Associated Banc-Corp's (ASB) CEO Phil Flynn on Q3 2016 Results - Earnings Call Transcript

| About: Associated Banc-Corp (ASB)

Associated Banc-Corp (NYSE:ASB)

Q3 2016 Earnings Conference Call

October 20, 2016 5:00 PM ET

Executives

Phil Flynn - President & CEO

Chris Niles - CFO

Scott Hickey - Chief Credit Officer

James Simons - Deputy Chief Credit Officer

Analysts

Scott Siefers - Sandler O'Neill

Jon Arfstrom - RBC Capital Markets

Chris McGratty - KBW

Terry McEvoy - Stephens

Jared Shaw - Wells Fargo

Operator

Good afternoon everyone, and welcome to Associated Banc-Corp's Third Quarter 2016 Earnings Conference Call. My name is Matt and I will be your operator today. At this time all participants are in a listen-only mode. We will be conducting a question-and-answer session at the end of this conference. This live presentation and accompanying press release, financial tables that will be referenced today's call are available on the company's website at investor.associatedbank.com. As a reminder this conference call is being recorded.

During the course of the discussion today management may make statements that constitute projections, expectations, beliefs with similar forward-looking statements. Associated's actual results could differ materially from the results anticipated or projected in any such forward-looking statements.

Additional detailed information concerning the important factors that could cause Associated’s actual results to differ materially from the information discussed today is readily available on the SEC website in the risk factors section of Associated's most recent Form 10-K and subsequent SEC filings. These factors are incorporated herein by reference. For reconciliation of the non-GAAP financial measures to the GAAP financial measures mentioned in this conference call please see page 10 of the press release financial tables. Following today's presentation, instructions will be given for the question-and-answer session.

At this time, I would like to turn the conference over to Phil Flynn, President and CEO for opening remarks. Please go ahead, sir.

Phil Flynn

Thanks and welcome to our third quarter earnings calls. Joining me today are Chris Niles, Chief Financial Officer, Scott Hickey, our Chief Credit Officer and Jim Simons, our Deputy Chief Credit Officer. Our third quarter results reflect our growing and diverse franchise. We reached record deposit levels and reported one of our highest revenue quarters in a while driven by mortgage banking and capital markets activity. We delivered solid performance across our businesses with measured loan growth, strong deposit and revenue trends and stable expenses. Our progress against our 2016 priorities is summarized on slide two.

We are committed to delivering solutions that benefit our customers. During the quarter we completed the rollout of Wi-Fi across our branch network to increase customer adoption of digital solutions. We are pleased to report our active mobile base is growing. In September, we had 33% more mobile customer site on than a year ago.

In addition we rolled out instant issue EMV chip card capability allowing bankers to give our customers an activated permanent card upon account opening and before they leave our branch. We also opened two new branches in Chicago. Average loans grew $411 million in the third quarter net of portfolio loan sales. Average loans have grown by 9% year-over-year. Year-to-date growth has been balanced across our major loan categories and remains on track to meet our 2016 guidance.

Average deposits grew $1.1 billion in the third quarter to a record $21.4 billion fueled by seasonal inflows and organic year-over-year growth. Non-interest income was up significantly in the third quarter in large part due to strong mortgage banking volumes and gains. We also reported higher revenues in several other fee categories.

Expenses came in at $175 million and we remain on pace for our fifth straight year of improved efficiency. We posted double digit returns on capital and we paid out 32% of third quarter's net income through dividends. Bottom line, we delivered 52 million of net income available to common equity or $0.34 per common share in the quarter.

Loan details for the third quarter are highlighted on slide 3. Average loans were up 2% from the second quarter. On the horizontal bar chart, we highlight the quarter's average growth by loan type. In orange, average commercial real estate loans were up $202 million or 4% from the second quarter driven by growth from our teams in Chicago and Ohio.

On a year-over-year basis, CRE lending is up 14% and retails and multifamily project loans have accounted for the largest portion of this growth. CRE line utilization was unchanged and remains in the high 50s in the third quarter. In green, residential lending was up $125 million or 2%. Absent a 239 million of portfolio loans sales residential lending would have been the largest contributed growth this quarter. Purchase and new construction activity continue to account for about 60% of production. We did see a significant shift towards fixed rate loan production during the quarter which is continued into this month.

In blue, average commercial and business loans were up $103 million or 1% from the second quarter. The increase was driven by continued growth and our mortgage warehouse, power and utilities and REIT lending businesses. Overall, our specialty commercial businesses saw lower utilization from an aggregate level in low to mid 60s. Corporate bank line utilization was down from the second quarter and remains in the mid 40s. Together corporate and general commercial lending balances were down $58 million on average.

In summary we saw growth across our asset classes. Our loan mix did not materially changed and we remain on track to meet our 2016 loan guidance of high single digit average growth.

On slide 4, we highlight our deposit trends. Average deposits were up $21.4 billion, 5% from the second quarter. We reached record deposit levels and were particularly pleased with double digit year-over-year growth in noninterest bearing demand deposits. Our loan to deposit ratio returned to low 90s in keeping with our seasonal deposit inflows.

I would just spend some time explaining the pronounced seasonality we see between the second and third quarters in regards to deposits. Some of our customers have varied seasonal inflows especially municipalities. Their deposits tend to peak in the third quarter when many have fiscal year ends and then move lower over the next 12 months. We are pretty comfortable with this seasonal pattern and we manage the ins and outs law. We believe an important measure of a successful bank is its ability to gather, retain and grow deposits. Deposit in the most cost effective and dependable form of funding and play an important role in our continued growth. We are focused on offering a well located branch network with competitive products and solutions that help us retain and track customers. We are pleased to report we grew deposits 12% year-over-year in Illinois a recent focus of ours, we recently believe kept the IC data.

On slide 5, we summarize the credit quality trends of our loan book. We continue to see low levels of stress and historically low levels of loss in our non-energy related loans. Potential problem loans decreased $16 million from the prior quarter and our accrual loans were up modestly to 1.46% of total loans up three basis points from last quarter. Total net charge-offs were down $2 million for the quarter. Outside of energy we saw net recovery of $4 million related to the general commercial book. Our non-energy portfolio is performing remarkably well. We have seen very low charge-offs for the past several quarters. Substantially all of the net charge-offs for the third quarter were related to our oil and gas book.

The total allowance for loan losses increased to 1.36% of total loans and this was slightly higher from the prior quarter as of provision more than covered net charge-off. Outside of energy we are pleased with the credit resiliency of our customers and businesses.

On slide 6, we provide more detail on our energy book which accounts for less than 4% of our loans. The shared national credit exam is complete and fully reflected in our third quarter results. We are also nearly 25% through the fall borrowing base pre-determinations and we expect to be completed by December. Prior end oil and gas loans were just under $700 million and decreased $60 million from the prior quarter as new funding were offset by repayments and charge-offs. Since the fourth quarter of 2015, we have funded 12 new credits for 253 million of commitments and 148 million of outstanding. Utilization levels have been stable over the past several quarters. At the end of the third quarter utilization remained in the low 70s.

We built up our oil and gas reserves late last year and into the spring in light of the volatility and stress in the market. Since then, we managed a handful of stress credits and like others we realized some losses. Three loans have caused all of our losses today. We don't believe we have remaining loans in the portfolio with similar loss content. Our oil and gas reserve of $38 million or 5.5% of outstanding is down from its peak in the first quarter reflecting the charge-offs we have taken but it's still higher than a year ago. The mark on the book remains consistently in the low 90s radically reserved for what we know now. Prices have improved and we believe the industry is operating on steadier ground today. Needless to say oil prices about $50 per barrel but well for our [indiscernible] industry. Importantly new credits generally have less leverage or equity and lower assumed future oil and gas prices.

Turning to slide 7, net interest income was up $2 million from the second quarter and up $8 million from a year ago. Year-to-date net interest margin was 2.8% as expected, our third quarter margin was slightly lower at 2.77, lower yields and investment securities accounted for most of the margin compression in the quarter. The yield on loans was flat at 335 and total commercial, residential and consumer yields were essentially unchanged quarter-over-quarter.

The cost of total interest bearing deposits increased 1 basis point. However higher levels of noninterest bearing deposits provided 1 basis point improvement in net free funds. So overall, deposit funding costs were essentially flat quarter-over-quarter. On a year-over-year total funding costs have only increased by 1 basis point. I would just spend a moment on the recent increase to the one and three month LIBOR rates. Our floating commercial book is predominantly one month LIBOR and we saw little benefit from the recent rise in the three month LIBOR rate. The mass improvement in the one month rate was offset by continuing competitive pressure on new and renewed loans across our markets. We don’t expect any material benefit in 2016 for possible Fed rate action later this year and we expect new term LIBOR gains to be offset by modest NIM contraction.

Turning to slide 8, noninterest income was $95 million up 39 from the prior quarter. Mortgage banking income increased $14 million to $18 million on higher gains. Loans originated for sale were $466 million up about 45% in the second quarter; we also recorded a $2 million benefit on the fair value of our mortgage pipeline at quarter end. In addition portfolio loan sales generated another $9 million gross gain during the quarter.

Insurance commissions were down $3 million for the quarter as you know we generate higher revenues in the first half of the year and we expect insurance revenue be lower in the second half. Year-over-year insurance commissions are up 11%. All other fee based revenue was higher in the third quarter equity, service charges, press service fees, card-based fees and brokerage annuity commissions. Capital markets revenue was up $3 million to a record $7million in the quarter driven by increased loans indication fees and derivatives activity. There are no investment securities gains in the third quarter as we didn't further restructure our investment portfolio; anyway securities currently represent about two-thirds of our securities.

Turning to slide 9, expenses came in at $175 million up a million from the prior quarter. This included a $2 million lease termination charge and million dollar of severance adjusted for these run rate expenses were essentially flat two year ago. Personal expense was up $2 million from the second quarter. The increase was related to severance, higher mortgage related commissions and a modest increase in risk and compliance colleagues.

Occupancy was up related to a $2 million termination charge on office space in Chicago. We continuously look for ways to better manage our office space and will be centralizing our commercial and private bankers in Downtown Chicago. Technology and equipment was slightly lower at 19 million. Outside of modest increases to FDIC and loan expense, all remaining expense categories were down in the third quarter. The reality is that we operate in a banking environment where rates are expected to remain lower for longer and we need to remain expense disciplined. We are constantly retooling our cost to make sure we are competitive while driving higher efficiency.

Regards to taxes our third quarter effective rate of 31% was up 30% in both prior and year ago quarters. So before I open up to your questions, I would like to address our community re-investment act rating of needs to improve which we recently received from the OCC. The CRA rating covers the period between 2006 and 2010. The rating reflects issues that have since been resolved in particular we have significantly enhanced our services below to moderate income and minority communities across our footprint and we have discontinued legacy depth detection products offered by third parties. The OCC has conducted a subsequent evaluation of the bank CRA performance for the period between 2011 and 2014 and we expect a new rating to be released in 2017. While there could be no assurance as the future CRA ratings we anticipate improved ratings next year.

With that we will turn it over to your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Scott Siefers from Sandler O'Neill. Please go ahead.

Scott Siefers

Good afternoon guys. Just looking for little bit more color on the oil and gas portfolio. So I guess pretty heavy charge-offs ever since limited basically just a single credit, I guess I am just curious you talked about sort of the refill of the non-accrual bucket and then I was little surprised the non-performers, the non-accrual not go down more by sizeable charge-offs. So I guess, just what are your thoughts on those dynamics?

Scott Hickey

Sure Scott. This is Scott Hickey. So I mean despite the fact that we have moved through and seen a number of charge-offs in the portfolio, we are still seeing a number of customers under stress and going into bankruptcy. So that in itself is not abated so some of these customers move into the bankruptcy role although we still feel we are well secured we nevertheless do move those into non-accrual.

Scott Siefers

Okay. And I guess what is it then if they are moving into non-accrual, I think you guys suggested in the prepared remarks that you wouldn't expect to see credit for similar loss [indiscernible] cause charge-offs or charges. What is it that give you confidence that despite these things moving, still moving into the non-accrual bucket they won’t have the similar type of loss?

Phil Flynn

Yes, this is Phil Scott. The two loans where we have taken the most significant charges add unique characteristics, I don't want to get too technical but there was a heavy reliance on non-operated working interest collateral. In both of those cases we had relatively weak operators that went bankrupt and both of those loans and the collateral backing them went to a liquidation process at very low prices that generated a lot of losses. Needless to say, we have gone through the rest of the book, we don't have loans that have those exact same characteristics nor of course, are we making loans like that anymore.

Scott Siefers

Okay. Alright, I appreciate that. Thank you guys very much.

Operator

Our next question comes from Jon Arfstrom from RBC Capital Markets, please go ahead.

Jon Arfstrom

Good afternoon.

Phil Flynn

Good afternoon Jon.

Jon Arfstrom

First of all go back to the pack tonight.

Phil Flynn

They’re going to need it.

Jon Arfstrom

Just curious if you’re going to run the earnings call from Lambo if you’re still in the office, but sounds like you’re in the office.

Phil Flynn

Lambo is too far away.

Jon Arfstrom

Just you touched a little bit on the commercial real estate drivers maybe give us a little bit more detail in terms of what you’re seeing and where that’s occurring and maybe what the pipeline looks like there?

Phil Flynn

Sure. The pipeline for our commercial real estate has been quite robust for literally years if you look at our year-to-date production it's pretty well balanced across our various offices around the Mid West so our Illinois teams have generated probably about 45% of the loan production followed by Minnesota Wisconsin, and then high single digits from Ohio, Missouri, Texas, etcetera. Actually multifamily has not dominated our new production this year. It's the second category, retail has actually led but we had good balance from retail multifamily industrial office, etcetera. So it's been well balanced as a number of banks are starting to bump up or get concerned about the OCC guidance on real estate concentrations, competition is starting to lessen little bit pricing continues to firm. Structures are pretty attractive. We happen to have plenty of room as we sit here today to take advantage of those dynamics.

Jon Arfstrom

Okay. Good and then I guess the foots at the general commercial being down maybe touch on what’s happening there, is that a few isolated things or is there something deeper there?

Phil Flynn

No. We had good growth in the first half of the year and from what I can tell from reading industry information and seeing what some other banks are reporting, number of banks are reporting slower general commercial loan activity in the third quarter. I don't know exactly what to attribute that to but there is nothing that we know of that’s a big concern.

Jon Arfstrom

Okay, got it. Alright that's all I have. Thank you.

Operator

Our next question comes from Chris McGratty from KBW. Please go ahead.

Chris McGratty

Thanks for taking my question. Chris one for you, how should we be thinking about the investment portfolio, obviously [indiscernible] pressure and yield can you help me on what your buying changed any material delta in pre-payment speeds and kind of the overall size would be great? Thanks.

Chris Niles

Yes we did see following -- or at the end of June we started to see an increase in the pre-payments going through July stepping up dramatically in August and further into September and obviously that trend we know it because we were to see prepayment, but what we are going to hit in October will continue to be an increasing prepayment. That combined with the fact that yields were lower during the quarter contributed to our lower net interest margin for the quarter and what we have been buying as you are well aware has been the Ginnie Mae, Plain Vanilla via securities and the yields on that despite the fact there is zero risk-weighted dynamics have also been attractive to others and actually yields not only fall in because the markets also fell the entire market seems to be buying that products and so we have seen the attractiveness of that investment portfolio options fall precipitously over the course of the quarter and so while that remains sort of our -- we haven't placed we are sitting here frankly looking forward and saying does that still makes sense as platform and we are reevaluating alternatives. I don't think that means we are going to do any of the stuff that we haven't done per say into the investment portfolio but it means we are thinking the allocation of the investment portfolio going forward.

Chris McGratty

Okay. With that temporarily given the mismatch in yield would that temporarily keep you out of the market so you thinking might lower investment balances in the next couple of quarters or is it kind of stability?

Chris Niles

Look we got an ongoing process. We are evaluating the market as we go. Obviously it breaks back up again or as the result of that hike in December we start to take up again we probably would jump in with both feet but as we said here today, it's tough as these yields to put into portfolio stuff that we know is going to be both dilutive to the margin and dilutive for the ability to earn have positive earnings overtime.

Chris McGratty

Got it, great. Thanks for taking the question.

Operator

Our next question comes from Terry McEvoy from Stephens, please go ahead.

Terry McEvoy

Hi, thanks. Good afternoon. Maybe Phil you mentioned the 60 plus increase in the number of employees was risking compliance related. The number did kind of catch my eye, anything specific in the quarter to - behind the increase in those employees?

Phil Flynn

No they weren't all in risk and compliance by any means. I think we just call those out as maybe there was I am guessing maybe there was a dozen of them or something. There was other people picked up here and there. We didn't have 60 people - we have plenty.

Terry McEvoy

Okay. Good. And then I guess sticking with the expenses of the efficiency ratio 63% but it benefited from the gain in the mortgage area. As you think about 2017 and Phil you talked about just the rate environment remaining low, what else are you looking at to improve the efficiency ratio particularly on the expense side or is it really just a waiting game for the revenue picture to start to look better?

Phil Flynn

It's as we sit here today, it's the same grind that we have been on. So we have been slowly increasing revenues. And we have been keeping expenses flat and so we are slowly grinding the efficiency ratio to a better number. I like the 63 this quarter too, but don't follow them up with it.

Terry McEvoy

And maybe just quick one last question, the capital market was up 5 million quarter-over-quarter I think it was around $7 million. How is the pipeline for capital markets look as we get into the fourth quarter here?

Phil Flynn

Yes. So there is a couple of drivers to that. It’s the indication business which in our case is largely commercial real estate driven and we have built a very good commercial real estate business and we are very active underwriters and then sellers of commercial real estate loan. So that pipeline continues to look good. The other piece is to grow this business that is more dependent upon what our customers; rate outlook is and how much they want to lock in their interest rate exposures. So that one is little harder to predict.

Chris Niles

And Terry, just for clarity it was 3 million quarter-over-quarter, from the second quarter 5 million year-over-year, 4.8 million year-over-year.

Terry McEvoy

Thanks Chris and thanks Phil as well.

Operator

The next question comes from Jared Shaw from Wells Fargo. Please go ahead.

Jared Shaw

Hi, good morning or good afternoon.

Phil Flynn

Good afternoon.

Jared Shaw

Looking at the $9 million gain on sales portfolio loans were those all residential mortgage and what drove the decision to sell those versus continue to hold them?

Chris Niles

Sure. The answer is yes. They were all residential and essentially two factors I think as Phil talked through the portfolio mix is generally where we wanted to be. It hasn't changed much. Had we not we would have changed the mix a little bit. But also we looked at [indiscernible] we were cognitive and expected pre-payments to be a factor moving forward and we looked at our overall portfolio and as you are aware most of our portfolios and arm product principally the arm so look at that mix and thought how much fixed rate exposure we want potential in environment where -- might accelerate and take some chip off the table.

Jared Shaw

Okay and just to confirm those came out of loan held for investment versus held for sale?

Chris Niles

Correct.

Jared Shaw

And then, when we look at the loans held for sale is that - what’s the mix there between the commercial real estate loans you are originating for syndication versus residential?

Phil Flynn

There is very small amount that usually might be there at quarter end. By and large the trade gets done within the quarter and they close out at quarter end on the commercial side. So that pipeline essentially is all residential.

Jared Shaw

Okay. And then looking at the slide where you talked about the energy exposure you talk about the new loans funded since third quarter 2015. What was the amount funded this quarter?

Phil Flynn

I am sorry Jared, I just don't have that in front of me. I mean, it would be a few loans I am guessing maybe $15 million bucks that's -- those are probably approximately right.

Jared Shaw

Okay. And then finally, on the change in the margin guidance or outlook being weaker. Is that really altered from the securities portfolio or is there something else that’s impacting the weaker?

Phil Flynn

Cost of funding looks pretty stable. Yields on loans was stable probably stablish maybe little down on pressure probably securities.

Chris Niles

Obviously we think competition for loans but securities were the key drivers of the margin compression and again I think as was asked earlier if we continued our current investment strategy there will be more downward pressure because rate are absolutely lower and pre-payments are accelerating.

Phil Flynn

Right, I think as Chris intimated we are taking a hard look at that right now.

Jared Shaw

Okay. Thanks and finally is this a good tax rate to use going forward we have been down 30.5% range for a while now is this still -- is this a new base or it should be still assume little bit higher for the future?

Phil Flynn

This is probably decent assumption.

Jared Shaw

Okay. Thank you.

Operator

Our next question comes from Scott Siefers from Sandler O'Neill. Please go ahead.

Scott Siefers

Hey guys just wanted to sort of a follow-up on margin. Chris when you were going through the margin you said in the fourth quarter we get a -- probably won’t do anything in the fourth quarter margin just wanted to know how you are thinking about things that we got one in December what that would do in the first quarter, first quarter this year following last December's rate. I think it really wasn't much impact with the real -- being those network deposits which [indiscernible] immediately. Is there any change to what the phenomena would be this time around or what happened last year pretty much same this time around?

Chris Niles

I would like to believe that we learned something from what we did last year. And so the outcome might be slightly more positive but just keep in mind that really has no impact at all in the fourth quarter and the carry over into the first quarter we saw some list on the gross yield on margin but we also do a lot of renewals in our book in the first quarter and it appears that essentially the competitive dynamic traded away some of the lift we saw with new lower rates on the renewals. And what we yet ended up with most compression from the cost of funds. What I will tell you is I think there are cost of funds positions as you finish the year here is looking relatively strong and I think we have learned something about managing that little better but that will remain to be seen in the first quarter and how the renewal affects weigh against any yield uptick in the one month LIBOR rate. At this point in time we don't expect any impact for Q4. It might be a modest positive going to Q1.

Scott Siefers

Okay. Alright. I appreciate it. Thank you very much though. I appreciate it.

Operator

And if there are no further questions I would like to turn the floor back over to management for any closing comments.

Phil Flynn

Thanks. So just in closing our loan deposits fees and expense trends were all steady deposit for the quarter and our credit metrics outside of energy remained very strong. So we look forward to talking with you again next quarter and if you have any questions in the meantime give us call and thanks again for your interest in Associated.

Operator

This concludes today's teleconference. Thank you for your participation. You may disconnect your lines at this time.

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