United Community Financial Corp. (NASDAQ:UCFC)
Q2 2016 Earnings Conference Call
July 20, 2016 10:00 AM ET
Gary Small - President and CEO
Tim Esson - CFO
Matt Garrity - EVP, Commercial Lending and Credit Administration
Scott Siefers - Sandler O'Neill & Co.
Michael Perito - Keefe, Bruyette & Woods
Good morning, and welcome to the United Community Financial Corporation's Second Quarter 2016 Earnings Conference Call. At this time, all lines are in a listen-only mode. A question-and-answer session will follow this presentation. [Operator Instructions] Please note that this event is being recorded.
At this time, I would like to turn the conference call over to Mr. Tim Esson, Chief Financial Officer of UCFC and Home Savings. Mr. Esson, the floor is yours sir.
Good morning, and thank you for participating in today's conference call. Before we begin, I'd like to take the time to refer you to the Company's forward-looking statements and risk factors, which are on the screen in front of you or can be found on our Investor Relations Web site at ir.ucfconline.com. The statement provides the standard cautionary language required by the Securities and Exchange Commission for forward-looking statements that may be included in today's call. Also a copy of our first -- second quarter earnings release can be obtained at ir.ucfconline.com.
I would now like to introduce to you Gary Small, President and CEO of both UCFC and Home Savings.
Thank you, Tim, and good morning to all and thank you for joining us today. Much has changed in Northeast Ohio since we last spoke. The Cavaliers are World Champions, the Indians are in first place in their division and the Republican National Convention is in full swing, and the greater Cleveland area has really had a chance to shine. And fortunately the news from Home Savings corner is the continuation of that theme, very good news.
For the second quarter, the Home Savings team delivered outstanding performance and the number speak for themselves. We saw net income growth to $5.3 million for the quarter. Our ROA was in excess of 1% for the quarter. Loan growth across all of our business lines was very strong, and fee income continues to climb, be it deposit fees, electronic fees, investment income, each were up double-digit over the prior year for the same period. And our residential mortgage activity remains very strong and Matt will cover that in detail a bit later on.
Net interest margin continues to improve and on an overall year-to-date basis our pretax pre-provision earnings is up 27% over last year for the six-month period. So very good momentum. I'm pleased to report revenue related tactical initiatives are performing as expected. Our expansion into the insurance agency space is going well. We've developed our mezzanine debt capability and actually have paper in place at this point in time. Our indirect dealer lending auto balances are on the move, and the expansion of our residential mortgage footprint in Morgantown, West Virginia that we mentioned on our last call is doing very well and actually in June had an outstanding month over $6 million and certainly feel good about the prospects of doing $80 million to $100 million in that market on a full-year basis.
We are seeing more small business activity, that’s credits under $500,000 for us than ever before. June was sort of a bellwether month for us. We probably did double the volume that we've done to that point and that was a very purposeful effort. Also I’m very pleased with the manner in which we are achieving this success. You'll see that we have very strong operating leverage. Year-to-date revenue is up over 10% versus last year and expenses when we adjust for the insurance agency acquisition continue to run in the 1%, 1.5% range versus last year per our original guidance. So great operating leverage and it's consistent with the results that we’ve been posting over the last few quarters and matches our near-term expectations.
Obviously, there are significant challenges for the banking industry and we're not immune. Second quarter, we recorded $275,000 hit related to a markdown on our MSR valuation as the 10-year Treasury drop significantly for the second quarter in a row. This brings our year-to-date MSR mark to about $725,000 unfavorable. And when you combine that with the accelerated amortization of our servicing portfolio that just comes with all the refis and so forth that are done.
We've had close to a $900,000 in unexpected unfavorable marks relative to that activity. However, we’re overcoming. We've taken steps to mitigate the situation. We moved more quickly than we had originally planned into our tax exempt portfolio from our government securities position. Gain on sale associated with that repositioning has helped out as we’ve also been able to improve margin with that move. We have tweaked deposit rates down and we’re doing a great job managing expenses. So every year brings us challenges. This year, it's MSR and we are finding ways to work through that.
Now I will turn the call over to Matt Garrity, and he will provide some more color on our lending and asset quality progress.
Thanks, Gary. I will be updating you on our performance in the commercial and residential lending businesses, as well as providing comments on asset quality. Our commercial business had another strong quarter both in terms of loan production and portfolio growth. Total year-to-date loan originations through June 30, are running approximately 30% ahead of same period last year. Balance growth for the second quarter was healthy at 7.5% for the quarter with year-to-date balance growth coming in at a strong 18.3%.
New commercial relationships established during the first half of 2016 were 97% higher than the first half of 2015. As a result, we are also showing growth in commercial deposits, which increased 11.7% for the first half of 2016. Unfunded commitments grew in excess of 14% during the quarter and on a year-to-date basis have increased by close to 35%. Activity across all of our major markets remains solid.
During the second quarter, we also successfully closed our first mezzanine loan transaction as part of our newly launched initiatives into this business line. While this product will be relatively modest compared to our core commercial lending business, we believe this portfolio segment will continue to highlight the value proposition we bring in commercial banking compared to other like-sized institutions, as well as provide an opportunity to improve interest margins. While the market remains competitive, we remain pleased with our performance levels through the first six months of 2016 and expect continued achievement for the balance of the year.
In our residential lending business, we experienced a strong quarter in loan originations. Mortgage loan production in the second quarter increased over 65% compared to the first quarter and over 26% compared to the second quarter of 2015. We experienced solid year-over-year improvement in our Pittsburgh and Columbus markets and we're off to a strong start in our Morgantown market, which we launched during the first quarter.
Pipeline levels remain good and as of June 30 we're running approximately 27% ahead of this time last year. In consumer lending, our core retained portfolio continues to show solid growth as balances in this segment grew over 4% for the quarter. Most notably, our auto portfolio grew during the quarter by over 42%. This is consistent with our strategic plan to grow the segment by expanding our business with high-quality loans sourced through local auto dealers.
Asset quality was stable during the second quarter as our NPL, NPA, and delinquency ratios, all showed small improvements for the quarter. Charge-offs fell back into line during the quarter consistent with our expectations coming in at 4 basis point. Our current outlook is for continued stability in our portfolio in terms of asset quality.
I would now like to turn the call over to Tim Esson, who will discuss our financial performance in greater detail.
Thanks, Matt. What I'd like to do now is touch on a number of financial highlights from the second quarter. As Matt pointed out, we've experienced really good solid loan growth in the quarter. Total loans including loans held for sale increased $182 million or $14.5 to $1.4 billion at the end of the current quarter compared to the same quarter last year. This increase would amount to 13% on an annualized basis.
Deposits on the other hand, increased $16.5 million to $1.5 billion or little less than 3% on an annualized basis during the first six months. As in the past quarter, we continue to see movement -- improvement in growing public funds. At the end of the quarter, public funds had increased 46% to approximately $122 million from the same quarter last year.
We also have enjoyed the benefit of non-interest-bearing checking accounts increasing approximately $30 million during the quarter. Additionally, as planned, we have seen an increase in business deposits of $14 million during the first half. This change in the deposit base mix over time has allowed our overall cost of deposits to drop to 41 basis points.
Let's move on to that net interest income. As I've indicated, we've seen a drop in our overall cost of deposit since year-end to 41 basis points, and along with a solid increase in the level of average net loan balances. That said, net interest income was up $15.5 million or 12% on an FTE basis from last year at this time. Looking at the first half of the year, net interest income was $30.5 million, up 10% compared to the same time last year.
Our current net interest margin of 3.25% did increase from the 3.16% reported in the second quarter of 2015. This increase was due to realizing the benefit from the prepayment of high cost debt in the fourth quarter last year and the decline in our cost of deposits. We also saw an increase in the margin in the first half of the year to 3.23% when compared to the 3.20% for the same period last year.
We will continue to take steps to mitigate the impact of the current challenging interest rate environment experienced by us and the industry as a whole, as low interest rates in the economy put pressure on the yield on earning assets, we will continue to manage the mix and volume of earning assets and funding to address these headwinds. These changes in mix, along with further growth of our balance sheet should allow for steady increase in our net interest income even as expansion of the net interest margin will remain challenging, should rates continue at these levels.
The provision for loan losses was $395,000 in this quarter compared to $2.2 million in the first quarter. I am pleased to say net charge-offs in the second quarter totaled only 4 basis points. The first quarter included the impact of the charge-off of a long held commercial real estate loan. Considering that charge-off, charge-offs to average loans were a little less than 46 basis points for the first six months. Going forward, we would expect to see a more normalized level of charge-off activity.
Net interest income was $5.8 million in the second quarter of 2016 compared to $5.3 million in the second quarter of 2015. Favorably impacting the change was the benefit of insurance agency income of $516,000, coupled with a 21% increase in debit, credit, and ATM card fees, along with a 60% increase in brokerage income.
We also recognized security gains of $233,000 in the quarter as we realign the investment portfolio to include higher-yielding municipal securities. But we did see very positive trends in noninterest income, we did experience some offsets to these gains. We saw a negative impact from the change in the valuation adjustment of mortgage servicing rights. This change totaled $498,000 at the end of the second quarter compared to the same time period last year. The negative change for the first six months was $772,000 when compared to the first six months of '15.
Additionally, but to a lesser extent, mortgage banking income was down $172,000 in the first quarter and $343,000 for the year. Noninterest expense was $12.9 million in the second quarter of 2016, an increase of $652,000 from the second quarter of '15. Included in this increase of $652,000 or expenses of $307,000 related to the operation of the insurance agency we acquired in early 2016.
After considering the acquisition of the insurance agency earlier in the year, noninterest expense was essentially flat in comparison to the same period last year. Overall, our efforts at controlling the expense base have been very successful. These efforts continue to translate into lowering of our efficiency ratio to 60.8% in the second quarter of '16 compared to 63.4% at the same time last year.
With continued growth in revenues in 2016 and continued expense management, we believe there is still more room for improvement in the efficiency ratio during 2016.
Thanks -- thank you, Tim. Good summation. I would just say for Home Savings in general, we developed a much more diverse business model over the last 24 months in addition to our traditional very strong residential mortgage program. And we’re really benefiting from those efforts today and we're better positioned to continue to deliver strong performance going forward in some less than certain times.
As is our custom, before we move to the Q&A session, I will comment on our vision for the remainder of the year. I will affirm the guidance for full-year earnings that we laid out earlier in the -- beginning in January. I expect we will deliver a 15% EPS growth for the year versus '15. Expect double-digit loan growth to continue with commercial growth being up for the full-year in excess of 35%. Earning assets in total in the 8% plus category, which is consistent with our earlier comments.
Revenue, we’re looking still at 12% with material upticks in deposit fees, interchange income, and residential mortgage fee income. The wildcard there is MSR valuation. I think, I said in the last call, it's hard to imagine that we will see that one again, and by gosh, we had another hit in the second quarter, but we closed it. I think 149 on the 10-year at 6/30. It seems to be the floor. So, hopefully no noise relative to that for the remainder of the year.
Expenses, as Tim mentioned, are doing very well. Insurance agency aside, apples to apples will be up less than 1%. I think from a run rate perspective, we're very comfortable with $52 million for the year as an expectation as we sit today. And as mentioned, net charge-offs 4 basis points, very consistent with the direction we were trying to get following the first quarter. I don't know that will match for going forward, but it's going to be very good. And I think for the full-year the guidance we gave at the end of the first quarter of 27 basis points plus or minus a couple bps is still good. And we have a lot of indicators credit wise in our portfolio to review each month and they all just continue to get stronger and stronger. So there is just nothing on the horizon that gives us pause for thought on the credit front.
So with that said, we will turn it over for questions.
Thank you, sir. We will now begin the question-and-answer session. [Operator Instructions] The first question we have comes from Scott Siefers of Sandler O'Neill & Co. Please go ahead.
Good morning, guys.
Good morning, Scott.
Gary or Tim, I was wondering if you guys -- I mean, you’ve done a tremendous job with the margin over the last couple of years. Was wondering if you could just talk about some of the additional -- either opportunities or support factors you would see going forward. I mean, obviously, the rate environment is not getting any easier, so just curious as to your thoughts on opportunities or support factors
Scott, it's Gary. I will take that one. It's similar to our earlier story. It's no one factor. It’s a multiple of item approach that we hope will give us 0.5 bp to a 1 bp at a time. Examples of that, Matt mentioned, our mezzanine product. Balance wise by the end of the year we will see something more meaningful than we have today we just kicked it off. And you know the mezz debt, its well underwritten. It's -- we do it on a real estate side. That goes off at 12% to 14% at an interest rate level. You'll see more unsecured paper on our consumer side well-written, all 6/85 goes and above. That's going off at double-digit rate increases. So on the asset side, there is a number of things we're doing just by adding product to our compliment that help us out. It will take a while to build the balances, but it will be meaningful over time. And we expect to see some of that before the end of the year. On the funding side, I wouldn't be surprised to see us take another swing at our deposit pricing, on the liquid pricing and so forth for a bp or 2 pickup. We’ve experienced that already this year, and we’ve got a little room. We have -- still have a few high-cost CDs back from the bad old days that are rolling off at a couple $3 million a year and we're repricing them, just a tick above current market to encourage folks to stay with this balance wise, but that’s been a real pickup. And in our public funds sector, we continue to see great growth as we reenter that marketplace and that comes -- just the product mix that comes with public funds we're playing liquid rates of 30 basis points and we're getting free balances with that as well. So just the combination of that business mix with what we’ve got brings our cost of funding down. So that’s a sample of all those added up, it's a 0.5 bp here. It’s a bp there. What’s working against that is obviously the mortgage market and we hold a large portfolio. So as there is refi activity out of 30-year-old paper, you’re swapping 5.5% rates for 3.25% rates and every quarter I think surely we're done with that -- and we're feeling less and less of it each quarter, because it's been such a constant drumbeat. But that’s the headwind that works against us on mortgage rates. Its less now than it was last year, but I've stopped predicting the impact of mortgage paydowns. So, that’s the falling knife that we're always aware of and working into our thoughts.
Okay. That’s terrific color. Thank you. And then, if I could do a follow-up, just wanted to get your thoughts on mortgages as it relates to the fee base, just given the dip we had in the long-end of the curve toward the end of second quarter, just curious what your outlook is for the second half of the year? In other words, do you see a noticeable improvement in the pipeline, for example? And then conversely, just with rates and the MSR, Gary, in your prepared remarks you made a number of comments about things you’re doing to sort of mitigate the negative impact on the MSRs, but just curious as to sort of what inning you think you’re in kind of resolving that as a headwind in your own mind?
I will ask Matt to comment on the status of our pipeline relative to our residential and even our commercial business a little bit to give you a flavor of the trajectory now versus prior quarters.
Hi, Scott. This is Matt. When we look at our residential pipelines right now, we’re actually very pleased with where we’re at. As I mentioned in our remarks earlier, our pipeline as of June 30, versus same period in the last year is up about 26%. So we’re very happy with the trajectory that we're seeing and that activity into July remains very solid for us. So, we feel good about how we’re lining up on a production side in the mortgage business for the second half of the years. Certainly across our markets we're seeing good activity and we certainly have gotten a nice lift initially from our startup in West Virginia, in the Morgantown market. They’re probably hitting the ball a little harder out of the gate than we’ve probably modeled, and we think there's more for us to get there. So we're very happy with that. And then as Gary mentioned, in our commercial business, our pipeline activity remains solid. It remains solid in all of our major markets. Still very competitive market out there, but we continue to be selective about the opportunities we pursue and remain solid in terms of our asset quality focus. So we're very happy with the level activity that we're getting given the market conditions.
Scott, on the MSR front, I guess I will step into it again. As long as the 10-year stays north of 149, I don't expect anything bad relative to MSR going forward. We're not going to make a full recovery of the 900 pain because some of that’s amortization and I don't see the 10-year going back to 230 or wherever it was at the end of the year. But our forward-looking statements for the remainder of this year, anticipate no real recovery of that MSR markdown. It’s a temporary markdown. If somehow we did bump back up to a 180 or 190 10-year, that might be 300,000 or so coming our way as a reversal of that mark. But again we are not counting on that happening or we are figuring out a way to win and to hit the goal that we set for ourselves for the year without regard to that $900,000 that we’ve taken so far.
Okay. Perfect. All right. Thank you guys very much.
The next question we have comes from Michael Perito of KBW.
Hey, good morning.
Good morning, Mike.
Gary, so a question on the -- and you guys kind of commented on it already, but just as you kind of look out and it sounds like the pipeline activity is strong and there is still some opportunities to reprice on the funding side and maybe kind of remix the cost of funds down. I mean, how do you balance that against obviously a strong growth outlook? And as your balance sheet capacity kind of decreases with that loan-to-deposit ratio moving up, can you maybe just provide some color on how you guys are thinking about that?
I will take that in reverse. It's -- we would still anticipate that we'll see our securities portfolio portion of our balance sheet drop $30 million to $40 million annually through the normal mortgage-backed security amortization and the maturation of our treasuries. We're spiked a little bit in the second quarter, because when we did make that we accelerated our move into tax exempts. We were going to do $10 million a quarter over -- nice dollar averaging, nice academic approach as we took money out of our government securities portfolio at 2% and reinvesting it in tax exempts at a 3.90% to 4% FTE margin, and with things that happen with the 10-year, we decided, well let's do all that in the first quarter or darn close to it. And we actually expanded our balance sheet maybe $15 million or $20 million to get that done quickly. So the fact you haven't seen a shrinkage in that portfolio to date, doesn’t mean it's not there. We just -- from a timing perspective, juiced it a little in the first half, but you'll still see that $40 million becoming available each year and we may make -- take some steps as loan demand is there I will swap 2% securities rate for Matt's 4.25% commercial on portfolio every day and we will take those steps. We are paying attention to our loan and deposit ratio and our core positioning again with the public funds and so forth, its great funding and we think at a portfolio level its meaningful. But if you’re scoring true just core deposits, some of those balances come in pretty large, and that’s why we want a portfolio of them not one or two big customers but that gives us comfort. We got tons of liquidity and we also look at financial institutions out there that are in the market that can bring us some core deposits in an M&A fashion. And I think that's always been part of our three-year plan that there'll be a point where we won't necessarily want to just keep borrowing on our liquidity and access to funds outside of the core realm, but it will start to move more strongly into the M&A discussion is a way to fund our additional growth. Through the end of next year we're good. Next year being '17, but it is on our radar that we pay attention to our loan deposit ratio.
And any updates you can provide on kind of what you’re seeing out there in the M&A environment? I mean, I did notice there was the announcement from DOJ on the [indiscernible] deposit divestitures, but anything else that you guys are -- are you feeling a bit better about what’s out there given the current rate environment, and we’ve seen some banks opt to sell, I mean, any color or update you guys can provide on that front?
Mike, I’d say in the Northeast Ohio market the activity levels really no different than it was last year at this time and certainly the FirstMerit-Huntington deal is sort of the that's an outsized opportunity and unique, but beyond that the normal activity at the bank level feels very consistent. We've been active. We chose to step away on a couple at some point, but we were right there. And what I would say is that the size of organizations we're looking at, there are still plenty of cash only or 50-50 cash/stock deals that help us relative to our currency trading a little bit below our peers. At these size deals and with the cash components that we're seeing we're very competitive in the process. But we do have our internal discipline where we will pack it up at some point if we can't get the number of the workforce, but there's activity in the market today.
Okay. And then, maybe just one last one for me. I mean, just looking at the insurance commissions this quarter of about $516,000, it seems like it may be tracked a little bit ahead of some of the initial guided range that you guys were providing. How do you guys think about the growth opportunity there now that the business is kind of combined with yours? Have you guys started to see any progress on cross-selling with your commercial clients, or has it pretty much just been all organic growth on the insurance end?
To this point, it would be more on the organic side. I'd still telegraph the full-year of that particular firm at $1.8 million or so on the revenue side. It can be lumpy from quarter-to-quarter. We are moving more quickly on the commercial side than we are actually on the consumer side in that we can share information immediately from a privacy standpoint and put our commercial guys with the insurance guys and compare clients and go right at it. It's just a long sales lead-time, Mike. You’re committed to your insurance on an annual basis. The good news there is each year it comes up for renewal and you can do an RFP and make a switch and be in good shape. We've seen opportunities. I don't think we will start ringing the cash register on that in a noticeable way until maybe this time or in the first quarter next year, you start to see the cross-sell benefit of some of that commercial business just because of the long sales lead-time that’s there. On the consumer front, we got privacy notices going out that have already gone out this month, which allows us to start marketing in an appropriate way between our 50,000 plus core bank clients or 15,000 residential mortgage only client and so forth and all the new business that we bring in. We just have to be very methodical and very disciplined about the way we do that because there are so many regulatory privacy rules around the consumer side, but it will come.
Perfect. Thank you. As always, appreciate it.
[Operator Instructions] At this time, it appears that we have no further questions. We will go ahead and conclude today’s question-and-answer session. I’d now like to turn the conference call back over to Mr. Gary Small, President and CEO for any closing remarks. Sir?
Well, again thanks everyone for joining us this morning. We're obviously very pleased with the quarter. I hope it feels in the neighborhood of what you're expecting coming out of our first quarter. We remain very optimistic on the second half and as we start thinking about '17 and '18 in our strategic planning process, again, I would say it's just a continued evolution of the three-year plan that we have had in the past and things are going as expected and we continue to see great opportunity. So I think next quarter I would expect we will sit here and have another good call. So, thanks -- thank you very much and have a great day.
And we thank you sir, and also the rest of the management team for your time today. The conference call is now concluded. At this time, you may disconnect your lines. Thank you. Take care and have a great day everyone.
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