First Commonwealth Financial Corp /Pa/ Q1 FY2024 Earnings Call

Ladies and gentlemen, thank you for being here. My name is Desiree, and I will be your conference operator today. I would like to welcome everyone to the First Commonwealth Financial Corporation First Quarter 2024 Earnings Release Conference Call. I will now turn the conference over to Ryan Thomas, Vice President of Finance and Investor Relations. Please go ahead.

Thank you, Desiree, and good afternoon, everyone. Thank you for joining us today to discuss First Commonwealth Financial Corporation's First Quarter Financial Results. Participating on today's call will be Mike Price, President and CEO; Jim Reske, Chief Financial Officer; Jane Grebenc, Bank President and Chief Revenue Officer; Brian Karrip, our Chief Revenue Officer; and Mike McCuen, our Corporate Banking Executive. As a reminder, a copy of yesterday'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've also included a slide presentation on our Investor Relations website with supplemental financial information that will be referenced during today's call. Before we begin, I need to caution listeners that this call will contain forward-looking statements. Please refer to our forward-looking statements disclaimer on Page 3 of the slide presentation for a description of 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. 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.

Thank you, Ryan, and welcome, everyone. Despite pressure on the net interest margin through higher depository costs, First Commonwealth exceeded consensus earnings estimates by $0.01 with $0.37 per share in the first quarter of 2024. Core ROA and the efficiency ratio were 1.31% and 55.05%, respectively. The bank set a number of earnings records in 2023 and had a particularly strong fourth quarter. That was certainly worth celebrating, but it affects most of the period-over-period comparisons. For example, in the fourth quarter of 2023, we had negative provision expense of $1.9 million due to the release of reserves. This quarter provision expense was a more typical $4.2 million. That swing strongly affected quarter-over-quarter comparisons of financial metrics like core EPS, return on assets and return on tangible common equity. In addition, interest expense increased by $4.6 million over the last quarter, overwhelming the $1.2 million increase in interest income and resulting in a $3.4 million decline in net interest income. As a result, the core non-GAAP measures that we report on a pre-provision basis, such as core pretax pre-provision net revenue and core pretax pre-provision ROA, also declined from last quarter. Importantly, balance sheet liquidity strengthened as our loan-to-deposit ratio fell from 97.9% at year-end to 95.6% at the end of the first quarter. End-of-period deposits increased over $254 million or 11.1% annualized while loans increased just 1.5% annualized or $33 million. Consumer CDs constituted the bulk of deposit growth, primarily from our core consumer customers, while business deposits fell due to seasonal factors. We've begun to taper CD pricing based on first quarter growth and market conditions, and we'll continue to watch competitor rates and consumer behavior. Loan growth for the quarter may appear to be on the low side for us, but it's very much in line with our long-term plan to tilt the balance sheet more toward commercial lending. Commercial loans grew at an annualized rate of 5.24%, right in line with our long-term mid-single-digit guidance. That commercial growth offset declines in consumer real estate balances and the movement in consumer balances is no surprise. We're now selling over 90% of our mortgage originations, including mortgage construction loans. In fact, mortgage gain on sale fee income increased over last quarter. Second lien products like HELOCs and HE loans are naturally down because of the rate environment and also because a lot of those balances were driven by refinancing activity during the pandemic. The auto book is replacing runoff and nicely pricing upward exactly as planned. Overall, we see the diversification of our loan portfolio as one of our key strengths, and slow growth or even modest declines in consumer balances in any given quarter provide us with the liquidity and capital to grow commercial loans and maintain our current mid-single-digits guidance. As we execute regionally and profitably grow core deposits, loans, and fee income, we will grow meaningfully in the years ahead. Becoming the best bank for businesses and their owners will be a big part of that growth. The capital Columbus and Cincinnati regions present significant opportunities for growth at First Commonwealth. Our branch and business-based deposit gathering efforts have also led to our low-cost funding advantage. With mild loan growth that might appear from the outside like this was an uneventful quarter for us, but nothing could be further from the truth. We've made a number of internal management changes to maintain our momentum and ensure our success. Since hiring the new Chief Lending Officer last September, we have made a concerted effort to upgrade regional leadership, create more enduring operational scalability, and improve our C&I expertise. Some recent actions include naming new regional presidents in Pittsburgh and Cincinnati, new leadership in the Harrisburg region, and a new Head of Corporate Banking portfolio management and commercial loan documentation. We've also hired 5 new commercial bankers during the same period. As we like to say, we always keep our feet moving. In other words, we actively cultivate a culture of continual transformation and improvement so that we can steadily improve financial results year in and year out. And with that, I'll turn it over to Jim, our CFO.

Thanks, Mike. Before I break down the margin and other elements of the income statement, I'd like to highlight a few balance sheet items. The regulatory capital ratio has improved due to strong retained earnings and the absence of any buyback activity in the quarter, combined with modest balance sheet expansion. Strong deposit growth, coupled with modest loan growth, improved our liquidity as well. Not only did it bring down the loan-to-deposit ratio, as Mike mentioned, but it also left us with $223 million of excess cash at the end of the quarter. The strength of our internal capital generation and our improved liquidity position has allowed us to announce two actions with first-quarter earnings. First, a regular increase in the dividend of $0.02 per year in keeping with prior years and our long-term goal of smooth and steady increases in the dividend for our shareholders. Secondly, the redemption of $50 million of our $100 million in outstanding subordinated debentures on June 1. The timing of this redemption was right for several reasons. First, the subordinated debt would have lost another 20% of its Tier 2 capital treatment on June 1, and refinancing options would have resulted in additional expenses. Second, the consolidated total risk-based capital ratio improved organically by 34 basis points in the quarter, mostly offsetting the 44 basis point impact of subordinated debt in the second quarter. We have modeled further organic growth in our capital ratios in the second quarter as well. Third, the excess cash at quarter end provided the liquidity with which to fund the repurchase without taking on any additional borrowings. Finally, the coupon on this tranche of subordinated debt was currently about 7.45%, and we're paying it off with funds that are currently sitting at the Fed earning 5.4%. So this redemption will save the company approximately $1 million in pretax expense per year and improve the net interest margin by about 1 basis point. Our strong deposit growth in the first quarter came at the expense of a net interest margin as our net interest margin compressed by 13 basis points in the quarter. We had expected that the yield on earning assets would improve by approximately 10 to 15 basis points, matching a 10 to 15 basis point anticipated increase in the cost of funds, producing net interest margin stability. It didn't turn out that way. Instead, the yield on earning assets only improved by 5 basis points, while the cost of funds went up 19 basis points. In the aggregate, we originated new loans at just over 8% in the first quarter, but the old loans that are running off were in the aggregate about 7%, resulting in relatively modest replacement yields. On top of that, the loan portfolio yield was negatively impacted in the first quarter by the continued effect of fixed macro swaps that we entered into several years ago. Fortunately, $25 million of those swaps will run off on June 30 of this year, and another $50 million will run off in December. Those will provide only a 1 basis point benefit to the net interest margin in 2024, but a further $250 million rundown in 2025, which we expect to produce a cumulative benefit to the net interest margin of 8 to 11 basis points, depending on the trajectory of rates. If rates stay higher for longer, the benefit of the macro swap roll-off will be on the high side of that range. On the liability side, deposit costs increased by 25 basis points as we saw a $233 million decline in low-cost deposit categories, combined with a $283 million increase in the more expensive category. Despite the movements in balances, we saw net gains in consumer households in the quarter. In fact, our deposit pricing strategies have been effective, not just in retaining our deposits, but we are also attracting new dollars to the bank. While the cost of deposits went up 25 basis points, the cost of funds only increased by 19 basis points because we benefited from participation in the Federal Reserve's Bank Term Funding Program in the quarter. We borrowed just over $500 million while the Fed was still pricing the borrowings on the forward curve. So we are grandfathered in, so to speak, at 4.76% on those borrowings until next March. We didn't enter the program with the intent to arbitrage the rate. We simply borrowed that much because that's what we needed at the time, and the Fed's rate was less than the FHLB. Ordinarily, we would use the excess cash generation from the strong deposit growth we enjoyed in the first quarter to pay off borrowings. But given the rate differential, we prefer to stay in the BTFP program for now, which is why we ended the quarter with $223 million on deposit at the Fed at 5.4%. While it's obviously accretive to income by about $0.01 per share in 2024, it did have a 3 basis point suppressive effect on the net interest margin in the first quarter. Fee income and noninterest expense are both little changed, but slightly unfavorable compared to last quarter. Back-to-back swap fees were nonexistent as customers had little desire to lock in fixed rates, and interchange was down seasonally compared to the fourth quarter with holiday spending. We were pleased, however, to see mortgage and SBA gain on sale income pick up from last quarter. The noninterest expense comparison to last quarter was also affected by a tax accrual reversal that benefited the fourth quarter and by higher occupancy expense in the first quarter. And with that, I'll turn it back over to Mike.

Thanks, Jim. And operator, if we could pause for some questions.

Maybe, Jim, I appreciate all the detail on the puts and the takes of the margin in the first quarter as well as what's coming in the next rest of the year and even into '25 with those swaps. But maybe you can kind of fill us in on how you're thinking about the core margin and the total margin path for the rest of the year?

Yes, thanks. You may have noticed that absent from my prepared remarks, there's any kind of forecast of the net interest margin. And that was intentional. Just to be clear, we are very cognizant of the fact that over the last three quarters, we have forecast instability, yet the margin compressed by about 10 basis points every quarter. I would tell you that the forecast we have suggests the same thing: net interest margin stability going forward. So that is our forecast. Those forecasts actually take into account a falling rate environment. The rate environment forecasts project the Fed funds down to 4.38% by the end of the year, with about four rate cuts. Slow down in rate cuts could lead to a higher for longer environment, which will benefit the net interest margin further. I will say we've sharpened our pencils and gotten better at forecasting deposit movements. That's something we were catching up on in the last couple of quarters. We're trying to understand where our depositors are going. We've also, in light of the disparity between loan growth and deposit growth this quarter, dialed back the aggressiveness of the deposit rates a little bit. So we still have specialists out there, but they're not top-of-market specialists. That's probably going to bring deposit growth more in line with loan growth and hopefully achieve that stability target. But that's how we're thinking about it now, Dan.

Okay. That's very helpful. And just to be clear, the 1 basis point benefit from swaps in 2024 and then the 3 basis point negative impact, I mean, from the funds at the Fed window, that's all baked into your assumption there?

The cash we currently have at the Fed has a suppressive effect of about 3 basis points, which I've mentioned before. The reason I'm highlighting this is that our cash has decreased somewhat in the second quarter so far. Without going into too much detail, we are around $150 million right now. If we had maintained $250 million throughout the full quarter, the suppressive effect would have been around 6 or 7 basis points. In the first quarter, our average was only $112 million, even though we ended with $223 million in excess cash, which is why the suppressive effect was limited to 3 basis points. Maintaining $250 million for the second quarter would have resulted in a 6 or 7 basis points effect, but the amount has decreased, so we have to remain cautiously optimistic. Additionally, we generally do not find a thin-margin balance sheet leverage business attractive and typically avoid it. However, now that we have it, we want to continue with the program since it generates some income for us. We would prefer not to pay off these borrowings only to discover that we experience significant loan growth in the latter half of the year, which would require us to borrow again from the FHLB at 5.4%. I hope this provides some clarity regarding the excess cash situation.

It does. Yes, it does. I guess, and then just lastly, what are your thoughts on accretion, what the contribution was in the first quarter and then where that may go for the rest of the year?

I think it was 7 basis points in the quarter. It's going to be fading about 1 basis point every quarter. It was 7 basis points for the first quarter, fading about 5 basis points each quarter.

Jim, I wanted to pick up on the margin discussion a little bit. When you talk about the swaps on Slide 14, should the message that we should take away be that the overall margin can drift higher over the next couple of quarters? I mean to '25, we think in near-term stability and those kind of roll-offs. Is that a fair way for us to think about it?

It could. If rates stay high and the replacement yields tick up a little bit, and we can bring the deposit costs under control, we might see improvement. We're getting closer and closer to your question about those macro swaps. We thought we’d provide some helpful disclosure this quarter to clarify the effect of those roll-offs. There's a page in our supplement that we put on the PowerPoint presentations, which we call an earnings presentation supplement available on the Investor Relations portion of our website. It's Page 14 that includes a bar chart showing the up and down volume of the swap maturities and the cumulative impact on the net interest margin for those. The real benefit of it is closer to next year. But to directly answer your question, that will help produce the stability we are looking for as we have that support from those roll-offs.

Jim, your team modeled really in a baseline scenario with a cumulative impact accreting to the margin of about 8 basis points and a flat rate scenario of 11 basis points. That's right. So it's material. And that's through 2025, Karl.

Yes, okay. And then on loan growth, so we've got deposit outstripping loans this quarter. I know you guys are trying to be very measured in aligning the two, but should we think about this quarter's performance as giving you a little bit of runway for the next year? Or do you think this case of loan growth is a fair assumption?

I think it does give us runway. I believe we've proven with 7.5% loan growth last year, notwithstanding our acquisition of Centric in the new capital region, that we can generate deposits. And through this first quarter, even if it cost us a little, we're excited about that. We've also grown deposits, the deposit households as Jim mentioned. So we're going to taper and dial that in better with each quarter, but we are excited about growing the corporate bank, maybe a real estate deal or two this year to turn that back on a bit. More importantly, growing C&I, small business, and SBA, which will become the core of the company over the next 5-plus years. So we're optimistic about the future and our ability to grow.

Before our next question, if I could circle back, I said 7 basis points in accretion was actually 7.6%. So it rounds up to about 8%. That's purchase accounting accretion for the first quarter just ended, just for the record.

I guess, kind of picking up on loan growth. I'm picking up on the question there. Just wondering if you could talk a bit about your pipelines, where you're seeing opportunities, and the best opportunities where you're seeing the most demand from your clients?

Yes. Right now, on the consumer side, we have pinched the volume there really across the board, and we're just replacing what is running off at best. On the commercial side, our SBA business has a pretty good pipeline. The C&I pipelines are building somewhat depending on the region, and commercial real estate demand is still tempered, but we expect a deal or two there. Our guidance is probably more like mid-single digits.

Sure. A couple of things. We are bullish on SBA, and it's important to note that only 25% of that hits the balance sheet. The other 75% ultimately gets sold, and we earn the gain on sale income instead of the balance growth. We're seeing good SBA business. The SBA business we are booking now is likely to be the best we'll see because we can secure approval under today's interest rate environment. Most of that SBA is for business acquisition. We like the SBA business a lot. On the commercial business, it's a bit more muted, but we are seeing pipelines growing, and I think customers and prospects are starting to feel that perhaps the recession is not imminent, and they're beginning to spend again.

Got it. That's super helpful. And then maybe actually switching to fees, mortgage. You had a nice quarter for mortgage. You just mentioned selling more production there. You also mentioned SBA, and I've heard from some other banks that the premiums have come back a bit in that line item. Just wondering if gain on sale was strong for both lines, and if this is a good run rate for those items with any sort of puts or takes off of Q1 levels would be great.

Yes. Jane, any thoughts?

Well, we feel good about the volumes. You're right, the premiums have come down in both businesses, some. It just means we have to work harder for each dollar. But I think the run rates in both businesses are about where we're going to be. I don't want to overpromise, but I believe we've reached a steady state.

Good afternoon, everybody. Mike, just a point of clarification. Traditionally, when we talk about kind of mid-single-digit loan growth, it's usually all-inclusive, but we've definitely made a difference this quarter in discussing commercial versus consumer growth. When you point to mid-single-digit growth for the rest of the year, are you implying all-in loan growth? Or are you just talking about commercial growth, meaning we'll probably see overall loan growth similar to what we saw this quarter?

I'd like to see it all-in, which implies we would get perhaps a little tailwind from the consumer side. We've done a nice job of pricing our consumer products and maintaining some volumes, particularly in the indirect auto, which is an end market business. We might get some momentum there, but it remains to be more commercially driven overall. That is the aim for the year, and we would need to achieve a lot more in the second half.

Okay. So all-in loan growth is likely to be on the lower side of mid-single-digit growth, with commercial being kind of the unknown factor?

I suspect you're right, but we're going to hold ourselves accountable internally for 5%.

Mike, we could increase consumer loan volume, but we'd have to lower our pricing, which we'd have to be cautious about.

Yes. We'll take some of the excess cash and be careful in deploying liquidity but not aggressively. Right now, securities will probably yield in the high 5s. We'll make sure to not put all our excess cash into securities and ultimately have to borrow overnight to fund loan growth.

Okay. I appreciate that. And then, Jim, historically, you do provide some updates on what kind of the forward outlook is for total fee income and expenses. Expenses came in actually better than expected this quarter, and I'd appreciate an update there.

Yes. Our guidance really isn't changing. I think fee income and expenses will adhere to the guidance we've previously given. Fees are projected to be around $67 million to $68 million. Previously, we had $67 million to $69 million for the quarter, but I don't mean to modify the guidance because I believe the analyst consensus on those and our previous guidance needed a revision.

There's always a few concerns. I'm comfortable with the fact that in office, we only have 11 loans over $10 million and probably around $18 million between $5 and $10 million. We’ve worked down our exposure somewhat over the last year. We're pretty thin on central business district exposure; I think we have just $73 million there. I have Brian Karrip, our Chief Credit Officer with us. Brian, do you want to add some additional color?

Sure, and thanks for your question. We have two deals above $20 million, both of which are performing well, with low loan-to-value ratios, strong debt yields, and strong debt service coverage ratios. One of these loans is maturing in the third quarter at $22 million. We're extending that loan for six months. We provided you a maturity ladder, allowing for greater clarity and focusing on how we think about our portfolio, and emphasizing how we break it out and what we consider regarding our overall office business. The slide is fairly complete, and I would be happy to answer any questions.

What is the nature of the extension?

We're looking to sell property, and we have agreed to a six-month extension to allow for an orderly exit. We proactively engage with each of our borrowers; we conduct physical inspections of their office properties that will mature between 2024 and 2025. This allows us to better understand their physical occupancy versus economic tenancy.

Okay. That makes sense. And you feel that if there's any loss content, you're well-reserved for that?

Absolutely. It's performing well.

A lot of the questions have been answered, but I was just wondering some of the marginal rates of things. What was the marginal deposit rates for what came on? And I'm going to ask about different loan yields as well.

Yes. We have a number of different specials; the current short-term blended threshold is 5.05%. The money market special is 4.5%. If you blend the volume, the overall rate on new deposits coming in was about 4.48%.

So that was 4.48% last quarter, and it's coming down a little bit, right? You're able to price down a little bit.

We are. The CD special from last quarter would have been 5.1% — actually 5.25%, and that's now 5.05%. I don't want to mislead you; if I said the overall blended rate has gone down from last quarter, I was referencing the current quarter being at 4.8% so it should be down from last quarter, not up.

And then new loan yields; we had strong equipment finance growth. Remind me the yields there and and indirect out?

Yes, indirect products yield in the high 7s after the net of the dealer reserve. Equipment finance was just around 8% for the quarter. The commercial loans are a bit higher, around 8, at 7.98%. And indirect already rolled off at 7.6% for the quarter.

Okay, nice. I was going to ask a question about better operating expenses; I think you called out a little bit of hospitalization expense, which didn't kind of improve linked quarter? Is that just going to bounce back a little bit?

Yes, that's fair to say. We don’t get too hopeful in hospitalization expenses; it tends to fluctuate greatly. We're self-insured, and we spoke previously about having reinsurance for certain layers of cost once we hit a certain threshold. If we experience good performance in a particular quarter, the hospitalization expense may be low, but it does bounce around.

Okay, so staying as previously expected.

Just in terms of — you've talked about tapering the CD rates here. It seems like your commentary was also that you're not at the high end of the market, but you're still competitive. I'm curious what you're seeing so far. Is the idea that given the loan growth expectations you've laid out, you can be competitive enough on the deposit side to grow the deposits in line with that and hold the loan-to-deposit ratio kind of flattish through the year? What's your thinking there?

Yes, I think that's right. We keep close tabs on it daily. It influences our thoughts on consumer lending fundamentally. But it's clear that the replacement yields in certain portfolios like indirect auto don't match previous levels. Our team has done an excellent job pricing our consumer products. Jane, do you want to add any commentary regarding liquidity?

No, Mike. I think Frank, it sounds simple, but that's exactly what we're striving to achieve.

And just curious, like the pressure now in the existing portfolio, is it mostly monetary at this point? Has the existing stuff sort of stabilized to a degree?

Jane, you can start, but let me also weigh in.

We still see new money coming in. On any given special, we see about 50% new money, and 50% of the existing book potentially repricing. We've been very lenient about this as we want to keep the deposits. We're seeing the rate of repricing slowing down. Six months ago, conditions were challenging. Today feels more normalized, and the pricing is noticeably decelerating.

Yes, yes. And then just lastly, regarding reserve to loan levels. Some of the smaller banks seem to be building reserves a bit here, considering where some of the larger banks are in their reserve coverage of the total book. For you guys, I'm curious how you think about that? Given that commercial is going to be the driver here, what does that imply for reserve to loan ratios? Should we expect a continued modest increase in that quarter-over-quarter as you grow the commercial book?

Yes. We obviously build reserves when we experience growth, which has been a key component. Brian, what would you add on that?

We have about $3.3 million in specific reserves from the acquisition, and about $2.9 million in PCD reserves. We've grown from $131 million to $132 million in our reserve ratio. We've adequate reserves to support our business and potentially facilitate some growth.

Just to add, our approach is distinctly bottom-up. We consider economic conditions and apply quantitative reserves accordingly based on GDP or employment factors. Qualitatively, we analyze changes in underwriting standards or staffing. We've made a few changes this quarter, as well as considering loan growth.

Yes. No, I guess I'm just thinking through how reserves in the commercial book stack up against the consumer book as a percentage of total loans.

I don't have the exact figures handy, but we'd be happy to provide that later.

We've maintained reserves higher than our peers generally, and that's typically been a robust mix between consumer and commercial, approaching probably 50-50. We anticipate seeing more transition to around 60% plus commercial potentially as we grow that segment.

There are no further questions at this time. Mr. Mike Price, I'll turn the call back over to you.

Thank you, operator. As always, we appreciate your engagement and interest in First Commonwealth. As we think about our 2024 strategic themes, we've shared these with you before, and they really don't change much from year to year. We focus on living our mission every day, which is to improve the financial lives of our neighbors and their businesses. We achieve this through growing our business, improving our loan pricing, enhancing partner introductions in the regional teams, and growing our C&I lending each year moving forward, particularly with the team we've built. We're also committed to continuous improvement. So live the mission, grow, get better not just vaguely, but in every region, in every line of business, in every business support unit, and we're aiming to digitalize every aspect of our business. So that’s our focus. Those of you who know us recognize that we approach these matters consistently, and we intend to achieve steady improvement each year, even as we surpass the $10 billion mark. We acknowledge a minor setback from Durbin this year, but we continue to persevere. This business is enjoyable; we make a meaningful difference in our consumers' lives, our small business clients, and the communities we serve. Thank you.

This concludes today's conference call. You may now disconnect.