Terra Via – IR
Bill Small – Chairman, President and CEO
Don Hileman – CFO
Timothy Orkins – FIG Partners
First Defiance Financial (FDEF) Q2 2012 Earnings Call July 24, 2012 11:00 AM ET
Good day and welcome to the First Defiance Financial Corp’s Second Quarter 2012 Earnings Conference Call. All participants will be in listen-only mode. (Operator Instructions). After today’s presentation, there will be an opportunity to ask questions. (Operator Instructions). Please note this event is being recorded.
I would now like to turn the conference over to Terra Via. Please go ahead.
Thank you. Good morning, everyone and thank you for joining us for today’s second quarter earning 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 second quarter. Last night we issued our earnings release reporting the second quarter and first half 2012 results. And this morning we would like to discuss that release and look forward into the second half of the year.
Joining me on the call this morning to give more detail on the financial performance through the second 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. We will answer any questions you might have at the conclusion of our presentation.
Second quarter 2012 net income on a GAAP basis was $3.9 million or $0.32 per diluted common share. This compares to net income of $4.8 million and $0.43 per diluted common share in the 2011 second quarter. Net income for the first six months of 2012 was $8.1 million or $0.68 per diluted common share versus $7.4 million and $0.70 per diluted common share for the six months ending June 30, 2011
While the earnings performance for the quarter was somewhat disappointing, there were several major strategic objectives that were met representing significant positives for the quarter. The redemption of $36 million of preferred stock related to the US Treasuries Capital Purchase Program being the highlight for the quarter. With the final $1 million of the preferred stock being acquired in July, we are now totally out of our $37 million TARP investment.
On the negative side of this quarter, additional credit related expenses and margin compression was the primary drags on the earnings performance.
As credit quality issues continue to be dealt with and as we continue to adapt to the interpretation of certain regulations under the guidance of our new regulator, credit related expenses remained at an elevated level.
Charge-offs while down from the last two quarters remained considerably above historic levels. Under current regulatory interpretation, any loan deem collateral dependent must be charged down to current market value regardless of whether the loan is paying current or not. In the past we would establish a specific valuation allowance for these credits as part of the reserve.
The increase was not related to any credits, were not previously on our watch-list. Provision expense was also up over both the link quarter and the second quarter 2011 level. Some of the increase in provision however relates to the loan growth this quarter.
On the positive side, related to credit, we saw reductions of classified loans restructure debt, non-accrual loans and 30 to 89 day delinquencies compared to the link quarter. We are encouraged by these indicators and remain confident in our credit administration as we continue to face the challenges of the stalled economy.
As we continue our diligent focus on loan quality, the strong increase in loan growth in the second quarter was certainly welcomed. The slow loan environment that we’ve all been experiencing over the past several years has made loan growth a challenge. So, this return to growth after the first quarter decline was certainly welcome.
The uncertainty amongst many businesses as to the overall economic environment has made many of them cautious regarding new capital investments. Our loan growth this quarter does reflect some increase in new demand. However, much of the growth came from opportunities to bring on new relationships through the diligent effort of our Call Program. We will continue to look for these opportunities while maintaining our strong underwriting practices and pricing discipline.
The deposit side of the balance sheet saw some additional growth which came primarily from our non-interest bearing deposits, as interest bearing deposits remain relatively flat. Non-interest deposits were up over 14% compared to the period ending June 30, 2011, and 6% over the link quarter on an average balance basis. The low rate environment has pushed many depositors to park funds in liquid accounts as a way an opportunity for higher returns.
Even with the increase in loan balances and the positive shift in the deposit mix, net interest income for the quarter was basically flat with the link quarter and down slightly over the second quarter 2011 results. Net interest margin however dropped compared to both periods.
The current interest rate environment does not show any sign of evading soon based on most forecasts. The challenges on the net interest margin in this low rate environment persist as we see continued competitive pressures on the asset yields. And as we know the last quarter, the ability to offset declining yields on the asset side with additional reductions on the deposit side, are diminishing. And this will remain a challenge for margin management.
Non-interest income was up in the second quarter of 2012 compared to the year ago period, but lower than the link quarter primarily due to the insurance contingent income traditionally recorded in the first quarter each year. Mortgage banking income was strong again in the second quarter as the low mortgage rates continue to attract activity. We did experience an increase in purchase activity during the quarter but refinances still dominated.
Fee income continued to hold steady and this is encouraging. But we will need to remain focused on recent regulatory changes and the impact they may have on certain fee structures. The increase in insurance revenue and wealth management income continued to positively impact our results and these are both there is that we will work to build on.
Non-interest expense was up over the second quarter of 2011, but lower compared to the link quarter. The increases in the year-over-year results were primarily compensation related, while this was partially offset by lower expenses related to occupancy and other real-estate owned.
I will now ask Don Hileman to give you the financial details for the quarter and the first half of 2012 before I wrap up with an overview and a look at what we see developing for the balance of the year. Don?
Thank you Bill and good morning everyone. In the second quarter, we reached the milestone with the effective redemption of TARP. We bid all our preferred stock in the auction in June after receiving approval from our regulators.
The company needed to get approval both the OCC and the Federal Reserve. The clearing per share of the preferred shares in the auction was $962.66 compared with the par value of $1,000 per share. And the company was successful in repurchasing 16,560 of the 37,000 shares outstanding through the auction process.
We also acquired an additional 19,440 shares in the secondary market prior to the end of the quarter. In July, we acquired the remaining 1,000 shares to complete the entire repurchase of 37,000 shares.
Second quarter was solid as we saw loan growth and strong non-interest income which partially offset a higher provision for loan loss, which was in part due to loan growth. We also continue to improve into the levels of non-performing assets and classified loans on a link quarter basis.
We saw strength in the mortgage banking originations which reached $130 million in the quarter, $82 million more than the second quarter of 2011. We also saw continued improvement in insurance of wealth management revenues. The total non-interest income grew 17% year-over-year. We are reassured with the overall profitability in the second quarter of 2012, and the improving asset quality trends that we are moving in the right financial direction.
Net income was $3.9 million or $0.32 per diluted share, compared with $4.8 million or $0.43 per diluted share in the second quarter of 2011. Credit related expenses, which includes the net gain loss on the sale of OREO, OREO repairs and write-downs and collection of secondary market buyback costs were $558,000 in the second quarter of 2012 compared to $918,000 in the second quarter of 2011.
We have seen continued high volume of mortgage production in part due to the low interest rate environment, and in part due to the improved economic activity with 21% of the loans originated being purchases and improvement over the last several quarters.
Overall mortgage banking income for this quarter was $2.3 million compared with $1.9 million in the second quarter of 2011, and $2.4 million on quarter basis. We had a gain on sale income of $2.5 million in the second quarter of 2012, compared with $1.1 million in the second quarter of 2011, and $2.5 million on the link quarter basis.
We also recorded a negative evaluation adjustment to mortgage servicing rights of $177,000 in the second quarter of 2012, compared to a deposit evaluation adjustment of $316,000 in the second quarter of 2011.
At June 30, 2012, First Defiance had $1.3 billion in loan service for others. The mortgage serving license associated with those loans had a fair value of $8.3 million or 65 basis points of the outstanding loan balance of service.
Total impairment reserves which are available for recapture in future periods totaled $1.8 million at quarter end. We do not have any OTT charges in the second quarter of 2012 reflecting a stable economic environment as it relates to our remaining investments in the trust preferred Collateralized Debt Obligations.
And to operating results, our net interest income was $17.2 million for the second quarter of 2012, relatively the same on the link quarter basis and down from $17.5 when compared with the second quarter of 2011. For the second quarter of 2012 our margin was 3.75, down 11 basis points from the second quarter of 2011 and 3 basis points on a link quarter basis. The continued low rate environment has put pressure on asset yields and particularly lower loan yields, which has impacted the margin. Overnight deposits increasing to $72 million at quarter end from $217 million on a link quarter basis.
We have accelerated our strategy over the course of 2012 to increase security purchases selectively deploying lower yielding overnight deposits in securities on the short to intermediate end of the yield curve until loan demand is more consistent. Our Available for Sale securities portfolio increased to $279 million at June 30, 2012 from $233 million at year-end 2011 and $212 million at June 30, 2011.
We believe that the economic outlook in our market area continues to remain somewhat subdued and we do not anticipate any significant improvement throughout the remainder of the year. We also do not anticipate any actions by the fed to raise rates in the near term.
We place a strong emphasis on non-interest bearing account and saw balances grow this quarter. Non-interest bearing represented 16% of total deposits at June 30, 2012. We saw competitive asset pricing continue in the second quarter. The overall loan portfolio grew in the quarter where we saw strong in the commercial category along with growth in the multi-family residential area. We expect growth to be more moderate over the course of the year.
Our yield on earning assets declined 10 basis points while our cost of funds declined 7 basis points on a link quarter basis with the overall margin decline in the 3.75% from 3.78% on a link quarter basis.
Non-interest income was $8 million in the second quarter up, from $6.8 million in the second quarter of 2011. The income was stable at $2.7 million in the second quarter of 2012, flat with the second quarter of 2011 and on a link quarter basis. Net SS fee income was $1.1 million in the second quarter of 2012 compared to $1.3 million in the second quarter of 2011 and $1.1 million on link quarter basis.
Insurance wealth management revenue was $2.2 million in the second quarter of 2012, up from $1.4 million in the second quarter of 2011 and $2.5 million on a link quarter basis. The 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 added approximately $683,000 in revenue in the second quarter of 2012. The link quarter comparison was impacted by contingent income of $504,000 received in the first quarter of 2012.
Other non-interest income decreased in the second quarter of 2012, to $54,000 from $130,000 for the same period in 2011. Overall, non-interest expense increased to $15.5 million this quarter compared with $15.1 for the second quarter of 2011, but down from $16.3 million on a link quarter basis. The quarter included $181,000 of expenses related to our participation from the treasury auction of the preferred stock.
The second quarter’s compensation benefits expense was $8 million, up from $7.5 million in the second quarter of 2011, but decreased from $0.5 million on a link quarter basis. The increase in compensation and benefits expense over 2011 second quarter is primarily due to the Acquisition of Payak-Dubbs which $389,000 compensation and benefits expense in the second quarter of 2012.
Other non-interest expense decreased to $3 million in the second quarter or $3.2 million in the second quarter of 2011, and decreased from $3.3 on a link quarter basis. The main driver behind the decrease between 2012 and 2011 second quarter is the $360,000 reduction in credit related cost
On a link quarter other non-interest expense decreased $258,000 primarily due to a decline in the value of the liabilities of deferred compensation plan. The following is a three quarter trend of certain significant expenses. Real estate owned expenses were $217,000 in the second quarter of 2012 compared to $678,000 in the second quarter of 2011 and $417,000 in the first quarter of 2012.
Credit and collection expenses were $289,000 in the second quarter of 2012 compared to $244,000 in the second quarter of 2011 and $248,000 in the first quarter of 2012. Secondary market and buyback losses were $73,000 in the second quarter of 2012 and $62,000 in the second quarter of 2011 while there were no losses in the first quarter of 2011. Secondary market buyback losses have not been significant in the past and the company continues to review and monitor our secondary market act procedures to comply with changing service or guidelines.
While we have elevated net charge-offs this quarter we believe the overall credit quality continues to improve. And the company believes the credit risk profile of the company is moving in the direction of improvement. We saw reductions in We saw reductions in both non-performing and classified loans on a link quarter basis as well as lower near-term delinquencies.
Our provision expense totaled $4.1 million, up from $2.4 million a year ago and $3.5 million on a link quarter basis. The provision was higher by approximately $475,000 due to the overall loan growth in the quarter. Our allowance for loan losses decreased to $26.4 million from $33.3 million at December 31, 2011.
The allowance percentage decreased to 1.76% from 2.80% a year ago. The overall reserve percentage declined on a link quarter basis as well from 1.96% to 1.76%. The allowance represents 58.32% of our not performing loans. The allowance to non-performing assets was 54.09% at June 30, 2012.
The 2012 second quarter provision was $2.4 million less than the net charge-offs for the quarter. We had seven credits that totaled $3.3 million or half of the total charge-offs for the quarter. Charge-offs were in part the result of previously identified credits with weaknesses finally working their way through the cycle and also changes in our treatment of credits based on continued understanding of the guidance from our regulators. We believe that we will have a good opportunity for recoveries in the future due to the nature of the conservative approach to charge-offs on some collateral dependant loans with an exhibited collateral shortfall.
The overall reserve level is adequate based on a continued general weakness in the economic but as we improvement in the economic environment and the continued reductions in classified loans we would expect a reduction in the required overall allowance level and corresponding provision expense.
We did see a slowdown on new credits migrating to a substandard rating this quarter as well as an overall reduction of substandard credits due in part to charge-offs. Classified loans declined 5.4% this quarter. Total classifieds loans decreased $5.4 million to $95.1 million at June 30, 2012 from $100.4 million at March 31, 2012. We expect the continued improvement in 2012 in the level of classified assets.
Annualized net charge-offs were 178 basis points for the second quarter of 2012, down from 218 basis points on a link quarter basis and up from 75 basis points in second quarter of 2011. Of the total charge-offs 80% related to commercial real estate loans, 7% commercial, 9% residential and 4% 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. Non-performing assets ended the second quarter at $48.8 million or 2.36% of total assets, up from 2.35% of total assets at June 30, 2011 and down from $52.6 million or 2.45% on a link quarter basis.
Total non-performing loans decreased to $45.3 million from $49.2 million on a link quarter basis but up from $40.8 million at June 30, 2011. Non-accrual loans saw a decrease in the second quarter of 2012 from the first quarter of 2012. The company 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 term of the borrowers. It is important to note that these loans still are accruing.
Total past due and non-accrual rate was 3.09% at June 30, 2012, down from 3.34% at June 30, 2011. The delinquency rate for the loan is 90 days past due and or are non-accrual increased to 2.76% this quarter up from 2.62% in the fourth quarter of 2011 and up from 2.37 on June 30, 2011. While we are not satisfied with the overall levels of 90 delinquencies and non-accruals of the total non-accrual loans of $41.7 million $23.9 million or 57% are under 90 days past due.
We are also encouraged that loans delinquent 90 days are more past due declined $3.9 million or 8% on a link quarter basis in the quarter. We also had a decline in the 3-9 day levels of delinquencies this quarter compared to the fourth quarter of 2011 and the second 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 from the second quarter of 2011 and basis and ended the second quarter of 2012 at $3.5 million, and up slightly from the link quarter of $3.40 million which was the lowest level since June of 2008. The OREO balance is made up $3.1 million of commercial real estate and $412,000 of residential real estate. We had additions of $1.7 million in the second quarter of 2012 offset by sales of $1.5 million in evaluation adjustments of $104,000.
We expect to see continued movement in the amount of credits in and out of OREO as we continue to move problem loans through resolution with activity consistent with this quarter which is an improvement over prior periods. We saw the balance sheet increase from the second quarter of 2011 with total assets of $2.1 billion at June 30, 2012.
On the asset side cash and equivalents declined $103.5 million from $213.8 million at June 30, 2011. Securities grew $67 million or 31.5% over the year to $279.4 million. Gross loans increased $51.6 million year-over-year and increased $26.7 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 I’m not focused on growth at the expense of taking in credit card risk or lowered rates aggressively to increase loan volume.
Total deposits increased $40.1 million over the same period a year ago and decreased $57.8 million on a link quarter basis. We are pleased with the mix of deposits as we are seeing a growth in non-interest bearing account balances. Managed balances, interest bearing deposits increased to $261.2 million at June 30, 2012 up from $225.9 million at June 30, 2011. Deposit mix and pricing opportunities are a continued focus of our overall strategy in efforts to reduce our costs of funds in this interest rate environment.
As noted we completed the redemption of the preferred stock during the quarter. Total period in shareholders’ equity ended June 30, 2012 at $249.9 million, down from $269.1 million at June 30, 2011, reflecting the reduction in capital due to the redemption of TARP. Our capital position remains strong with average shareholders’ equity to average assets improving to 13.37% at June 30, 2012 from 12.91% at June 30, 2011.
The bank’s risk base capital is strong at approximately 13.6%. We are pleased that we were in a strong financial position that enabled us to participate in the Treasury Auction upon receiving regulatory approval, which allows us to start to process in the exiting TARP, which was completed with the remaining shares repurchased in the short period afterwards. The company will no longer have the impact of the reduction to income applicable to common shares associated with the dividend paid on the TARP investment at a rate of 5%.
While we know there are still many challenges to deal with moving forward. We believe that we may have continued – we have made continued progress and the repayment of TARP is an important milestone in the overall strategic plan. We still are focused on and we still are focused on continued asset quality improvement and the continued growth of the first Federal franchise. We believe are taking the right steps to well position the company for future success.
That completes my overview of the quarter and I’ll turn the call back to Bill.
Thank you Don. Don and I have both, the repayment of TARP represents the accomplishment of one of our most important strategic objectives for 2012. We’re always confident that should be done before the five-year anniversary of our Grant Dated Program, but we are focused on getting it done this year and without an additional capital raise.
The permission of the regulators allowing us to spend the capital to do this demonstrates the strong capital position we are in. Prudent capital management has always been a priority focus of our board and management team. And because of that focus, we were able to accomplish this strategic goal.
As we progress through 2012, we are aware that there are still many challenges to a sustained economic recovery. Throughout the first half of 2012, our primary objectives have been asset quality, expense control and revenue growth. We’ve made positive strides in all three of these areas to date and we will continue with this effort to meet the challenges and return to higher levels of profitability.
While we are focused on these, we will be monitoring developments and changes in the economy, locally, nationally and globally. It remains an extremely challenging business development market out there with uncertainty in the economy, limited loan demand at all banks and high liquidity positions.
We are actively engaged in a calling program both on potential and existing clients to develop new business and solidify existing relationships. We’re hoping, the recent indications of increased opportunities and stronger loan demand continue to build.
The overall economic climate throughout our market area is subdued after showing indications of gaining momentum last year. Uncertainty relative to regulations, taxes and the November Elections in this country, combined with the concerns with the global economy has stalled what was already viewed as a tentative recovery.
Unemployment has actually been lower in recent months in many parts of our market compared to the National average, as manufacturing became stronger. However, things continue to slow, we could lose that advantage.
Agriculturally, it has been a rollercoaster ride this year. An unseasonably warm spring allowed crop inputs to be completed early and build enthusiasm for another strong harvest. However, the spring hopes have given way to serious concerns as much of our market area is in extreme drought conditions. We’ve been monitoring the situation assessing crop insurance and liquidity positions of our farm clients. The strength of this industry over the last several years will help many of them battle through this.
The housing market continues to be one of the biggest issues facing the full recovery of the economy, with supplies still high and pricing remaining soft, it appears that this sector’s recovery will remain slow. However, even in this environment, our mortgage production continues to be a strong contributor as the low rates have stopped the refinance activity. And as I mentioned earlier, we have recently seen an increase in purchase loans.
Our mortgage pipeline appears to be strong for the third quarter but beyond that it’s hard to predict. We’re still keeping a cautious eye on the regulatory and legislative scene as regulator slowly works on developing more of the regulations that will implement the Dodd-Frank Act.
We have concerns with the recent direction of the Consumer Financial Protection Bureau, and some of their proposed rule making. We will be working with our industry to hopefully reach final regulations that offer protection to consumers without hindering the ability to offer affordable financial products.
Throughout all these challenges and in this tentative environment, our mission is to be a community bank that provides a complete line of financial services with a relationship oriented approach on a profitable basis. The staff we have throughout this organization, all work so hard that we can achieve it. 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). The first question comes from Timothy Orkins of FIG Partners.
Timothy Orkins – FIG Partners
Hi good morning everybody.
Timothy Orkins – FIG Partners
You went by kind of fast but I thought I heard that you’re expecting a continued reduction in allowance in the future. What does that reduction tie to, is it classified balances, is it any charge-offs or is it something else?
We partner only – tied to the classified balance reduction that we expect. And obviously that could be offset if we have loan growth that would be – need to provide allowance for the loan growth. But in general we anticipate the continued reduction in the classifieds which really is a pretty big driver of our required reserves.
Timothy Orkins – FIG Partners
Okay. And what can I expect for a target coverage ratio?
I think we’ll probably be looking somewhere above the 1.5, I think that would be kind of where we think we historically would want to level out.
I would say, 1.50 to 1.75 Tim.
Timothy Orkins – FIG Partners
Okay. Thank you guys for the color. Also, what are going to be the drivers of lower charge-offs in the future?
I think a lot of that has to do, as we talked about continued stabilization in asset values, especially in our acquired credits, and we’ve seen – we’re now fully phasing in where we get appraisals every 12 months on classified credits. And as we see continued stabilization in market values, that will dictate a little less charge-offs necessarily to bring that back to market, is one thing.
And as we see improvement in the cash flows of real borrowers, I think that will get there. We’re comfortable that we’re getting – improving in that respect. We haven’t seen a dramatic decline. But as we talked about, we had a process to get us to where we were fully phased in our classified market values.
Timothy Orkins – FIG Partners
Okay. And then, just one more question, I’ll get off the horn. But – are you considering any sort of share repurchases?
Right now we’re still not in a position to do that from a regulatory aspect. I think once we clear any kind of regulatory hurdles, we look at that in a long-term capital plan. We still – we’re pretty close to right now where we strategically set our capital levels, especially at the bank level on a risk basis are comfortable with. So, I wouldn’t expect that in the near term even if we have regulatory hurdles from the regulatory standpoint are eliminated.
Timothy Orkins – FIG Partners
All right, thank you very much.
Yeah, you’re welcome Tim, thanks.
(Operator Instructions). This concludes our question-and-answer session. I would like to turn the conference back over to the management for any closing remarks.
Well, thank you for joining us today. And that concludes our call. Thank you.
The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.