Merchants Bancshares, Inc. (NASDAQ:MBVT)
Q2 2016 Earnings Conference Call
July 22, 2016, 10:00 ET
Geoffrey Hesslink - CEO
Marie Thresher - COO
Eric Segal - Interim Principal Accounting Officer
David Bishop - FIG Partners
Matthew Breese - Piper Jaffray
Welcome to the Merchants Bancshares' Second Quarter 2016 Earnings Conference Call. [Operator Instructions]. This call contains forward-looking statements regarding strategic objectives and expectations for future results of operations and financial prospects. They are based upon the current belief and expectations of Merchants' Management and are subject to certain risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements.
Please see the Forward-Looking Statements contained in the earnings release which identifies a number of factors that could cause material differences between actual and anticipated results or other expectations expressed. Additional factors that could cause Merchants' results to differ materially from those described in the forward-looking statements can be found in the Company's filings submitted to the SEC. All subsequent written and oral forward-looking statements attributable to Merchants or any person acting on its behalf are expressly qualified by these cautionary statements.
Merchants does not undertake any obligation to update any forward-looking statements to reflect circumstances or events that occur after the forward-looking statements are made. Please note that this event is also being recorded.
I would now like to turn the conference over to Geoffrey Hesslink, Chief Executive Officer. Please go ahead, sir.
Thank you. Good morning, everyone. I'm joined today by Marie Thresher, our Chief Operating Officer and Eric Segal, our interim Principal Accounting Officer. We thank you for joining us on our second quarter earnings release call. We're delighted to have you with us this morning. We're pleased with our results. Core earnings of $0.61 and reported return on equity of 11.3% are evidence of solid performance for our Company. We had a number of meaningful accomplishments in the second quarter. First, active balance sheet management resulted in an increase in our net interest margin. Additionally, although the loan growth was modest in the quarter, our commercial banking team made meaningful progress with the commercial pipeline and we're well-positioned for increased loan growth in the second half of the year.
And Marie is going to provide you some color on two other impactful accomplishments in the second quarter, namely completion of the NUVO integration and expense control. Marie?
Thanks, Geoffrey and good morning, everyone. We continue to execute our strategy on NUVO as we outlined in the January call. I'm pleased to say that we completed our conversion and operational consolidation activities on time and under budget. I'm even happier to say that our customers were pleased with the results of our new system capabilities and it gives us good credibility in that market. So we're positioned well as we move through the remainder of the year.
The last part of the NUVO strategy relates to our deposits and funding and there will be some more information on that later in the call. Part two of our execution is our story on discipline around expenses. We broke below 60% on our efficiency ratio in the second quarter. Our second quarter efficiency ratio was 59.72% which compares to 64.27% on a linked quarter basis and 65.42% year over year. We're pleased with our progress so far. We feel it's solid and we're getting the investment that we made in the last couple of years, but we remain disciplined in how we execute our strategy.
With that, I'm going to turn it over to Eric.
Thanks, Marie and hello, everyone. I will walk through some of the financials. Starting with the P&L, as Geoffrey said the Q2 income of $4.36 million is $0.62 per diluted share and that is up from $3.5 million and $0.50 per diluted share in Q1. And as in Q1 and year end before that, adjusting out the merger-related expenses and severance costs, brings us to core net income of approximately $0.61 per diluted share or $4.23 million. Return on assets was 0.9% for the quarter compared to 0.7% for Q1 and again 0.7% for the same period in 2015; a nice increase. As Geoffrey said, the return on average equity was 11.3% compared to 9.3% for Q1 and 9.7% for the same period last year.
Now on a core basis it's 11.2% which is up from 10.2% in Q1 and also the return on tangible capital is 11.4% for the second quarter. Our provision was flat on a linked quarter basis at $200,000. Net interest income was up slightly to $14.4 million and that's driven mostly by higher loan balances. And to echo what Marie says, the operating expenses of $10.8 million or $11 million on a core basis, reflects the completion of the NUVO merger and the difference between the GAAP and the core numbers is largely attributable to savings on the conversion and integration activities which were completed at lower costs than we originally estimated. Margin has improved to 3.08% which is an increase of 6 basis points from last quarter.
Business drivers here are asset yields offset by a slight increase in the cost of funds. However, it's important to note that the normal seasonal decline in the municipal business also reduced the average asset size. So if you normalize for that, the margin is 3.06% which is an increase of 4 basis points from the prior quarter. Also it's important also to note that purchase accounting accounts for less than 1 basis points of that margin. So the accretion and amortization is a very small impact. And the effective tax rate ticked up to 25.5% and that is driven by a change in the mix of income which tilted more towards taxable income as we grow the commercial lending faster than the municipal lending. Also the impact of low income housing credits has declined.
When you calculate that out it looks like 27%, but that is because we had to true-up our first quarter taxes which were booked originally at 23% which was our prior effective tax rate. Our effective tax rate on a year-to-date basis is 25.5%. Flipping to the balance sheet, the average loans have increased to $1.4 billion. It's an increase of $200 million over 2015 at this time. Remember that approximately $150 million of that is related to the NUVO acquisition, so that by subtraction shows a growth of around $50 million in the core Vermont franchise.
We have a seasonal decrease in total deposit that masks a year-over-year growth in total core deposits for Vermont franchise of about $32 million or 2.8%. And, as Marie touched on, the NUVO high cost CD portfolio continues to decline. $8.9 million left the bank in Q2 and there is still more to come on that. Tangible book value per share increased about $0.50 driven by earnings and mark-to-market gains in the securities portfolio.
So there is a summary financial review and Geoffrey will take it over from there to knit it all together for us.
Thank you, Eric. So I will touch quickly on the asset quality which I think many of you know is a pillar of strength and a core competency for our Company. The quality remains very strong. The non-performing loans stabilized at 34 basis points at quarter end. We have plans in place for all of our troubled assets and we expect material reductions in our non-performing loans over the second half of the year. Delinquency at the end of the quarter was very low at 6 basis points. It is our expectation that credit costs will continue to be nominal for Merchants Bank.
In terms of the outlook, we remain optimistic for the second half of the year. We do anticipate to hit our 5% to 6% loan growth objectives for the year. Obviously mathematically we will, that means we expect to see a higher rate of loan growth in the second half of the year and that will be driven by our commercial sector. The interest rate environment is a challenge. The asset yields are pressuring the margin. We expect that pressure will continue throughout the second half of the year. Our fee businesses in total are performing well and should continue with what we've experienced in the first half of the year. As Marie mentioned, expenses are extremely well controlled.
They will tick up a little bit from the second quarter level, but we expect to continue to have well controlled operating expenses. And last, Eric gave you some color on the tax rate. Our view is that 25% tax rate will hold in the second half here. That would be conditioned upon us buying some additional tax credits which we think we can accomplish.
With that, I'll conclude our prepared remarks and we would be delighted to take any questions that the callers may have of us.
[Operator Instructions]. And our first question will come from David Bishop of FIG Partners. Please go ahead.
Quick question, nice bump up in core profitability here hitting that about the 90 basis point bogey. What do you think that the next step is needed to get you to that 95 maybe 100-basis point ROA? Are there more cost saves you think available from NUVO or elsewhere or are you going to need some sort of Fed rate hike? Just curious what you are thinking in terms of profitability outlook and targets.
Yes, so a couple of questions there. In terms of the efficiency ratio, David, that's both revenue and expense. And we certainly always strive to get operating leverage of our business. We do think we can grow the revenue faster than the expense and that will benefit that efficiency ratio. ROA targets, yes, to move that ROA it's all going to be about growth for us. We will change the mix some, but it will be about loan growth and it can maybe move up a little bit for us.
And it looks like you have hit most of the NUVO cost saves. Any more efficiencies you can wring out of their legacy system there or have most of those expense saves have been realized?
We haven't seen the full benefit yet because that was only a partial -- the second quarter is partial of it and we will be well set up for the rest of the year. So we will see a little bit more gain out of that.
And I think there was some commentary regarding the NUVO deposit, their high-cost deposit, there was some runoff and repricing. Maybe just talk about what flowed out or reprice this quarter and what remains.
David, I can address that. This quarter was about $9 million. I think the exact number was $8.9 million that flowed out. Less than that for the balance of the year, but over the next two years there is still another $22 million to go.
Do you have the weighted average rate on that?
Off of the top of my head I will tell you that it is in the 1.3% range.
On the balance sheet again, David, we have taken the cash and we funded the loan growth we've had and we have also used some of that to replace the expensive Western Massachusetts CDs as they come up. That's been a nice trade for us. We've executed well on it. As Eric points out, there's yet a little more to go which will provide some more benefit.
How about on the core loan growth, accessing the municipal runoff here? Maybe talk about where you saw some of that commercial growth, how much actually was from that Springfield market versus the legacy Vermont market.
Yes, sure. That's changed a little bit, I'll repeat that we think we're going to hit our objective of 5% to 6% loan growth for the year. We're running first half of the year, absent the noise of the short term municipal loan outflows we grew a little over 2% in the first half of the year. We're going to see an accelerated loan growth rate in the second half of the year. It will all be in the commercial sector and when we spoke last quarter it was our view that on an absolute basis that growth was going to be half from Vermont and half from Western Massachusetts.
And that has changed in the last quarter. We expect Vermont to contribute closer to 75% to 80% of the absolute rate of growth and NUVO or the Western Massachusetts 20% to 25% of the absolute rate of growth. Stated differently, we expect that 4% or 5% in Vermont and a mid-teens growth rate in Western Massachusetts. So there has been a change in what we expect from the contributions of those markets.
Any sense of what's driving that change?
Sure. A couple things, frankly we had some elevated prepayments in Western Massachusetts. Some of those were call it credit initiated where maybe we had some influence on; there were some customer driven prepayments there as well. So those were unanticipated events that happened that occurred in the past quarter that will impact our rate of growth in that market. I guess the other thing that I can tell you that's impacting rate of growth we expect in Western Massachusetts is pretty intense pricing competition, David. It was an intense quarter for price competition in Western Massachusetts.
And I assume that is getting to the point where you just are to the point big incentive to just step away or pass on those types of credits, those deals?
Deals fell out of the pipeline because of price. Deals that we expected to happen didn't on rate.
[Operator Instructions]. Your next question will come from Matthew Breese of Piper Jaffray. Please go ahead.
There was a real nice pop in the margin this quarter. I know there is still some pressure on it as you look to the back half of the year. Could you just walk us through how you think that will play out, what kind of pressure we will see, especially considering some of the factors with the new low deposits?
Sure. Right there is still going to be some benefit from the NUVO deposits. And Matt if you -- so seasonally when you look at that 3.08% margin, I just want to recognize that seasonally our balance sheet contracts in the second quarter. So, some of that bump is due to that seasonal contraction in earning assets. And that will rebound, so really looking at the core margin up to 3.04% for the quarter. Where do we see that trending down over time, because again the pressure on the asset yields, as you point out we've got some opportunity on the funding side that will push back against that.
But we see a basis point, a quarter reduction in the margin going forward. And I guess the only qualifier I will put on that and that is that assumes that prepayment speeds remain pretty constant with the first half of the year and we've seen some of the movements in the market indices recently. We're beginning to see some very early stages of maybe accelerated loan prepayments or really repricing. So too early to make a call on that, but obviously if we have an accelerated rate of repricings that will put yet further pressure on that margin.
Okay. And then thinking about new loan yields, could you give us an idea of pricing? If you want to talk about specific markets or on a blended basis that would be fine, but new pricing for your typical commercial real estate deal and your scene ideal and I guess what I'm trying to gauge is as the yield curb flattened did you see spreads compress as well or did spreads hold up?
Yes, spreads compressed in the last quarter for sure and I wish I had Bruce Bernier on the call with me here. He's much closer to this. But spreads definitely contracted in the second quarter. In terms of our strategy, it has been a strategy we have had for over a year now which you understand, Matt and that is look, we have capacity for fixed rate assets on our balance sheet. We can assume some more rate risk.
We can take some duration on our balance sheet. We've decided to do that in the loan portfolio rather than the investment portfolio. So that has been effective for us. We've been able to offer mainly 10-year to 15-year fully amortizing fixed rates. That is where we gained our traction. So every bank is positioned differently and the pricing pressure all comes in different forms. That has been our strategy and it has been successful for us.
And then on those types of loans what is the gap between the existing yield on the balance sheet and the new yields coming on?
Yes, so I'm going to tell you that marginal loans are coming on at roughly 3.25%, maybe a little bit north of that. And that is a blended average. And look, the loan yields are higher that, they're in the high 3%s. Marginal asset yields are coming -- are below average asset yields in both the loan category and we weren't active in the investment front, but when and if we do buy investments I would expect the marginal investment yields will be lower than the average yield. So that is the asset pricing pressure that will continue for us.
Okay. Could you give us an update on the internal CFO search? What inning are we in and where are we in that process?
Sure. We're in innings six through nine somewhere. We've got some good candidates and we're hoping it doesn't go into extra innings. We're making good progress there.
My last question, with NUVO in the rearview mirror, how do you feel about future M&A? Is that something you will be more aggressively pursuing or status quo in terms of how you pursue M&A?
Yes, we're very excited about Western Massachusetts and with this integration complete we think that offers us a lot of growth potential. We're going to see a pick-up in business in the core line in the commercial banking, but remember we're going to introduce government banking expertise there and wealth management businesses. So short term I see us focusing on Western Massachusetts just because there is a wealth of opportunity -- we're just delighted with the market and the team we have there and we want to build that team out and have some fun in that market. That would be the short term view for us.
I'm sorry, just one last one on the expenses. Since it was a partial conversion or the conversion was completed halfway through the quarter, what is the trajectory on the quarterly expense run rate here?
I think it's going to run a little higher than it did in the second quarter. If you were to average the first half of the year, that would probably give you a good stepping off point for what it will look like going forward.
[Operator Instructions]. And in showing no additional questions, we will conclude the question-and-answer session. I would like to hand the conference back over to Geoffrey Hesslink for his closing remarks.
Thank you. Once again thank you all for joining us on the call. We're delighted to have you participate. Thank you for your interest in our Company. For those of you that own stock, we thank you for your confidence in us and your investment in our Company and we look forward to getting together with you all again in 90 days. Thank you.
Thank you, sir. Ladies and gentlemen, the conference is now concluded. To access the digital replay of this conference you may dial 1-877-344-7529 or 1-412-317-0088 beginning at approximately 12 PM Eastern time today. You will be prompted to enter a conference number which will be 10068684. Please record your name and company when joining. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.
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