Columbia Banking System, Inc. (NASDAQ:COLB) Q3 2018 Earnings Conference Call October 25, 2018 4:00 PM ET
Hadley Robbins - President and CEO
Greg Sigrist - EVP, Chief Financial Officer
Clint Stein - EVP, Chief Operating Officer
Andy McDonald - EVP, Chief Credit Officer
Jeffrey Rulis - D.A. Davidson
Jackie Bohlen - KBW
Aaron Deer - Sandler O’Neill
Jon Arfstrom - RBC Capital Markets
Matthew Clark - Piper Jaffray
Ladies and gentlemen, thank you for standing by. Welcome to the Columbia Banking System's Third Quarter 2018 Earnings Release Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session through both the telephone and web and instructions will be given at that time. [Operator Instructions] And as a reminder, this conference is being recorded.
I would now like to turn the call over to your host, Hadley Robbins, President and Chief Executive Officer of Columbia Banking System.
Thank you, Elizabeth. Good afternoon everyone, and thank you for joining us on today’s call as we review our third quarter 2018 results. The earnings release and a supplemental slide presentation are available on our website at columbiabank.com.
Third quarter was solid on many fronts and we thank all of our employees for their ongoing efforts and contributions. This was a special quarter for us because it marked our Silver Anniversary. Over the last 25 years, our teams have worked hard to create a distinctive Columbia Bank experience and I believe we’ve been very successful on doing so.
During the quarter, rising interest rates coupled with disciplined deposit pricing and a favorable deposit mix expanded the Bank’s net interest margin. We also generated record levels of loan production. However elevated levels of repayment activity continue to create headwinds for net loan growth.
Additionally, persistent efforts by our credit administration team successfully led to a meaningful reduction in non-performing assets.
As I’ve previously mentioned, we have been evaluating a path forward to best position the Bank for the digital age. We consider it a transformative project, one that will require upfront investment in order to continue expanding sustainable revenue streams and to help us effectively scale the Bank as we grow. In order to accelerate our efforts, we’ve engaged an outside consultant to assist us.
As we finalize our thinking, we will share the framework and important financial dimensions of the plan with you.
On the call with me today are Greg Sigrist, our Chief Financial Officer who will provide details about our earnings performance; Clint Stein, our Chief Operating Officer, who will review our production activity; and Andy McDonald, our Chief Credit Officer, who will review our credit quality information. I will conclude by providing an update on business conditions. Following our prepared comments, we’ll be happy to answer your questions.
It’s important that I remind you that we’ll be making forward-looking statements today, which are subject to economic and other factors. For a full discussion of the risks and uncertainties associated with the forward-looking statements, please refer to our Securities filing and in particular our 2017 SEC Form 10-K.
At this point, I’d like to turn the call over to Greg to talk about our financial performance.
Thank you, Good afternoon, everyone. Earlier today, we reported third quarter earnings of $46.4 million, which is $0.63 per diluted common share excluding pretax, acquisition-related expenses of $1.1mln this quarter, reported EPS would have been $0.65 per share. A key driver in the quarter was the strength of our net interest income.
Our operating net interest margin was 4.38% for the third quarter. This was a linked quarter increase of 11 basis points. On a tax-equivalent basis, the yield on earning assets was up 15 basis points in the quarter. On the deposit side, we did see some nice growth and a bit of mix shifts during the quarter as non-interest bearing deposits increased to nearly 50% of total deposits and our proportion of non-interest bearing deposits is obviously a structural benefit for the Bank.
For interest-bearing deposits, pricing continues to be adjusted on a disciplined basis. Selected money market rate adjustments early in the quarter increased deposit – interest-bearing deposits by five basis points to 24 basis points. However, we do see competitive pressures building, but we continue to actively manage our deposit base and are closely monitoring market dynamics.
As expected, we did see a $2.5 million impact from the application of the Durban Amendment on July 1st. Absent this impact, non-interest income remains fairly flat to the prior quarter. We remain committed to growing non-interest income and our other business lines to help offset the reduced interchange revenue.
As mentioned earlier, acquisition-related cost in the quarter were $1.1 million, which compares to $2.8 million in the prior quarter. Transition and retention agreements were responsible for most of these costs. Essentially, all of the acquisition-related costs have now been incurred with only a small amount remaining for the fourth quarter.
As we mentioned last quarter, we are seeing the benefits of the Pacific Continental integration come through our expense runrate, most notably in compensation and benefits, as well as occupancy expenses. We will continue to look for additional operational efficiencies as we move forward.
After removing the effect of acquisition-related cost, our core non-interest expense was flat on a linked quarter basis. Our operating efficiency ratio continues to trend down in the third quarter to 54.8% as compared to 56% in the prior quarter. Our long-term target is to remain in the mid-50s range. Our effective tax rate of 19.7% for the third quarter is in the range we would expect for full year which is 19% to 20%.
At this point, I would like to turn the call over to Clint to talk about our production activity.
Thanks, Greg. Good afternoon, everyone. Our bankers had a very busy quarter successfully earning new business and deepening existing relationships on both sides of the balance sheet. We took a total team effort which is reflected in our third quarter and year-to-date results. Deposits grew $220 million or over 8% annualized during the quarter.
The seasonal trends we have experienced in prior years continue to play out in 2018 with the third quarter typically being strong for deposit growth. As Greg mentioned, our deposit base has a structural benefit with roughly half in non-interest-bearing accounts. This benefit has enabled us to maintain a low overall deposit beta, despite some of the repricing activity that occurred during the quarter.
Our cost of deposits of 12 basis points during the quarter is just two basis points higher than the prior quarter. Quarterly average tax adjusted coupon rate for new loan production was 5.14%, compared to a portfolio rate of 4.87%.
The portfolio coupon rate increased five basis points during the quarter. The production mix was 44% fixed, 48% floating and 6% variable. The overall portfolio mix is now 44% fixed, 32% floating, and 24% variable.
Loan production in the third quarter was $409 million, which is an increase of $154 million or about 60% from the third quarter of 2017 and, as Hadley mentioned, a record for quarterly production. Our seasonal decline in line utilization started a little earlier than typical. At the end of the third quarter line balances were down roughly $97 million from the prior quarter as the utilization rates declined from 52.5% to 50.8%.
Pipelines remain to our satisfaction and gives us confidence in the continuation of our production opportunities. However, prepayments continue to negatively impact net loan growth. 2018 year-to-date prepayment activity is up $330 million or 70% from the same period in the prior year. We did see this trend moderate in the third quarter as prepayment activity of $279 million was about $25 million or 8% lower than the prior quarter.
However, when thinking about how to adjust your models, predicting when prepayment activity will revert back to historical level remains a challenge in the near-term. Roughly half of the new production in the quarter within C&I while commercial real estate loans accounted for 29% of the production. The CRE production was mostly absorbed by activity within this sector as linked quarter balances were essentially unchanged.
However, there was some migration between buckets with construction balances declining $39 million and firm balances increasing by $29 million. Firm loans accounted for roughly $276 million of total production, while new lines represented the remaining $133 million. The mix of new production remains granular in size with 23% in loans over $5 million, 31% in the range of $1 million to $5 million and 46% under $1 million.
In terms of geography, 56% of new production was generated in Washington, 27% in Oregon, 5% in Idaho and 12% in other states. Our production in other states is growing as a result of our national healthcare group that came to us as part of the Pacific Continental acquisition.
As I mentioned at the beginning of my prepared remarks, our performance for the quarter required a total team effort. We could not have achieved our production and growth results without the hard work of our team members in the back-office areas such as loan and deposit operations.
Now I’ll turn the call over to Andy to review our credit performance.
Thanks, Clint. Our third quarter provision for loan and lease losses of $3.2 million compared favorably to the $4 million in the prior quarter. This included provisions of $4.5 million for the originated portfolio and $75,000 for the Intermountain portfolio. Offsetting these provisions were releases from Pacific Continental and West Coast of $600,000 and $280,000 respectively and a release of $502,000 from the PCI portfolios.
The provision in the originated portfolio was primarily driven by new loan balances followed by a impairment since the modest negative migration. The portfolios where releases occurred were driven by net recoveries and of course the liquidating nature of those portfolios. As of September 30, our allowances for loans was 0.98% as compared to 0.95% last quarter and it was 0.91% as of December 31, 2017.
This ratio was impacted by our acquisition and the associated loans that were recorded at fair value. Embedded in those valuations is approximately $28 million of discount for which approximately $20 million is associated with the Pacific Continental portfolio.
For the quarter, non-performing assets decreased $8.8 million due primarily to a $9.2 million decline in non-accrual loan. All in, non-performing assets, total assets decreased to 52 basis points, down from 61 basis points last quarter.
In summary, it was a good quarter. Past dues were 32 basis points. NPAs were down as discussed. We enjoyed net recoveries and our impaired asset to capital ratio of 17% compares favorably to 21% as of the prior year end.
Okay. Thanks, Andy. The Pacific Northwest economy remains robust and continues to grow faster than the rest of the nation largely due to broad industry diversification, our proximity to the Asian markets and a strong population growth.
Favorable economic conditions continue to look sustainable for the near-term although labor markets remain tight. With the tight labor conditions across the number of industry segments affecting the pace of growth, and putting upward pressure on labor costs.
Chinese tariffs are also a concern for growth, regionally industry segments that are most exposed include, aircrafts, agriculture, and electronics. At this point broad based negative economic impacts associated with tariffs are not evident. However, business owners remain concerned.
Shifting back to the communities we serve, we are pleased to have announced our 25th Anniversary Community Giving Campaign. We created a campaign to commemorate 25 years of serving our clients and communities donating 25,000 to four non-profit organizations nominated and selected by employees and customers to show our appreciation with their efforts in making a positive difference in communities across the Northwest.
Earlier today, we announced a regular dividend of $0.26 per common share and a special dividend of $0.14 per share, which together constitute a payout ratio of 63% for the quarter and a dividend yield of 4.83% based on the closing price of our stock on October 24, 2018.
With the Pacific Continental integration largely behind us, the full earnings power of the combined companies will continue to generate capital in excess of our requirements for organic growth. Similar to prior years, we will utilize a special dividend as one of our capital management tools and we will evaluate future dividends on a case-by-case basis.
This quarter’s dividend will be paid on November 21, 2018 to shareholders of record as of the close of business on November 7, 2018.
This concludes our prepared comments this afternoon. And as a reminder, Greg, Clint, and Andy are with me to answer your questions. And now, Elizabeth, we’ll open the call for questions.
Thank you. [Operator Instructions] Your first question comes from the line of Jeff Rulis. Your line is now open.
First question, maybe for Andy. Just looking at the comments in the release about kind of a results not indicative of the long run credit profile, do we read that as more of a long-term cautiousness or, I guess, what I am getting at is, it seems like your credit trends have cured from some one-off issues over the last few quarters and settling in. I guess, those comments was, is that anything indicative of anything forthcoming that you are seeing in the short-term?
Well, I think, one, the net recovery positions are really fun one to be in, but I don’t believe that we are going to be in that position. We get one of those quarters every now and then, but it’s not – it’s not something that is consistent. And that obviously helps the provision this quarter. So I am really trying to just help you with the ideas and thoughts around what you would be modeling from a provision standpoint. It’s not that I have any particular concerns on the industry or portfolio
Got it, okay. And then, the negative migration that you did see, what sector, was it pretty mixed or was there anything particular that that was migrating that you spoke of?
Yes, it was primarily in wholesalers and distributors and then it was not in particular industry. One was oil-related. So you kind of think like oil is kind of rebounding now. But, and – so it wasn’t anything unique. But that kind of what impacted Intermountain.
Got it, okay. And allow me one last one.
Sure, go ahead.
Yes. Just switching gears on the deposit growth that mix being somewhat favorable. Is that something that you all are saying on the customer change or is it something that you are driving some change within the staffs to kind of seek out a better mix?
I don’t think it’s anything that’s anything is intentional on our part to shift the mix. If we go back and look at the mix in the third quarter of 2017, I think it’s within a 10th of a percent of what our mix was at the end of the third quarter this year. And that’s both one period is pre Pacific Continental the other one is post.
So I think it’s some of it is, is just our customer base in general. Our percentage of commercial accounts is nearly 60% and then, I think the other side of it is, is it appears that we are seeing as with a lot of our peers as well they are experiencing some growth in this area.
All right. Thank you.
Next question comes from the line of Jackie Bohlen. Your line is now open.
Hi, good afternoon everyone.
Hello, Jackie. Clint, I missed the yield on new production. Did you say it was 5.14?
Okay. Just want to make sure I wrote it down correctly. Looking at deposit, in terms of re-management fees, that was steady over the past two quarters and then it picked up nicely in the third quarter. Was there anything unusual that drove that?
I think with our reciprocal deposits, there is a bit of uptick, we disclosed with that. But there is some offset down in non-interest expenses. Well, Jackie, because it’s, again it’s part of the reciprocal arrangement. Beyond that, I am not really thinking there is anything else I’d pull forward.
Okay. So, that line item and then the reciprocal expenses will probably to fluctuate a bit going forward?
Yes, and they do offset.
Okay. And then, turning – sorry, I am shifting around quite a bit on it, looking ahead, you’ve had higher prepayments. I know you said that it mitigated some from the third quarter. Are you seeing an impact in the deposit growth from some of these prepayments, meaning that, as customers are maybe selling properties and businesses, are they then turning around and putting them in their deposit accounts?
That’s always our objective is that, as our clients move through their different points of their lifecycle to have the right set of products available for them and the loans pay-off in business itself, we always strive to move them into our wealth management group or deepen the relationship between they already have. We have seen some of that. We’ve seen some of it even in terms of where we didn’t necessarily have the lending relationship but when the business sold, we were very compelling on what we could do from a wealth management perspective and we’ve won some new relationships in that manner as well. But it’s just on the deposit side. And so, it’s a combination of all of those factors I think.
Okay. So, providing a little bit of a benefit to see if it well then through the wealth management?
Yes, I mean, it’s – that’s a long-term margin. We see our assets under management in the wealth management side as well as our trust company continues to make progress and grow year-after-year. We are satisfied with what we are seeing there and in long-term, yes, it should translate into some additional opportunity for us.
Okay. Thanks, Clint, that’s helpful. I’ll sit back.
Next question comes from the line of Aaron Deer. Your line is now open.
Hey, good afternoon everybody.
Hadley and Clint, I think you both mentioned that pay downs are a bit of a headwind again this quarter. Can you talk about what’s really driving that in terms of, is it other banks or is it other types of lenders that are housing refis or is it similar to maybe what you were just describing where more customers are seeing aside toward the top of the real estate cycle and selling properties and that sort of activity?
Yes, there is some variability in terms of the forces that are driving that based on the different parts of our geography. So, specifically, when we think about Eastern Washington, Eastern Oregon, Northern Idaho, still some pretty intense from credit unions. They are aggressive in terms of financial structure, pricing, they have a pricing managers, there is no demand in that.
But it’s really, lack of guarantees, lending deeper into the collateral value, higher – I guess, higher growth loan proceeds. When we are in the – and we are also seeing actually some private equity activity in parts of those markets and we are seeing that in our metro markets as well. So we are additional lenders, increased competition from credit union.
One of the comments I got back from one of our key market leaders on the commercial side that, I’d almost found humorous, but it’s really the state of the competitive nature or competitive environment that we are in and it was in reference to a rather large competitor that’s more of a super regional, I won’t mention anything beyond that.
But the comment was, are they even regulated and so that’s the kind of stuff that we are seeing that creates pressure. And then there is also the demographic part of it where it was pretty deep into this economic run. There is – I think people have rebuilt their businesses and everything coming out of the downturn. So we are seeing some of those folks that are ready to retire and so they are selling.
Some of it’s just casual as well. So, it’s not necessarily going to different lenders. And then there is always just certain times where we may want to be at a certain price for a deal that makes sense for us and if we can get our pricing terms and we are okay with it going to another lender.
That’s great and it actually leads to my next question. I was on a conference call with a CEO of another company at a different market that also is a similarly attractive deposit base and he was commenting that with deposit rates having gone up quite a bit over the past year or two that the competition in the market is finally starting to realize that spreads are getting pinched and being forced to really raise their lending rates and that’s now giving him an advantage to undercut some of those other lenders given his higher quality deposit base.
You guys also have just a really impressively low cost funding base. So, are you now thinking about it in other’s terms, where you can come in with a little better pricing and win more deals and what does – how does that play into your outlook?
We always want to make sure that we are getting at appropriate returns for the risk that we believe is in any transaction. But we also maintain and I think this is the point we are getting at is that, the composition of our balance sheet and specifically our funding base gives us the advantage that we can compete on price if it’s a great deal and we’ve done that.
We have done some of that for either to retain key relationships or to gain new relationships in the market that are very attractive to us. But what we won’t give on are the terms and so that’s always the challenge. Going back to my prior comment, on the large bank, the – we had a deal we lost and this was a longstanding account of ours. It’s about a $15 million relationship.
But that bank gave on some of the financial reporting and valuation requirements that we weren’t willing to be flexible on and so, that’s where Hadley looks at it, and so as he get it, hey, look yourself in the mirror and take a deep breath and make sure you are making the right long-term decision and it’s tough because it doesn’t pass current period’s outstandings, but in the long run, it served us well over the 25 year history that we maintained that discipline.
Sure. That’s good color. Thank you. I appreciate you taking my questions.
The next question comes from the line of Jon Arfstrom. Your line is now open.
Thanks. Good afternoon.
Question for you on your deposit costs. You had much better performance relative to a lot of your peers and the chart you put on in Slide 7 on your presentation, it shows that you kind of track with peers. Would you were able to lag? But I look at history and you’ve really increased your non-interest bearing percentage of deposits.
So, I guess the question is, how much pressure is there really on deposit costs in the near-term? Is there a risk that you have to do a catch-up type quarter or is this really just kind of a gradual pressure if that makes sense?
Yes, I mean, I think we are looking this more as a gradual pressure. We obviously maintain our disciplines over time and I think as you go back in time too, that proportion of non-interest-bearing is also been a factor of some of the acquisitions we’ve done which changes some of the mix.
But as I kind of look ahead, given the structural benefits we got, what we continue to lag, we continue to be pretty rational and as I kind of think about, if you model things out, whatever you think the market betas are going to be as we kind of roll for this rate environment, it seems to me we are probably going to be 50 to maybe half to two-thirds of the beta that you might see for someone with less of that sort of a structural benefit.
So I think we are going to continue to be in line with market, but kind of a bit slower and in a bit lower trajectory.
Okay, okay. Good. And then, you guys go through the fixed floating variable piece. And I am just curious on something like the September rate increase, how much of that do you think is reflected in your earning asset yields today and how long does that take to work its way through?
Well, I’ll start and maybe Clint can jump in if he think that was straight on this. But, we’ve got, I think, Clint sort of gone through some of the new production pieces. We got I think it’s roughly 80% of our floating, we actually pull out old numbers.
It’s about 80% of our floating I think is going to adjust in the fourth quarter, just pretty quickly. But we’ve got about 20% of our floating in variable that it really is just coming off the floors, but in longer term, you are going to continue to see some uplift of that piece. You know if that gives you the color you are looking for, Clint, do you have anything to add?
The only thing I would add is, probably very little of that benefit from the September rate hike, it is in the current quarter numbers. What you are seeing flow through been what been received in June. So, there should be some additional room designed. The wildcard being deposit betas.
Okay, okay. Good. And then just couple more. As you talked about, one utilization coming down a little bit earlier, maybe some moderation in pay-offs and so you guys have some seasonality in Q4 and Q1. And then, you throw the Pacific Continental in there as well, which may not have the same seasonality. So how are you thinking about loan balances or how do you want us to think about loan balances in the coming quarter?
That’s a difficult question, just because of the unknown about the prepayments. My prepared remarks, we are really pleased with the pipeline and the things that we can control are – looks very promising. The typical headwinds that we have with the seasonality and line utilization, what we saw in the third quarter was more related to our finance company portfolio and things outside of the Ag book.
We’ll see the Ag book activities, pay down activity in the fourth quarter. It’s – I guess, I would just look at kind of our runrate over the last several quarters and we think if you look long-term, it’s a low-single-digit growth rate. And I’d say long-term, if you take a period of four quarters or so. From quarter-to-quarter, it could pop up. Fourth quarter typically, we have people – customers they are doing things around year end and that can create a bump. But then, first quarter same slowdown.
Okay, okay, that helps on the context. But, good job guys. Nice job.
[Operator Instructions] Your next question comes from the line of Matthew Clark. Your line is now open.
Hey, good afternoon.
Can you speak to your tech reinvestment, systems reinvestment plans for the upcoming year? It sounds like you are planning something, but just want to get a sense for kind of what might be built into the runrate or if there is something we should be thinking about in terms of a step-up or should we think of it from an expense to asset ratio perspective? Just want to get that related outlook?
Yes, well, Matt, really, let me just speak a little bit in a general way. The project that we are talking about is really one that, it takes a comprehensive look in the coming quarters if you will. And it starts first having a very clear view of the expectations of our customer and it looks at the internal connections required for the lines and activity which will all be pointed at creating the desired customer experience.
So the project will touch, products, process and systems, data, how we work together within the bank. And it’s a foundational project that we would think at least the first phase is about three years. We are in the assessment phase, right now. And I’ll probably be in a position to provide a bit more color next year.
But as far as runrate goes, we have some CapEx that’s planned, that’s already part of our budgeting process and we’ll have those expenses flow through. I think that the technology slide which was 13 reflects some of the projects that we have on our roadmap and have already kind of flows it on to our capital planning. And, Greg, do you have anything to add?
Maybe, as I said in my prepared remarks, I mean, I think our long-term goal on our operating efficiency ratio is to stay in the mid-50s. I think to Hadley’s point that this is a multi-year journey. And it’s not just about the expense off the door, I mean, this is really about enabling our client-facing teams to really have the right interactions of clients and the client experience.
So, I also think we are going to be over that horizon looking at what it does to really driving our client value as well. So, I think to Hadley’s point, we’ll be in a position as we kind of roll through time to give you some better dimensions around it. But, I think it’s a positive story and something we are looking forward to.
Okay, great. And then, just on the reserve ratio, reserve to loans, up I think four basis points. You mentioned a little bit of migration, but can you maybe, Andy, can you talk to what drove that increase in the reserve ratio? Was there something going on in credit class 5 that we can’t see here? Or was it just renewal from required loans that you had to set something aside for?
Yes, so, in the originated portfolio, you have about $242 million of growth and part of that growth in loans that are migrating out of the discounted and PCI portfolio – out of the discounted portfolios into the originated. So they no longer enjoy the benefit of any kind of discounts and that’s been totally accretive into income.
And so, there is a big difference in terms of the amount for the same – basically, the loan that you had before that you are simply renewing from period-to-period. And so, for example, the Intermountain portfolio with the discount that has a 40 basis point allowance.
So, when you move out of the Intermountain portfolio into the originated which is little over 1%, the same loan all of a sudden will draw more because there is no more discounts to help benefit the allowance positions. So, it was a lot of growth there. Second thing we had, about $1 million in impairment and then, the migration was really the third factor and only really accounted for about $500,000 in the provision.
So, should we assume that that 74 basis points just migrates toward the 1% or maybe the 1% comes down a little bit overtime. Is that the right way to think about it?
Well, as they migrate out of the lower percentages, it’s going to drive the overall percentage up.
Yes, I got it. Okay. And then, maybe, Hadley, just your updated thoughts on the M&A landscape. What your appetite might be? What you are seeing of late?
Yes, I haven’t talked to anybody just recently with off of the movement of stock values. But, M&A continues to be a vital part of our strategy and the way we look forward. And for us, it’s something that we are always engaged in and have conversations routinely. At this point though, it’s pretty quiet.
Okay, great. Thank you.
There are no further questions at this time. Please continue presenters. There are no further questions either. So we can go ahead and end the call.
Okay, thank you everyone.
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