Independent Bank Corporation (NASDAQ:IBCP)
Q2 2016 Results Earnings Conference Call
July 28, 2016 11:00 AM ET
Brad Kessel - President and CEO
Rob Shuster - EVP and CFO
Matthew Forgotson - Sandler O’Neill & Partners
Damon DelMonte - KBW
Scott Beury - Boenning & Scattergood
Good morning and welcome to the Independent Bank Corp. Second Quarter 2016 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded.
I would now like to turn the conference over to Brad Kessel, President and CEO. Please go ahead.
Good morning. Thank you for joining Independent Bank Corporation’s conference call and webcast to discuss the Company’s 2016 second quarter results. I am Brad Kessel, President and Chief Executive Officer and joining me is Rob Shuster, Executive Vice President and Chief Financial Officer. Before we begin today’s call, it is my responsibility to direct you to the cautionary note regarding forward-looking statements. This is slide two in our presentation. If anyone does not already have a copy of the press release issued by Independent today, you can access it at the Company’s website www.independentbank.com. The agenda for today’s call will include prepared remarks, followed by a question-and-answer session and then closing remarks.
We are very pleased to report strong overall results for the second quarter of 2016. Solid loan growth, continued improvement in asset quality, a rise in net gains in mortgage loans, as well as our continuing efforts to reduce non-interest expenses contributed to a 14.6% increase in net income. Diluted earnings per share rose by 25%, reflecting both the increase in net income and the benefit from our share repurchase activity. Further, despite continued pressure from the low interest rate environment, we did achieve net growth in net interest income on a quarterly and year-to-date basis compared to 2015.
Turning to page five. This quarter, we are reporting net income of $6.4 million or $0.30 per diluted share versus net income of $5.6 million or $0.24 per diluted share in the prior year period. For the six months ended June 30, 2016 the Company is reporting net income of $10.5 million or $0.48 per diluted share compared to net income of $9.4 million or $0.40 per diluted share in the prior year period. The second quarter’s results were driven by net interest income of $19.6 million, up $900,000 or 5% from the year ago quarter $700,000 credit provision fueled by $0.95 million in loan net recoveries and gains on mortgage loans of $2.5 million, up $700,000 or 41.8% from the year ago quarter, all while reducing expenses under the $21 million mark for the quarter.
The fundamentals of our balance sheet including capital, liquidity and asset quality, all continued to be strong or we continue to grow loans and optimize our earning asset mix. During the second quarter, our loan portfolio grew by $36.4 million or 9.5% annualized. Our loan to deposit ratio at 74%, holds further opportunities for growth in net interest income.
Today, Independent Bank is the fourth largest bank headquartered in Michigan and operates 63 branch locations in 21 counties and 11 MSAs as seen on page six of our presentation. Through the first half of 2016, Michigan market conditions continue to be good, as measured by labor, housing and commercial real estate markets. The state unemployment rate is now at 4.6% versus the national rate of 4.9%. Michigan payroll jobs totaled 4.354 million in May, 75,000 higher than one year ago. Since June 2015, Michigan job gains have occurred in almost every major industry.
The largest year-over-year increases have been in professional and business services, education and health, leisure and hospitality, and manufacturing. Michigan housing conditions also continue to exhibit positive trends, as measured by total housing sales, housing starts and the medium sales price of single-family homes. The Detroit housing prices were up 5.75% year-over-year, according to the Case-Shiller Home Price Index. Michigan building permits for new houses are up based on an annual 12-month moving average. The latest 12-month moving average is 27.3% higher than a year ago. While still down from the highs in the early 2000s, building permits continue to increase.
Occupancy rates for multi-family, office, light industrial and retail continue to trend positively in each of our markets. Michigan motor vehicle production totaled 229,000 units in May, which was up 10.8% from the prior month and up 9% from a year ago. The favorable economic conditions are seen in our loan origination and deposit gathering results. Page seven contains a good summary of our loans and deposits by region. We have seen growth in each of our four markets for loans and growth in three of our four markets for deposits. On the loan side, our year-over-year growth has been 9.6%, led by our West Michigan market, while on the deposit side, our year-over-year growth has been 8.6% and led by our Southeast Michigan market.
Total deposits, as seen on page eight, were $2.13 billion at June 30, 2016, an increase of $167 million from June 30, 2015. The increase in deposits, in addition to being spread across our markets, has also been in both retail and commercial portfolios. The company’s deposit base is substantially all core funding with $1.7 billion or 79% in transaction accounts. Consistent with the industry trends, we continue to see increases in usage of our digital platforms and call center, while at the same time seeing declines in branch transactional traffic. Accordingly, we continue to expand our digital product offering and call center hours.
We also continue to emphasize with all our associates the importance of growing our deposit base and related fee income services. A new direct mail initiative soliciting new checking accounts we initiated earlier this year has generated on average 4% increase in new account openings per branch over the same period one year ago. I’ve mentioned on previous calls our efforts and results to improve the overall efficiency and productivity of our branch network. These efforts have included reducing our branch delivery channel from 106 locations to the present 63 through a combination of sales, consolidations and closures. In doing so, we have improved the overall profitability of our branches and increased the average deposits per branch from $20 million at the end of 2011 to an average of $34 million at June 30, 2016.
We continue to work toward improving the productivity of this delivery channel, most recently making a change in our branch capture system, fully outsourcing item processing, further reducing our FTE account. In coming quarters, we plan to move from the pilot phase to full implementation of electronic signatures for all our documentation, eliminating paper and improving workflow throughout our Company.
I continue to be very pleased with the job of our associates due to originate new loans and grow our loan portfolios. This past quarter was no exception. As seen on page 9, loans, including loans held for sale increased to $1.61 billion at June 30, 2016. This represents the ninth consecutive quarter of net loan growth for our Company. The commercial team generated $64 million in new and renewed production that on an adjusted net loan growth basis was $14.4 million or 7.5% annualized. Line usage was 47% at June 30, 2016, up from 44% the prior quarter but down from 50% the same quarter one year ago.
The risk profile continued to improve with watch credits now making up less than 4% of the portfolio. The portfolio continues to be diversified by loan type and by size. Unplanned pay-offs were up over the prior quarter or not excessive. Overall, the commercial pipeline continues to be very healthy and supportive of our targeted growth rates. Our retail lenders generated $62 million in portfolio originations that netted consumer and mortgage portfolio loan growth of $23 million or 12.5% on an annualized basis. In addition, our mortgage team generated $92 million in originations and $70 million in sales or $2.5 million in net gains. Consumer originations from our indirect team were $29 million for the quarter and represented almost half of all retail production. The mix included $20 million in powersport financing and $9 million in recreational vehicle financings.
The 30-year conforming fixed rate mortgage averaged 3.42% in mid-July, as compared to 4.09% one year ago at this time. Correspondingly, we are starting to see an increase in refinance applications on top of a healthy purchase market and at present, the pipeline mix is 50% refinance and 50% purchase transactions. The overall pipeline is strong and margins are improving.
Page 10 provide some information on our capital. And as we have consistently stated, our near-term target for tangible common equity is 9.5% to 10.5% and the longer-term target is 8.5% to 9.5%.
Our plan is to retain capital for our organic loan growth and return capital through a consistent dividend payout plan and share repurchase plan. Tangible common equity totaled $244.8 million or 9.99% of tangible assets at June 30, 2016, right in the midpoint of our targeted near-term range as compared to 11.02% for the same quarter one year ago. Over the last year, we have deployed capital organically with $132 million or 9.1% growth in loans and $164 million or 7.1% growth in total assets.
Over the same period, we have returned capital through dividends and share repurchases. This includes $0.02 or 33% increase in our quarterly dividend to the current rate of $0.08 per share. And since the start of 2015, we have repurchased 2.12 million shares of IBCP. At June 30, 2016, our tangible book value per share is $11.49 per share, up from last quarter’s $11.22 per share. Finally, on July 26, 2016, we again announced a quarterly cash dividend on our common stock of $0.08 per share, payable on August 15, to shareholders of record on August 8th.
I will make a few more comments on this subject in my closing remarks, but at this time, I would like to turn the presentation over to Rob Shuster to share a few comments on our financials, credit quality and management’s outlook for the balance of 2016.
Thanks, Brad and good morning, everyone. I’m starting at page 11 of our presentation. Our net interest income totaled $19.6 million during the second quarter of 2016, an increase of $900,000 or 5% from the year ago period and a decrease of $133,000 or 0.7% on a linked quarter basis. Our tax equivalent net interest margin was 3.52% during the second quarter of 2016 compared to 3.62% in the year ago period and 3.61% in the first quarter of 2016. The decline in the linked quarter and net interest income was due to $0.4 million decline in net interest recoveries on previously charged-off or non-accrual loans.
Although the net interest margin remains under some stress due to the prolonged low interest rate environment that has pressured yields on the company’s loan portfolio, we remain optimistic that we can offset this stress by a remix of our earning asset base, largely through loan growth. Average interest earning assets were $2.26 billion in the second quarter of 2016 compared to $2.08 billion in the year ago quarter and $2.21 billion in the first quarter of 2016. Page 12 contains a more detailed analysis of the linked quarter decrease in net interest income. This decrease was primarily due to a decrease in interest income on loans, and a slight increase in interest expense on deposits and borrowings that was partially offset by an increase in interest and dividends on investment securities. If you adjust the first quarter 2016 net interest margin to normalize net recoveries of interest and charged-off or non-accrual loans, the 3.61% would adjust down to 3.54%. So over the last four quarters, the net interest margin has been 3.58% in the third quarter of 2015, 3.56% in the fourth quarter of 2015, 3.54% as adjusted in the first quarter of 2016 and 3.52% in the most recent quarter. This represents a pretty consistent rate of change. We will comment more specifically on our outlook for net interest income for the remainder of 2016 later in the presentation.
Moving on to page 13, non-interest income totaled $9.6 million in the second quarter of 2016, as compared to $11 million in the year ago quarter and $7.8 million in the first quarter of 2016. Our mortgage banking operations caused much of the quarterly comparative variability in non-interest income. In the second quarter of 2016, gains on mortgage loans did increase to $2.5 million due primarily to improved profit margins on loan sales. However, a decline in mortgage loan interest rates resulted in an impairment charge of $0.65 million or $0.02 per diluted share after-taxes on our capitalized mortgage servicing rights in the second quarter of 2016.
Interchange income also declined on a year-over-year basis. Although we experienced 4.4% increase in transaction volume, this was more than offset by an 8.1% decline in interchange revenue per transaction. We are seeing merchants direct more transactions through this PIN base, which has a lower level of revenue than signature-based transactions. In addition, the second quarter of 2015 had $178,000 of volume-based incentive revenue. We moved from a quarterly to an annual volume-based incentive calculation in 2016, under our debit card brand agreement. Thus far, we have elected not to record any accrual for volume-based incentive revenue during 2016 due to uncertainty as to where the year will end up.
As detailed on page 14, our non-interest expenses declined to $20.9 million in the second quarter of 2016, as compared to $21.6 million in the year ago quarter and $22 million in the first quarter of 2016. As I outlined in last quarter’s call, we estimated about $750,000 of reduced quarterly non-interest expenses in 2Q 2016 as compared to 1Q 2016. Generally, these cost reductions materialize along with $0.4 million decline in loan and collection costs.
Page 15 provides an overview of our investments at June 30, 2016. 31% of the portfolio was variable rate and much of the fixed rate portion of the portfolio is in maturities of five years or less. The estimated average duration of the portfolio is about two years, with a weighted average tax equivalent book yield of 2.09% at June 30, 2016. This compares to an estimated average duration of 1.84 years and a weighted average tax equivalent book yield of 1.67% at June 30, 2015. So we have been able to move the yield up by about 42 basis points, while keeping the duration of the portfolio at about two years.
Page 16 provides data on non-performing loans, other real estate, non-performing assets and early-stage delinquencies. We made further progress on improving asset quality. Non-performing assets declined by 4.5% during the second quarter of 2016 and were down to 0.67% of total assets at quarter end. Moving on to page 17, we’ve recorded a credit provision for loan losses of $0.7 million in the second quarter of 2016 compared to a credit of $0.1 million in the year ago quarter. We actually recorded net recoveries on loans of $0.95 million or 0.24% of average portfolio loans in the second quarter of 2016. The allowance for loan losses totaled $22.7 million or 1.44% of portfolio loans at June 30, 2016.
Page 18 provides some additional asset quality data, including information on new loan defaults and on classified assets. New loan defaults totaled just $2.3 million in the second quarter of 2016, and stand at $4.5 million for the first six months of this year. Page 19 provides information on our TDR portfolio that totaled $85.4 million at June 30, 2016. This portfolio continues to perform very well with 91% of these loans being current at June 30, 2016.
On page 20, we provide a summary of our actual year-to-date 2016 performance, as compared to our original outlook. Overall, we believe our performance in the second quarter and first half of 2016 was generally in line with or somewhat better than our original outlook. We continue to target high-single-digit percentage growth per loans, as we move forward in 2016. For the first half of 2016, our adjusted annualized net portfolio loan growth was 8% annualized. We indicated an expectation for mid-single-digit growth in net interest income for 2016, and we believe we remain on track to achieve this through general stability in our net interest margin and the aforementioned loan growth. Asset quality metrics generally improved across the board in the second quarter of 2016, which led to a credit provision that I discussed previously. As we look ahead to the remainder of 2016, the level of loan net charge-offs, loan defaults, watch credits and the performance of the TDR portfolio will be the key factors influencing our provision levels. We are optimistic that our asset quality metrics will continue to be stable or improve.
Non-interest income of $9.6 million in the second quarter of 2016 was within our expected range of $9.5 million to $10 million. As I already mentioned, the second quarter of 2016 was adversely impacted by $0.65 million impairment charge on capitalized mortgage servicing rights. Assuming the absence of MSR impairment charges, we believe non-interest income will be within our forecasted range during the last half of 2016. Non-interest expenses of $20.9 million in the second quarter of 2016 were just below the lower end of our forecasted range. We believe non-interest expenses can remain toward the lower end of our forecasted range during the last half of 2016.
Our adjusted effective income tax rate of 32.1% in the second quarter of 2016 was in line with our forecasted range. This adjustment removes the impact of our implementation of ASU 2016-09 in the second quarter, which reduced income tax expense by $0.3 million.
That concludes my prepared remarks, and I would now like to turn the call back over to Brad.
Thanks, Rob. As we look ahead to the remainder of 2016 and beyond, we are focused on building on the momentum generated in the first half of this year. We are pleased to report solid first half results in 2016 with growth in earnings and earnings per share as compared to last year. The improvement is directly related to the successful execution of our strategy to migrate earning assets from lower-yielding investments to higher-yielding loans in order to grow net interest income. Similarly, improvement was seen with reductions in non-interest expense on both a sequential and year-over-year quarterly basis. Our quarterly return on average assets was 1.06% compared to 0.98% for the same quarter one year ago and our four-quarter moving average return on assets improved to 0.88% from 0.80% one year ago. Our quarterly return on average common shareholders’ equity was 10.66% compared to 8.86% for the same quarter one year ago and our four-quarter moving average return on equity improved to 8.50% from 7.26% one year ago.
Our management team recognizes we need to continue to grow revenue and improve our overall earnings, as we work toward sustained performance milestones of 1% or better return on assets, 10% or better return on equity in 2016 and beyond.
As previously stated, our target or roadmap to this level is built on improving net interest income to $20 million per quarter, non-interest income of $10 million per quarter, non-interest expense of less than $21 million per quarter and a normalized provision. We believe sound execution on these strategies will generate solid total shareholder returns over the long run.
At this point, we would now like to open up the call for questions.
We will now begin the question-and-answer session. [Operator Instructions]. Our first question comes from Matthew Forgotson of Sandler O’Neill & Partners. Please go ahead.
Just wondering if you can talk to us a little bit about the remixing capacity that you have to rotate cash flows from the securities portfolio into loans, how do you think about that here?
I guess, I would start with our loan to deposit ratio at 70-odd percent. And so we think that there is quite a bit of upside running that to 85%, 90% and really, it’s a function of market’s loan demand and our execution on new loans. So we think there is a significant upside to improve the net interest income. On top of that, I think as you heard in Rob’s comments, we’ve had nice improvement in the overall yield of the investment security portfolio was really not taking on additional extension risk and/or significant credit risk.
Can you give us a sense of kind of where new loans are coming on relative to the portfolio yield? I guess it was for 4.64% in the second quarter?
Yes, for the commercial side, for the fixed rate component, we’ve been in that mid-4 range, so we’re really not seeing much pressure on the portfolio yields from the fixed rate commercial loan component. The variable rate is coming on at about 3.75%, so to extent we’re getting, in the last quarter, it was about two-thirds variable rate and one-third fixed rate, so that of course puts a little bit of downward pressure on, although those are also assets that are going to reprice immediately, if we get our upward movement in the prime rate.
On the retail side, it’s coming in at around 4% give or take and so that’s having a little bit of pressure, as well. I think where we still are feeling that eventually we’re going to get some either slow down or stopping of the downward drift is by that remix, so that even though the loan portfolio yield may drop a little bit, because that represents a greater share of our earning assets versus the investment securities that we still would get the margin stabilized or perhaps even slightly improving. Now it hasn’t quite happened yet, but if you go through my comments, we’ve been going down about two basis points a quarter over the last four quarters, but again, we’re hoping that we’re kind of coming to the end of that to at least get to a more stable NIM at around 3.5%.
Okay. I guess on mortgage, good production volume and the gain on sale margin was quite thick this quarter, I guess, around 350. Can you talk about your expectations for sustaining the gain on sale margin at that level?
Well, I think that we can sustain it at that level, at least looking out through the third quarter and looking at today’s pipeline. And then I would imagine we probably see that come down a little bit, as we trail to the end of the year and due to seasonality and so on, but at least for the next quarter, I would envision that we would be at that level.
Okay. And I guess lastly and then I’ll hop out, in terms of the credit provisions that we’ve seen, I know it’s a challenging area to forecast, but I guess I could ask the question by saying, is there anything large or lumpy in the recovery pipeline that we ought to be taking into consideration as we model that going forward?
Well, so, Matt, you asked a question. We have tracked all the charge-offs, obviously over the years. And today what’s nice is that we really look at our recoveries in two categories. There’s the sort of just reoccurring payment stream that we have built in today through retail as well as the commercial base. We had a pretty good feel for that and then there is the lumpy ones, if you will and those predominantly are more on the commercial side. This past quarter, I think we had, Rob probably, I don’t know, was there 200,000, 250,000 in that number in terms of lumpy.
Yes, maybe a bit more, but a good half of what we’re seeing right now is more along the lines of the consistent recurring recovery. So there is always a few outliers here and there, but I think we don’t see any real pressure from new defaults for a couple of reasons. One is, the level is quite low and two the loss content is much subdued, because of the collateral position, so that’s helpful. So that means hopefully that new charge-offs are fairly low and so those recoveries that we’re just talking about sort of gets us to either a net recovery position like we’ve had in the last couple of quarters or certainly a very low charge-off position. And if you combine that with the TDR portfolio continuing to pay down, where we have fairly high specific reserves, you could certainly paint a picture where your provision levels are either close to zero or perhaps a credit like we’ve had in the first couple of quarters.
Our next question comes from Damon DelMonte with KBW. Please go ahead.
I just wondered, when you look at your outlook for the loan growth, where in the footprint are you seeing the best opportunities for the growth?
Okay, we had a slide in our deck that sort of give us the breakdown by market. And at the slide seven in our deck and year-to-date, the largest loan growth has come from our West Michigan market and I would expect that we’d continue to see that. It’s also been very strong in Southeast Michigan market. I think that a difference between those two markets, there are probably four competitors in the West Michigan market similar to us in size in the community banking profile then say maybe in the Southeast Michigan market. So we continue to look for both those regions being strong and then also, sort of filling in the gaps with our team in the lending market, they are in the Lansing market as well as in the Bay City, Saginaw and Thumb region.
Got you. Okay. And then the installment portfolio, that had pretty good growth this quarter. I think you touched on that briefly, but could you just kind of go through that again as to what types of loans are coming on?
We referenced that probably half of the consumer originations were through the branch network and then half were through our indirect desk. The indirect desk is really two-fold. RV, which is two-thirds of that and then, or actually power sport and then the other third would be RV. And those are long-term relationships that we’ve had with dealers throughout the State of Michigan. And it’s interesting with that assured internally with our team today, but we actually have a very nice book-to-look ratio, if you will, on the indirect desk, 50% matter of fact. So they’re only sending us the higher quality deals. And so that’s, and Rob referenced roughly in the 4% yield range. And then over the branch side, it’s a mixture of, to our customers that are home improvement loans and maybe vehicle loans and a sundry of smaller dollar installment purchases.
And then there’s been a couple of larger M&A transactions across your marketplace. Are you guys seeing any disruption that’s creating opportunity for you to either A, win over new lending and depository relationships or B, hire talent from other organizations?
There is a lot of disruption in the Michigan market today and it does create both of the opportunities, which you mentioned, opportunities to bring in new customers as well as opportunities to speak with talented staff that may be interested in a change. I’d say that we believe there is benefits for an Independent Bank on both those fronts and I think that will enable us to hit some of these projections and/or exceed these projections possibly.
Our next question comes from Scott Beury of Boenning & Scattergood. Please go ahead.
Just had a quick question, looking specifically at the loan growth, it looks like you had really strong production in the installment book, as you had mentioned. And I’m just wondering in terms the back half of the year, to what degree do you think that’s impacted by seasonality, imagine a lot of the assets being financed with those relationships are kind of more in demand in the warmer months, if you will. And just wondering how you are thinking about that?
I’ll let Rob jump in here too, when I look at our loan portfolio, I would say the most consistent, year around, we’d probably going to, we’re going to see on the commercial side. And I’m hopeful that we see more of the same there. On the mortgage side, we had a nice second quarter, I would see that that will continue into the third quarter and probably slowdown in Q4 and then back into Q1. I do look for us to hopefully actually get some more portfolio loans in the mortgage side and we’re working on initiatives to accomplish that. On the installment portfolio, particularly the indirect desk, second quarter, third quarter, those are the higher peaks for that demand. And then Q4 and Q1, we should see that settle back down.
Okay, thank you. That’s very helpful. All my other questions have been answered. So, I am going to hop off now. Thanks.
This concludes our question-and-answer session. I would like to turn the conference back over to Brad Kessel for any closing remarks.
Very good. I thank each of you for your interest in Independent Bank Corporation and for joining us on today’s call. We wish everyone a great day.
The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.
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