Mercantile Bank Corporation Q1 2010 Earnings Call Transcript

| About: Mercantile Bank (MBWM)

Mercantile Bank Corporation (NASDAQ:MBWM)

Q1 2010 Earnings Call Transcript

April 20, 2010 10:00 am ET

Executives

Mike Price – Chairman, President and CEO

Chuck Christmas – SVP, CFO and Treasurer

Bob Kaminski – EVP and COO

Analysts

Stephen Geyen – Stifel Nicolaus

Dennis Klaeser – Raymond James

Terry McEvoy – Oppenheimer

Steve Covington – Stieven Capital

Operator

Welcome to the Mercantile Bank Corporation first quarter earnings conference call. There will be a question-and-answer period at the end of the presentation.

(Operator instructions)

Before we begin today’s call, I would like to remind everyone that this call may involve certain forward-looking statements such as projections of revenue, earnings and capital structure, as well as statements on the plans and objectives of the company or its management, statements on economic performance, and statements regarding the underlying assumptions of the company’s business.

The company’s actual results could differ materially from any forward-looking statements made today due to important factors described in the company’s latest Securities & Exchange Commission filings. The company assumes no obligation to update any forward-looking statements made during this call. If anyone does not already have a copy of the press release issued by Mercantile today, you can access it at the company’s Web site, www.mercbank.com.

On the conference today for Mercantile Bank Corporation, we have Mike Price, Chairman, President and Chief Executive Officer; Bob Kaminski, Executive Vice President and Chief Operating Officer; and Chuck Christmas, Senior Vice President and Chief Financial Officer. We will begin the call with management’s prepared remarks, and then open the call up to questions. At this point, I would like to turn the call over to

Mr. Price.

Mike Price

Thank you, Karen. Good morning everyone and welcome. While we are beginning to see some positive signs in our marketplace, and especially within our other real estate owned portfolio, the distressed economic conditions negatively impacted our quarterly loan loss provision, and thus our overall results. Bob Kaminski will detail the entire dynamic of our loan portfolio and the provision for loan losses during his comments.

While we suffered another loss quarter, the significant improvements in net interest margin and overhead that were initiated in 2008 and 2009 continued to help mitigate the effects of the elevated loan loss provision costs. We expect these improvements to continue and allow our bank to weather the storm. Chuck Christmas and Bob will detail these actions in their comments. While our improvements were not robust enough to completely counteract the higher loan loss expense, they are continually improving and allowing us to maintain our well-capitalized position.

At this time, I will turn it over to Chuck Christmas.

Chuck Christmas

Thanks, Mike, good morning everybody. This morning we announced that we recorded a net loss of $3 million during the first quarter of 2010 compared to a net loss of $4.5 million during the first quarter of 2009.

On a pretax basis, which we believe provides a more accurate comparison given the establishment of a valuation allowance on our deferred tax asset during the fourth quarter of 2009, and the issuance of preferred stock during the second quarter of 2009, our net loss during the first quarter of 2010 was $3.1 million compared to a net loss of $7.3 million during the first quarter of 2009. While we are of course disappointed with the net loss, we are encouraged by the 58% improvement on a pretax basis, as well as with a continued improvement in many key areas of our financial condition and performance.

Our financial performance during the first quarter of 2010, like that throughout 2009 and 2008 was impacted by significant provision expense as we needed to increase our loan loss reserve in light of the quality of our loan portfolio, and to cover net loan losses. Unfortunately, continued state, regional and national economic struggles have negatively impacted some of our borrowers cash flows, and underlying collateral values leading to increased nonperforming assets, higher loan charge-offs, and increased overall credit risk within our loan portfolio when compared to the historical norms.

From the time we sensed the economic weakness over two years ago, we have been working with our borrowers to develop constructive dialog, which has strengthened our relationships and enhanced our ability to resolve complex issues. With the environment for the banking industry likely to remain stressed until economic conditions improve, credit quality will continue to be our major concern. We will remain relentlessly vigilant in the identification and administration of problem assets.

Unfortunately, provision expense as well as nonperforming asset administration and resolution costs will likely remain higher than historical levels dampening future earnings performance. But during the first quarter of 2010, we saw the continuation of very positive trends we reported throughout 2009 as well, and I would like to touch on some of them with you this morning.

Despite a reduction in our total earning assets, an improved net interest margin has provided for increased net interest income. Net interest income during the first quarter of 2010 was $2.5 million higher, that is an increase of 21% from the first quarter last year. Our net income margin during the first quarter of this year was 3.25% compared to 2.28% in the first quarter of 2009, an improvement of 97 basis points over 42%. The improvement is primarily due to a significant decline in our cost of funds, and we expect a continued reduction in our cost of funds during 2010, although at a slower pace than during the past several quarters.

During the remainder of 2010, we have about $430 million in wholesale funds maturing at an average rate of 1.80%. During the first quarter, our average rate on new wholesale funds was about 1.1%. Also contributing to our improved net interest margin has been a very stable yield on assets. The loan pricing initiatives we have undertaken within the commercial loan function have almost completely mitigated the negative impact of the increase in nonaccrual loans.

Overhead cost reduction strategies are becoming realized. Excluding nonperforming asset administration and resolution costs as well as FDIC insurance premiums, our overhead costs declined by about $1.2 million during the first quarter of 2010 compared to the first quarter last year. Non-performing asset administration and resolution costs totaled about $2.5 million during the first quarter of this year compared to $1 million last year. During the first quarter of this year, valuation write-downs on foreclosed properties and property tax payments both totaled about $0.8 million with legal expenses totalling $400,000.

We remain a well capitalized banking organization and our regulatory ratios increased during the first quarter of this year despite our net loss. At the end of the first quarter of 2010, our bank's total risk based capital ratio was 11.2% and in dollars was over $20 million higher than the 10% minimum required to be categorized as well capitalized. At year-end 2009, our bank's total risk based capital ratio was 11.1% and the surplus was about $18.5 million.

Local deposits and sweep accounts were up over $7 million during the first quarter of this year and up about $219 million since the beginning of 2009. Combined with a reduction in our loan portfolio, we have been able to reduce our level of wholesale funds by about $475 million since the beginning of 2009. As a percent of total funds, wholesale funds have declined from 71% at the beginning of 2009 to under 55% at the end of the first quarter this year.

Our loan loss reserve totaled $50.1 million that is an increase of $2.2 million from the beginning of the year, and an increase of $18.2 million from the end of the first quarter of 2009. As a percentage of total loans, the loan loss reserve was 3.35% at the end of the first quarter this year compared to about 3.1% at the end of 2009, and about 1.8% at the end of the first quarter last year. Although the increase was accomplished through a high provision expense, the higher loan loss reserve level provides additional cushion for potential loan losses.

Those are my prepared remarks, and I will now turn it over to Bob.

Bob Kaminski

Thank you Chuck and good morning. My comments today will discuss the asset quality performance during the first quarter. You will find numerous tables containing all the asset quality information in our press release, while I focus this morning on some of the key points.

March 31, 2010 brought a $5.9 million net increase in nonperforming assets over December 31. That net number was a result of the addition of $23 million of new nonperformers and offset by principal paydowns of $4.2 million sale proceeds on assets of $5.1 million, charge-offs and valuation write-downs of $7 million, and loans returning to performing status of $800,000. Also included in the nonperforming total was an increase of $3 million attributable to loan restructuring where the bank is working with the stress borrowers to provide some relief with the loan modifications.

While commercial real estate administration and problem loan disposition continue to be quite challenging, as these numbers seem to indicate, we are starting to see increased inquiries and activities in the movement of some troubled commercial real estate.

Net charge-offs during the quarter were $6.2 million compared to $10.9 million in the fourth quarter of 2009 and $5.6 million in the prior year quarter. Over half of the charge-offs in the first quarter or $3.7 million was attributable to commercial real estate and development while another $1.5 million was for residential real estate and development. The remaining $1 million was attributable to commercial loans.

Provision expense for the quarter totaled $8.4 million. The major allocations of that provision among the various loan types show $3.7 million covering land development and construction, $5 million allocated towards owner occupied and non-owner occupied commercial real estate, $700,000 covering commercial and industrial loans, and finally, a benefit of $1.2 million was derived from recoveries and portfolio shrinkage.

Loan delinquencies in the category of 30 to 89 days past due totaled $12.8 million for March 31. $12.1 million of the total is derived from two lines of credit that are in various stages of workout negotiations. I will note that off the $12.1 million, $8.1 million is not contractually current as of April.

The key strategic initiative for Mercantile has been the reduction of commercial real estate and development loans. Since January 2009, land development and construction outstanding have been reduced $103 million, while owner occupied and non-owner occupied commercial real estate had been reduced another $69 million. As I mentioned, much more information is included in the press release and I will be happy to answer any questions in the Q&A session.

Now, I will turn it back over to Mike.

Mike Price

Thanks Bob and thanks Chuck for your comments. Karen, we would like to open it up for questions at this point.

Question-and-Answer Session

Operator

(Operator instructions) Our first question is from the line of Stephen Geyen of Stifel Nicolaus.

Stephen Geyen – Stifel Nicolaus

Hi this is Stephen Geyen, how are you doing today?

Mike Price

Hi Steve.

Stephen Geyen – Stifel Nicolaus

A question on the decline in local certificates or deposits, just wondering if that was due to a pricing change or a change in kind of the plans. In previous quarters, you guys were talking about possibly pricing up a little bit to gain those CDs and potentially the relationships as well, and I am just wondering what your thoughts are on that.

Chuck Christmas

Hi Stephen, this is Chuck. One of the things that we did in the first quarter of 2009 is we ran a special CD campaign that happened to be a one-year term, and we raised I think about $65 million through that campaign and generating local certificates and deposits. Those matured primarily in February and March of this year, and a lot of those monies we retained I think about 70% in total. A lot of that retained actually went into interest bearing checking accounts. We have a pretty attractive what we call executive banking, which is an interest bearing checking account, as well as into the money market account. So that is the reason for most of that movement.

Stephen Geyen – Stifel Nicolaus

Okay and in relation to the broker deposits, is it more of a pricing issue? Does the decision to go with broker deposits an increase in broker deposits versus local deposits CDs?

Chuck Christmas

The increase in the broker deposits although when you net out the reduction in FHLB advances it mitigates that. We continue to maintain a relatively high level of on balance sheet liquidity, primarily Fed funds, and we also have a money market account in another corresponding [ph] bank, and if you just kind of compare actual balances to actual balances during the first quarter compared to year-end 2009, you see we did not have a lot of Fed funds sold on the actual year-end date. So we built that up primarily in January and ran with a pretty high level of Fed fund.

So we just continued to look at our on balance sheet liquidity in light of the economic as well as the banking conditions (inaudible) ourselves and at this point in time continue to maintain a relatively high level there.

Stephen Geyen – Stifel Nicolaus

Okay, and a question for Bob, just wondering about the pricing in the OREO as far as – were there any mark-downs and could you talk a little bit of the in and out of OREO? It looks like OREO was down a bit from the fourth quarter.

Bob Kaminski

Yes, we had a large OREO sale in the first quarter, it was good to see and really the focal point of my comments about being some movement and some activity in the OREO account. As you might imagine, there is a lot of multi-activity there. We have some properties coming in and some properties going out. We are continuing to value those properties each and every month to make sure that we have got an accurate balance based on the market value that we are carrying on our books.

But during the first quarter I am very pleased, we saw a number of, besides that large sale, we saw a number of sales to small properties throughout the quarter both on some commercial properties, some residential properties, amounts that made us approach that comment there about the activity in the marketplace, and there continues to be some offers and some interest heading into the second quarter. Whereas six months ago, nine months ago, a year ago, there was not a whole lot of interest in bank owned properties, we are starting to see some activity and some movement there as I indicated.

Stephen Geyen – Stifel Nicolaus

Okay and the last question on credit, just wondering about TDRs, what portion of net charge-offs came from TDRs or connected to the TDRs?

Bob Kaminski

Yes, I think that in the first quarter there were no percentage of charge-offs coming from TDRs.

Stephen Geyen – Stifel Nicolaus

Okay and the last question, the net interest margin, we briefly noticed improvement, just curious, you mentioned Chuck that there was about $430 million maturing, of CDs maturing in 2010, is that more weighted to the first-half, last-half of 2010, could you give some more color?

Chuck Christmas

Yes Steve, that is not only just broker CDs but also FHLB advances just to be clear on that, it is pretty well weighted throughout the rest of the nine months fairly equally, maybe a little bit more on the second quarter than the third and fourth but not materially.

Stephen Geyen – Stifel Nicolaus

Okay, thank you.

Operator

Thank you sir. Our next question is from the line of Dennis Klaeser of Raymond James.

Dennis Klaeser – Raymond James

Good morning.

Mike Price

Good morning.

Dennis Klaeser – Raymond James

First on your capital levels I noticed today, and you commented on your prepared remarks that your regulatory capital ratios actually increased despite the loss and you have a fair amount of cushion over the well capitalized threshold. I am wondering if you have talked to the regulators about what your sort of appropriate target capital levels should be with and without TARP capital?

Chuck Christmas

Yes Dennis, this is Chuck. We have not had any specific discussions with regulators about being a TARP recipient or not. They obviously do their annual examination, which we continue to enjoy and from our discussions today, our level of capital is seen sufficient. Obviously they have concerns about our net losses, but I am pleased with the fact that not withstanding the DTA valuation allowance at the end of the fourth quarter of last year that we are able to actually increase our regulatory capital ratios and keep down obviously even the risk based ratio above 11% despite their earnings performance. So they seem to be satisfied with where we are at and what we are able to do given the current financial condition.

Mike Price

Dennis, this is Mike, I will just add to that, I think that one of the things that we constantly are pointing out is that obviously it has been a very difficult couple of years for many, many community banks throughout the country, and we certainly have felt what is going on in the economy. But if you go back to two years ago to the end of the first quarter of 2008, for example, our total risk based capital was 11.18% despite all of the things that have happened to us and the difficulties that we have had at the end of the quarter, our total risk based capital was 11.21%.

So we have done the things we had to do. Some of them were very difficult, some of them were very painful but obviously being TARP recipient has helped but some of the initiatives that we started just about two years ago have really allowed us to weather the storm and fight through this very difficult environment.

Chuck Christmas

And added to that as well Dennis, Chuck again, as you know it was great to get the TARP proceeds from a capital ratio standpoint. In the second quarter we down streamed, off the $21 million we down streamed $19 million of debt to the bank as a capital injection, but of course had to do the DTA valuation allowance in the first quarter which pretty much equaled what we had to do with the proceeds on the TARP and obviously we do not get to show that benefit going forward because any benefit derived from net loss from operations we just have to increase our valuation allowance.

So from a long-term standpoint, we are obviously hoping to get back to profitability as soon as possible and with that brings the idea that we would be able to start reducing that valuation allowance which would certainly benefit our capital ratios. We can obviously back in the fourth quarter Congress approved the regulation allowing banks to go back five years in their carry-forward analysis, as I am sure you know.

Dennis Klaeser – Raymond James

Yes.

Chuck Christmas

TARP recipients did not get that benefit. You obviously were looking to return the profitability and start reversing the valuation allowance, which it was well over $20 million now, which obviously would benefit not only earnings but our capital positions going forward as well. So that certainly helped there hopefully not in the near-to-distant future.

Dennis Klaeser – Raymond James

Sure. Just overall your decrease in your loan balances over the past few quarters has helped the capital ratios. When you looked forward, do you see the overall loan balances continue to decrease in size, and at what point do you think that would stabilize and start increasing again?

Mike Price

That is a very good question, we were just talking about that in our management [ph] meeting this morning, and we expect our commercial real estate balances to continue to decline. That is a stated goal that we have had and that has continued to march on. An interesting change that has happened really only in the last month or two is that we started to see our C&I customers utilize our lines of credit more. And overall it is a very good sign because we have really been in a two-year decline where our customers have just not needed their lines of credit because volumes have been down and so we are starting to see a reflection of the increase in economic activity, increases in the C&I lines of credit.

So that has the tendency down to start to flatten out as far as the loan balance decline goes, which is kind of where we expected. About two years ago, we kind of thought to ourselves looking out that if we could get the total assets of the bank mostly to shrinking the loan portfolio from about $2.2 billion to about $1.8 billion that seemed about the right number and there was nothing real scientific in that although there were some very good thought in looking at what we needed to do as far as reducing commercial real estate, and it is kind of where we are headed, and we would expect that to continue in the next couple of quarters.

Bob Kaminski

This is Bob, I think what you will see is a shift in the mix of the portfolio away from the commercial real estate that as the economy improves, a shift towards C&I relationship that we wanted to further foster.

Dennis Klaeser – Raymond James

Sure. Within the broad category of commercial real estate or loans secured by real estate, you have got the various categories of land loans that they can land in the land development in both commercial and residential, those balances have not changed a great deal over the past quarter or two, could you give an outlook on that, part of the portfolio, how much of that is sort of is up for renewal over the near term, and what are the sort of trends in terms of underlying values of those properties?

Bob Kaminski

If you look at the trends in those buckets, they only happened on quite a bit over the last year, obviously the rate of reduction has slowed a bit in the last couple of quarters but there is some reduction there. And you have some construction relationships that have concluded, their projects are completed, and those are being moved from the development of construction buckets into the amortizing buckets. We have some relationships there where there are some development activity, where the principals and the guarantors are obviously providing significant support for the development, as the climate hopefully improves and there starts to be some additional activity in terms of both (inaudible) of real estate for sale.

So when you look at the reductions we have made over the last 12 months, the last 18 months, there has been quite a significant percentage of that portfolio, I do not think it had ever been zero necessarily but I think we just have to see as there continues to be some movement there, shifts in terms of sale, in terms of liquidation of those parcels, and as well as shifting to amortizing type real estate loans.

Dennis Klaeser – Raymond James

And then one final question, your reserve building obviously has been very significant over the past year, I particularly look at the loan loss reserve to total loan ratio which I think has nearly doubled year over year and it has increased quite a bit over the last two quarters, what is your outlook for that particular ratio? Do you see you need to continue to build that ratio or will that peak out here at some point?

Mike Price

We would like to think that – as you know, subsequent to year-end we went back and really looked at conditions in the portfolio and we beat it up even more. We would like to think that we did a very good job of identifying where we needed to be and even more importantly, as we look out over the last few months and we look out over the next couple of months, we are seeing more positive signs than we have seen in probably two years.

So the prediction of where that is going to be, we pledged that we are going to keep it where it needs to be, and if it needs to go up we will do it but I would tend to think that because we have been pretty aggressive with reserve building in the last few quarters especially as you pointed out that we would like to think with some of the positive things we are seeing out there in valuations and in the economy in general that we are not going to need to be quite as aggressive over the next few quarters.

Chuck Christmas

Yes I think the bottom line is the reserve will move directionally consistent with the metrics in the portfolio.

Dennis Klaeser – Raymond James

Okay, thanks guys.

Chuck Christmas

Thank you Dennis.

Operator

Thank you sir. (Operator instructions) And our next question is from the line of Terry McEvoy of Oppenheimer.

Terry McEvoy – Oppenheimer

Good morning, thanks.

Mike Price

Hi Terry.

Terry McEvoy – Oppenheimer

Could you just talk about the discussion that goes into whether you should or should not pay the TARP dividend? Obviously you guys have had a tough couple of quarters where you have had operating losses and whether that plays into that type of discussion, and then as part of that, I believe over the years you have participated and pooled [ph] trust preferred, have you deferred the dividend on any of those securities?

Chuck Christmas

Terry this is Chuck, we have not deferred the dividends and the trust preferred, the $32 million that we have got as you correctly stated in the pools obviously we continue to pay the dividend on the TARP as well. It is certainly something that we talk about and think about as we look at our capital levels, look at where they currently are, look at our projections, obviously look at our bottom line earnings performance, it is our belief that as long as we can show at least steady, obviously we continue to show improving capital ratios that we will continue to expect to pay interest on both TARP as well as the trust preferred but it is certainly in the mix and that is certainly again something that we look at, at least on a quarterly basis, and put that in the context with our earnings performance and then obviously the impact of the capital ratios.

Terry McEvoy – Oppenheimer

Is there any restrictions at all on utilizing the brokerage CD market for you guys?

Chuck Christmas

No.

Terry McEvoy – Oppenheimer

And then the last question was, in terms of the OREO sales that happened in the first quarter, could you just talk about where those sales occurred versus where you were carrying those assets, was there a major discrepancy there as well as some of the smaller transactions that were mentioned as well?

Chuck Christmas

Yes I think the way we handle our (inaudible) ORE is that we do monthly valuations to make sure the number is correct and I think what the bottom line number ended up, we sold the properties, it was pretty accurate obviously over the course of the last six months to a year. To get us to that point, we absorbed some pain and had some write downs there, but I think the fact that properties were sold pretty much where we had pegged in the account (inaudible) I think it showed that we were pretty much on the mark with the evaluations of those properties in the portfolio.

Terry McEvoy – Oppenheimer

I appreciate it, thank you.

Mike Price

You bet.

Operator

Thank you and our next question is from the line of Steve Covington of Stieven Capital.

Steve Covington – Stieven Capital

Good morning guys, thanks for taking the question. I guess Chuck, you touched on this a little bit about the NPA expenses, I know it is in the reconciliation you had $900,000 in valuation of write downs but was there anything else unusual within that nonperforming asset expense category, and what do you think a good number is to look going forward?

Chuck Christmas

Yes, that one is pretty hard to get our arms around, there is obviously a lot of different dynamics. One of the things that happens in February of every year is to make sure that we protect our first lien positions against tax liens, property tax liens, and so we did have to think about $600,000 or so, make some property tax payments again about $600,000 in February to protect our first lien positions, so we went ahead and did that.

So from the property tax standpoint, we are hoping that the first quarter is a little bit higher than the rest of the quarters will be just because of the annual event. But whether there would be continuing to be property taxes of course the legal bills and the write-downs, it is certainly going to be elevated like our provision expense and of course these come a little bit later as everything works its way to (inaudible) as we would like to say. So I really do not know Steve to give you a really hard number. I am certainly hopeful that it is smaller in the first quarter as we go forward, but it is really hard to peg a number.

Steve Covington – Stieven Capital

Okay and then I guess, on the capital side, before we get there, I guess number one I just wanted to make sure I totally understand the growth in the net interest margin, was there anything unusual in the flow through the net interest income line item or was that pretty sustainable margin?

Chuck Christmas

Yes Steve, good question. The first quarter, there was no one-time event in the first quarter, and in fact as I mentioned or briefly discussed before, we continue to keep a pretty high level of Fed funds. So, we can certainly improve that margin a little bit by a handful of basis points as we got the Fed funds down but we continue to look at the volatility in the marketplace and things that keeping the Fed funds elevated a little bit makes a lot of sense, but to answer your core question, there is nothing one time in the first quarter.

Steve Covington – Stieven Capital

Okay and then lastly on the capital side, you have seen a handful of companies at least initiate discussions or go ahead and exchange TARP preferred for either some other type of convertible preferred or trust preferred, is that something that the management and the board is considering or is there anything you can comment about that?

Mike Price

Steve, this is Mike, we have not talked a lot about that yet at the board level. It is something that we continue to kind of watch as possibilities but we have not gotten in to any serious discussions. But that being said, like you have seen the performance of this organization over the last couple of years, all things are discussed from time to time as far as capital strategies and profitability strategies, asset quality strategies. It is something that is, I think Chuck used the term early on and other issues, in the mix.

Steve Covington – Stieven Capital

Okay, thanks guys.

Mike Price

Thanks Steve.

Operator

Thank you sir and we have no further questions in queue, I would like to turn things back to Mr Price for any further comments.

Mike Price

Thank you, Karen. Thank you again for your interest in our company. Again, although, as Chuck mentioned, we are not happy with the loss, we continue to make tremendous progress in increasing net interest margin, controlling overhead, reducing wholesale funding reliance, and for the first time in a long time, I think we feel better about what we are seeing out there on an asset quality side, still a lot of work to do but we are a lot stronger from our core operations to withstand the storm, and I look forward to coming out of it as quickly as we can.

With that we will end the call, thank you.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program, you may now disconnect. Everyone, have a great afternoon.

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