expectations for the majority of growth to come out of the bigger the Fort Wayne, Toledo Columbus markets?

Don Hileman

I think that’s what we’re seeing and that’s what we would expect, because just if you look at from a market share standpoint we have a very smaller market here in those areas so the upside to grow at is greater than in some of our legacy markets. We think all of our markets will grow, but clearly the high opportunity and stronger growth rates will come from some of those metro markets.

Daniel Cardenas

Okay. And then as you talked about fee income and a focus on growing in insurance and wealth management expectations is that growth going to be entirely organic or do you see opportunities to make small acquisitions throughout the footprint?

Don Hileman

I hope and my plan is it will be both to grow organically and supplemental with acquisition especially on the insurance side. The wealth management side we clearly would look at possibility they are growing that through pursuits of [ph] acquisition as well. But we think we can still have a good organic growth rate and then supplement that through acquisition.

Daniel Cardenas

And in terms of acquisitions for those two areas are the pipeline is robust or is it kind of hit or miss?

Don Hileman

Hit or miss I wouldn’t say they were robust at all, I think it’s hit or miss we’ve had a lot of conversations going on some are more interested in others. So it’s clearly a hit or miss.

Daniel Cardenas

Okay. And then just on the credit side, I mean the numbers are good but are you seeing any weakness any of the predictive indicators that you look at?

Kevin Thompson

I would say no Dan, our delinquency continues to run really-really well versus historical comparisons. We’ve had still a loan or two here and there get classified, but the overall trend is still very positive in our portfolio. I don’t think we see any concerns on that front in terms of the performance and in terms of our underwriting as Don said we’re being pretty vigilant and we’re still getting good growth.

Our pipelines are still strong. We’re not going to win every deal, but we’re going to win the deals I think that we want to win and continue to be strong in our underwriting standards. So at this point, I think we’re very favorable in terms of our outlook in that regard.

Daniel Cardenas

Okay, great. Right guys, thanks. Good quarter.

Kevin Thompson

Thank you.

Operator

This concludes our question-and-answer session. I’d now like to turn the conference back to Tera Murphy for any closing remarks.

Tera Murphy

Thank you for joining us today as we discussed our quarterly results. We appreciate your time and interest in First Defiance Financial Corp. Have a great day.

Operator

The conference is now concluded. Thank you for attending today. You my now disconnect your lines.

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