First Financial Bancorp /Oh/ Q3 FY2022 Earnings Call

Hello everyone and welcome to today’s First Financial Bancorp Third Quarter 2022 Earnings Conference Call and Webcast. My name is Victoria, and I'll be your operator for today. I will now pass over to your host, Scott Crawley, Corporate Controller, to begin. Please go ahead.

Thanks, Victoria and good morning everyone, and thank you for joining us on today's conference call to discuss First Financial Bancorp’s third quarter and year-to-date 2022 financial results. Participating on today's call will be Archie Brown, President and Chief Executive Officer; Jamie Anderson, Chief Financial Officer; and Bill Harrod, Chief Credit Officer. Both the press release we issued yesterday and the accompanying slide presentation are available on our website at www.bankatfirst.com under the Investor Relations section. We'll make reference to the slides contained in the accompanying presentation during today's call. Additionally, please refer to the forward-looking statement disclosure contained in the third quarter 2022 earnings release as well as our SEC filings for a full discussion of the Company's risk factors. The information we will provide today is accurate as of September 30, 2022, and we will not be updating any forward-looking statements to reflect facts or circumstances after this call. I will now turn it over to Archie Brown.

Thanks Scott. Good morning, everyone and thank you for joining us for today's call. Yesterday afternoon, we announced our financial results for the third quarter. I'm very pleased with our performance, which was highlighted by strong loan growth, stable asset quality, and exceptional earnings. Adjusted earnings per share increased approximately 9% from the second quarter due to record revenue which was driven by an 18% increase in net interest income. For the quarter we achieved adjusted earnings per share of $0.61, a 1.4% return on average assets, and a 23.12% return on average tangible common equity. Recent rate increases continued to positively impact our asset sensitive balance sheet. Our net interest margin expanded in the third quarter by 53 basis points, as yields on assets increased much more rapidly than deposit costs. Credit trends remained stable across the portfolio with slight reductions in non-performing loan and net charge-off ratios. Even with these improvements our loan loss reserve grew modestly to account for loan growth and the intermediate economic outlook. We're very pleased with loan growth in the third quarter. Loan balances increased by $377 million or 15.9% on an annualized basis. Growth in the quarter was again broad-based and was driven by increases in CNI, consumer, and residential mortgage. Given our expectations for the economy in the near term and moderating loan pipelines we expect loan growth to squeeze in the coming months. Non-interest income was once again negatively impacted by rising rates and changes made to our overdraft program in the second quarter of this year. We also experienced a net expected decline in foreign exchange income from a record second quarter and mortgage activity weakened further. Fee income continues to reflect the strength of our diversified businesses and we expect a modest increase in the coming quarter as our leasing business grows. With that I'll now turn the call over to Jamie to discuss the third quarter results in more detail. After Jamie’s discussion I'll wrap up with some additional forward-looking commentary. Jamie.

Thank you Archie. Good morning. Slides 4, 5, and 6 provide a summary of our third quarter financial results. The third quarter was highlighted by an expanding net interest margin, strong loan growth, and stable asset quality. Our balance sheet reacted positively to additional Fed rate hikes with our net interest margin increasing 53 basis points. We anticipate this trend will continue as the Fed is expected to increase rates over the remainder of the year. However, the margin expansion will not be of the same magnitude due to expected deposit pricing pressures. We were very pleased with another quarter of strong loan growth. Total loans grew 16% on an annualized basis with the growth widespread across the portfolio. Fee income declined from elevated levels in the second quarter and particular Bannockburn income met our expectations, but was lower than record levels of the second quarter. As expected Mortgage Banking income declined compared to the second quarter as well as the mortgage business has been negatively impacted by higher interest rates. Additionally, service charge income declined from the linked quarters as we continue to feel the impact from changes to our overdraft programs. Finally, other non-interest income declined due to higher than expected revenues from limited partnership investments during the second quarter. Non-interest expenses were slightly higher than our expectations, due primarily to incentive compensation tied to the company's performance. We were pleased on the credit front as net charge off declined to 7 basis points and non-performing assets declined to 29 basis points of total assets. While asset quality remained strong, we recorded $8.3 million of provision expense during the period which was driven by loan growth during the period and slower prepayment rates. From a capital standpoint our regulatory ratios remained in excess of both internal and regulatory targets. Similar to the second quarter accumulated other comprehensive income declined, negatively impacting both tangible book value and our tangible common equity ratio. Slide 7 reconciles our GAAP earnings to adjusted earnings, highlighting items that we believe are important to understanding our quarterly performance. Adjusted net income was $57.8 million or $0.61 per share for the quarter. These adjusted earnings account for $900,000 of losses on investment securities and $1.7 million of acquisition and other costs not expected to recur. As depicted on Slide 8, these adjusted earnings equate to a return on average assets of 1.4%, a return on average tangible common equity of 23.1%, and an efficiency ratio of 58.5%. Turning to Slides 9 and 10, net interest margin increased 53 basis points from the linked quarter to 3.98%. Once again, this increase was primarily driven by an increase in asset yields during the period resulting from rising interest rates. The increase in asset yields was partially offset by a slight increase in funding costs. As a result of rising rates, asset yields surged during the period with loan yields increasing 89 basis points. In addition, investment yields increased due to higher reinvestment rates and slower prepayments on mortgage-backed securities. Our cost of deposits increased 11 basis points compared to the second quarter and we expect these costs to increase further in reaction to competitive pressures from an increasing rate environment. Slide 11 details the asset sensitivity of our balance sheet. We remain well positioned for the expected rate increases as approximately two-thirds of our loan portfolio re-prices fairly quickly. Slide 12 details the betas utilized in our net interest income modeling. And while we haven't realized aggressive increases in costs to this point, as additional rate increases occur we expect our deposit beta to be approximately 30% over the full cycle. Slide 13 outlines our various sources of liquidity and borrowing capacity. We believe our liquidity and borrowing capacity sufficiently provides the flexibility required to manage the balance sheet through the expected economic environment. Slide 14 illustrates our current loan mix and balance changes compared to the linked quarter. As I mentioned before, loan balances increased 16% on an annualized basis with every portfolio growing compared to the linked quarter. The largest areas of growth were in the CNI, retail mortgage, and consumer portfolios. However, we were also pleased with the trajectory of the ICRE and Summit books. Slide 15 shows our deposit mix as well as the progression of average deposits from the linked quarter. In total, average deposit balances declined $167 million during the quarter driven primarily by a $77 million decline in public funds, a $58 million decline in retail CDs, a $49 million decline in money market accounts, and a $47 million decline in non-interest bearing accounts. Slide 16 highlights our non-interest income for the quarter. Overall fee income declined from the second quarter driven by declines in foreign exchange, service charges, mortgage, and other non-interest income. Bannockburn met our expectations for the quarter, however, their total income was lower in the third quarter, following record output in the second quarter. Also consistent with our expectations, deposit service charge income declined in the third quarter as we realized the impacts of overdraft program changes. Consistent with the second quarter, mortgage demand was light due to higher rates and record production in prior years and we continue to expect further pressure on this business for the remainder of the year. Finally, other non-interest income normalized during the period which was higher in the second quarter due to elevated income from limited partnership investments. Non-interest expense for the quarter is outlined on Slide 17. Like the second quarter, the third quarter was relatively quiet in the net interest expense front. On an operating basis and excluding summit, expenses increased $2.6 million compared to the linked quarter due primarily to an additional incentive compensation tied to the company's performance. Turning now to Slide 18, our ACL model resulted in a total allowance which includes both funded and unfunded reserves of $141 million and $8.3 million in total provision expense during the period. This resulted in an ACL that was 1.27% of total loans at September 30th. As I mentioned previously, the provision expense was driven by strong loan growth and slower prepayment speeds, which increased the duration of the portfolio. Despite the increase in provision expense, credit quality remained stable. Net charge offs as a percentage of loan decreased slightly to 7 basis points on an annualized basis while non-performing assets declined at 29 basis points of total assets. In addition, classified assets declined $4.6 million during the quarter. Our view on the ACL and provision expense remains unchanged. We expect our ACL coverage to remain stable or increase slightly in the fourth quarter as our model responds to changes in the macroeconomic environment. Finally, as shown on Slides 20 and 21 regulatory capital ratios remain in excess of regulatory minimums and internal targets. During the third quarter tangible book value and the TCE ratio continued to decline due to a drop in accumulated other comprehensive income. Absent the impacts from AOCI, the TCE ratio would have been 8.1% at September 30th compared to 5.8% as reported. Our total shareholder return remains robust with approximately 40% of our earnings returned to our shareholders during the period through the common dividend. We believe our dividend provides an attractive return to our shareholders and do not anticipate any near-term changes. However, we will continue to evaluate various capital actions as the year progresses.

Thank you Jamie. Before we end our prepared remarks, I want to comment on our forward-looking guidance which can be found on Slide 22. Loan demand remains solid, pipelines are beginning to ease, and we expect growth to moderate to high single-digits over the fourth quarter. We expect total deposit balance to remain flat or decline slightly over the near-term. Our asset sensitive balance sheet continues to benefit from rising rates and although there are many variables that impact magnitude and timing, we expect the margin to continue to expand to a range of 4.3% to 4.45% in the fourth quarter based upon anticipated interest rate increases. The competition for deposits is increasing and we expect the margin expansion to moderate as we get further into 2023. Regarding credit, much uncertainty remains regarding inflation and the impact of rate hikes on the economy and our customers. Over the fourth quarter we expect continued stability in our credit quality trends and ACL coverage remains stable to slightly higher. We expect fee income to be between $44 million and $46 million in the fourth quarter with continued strength in our diversified fee producing businesses. Specific to expenses, we expect to be between $105 million to $107 million but understand expenses could fluctuate with fee income performance. As our operating lease portfolio grows, we will see corresponding depreciation expense growth of approximately $1 million per quarter, which is included in our range. Regarding Summit, our outlook is unchanged and we expect the acquisition to have minimal impact on overall 2022 earnings and provide approximately $400 million in annual originations. Lastly, our capital ratios remain strong, and we expect to maintain our dividend at current levels. Overall, we had a really nice quarter and we are optimistic that we can sustain this momentum over the remainder of 2022 and into the New Year. With a strong balance sheet well positioned to continue to benefit from rising rates with a loan deposit ratio under 80%, strong liquidity, and positive credit trends, we believe we are well situated to manage potential economic downturn. We will now open up the call for questions. Victoria.

Our first question comes from Scott Siefers at Piper Sandler. Please go ahead. Your line is open.

Thank you. Good morning guys and how's everybody doing?

Good.

Hey, Jamie, I think the first question is for you. You've been adjusting to the tightening trend, and it seems you have been more asset sensitive than initially projected. It appears we will see another significant increase in the fourth quarter. Archie, you mentioned a moderation in branches moving into 2023 as deposit costs continue to rise. Once the Fed stops increasing rates, could you share your thoughts on how much further you could expand the margin and whether you can maintain positive net interest income momentum after the Fed halts rate hikes?

Yes, this is Jamie. We anticipate another significant increase in margin during the fourth quarter, influenced by the ongoing interest rate hikes. We expect to see this lift in the fourth quarter and even into the first quarter, based on our expectations for rate increases at the start of next year. Initially, I would have estimated our margin would peak around 420, but considering recent developments, I now believe the peak will be slightly higher, likely in the range of 440 to 450 as we move into next year. Once the Fed pauses its rate hikes, we expect the deposit side to improve significantly, as it hasn’t had the opportunity to catch up yet. As this happens, we anticipate that margins will gradually decrease and stabilize in the middle to latter part of next year.

Thank you for your insights. As we approach the end of the tightening cycle, have you considered how to moderate asset sensitivity to mitigate any impacts? Many companies are using swaps for this purpose. What do you think would be the best approach?

We are currently evaluating several options, but so far we haven't made any significant changes. The only adjustment we've made is a slight rebalancing in the Investment Portfolio to extend some duration. This is a minor change, but we are actively considering various strategies to protect the net interest margin on the downside and reduce asset sensitivity. We are exploring options such as adding floors, but we haven't implemented anything yet. We expect to take action within the next quarter.

Perfect, alright, good. Thank you guys very much for taking the questions.

Thanks Scott.

Thank you very much Scott for your question. Our next question comes from Daniel Tamayo at Raymond James. Please go ahead. Your line is open.

Thank you. Good morning, guys. Maybe we just start on the fee guidance, the decline there, if we could just talk through some of the puts and takes in terms of what drove that and maybe if we could just talk a little bit about what your expectations are for Bannockburn in particular going forward that would be great, thanks?

Thanks, Daniel. This is Jamie. I'll begin by addressing the line items. First, we recently made some changes to our overdraft program, which we closed a few months ago. The resulting impact was in line with our expectations, driving service charge revenue down in the third quarter. Regarding mortgages, our rates have increased by about 400 basis points compared to last year, leading to a significant drop in activity. On the wealth management side, many fees are linked to the market values of assets under management, and the decline in the market has affected those fees. However, we are still seeing strong income from foreign exchange, which was slightly lower this quarter after a record prior quarter. We anticipate that foreign exchange income will stabilize around $12 million per quarter, translating to about $48 million annually at Bannockburn. Looking ahead, we expect this to grow by 5% to 10% annually in the near term.

Okay, great, that's helpful Jamie, thanks. And then I guess a similar question, but on the expense side, in particular it looks like the guidance for the fourth quarter is similar to what you put up in the third quarter. And then you called that specifically the million increase in leasing expenses. Just curious how we should be thinking about kind of growth rates from there if that's just a unique situation in the fourth quarter where expenses should be roughly stable and also if that million is included in the guidance that you've given? Thanks.

Yes, the million is part of that guidance, and as we include operating leases on the books, that line item will continue to increase. However, the main pressure we are experiencing is on employee costs. Apart from that, I would attribute it to inflationary pressures on employee expenses. Other costs remain relatively stable. Essentially, you see the increase on the Summit side each quarter gradually increasing, alongside some upward pressure from wage and healthcare costs impacting the employee cost line. Outside of that, expenses are generally flat.

Hey Dan, this is Archie. Jamie, you are relying on the corresponding size as that leasing business expense goes, you are also seeing corresponding benefit in the P side.

Yes, correct, the operating leases, yeah.

Alright, thanks for all the color, guys, that's all for me.

Thank you for your question Daniel. Our next question comes from Terry McEvoy at Stephens, Inc. Please go ahead, your line is open.

Good morning, this is Brandon Rud on for Terry. My first question is about deposits, non-spring deposits pre-COVID and the 2019 were about 26% of total deposits. In this last quarter, they were about 32.5%. You think they can return back to that pre-COVID level in the next year, year and a half or so?

Hey, this is Archie. Certainly there's some money that's surged into demand deposit accounts during COVID and you would expect over time that will work its way back out as businesses and individuals spend some of that or start to put some of that money to work. So I don't know if we will be able to hold it at the low 30s but I think we believe just given our strategy and focus on growing our business sector particularly we think that number will probably be higher than where it was pre-COVID.

Okay, perfect, thank you. Next one here is, you mean sectors or regions across your footprint they are expecting to drive your loan growth going forward?

This is Archie again. I think our operations are well-positioned within a four to four and a half hour radius across our entire footprint. The growth is coming from various locations. Additionally, we have some national businesses with Oak Street and Summit, along with our more regional and commercial real estate ventures. All these areas will contribute to driving growth as well.

Thank you. Can you discuss how your restaurant franchise borrowers are managing in the current environment and also your exposure to office, hotel, and retail commercial real estate, particularly regarding how you are addressing those portfolios with the higher interest rates?

Yeah, this is Jim. I will start and then I will turn it to Bill to kind of get into details. On the restaurant book and hotel book just we have those books are much smaller than they used to be. So I think the restaurant portfolio is now under 300 million. So it's about half of what it was four years ago. And the hotel book is down about 40% from where it was to two to two and half years ago. So, I think it's a little bit over $300 million. So they are much smaller, but we have Bill Harrod, our Chief Credit Officer talk about what he is seeing in those portfolios as well as I think you said the retail portfolio?

Certainly. The office and retail sectors, as well as the hotel sector, are performing very well. Hotels have bounced back significantly and in some cases have surpassed pre-pandemic performance, which makes us quite pleased with that segment. We've seen progress. In the franchise sector, there are some cost pressures related to labor and inputs, but we're also observing price increases across many platforms that will help offset those costs. Volumes remain strong compared to 2019, so we maintain a positive outlook there. Regarding the office sector, we are actively monitoring our portfolio with careful stress testing, not just for the interest rate environment. A significant portion of our real estate assets have interest rate hedges in place, which gives us confidence. We incorporate various models to assess risks, considering not only interest rate fluctuations but also potential changes in the market over short, medium, and long-term periods. This helps us address any risks proactively before they become significant issues with interest rates.

Yeah, that's very helpful. I appreciate you taking my questions. Thank you.

Thank you.

Thank you very much. Our next question comes from Chris McGratty at KBW. Please go ahead. Your line is open.

Oh great, thanks. Hey guys. Jamie a question on just spot rates. Do you have the spot deposit, interest bearing deposit in the spot loan yield?

So, like for September, is that what you're asking?

Yeah, like in the pretty end of the quarter exactly?

Yeah, so our cost of deposits in September was 27 basis points. And hang on here, I will go back into it, and our loan yields for September, let's see here, was around 540.

Okay, thank you. And the 30% beta you decided, was that total or is that interest bearing, just to make sure I am clear?

We are experiencing significant growth so far in the cycle, but we are beginning to encounter some pressure, particularly in the fourth quarter, due to competitive challenges. Additionally, the beta is expected to increase. On the other hand, as I mentioned, the data will substantially move up following the rate hikes.

Great. Regarding the loan yield outlook, as they continue to reprice higher, borrowers will be paying over 6, possibly in the mid 6s for loans. At what point does the pressure on borrowers become more severe in relation to credit?

It is challenging to assess this on a global scale. However, when we evaluate credits and underwriting, we have built-in shocks that vary in duration and size based on individual deals. We conduct thorough testing to ensure that these parameters hold up. Additionally, a significant portion of our portfolio is hedged on the loan side, both in commercial and ICRE sectors. That hedging has diminished somewhat due to the current rising interest rate environment, as people are not looking as far ahead. Nevertheless, the portfolio remains protected, particularly through our assessments of downside scenarios, including severe cases, which demonstrate that risks are contained. Naturally, like any expense, pressures are increasing, and we will find ways to manage them.

Hey Chris, this is Archie. I think this is part of the case for where we are seeing a little bit of softening in the pipeline and slowing down of the growth as we know especially in our ICRE group. Certain projects are being postponed or put on hold and just waiting for the environment to get a little bit better. So that is driving some of our outlook around loan growth.

Thank you.

Thank you very much for that question Chris. At this time there are no further questions and I would like to pass back over to Archie Brown for any final remarks.

Thank you, Victoria. Thank you all for joining us on today's call and hearing more about our story in the third quarter. We're excited about the fourth quarter and 2023 and we look forward to talking to you again next quarter. Have a great day.

Thank you everyone for joining today's conference call. You may now disconnect.