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First Merchants Corp. (NASDAQ:FRME)

Q2 2008 Earnings Call

July 23 2008, 2:30 pm ET

Executives

Michael Rechin - President, CEO

Mark Hardwick - CFO

Dave Spade - Chief Credit Officer

Analysts

David Scharf - FTN Midwest Securities

Brian Martin - Howe Barns

Operator

Welcome to the First Merchants second quarter earnings conference call. (Operator Instructions).

During the call, management may make forward-looking statements about the company's relative business outlook. These forward-looking statements and all other statements made during the call that do not concern historical facts are subject to risk and uncertainties that may materially affect actual results. Specific forward-looking statements include, but are not limited to, any indications regarding the financial services industry, the economy, and future growth of their balance sheet or income statement.

(Operator Instructions).

Now, I would like to turn the conference over to Michael Rechin. Mr. Rechin?

Michael Rechin

Thank you, Annie and good afternoon. Welcome to everyone that's taking time out of their afternoon to listen in on our earnings conference call for our second fiscal quarter, the six month, ending June 30th, 2008. Joining me today are Mark Hardwick, our Chief Financial Officer, and Dave Spade, Chief Credit Officer, who are available for our question-and-answer session following our prepared comments. I like to begin with the few thoughts on our financial results, and then ask Mark to provide additional detail with his remarks to follow.

As our release states, the one released earlier today, our second quarter earnings per share grew year-over-year by 5.9% to $0.36 per share and net income for the quarter totaled $6.5 million. For the first six months of the year, our earnings per share totaled $0.81, versus the $0.76 in the prior year, a gain of 6.5%. A driver of our earnings growth is our revenue growth, driven by an expanding net interest margin that produced $4.6 million of incremental net interest income year-to-date.

Our bankers are focused in managing our business, and getting a fair price from employing our capital and proactive in liability pricing through the rate reductions announced by the Federal Reserve earlier this year. We're balancing the competitive market pressures in deposit pricing with the overriding strategy to build deposits and funding our loan growth. I'm pleased to report that our total deposits were up 2% in the quarter and up nearly 5.5% from the second quarter of last year. As importantly non-interest bearing demand deposits were up 11% from the prior year, reflecting our emphasis on the lower middle market, small business, and retail.

We're advancing our credit processes around common underwriting practices and risk identification for a new opportunities and our seasoned portfolio. Let me return a moment to our earnings. Our revenue in net interest income gains were offset largely by the need to increase our provisioning in the quarter. While our charge-offs for the first six months were high, we used the second quarter provision to build our loan loss reserve by 7 basis points over the level of last June. During the quarter, we completed a rigorous evaluation of our commercial portfolio, in particular, real estate development, and made many appropriate grading changes and value adjustments based on fresh appraisals.

While we are disappointed in the direction and level of our non-performing assets, we feel our measurement of impairment is very current and reflective of an environment that we expect to remain weak. Dave Spade, will follow Mark with a discussion of our overall credit quality and portfolio activity.

Our plan for 2008 is to remain active in managing credit and our overall expense levels. We are pleased that our efficiency ratios continue to decline. The efficiency ratio measured 58% in the second quarter, continuing a trend that began with our organizational changes last year. As stated earlier in my remarks, and as you'll hear from Mark and Dave, we recognize the environment we're operating in, and really prioritize managing through this credit cycle in a manner that positions First Merchants well for the future.

We find our customers in prospect and employees are looking for affirmation that our bank is active and very much open for business. I assure you that our activity levels, in regards to customer calling, deposit-gathering, the winning of new households and commercial accounts remains robust.

At this point, I would ask Mark to probe deeper into our financials.

Mark Hardwick

Thank you, Mike. I like to thank all of our interested shareholders for joining us today. As Mike mentioned, that we are off to a solid start in 2008, and the corporation's assets reached a record $3.822 million as of June 30, 2008, an increase of 4.2% over this time last year.

Total loans and investments, the corporation's primary earning assets, increased by $142 million or 4.3%, as investments declined $71 million and total loans increased by $213 million, of that $213 million increase in total loans, commercial and industrial loans increased by $225 million, commercial and farm real estate increased by $59 million, and agricultural production loans increased by $22 million. Individual loans for household and personal expenditures declined by $45 million, as the corporation strategically exited the indirect lending business, due to the lack of customer relationships and low yield.

The corporation has additionally reduced its exposure to residential real estate for similar spread related reasons by reducing outstanding by $50 million, and is focusing all of its mortgage efforts around the origination of fee-for-service business. Total deposits increased during the past year by 5.2%. The combination of investment portfolio run-off and deposit growth allowed borrowings to decline by a $1 million year-over-year, reducing our dependency on wholesale funds. Total stockholders equity increased by 20 million from June 30th, 2007 to June 30th of 2008, despite the repurchase of 458,000 shares totaling $10 million, and the payout of nearly $16.8 million in dividends.

First Merchants remained confident in its ability to produce the net income sufficient to maintain adequate capital levels, our dividend payout and a growing balance sheet. Net interest income is a primary driver of First Merchants Corporation's earnings, for the quarter, net interest income improved by $4.6 million or 16.5%, as net interest margin expanded by 35 basis points to 3.85%. As we discussed in our last call, the corporation received 5,216,000 in connection with the termination of its three interest rate floor agreement. The three interest rate floors, which had an aggregate notional amount of $250 million and strike rates ranging from 6% to 7%, were purchased on August 1st, of 2006 for $553,000. The contractual maturity of the floors was through August 1 of 2009.

The pretax gains of $4,662,000 million are to accrete into earnings over the remaining 16 months of the original contract. In March, the corporation recorded $236,000 of the gains in net interest income and $277,000 into other income. During the second quarter, the corporation recorded $561,000 to net interest income, leaving the remaining $3.6 million gain to be recognized over the next 13 months.

Loan loss provisions for the quarter increased by $5.4 million to $7.1 million based on the Corporation's continued evaluation of the allowance for loan loss calculations, our most significant accounting estimate. Net charge-offs totaled $4.6 million or 61 basis points on an annualized basis for the second quarter. The net effect of the allowance for loan losses was an increase to 1.05% of loans outstanding.

Specific reserves at quarter end declined by $100,000 from the same period last year, while general historical and environmental factors accounted for the $4 million increase in the total allowance for loan losses, period-to-period. Dave Spade will add color to our NPLs and our NPAs, as well as, the granularity of our loan portfolio in just a moment. Non-interest income remained strong, increasing 5.8% and total expenses decreased 1.3 million as the efficiency ratio improved to 58.24% for the quarter. The end result is a 5.9% quarter-over-quarter increase in earnings per share, and a 6.6% year-to-date improvement, respectable, given the environment.

Dave Spade will now cover our credit quality.

Dave Spade

Thank you, Mark. As Mark and Mike mentioned, we continue to operate in the challenging economic and credit environment. Although, volatility in certain regions of the country remains high, the Midwest is not immune to the larger economic issues facing housing and real estate markets. Allow me to highlight some more significant change in our credit portfolio during the second quarter. As of June 30th, 2008, First Merchants Corporation continued to see increases in the non-performing asset totals, primarily in two additional commercial and industrial loans that represent 10.1 million in outstanding balances.

In line with our last market call on April 22nd, the remaining loan exposure for one particular Indianapolis based residential land developer was also moved to the other real estate owned classification, as three properties were deeded to the bank during that second quarter. Finally, one residential land development credit from our Lafayette market was deeded to the bank during the second quarter, representing the only other major addition to the non-performing asset category.

With those changes referenced in these remarks, the other real estate owned and repossessed asset classification balances moved to 17.5 million, as compared to 7.4 million at the end of the first quarter of 2008. Non-accrued loans increased by 6.9 million for the 90 day and over past due delinquent loans fell by 1.5 million. The affiliate banks of FMC have an active marketing plan through auction companies and direct sales opportunities to reduce the other real estate (inaudible).

Annualized net charge-offs year-to-date to average loans outstanding stood at 0.61% as of the end of the second quarter, compared to 0.12% for the same period one year ago. These performance numbers reflect the challenging stage of the economic cycle affecting the corporation. By comparison, annualized net charge-offs as a percentage of average total loans outstanding represented 0.24% at December 31, 2007. Total residential mortgage loan delinquencies at First Merchants Corporation as a percentage of total mortgage loans outstanding increased to 2.31% compared to the first quarter delinquency of 1.9%.

Total commercial loan delinquencies over 30 days past due were 0.93% of total commercial loans outstanding, which compared favorably to the first quarter past due report of 1.06%. Except non-accrual balances, total First Merchants Corporation loan delinquencies declined from 1.3% of outstanding loans during the first quarter to 1.17% at June 30th, 2008. The seasonally adjusted delinquencies for residential mortgages provided for all banks, as presented in the latest release by the Federal Reserve, stood at 3.68%, while commercial loan delinquencies during the same timeframe represented 1.41% of total C&I loans outstanding for all banks. By comparison, FMC continues to perform favorably in the control of delinquencies, as compared to the composite totals for all banks in the United States.

Construction and land development loans as defined by the OCC, were $181.6 million as of June 30th, 2008, those loans represented 52.2% of capital and 6% of total loans at FMC at the end of the second quarter. Federal family loans of $102,800,000 represented 29.6% of capital and 3.4% of total loans.

Finally, investment, commercial real estate and multi-family loan balances of 386 million represented 111% of capital and 12.8% of total loans. Overall, the total commercial real estate including land development, non-owner occupied property and multi-family loans represent 27.6% of total loans at First Merchants Corporation. There continues to be a balance of components within the commercial real estate portfolio. And we continue to pay particular attention to our asset mix, as we review new opportunities and move to grow the commercial portfolio.

Michael Rechin

Thanks, Dave. It's Mike Rechin again, and we'll open up for questions here in a moment. I would just add that while some of the credit statistics you see in our industry and some of the deterioration we've had in our portfolio, portray a duller environment. I am pretty pleased with our asset mix, some of the changes that Mark referred to earlier in terms of strategic exits from indirect and such, are beginning to play into our margin. And while our balance sheet clearly has risk in it in our lending emphasis, I look at it absent some of the ingredients that some of our peers are deeper in, for instance, home equity lending, which is less than 5% of our earning assets, and the credit business, which appears to gather more scrutiny, which is not in our balance sheet at all.

So at this point we would be happy to take any questions from those on the phone.

Question and Answer Session

Operator

(Operator Instructions). Our first question comes from David Scharf at FTN Midwest Securities.

David Scharf - FTN Midwest Securities

Hey. Thanks for taking my call.

Michael Rechin

Hey, David.

David Scharf - FTN Midwest Securities

Hi. I was wondering if we could kind of just diving into a little more of what was going on with the non-performing loans? And what was in that, maybe I miss understood you. But what was in that about $70 million of quarter increase in NPLs and also what came out of OREO? I understood what went into it, but what came out of it?

Michael Rechin

Loans coming out of OREO would be some pay-downs of some of our development loans where we take an ownership, I can speak to the Lafayette Credit that I mentioned that had some particular sales, and in fact, had those lot sales at retail prices. We had some other sales of residential-type properties. In fact, this year we've had at least six loans that we were outbid at, at the [share of] sale. So, a smaller number on that side, but particular interest in the Lafayette project.

David Scharf - FTN Midwest Securities

Okay. So mainly [CNB]?

Michael Rechin

Yes.

David Scharf - FTN Midwest Securities

Okay. And then, what was led to the increase in the non-performing loans?

Michael Rechin

Mark, can you repeat that question?

Mark Hardwick

Yeah, I think I heard you, but...

David Scharf - FTN Midwest Securities

Dave, I apologize. The link quarter increase in NPLs and non-accruals?

Michael Rechin

Yes, it came from two particular C&I credits.

David Scharf - FTN Midwest Securities

That was the 10 million?

Michael Rechin

Up to $10 million, right.

David Scharf - FTN Midwest Securities

So, the residential land from Lafayette was also in the non-accruals?

Michael Rechin

We took it into other real estate-owned.

David Scharf - FTN Midwest Securities

Okay. I misunderstood that. How is the sale process going as far as from when it gets to you are selling the property relative to the original value, meaning like if you appraised it, what sort of write-down is occurring?

Michael Rechin

On the residential types, we got fairly conservative appraisals. We've had write-downs of probably less than 10%.

David Scharf - FTN Midwest Securities

Okay. Is that a fair gauge, is that 10 to 15?

Michael Rechin

Well, that's just general statement. But the ones I can think of right on top of my head haven't been additional adjustments downward from the appraised values after we've taken them into other real estate-owned.

Mark Hardwick

David, I think we are assessing those really case-by-case. The benefit of the fresh appraisals is it is underwritten of our market conditions arms length valuations that help us to better understand what is that, as you have probably seen a significant amount of non-bank activity in trying to take advantage of distressed assets. So we are assessing those and probably through the balance of the year, we will take advantage of a deeper market for properties, as we get more comfortable with what their actual worth is.

David Scharf - FTN Midwest Securities

Okay. And as far as loan categories, what are the other portions of the non-performing loans about? Looks like about a third of it is the C&I that you mentioned. What would the other two thirds be?

Mark Hardwick

In non-accruals?

David Scharf - FTN Midwest Securities

Yeah.

Mark Hardwick

Let me refer back to couple of my notes here. Yeah, thank you. I am sorry, thanks for bearing with me here.

David Scharf - FTN Midwest Securities

Sure enough.

Mark Hardwick

1-4 family residential properties, approximately $10.5 million, loan secured with owner-occupied, non farm properties $7.6 million, loans for C&I $8.4 million. Those are some of the biggest categories.

David Scharf - FTN Midwest Securities

Okay.

Mark Hardwick

They breakdown from there.

David Scharf - FTN Midwest Securities

Okay. Well, I take a step back here for now and thanks for answering my questions.

Mark Hardwick

Yes.

Michael Rechin

Thanks, David.

Mark Hardwick

Thank you.

Operator

Our next question comes from Brian Martin of Howe Barns.

Brian Martin - Howe Barns

Hey.

Mark Hardwick

Hey, Brian. Good afternoon.

Brian Martin - Howe Barns

May be I didn't write it down fast enough when Dave was talking, but the construction development portfolio, how big is that at this point? Can you quantify what that number was, or maybe I just didn't hear you?

Dave Spade

It was about 182 million.

Brian Martin - Howe Barns

Okay. And of the 182, how much is non-performing at second quarter?

Dave Spade

Yes. Let me refer to a couple other notes that I have got here.

Brian Martin - Howe Barns

Okay.

Dave Spade

Bear with me a moment please. Just adding up a couple of things it's probably about, out of that total, probably about, including non-accrual?

Brian Martin - Howe Barns

Yeah.

Dave Spade

It would be about 15 to 16 million. That was just quick addition here. I am sorry.

Brian Martin - Howe Barns

Okay. All right, and as far as just couple other items, on the loan side, the strong growth in the C&I book at this point, given that you've seen a little bit of weakness in the couple of credits this quarter. Can you just talk a little bit about your outlook on that growth going forward? Are you slowing it down a little bit or is this just capitalizing on other banks kind of withdrawing on the market, or just trying to understand, what your outlook on that growth is and the opportunities you are seeing in the market?

Michael Rechin

I'll take that, Brian, its Mike. Yes, it has been, as you look at some of the information provided the dominant growth engine of the commercial loan category overall, and I would characterize us as one of the banks, that we looked at our leverage parameters around C&I lending, cash flow leverage in particular. Pretty mindful of our fresh underwriting has been I think very commensurate with the conditions of the time. We've had some issues, as you know, with some of our seasoned work that might have been underwritten in earlier time periods.

What we're really focused on now is better structure, first and foremost, better pricing to compensate us for the risk we are taking. I think part of your question was, a little bit of a forward look. I would think that our loan growth should plug along at a in my mind, conservative mid single-digit annualized rate that would account for both the new volume, netted by the shrinkage I think you will continue to see in our indirect book.

Brian Martin - Howe Barns

Okay. So it's still continue to be at a pretty, double-digit type of clip in the C&I book going forward?

Michael Rechin

I think it will be, because you referred in your question to something that's hard for us to ignore and that is the opportunistic growth that's available based on a number of the regional competitors that we have really backing away from the market. And our parameter there beyond loan structure that I referenced earlier is just to do it in the context of full relationship banking and to make sure that we are partaking in the deposit opportunity and the fee opportunity.

Brian Martin - Howe Barns

Okay. And to that end, have you guys added with some of these other banks withdrawing from the market. I mean any news on this quarter as far as taking talent from other markets? I thought last quarter-to-quarter before you kind of talked about the Indianapolis market might being an opportunity. Have you seen any additions in that market?

Michael Rechin

Our net numbers are not up dramatically. But in the places that we are seeing continued growth, Indianapolis being one in this past quarter. We would have added relationship managers in Cincinnati, Ohio, in Columbus, Indianapolis, and Lafayette for that matter. Yet, our net numbers shouldn't grow that higher. We are mindful of the expense of those folks and are continuing to look at the efficiency and the quality of that folks on the field.

Brian Martin - Howe Barns

Okay. All right. How about maybe, just question for Mark on the margin. Kind of where you are positioned versus what you've re-priced on the deposit side, kind of how you feel about the margin at this point?

Mark Hardwick

We feel great about the margin in today's rate environment.

Brian Martin - Howe Barns

Yeah.

Mark Hardwick

And I, actually we feel pretty good about the margin in a modest movement upward or downward, really either direction. We think we still have a little room on the deposit side if rates were to decline. It does not look like that's where we are headed. If rates are to move up, we have the historical kind of proven capacity to lag our deposit rate and to have our $500-plus million in prime rate loans repriced upward. We've actually been selling this year pretty successfully some interest rate swap arrangements with some of our larger commercial borrowers allowing the borrower to have a fixed rate loan.

And that would be floating on our books, which allows us to have a little more rate movement in the upside. So within some reasonable range, that 100-basis point movement to 150 up. We feel really good that we would be able to maintain our margin or slightly expand. So at least where we are today, we feel like we have a pretty strong net interest income engine running in the company that is allowing us to offset some of the additional provisioning that we've seen this year.

Brian Martin - Howe Barns

Okay. How about just going back to credit for a minute and maybe Dave. You talked about the breakdown of the non-accruals. Can you talk about maybe the two largest credits in there, top credits, how big in size we are talking about?

Dave Spade

Are you talking OREO, or non-accrual?

Brian Martin - Howe Barns

I guess maybe just both separately or just which in each is of significant size? You talked earlier about kind of the granularity. I'm just trying to get a sense for what the profile of that the non-performers are?

Dave Spade

Yes. One is a fairly recent one, that's C&I credit, and it's in our Anderson market. There is some cash associated with that. Well we haven't recognized yet and...

Brian Martin - Howe Barns

In size wise that was how big?

Dave Spade

That's about 4 million.

Brian Martin - Howe Barns

4 million, okay.

Dave Spade

And then the other credit is another C&I credit in the Indianapolis market. In fact there are a couple of apparently written offers that's about 6 million roughly.

Brian Martin - Howe Barns

Okay.

Dave Spade

A couple of letters of intent rather, not offers, but letters of intent to acquire that company and if those are successful, we will be paid in full.

Brian Martin - Howe Barns

Okay.

Dave Spade

Those were the non-accruals. And the largest other real estate would be credits that I have mentioned in the past, in Delaware County. It's our commercial development, and we have some level of activity at this point in time, have provided an offer and a counter offer back to it's buyer for about 40% of that. And that dollar figure is roughly on our books, it's roughly at about 5.9 book balance on that today.

Brian Martin - Howe Barns

Okay.

Dave Spade

And the other largest OREO property that we have would be the developer that I had mentioned in Indianapolis, that's roughly 6 million.

Brian Martin - Howe Barns

Okay. So I mean two credits are about 12 million are in OREO, and two credits at about 10 million, is that right?

Dave Spade

That's correct.

Brian Martin - Howe Barns

Okay. Do you guy's by chance have the regulatory capital levels at quarter end?

Mark Hardwick

No, I didn't bring that with me.

Brian Martin - Howe Barns

And was there much, much change Mark, do you recall from, or I can get it from you after the call if that's easier or...

Mark Hardwick

I can give that to you after the call. I mean our standard capital plan is with all of our banks and then the corporate borrowings etcetera, we've had very little fluctuation. And we have no negative movement downward in the tangible capital or the regulatory capital. But I don't have the number in front of me.

Brian Martin - Howe Barns

Okay. All right, I think that's it. Thanks.

Michael Rechin

Thanks, Brian.

Operator

(Operator Instructions). At this time we show no further questions.

Michael Rechin

Thank you, Annie. And thanks again to all of our listeners and participants today. Look forward to sharing an update on our third quarter results come mid-October. Thank you.

Operator

This conference is now concluded. Thank you for attending today's presentation. You may now disconnect.

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