Terra Via – IR
Bill Small – President and CEO
Don Hileman – EVP and CFO
John Barber – KBW
First Defiance Financial (FDEF) Q1 2012 Earnings Call April 24, 2012 11:00 AM ET
Good day and welcome to the First Defiance Financial Corp. First Quarter Earnings Conference Call and webcast. 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 Terra Via. Please go ahead.
Thank you. Good morning, everyone and thank you for joining us for today’s first quarter 2012 conference call. This call is also being webcast and the audio replay will be available at First Defiance's website at fdef.com.
Providing commentary this morning will be Bill Small, Chairman, President and CEO of First Defiance and Don Hileman, Executive Vice President and Chief Financial Officer. Following their prepared comments on the Company’s strategy and performance, they will be available to take your questions.
Before we begin, I’d like to remind you that during the conference call today, including during the question-and-answer period, you may hear forward-looking statements related to the future financial results and business operations for First Defiance Financial Corp.
Actual results may differ materially from current management forecasts and projections as a result of factors over which the company has no control. Information on these risk factors and additional information on forward-looking statements are included in the news release and in the Company’s reports on file with the Securities and Exchange Commission.
And now, I’ll turn the call over to Mr. Small for his comments.
Thank you Terra. Good morning and thank you for joining us for the First Defiance Financial Corp conference call to review the 2012 first quarter. Last night we issued our earnings release reporting the first quarter 2012 results and this morning we would like to discuss that release and look forward at the balance of 2012. At the conclusion of our presentation we will answer any questions you might have.
Joining me on the call this morning to give more detail on the financial performance for the first quarter is Executive Vice President and CFO, Don Hileman. Also with us this morning to answer questions is Jim Rohrs, President and CEO of First Federal Bank.
First quarter 2012 net income on a GAAP basis was $4.2 million or $0.37 per diluted common share. This compares to net income of $2.7 million and $0.25 per diluted common share in the 2011 first quarter. The 2012 first quarter earnings results are an encouraging start to the year but still demonstrate the challenges of the last several years. Among the strong positives in the quarter was our non-interest income which was driven by very solid mortgage production throughout the quarter and we held the line on expenses.
However while we see improvement in the overall credit quality at the bank continuing we still saw asset issues negatively impacting earnings. Margin compression also worked as a deterrent to higher earnings as the historically low interest rate environment drags on.
Credit quality has been the most significant factor impacting earnings over the past couple of years and while we are still seeing a degree of stress on certain credits overall we saw marked improvement in several key metrics.
Reduction in classified loans and lower delinquencies are both strong indicators of the overall improvement of the credit quality however increases in non-performing loans, primarily driven by additional loans placed on non-accrual and another quarter of high levels of charge offs continue to show the late period effects of the recent economic recession.
Some of these increases are the result of credits finally working their way through the cycle and also to changes in our treatment of credits based on guidance from our new regulator. The increases involve credits that had been previously identified as having weaknesses but we have adjusted our procedures and the treatment of some of these credits based on the guidance.
Loan balances dropped during the first three months of 2012 in virtually all loan categories after two consecutive quarters of growth. Soft loan demand, strong liquidity position on the part of borrowers, and a very competitive lending environment, all contributed to the decrease in loans.
Loan balances have been effected by the higher level of charge offs last several quarters also. One significant characteristic that was very notable that quarter was a decline in outstanding balances on farm lines of credit. Many of our agricultural customers have had several consecutive strong performance years that puts them in a position to utilize cash for input expenses this year and as a result they have or dramatically reduced draws on their operating lines. This is obviously a positive for all but it has had a negative impact on loan balances.
The one strong area for loan production during the first quarter was in residential real estate loans. Mortgage production continued, in fact increased its strong performance that goes back to the middle of last year. First quarter 2012 mortgage production more than doubled the 2011 first-quarter and the month of March 2012 production alone nearly exceeded the entire first quarter 2011 level. This is not only the result of outstanding work by our loan originators but a tremendous and efficient effort fire underwriters and processors to keep up with our originators.
On the deposit side of the balance sheet we continue to see balances grow even as rates remain near record lows. The mix continued to change in a favorable way as CD balances declined, dropping by almost $12 million but this was more than offset by growth and DDAs in money market savings accounts as customers parked funds in hopes of higher rates in the future. This resulted in an increase in deposits of over $74 million since the end of 2011.
Net interest income was virtually unchanged compared to first quarter 2011 while loan balances were down compared to the link quarter. They were $2 million higher than the first quarter of 2011 levels and this helped offset the net interest margin compression. Net interest margin was down 11 basis points from the first quarter of 2011. The change in the deposit mix and discipline pricing has helped us control the compression of the margin in this challenging rate environment. Non-interest income was the real star of the show in the first quarter but as I said earlier by very strong mortgage home production. While this was driven to a large extent by refinancing by homeowners we still were able to grow the servicing portfolio demonstrating our ability to increase market share.
The increase in insurance revenue over first quarter 2011 was positively impacted by increases in contingent revenue as well as the increased production resulting from the July 2011 acquisition of another insurance agency located in the Tweto (ph) area. The result of these items is an increase of almost $900,000 year-over-year in insurance revenue.
Wealth management income also was up and we continue to hold steady on other fee income sources. Non-interest expense compared with the link quarter but down compared to first quarter of 2011. Increases in compensation of benefits year-over-year were offset by lower FDIC insurance premiums and reductions in credit related expenses. The FDIC insurance premium reduction is a result of the change in the assessment calculation affected by the Dodd-Frank legislation.
Before I turn it over to Don for more detail on the order I do want to report that issued an additional press release last night announcing that our board has approved the payment of a common dividend for shareholders. The dividend of $0.05 per common share will be paid on June 1 to shareholders of record as of May 15, 2012.
Our prudent capital management throughout the extended economic recession has put us in the position to declare this dividend. We will carefully monitor our capital position and evaluate future dividend decisions in the same prudent manner.
I'll now ask Don Hileman to give you the financial details for the quarter before I wrap up with an overview and look at what we see developing for the balance of 2012. Don?
Thank you Bill and good morning everyone. The first quarter was an overall good start to the year. We saw strength in mortgage banking as well as an improvement in insurance revenues. Total non-interest income grew 42% year-over-year and 7% on a link quarter basis.
We are encouraged with the overall profitability in the first quarter of 2012. We saw solid mortgage production throughout the first quarter of 2012 which has continued into the second quarter. Net income was $4.2 million or $0.37 per diluted share compared to $2.7 million or $0.25 per diluted share in the first quarter of 2011, a 44%. Lower other non-interest expenses also added to the improvement in profitability. Credit related expenses which includes net gain loss on the sale of OREO, OREO repairs and write downs and collections in secondary market buyback cost was $698,000 in the first quarter of 2012 compared with $1.4 million in the first quarter of 2011. We saw continued high volume mortgage activity this quarter compared to the last two quarters.
Overall mortgage banking income for the quarter was $2.4 million compared with $1.3 million in first quarter of 2011 and $1.9 million on a link quarter basis. A gain of sale income of $2.5 million in the first quarter of 2012 compared with $726,000 in the first quarter of 2011 and $1.7 million in the fourth quarter of 2011. We also recorded a negative evaluation adjustment to mortgage servicing rights of $79,000 in the first quarter of 2012 compared with the positive evaluation adjustment of $171,000 in the first quarter last year.
At March 31, 2012 First Defiance had $1.3 billion in loan service revenues. The mortgage serving license associated with those loans had a fair value of $8.5 million or 68 basis points of the outstanding loan balance of service.
Total impairment reserves with our available free cash and future periods totaled $1.6 million at quarter end. We do not have any other than temporary charges in the first quarter of 2012 reflecting a stable economic environment as it relates to our really the remaining investments in trust preferred Collateralized Debt Obligations or CDO. (inaudible) the probably is very low that we will have any significant OTTI charges in the future. The stability of the marketplace and continued analysis of our current portfolio assist us in making this conclusion.
Turning to operating results, our net interest income was $17.2 million for the first quarter relative to the when compared to the first quarter of 2011 and $17.5 on a link quarter basis. For the first quarter of 2012 our margin was 2.78%, down 11 basis points from the first quarter of 2011 and five basis points on a link quarter basis. The continued high level of liquidity along with lower loan yields has impacted the margin. Overnight deposits increasing to $217 million at the end of the quarter with $143 million on a link quarter basis.
We have accelerated our strategy to increase securities purchased selectively deploying lower yielding overnight deposits into on the short to intermediate end of the yield curve until loan demand is consistent. Our Available for Sale securities portfolio increased to $243 million at March 31, 2012 from $233 million at year-end 2011 and $180 million at March of 2011.
We have been pursing investments in the four to five year weighted average life range. We believe that the economic outlook in our market area continues to remain somewhat subdued and we do not have dissipate any significant improvement in the near term. We also do not anticipate any actions by the fed to raise rates in the near term. We will continue this strategy until we see evidence of sustainable net loan growth even with the give up in yield associated with the high liquidity level we believe a higher liquidity position continues to be important and give us added flexibility but not necessarily at these levels.
We place a strong emphasis on non-interest bearing account since balances grow this quarter. Non-interest bearing represented 16% of total deposits of March 31, 2012. We saw continued competitive asset pricing in the first quarter as well as a decline in loan balances. We saw the decline mostly in the commercial category where the competitive pricing has been particularly aggressive. Our yield non-earning assets declined 9 basis points while our cost of funds declined 4 basis points on a link quarter basis.
We have seen a broader base of very competitive pricing in our market area which puts additional pressure on loan growth and asset yields. Non-interest income was $8.4 million in the first quarter, up from $5.9 million in the first quarter of 2011. The income was stable at $2.7 million in the first quarter of 2012, up slightly from $2.6 million in the first quarter of 2011 and declined from $3 million on a link quarter basis. Net SSC income was $1.1 million for the first quarter of 2012 compared to $1.2 million for the first quarter of 2011 and $1.4 million on link quarter basis.
Insurance revenue was $2.5 million in the first quarter of 2012, up from $1.7 million in the first quarter of 2011 and $2 million on a link quarter basis. Year-over-year increase in insurance revenue as result of the additional revenue provided by the acquisition of a full-service agency which closed July 1, 2011. This acquisition approximately $622,000 in in the first quarter of 2012. The link quarter comparison was impacted by contingent income of $504,000 received in the first quarter of 2012. Contingent income is usually booked in the first quarter of the year.
Other non-interest income increased in the first quarter of 2012 from negative $151,000 one thousand for the same period in 2011. This was a primarily a result of recording net losses of $60,000 on real estate rental property in the first quarter of 2012 compared to net losses of $291,000 for the same period in 2011.
We also recorded an increase in the value of the assets of the deferred compensation plan of $131,000 in the first quarter of 2012 compared to an increase of $28,000 in the same period of 2011. Overall non-interest expense decreased to $16.3 million this quarter compared to $16.6 million in the first quarter of 2011 but up from a linked quarter basis of $15.6 k.
The first quarter compensation benefits expenses were $8.5 million, up from $7.8 million in the first quarter of 2011, an increase from $8.1 million on a link quarter basis. The increase in compensation and benefits expense over 2011 first quarter and the link quarter is primarily due to the company grade and pay increases coupled with an increase in commission expense related to increased insurance revenues. Also the acquisition of that (inaudible) added $407,000 compensation benefits expense in the first quarter of 2012.
Other non-interest expense decreased to $3.3 million in the first quarter or $4.1 million in the first quarter of 2011, an increase from $3.2 on a link quarter basis. The main driver behind the decreases between 2011 and 2012 first quarters is the $508,000 reduction in credit related cost.
On a link quarter other non-interest expense increased $103,000 primarily due to an increase in legal and other professional expenses of $252,000 and following is a three quarter trend of certain significant expenses. Real estate owned expenses were $417,000 in the first quarter of 2012 compared to $718,000 in the first quarter of 2011 and $741,000 in the fourth quarter of 2011. Credit and collection expenses were $248,000 in the first quarter of 2012 compared to $193,000 in the first quarter of 2011 and $242,000 in the fourth quarter of 2011. Secondary market buyback losses were $228,000 in the first quarter of 2011 and $23,000 in the four quarter of 2011 while there were no losses in the first quarter of 2012.
While we had elevated net charge offs this quarter we believe the overall credit quality is improving. We are focused on working through troubled credits and moving into the credit process. Overall we believe our credit risk profile of the company is moving in the direction of improvement. Our provision expense totaled $3.5 million, down from $4.1 million on link quarter basis and up from $2.8 million a year ago. Our launch for loan losses decreased to $28.8 million from $33.3 million at December 31, 2011.
The allowance percentage decreased to 1.96% from 2.77% a year ago and from 2.24% on a link quarter basis. The allowance represents $58.6 of our not performing loans. The allowance to nonperforming assets was 54.84% at March 31, 2012. The 2012 first quarter provision was $4.4 million less than net charge offs for the quarter. We had eleven credits that totaled $6.2 million of the total charge-offs for the quarter. The increased level of charge offs are the result of previously identified credits with weaknesses and are finally working their way through the cycle and also changes in our treatment of credit based on guidance from our new regulator. The reserve level is adequate based on a continued general weakness in the economic but as we improvement in the economic environment and we continued reductions in classified loans we would expect a reduction in the required allowance level.
We did see a slowdown on new credits migrating to a substandard rating this quarter as well as an overall reduction of substandard credits. Classified loans declined 18% this quarter. Total classifieds increased $22.1 million to $100.4 million at March 31, 2012 from $122.5 million at December 31, 2011. We expect a continued improvement in 2012 in the level of classified assets.
Annualized net charge-offs were 218 basis points for the first quarter of 2012, down from 249 basis points on a link quarter basis and up from 85 basis points in first quarter of 2011. On the total charge off 65% related to commercial real estate loans, 33% to commercial loans, 9% residential and 3% home equity.
As we see improvements in our asset quality trends as well as in the economy we will be more confident that we are headed toward a consistent and steady improvement in the level of classified loans. Non-performing assets ended the quarter at $52.6 million or 2.45% of total assets, up from 2.24% of total assets at December 31, 2011 and down from 54.7% or 2.65% of total assets a year ago.
Total non-performing loans increased to $45.4 million from $39.3 million on a link quarter basis and were up from $41.0 million at March 31, 2011. Non-accrual loans saw an increase in the first quarter of 2012 from the fourth quarter of 2011. Management continually evaluates the likelihood of the company not recovering the full principal and interest as agreed to in the original contract.
Restructured loans remained relatively stable on a link quarter basis. Restructured loans are considered nonconforming but because of changes in the original (inaudible) of borrowers. It is important to update these loans are still accruing.
Total past due and non-accrual rate was 3.4% at March 31, 2012, up from 3.21% and March 31, 2011. The delinquency rate for the loan is 90 days past due and or are non-accrual increased to 3.05% this quarter up from 2.62% in the fourth quarter of 2011 and up from 2.76 on March 31, 2011. While we are not satisfied with the overall levels of 90 delinquencies and non-accruals of the total nonaccrual loans of $45.3 million $25.3 million or 56% are under 90 days past due.
We are also pleased to have loans that are delinquent 90 days or more past due declined $2 million or 11% in the quarter driven by charge-offs. We are also encouraged by the decline in the nine day levels of delinquencies this quarter compared to the fourth quarter of 2011 and the first quarter of 2011.
As I have mentioned in the past we expect this indicator to be somewhat choppy in the near term until we see consistent downward trend develop. Our OREO balance declined on a link quarter basis and ended the first quarter at $3.4 million, the lowest level since June of 2008. The OREO balances made up $2.7 million of commercial real estate and $675,000 of residential real estate. We had additions of 264,000 in the first quarter offset by sales of $286,000 and evaluation adjustments of $137,000.
We are pleased with the declining level and the overall sales activity this quarter. We expect to see continually movement of credits in and out of OREO as we move problem loans through resolution with activity consistent with this quarter which is an improvement over prior periods. The balance sheet increase from the first quarter of 2011 with total assets of $2.1 billion at March 31, 2012.
On the asset side cash and equivalents grew $14.5 million or 6% over the year to $249.9 million on March 31, 2012. Securities grew $63.3 million or 35% over the year to $243.6 million. Gross loan balances increased to $2.7 million year-over-year and declined $13 million on a link quarter basis.
Loan activity in general has shown mixed signs of picking up and we will continue to be prudent in our new lending activities. We have been disciplined in our underwriting and not focused on growth at the expense of taking in greater credit risk or lowered rates aggressively to increase loan volume.
Total deposits $79.3 million over the same period a year ago and increased $75.1 million on a link quarter basis. We are pleased with the mix of deposits as we have seen a growth in non-interest bearing account balances. Managed balances increased to $265.7 million at March 31, 2012 up from $219.4 million on March 31, 2011. Deposit mix and pricing opportunities are a continued focus of our overall strategy in the efforts to reduce our class of funds in this interest rate environment.
As noted we completed a counter stock offering in March 2011 that increased shareholders equity by approximately $20 million. Total shareholders' equity ended March 31, 2012 at $281.4 million, up from $263.1 million March 31, 2011. Our capital position remains strong with average shareholders' equity to average assets improving to 13.45% at March 31, 2012 from 11.81 at March 31, 2011.
The bank capital rates are strong approximately of 15.7%. As our financial performance improves we continue to evaluate our overall capital levels and our strategy for dividends and the repayment of our CPP investment. The board continually assesses our involvement in this program. As we previously said, we continuously review our capital position and believe we can repay the CPP funds without additional equity offering. While we know there are still many challenges to deal with moving forward we believe that we have made continued progress and moving in the right direction and are well positioned for future success/
That completes my overview of the quarter and I'll turn the call back to Bill.
Thank you Don. As we progressed through 2012 we are still trying to assess the speed and strength of the economic recovery. Based on national economic indicators and our observations here on the local markets we certainly see evidence of strengthening. Balance sheets of clients and their cash flows continue to improve however there still remains some hesitancy on the part of many to declare the economy totally out of the woods.
Many business people expressed concern about what the future holds in regards to regulation, taxes and healthcare costs. We hear reports from many clients of increases in orders and overall improvement in their operating environment but they are advancing cautiously and making capital investments and adding to their permanent workforce.
Sustaining and increasing the speed of the recovery is going to depend to a large degree on the level of confidence growing within the business community. We see the trend toward optimism but it is guarded optimism. Our three primary focuses remaining asset quality, expense control and core deposit growth. We have made significant strides in all three of these areas in recent quarters and we must continue with this effort to return to higher levels of portability.
We do not see any sudden and huge increase in loan demand on the immediate horizon and this requires our focus on building our other revenue sources and controlling cost. We are committed to maintaining our underwriting standards and will not compromise on to get loan growth. Pricing will be a challenge in this competitive environment and while we are not going to be out trying to buy business with the illogical rates we will work hard to maintain our existing relationships.
We look for loan demand to slowly pick up as economy improves. As stated previously we had hoped the carry the growth momentum of the two previous quarters into the start of this year but that did not happen. We are hearing from existing customers of possible expanded needs in the near future and we are also getting a chance to look at new relationship opportunities. Only time will tell what growth this might produce for future periods.
Unemployment rates throughout our markets have lowered in recent months but still are higher than the national rate. Manufacturing led by the automotive industry has been the primary reason for the serious improvement. While our direct column exposure to the automotive industry is minimal, many of our customers have ties to it that impact their results with the overall performance of the sector.
We are keeping a cautious eye on the regulatory and legislative scene. The good news is that with this being an election year and having a split legislature, little if any new legislation will be enacted. However there are still many unanswered questions regarding the Dodd-Frank legislation passed in 2010 and our industry continues to work hard to help shape the final regulations that would have the least damaging effect to banks and their customers.
Our mission at First Defiance is to be community financial services provider that offers a complete line of financial products with relationship oriented approach on a profitable basis. The staff we have throughout this organization understands the importance of relationship banking and the importance of delivering on that mission. I thank them for their diligence and loyalty and I thank you for joining us this morning on the call.
And now we would be happy to take your questions.
(Operator Instructions). Our first question is from question is from John Barber, KBW. Please go ahead.
John Barber – KBW
Just wondering, you mentioned part of the increase in non-performing loans this quarter was regulatory driven. Just to clarify, does that mean there was no deterioration in the credit and so it was just a classification issue?
I'd say primarily it was just a classification issue. I'm not saying all of it was related to that but most of it was. How we look at the accrual status versus the classification.
The one I guess bright spot bright spot in it was John, there were no, no new credits that we have not previously identified. So as Don said, some of it was just the classification part of it. That was a little bit where we had some additional deterioration of value that impacted some of the changes also.
John Barber – KBW
Okay, thanks. And then on net charge-offs this quarter, could you quantify just how much of the charge offs had specific reserves again?
It would have been about 60 some percent.
John Barber – KBW
Okay. And then just switching over to the margin, could you talk a little bit more about maybe some of the opportunity you have on the funding side of the balance sheet, potentially CDs you have maturing at more favorable rates or anything you do with your borrowings
Yes, we're getting pretty tight on our cost of funds and our opportunity to reduce the CD. We've been pretty aggressively low environment for a while now and a lot of the renewals are coming in, pretty tighter to what they were a year ago. So I think we have still some mixed opportunity there but the roll off of CDs and like products, there is not going to be a whole lot of additional reduction in cost of funds there but we still think we have some decent opportunity for a continued mix change.
John Barber – KBW
Okay. And the last one I had was, do you have any updates on your MOU?
At this point we still haven’t gotten our OCC Report from their first exam. We've been told that this is an issue that most thrifts are having with the OCC exams as OCC tries to standardize some variances that they found in OTS's approach. So until we get that official report we really don't have any definite indication on that.
Seeing as there is no further questions this concludes our call. Thank you for joining us today.
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.