Good morning, and welcome to the Mercantile Bank Corporation Third Quarter 2023 Earnings Results Conference Call. All participants will be in a 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 like now to turn the conference over to Zack Mukewa, Lambert Investor Relations. Please go ahead.

Good morning, everyone, and thank you for joining Mercantile Bank Corporation's conference call and webcast to discuss the company's financial results for the third quarter. Joining me today are members of Mercantile's management team, including Bob Kaminski, President and Chief Executive Officer; Chuck Christmas, Executive Vice President, and Chief Financial Officer; and Ray Reitsma, Chief Operating Officer and President of the Bank. We will begin the call with management's prepared remarks and presentation to review the quarter's results, then open the call to questions. Before turning the call over to management, it is my responsibility to inform you 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's business. The company's actual results could differ materially from any forward-looking statements made today, due to the factors described in the company's latest Securities and Exchange Commission's filings. The company assumes no obligation to update any forward-looking statements made during the call. If anyone does not already have a copy of the third quarter 2023 press release and presentation deck issued by Mercantile today, you can access it at the company's website at www.mercbank.com. At this time, I would like to turn the call over to Mercantile's President and Chief Executive Officer, Bob Kaminski. Bob?

Thank you, Zack, and thanks to all of you for joining us on the conference call today. This morning, Mercantile released its earnings report for the third quarter, and as one can see, our company carried the momentum of the outstanding work done as we passed the midpoint of the year into the second half of 2023. During the third quarter, Mercantile produced earnings of $1.30 per share on revenues of $58.2 million. For the year-to-date 2023, our company has produced earnings of $3.89 per share on revenues of $168.7 million. This morning, we also announced a cash dividend of $0.34 per share, payable on December 13, 2023. Headline in the quarter was exceedingly solid performance in several metrics, most notably, continued strength in net interest margin reflecting an appropriately structured balance sheet. Additionally, Mercantile exhibited ongoing success in the performance of its loan book as reflected in the asset quality numbers, well-managed expense control as demonstrated in its efficiency ratio, consistently robust levels of capital and continued success in core local deposit growth. Ray and Chuck will provide more details on our financial performance shortly. The strong performance we have demonstrated is only possible through the great work of the Mercantile team. As we approach the 26th anniversary of our company's founding, the impetus that drove the formation of Mercantile still holds true today. Our team consists of an entrepreneurial group of bankers who care deeply about our customers and communities with a focus on assisting clients in reaching their financial goals and making our communities better places for all of us to live and work. At the centerpiece of our existence is the desire to forge deep, meaningful, mutually beneficial and lasting relationships with our customers. It is through these relationships that we are able to add value,…

Thank you, Bob. My comments will focus upon commercial loan growth, net interest margin and income, asset quality, non-interest income and core deposit growth. Commercial loan growth was solid this quarter increasing $30 million or 4% annualized, despite $73 million in reductions, primarily due to borrowers' application and excess cash flow to debt balances. Commercial growth in the third quarter occurred primarily within the non-owner-occupied commercial real estate portfolio, although commercial and industrial and owner-occupied CRE loans represent 57% of the commercial portfolio. The commercial pipeline remains near record levels at $667 million consisting of $379 million committed under construction loan facilities and $288 million under other commercial loan commitments. Residential mortgages grew $22 million and the construction commitments related to this asset type remain stable at $54 million. Net interest income benefited from the growth described above as well as from an increase in earning asset yield from 5.61% in the prior quarter to 5.78% in the current quarter. The commercial portfolio is well-positioned for any change in the interest rate environment as 65% of the portfolio consists of floating rate obligations compared to 50% six quarters ago, accomplished through disciplined application of our swap program, coupled with a fixed rate deposit portfolio that correlates in size and duration to our fixed rate loan portfolio. Asset quality remains very strong as non-performing assets totaled $5.9 million or 11 basis points of total assets at the end of the current quarter compared to $2.8 million or 4 basis points of total assets at the end of the prior linked quarter. The majority of this increase is attributable to a single C&I credit placed into non-accrual status. Past dues are very low at 4 basis points of total loans. We remain vigilant in our underwriting standards in monitoring to identify any…

Thanks, Ray. Good morning to everybody. As noted on Slide 6, this morning, we announced net income of $20.9 million or $1.30 per diluted share for the third quarter of 2023 compared with net income of $16.0 million or $1.01 per diluted share for the respective prior year period. Net income during the first nine months of 2023 totaled $62.2 million or $3.89 per diluted share compared to $39.3 million or $2.48 per diluted share during the first nine months of 2022. The improved operating results were in large part driven by a higher net interest income stemming from an improving net interest margin and ongoing loan growth, and continued strength in loan quality metrics providing for limited provision expense. Turning to Slide 7, interest income on loans increased during the third quarter in first nine months of 2023 compared to the prior year periods, reflecting the increase in interest rate environment and solid growth in commercial and residential mortgage loans. Our third quarter 2023 net interest margin was 42 basis points higher than the third quarter of 2022, and our net interest margin for the first nine months of 2023 was 110 basis points higher than the respective prior year period. The improved net interest margins primarily reflect the combined impact of an aggregate 525 basis point increase in the federal funds rate since March of 2022, and approximately two-thirds of our commercial loans having floating rate. Interest income on securities also increased during the 2023 periods compared to the prior year periods, reflecting growth in the securities portfolio and the higher interest rate environment. Interest income on other earning assets, a vast majority of which is comprised of funds on deposit with the Federal Reserve Bank of Chicago also increased during the 2023 periods compared to the prior…

Thank you, Chuck. That concludes management's prepared comments, and we'll now open the call up for the question-and-answer session.

[Operator Instructions] The first question today comes from Daniel Tamayo with Raymond James.

Just starting on the margin, just curious, as we think about -- we've got your fourth quarter guidance here, but as we think about going forward beyond the fourth quarter, perhaps, assuming we stay at this, interest rate levels here and maybe we've seen most of the increase in asset yields now, how you're thinking about where the NIM may bottom eventually? I know we've had this discussion before. But what are your current thoughts there? And then perhaps a trajectory as we move through 2024. And sorry to continue on here. But your deposit costs have been very low so far. So I'm just curious what that bakes-in in terms of maybe a terminal deposit beta as well?

This is Chuck. We're just in the initial stages of the building out our 2024 budget. So my comments will be relatively general. But given the backdrop of the federal funds rate staying unchanged throughout next year, which is what we'll likely -- as we sit here today is what we'll likely budget, we'll see a steady but lower decline in our margins, kind of the decline that we've seen over the last couple of quarters and taking into account my guidance. I would say probably in the mid-single-digits decline on a quarterly basis. Clearly, we have some deposits that are going to continue to reprice and some FHLB advances that are maturing as well. However, a lot of those FHLB advances are actually match funded against fixed rate loans that are also scheduled to reprice next year as well. And then we also have some investment securities that are maturing, that are at very, very low rates that either will be reinvested at much higher rates in the investment portfolio and/or some of that money will go in the loan portfolio, which obviously will provide us even higher rate. So without putting all the Excel spreadsheets together and letting them do their thing, I would expect the decline on a quarterly basis probably in the mid-single-digits.

And did that assume any particular cumulative deposit beta where you guys end up?

No, I wouldn't have that off the top of my head, Danny, but on an overall basis, don't really expect it to go too much higher.

Okay. And then just to follow up on credit. Obviously that's still very strong story for you guys. But if you could just provide a little more detail on the commercial loan that really drove the increase in NPAs that'd be great.

Yes. Danny, this is Ray. So that single credit was one that was under some pressure from a margin standpoint in a particular industry that it serves. Management made some, in hindsight, poor decisions about how to manage their business. And the owner supported it for a while with cash injections, made the decision not to continue to do that and shut the doors. And so as we compare that particular company to others that we serve in the same industry, we've tentatively drawn the conclusion that it was a company-specific, rather than an industry-specific malaise that struck this particular company. And we've begun collection efforts and expect to get full resolution to this within a quarter or two.

Okay. There's no broad industry that you could give us, just an indication of where that would be from?

Given its status as the only one, I'd prefer not to.

The next question comes from Erik Zwick with Hovde Group. Please go ahead.

One, just wanted to -- I appreciate that Slide 14 and kind of the breakdown of the loan repricing. And I'm curious about the pie chart in the bottom right hand corner, and specifically the 28% of loans expected to reprice in the one to five years. Certainly a larger majority of your portfolio has seen the rate on their loans go up over the past year and a half or so. But for that segment that hasn't seen it yet, it could be some fairly large increases. I'm wondering how you guys think about that if you're proactively talking to some of these borrowers so that there's not kind of a big shock when these rates adjust higher as they kind of reprice or come due for renewal. So I'm curious about the thoughts on that segment?

Yes. This is Ray. We have engaged in proactive discussions with our borrowers as the rates have filed their paths that they have and provided opportunities to them to blend and extend or reprice early. And if that was important to their particular situation, many of them have taken advantage of that. So, that is an activity that we've undertaken fairly regularly in the last couple of years.

Thanks. I appreciate the color. And it sounds like you're fairly comfortable then that there's not going to be any surprises or any loans that have difficulty once those rates do move higher and reset?

We're not aware of any at the current time, but things -- as the environment is very dynamic and things change, it's possible. So any is a strong word, but certainly not massive waves of that, by any stretch, the imagination.

And Erik, what it really points to is that we're continually engaged with our clients and we understand their business structure and their cash flows. And so, it won't be the first conversation that we've had with them about raising rates because we're concerned that they address their situation and make sure they plan for any upcoming cash flow drains as a result of increased loan pricing. So continual engagement, we stay ahead of those situations that may potentially be some challenges -- present some challenges, and it's how we do business.

Got it. I appreciate that, the follow up, and I agree, constant dialogue is definitely important. Moving to the securities portfolio, you made some commentary just about the unrealized loss position at this point. And curious, first maybe Chuck, if you could remind us what the duration is on the total portfolio? And then have you guys given any thoughts to restructuring a portion of the portfolio at this point? And if not, what might cause you to change your mind and reconsider?

Hey, Erik, the duration is right around five years. The investment portfolio is a relatively small part of our balance sheet. It's currently about 13%. It's actually a little bit above our policy guidelines of 10% to 12%. We haven't given -- I mean, we definitely have thought about doing some restructuring. But on an overall basis, we don't think that that's the right thing to do at the current time. Like I provided the adjusted capital ratios, we still feel good with our regulatory capital, even taken into the unrealized loss. As I mentioned, the -- we have always managed the portfolio on a laddered basis, and we are just now starting to get into the time period of when we -- we took some of the excess liquidity during the COVID period to invest in some investment securities. And this is the first quarter, we'll be really start getting into a good volume of maturities. So we'll see some really good repricing opportunities as I mentioned, starting this quarter going forward for the next several years. And when we kind of blend that cash flow, bend those repricing opportunities into the rest of our balance sheet, we feel comfortable with where that's at currently. But certainly, like all things, we on a regular basis look at our balance sheet and make determinations whether any type of restructuring, whether it's the securities portfolio or any other segment of the balance sheet is needed or warranted.

Got it. And then just moving on to non-interest income, obviously had some nice growth in the interest rate swap income, credit, debit card income, and payroll servicing. And I know you called attention to some successful marketing of products and services to help drive those. And based on your projections for the fourth quarter, it seems like those should be -- those weren't just kind of a one quarter bump, those should be pretty sustainable going forward. And kind of any additional thoughts you could provide there?

I think you are spot on. When you look at the fee income categories that you mentioned, those are very important products and services that we can provide to our commercial borrowers. So as we continue to market those to existing borrowers, certainly when we bring new commercial loan relationships into the bank, we're marketing those products and services as well. So yes, we would expect -- as the commercial loan segment, especially the C&I segment continues to grow, we would expect growth in those fee income categories. Swaps are definitely a very important part of managing our balance sheet. We continue to -- our basic guideline, if somebody wants a fixed rate commercial real estate loan over, say $2.5 million is they're going to get a floating rate. And if they want to fix it, they can do a swap. And then obviously we back out of that by simultaneously doing the opposite swap of the correspondent to -- because we want the adjustable rate, obviously. On a quarter-by-quarter basis, there'll be some lumpiness, if you will, just because of the activity that takes place in any one quarter. However, from our policy standpoint, this is a product that we will continue to have in place and we'll continue to use -- gaining income, which obviously is good, but the most important part of that product is managing the interest rate risk position of our balance sheet. And we think that that's very important. So we would certainly expect swap fees to continue. Just want to put it out there that, that can be lumpy on a quarter-to-quarter basis, depending on the activity in any one quarter.

And last one for me, maybe for Bob or Ray, just curious about your thoughts on the UAW strikes just given the importance of auto manufacturing in the State of Michigan. And correct me if I'm wrong, I don't think you have any direct exposure to any of the major auto manufacturers, but maybe some secondary or tertiary exposure to suppliers or even on the consumer side some employees that may be participating in the strikes and what impact that could have and how you think about the impact there?

This is Ray. You are correct. We don't have any direct exposure. The tertiary and secondary impacts that you referenced are still pretty minimal on our portfolio at this point. The employee bases that have been impacted are primarily in the Southeast side of the state where we don't have a heavy retail business. So we haven't felt much impact there. Some of our customers that provide piece parts as opposed to tools and dyes, their volumes are starting to contract to some level. But again, it's not terribly broad-based. So it is a situation where they can tread water, if you'll permit the expression, for this period of time until resolution. But there hasn't been a lot of damage to individual or corporate balance sheets to this point. Obviously, the duration of the strike and the breadth and depth of it will determine what ultimately that looks like. But it's so far so good.

It seems like some of the feedback that we're getting from our clients at this point is that these platforms and these things that are being worked on from their perspective will happen. It's just that the timing will be different than originally planned in a lot of cases. And it'll be pushing it back a little bit. But hopefully, as we all think they get this resolved sooner than later, but we'll see.

[Operator Instructions] Your next question comes from Damon DelMonte with KBW. Please go ahead.

First off, congrats Bob on the retirement announcement and Ray on the promotion. Both very well deserved. So just wanted to circle back on kind of a broader margin picture question. Chuck, just given the high percentage of floating rate commercial loans, if the Fed does start to cut rates in the back half of '24, have you guys given any thought of trying to maybe put on some hedges to protect on the downside for risk there?

Well, we're always thinking about both sides of the interest rate spectrum and certainly it's likely over time, especially that rates will be going down before they go up much more, maybe another increase here soon. But likely they'll be going down. So we're always managing our balance sheet to the degree that we can make any change in interest rates to make that -- minimize the negative impact or this could be negative impacts. So clearly, I think where you're going is, we got the benefit of rates going up because of the structure of our balance sheet. What happens if rates go down? Clearly there's a question there of magnitude. Rates going up 525 basis points, obviously very substantial. Don't see a decline of any of that degree on the horizon, obviously it could happen. But we think that in general, as rates go down assuming at some point they will, we feel pretty good about our position. We would see some negative impact to our net interest margin if you look at our simulations. But there are definitely some things that we can do and obviously would react if we did start seeing interest rates go down. As far as hedges, we look at those from time to time for sure. The one thing that we see with hedges is that they're incredibly pricey, because of the volatility in the market. So with that volatility priced in into the cost of hedging products, it's very, very expensive to do. And, given where we are with the structure of our balance sheet, our expectations on rates and the impact that a lower rate environment would have, we have so far felt comfortable not putting hedges on our balance sheet, but clearly continue to manage the balance sheet with the idea and the expectation that at some point rates will go down.

That's helpful, thank you. And then with respect to the kind of the outlook for provision, I mean, credit continues to be extremely strong. It sounds like this quarter’s uptick in NPLs is clearly a one-off for you guys. If we kind of look at the specific reserve that went into that credit, and we kind of back that out of the provision level, is that a reasonable run rate to expect kind of over the upcoming quarters?

Yes, I think given, we think our growth going forward will be similar to what it has been in the recent past. Obviously like you said, the assumption of no further large specific reserves that -- yes, I think that would be a good run rate going forward, all things being equal.

Okay, great. And then just lastly. Any updated thoughts on capital management with regards to the buyback? Capital levels remain strong and you still have 6 and change, 6.8 million left on the current buyback. And kind of given where shares are trading now, what are your thoughts on getting back into the buyback game?

Damon. Yes, that's certainly something that we have at our disposal. We've engaged in it not in the last year and a half certainly, but it's something that's out there, especially at the stock price where it currently is sitting at. But we continue to evaluate that question in terms of our overall capital management and what we need for growth and lots of other potential uses of the capital. So it's something that we'll certainly consider. Hopefully, the stock price will continue to go in the right direction. So it'll be a move point. But it is certainly a tool in our toolbox.

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

Yes. Thanks, Betsy. And thank you all for your interest in our company. We look forward to speaking with you next at the end of the fourth quarter in January. This call has now ended. Thank you.

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