Good day and welcome to the Independent Bank Corporation First Quarter 2019 Earnings Conference Call and Webcast. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mr. Brad Kessel, President and CEO. Please go ahead.

Good morning. Thank you for joining Independent Bank Corporation's conference call and webcast to discuss the company's 2019 first quarter results. I am Brad Kessel, President and Chief Executive Officer. And joining me is Rob Shuster, Executive Vice President and Chief Financial Officer. Before we begin today’s call, it is my responsibility to direct you to the important information on page 2 regarding the cautionary note for forward-looking statements. If anyone does not already have a copy of the press release issued by Independent today, you can access it at the company’s website, www.independentbank.com. The agenda for today’s call will include prepared remarks, followed by a question-and-answer session, and then closing remarks. To follow along, I will begin with slide 5 of our presentation. We are pleased to report a solid start to 2019 with first quarter net income of $9.4 million or $0.39 per diluted share, versus net income of $9.2 million or $0.42 per diluted share in the prior year period. Impacting our first quarter 2019 results is the acquisition of TCSB, which closed on April 1 2018. Also significantly impacting both the first quarter of 2019 and 2018 were the changes in the fair value due to price of our capitalized mortgage loan servicing rights. For the first quarter of 2019, the change was a negative $2.2 million or $0.07 per diluted share after tax and a positive $1.5 million or $0.05 per diluted share after tax for the first quarter of 2018. When excluding the after tax impact of the MSR change, net income and diluted earnings per share increased by 38.9% and 26% respectively in 2019 as compared to 2018. The positive change in year-over-year quarterly results was driven by growth in net interest income and growth in mortgage loan gains, partially offset by the…

Thanks, Brad and good morning, everyone. I am starting at page 12 of our presentation. Brad discussed the year-over-year increase in our net interest income during his remarks. So I will focus on our net interest margin. Our tax equivalent net interest margin was 3.88% during the first quarter of 2019, which is up 17 basis points from the year ago period, but down 5 basis points from the fourth quarter of 2018. I will have some more detailed comments on this topic in a moment. Average interest earning assets were $3.15 billion in the first quarter of 2019 compared to $2.61 billion in the year ago quarter and $3.12 billion in the fourth quarter of 2018. Page 13 contains a more detailed analysis of the linked quarter decrease in net interest income. There is a lot of data on the slide, but to summarize a few key points, a 5 basis point decline in the linked quarter net interest margin was primarily due to changes in the mix of interest earning assets and the decline in average non-interest bearing deposits. Two less days in the first quarter of 2019 reduced net interest income by $319,000 compared to the fourth quarter of ‘18. Interest recoveries on non-accrual or previously charged off loans declined by $111,000 compared to fourth quarter ’18. The average cost of funds was up 9 basis points to 0.82% from 0.73% in the fourth quarter of ‘18. A couple -- a little more color on a couple of these points. The amount of average loans actually declined by $5.7 million in the first quarter of ’19 and average loans represented 83.2% of total earning assets in the first quarter of ’19 as compared to 84.2% in the fourth quarter of ‘18. This decline was principally due to…

Thanks, Rob. For many years, we have shared our performance goals, including return on assets and return on equity, which we believe to be two of the most significant drivers of total shareholder return. Our current year performance goals include an ROA of 1.3% and an ROE of 13%. For the first quarter of 2019, our return on average assets and return on average equity were 1.13% and 11.14% respectively. These ratios increased to 1.4% and 13.2% when excluding the after-tax impact of the MSR change. We have listed our strategic initiatives on slide 24. During the first quarter of 2019, we made progress on each of these. We believe successful execution on these initiatives will continue to drive strong returns. As a community bank, at the center of all our strategies is staying focused on serving our customers, and investing in our markets and in our people. At this point in time, we'd like to now open up the call for questions.

[Operator Instructions] Our first question comes from Brendan Nosal of Sandler O'Neill.

Just want to start off here on the NII outlook. So, you guys maintain the outlook for 10% to 11% growth and it looks like the loan growth side of that is holding in quite nicely and should ramp up throughout the year. But it feels like the NIM is a little more pressured now than we would have thought three months ago. Just help us understand how, if the growth outlook is more or less the same and the NIM outlook is a little worse. What is it that allows you guys to maintain that 10% to 11% NII growth for 2019?

I think a couple of things. One is, I think on the loan growth side, we're going to be probably a bit more toward that higher end of that range. The second thing is, I do think the mix change will continue to help with a bit more loans. And investment securities being at the level or maybe down a bit. So the remix will help a little bit as well. And generally, the last thing I would say is, even with the flat curve, we're generally seeing the new loan growth at or better than the average yield for the portfolio. So we’d expect an upward move on yield on earning assets, even with the Fed kind of on hold and a flatter curve. So I think it's those things in combination allow us to still feel comfortable with that overall growth in dollars of net interest income.

Got it. Okay, that makes sense. And then one more for me, moving over to the mortgage side of things and obviously a strong start to the year for gain on sale of mortgage. Just curious, your updated thoughts on mortgage banking throughout the year. I mean, obviously the dip in rates could help refi volume. But how are you seeing things progress in your markets?

Yeah, so I mean, we did see some pickup in refinancing. Now, recognize with the pipeline growth, you're sort of capturing a little bit of that within the first quarter gains. But even with that, we've seen an acceleration in application volume here through the first three weeks of April. So you have two things working, you have seasonal factors where home sales and purchase activity and we're 80% plus purchase mortgage activity. So you see that picking up and then there is some pickup in refinance volume, although, as I mentioned, we had subsequent to March 31, the 10 year treasury and mortgage rates sort of come back up a bit. So I don't think it's going to necessarily be a refinance boom. But I think it's going to be more than what we anticipated at the outset of the year combined with a strong purchase market. So we feel that that is going to be a solid part of our results for the next few quarters. Brad, I don’t know if you want to add anything?

No. I think you’re right on track there, Rob.

Our next question comes from Damon DelMonte of KBW.

So my first question, just to kind of circle back on the margin, Rob, can you give a little color on the amount of compression you could be expecting in the next couple of quarters?

Well, the one wild card, if I knew exactly what was going to be happening on the deposit side, and we did see a bit of pressure really from rotation out of non-interest bearing into interest bearing, that's the one where it's a little bit harder to predict. But, we're extremely mindful of trying to walk this fine line of managing our interest costs, yet not losing deposit relationships where you're replacing funds north of 2%. So, I'll caveat my comment with the fact that we're not expecting any significant pressure on the deposit side. We're expecting that more kind of move up as it has the last few quarters. So, given that and given what we anticipate on the earning asset side, and I mentioned earlier, with loan growth accelerating and where we're seeing sort of incoming loans, the rates on incoming loans being a benefit versus our average yield in the loan portfolio, the compression would be very modest. So, I'm not anticipating anything of significance, maybe a couple of basis points. And I will say in the first quarter, one sort of odd item and you could see it kind of in the balance sheet or in our average balance and yield table, we had a fair amount of seasonal growth in deposits. We typically see that, particularly with our municipal customers in the first quarter and we weren't able to peel off broker deposits lockstep with that growth. So, we had about 30 million more in kind of overnight deposits, which were at lower yield. So that kind of affected the first quarter margin a little bit as well. And I don't expect that to recur here as we move through the next couple of quarters. So that's the other reason I feel like the pressure is not going to be very significant on the net interest margin.

But again, if I miss, it's probably going to be on that deposit base.

And then as far as like the impact from fair value accretion, I think it was 357,000 this quarter. Last quarter is 423,000. So, should we be modeling something in that $300,000 to $400,000 range?

Yes, it's just drifting down a little bit quarter by quarter. So, that kind of rate of decline, you could probably kind of project for the next couple quarters. So it's going to be drifting down toward 300. And maybe by end of year, maybe being a bit below that. But when we talk about our expectation of growth in net interest income, we take that downward drift into account.

And then with respect to the loan growth, you guys are saying you’re comfortable on the kind of the higher end of your previously disclosed range, could you talk a little bit about some of the drivers of the growth and what areas of the footprint you’re seeing the best opportunities?

Sure, Damon. It’s Brad and I feel really good about getting out of the gates in 2019, particularly with our commercial team, we saw the strongest growth here in our West Michigan market and followed closely by the southeast Michigan group, but what was really nice, it was a very balanced mix in terms of CRE and C&I and that’s actually what is very intentional and I was looking at some reports here and it’s very granular. We had 25 credits that were 500,000 and above and only one of those credits during the first quarter of new business was over $10 million. So, spread out through our footprint, very granular. And, a good mix between C&I and CRE.

And then I'd add on the retail side, just for seasonal factors, we have historically seen a pickup on the consumer installment side, although that's another area where we started out strong right out of the gate. And then certainly on the mortgage side, we'll see some seasonal pickup there, both on the portfolio side, and then holding larger balances of mortgages held for sale where we're earning interest on those loans during the time period, we're holding them for sale. So all of those things we think will contribute to that movement up toward the higher end of our range.

Our next question comes from John Rodis of FIG Partners.

Rob, I guess per your earlier comment, I guess, on the securities portfolio, it sounds like flat to down some. Is that correct?

Yeah, some of that will just be driven by what's going on, on the deposit side. So, what we kind of added were relatively short duration in the first quarter. But we, for liquidity reasons, we do want to see that portfolio represent a certain percentage of our earning assets. And the one thing that you're doing there is if you're bringing in wholesale funds and putting it into securities, that spread is not that high, although it contributes to dollars of net interest income. And so I view that as a positive, it doesn't help the NIM. So yeah, I think the flat to maybe a little drift down is a good kind of place to be, with the dollars being made up in the loan portfolio.

Got it. And on the buyback, so you guys walked back a little bit over 100,000 shares in the quarter? How should we sort of think about activity going forward? Is it more opportunistic? Or do you really want to buy back the 5% this year?

I would say it's somewhat more opportunistic. I mean, we'll kind of see where things fall out. I mean, we get a lot of feedback about what levels and where, I mean, we certainly, you kind of see from what we did last year to what we did in the first quarter, kind of where we've been buying at, it's generally been south of 22. But, I don't think we're set on getting to the 5%. But I think we, if the opportunity presents, if we'd like to buy back more.

Yeah. And Rob, I’d add there. It's also a function of what all the other opportunities are. And today, there was a period, we were running a little bit above our targeted TCE range. And in 2018, we were able to buy back quite a few shares, get back within our range, we used a lot of cash. Now we're in a very comfortable level. And, we'll see what the opportunities are here for the balance of 2019, John.

Okay, that makes sense, Brad, thank you. And, guys, just one other question for me, just the, I know, it's early, but the chemical TCF merger, have you seen any sort of early opportunities or probably still too early to tell.

That is ongoing. And we dare say it, when we look at our competitor base, chemical probably would be one that matches up with us on a branch footprint more than anybody else, let’s say, of our 69 locations, we probably crossover with them, 60 -- on 60 locations. And so our team is out there, knocking on doors and having success in, but it's a long race and they’re a good competitor. And I'm sure it'll all be good at the end.

Our next question comes from Scott Berry of Boenning & Scattergood.

Most of my questions have already been answered. But looking at the fee income piece, I was just curious, one thing I noticed was the service charges, looking year-over-year, they're actually down from previous levels, like prior to TCSB. And I was just curious, is that just the ongoing industry pressure on that revenue source? Or any commentary you have there on kind of how you're thinking about that going forward?

You're dead on with that observation. And, I think a lot of that has to do with, we are seeing a higher and higher adoption rate of our customer base, using online and mobile banking. And, they're getting real time views of their account balances. And so I think people are just being smarter about and more prudent about managing their money. And so we have observed that, we expect to probably see a continued challenge on that line, and, quite frankly, so our efforts are geared towards getting in the interchange category and getting new customers on board, debit cards, in those customers’ hands and incenting them to swipe and generate that interchange income.

That's definitely a helpful explanation. My only other question that I had was just as it relates to the MSR portfolio, obviously, I know this is a sophisticated endeavor. But, you've seen a lot of volatility in that line item quarter to quarter as rates move and prepayments change. Is there anything you can do, even on a high level to kind of get some stability in that mark that you're having to put on the MSRs every quarter, with some hedging programs?

Yeah, that's a fine observation. And we have debated that here for quite some time. The issue we have is twofold. One is, when you hedge, there's a cost to that. So no matter how good you are at hedging it and sometimes, for example, if you're using treasuries to hedge, you can get a decoupling where mortgage rates and pre payments move differently than treasuries. So you could have more than just a little bit of hedging effectiveness. Even if you were very effective at hedging, there's still a cost to it. So you're giving up real economic value to smooth earnings. The other point for us, which is unique, at least and not probably to community banks, but it might be to someone who is more on the wholesale side, all we do is retail origination. So our belief is when we get that volatility and declines in fair value, eventually, we will recapture some of that refinancing. So we kind of have a natural hedge, even though it's not smoothing out earnings from an economic standpoint, because we're a retail shop, we’re recapturing we believe a good share of that refinance activity, which allows us to kind of rebuild that servicing asset. So, again, we feel the economics weigh against hedging it. But the way we'd like to see, not the earnings volatility that we get, I think the fortunate thing is, our analysts group sort of gets it and looks more to the core or operating numbers and we really do appreciate that. As I just mentioned, we've already retraced about 60% of the first quarter decline. So if that holds out, we're likely to get a jump back on that fair value change. So while frustrating, that's kind of where we end up when all the dust settles.

And Rob, when we look at 2018, there was a lot of volatility there for the entire fiscal year.

We – it changed 200,000. So if you go look at last year, we were up in fair value due to price in the first three quarters, the two middle quarters were lower numbers, and then we gave back most of it in the fourth quarter. So we ended the year, as Brad said, we're plus 190,000. So that's what we kind of hope when all the dust settles this year that when we get to year end, it's not a big number either way, but I know it is frustrating for us too.

Good question, Scott.

That's a great explanation. Yeah, I understand. It's not a simplistic answer. And thanks for giving the color on how you guys are thinking about it.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Brad Kessel for any closing remarks.

We would like to thank each of you for your interest in Independent Bank Corporation and for joining us on today's call. We wish you all a great day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.