Earnings Call Transcript - ASB Q3 2020

Operator, Operator

Good afternoon, everyone, and welcome to Associated Banc-Corp Third Quarter 2020 Earnings Conference Call. My name is Diego, and I will be your operator today. At this time, all participants are in a listen-only mode. We will be conducting a question-and-answer session at the end of this conference. Copies of the slides that will be referenced during today's call are available on the company's website at investor.associatedbank.com. As a reminder, this conference call is being recorded. As outlined on slide one, during the course of the discussion today, management may make statements that constitute projections, expectations, beliefs or similar forward-looking statements. Associated’s actual results could differ materially from the results anticipated or projected in any forward-looking statements. Additional detailed information concerning the important factors that could cause Associated's actual results to differ materially from the information discussed today is readily available on the SEC website and the Risk Factors section of Associated's most recent Form 10-K and subsequent SEC filings. These factors are incorporated herein by reference. For a reconciliation of the non-GAAP financial measures to the GAAP financial measures mentioned in this conference call, please refer to pages 21 and 22 of the slide presentation and to pages 10 and 11 of the press release financial table. Following today's presentation instructions will be given for the question-and-answer session. At this time, I would like to turn the conference over to Philip Flynn, President and CEO, for opening remarks. Please, go ahead, sir.

Philip Flynn, President and CEO

Thank you and welcome to our third quarter 2020 earnings call. Joining me today are Chris Niles, our Chief Financial Officer; and Pat Ahern, our Chief Credit Officer. It goes without saying that this has been a challenging and unusual year. We pivoted in March in response to the pandemic and have been retooling our delivery channel since to best meet our customers' needs. We deployed ourselves to seamlessly interact through virtual channels and have seen an accelerating shift to mobile and online banking. With a likely very low interest rate environment facing us for an extended period, it became critical to respond in areas we can control. Let's start with the actions we took during the third quarter. On slide two, we have detailed our optimization efforts and the restructuring of our securities and real estate lending subsidiaries. During the third quarter, we announced the sale and planned consolidation of 22 of our branches. We also announced the strategic streamlining of several corporate managerial and back-office functions. As a result of these actions, we incurred $16 million of pre-tax charges in Q3, but we expect these changes to drive a $40 million per year reduction in our run rate expenses as we move into this quarter and 2021. We also deployed about half of our excess liquidity position to repay $950 million of FHLB advances. This prepayment resulted in a $45 million Q3 pre-tax expense. However, we expect this to improve annualized net interest income by $20 million, beginning in Q4 2020, continuing through 2021, with diminishing but continuing savings through 2022 and into 2023. Finally, we were able to unlock capital losses through the restructuring of our securities and real estate lending subsidiaries, and this resulted in a $49 million after-tax benefit during the quarter. Turning to slide three. We've highlighted the impact of our Q3 initiatives on our pre-tax pre-provision income. Adjusting for the $60 million of restructuring and prepayment costs, third quarter PTPP would have been $90 million. On slide four, we've provided a walk forward of EPS, which breaks down the various initiatives executed during the quarter. You'll notice when tax affected, the one-time costs of our efficiency initiatives were more than covered by the tax benefits we realized from the reorganization of our subsidiaries. If you were to exclude both the restructuring charges and the tax benefits from our EPS for the third quarter, the adjusted $0.24 result is within $0.02 of our reported GAAP EPS of $0.26. So in effect, the items largely offset each other. The actions this quarter were net additive to our tangible book value. Turning to slide five. Average loan balance trends are shown. Total average loans came in at $25 billion, down slightly from the prior quarter's average. Commercial real estate grew $312 million, driven by the continuing funding of construction loans. And at September 30, we still had $1.9 billion of unfunded commercial real estate commitments. Commercial and business lending, on the other hand, declined by $271 million on average, as our general commercial customers largely used their increased excess liquidity balances to pay down open lines of credit. Turning to slide six. We highlight changes in the end-of-period loan balances. Period-end loans were up $171 million or 1% for the quarter, driven again by strong growth in commercial real estate lending, which was up $298 million. Mortgage activity remained strong, which was reflected in our elevated mortgage warehouse lending balances at quarter end. Power and utilities lending, along with commercial real estate construction and investor loans, have continued to grow throughout 2020. I'll also call out oil and gas, which declined nearly $100 million during Q3 and now represents only 1.3% of our total loan portfolio. Consumer lending balances came down during the quarter, driven by refinancing activity and our decision to sell $70 million of prepayment susceptible mortgages. Now let me provide an update on our deferral programs. On slide seven, you can see our commercial deferrals have continued to steadily decline. As of October 19, we have approximately $227 million of active commercial loan deferrals, down 73% from June. Our commercial deferrals have largely rolled off their initial 90-day terms, and the remaining deferrals are primarily related to COVID-impacted portfolios. Commercial real estate loan deferrals were $182 million of that $227 million and are primarily related to hotel and retail borrowers. Commercial and business lending deferrals have declined to just $45 million at October 19, and they now comprise less than 1% of the commercial and business loan book. Taken together, the $227 million of active commercial and commercial real estate deferrals at October 19 make up about 1.4% of our total commercial loans outstanding. Our consumer-related COVID relief efforts are highlighted on slide eight. In the beginning of the pandemic, we granted deferrals to virtually any customers who asked for assistance. The deferrals granted were for six months, so the bulk of those deferrals began to expire during September. At October 19, we had $269 million of active deferrals, down 63% from June. These loans now represent approximately 3% of outstanding consumer loan balances. It's important to note, however, that of the remaining $269 million of active deferrals, $263 million of that is still on their first deferral period. The bulk of those deferrals will expire during the balance of October, and we expect most will not require additional assistance. So of those loans that have come off deferral in the consumer book, at this point only $6 million have asked for additional assistance. Among consumers whose deferrals have ended, 97% are current or less than 30 days past due. The trends we're seeing as deferrals roll off continue to be positive, and we feel confident many of these borrowers will return to their pre-COVID performance. On slide nine, we've provided an allowance update. We utilized the Moody's September 2020 baseline forecast for our CECL forward-looking assumptions. The baseline forecast assumes additional stimulus, continuing low rates, and a COVID vaccine that becomes widely available in Q2 of 2021. For Q3 of 2020, our net allowance build was only $13 million, down from $35 million in the prior quarter. I'll direct you to the top right chart, where we illustrate the ACLL trend during 2020. You can see our net reserve build has tapered off throughout the year. This reflects the overall stability of our loan portfolio and our real-time outlook for all our credit exposures at quarter end. As you can see from the lower table on this page, during Q3 we actually released reserves in four lending categories and added reserves in three. The largest net build was in our commercial real estate investor portfolio where we added to our reserves related to shopping malls and other retailer exposures. Reserves on our oil and gas portfolio declined $33 million as we continue to manage that portfolio down. As of September 30, our total allowance was $442 million and covered 1.8% of total loans. Credit metrics are presented on slide ten. As a reminder, these metrics reflect our real-time risk rating and credit evaluations with the expectation that substantially all the active deferral activity will come to some conclusion of remediation this quarter. Potential problem loans decreased $14 million, primarily driven by the migration of COVID-affected loans to non-accrual. Overall, non-accrual loans increased $60 million, driven primarily by the migration of two commercial real estate mall-oriented REITs and our only sand fracking company into non-accrual. Loans included in our key COVID commercial exposures made up 37% of non-accrual loans at the end of Q3. This inflow was partially offset by non-accrual oil and gas loans, which declined $42 million due to charge-offs, note sales, and payoffs. Charge-offs for the quarter were $30 million. Outside of oil and gas, net charge-offs were again less than $10 million for the quarter. Reserves on the remaining oil and gas book remained over 15%. Turning to slide eleven. Average deposits were $26.8 billion, up nearly $700 million, or 3% over the second quarter. Average deposit growth again came from low-cost savings and checking accounts this quarter. Liquidity remains high, and our deposit mix continues to improve. Low-cost deposits accounted for nearly 63% of our balances at the end of the third quarter. Turning to slide twelve. Third quarter net interest income was $182 million, with a net interest margin of 2.31%. We previously guided that net interest margin would bottom out during Q3 and begin to pick up in Q4. And as we expected, margin hit bottom in July and August and then rebounded to 2.35% in September. Asset yield stabilized during the third quarter, while our liability cost trended downward. We continue to expect to see margin expansion further into Q4 and into 2021. We expect spreads to widen on our LIBOR-based commercial loans as we continue to implement new LIBOR floors into our new and renewing loans. This will happen over time or in conjunction with other repricing or credit actions, including the anticipated migration to SOFR and other indices later in 2021. On the liability side, our time deposit levels have both been declining and repricing lower. When CDs renew or roll over today, they're generally repricing from approximately 1.2% to below 15 basis points. We expect this repricing to provide margin lift going into 2021. Additionally, we'll see a full quarter impact during Q4 from the prepayment of our FHLB advances. We expect this will provide a $5 million benefit to net interest margin in the fourth quarter and about a $20 million improvement in '21. Turning to slide fourteen. Second quarter non-interest income came in at $76 million. Non-interest income was lower in Q3 than Q2. However, this was driven by the large gain from the sale of Associated Benefits and Risk Consulting in Q2 and, of course, the lack of revenue from ABRC going forward. Service charges and deposit account fees came in at $14 million, an increase of nearly $3 million quarter-over-quarter. Card-based fees increased 15% from the second quarter up to $10 million. The combination of COVID relief winding down as well as more normalized economic activity is driving these fee lines. Our mortgage banking activity remained strong this quarter, with nearly $600 million of mortgages sold to the agencies generating $13 million in net fee revenue. After $17 million of MSR impairment in the first half of the year, impairment for the third quarter was just over $1 million. We expect positive fee trends heading into Q4. On Slide fourteen, we highlight our expenses. The third quarter came in at $228 million, including $60 million of restructuring costs previously mentioned. Core expenses continued to trend lower, largely driven by the reduction of expense following the sale of ABRC. We expect the expense initiatives executed in Q3 to provide further savings as we move into 2021, and as you can see from the lower right chart, on an adjusted or run rate basis, our expenses to average assets ratio is already trending below 2%. As shown on Slide fifteen, our regulatory capital levels remain strong. At the end of Q3, our regulatory capital levels were at or above where we ended the year for 2019, and our tangible common equity ratio increased 25 basis points to 7.5%. Tangible book value per share also increased to $16.37 per share, up from $16.21 in the prior quarter, reflecting the net additive benefit to shareholders of the actions we took during the quarter. On Slide sixteen, we're updating select items for the remainder of 2020 and reiterating our expense guidance for 2021. We expect a net interest margin of 2.5% or slightly higher in the fourth quarter. We expect fee revenue to continue on a positive trend through the end of 2020. Expenses for Q4 are expected to come in at $175 million, including about $3 million of remaining restructuring costs. We reiterate our full year 2021 expenses are expected to be approximately $685 million. The full year 2020 tax rate will be in the low to mid-single digits, and we expect the full year 2021 tax rate to be between 15% and 17%. Thank you.

Operator, Operator

Thank you. Our first question comes from Michael Young with Truist Securities. Please proceed with your question.

Michael Young, Analyst

Thank you for taking the question. I wanted to ask about loan growth. You mentioned the commercial construction pipeline with $1.9 billion yet to be funded. It sounds like that's a good opportunity for a return to stronger loan growth. Is that the correct way to think about it, or are there other factors in the commercial categories that we should consider?

Philip Flynn, President and CEO

Yes. Thanks, Michael. So yes, certainly commercial real estate, as you've seen throughout the year, will continue to provide loan growth based upon the backlog we have. And there is some amount of new business being done in that area as well. Our specialty areas, Power & Utilities, the mortgage warehouse business continue to show good growth. And we expect certainly the Power & Utilities area to keep growing. Mortgage warehouse will depend upon refinance activity. The mortgage business still has some tailwind, and we may choose to retain some of our mortgage production going forward. General commercial lending is probably somewhat slow. We don't have great visibility into that line item into next year yet, but we expect to have more information on that as we get through the fourth quarter and get to the January call. So there are certain areas that continue to show good growth. There are areas that continue to have the backlog, like CRE that will fund up. But general activity in the commercial lending space needs to show some more growth going forward and we'll see what happens as we go along.

Michael Young, Analyst

Okay. And just maybe on a core basis as we're thinking about the margin for next year, is really kind of loan growth the main driving factor to upside from kind of what you've already talked about in terms of just the funding costs coming down?

Philip Flynn, President and CEO

So we expect our liabilities to continue to grind lower. We took the actions on the FHLB prepayment, which is a significant improvement to NII next year. We are getting decent traction on imposing floors on our LIBOR-based loans, which is the bulk of our loans. We'll continue to work on that. So the combination of winding liability costs down, the FHLB prepayment, LIBOR floors, and then transitioning to new indices should provide stable to growing net interest margin as we look forward, but we'll have better guidance for you in January on that.

Michael Young, Analyst

Okay. And if I could just sneak in one last one. Just on the commercial deferrals, I understand obviously those have come down a good bit. But I guess are there some that have been modified? Is there a large portion that's maybe paying interest-only or some other modification that has been made that's maybe not captured in that deferral number?

Philip Flynn, President and CEO

Yes. So we're down to 1.4% of the total commercial and commercial loans that have requested some additional deferral. Pat, do you have a little more color on that for Michael?

Pat Ahern, Chief Credit Officer

Yes. On the commercial portfolio, we evaluate each situation on an individual basis. We have a variety of clients, some of whom have switched to interest-only payments. The hotel industry, in particular, will require more time for adjustments. These modifications are tailored to help clients bridge their financing needs for at least the next year. Each credit situation comes with its own set of complexities.

Michael Young, Analyst

Is there an amount that has been modified? Would it closely match the initial $800 million, or is it more like $600 million? Is there any way to estimate that?

Philip Flynn, President and CEO

Well, the modified loans, Pat, correct me if I'm wrong, are included in the $227 million that you see, Michael.

Pat Ahern, Chief Credit Officer

Right. The bulk of those have rolled off and don't need any further assistance or modification.

Michael Young, Analyst

Okay. So they've fully captured that number. Thank you. Appreciate it.

Pat Ahern, Chief Credit Officer

Yeah.

Operator, Operator

Our next question comes from Scott Siefers with Piper Sandler. Please state your question.

Scott Siefers, Analyst

Good afternoon, everyone. Thank you for taking my question. My first inquiry is fairly straightforward. I would like to clarify what you believe the run rate cost base will be in the third quarter, considering all the variables at play. I'm trying to align the information on slide fourteen with the commentary provided in the text. If we consider the $109 million and the $69 million, that totals about $178 million in core expenses. You mentioned a $50 million restructuring cost related to the FHLB and real estate. Could you clarify where the $10 million in severance costs are accounted for? Is that included in the first...

Philip Flynn, President and CEO

That $10 million is embedded in that $109 million, so you can take it out of there too, Scott.

Scott Siefers, Analyst

Yes. Okay. Perfect. So then we're discussing a core number of approximately $167 million. Is that a reasonable estimate?

Philip Flynn, President and CEO

For that quarter, yes.

Scott Siefers, Analyst

Yes. Okay. Perfect. Yes, sorry for a kind of basic one there. Just trying to get through all the moving parts.

Philip Flynn, President and CEO

That's okay.

Scott Siefers, Analyst

All right. Perfect. And then...

Philip Flynn, President and CEO

Well, you thought there were moving parts, really?

Scott Siefers, Analyst

Yes. And then more just a top level one on how the credit cycle kind of plays out. It seems like every 90 days we sort of push out the time until we see more accelerated loss migration. I guess with the benefit of at least a bit more clarity vis-à-vis say 90 days ago, Phil maybe how are you thinking about when we should expect losses to begin to accelerate at some point in 2021? Is that like a mid or even later 2021 event? Or how are you guys preparing for things?

Philip Flynn, President and CEO

It's always hard to tell. You can see that our reserve build is moderating to being pretty flattish at this point.

Scott Siefers, Analyst

Yeah.

Philip Flynn, President and CEO

I believe a lot relies on whether there will be more stimulus and how the economy appears as we approach next year. There is likely a delay, probably a couple of quarters, before we can process the current issues with troubled credits and assess the outcomes. Additionally, we've made progress in managing our oil and gas operations and moving past those challenges. We are currently in the fall re-determination period and are about a third of the way through it without any problems. However, we are still maintaining substantial reserves in case we encounter more troubled credits.

Scott Siefers, Analyst

Okay. Perfect. All right. Well, thank you guys very much. I appreciate it.

Philip Flynn, President and CEO

Yeah.

Operator, Operator

Thank you. Our next question comes from Terry McEvoy with Stephens. Please state your question.

Terry McEvoy, Analyst

Hi. Good afternoon, guys. On your capital slide, you typically prioritized your usage for excess capital. I didn't see it this quarter. I was wondering if you could run through how you're thinking about excess capital, specifically the buyback just given where the share price is relative to tangible book value.

Philip Flynn, President and CEO

Sure. So that leaving out the chart caused a question. We haven't changed our level of priorities, but it is more than fair to say when we're trading at a discount to book, which frankly we don't understand why we are given all of our actions and given our outlook. But when we're trading at that type of level, share buybacks certainly become interesting to us. It's probably still a little bit early, but as we get into next year, Terry, clearly as we sit with growing capital and depending on where we're trading at, share buybacks become of great interest.

Terry McEvoy, Analyst

Thanks for the follow-up. Regarding the $1 billion-plus in retail and shopping centers, how much of that consists of typical malls, which may have been struggling before COVID? We haven't experienced any charge-offs for the entire bank. What are your thoughts on when the deferrals will end? Which segments are most vulnerable? Is it the traditional mall, and if so, how large is the portfolio? Do you have any statistics, such as average loan-to-value ratios, to provide more insight into the portfolio?

Philip Flynn, President and CEO

Sure. Pat, do you want to give some color on the mall-based that we were...

Pat Ahern, Chief Credit Officer

In general, the areas that continue to face challenges are the enclosed mall spaces, where people are having difficulty accessing due to social distancing. Most of our retailers are located in neighborhood strip centers and net lease spaces, which have seen rent collections return to nearly normal levels, around 85% to 90%. Many of these have moved past deferrals, and we feel optimistic about their performance. There are still a few that we are managing. Additionally, we have only a small number of exposures to public REITs related to enclosed malls, and those have been performing well, with the exception of two that were mentioned earlier regarding non-accrual. Overall, we feel positive about the retail client base's trajectory.

Terry McEvoy, Analyst

Thank you, Pat. Thank you, Phil as well.

Pat Ahern, Chief Credit Officer

Thanks.

Operator, Operator

Our next question comes from Jon Arfstrom with RBC Capital Markets. Please state your question.

Jon Arfstrom, Analyst

Hey, thanks. Good afternoon.

Pat Ahern, Chief Credit Officer

Good afternoon.

Jon Arfstrom, Analyst

Can you talk a little bit about the timing of the expense reductions for the branch optimization project? How we should roll that in?

Philip Flynn, President and CEO

Sure. So the consolidations, internal will be done this quarter. The sales in Peoria and of two branches in Southwest Wisconsin will complete this quarter. We expect them to complete this quarter. And the remaining one branch, which we're selling to a third party, will close sometime in the first quarter. So you should expect to see everything clean starting January 1, with a very minor exception of one branch.

Jon Arfstrom, Analyst

Okay. The message is similar to your comments about net interest income with the $5 million. You are suggesting that it could be as straightforward as reducing expenses by an additional $10 million for Q1. Is that correct?

Philip Flynn, President and CEO

Well, Chris, do we have all the charges accounted for in the fourth quarter?

Chris Niles, Chief Financial Officer

Correct. Yes. So, as you said, 2021 should be a clean start from January 1. So Jon, I think you're thinking about it the right way.

Jon Arfstrom, Analyst

Okay. Thank you for that. Can you provide any insights on the rebound in service charges and what magnitude you expect? I understand there's been a bit of a bounce back, but any additional commentary would be appreciated.

Philip Flynn, President and CEO

Yeah. So we expect to see continued growth there. As you know, at the start of the pandemic, we gave quite a bit of relief to customers. That is now completely rolled off as we get into Q4. And rightly or wrongly, economic activity has picked up, particularly in the Wisconsin footprint. And so we're seeing more activity there as well. So our guidance that we expect to see fee income continuing to grow into the fourth quarter is based on those factors.

Jon Arfstrom, Analyst

Okay. And then one more, maybe not an easy question, but you've had some really good deposit growth the last few quarters. And do you all think about how much of this might be permanent versus temporary if things return to normal?

Philip Flynn, President and CEO

Chris, do you have a view on that you want to express?

Chris Niles, Chief Financial Officer

Yes. So, Jon, I think if you had asked us a couple of quarters ago, certainly we would have said we saw it all as surge. As we sit here moving into October and the balances have stayed through the entire third quarter, they're staying as we move into the fourth quarter, we're starting to feel that the balances are a lot stickier, which is part of the reason we are comfortable repaying the $950 million of Federal Home Loan Bank advances because we think a good portion of this is sticky. And the dollars that we're still continuing to see come in, we think will continue to be sticky as we move forward. So as we sit here today, it feels a lot stickier than we would have expected, and it feels like we have room to move things around.

Jon Arfstrom, Analyst

Okay. All right. Thanks for the help, guys.

Philip Flynn, President and CEO

Yes.

Operator, Operator

Our next question comes from Chris McGratty with KBW. Please state your question.

Kelly Motta, Analyst

This is actually Kelly Motta in for Chris. Thanks for taking my question. I guess, you've talked a lot about what we've done on the funding side with prepaying that FHLB borrowings, and you're still repricing to be lower. Just wondering if you could give us color on reinvestment yields of securities and how new loan yields compared to what you have on book right now.

Philip Flynn, President and CEO

Chris, do you want to handle that?

Chris Niles, Chief Financial Officer

Sure. So on the reinvestment securities, I think one thing to keep in mind is we're not aggressively growing the balances. And so what you're seeing is essentially a relatively stable level to what you'll see reported for the third quarter averages and not a lot of net movement, because of incremental significant investment activity. So I don't expect there to see the continuing drift downward because there just isn't a lot of net new that we're expecting to put into that portfolio. On the commercial loans, I think we've showed the trends on the slides. And again, we started to highlight monthly trends. So if you take a look at the slide, page twelve, you'll notice that commercial loan yields actually bottomed in June, and that's for the commercial and business lending. We've been working with our lending business on spread and floors in order to sort of bounce that back up a few basis points and hold that line above 250 on the commercial book and as a whole over the last several quarters, and that seems to have gone successfully, and that reflects the activity we're doing on new. You can also see that commercial real estate has held steady, and again, what we're holding in portfolio is holding steady on the residential book as well. So I think those month-to-month trend lines give you a good indication of sort of where the new volume is coming in.

Kelly Motta, Analyst

Great. Thank you. And then last question for me. On tax rates, with potentially tax rates going up again and from Washington, is there any differences on how we should think about it? Or is kind of looking at it what happened in 2018 a valid proxy? Thank you.

Philip Flynn, President and CEO

Well, your guess on what happens is as good as ours, but our best guess right now is that we've got tax rates in that 15% to 17%-ish range, but that can all change.

Kelly Motta, Analyst

All right. Thank you.

Philip Flynn, President and CEO

Yes.

Operator, Operator

Ladies and gentlemen, there are no further questions at this time. I'll turn it back to Philip Flynn for closing remarks. Thank you.

Philip Flynn, President and CEO

Thanks. Well, everybody please stay safe. Thanks for joining us today. We look forward to talking to you again in January. And as always, if you have any questions, give us a call. And thanks as always for your interest in Associated.

Operator, Operator

Thank you. This concludes today's conference. All parties may disconnect. Have a good day.