First Merchants Corporation (FRME) Q4 2012 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the First Merchants Corporation Fourth Quarter 2012 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 risks 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 the balance sheet or income statement. Please note this event is being recorded. I would now like to turn the conference over to Mike Rechin, Chief Executive Officer. Please go ahead, sir.

Thank you, Rocco. Welcome, everyone, to our earnings conference call and webcast for the fourth quarter ending December 31, 2012. Mark Hardwick, our Chief Financial Officer; and John Martin, our Chief Credit Officer, are joining me here today and will make their remarks here in a moment. We released our earnings and a press release at 10:30 a.m. Eastern Daylight Savings Time this morning, and our presentation speaks to material from that release. The directions that point to the webcast are also contained at the back end of the release, and my comments begin on Page 4, a slide titled 2012 Highlights. So the majority of this first slide covers full year results whereas the press release provides detailed fourth quarter activity in addition to full year results. Mark and John's comments speak to the most recent quarter with greater specificity. We're really pleased with the year, saw a lot of things come together for us. Our full year 2012 earnings per share of $1.41 is greater than 4x our 2011 earnings per share of $0.34. We finished the year well, earning $0.32 per share in the fourth quarter, a 33% increase over 2011's fourth quarter. Considered as a whole, First Merchants produced record net income of $40.6 million. The driver of the earnings are in the bottom half of the slide: organic loan growth that grew in strength through the year, coupled with strong execution of an accretive in-market acquisition in the first quarter. I'm very pleased with our active margin management activities outside of the positive aspects of the discount accretion associated with the Shelby County Bank purchase transaction. Growing net interest income and growing noninterest income from several sources produced higher revenue and greater pretax provision income. At this point, Mark's going to join the call and add his thoughts more specifically on the quarter's results.

Thank you, Mike. Good afternoon, everyone. We're again satisfied with our quarter, and we are very pleased to have set a new net income record in 2012. You'll notice on Slide 6 where my comments will begin that our loans now exceed the 2010 levels by $66 million after a decline in 2011. The addition of $189 million in loan outstandings during 2012 pushed our loan-to-asset ratio to a healthy 67% and positions us well for 2013. The composition of our loan portfolio on Slide 7 allows for pricing power and continues to produce nearly a 5% yield. Without Shelby County's fair value accretion this quarter of $1.3 million, the loan yields totaled 4.79%. Last quarter's adjusted yield was 14 basis points higher, totaling 4.93%. We're particularly pleased with the growth in the commercial and industrial loan category as this now totals 22.9% of total loans and has increased from this time last year by $97 million per John Martin's detail on Page 21 of the presentation, which he'll get to a little later. On Slide 8, our bond portfolio continues to perform well, producing higher-than-average yields with a moderately longer duration than peer. Our 3.7% yield compares favorably to peer averages of approximately 2.85 and our duration is just 8 months longer, totaling 3.7 years. Our bond portfolio balances peaked in the first quarter of 2012, totaling $960 million and has declined each of the last 3 quarters. We anticipate having a slightly smaller bond portfolio throughout 2013. However, like this quarter, the yield should rise as our runoff includes lesser-yielding bonds than our core portfolio. 2013 maturities are estimated to total $154 million with an average yield of 3.13% and we do plan to shift those earnings assets from bonds into higher-yielding loans as we progress throughout 2013.…

Thanks, Mark, and good afternoon, everyone. I'll be covering asset quality, as Mark mentioned, starting on Page 18, followed by allowance coverage in nonperforming asset migration before concluding with portfolio trends and some several higher-level thoughts on the portfolio. So if you'd please turn to Page 18. Overall, asset quality continues to show improvement in the fourth quarter and concluded a year of positive asset quality trends. For the linked quarter, nonaccrual loans on Line 1 declined $3.6 million and were down $16.2 million year-over-year or approximately 23%. Other real estate continues to be an area of focus. ORE was essentially flat for the quarter, falling from $13.8 million to $13.3 million. In total, there are roughly 50 properties in ORE. And while we sold roughly 20 properties during the quarter, we also repossessed or otherwise foreclosed roughly the same amount with the $500,000 decline that you see, resulting primarily from lower dollar inflows over a modestly higher dollar outflow. The largest 3 ORE relationships still represent more than 1/2 of the total $13.3 million in ORE and consist of both raw land and developed residential and commercial parcels. Jumping to Line 3. As mentioned during prior calls, we continue to actively restructure loans as a way to resolve borrower over leverage and favor the A/B note restructure. This approach accelerates charges in the current quarter with the charge-off of a B note and serves to quickly define the path to performing loan. You can see the effect on Line 3 where, during the fourth quarter, we restructured a $5.5 million relationship secured by multiple pieces of commercial real estate while charging off a $1.7 million B note that had been reserved in the prior quarter. While seasoning in performance of the A note, the loan will be excluded from…

Thank you, John. I'm going to make a few summary comments on 2012 before looking forward to the current year and then taking questions. I'm on Slide 24. And as you've heard in this call from my colleagues, we're pleased to show progress on several fronts. Our loan pipelines, which had been building, have been moving on to the balance sheet becoming earning assets. The slide, itself, references commercial loans, but our mortgage, business banking and consumer efforts all contributed to the fourth quarter's greater than 2.25% growth. John's slide earlier showed the diversification of the growth in different types of balances, which really reflects our balanced sales effort. Mark covered a consolidating slide on noninterest income sources that reflects growing revenue and trust, insurance and record results in our mortgage business. While the mortgage volumes are likely to moderate at some point, the investments we've made in proven originators and fulfillment folks that support them have proven to be quite timely. Our originators' production is in our footprint and well situated to capture the growth in the home purchase market that has begun to gain strength here in the second half of 2012. Our gains in insurance and trust are equally pleasing to me. While the growth rates are not as impressive, the businesses are less cyclical and strongly but not exclusively linked to our progress in the banking business. We've mentioned enough perhaps the impact of Shelby County Bank acquisition on our earnings. Our ability to assimilate a franchise addition is critical to achieve any financial upside. Our management experience shone bright in my view in our execution earlier in the year. Our senior line management, managers who joined us from Shelby County Bank, our IT and operations teams, finance, marketing, human resources performed at the high level…

[Operator Instructions] Our first question comes from Stephen Geyen of Stifel, Nicolaus.

Appreciate the commentary and thoughts on loan growth and your thoughts on margin. But just curious about the potential 7% loan growth, where you think that might come in? Will it be more oriented toward commercial? Or do you think there'll be some mix change in the type of loans that you add to the balance sheet?

Well, on the balance sheet, yes, I would think it would be dominated by commercial. And the 7% or 7.5%, I think, was a more actual reference year-over-year. But I do see, when I might have said that we see similar opportunity in 2013, I think a mid-single-digit number is clearly achievable for us. We kind of plan around something like that. And so -- but on-balance sheet aspect of that will be dominated by commercial loans from the business banking sector that's somewhat branch-centric right up through the middle market coverage that's the core of our business. The mortgage volume at whatever level it comes in at will likely continue to look like 85% to 90% of it being sold off and with a real modest amount of it showing up on the balance sheet.

Okay. Mark, you talked about the capital and the -- and then additional comment about the classified and criticized. And I'm just curious if the repayment of the SBLF and the potential -- if there is a potential for that to be accelerated. You mentioned the second half of 2013 as a next possible tranche. Could that be accelerated if you see a little bit more improvement in classified and criticized loans than what you're currently projecting? And is that likely the real driver of the prepayment?

Well, it's one of the significant variables. I mean, the ability to upstream capital from the bank to the holding company provides the flexibility that we're looking for. And our plans really incorporate not streaming the earnings of the bank to allow for the next payment and -- so a like amount in the second half. If classifieds just continue to improve at this pace, it could allow you to upstream more. And then we're also evaluating the possible refinance alternatives, which are fairly attractive. But I would say we're evaluating all of the different possibilities, but at this point primarily considering just using bank earnings to make future payments and keeping the capital level at the bank constant to support future loan growth.

Okay, great. And then the deposit costs, I think, they're right around 50 basis points or end of the year, right around 50 basis points. What's the potential for that to come down? And do you see -- we had talked in the past about some margin pressure in 2013. Is it kind of trending out how you expected it and how we had discussed in the past?

Yes, it is. We're -- as we moved through the latter half of 2012, I was pleased that we were still making the progress in the deposit costs that we were anticipating just given how low the rate environment is or the overall expense. And -- but we're continuing to see these mature and reprice at lesser rates, albeit much smaller differences from 70, 75 basis points down to 45 or 50. And then the nonmaturity deposits, they're at the lowest level. They're as low as we think they'll ever be. So maybe some modest decreases in interest expense in that category, but it's not the driver for our year end 2013.

Okay, great. And then last question related to mortgage banking. You've added some producers. Just curious if you could give us a little bit of update as far as the number of producers added recently in the last quarter or 2, and kind of what your outlook might be for 2013 for that group. And then just maybe one add-on question to that related to the expense associate -- or variable expense associated with mortgage banking activity. If I kind of do some back-of-the-envelope calculations, I come up with maybe a variable expense of maybe 35% or so tied to mortgage banking. And just curious if that might be kind of a good starting point.

Steve, it's Mike. Yes, I'll refer to the front half of your question. Most of our addition in the mortgage business really took place in the second half of 2011. And so the portion of their -- well, their expense overall, and clearly the fixed portion of it, we've had with us for several quarters that, as you know, when you move mortgage folks around, we had did effectively a lift-out in Indianapolis under the management of our overall line of business leader, but a manager that brought over what had turned out to be 8 originators and the fulfillment people that support that team. And so that expense and their production has been with us since late 2011. But when you get acclimated to a new environment, find out who your colleagues are, just really get up to speed, it's really what put a little wind at our back on top of the healthy market to begin with. And so relative to the fixed cost component of that...

Yes, just curious about -- or yes, the fixed cost and then about the variable cost, if you could provide some thoughts.

I think we think of the fixed component being more like 30.

The fixed component, okay.

And then I think you made another forward-looking request relative to the mortgage business. And it ended the year strong in the fourth quarter. It even moves into the first quarter with the materially larger pipeline than what it had moving into 2012, about $50 million greater. We tracked that pretty close.

Our next question comes from Scott Siefers of Sandler O'Neill.

I guess, Mike, first question probably most appropriate for you. You guys gave us some color on the potential for additional SBLF repayments, which I certainly appreciate. I'm wondering if you can speak to capital management more broadly as well. I know you guys, for example, began the process of restoring the dividend earlier in -- I guess, last year, 2012, and you're building capital and still going to have a pretty low payout ratio on the $0.03 quarterly dividend. What's your sense for bumping that up or do you really just want to take care of the SBLF stuff before you look again at some of those internal capital management opportunities? Or how are you thinking about capital management broadly?

Well, I'll let Mark add on. But in my view, the common dividend level competes with all those other alternatives that you referenced. As I think when we got into SBLF, we didn't feel like, based on the starting point, that we had the ability to drive that coupon lower and so where it sits is the highest cost capital we have. So anything we can do to accelerate the repayment of that is a priority for management. The board looks at that payout level knowing the preferences of a good number of our shareholders and that payout ratio that you referenced at $0.03 out of $0.32 is pretty low. I suspect -- well, it gets addressed at every single meeting. And I'm sure that if you look at the like time in 2013 per the timing of our change in 2012, it does suggest that there's some room to relook at that. I know it'll be reviewed.

Okay, perfect. And then, I guess, John, I had a question for you. You referred to potentially drawing down the reserve over time toward kind of a 2% ratio. And I guess, given the current pace, you've been nearly matching charge-offs in the provision for the last few quarters here, which suggests it could take -- at least in the current base, would take a while to get you down to that 2% level. I mean, how are you thinking about things in terms of timing? Is it loan growth that will get the reserve-to-loan ratio down farther? In other words, just a more rapid build in the denominator. Or would you potentially start drawing down the reserve a little more aggressively in the coming quarters, say, this year?

Yes. Well, I think that it's going to be a combination really of a couple of things. The first is, as you explained what is going to happen to the loan portfolio, the increase in the denominator. And I think based on our estimates, you're going to see that level decline as a result of increases in the portfolio. I think the second component to it is going to be a relative confidence in the economy as well as -- combined with really what we're seeing in terms of the progression of those criticized and classified assets continuing their slope downward. But based on the trend that we're seeing, I would expect over the course of the next number of quarters, call it 4 quarters, that you're going to start to see us begin to release some of the allowance as we continue to see that trend continue downward.

Our next question comes from John Barber of KBW.

Just building off of Scott's question, in the slide deck, you listed allowance for loan loss as a percentage of your net charge-offs and a look-back of a couple of different periods. Could you just provide some context of maybe why you presented that ratio and what you think it should look like?

Yes, the purpose of that ratio, John, is to get at our look back within the allowance. We use a look-back period that we consider to be -- it's varied from 2 to 3 years. But on balance, that measure is a good indicator of the adequacy of the coverage of that allowance to expect the charge-offs going forward. So it's really just to show the adequacy of the allowance over the charge-offs and the degree of flexibility we have within it given coverage looking back.

And just one more on credit. You guys talked about the A/B restructurings. How long do you have to wait until you can -- those restructured loans can return to accruing status?

Well, we'll make a distinction between the accruing status of a loan and it -- coming out of the restructured bucket. What we generally do is after a period of seasoning, generally we look at it around 6 months or so after the A note's been in the pool performing as we originally structured it and modeled it. We'll take it out of the category.

And Mark, just on the margin, last quarter, you talked about 3 in the mid-9s core margins that's x the discount accretion. It sounded like you're still comfortable with that guidance. Could you talk about NII, what the expectation is there?

Could you repeat that question? I didn't hear your first.

Oh, sure. Sorry, Mark. Just the last quarter when we spoke, you talked about the core margin just being in the 3.95% around that range and it sounds like you're still comfortable with that. But I was also wondering if you could talk about NII growth and what the plan is there if you think you can sustain where it is right now?

Yes, I do think we can maintain the level, if not grow it slightly, in the overall non -- or net interest income category based on the plan that we have developed. And our -- the basic thought premise is to back out the fair value accounting, which was 2.6% last quarter and 1.3% this quarter, we've run our model as if we had a static balance sheet and then we evaluate the loan growth that we anticipate for the year. And really shifting out of lower-yielding bonds into higher-yielding loans is where the ability to keep margin from declining or to keep our net interest income from declining and to allow it to grow slightly is the way we put together our plan and the way we think about 2013. So there clearly is pressure on bank balance sheets for net interest income if you're not growing the loan portfolio. And -- so I mentioned that I expect our bond portfolio to decline slightly where we have $154 million that will mature over a 12-month period. And we'd like to take a large percentage of that deploy it in the loan portfolio.

John, this is Mike. I think to complement Mark's answer. We had a lot of liquidity ourselves at year end that was not returning at a high level and the loan growth we had, it was our largest loan growth quarter of the year, but a lot of that was back half of the quarter. John Martin referenced some of the impetus for the volume that we enjoyed and much of it was, I'll call it, capital gains-driven closings that had December be pretty robust. And so if that's the case, then we didn't have the current balance sheet levels accruing through a lot of the quarter.

My last question. Mike, this was on your last slide that you reviewed, achieve top tier performance. I was just wondering how you measure that, where you are right now and where your top peers are?

That's a great question. We use that term and it's tough to provide you all of the detail your question implies. We use top tier relative to a peer group that we build for board comparisons. It's 24 banks, $2 billion to $10 billion, and would imagine, as you can think that many different performance levels. And so we -- the top tier speaks to being in the top quartile of that group. And so depending on what ratio you're looking at, it can mean different folks, whether it be -- but the 2 primary ones that we use are our own stock price relative to tangible book value and earnings per share multiples in terms of valuation top tier and then we have a whole series of bank performance levels as well.

Our next question comes from Brian Martin of FIG Partners.

Most of my questions have been asked, but just a couple of things. I guess, can you talk about -- I guess you talked a little bit about how quickly the reserves comes down. I guess, Mark, can you just gives us what the, at quarter end, where the cash at the parent was and what you upstreamed this quarter?

Boy, yes. I have that here, if you give me a moment.

Yes, I got a question for John as well, Mark. So, I guess -- John, I guess I was wondering, on the OREO, you talked about that OREO balance being $13 million or so and half of that tied to a couple of properties. When were the reappraisals -- the most recent appraisals done on these properties? And I guess, what are your -- I guess, is there risk in your mind that there's further declines there as you guys maybe try and exit those in a more rapid pace than you are now? Or I guess how are you thinking about that?

Yes, those properties, Brian, I think a similar question came up last quarter around the length in OREO. And they really range in time from 3.5 years to about 1.5 years depending on each individual parcel. The properties do get appraised annually and they're staggered throughout the year. Some of the things that are challenging around it are individual issues that we have with use of the property from a zoning or some other issue similar to that. And that's just, frankly, is just slowing us down from getting to the end with an ultimate sale. We do have, and I think I've mentioned this on -- in other quarters, we do have contracts on 2 of the 3 largest pieces in there. But it got contingencies to them that we're literally trying to sort through quarter-after-quarter, trying to make sure that we can execute it and the buyers are being patient as we continue to work through the issue.

Okay, perfect. I didn't know that, so -- okay. And maybe one other question for you, Mark. Just on the FDIC assessments, I mean, those have been coming down pretty nicely throughout 2012. I guess, have you guys gotten to a point now where it ought to be a pretty good run rate as we look forward? Or are there still things bouncing around in there?

I don't anticipate additional room from this point forward. We've been a little surprised with, I guess, the nice improvement that we saw this year in '12 over '11. And then, so I think you have a good run rate. Going back to parent company liquidity, we tend to make sure that we always have at least 2x parent company cash flow, 2 years worth of annual cash flow. And so we ended the year with that amount and excess, enough excess that we were comfortable making the $22 million paydown. And then we're anticipating upstreaming about 1/4 of what the bank would make or the entire quarter's earnings up to the parent in March before the end of the first quarter. And the bank's earnings are, on an annualized basis, are well over $40 million. So looking at making that a full upstream of bank earnings throughout each quarter as we move through '13. And last year in the fourth -- each of the quarters our standard dividend, a year ago it was about $2.5 million. And we did one excess dividend of about, I think, it was $10 million.

Okay. And then that annual number you talked about that you're covering twice, how much is that right now with the recent redemption?

It's right at $10 million for 2 years' worth of coverage.

Our next question comes from Dan Cardenas of Raymond James.

Just a couple of quick questions. A lot of good questions have been asked already. As I look at your mortgage banking activities this quarter -- this past quarter, can you tell me how much of that was purchased versus refinanced?

My coach here joining me, our Chief Banking Officer, Dan, is telling me that it's about 65% refi, 35% purchased.

Okay. And then as you kind of look forward into 2013, I mean, are you expecting as robust a year on the mortgage banking side, or are you looking for that to begin to subside sometime in the year?

Wow, it'd be tough for me to think we're going to have a bigger year than what we did. We aren't planning to have a bigger year than what we did unless we were to add resources. We clearly think that what we've been able to do in Indianapolis in terms of adding a lift-out of a led team is an opportunity that exists at least in Columbus, Ohio, if not other places as well. But from a steady state in terms of originators, we would look at -- in my mind, 2012's results is kind of the top of what we can do. I would just offset that as I might have said the same comment a year ago speaking to 2011. So I welcome the chance to be wrong. And as I mentioned to one of the first questions, we actually entered 2013 with $50 million more in-process pipeline approved mortgages then we had in January of 2012.

This concludes our question-and-answer session. I'd like to turn the conference back over to Mike Rechin and the rest of the management crew for any final remarks.

Rocco, I have no final remarks other than my appreciation for the questions and the interest in hearing what our company is doing. And we'll have another call scheduled probably right around the first of the May to talk about our first quarter results this year.

Thank you very much for your time, sir, and thank you all for your attendance. The conference is now concluded, and we thank you for attending the presentation. You may now disconnect, and have a wonderful day.