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Macatawa Bank Corp. (NASDAQ:MCBC)

Q1 2008 Earnings Call

April 22, 2008 10:00 AM ET

Executives

Benjamin Smith III – Founder, Chairman, CEO

Jon Swets – CFO, Principal Accounting Officer

Ronald Haan – Exec. VP of Macatawa Bank

Phil Koning – Pres, Sec, CEO of Macatawa Bank

Analysts

Terry Mcevoy – Oppenheimer & Co.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

Jon Arfstrom – RBC Capital Markets

Stephen Geyen – Stifel Nicolaus & Company, Inc.

Operator

I would like to welcome everyone to the Macatawa Bank Corporation’s First Quarter Earnings Conference Call.

(Operator Instruction)

At this time, I would like to turn the call over to Mr. Ben Smith, Chairman and Chief Executive Officer. Thank you, you may begin.

Ben Smith

Good morning! My name is Ben Smith and thanks a lot for taking time to join us. With us this morning are Phil Koning, President and CEO of Macatawa Bank, Jon Swets, our CFO, and Ron Haan, Executive Vice President. What we will do is we will give you the normal information, go over the information that was distributed earlier and take time for questions and answers. Jon, would you care to give the first quarter.

Jon Swets

Yes, thank you, Ben. I am just going to touch on a few topics for a little more clarity.

First off, regarding the quarter, the results reflect our continued caution relative to asset quality. We set aside $2.7 million in earnings for our provision for loan losses for possible future loan losses. It is still obviously an elevated number but we are seeing signs of asset quality measures beginning to stabilize. Ron Haan will provide more color on those trends.

We did see a little bit of balance sheet growth which I will explain a little bit. And then we are also pleased that our net interest margin was virtually flat on a consecutive quarter basis and I will touch on what happened with net interest margin.

First off, the provision for loan losses, our net charge-offs for the quarter were $4.2 million. So obviously, an elevated number for us, of this $4.2 million however, approximately $3 million had already been set aside in our reserves for loan losses through specific reserve allocations. So there is only about $1.2 million in charge-off that had not been previously set aside. And again, our provision was $2.7 so we covered the $1.2 and then some. We added another $1.5 million to the allowance for loan losses for various reasons, to cover the loan growth we experienced during the quarter. Looking at non-performing loan levels, it did increase a bit. But various factors went into determining that $2.7 million provision. But big picture again, it is just our general sense of caution in making sure we are doing the right thing, a prudent thing in setting up the allowance for loan losses.

Net interest margin as I mentioned down only 1 basis point from the fourth quarter to the first quarter so on a consecutive quarter basis, very little movement in net interest margin. Lots of movement within the components of net interest margins, so I thought I will explain that a little bit. Yield on assets decrease by 42 basis points when looking at fourth quarter of last year compared to this first quarter. Decrease of course related primarily to the fed funds rate cut that had taken place in the time frame.

Cost of funds however, was also down significantly, cost of funds was down 47 basis points. So we were able to respond to those fed funds rate cut with our own deposit rate reductions and we did continue to see our fixed rate deposit portfolios repriced downwards.

Now, those two things of course net out to a spread increase of five basis points while the margin actually decreased one and that is just related to the fact that we have not more interest earning assets than we do interest bearing liabilities. In several of the last few quarters, the non-performing assets have also created a lot of noise in our net interest margin so I thought I will provide a little commentary on that as well.

In the current quarter, the impact of non-performing assets was actually a positive four basis points on net interest margin. We did have a higher average balance of non-performing assets when looking at first quarter compared to fourth quarter. That factor caused an eight basis point decline in margin but we did have fewer reversals of interest income as we moved loans into non-accruing status in this first quarter compared to fourth. And that amounted to a 12 basis point pick up. So the two net to a four basis point positive influence on margins which essentially leaves about a five basis point reduction in margin through kind of core reduction in margin. This is in the context of 250 basis points fed fund rate cuts since the beginning of the fourth quarter. So over that six months time period that we are looking at, our margin responded with only a five basis point reduction.

So we feel that we have done a good job at managing our interest rate risk profile to a very balanced position to have core margin decrease by only five basis points in the context of that kind of a rapid market rate reduction.

Couple of things on non-interest income, as you may have noticed from the release. We did have an increase in non-interest income, $1.3 million increase but $832,000.00 of that are related to gain on disposition of interest rate swaps. We did this in early February, all of our swap arrangements were disposed off and that was very possible as a result of what we have just talked about. Our interest rate risk profile is very well balanced at this point so the need for the swaps and what they are accomplishing is diminished heavily in the context of our profile. The $832,000.00 and $540,000.00 after tax so it had a $0.3 per share impact on earnings per share.

After factoring that out, we still had a 12% increase in non-interest income. And as I mentioned in the last several quarterly conference calls, we continue to see good trends in many categories of non-interest income, deposit service fee income, investment services income, debit card interchange income, title insurance services and our reverse mortgage activity, all showing positive trends.

Non-interest expense of $1.8 million versus the prior year first quarter, $1 million of that relates to the categories of salaries and benefits, occupancy and furniture and equipment. Most of the increase in those line items can be tied to the four new facilities that we have put up really in that time frame. We relocated two facilities from leased locations to owned locations and then in addition, we had two new branches that we had put up. The first of those new branches was early to mid first quarter last year and the other new branch came late second quarter and the two new buildings that we relocated were also kind of first, second quarter, kinds of things. So they still had an impact on this comparison from first quarter of this year to first quarter of last year.

Other non-interest expense constituted the remaining $800,000.00 of the $1.8 million increase in total non-interest expense. Some of the larger causes for that increase related to our continuing work with administering and disposing of our problem assets, cost associated with that work amounting to $455,000.00 in this first quarter. That is about a $300,000.00 increase over the first quarter of the prior year plus our FDIC insurance cost also increased a $137,000.00 over the first quarter of last year.

Moving on to our balance sheet information, in the first quarter we did see some loan portfolio growth, albeit nominal, up almost $14 million. Within our loan portfolio, our loan growth actually took place in the consumer mortgage are which is consistent with what we have been experiencing over the last few quarters, $23 million in growth in loans in this category, one to four family residential mortgages. Many of the loans we are booking are jumbos. This portfolio continues to be a very healthy portfolio for us. Delinquency trends remains stable, levels of non-performing assets are very low so we feel good about the growth in that category.

Deposit portfolio grew in the first quarter, up $47 million, $43 million of which was in core deposits and I know Phil Koning will touch on this a bit on his comments.

I am going to turn it over to Ron Haan, who will provide some more background on loans and asset quality.

Ron Haan

Sure, thanks Jon. You know clearly asset quality continues to receive a lot of attention at the bank and while we did not see a material change in our credit metrics during the first quarter, we are optimistic about some of the trends that we are seeing. Real estate markets in Western Michigan do remain fragile but we did see positive first quarter trends in our loan delinquencies. Commercial loan delinquencies decreased by nearly $10 million during the quarter from 6% on 12/31/07 to 5.34% at the end of March.

Mortgage and consumer delinquencies remain flat at 0.97%. These loans have never really given us much problem with delinquency rates remaining below 1%. Our total delinquencies decreased from 4.97% at the end of 2007, the 4.43% on March 31. While 4.43% is still very high, if you consider our level of non-performing loans primarily to residential land developers, our other delinquency trends are generally satisfactory in improving.

Non-performing loans stayed about the same during the quarter. March 31 numbers were $75.5 million versus $73.9 million at the end of the year. The bulk of these loans are nearly $56 million are related to residential land development and construction loans that we have discussed in previous communications. Again, while $75 million remains high and unacceptable for us, the upward pressure we have seen in this area seems to be leveling. As I indicated last quarter, we continue to see limited lot sales. The trend has been very gradual but the inventory is moving. We also expect to see some seasonal improvement at this time of year as building activity in Michigan increases during the summer months.

There continues to be significant inventory of lots and residential homes in the market but again by nearly all accounts, those inventories are starting to work their way down and we should see it gradual decrease in our exposure as these lots and homes sell. We expect a gradual process throughout this year possibly extending into 2009 before we see a material reduction

Our non-performing assets increased slightly during the first quarter as foreclosed properties worked the way through the system. But again we are cautiously optimistic in that we have contracts for sale at nearly 50% of our current inventory at prices that are consistent with their book values. We anticipate closings on this real estate during the second quarter.

Looking forward, while we have much work to be done on our non-performing loans or getting those loans back to acceptable levels, we are encouraged by the first quarter trends. Lower interest rates along with regional job growth should help stabilize the real estate markets and work down the excess land in housing inventories. As real estate markets in Western Michigan stabilize, we should see more normal operating performance.

With that I will turn it over to Phil Koning.

Phil Koning

Thank you, Ron. I would like to make a few comments about our local economy, our deposit base and what we see going on in our market place. Relative to our economy, we seem to be treading water here in West Michigan. Our population and the number of jobs are relatively stable. I believe Ottawa, Calhoun and Allegan counties where we do business actually did experience a small amount of population growth this past year which is bucking the trend of our state as a whole.

Our unemployment rate is up slightly and now stands close to 6%. With lower interest rates and home prices, we are beginning to see some residential sales activity. However, the potential national recession and reductions in consumer confidence do concern us. And while we are not anticipating a strong resurgence of residential housing demand, we are hoping for moderate activity based upon reports that foreclosures are down from their peaks and sales are up from their low points last year here in West Michigan.

We are very happy that our deposit base continues to grow in this challenging environment. Both our retail and business customer base continues to expand. Most of the dollar growth has been in the certificate of deposit area as consumers move funds from lower paying checking and money market accounts to certificates. We also continue our initiative to grow our institutional and government deposit base. Our treasury management area has targeted these customers with good success.

In conclusion, while we continue to be challenged by the current environment, we do see opportunity in the market place. While some of the large regional banks are withdrawing resources from this West Michigan market, we remain committed to growing our franchise. We need to be disciplined in our allocation of resources and control cost wherever we can, but we remain committed to our vision of becoming the dominant bank headquartered in and serving West Michigan.

And I will turn it over to Ben.

Ben Smith

That completes the formal portion of our meeting. At this time we will throw it open for questions.

Question and Answer Session

Operator

(Operator Instruction)

Your first question comes from the line of Terry Mcevoy.

Terry Mcevoy – Oppenheimer & Co.

Good morning. I just was hoping that you would help me kind of walk through, as it is really a surprise me to see the provision about a million for below net charge offs just kind of given a little bit a loan growth from the quarter as well as a little bit loan growth in non-performing assets, you know, much different from we are seeing from any of your peers who are still in the reserve building modes so to speak.

Ben Smith

Yes, one of things I had touched on that I had hoped would help explain this is the fact that of that $4.2 million in charge offs, we had already specifically reserved for $3 million of those in prior quarters. So those reserves had already been set aside specific allocations. So then when you look at it, there is only $1.2 million in actual charge offs that the $2.7 million in provision really related to and so we covered those charge offs and then added some.

Terry Mcevoy – Oppenheimer & Co.

And then it has been, I guess a full year since the bank bought Smith and Associates, how is that transaction one year into it, is it meeting expectations and just an update on that deal.

Ben Smith

Yes, I think it is meeting expectations. It is the reason our trust income is up pretty substantially over previous periods. Obviously with the market where it is today, we have not seen much growth in asset values which we had hoped for but we did keep most of the customers and we are happy with that transaction.

Terry Mcevoy – Oppenheimer & Co.

Thank you.

Operator

Your next question comes from the line of Jason Werner.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

Good morning guys. Just to kind of get some further color on the charge offs, this $3 million in specific reserves that are already set aside, is that for one credit or is that multiple credit, can you give us some color on what type of credits was that for?

Ben Smith

Those are really multiple credits. I think probably the largest one in there was I believe a $1.2 million but the rest of those spread over multiple credits.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

But the $1.2 million, what type of credit was that?

Ben Smith

That would have been a residential, actually, that was vertical, that was a write-down on some commercial real estate intended for our commercial office use.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

Okay. And then, when you take into account the charge offs, and pull NPAs and equal or probably closer to $8 million. I was curious what were being added into - one of the causes is non-performing loans, other non-performing loans booked into ORE, so what was being added into the problem loan category?

Ben Smith

Total non-performing assets essentially went from just under $80 million to about $84 million so total non-performing assets were up, I think it was a little over $4 million when you look at everything combined. I think Ron mentioned that the ORE numbers are up and that is where almost $3 million of it is and then the types of property in there are just some of this residential developer stuff.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

So the increase is still in that category?

Ben Smith

Yes, for the most part that is the case.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

I mean, looking at what you had put in numbers on the press release, a small increase in C&I and then if you break out the residential developer or the commercial real estate, looks like that was up a little bit too but not a whole lot. Certainly I guess not a trend we can point to, it does look like compared to some of the other Michigan peers that we are seeing more commercial real estate problems at this point.

Ben Smith

Yes, right. It’s not kind of migrating out in the other portions of our portfolio all that much, it remains kind of mostly residential developers stuff.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

Okay, and then another question regarding the margin, your asset sensitivity and the swaps and I know you said you are kind of balanced and that is why you got rid of them but I figured the swaps were helping you be balanced. Now that they are gone, you are saying you are still are fairly balanced?

Ben Smith

Yes, we got rid of those early first quarter. It was early February so there were two months in this first quarter where we were without them. And yes, frankly pricing on those things too has changed. And so in retrospect, this was not a part of our growth process but in retrospect, it was a good timing in terms of the gain we got out of it.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

Last question, what do you think in terms of margin going forward, are you guys anticipating further fed cuts and do you think it stays fairly stable or do you see slight pressure if they do cut again?

Ben Smith

We have experienced a little bit of pressure early when those fed rate cuts happened as evidenced by our five basis points but over the course of a full 12 months, we see actually a little bit of rebound and I think our last few quarters are, I guess, ratifying that that’s the case.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

Okay, thank you.

Operator

(Operator Instructions)

Your next question comes from the line of Jon Arfstrom.

Jon Arfstrom – RBC Capital Markets

Good morning guys. Can you just compare the Lake Shore market to the Grand Rapids in terms of health, compare and contrast how they are doing.

Ben Smith

They are two different markets certainly. The Grand Rapids market is probably in some ways got a little more going for it in the medical and area in the hospital growth and so on in that market, I would say the manufacturing economies are pretty similar in both markets. Both markets are seeing a small amount of growth but I think in the Lake Shore, we certainly are experiencing less growth than we have historically.

Jon Arfstrom – RBC Capital Markets

Are the lake shore values holding on?

Ben Smith

On the actual lake shore and by that I mean on the water values are holding up very well. In other areas of the lake shore I would say is probably done on 10% to 20% on home values, if that is what you were referring to?

Jon Arfstrom – RBC Capital Markets

Yes. And then Ron, you have mentioned something in the prepared comments and I missed the beginning of it but you said you had 50% of certain category contracted for sale? What was that?

Ronald Haan

That is REO, Jon, as we take stuff into Real estate owned, we write it down to market value obviously and what we are starting to see now is that stuffs are moving the other end. About half of the REO that we had on is under contracts for sale, and it is under contract that values that are consistent with our book value, so we do not anticipate any additional losses.

Jon Arfstrom – RBC Capital Markets

Okay, and are these sales you think would happen before the end of the quarter?

Ronald Haan

Most of them are going to be happening really in April and May so we are optimistic and hopeful that the trend will continue in the May and June and as stuff works its way through its way though the pipeline, we will continue to sell it out the other end and return those to performing assets.

Jon Arfstrom – RBC Capital Markets

And then one more for you Ron, you talked about potentially seeing some activity pick up at residential real estate in the spring. I am just curious if you have seen any early find of that?

Ronald Haan

I think I would not say we are giddy about it but we are seeing lot sales, so in most of the developments that were involved in, we continue to see kind of a gradual pick up in activity. We are a long way from where we were two years ago but the trends look better than where we were six to nine months ago where we were seeing virtually no sales.

Jon Arfstrom – RBC Capital Markets

Okay. Thanks guys.

Operator

(Operator Instruction)

We have a follow up question from the line of Jason Werner.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

Hi, I just wanted some clarification on the REO stuff that is contracted for sale. Is that actual vertical constructed homes or is there lots in there that you are trying to sell?

Ben Smith

Both.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

So you are actually successful in getting contracts for some lots then?

Ben Smith

Yes.

Jason Werner – Howe Barnes Hoefer & Arnett Inc.

Okay. Thank you.

Operator

(Operator Instruction)

At this time, we have no further question.

Ben Smith

We appreciate everyone for joining us and we hope and look forward to talking with you next quarter.

Operator

Thank you, this concludes today’s Macatawa Bank Corporation first quarter earnings conference call. You may now disconnect.

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