First Commonwealth Financial Corp /Pa/ Q3 FY2020 Earnings Call

Good day, and welcome to the First Commonwealth Financial Corporation Third Quarter 2020 Earnings Call. Please note, this event is being recorded. I would now like to turn the conference over to Ryan Thomas. Please, go ahead. Thank you, everyone, for joining us today to discuss First Commonwealth Financial Corporation's third quarter financial results. Participating on today's call will be Mike Price, President and CEO; Jim Reske, Chief Financial Officer; Brian Karrip, Chief Credit Officer; and Jane Grebenc, our Bank President and Chief Revenue Officer. As a reminder, a copy of today's earnings release can be accessed by logging on to fcbanking.com and selecting the Investor Relations link at the top of the page. We have also included a slide presentation on our Investor Relations website with supplemental financial information that will be referenced throughout today's call. Before we begin, we need to caution listeners that this call will contain forward-looking statements. Please refer to our forward-looking statements disclaimer on Page 2 of the slide presentation for a list of descriptions and risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Today's call will also include non-GAAP financial measures. Non-GAAP financial measures should be viewed in addition to and not as an alternative for our reported results prepared in accordance with GAAP. A reconciliation of these measures can be found in the appendix of today's slide presentation. And with that, I will turn the call over to Mike.

Thanks, Ryan. The team and I here are pleased with the quarter. We are enjoying playing some offense in our consumer lending businesses. Over the last several years, we've made significant investments in our digital capacity, our regional business model to spur growth, fee businesses, and a stronger consumer lending platform. The fruits of these investments are apparent in our third quarter results. With several recent efforts like project THRIVE, we have made these investments while maintaining positive operating leverage and improving our efficiency. Third quarter core earnings per share of $0.24 were consistent with last quarter, even as we further increased loan loss reserves. The core efficiency ratio improved to a record low of 54.45% and the core pretax pre-provision ROA strengthened to 1.74%. Core pretax pre-provision net income was $41.1 million, up some 14% over the second quarter. The company achieved record quarterly fee income of $26.7 million, an increase of $4.9 million from the previous quarter. This more than offset a $4.4 million increase in provision expense to $11.2 million. Several important themes continue to unfold, namely: first, in the third quarter, credit was solid and we continue to build loan loss reserves to recognize the impact of the pandemic. Excluding PPP balances, the allowance for loan losses as a percentage of total loans increased 10 basis points to 1.38%. Including previously disclosed day 1 CECL adjustment, the coverage ratio, excluding PPP loans would increase to 1.59% as seen on Page 10 of the earnings supplement. The reserve build was driven by several qualitative factors in our incurred loss model, which Brian will cover during his remarks. Our nonperforming loans fell from $56 million at the end of the second quarter to $49.7 million at the end of the third quarter. On Page 13 of the earnings supplement, COVID-19 deferrals totaled 2.68% as of July 24. Those deferrals fell to 17 basis points as of October 23 or last Friday. Similarly, on Page 12 of the earnings supplement, deferrals on the commercial portfolios most impacted by COVID declined again from 3.4% on July 24 to 14 basis points as of last Friday. I believe we are well positioned at this stage of the pandemic with a strong balance sheet that can weather uncertainty. Next, third quarter fee income as a percentage of revenue was 28.8%. We are particularly proud of this number as it reflects years of focus and investment as we've diversified our revenue stream. Our third quarter fee income was driven by strength across multiple business lines. First, interchange income was $6.4 million, up roughly $500,000 over the second quarter. The team's retention of households and execution through five smaller acquisitions has really borne fruit here. Mortgage gain on sale income was $6.4 million, with a record quarter of $240 million in production. As an aside, 40% of these loans were not sold and remain on our balance sheet. Again, we've delivered our way into this business just over five years ago. Despite lackluster industry-wide small business demand, SBA gain on sale income was $1.4 million, which also contributed to fee income. Despite our smaller size in some of our larger metropolitan markets in which we compete, our 2020 SBA origination performance now ranks us number two in Western Pennsylvania and number four in Northern Ohio. Also on the fee income front, trust revenue totaled a record $2.6 million as well. The third theme is loans. Loans grew $33 million or 2% on a linked-quarter basis as the consumer lending business led the way. And commercial lending, however, utilization of lines of credit fell some $55 million from 38% at the end of June to 34% at the end of September as business investment and working capital utilization has stalled. Our mortgage, branch-based consumer, and indirect lending businesses have been robust even as underwriting standards have been tightened. Fourth, the net interest margin contracted about 18 basis points to 3.11% in the third quarter despite respectable loan growth and resilient loan spreads, particularly on the consumer side. Net interest income, however, was virtually unchanged, falling only $300,000 to $66.7 million. Excess liquidity and negative replacement yields on loans were the primary drivers of the decrease in NIM. Jim will provide more color here. Fifth, core noninterest expenses were down $63,000 for the quarter to $52.3 million even as we continue to invest in our digital platform and tools for our clients. Importantly, the team launched a new digital platform in mid-September called Banno, which replaced both our online banking and mobile banking platforms. The team also completed the conversion of our larger business customers to our new treasury management system. We also added the person-to-person payment option of Zelle. These launches impacted well over 200,000 consumers and small businesses and by all accounts went smoothly. And with that, I'll turn it over to Jim.

Thanks, Mike. This was a very solid quarter for us. Core earnings per share matched last quarter's results even with $6.9 million of reserve build. And we hit consensus estimates even without any PPP forgiveness. This is a significant point that's easy to overlook. While our provision expense of $11.2 million came remarkably close to the consensus expectation of $11.1 million, our spread income came in roughly $3.5 million lower than consensus expectations, and yet we still hit consensus. To be completely fair, this differential in spread income is likely the result of our own previous guidance that PPP forgiveness would take place in the third and fourth quarter of this year. And as such, it would have been perfectly reasonable to expect third quarter net interest income to benefit from the acceleration of PPP premium amortization. In reality, we had no such PPP forgiveness income in the third quarter. Instead, strong fee income made up for the lack of PPP forgiveness income. At this point, we do not expect any significant PPP forgiveness until the first and second quarter of next year. Our core earnings figures excluded two nonrecurring expense items from our results: $3.3 million of expense associated with a voluntary early retirement program and $2.5 million of expense associated with the branch consolidation effort, both of which have been previously disclosed. These efforts combined with other expense initiatives are expected to help keep noninterest expense flat in 2021, not only by allowing us to continue the reduction in total salary expense that we have benefited from in 2020 due to our hiring freeze, but also by absorbing increases in other expenses as we return to a more normal operating environment. Brian will provide commentary in a moment on credit, but I'd like to provide a little more color on a few things before turning it over to Brian. First, our stated NIM was 3.11%, but was affected by negative replacement yields, a shift in mix toward consumer loans, and most importantly, an average excess cash position during the quarter of approximately $343.3 million or about 4% of average earning assets. Consistent with prior disclosure, we calculate a core NIM excluding the impact of PPP loans and excess liquidity of 3.28% in Q3. The NIM should benefit in the near-term from time deposit and other deposit repricing, as well as some balance sheet management efforts designed to move excess customer funds off-balance sheet, thereby reducing excess cash. These efforts are expected to help offset negative replacement yields and keep the core NIM relatively stable in the near term. Over the course of next year, however, we currently expect the core NIM excluding PPP to continue a path of modest contraction in the 3.20% to 3.30% range. Second, Mike mentioned that our fee income of $26.9 million was very strong in Q3, up by nearly $5 million from last quarter. Because much of this was driven by mortgage, fee income is expected to seasonally adjust to approximately $24 million to $25 million in the fourth quarter. And finally, I know Mike already mentioned this, but if you look at Page 10 of the supplement, you will see graphically what we have verbally explained in prior quarters, that even though we delayed the adoption of CECL, the addition of our day one CECL number to our current incurred ALLL results in a reserve of $101.2 million and a reserve coverage ratio of 1.59%. I can add that reserve figure is not materially different from our internal parallel CECL runs as of September 30. So even though facts and circumstances may change before we adopt CECL next quarter, not the least of which is the economic forecast, our cumulative reserve building in 2020 under the incurred model has left us in a very good position ahead of CECL adoption next quarter. And with that, I'll turn it over to Brian.

Thank you, Jim, and good afternoon. It's good to be with you again. As outlined in our investor deck, credit quality was solid for the third quarter in spite of the uncertain economic environment. As expected, delinquencies ticked up modestly due to the runoff of stimulus and a reduction in payment relief. We are cautiously optimistic by the improvement in unemployment and the reopening of the economies in Western Pennsylvania and Ohio. We continue to be watchful of our deferral roll-off reports to evaluate our borrowers as they resume full payment status. Net charge-offs for Q3 were $4.3 million, which includes approximately $1.2 million in consumer charge-offs. Net charge-offs annualized were 0.27%. Our NPLs improved approximately $6.3 million to $49.7 million, improving to 0.78% from 0.88% of total loans, excluding PPP loans. This is the second consecutive quarter for us to report an improvement in NPLs. Reserve coverage of NPLs rose to 177% from 145%, again, excluding PPP loans. Similarly, our NPAs improved $6.7 million to 0.80% percent of total loan assets from 0.91%. We conducted yet another loan-by-loan review of the higher risk portfolios and adjusted risk ratings as appropriate. Our proactive approach to risk ratings resulted in criticized loans increasing approximately $60 million, while classified loans increased modestly. These trends formed the backdrop of our approach for loan loss reserve in the third quarter. As shown in the slide deck, the provision for the quarter totaled $11.2 million, which resulted in a reserve build of $6.9 million under our incurred loss model. The allowance for loan loss as of September 30 totaled $88.3 million as compared to $81.4 million at June 30. The reserve balance grew to 1.38% excluding PPP loans from 1.28%. Let me offer some color related to the reserve build for the quarter. Net charge-offs were $4.3 million. We had a slight increase in specific reserves of approximately $500,000. Our standard qualitative reserves increased approximately $900,000 quarter-over-quarter, reflecting a mix of economic conditions. Our COVID qualitative overlay reserve increased by $4.7 million for Q3 to $14.6 million. We released approximately $1.9 million in consumer reserves due to improving deferral experiences as well as improved economic conditions. We increased our high-risk portfolio reserves by approximately $6.6 million, largely due to increases in the overlay reserves for our hospitality and retail portfolios. Thank you. And now let me turn it over to Mike.

Thanks, Brian and Jim. And operator, we'll now take questions.

Just starting off with credit here. Obviously, nice decline on the deferrals. Just wondering about the additional reserves for hospitality and retail as well. What are the thoughts on possible redeferrals? Or how are you thinking about possible credit formation in those books?

Well, if I understand your question, Steve, as for the deferrals, this is playing out how we thought it would play out. As these forbearances or deferrals or modifications roll further, we are spending time to evaluate each credit on a name by name basis. Oftentimes, it really starts with management; if we understand our borrowers, their commitment to the properties, we understand what they'll do with it. We can do a thorough analysis and take a look at whether the credit needs to migrate from a pass rated to a special mention or onto a substandard. As you roll off the deferrals, oftentimes, that does necessitate a real meeting and understanding of liquidity of recourse and how we address each credit. Did I answer your question?

Yes. And I guess just as you think about where things are progressing, what are you seeing for your customer performance when it comes to hospitality and restaurants?

That's a good question. So we've dissected the portfolio in a number of different ways. We sliced it into business, college campus, leisure, and resort-style properties for our hotel book. We keep coming back to recurring themes, which is we are seeing continued improvement in that portfolio, although it is uneven and slow. Let me give you some anecdotal evidence. I think it will help. Occupancy, average occupancy from 13 of our properties for August was 51%, that ranged from a low of 35% to a high of 79%. When we compared the same properties back to June, it was 29%, and now we're up to 51%. We are seeing increasing occupancy. Similarly, we are seeing an increase in ADR, and so as we think about these hotel properties, ADR's up to $111. That's an increase from roughly $90 in June. So anecdotally, we're seeing improvement. Our portfolio is getting an awful lot of internal scrutiny. When we went into this pandemic, we were about 63% LTV, and we covered 154 basis points. It's worthy of ongoing monitoring and managing the credit risk.

Steve, this is Mike. Just to add a little bit more color. We're honored. We really had combinations quickly upfront. And then in the first deferral period, we made a credit decision. We made a commitment not to kick the can down the road irrespective of what might have happened with the government or other types of programs. I think Brian and his team did a really good job of calling balls and strikes and getting the credit into the appropriate category of classified or watch. That's why you see a little movement in those categories this quarter. Is that helpful?

Yes. That's helpful for sure. And then in terms of business activity and loan growth, you had modest positive loan growth from the consumer side of the business. Just kind of curious, it sounds like that will probably continue into this quarter. What are you seeing on the commercial side in terms of pipelines and business activity there?

Yes. The pipelines on the commercial side are a little shallow. The things that we're getting are really just through a lot of effort and better execution. That being said, in small business, for example. And I think this is more about execution and just our ground game is getting better. We're up about 33% in approved small business loans from the third quarter of last year to this year. We are also seeing that kind of peak through our SBA lending. A lot of that is triage. We're doing on credits that just might have some systemic credit weakness in adding an SBA guarantee. But I just think, as I said in my opening remarks, we're seeing lower utilization because of working capital lines of credit. It's just not the same level of investment yet on the commercial side. On the consumer side, we're seeing good activity. I mentioned mortgage. We're at a record in mortgage originations. Jane Grebenc, our Bank President, just shared with me before the call that only 46% of ours are refis because we still have a mortgage business that's growing organically. On the consumer lending side year-over-year through our branches, our applications are up 25%. Online real estate applications are up 89%. I mentioned small business lending is up 33%, and indirect auto was up 29% year-over-year. So there's enough there on the consumer side that carried the day for us in the third quarter. And on the small business side, this is just the way it is in recessions in my lifetime; that volume or those pipelines will be dampened for a season.

That's helpful. And then I guess the last question for me, and then I'll step back. In terms of buybacks, you completed the repurchases. And I'm curious how you're thinking about the possibility of repurchases moving forward or other capital deployment?

Yes. Jim?

Yes. We have no further share purchase authorization right now. We are very pleased with the execution of the remaining portion of our previous authorization. We started that the last week of September when all the bank stocks were down. We were able to retire those shares right around book value, which was very accretive. We're very pleased with how that came out. But right now, there's no further authorization plan. We'll watch it closely though because the bank is still quite profitable, and we're still generating capital. It will depend on our projections for loan growth and how much internal capital generation we need to capitalize that for the loan growth. If there's excess capital, that would present an opportunity for further repurchases. So we're very pleased about how that program took place, and we hope it was perceived as our confidence in our future prospects, really taking shape.

On the expense side of things, I wanted to circle back to the targeted expense savings from the branch reduction. I believe it's $8 million on an annual basis. How much of that considering other franchise investment do you guys expect to be able to drop to the bottom line?

Jim, you might have those numbers. But I know it's not all of it with our digital investment.

Thank you for your question. We've been trying to clarify our expectations regarding the net effects of expense reductions on our total noninterest expenses. As I mentioned earlier, we are already benefiting from some expense reductions due to the hiring freeze implemented this year, which has saved us on salary costs. As a result, even though we're consolidating 20% of our branches, we anticipate minimal job losses during the consolidation because we can relocate staff to available positions, which is a positive outcome for the community. This also means we’re realizing some of those benefits in our current earnings. Last time, we mentioned a total of approximately $8 million, with about $2 million earmarked for reinvestment in other projects. Around $4 million is attributed to savings from the hiring freeze in terms of headcount reduction we’ve achieved so far this year, leaving us with $2 million remaining. However, there are many factors at play right now, and we aim to maintain consistency in conveying that all these elements work together to keep our expense base for 2021 in line with 2020.

That's very helpful, Jim. And very clear. I guess, just the one follow-up would be as a part of project THRIVE, are there other measures being considered beyond the salary freeze and branch reduction that we might talk about either today or in the near future?

Yes. We're looking at everything from some of our benefits in health care. We're looking at everything on the table. And just trying to dial it in appropriately given the specter of this pandemic and interest rates and what it means for the long-term financial path we have. We've been really good over the years about operating leverage and we think about that in all of our budgets from quarter-to-quarter and from month-to-month. I think all businesses, quite frankly, are like that.

I do. Yes. So we added some disclosure right in the text of our earnings release on operating leverage. I don't know how common this is. I can tell you that internally, at the start of the pandemic, when the Fed cut rate by 150 basis points, and we, like every other bank, saw the impact on our margin, immediately thoughts of positive operating leverage started to go away. We thought, well, it's going to be a very difficult year to achieve positive operating leverage. But we were very pleased to have these results, and we published this. Like I said, it's on Page 2 of our earnings release, about how our core revenue increased $4.6 million from the previous quarter and $6.4 million from the previous year, while core noninterest expense will increase $39,000 and $2.9 million from the previous year. We're extremely proud of the fact that we've been able to generate positive operating leverage in this environment. I appreciate the question.

I appreciate the answers there. Switching gears to loan growth a bit. I heard you loud and clear on the commercial pipeline. Growth this quarter was consumer-driven. I just want to get a sense for how that would translate going forward. Should that dynamic continue? And what are you thinking overall on organic growth?

We believe that it will. Jane, do you have any thoughts you'd like to share?

Thanks, Mike. I expect that fourth quarter will continue with muted commercial growth. The pipelines are light, but I think the small business and the consumer businesses will continue to be strong through the fourth quarter.

And then last question for me. You guys mentioned the core margin going forward, the $320 million to $330 million range? It looked like core loan yields were down in the high single digits this quarter. What needs to come together to be at the higher end of that range?

Yes. We have a few irons in the fire here. Jim?

Yes, thanks for your question. Several factors contribute to our guidance of maintaining stability. It's important to consider that our participation in the PPP program has added a layer of low-margin assets to our balance sheet. While this has generated net interest income, which we appreciate, it has also lowered our overall loan yield. Another significant factor is the excess cash on our balance sheet, averaging $343 million and representing 4% of our average earning assets. We're working with clients to transfer some of these excess funds into sweep accounts, which will improve our net interest margin by reducing non-cash assets. Additionally, there's potential for improvement on the deposit side. According to our press release, we have $700 million in time deposits at 1.28%, with about $200 million maturing in the fourth quarter, which will reprice downward by at least 100 basis points. Another $100 million in money market deposits at 1.39% will also decrease by about 5 to 10 basis points. This means we could save over 100 basis points on $300 million of deposits during the quarter. While moving excess funds off the balance sheet should aid the net interest margin, we're transparent about the ongoing negative replacement yields on loans, which will likely counterbalance each other, keeping the core net interest margin within a stable range in the upcoming quarter.

Maybe my first question, just on the FDA outlook. Mike, you've given kind of where your strength lies there and your positioning in your regions, so it seems pretty positive. How should we be thinking about the fee contribution of the SBA going forward? And it's been a little bit lumpy, but do you think it can be a meaningful contribution as we look into the fourth and beginning of next year?

We do. First of all, we think it's an important part of our mission within our respective communities and to find ways to thoughtfully get deals done and protect the bank. Throughout the pandemic, PPP was such a big part of that, we really have the talent. Jane has hired a gentleman who is running our consumer lending function that has built big SBA lending platforms. Part of Project THRIVE is not just expense, but it's also revenue. We will make a big play to grow that business over the next few years. Jane, why don't you add some color to Collyn's question?

Thanks, Mike. And thanks, Collyn, for the question. We really credit water, Collyn, in the SBA business for a full three or four months as we worked through PPP. Although the pipelines are a bit light now, we expect 2021 to be a good SBA year for a couple of reasons. The first is the gain on sale on PPP. SBA loans has been very strong of late, and the pipelines are starting to fill up, and the regional business model is creating very good partnerships with the SBA BDOs as well as the middle market and small business lenders in the region. I think I'm bullish on the business.

That's great. That's helpful. And then just last question. Jim, just on the buyback - I appreciate your comments about keeping an eye on capital build or where you might need the capital to grow loans. But I guess just to hold you a little bit tighter in terms of near-term catalyst, or what would you need to see in the near-term to reengage more aggressively on the buyback?

Yes, it's not much more complicated than that. Thank you for the question, Collyn. I hope you've noticed that we are trying to present the tangible common ratio along with other ratios, both including and excluding PPP in the press release. Our tangible common ratio has decreased to 8.4%, partly due to the need to capitalize those PPP assets, which obviously do not require risk weighting. We're showing the tangible common ratio at 9% when excluding PPP. While we don’t have a formal target for tangible common equity below 8%, it is a bit thinly capitalized, and anything above 9% indicates excess capital. Given the current global pandemic, we are monitoring this closely like everyone else. No one wants to be undercapitalized, but we also need to be careful and responsible with our capital. If it goes much higher, we will need to find ways to utilize it effectively. If we cannot achieve that through loan growth, we will consider additional buybacks. However, it's challenging to provide a specific threshold like 9.1% for reinitiating the buyback program. Our decision will depend on multiple factors including credit, capital, and the economic outlook at the time.

Just back on the margin. Your loan yields excluding PPP were 3.97%, down 17 basis points. Do you see that tapering off next year? By the fourth quarter of next year, where would you expect to see the core loan yield?

Yes. Steve, it's a good question. It's a nice technical question. I don't have an exact answer for you because we don't have a projection on that at exact production. I will tell you that in general, right now, the commercial loans, even now that the Feds cut rates, the yield curve is flat, the 10 years in the 70s or 80s, and we had these lower for longer expectations. The commercial loans are still coming on in the mid-3s, and the consumer loans are coming on in the low-3s. That will probably continue for the foreseeable future. And so if that continues, you'll see the overall loan yield come down a bit, but it probably won't go below 3%. If we can keep the loan yields coming on in the mid- to low 3s, we can get our deposit costs trending towards 0 that allows us to maintain a reasonable margin and build capital. That's the big picture we're looking at it. Sorry, I don't have a more direct equation, like an exact projection for you on fourth quarter 2021 loan portfolio. We didn't mention it, but I can pull it up for you if you give me one second. I think it's about $570 million of PPP average balances in the third quarter. Here it is, $572.4 million, that was the average PPP balance in the third quarter. The yield on those loans, I think we did disclose that somewhere. That's about 2.7%. That's the 1% stated yield, plus the amortization of the premium over time. It's about 2.7%. The total earnings on those loans with all of that together was about $3.8 million of net interest income.

But Jim, I don't think any of that was from fees. Was it?

No. That would be the quarter's worth of interest income and fee amortization that we're taking over the 2-year life of the PPP loans.

Right. So the $3.8 million includes the interest and the amortization. Is that correct?

Yes, yes, yes. But no accelerated amortization. What we did this year... yes, yes, yes. We thought by now we’d have a whole bunch of PPP forgiveness, so we’d be rushing all that amortization forward and taking it into income. We didn't have any of that in the third quarter, and now we don’t expect any until the first half of next year.

Okay. So we just have to back it out of the 2.7% yield on your average balance, you get the fee.

Yes. And actually, if you do that, and you also take out the average cash balance we had of $344 million, which earn next to nothing. That gives you a new average earning asset figure. That’s how we did our core income calculation. We're not looking to replace it. So what we found in this environment, that there’s not much rate-seeking behavior left. For example, our 12-month CD rack rate is 10 basis points right now. And when these CDs roll off, a lot of them are 12-month CDs, not all of them, but when they roll off, about 60% tend to roll into the rack rate. That’s probably pretty close to the industry experience. But that’s what we’re seeing right now. To be honest, a lot of the ones that don’t, we’ll just move into one of our savings accounts or a checking account. They won't roll into a CD, they’ll take it out, and the deposits will stay with us just in some other form. Our strategy for now has been to not pursue those with higher rates and let them roll over. We obviously don’t need the funds.

Steve, this is Mike. Just a reminder, we probably had a much lower percentage of CDs heading into this pandemic than most of our peers. We had between our noninterest-bearing checking accounts at 25% plus in our money market rates, we had a very low-cost of funds. We’re not chasing CDs for our funding, and that’s another factor playing as we think about it. Those are predominantly small business deposits and middle-market deposits as well. So I don't think we'll have the pressure there that perhaps others might to keep the households.

If I could build on that, if I could just build it because that Mike's comment gives me a chance to make another point. Going into this crisis, we had a very finely tuned balance sheet. Because of the recent Santander branch acquisition, we paid down all our borrowings. The balance sheet was funded really with core deposits without any borrowings. That was a good thing and a great position to be in, and it was intentional. We wanted to "pay off our debts" and that puts us in a great position going into the crisis. It means we're left empty hands, and we are thinking about the strategies. We're looking at the types of opportunities and securities, and it's very difficult to get yield unless you reach for very long duration. Larger banks that reported earnings this cycle said that they purposely are not investing any cash. They're going to stay in cash, and they're not going to take on that risk. We don't have that philosophy. We want to move excess cash off the balance sheet, if possible. If there's some portion of remaining excess cash, we will judiciously put some of that to work. We don’t want to extend duration and hurt ourselves too much, but we have an obligation to get some earnings on that. We can’t sit on the sidelines forever.

Got it. And then Mike, just last one for me. Just coming out of this pandemic. Is there a profitability target that you're aspiring to if we're in this lower-for-longer rate environment?

Not an absolute, but a relative. Part of our theme for Project THRIVE was to emerge from this as a stronger institution with top decile profitability. We've significantly improved our efficiency and will continue to do so. We've also developed more revenue streams compared to four or five years ago. Jane and the team have built the mortgage business from the ground up, and we're gaining traction in consumer lending, which balances well with our already strong commercial franchise. The team is effectively advancing small business lending and banking as an SBA. Although indirect business may be slightly affecting our margins, the spreads are increasing and remain profitable. The company's nature and our geographical presence have also evolved. Our business model and approach to the market, along with cross-functional teamwork, are enhancing household engagement, cross-selling opportunities, and overall customer satisfaction. Our brand is increasingly recognized in communities like Cincinnati, Columbus, Northern Ohio, and rural areas such as Pittsburgh. We believe we are strategically progressing in the right direction. Our profitability trends are continuously improving. While the absolute numbers may be lower than pre-pandemic levels and affected by the current interest rate environment, we are confident it will perform well comparatively.

It's actually Justin Crowley on for Frank this afternoon. Just a couple of last ones here for me. So clearly, strength on the residential and consumer lending side, which we've talked about at length at this point, not something that's totally new. I was wondering if from a high level, you could characterize your approach in weighing residential versus commercial? Even looking out over the immediate term, not necessarily just over the next quarter. Obviously, as we head into year-end, you mentioned the shallow commercial pipeline. So not sure if you would put out there a targeted percentage that you would like residential to get to as a percentage of the whole book? Or how that could change as you start to see commercial demand pick up over the coming quarters?

Our philosophy has been straightforward: to achieve a better balance between our consumer and commercial businesses. We began this journey several years ago and have made significant progress. We also aimed to shift from a variable to a more fixed rate structure, which we managed to implement effectively before the pandemic hit. Ideally, I would like to reach a 50-50 balance. I believe the economy will rebound, and our commercial sector will thrive with higher spreads, potentially leading to similar challenges in a few years. We value having robust consumer and commercial sectors. Although demand in the commercial space is currently weak, we are grateful for our investments in the consumer side, which tends to be more cyclical. It is beneficial to have both segments. Regarding residential mortgages, we have established some limits, though I won't disclose them during this call. We maintain strict discipline regarding credit conditions. Whether looking at our commercial real estate or SIC codes, we have set hard caps on the amount of loans we will issue, but achieving that 50-50 balance remains the goal. At present, our position is acceptable.

Great, that's really helpful. I appreciate the color there. And then sort of just bouncing off of that, looking at fees in the mortgage banking line item. As we get through this wave of refis, how much will depend on that breakdown between residential or consumer versus commercial? And what you decide to portfolio or sell off? So I guess what I'm really asking is how much investment and focus would be going into the fee income side of that going forward when there's not as much of an emphasis on holding more residential just given the lack of commercial growth within the portfolio?

If I understand the question, I don't think that they're mutually exclusive. We've always targeted somewhere around 60% to the balance sheet and about 40% that we sell. That’s about what we’re doing right now. However, at any given time, we can pivot and we can pivot quickly because we underwrite for sale. We give ourselves fair flexibility at the deal level. Did I get your question?

Yes. No, no, I appreciate that. That’s helpful. One last one here for me. We've talked about it at length, but just on the expense side, I appreciate the guidance and helpful color looking into next year in terms of where you think things could shake out. You discussed some of these strong digital adoption metrics. Taking that, Projects THRIVE, the branch consolidation, and looking at the consolidation, from what I can tell you, you were one of the first movers on that back in July, and we've seen a number of these as of late. So even from three months ago, have you seen a meaningful change that would cause you to maybe take another look at the branch count or take another look at digital?

Wow, is frankly you're still out.

Did you catch any of that? I had quite a bit of feedback on my line.

We did experience some feedback for about 30 to 40 seconds, and we apologize for that. I'm not sure where it originated, but I hesitate to ask you to repeat the question.

I think I understood the question. With the gist of the question, whether we've got a next wave potentially of branch consolidations on the horizon?

Yes. I'm not trying to push you for a timeline on when you'll announce your next branch consolidation plan. However, you were one of the first banks to proactively share such a plan. I'm curious if, considering the pandemic and the changes in consumer preferences towards online options, this has prompted you to reevaluate the necessity of all your branches. Could there be an opportunity to reduce their number?

Yes. From that at this time, we also, I think numerically went a little bit deeper than some of the other banks. We were at 25% of our network. We think that's just about where we want to be, but we still like branches. We’re bullish on branches. Lots of that consumer loan growth is coming from branches. We feel really good about where we are right now. We run a very, very efficient branch network.

Yes. Just one adjunct to Jane's comment is our branches have been open, and our lobbies have been by appointment. That's been an opportunity culturally for us to do a lot of outbound calling, which has really spurred our loan growth. It's a little paradoxical that we’ve had a lot more outreach to customers from our lobbies than ever before. I love what that’s doing in terms of building a better sales culture, and the branch people have been terrific.

My question, two. First one is, do you expect to generate positive operating leverage next year, given some of the challenges on the NII and NIM side?

We do, but I'll let Jim answer that question, too. He's currently putting together the budget for next year.

Yes. Some of that's still in the state of flux, but look, that's still our goal. That’s been our long-term plan for a long time. If we're able to hold operating costs flat and then maintain some reasonable margin and continue the trajectory on fee income. I don’t have exact numbers for you next year, but that is to our long-term goal.

What do you think the best use of capital will be for next year? Would it be to continue with buybacks or possibly think about something more strategic on the M&A front?

We generally think the best use of capital is organic growth. Organic balance growth, as Mike was laying up before balance between consumer and commercial lending. If we have opportunity to do M&A that is both strategic and financially accretive, that generally is preferable over buybacks. If you’re still generating excess capital and you don’t have those opportunities, then buybacks are a viable option.

I have two quick follow-up questions. Regarding the branch reduction, I apologize if I missed it. What are your expectations for the impact on deposits?

Yes. We expect that the deposits at risk from the branches we consolidated will be less than 5% of the company's total deposits. We believe we can retain most of those households, especially considering the close location of the consolidated offices.

Got it. Appreciate that. And then just a last quick one. I noticed that you have 40% of your employees working from home currently, I believe. How much do you think this would be permanent for you? And to the extent that it is, would that potentially adjust your real estate strategy further?

It absolutely could. We’re really wrestling with this. We're looking for those leases and also facilities that we might sell and just getting a little leaner. We expect that 40% number perhaps to go down a bit. But anybody else want to take a shot at this one? We talk about it a lot. I don’t know that we have a definitive critical path forward. But as part of our Project THRIVE is our work-from-home and our long-term real estate needs. One reason we got after branches this year, we started it in March, even though we announced it in July. We could get the branches consolidated in December and before the end of the year and go into 2021 clean and that will allow us to look at office buildings and other things that we might close and consolidate into other facilities. We do have plans for a building or two. Jane, do you want to add anything to that or Jim?

The only thing I would add, Mike, is that I’ve been really pleased with the progress that our facilities group has made with disposing of the real estate as a result of the branch consolidations. So that’s been a big win. Our consolidations were announced earlier than some other competitors. We've got those branches to market faster, and that was terrific. With respect to the multiuse buildings where we've got groups of employees, I think that will be a little bit more on the edges. The reason I think that is the humans miss the other humans. They like working with each other at least part of the time. We'll need to figure out exactly how to make this work long-term. But I don't think they're all going to be at home all the time. They're getting fatigued.

Understood. We don’t let a lease renew without being ruthless about it. Our real estate footprint looks dramatically different today than it did 5 years ago, 6 years ago, 7 years ago. It just couldn't be done all at once, slow and steady. We like to think we've gotten better every year and where we started a decade ago in terms of our fee income as a percentage of our revenue, our efficiency ratio, our return on assets was quite different. We've had dozens of initiatives to just to get where we’re at, and we're constantly changing and moving our feet, which will continue certainly around the expense side. We have to produce operating leverage and earnings per share growth.

There are no more questions in the queue. This concludes our question-and-answer session. I would like to turn the conference back over to Mike Price for any closing remarks.

Just thank you. I always say that I appreciate the partnership. I appreciate when you get us in front of prospective investors. Thank you so much, and we look forward to being with a number of you over the course of the next quarter. So virtually, I think. Thank you.

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