First Commonwealth Financial's (FCF) CEO Mike Price on Q2 2016 Results - Earnings Call Transcript

| About: First Commonwealth (FCF)

First Commonwealth Financial Corporation (NYSE:FCF)

Q2 2016 Earnings Conference Call

July 27, 2016 02:00 PM ET

Executives

Ryan Thomas - VP, Finance & IR

Mike Price - President & CEO

Jim Reske - EVP, CFO & Treasurer

Bob Emmerich - EVP & CCO

Mark Lopushansky - Chief Treasury Officer

Analysts

Bob Ramsey - FBR Capital Markets

Matt Schultheis - Boenning & Scattergood

Collyn Gilbert - KBW

Operator

Good afternoon, and welcome to the Second Quarter 2016 Earnings Release 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 Ryan Thomas, Vice President of Finance & Investor Relations. Please go ahead.

Ryan Thomas

Thank you, Nickel. As a reminder, a copy of today’s earnings release can be accessed by logging on to fcbanking.com and selecting the Investor Relations link at the top of the page. We have also included a slide presentation on our Investor Relations page with supplemental financial information, as well as a slide deck for today’s branch acquisition announcement that maybe referenced throughout today’s call.

With me in the room today are Mike Price, President & CEO of First Commonwealth Financial Corporation and Jim Reske, Executive Vice President & Chief Financial Officer. After brief comments from management, we will open the phone for your questions. For that portion of the call, we will be joined by Bob Emmerich, our Chief Credit Officer and Mark Lopushansky, our Chief Treasury Officer.

Before we begin, I would like to caution listeners that this conference call will contain forward-looking statements about First Commonwealth, its businesses, strategies and prospects. Please refer to our forward-looking statements disclaimer on Page 2 of the slide presentation for a description of risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements.

And now, I would like to turn the call over to Mike Price.

Mike Price

Hi. Thank you, Ryan. And welcome to our second quarter earnings conference call. We appreciate your interest and investment and time in First Commonwealth. Joining me this afternoon is Jim Reske, our Chief Financial Officer. This morning we reported second quarter earnings of $0.14 per share with $12 million, which was in line with the previous quarter. Despite some good underlying performance trends earnings were negatively impacted by $7.5 million specific reserve for a mine safety equipment supplier whose revenues are closely tied to the coal industry.

This morning, we also announce the acquisition of 13 branches in Canton and Ashtabula, Ohio from FirstMerit. This opportunity stems from the proposed merger of Huntington and FirstMerit announced earlier this year. This acquisition brings us $735 million in deposits and $115 million in consumer and small business loans. More importantly, these branches will add 34,000 new consumer business households and another platform to build upon. We anticipate that this branch acquisition will complement our loan production office in Cleveland, our mortgage loan production office in Stow, Ohio, our bank in Columbus and our mortgage LPO in Dublin, Ohio.

I will begin with the trends in the second quarter and then speak to the acquisition, before turning the call over to Jim. Net interest margin remained relatively stable at 3.27% and net interest income grew for the fourth consecutive quarter. Loans grew at 4.2% annualized. As we reflect in the strong growth year-to-date the bulk is occurred in commercial real estate to include construction followed a modest bump in C&I lending.

Deposits grew 8.6% annualized. Expenses remained flat to down at 37.4 million despite our continued commercial and mortgage build out it will higher. The efficiencies fell below 58%, fee income increased 1.8 million on a linked quarter basis, this is due impart to improved mortgage gain on sale income as well as better interchange income in strong corporate banking fees. Our mortgage platform just crossed $50 million in booked quarterly origination as that business continues to scale up steadily.

Standing in the way of a strong quarter was $10 million provision expense, spending largely from $7.5 million specific reserve or the $10.5 million loan to mine safety equipment supplier whose revenues are closely tied to the coal industry. We were one of four regional banks in a $55 million facility that we moved to non-accrual this past week. The credit had previously been identified as sub-standard but was still accruing, this followed several quarters of heightened credit cost that stem largely from the deterioration in three energy related credits and one steel servicing company.

I cautioned during our call last quarter, that we could experience additional strain as we continue to work through a handful of credits that have been negatively impacted by the downturn in energy and commodity prices. This particular credit was the largest of the problem loans that we have been monitoring closely.

Shifting gears to our acquisition of 13 branches in Northern Ohio, this is a logical continuation of our Ohio strategy in a continuous market that we know well. The demographics are similar to Pennsylvania with a little stronger growth. The execution risk is low however we assume some 10% run-off in deposits between announcement and closing. The branches will provide over 700 million in low cost funding enabling us to pay down borrowings and helping us lower our loan to deposit ratio from 112% to below 100%. This opportunity is immediately accretive to earnings with a healthy IRR. We expect to earn back the tangible book value dilution in less than five years.

Like our Columbus acquisition last year, these branches in Canton and Ashtabula will serve as the platform to build our mortgage brokerage and business banking capabilities. Once the deal closes which we expect will occur in the fourth quarter of this year, we should have approximately $680 million in loans and $750 million in deposits in the State of Ohio. These 13 branches are appreciably larger in deposit footings than our current average and are already surrounded by mortgage lending offices I mentioned earlier in Stow Ohio and a commercial loan production office in Cleveland. This is good measured progress, considering we hung our first sign on the building in Northern Ohio, just two years ago with the opening of our business center in Cleveland.

With that I’ll turn it over to Jim.

Jim Reske

Thanks Mike. We are excited about this branch transaction that we announced this morning and the long-term opportunities it presents. I’ll discus the transaction in some detail in a moment. But first let me say a word or two about the second quarter. Mike has already addressed credit, but few other items are worth mentioning. First, spread income was up slightly compared to last quarter, benefitting from the strong loan growth early in the year and a relatively stable margin. Deposit growth was actually much stronger than loan growth in the second quarter, reducing the loan to deposit ratio slightly from 111.7% at March 31st to 110.5% at June 30th. Average loan balances grew by 88.1 million, while total average deposit balances grew by 131.6 million.

Non-interest expense of 37.4 million was down $700,000 from the first quarter and benefited from the previously announced retail restructuring, which was in full progress in the second quarter. We expect non-interest expense to normalize somewhat in the remainder of 2016 at a level that is still below our $40 million quarterly target, before taking into account the effects of the branch transaction that we are announcing today. In sum, our revenue growth combined with effective cost containment is helping us execute on our goal of sustainable positive operating leverage, which we have now achieved for four quarters in a row.

Now let me turn to the transaction. From the moment that we learned about the opportunity to acquire these branches several months ago. We understood that this represented a unique opportunity for the company in four ways. First, it builds on our successful Ohio expansion strategy and is consistent with our previously announced strategy to expand in contagious geographies in Ohio, adding to our branch presence in Columbus, our commercial loan production office in Cleveland and our mortgage loan production offices in Suburban Akron and Suburban Columbus.

Second the deposit and loan mix here is very attractive, only 4% of the deposits are time deposits and 36% are transaction accounts. The loans we are acquiring are all associated branch households and have a yield of over 4%. Third, ideally the cost of funding to pay down short-term borrowings, the acquisition will result in minimal expansion of our balance sheet. We will in connection with the transaction, discontinue the remaining authorization on our buyback program, as the transaction is more accretive than the buyback and represents a more strategic use of our capital.

And fourth and finally, the replacement of short-term borrowings that have a three month duration, with core deposits that have a duration of approximately five years, will add to our asset sensitivity. We intend to monetize some, but not all of this asset sensitivity by moving some of our variable rate assets further out in the yield curve through the use of macro swaps, this is nothing new for us. As we successfully executed this strategy several times in the past few years and even after we do the swaps, it will be more asset sensitivity than we are today.

In terms of financial impact, we don’t want to explicitly forecast earnings but I will provide some direction for you. On the revenue side, we are going to replace short-term borrowings with the deposits we are getting here. We are also getting $150 million loan portfolio, which we will obviously grow overtime, so that will provide some additional interest income. These two items together drive approximately 6.3 million in additional spread income in the first year, which we expect will grow overtime. We anticipate approximately $1 million of additional spread income from the macro swap strategy that I mentioned earlier, along with roughly $0.5 million of accretable yield.

We expect to see incremental fee income of approximately 1% of total deposits. And on the expense side, we expect that this will add approximately $6.5 million to $7 million in operating expense annually. In addition to amortization expense associated with the core deposit intangible that we will be creating here. The result of the transaction that strategically is a perfect step and financially is quite compelling. Mike already mentioned that it is immediately accretive to earnings and provides a healthy IRR. The transaction also provides a meaningful improvement to ROA, ROE and the net interest margin accelerating our financial progress.

And with that, we will take any questions you may have.

Ryan Thomas

Questions from the group.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Bob Ramsey of FBR. Please go ahead.

Bob Ramsey

On expenses, obviously a really good quarter on the expense front, I know you said in the prepared comments that expenses will probably normalize below the $40 million level you all had talked about in the past, before adding on the transaction. Could you just provide a little more detail on sort of what you are thinking about the expense level for your legacy operations because you are well below 40 million this quarter? And now that you have got the efficiency ratio, I mean really in the mid-50s, I mean sort of where does that normalize a little bit higher here too, and how are you thinking about efficiency today?

Mike Price

Well, we are probably down about 118 FTE year-over-year that’s impart due to what we are doing in our branches and our transformation there with our staffing model. And we expect that we will staff up a little bit between -- we will probably take half of that 118 back. And we are looking really to pay for our investments to include this acquisition and I think Jim and we are estimating this is going to add about $6.5 million in cost that will really hit the ground in the first quarter of next year.

Jim Reske

Yes.

Mike Price

So hopefully we can compensate for that and still be around the $40 million mark.

Jim Reske

Yes. And as we get closer to closing the acquisition, we will provide further guidance, to the extent that we are able to and so there is always a little bit of noise going on in the non-interest expense and different things that are so it is hard to kind of pin it down to the dollar and I know we have been below our $40 million target. So when we say below $40 million target, you can think of that as a $40 million kind of range for the normalized non-interest expense. There was some benefit this quarter as this whole retail restructuring was unfolding as Mike just mentioned, there is going to be some additional hiring that’s going on, so I think it we will normalize a little bit higher than that, but not tremendously so. And then we expect to use those savings and enable us to hire other people and pay for those other investments in the business going forward.

Bob Ramsey

Okay great. And then I know you have talked today and the past about sort of realigning the branch staffing etcetera, I think you guys said with the branches you are acquiring that there are not any a planned layoff. I am just kind of curious, how the staffing model in the FirstMerit branches compares what where you guys are going or you have gotten to at First Commonwealth?

Mike Price

They have more staff, but they also have more customers per branch and transaction and they also have a very nice robust non-interest bearing and savings book of business they have very little time. And I think they are running on the $60 million per branch or about 57-58. And we are really running well short of that probably just a little over 30 million.

Jim Reske

Yes, I'd say something like a little over $40 million.

Mike Price

Yes, and so they will need a little bit more staffing and we will keep that staffing in place at least for a year.

Bob Ramsey

Okay great. And then I know you talked about the -- with using this to deploy capital that you were going to scale back or discontinue share repurchases in the immediate term. What is the pro forma TCE when the deal closes do you have that number by any chance?

Jim Reske

Yes. The pro forma tangible common equity ratio will get close to 8%. It looks like the deal will have about roughly 60 basis point impact on tangible common equity. Now we’re going to make a little money retain earnings between now and the end of the year and, because we expect to close this transaction in the fourth quarter but there will be definitely an impact on tangible common equity.

Operator

Our next question comes from Matt Schultheis of Boenning. Please go ahead.

Matt Schultheis

Sort of away from the deal a little bit, you did have very strong deposit growth in the quarter I am just was wondering if you could shed some light into whether you’re running specials, whether you’ve got some new relationships that brought in large balances or what the drivers upon that were?

Mike Price

Really two things, we’ve really refocused our branch staff on deposit gathering quite simply. We also hung a little rate and then we pulled back the rate pretty quickly and we were just testing the price elasticity of deposits, but that was probably two-thirds of the growth and then probably the other third was just more accounts. We grew our households I think in the second quarter about 67 basis points for almost 1%, which was a nice outcome as well.

Matt Schultheis

Okay. And then back to Bob’s question about branch staffing. As we look forward can we -- and excuse me, if you’re already down this path a little bit, can we expect some more technological advancements, we’re seeing smart kiosks being put into certain branches and other technology that effectively are replacing branches. Have you started down the path, can we expect to see more of those investments, if you have or what’s your attitude about them?

Mike Price

Yes. We just opened a new branch in our downtown Greensburg office. It really has enhanced ATM and other new technologies for customers. We also are really focused on really getting our mobile our bill payment percentages up in past years. And just really image ATMs will be a big part of the answer. We’re also looking at smaller footprint branches with appreciably smaller square footage. So kind of all of the above, I think the most important piece is to get the staffing scaled to the transaction volume, which has decreased in the branches, that’s actually gone up in ACH, mobile and another in mobile remote deposit capture in other places, so just trying to scale it for what the customer preferences. We’re also freeing up and we have a close eye on expenses simply because we have to have continued to invest in digital, which we’ve done.

Operator

Our next question comes from Collyn Gilbert of KBW. Please go ahead.

Collyn Gilbert

I wondered if you could Mike just give us a little bit of color as to what you’re seeing in the loan growth buckets. And what your outlook is there and if you feel like these deposits, I know you kind of ran through some of the accretion that you expect. But if you think these deposits could accelerate, your kind of longer term loan growth views, but just curious get a little bit more color there on the loan side?

Mike Price

Yes. I think the branches will help accelerate our loan growth in Ohio. I think the slide deck that we provided you we go from about 145 million eight quarter ago to well over a $0.5 billion prior to this acquisition, and that is just with four branches an LPO and 2 mortgage offices. So we defiantly feel that this would help us continue that trajectory. I think as we look at the texture of the loan growth, I would say admittedly over the course of this year in particular it's been a lot of commercial real estate. We are still at about 235% of capital, so we have a little runway. But we have seen some nice quality projects, warehousing supply chain for larger companies, grocery store and really good Class A tenants in some larger metro markets. And we have really followed some quality developers out in Western PA and in Columbus and Northern Ohio, and so that’s really been the bulk of it. And consequently we have a pretty nice construction portfolio that will continue to be drawn down upon probably through the remainder of the year that would give us a little bit of a tailwind. I see these markets perhaps -- they are getting pretty build up and so we just need to be cautious at this point.

Collyn Gilbert

Okay.

Jim Reske

Actually I’ll add to that just a little bit, from a big picture perspective. It is one of the things we are saying about this branch deal that it's a perfect fit strategically because of our Ohio expansion, it's already underway but also financially, so one of the issues we have talked to you and others about is the loan to deposit ratio as a whole, we have got a tremendous opportunities for loan growth and that’s put our loan to deposit ratio in the 110%-112% range. And we have had some success in rate and deposits, we will -- deposits growth in the first quarter matched the loan growth and the second quarter actually exceeded. But we have, to the extent we have those loan growth opportunities and the loan to deposit ratio comes under pressure, it puts additional pressure on the margin. So by getting these additional three quarters and 1 billion of deposits, and paying down borrowings so that gives us a lot more run rate because it will take the loan to deposit ratio to back down under 100% and I guess we need that kind of pressure on the margin.

Collyn Gilbert

Okay. And actually at that point Jim and if you have it in the slide deck I apologize. But just specifically what -- the borrowings that you are paying down were carrying what in the way of costs?

Jim Reske

Yes, right above 26 basis points, they are all short-term borrowings.

Collyn Gilbert

Okay.

Jim Reske

One to three months.

Collyn Gilbert

Okay, okay. And then can you talk about…

Jim Reske

Go ahead.

Collyn Gilbert

Sorry go ahead.

Jim Reske

I was just going to say by the time we close obviously they will all be in the overnight bucket and we will pay those off when we get the funds from the deposits.

Collyn Gilbert

Got it, okay, okay and then in terms of mortgage banking, obviously it was a great quarter, it sounds like things are starting to together in that regard. What is your sort of outlook from here as to where you think that revenue line can go?

Mike Price

I mean we are at about 50 million a quarter and that’s generating about 900,000 in gain on sale. We are still keeping more on the books that we thought we would, we probably are at about 40%, we are keeping some of the construction perm that is a little larger balances. I think overtime you will see the mix would change probably more towards 25% portfolio and about 75% gain on sale. So you will see the gain on sale move up a little bit probably over the course of the next year or so. And it's driving the portfolio nicely, in terms of what that can scale to, I think we are just finding out, I thought I think initially we thought it might scale a little quicker but we are pleased with where it is at. I think we have kept the cost structure in line, I think we run a clean shop which is very important in this day and age from a regulatory standpoint. I would hope that could continue to scale at this space but we will see and we’ll keep you posted. I’d be happy to share that origination number with you from time-to-time, so you can keep track of this.

Collyn Gilbert

Okay. That’s helpful. And then Jim, just back to the margin I mean, obviously you talked about the dynamics of the branch deal, but just putting that aside just within the core business.

Jim Reske

Right.

Collyn Gilbert

There has been some stabilization it looks like a little bit on the asset side. But how are you seeing that NIM trend over the next few quarters?

Jim Reske

We are still seeing really it is in that kind of 320 to 330 guidance I had given earlier in this quarter on the commercial side we saw replacement yield essentially neutral. Now we did have as Mike alluded to some deposit specials there so you kind of -- we’re gathering some deposits here in the first quarter that probably cost about 2 basis points in the margin. So that’s why we went from 329 to 327 so that’s why we’re referring to it as relatively stable at this point. This transaction is because we’re going to be picking up deposits that have an average cost of 22 basis points and paying down borrowings at 46 that is going to help the NIM a little bit 85 basis points or so.

Collyn Gilbert

Okay, that’s helpful. And then just final question on credit, so Mike you’d indicated that what you saw this quarter was one that you had been on your watch list as you guys were kind of looking at some of these credits. Can you just kind of give us an update of the ones that you’re monitoring and then maybe where sort of what those loans or just what you’re seeing in general might affect future provisioning?

Mike Price

Yes. I think last quarter I gave the guidance on about six or seven credits that I enumerated the credit in the first quarter which is the steel servicing was in this, one this quarter were the two largest there. When we look into just each portfolio, let’s just start with petroleum and natural gas. That is currently at about 67 million about 26, I think and that’s probably close to the same number as last quarter I shared is non-pass. And there is two credits in there, one is you have heard me talk about before just a longer term shallow gas operator direct loan about 3.7 million and then another one. And this probably the only new name to the group is tanks and frac and brine water on the Marcellus and the Utica, that’s about 3.4. So the dollar amount in that pipeline has fallen a little bit. And then when we look on the coal side here. Now the coal side, we have about 31 million in outstandings and really there is the credit this quarter, which was 10.5, which we took a $7.5 million specific reserve. And then it drops way off. The next credit really in the pipeline is about 1.8 million that we’re watching closely and that’s a surface mining company. So we’ve had a lot of these kinds of gains in our portfolio over the years probably a couple dozen in each call in natural gas and I think that’s one of the things that gives a certain degree of comfort through the Marcellus and the Utica as we got involved in this five or six years ago.

Collyn Gilbert

Okay, okay that is help…

Mike Price

Hope that’s helpful.

Collyn Gilbert

Yes. No, that is very helpful. And then just the one credit this quarter, you’d mentioned it was one of four other banks participated. Was it local participations or this has been classified more as a SNIK credit?

Mike Price

These were just in our state and in adjacent state those banks.

Operator

[Operator Instructions] This concludes our question-and-answer session. I would like to turn the conference back over to Mike Price for any closing remarks.

Mike Price

We just appreciate your interest as always. Look forward to being on the road with a number of you over the course of the next quarter and talking to investors. Thank you and have a great afternoon.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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