Earnings Call Transcript - FFBC Q3 2023

Operator, Operator

Good morning and welcome to the First Financial Bancorp Third Quarter 2023 Earnings Conference Call and Webcast. My name is Brianna and I will be your conference operator today. Please note that this call is being recorded. I will now turn the call over to Scott Crawley, Corporate Controller. Please go ahead.

Scott Crawley, Corporate Controller

Thank you, Brianna. 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 2023 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 2023 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, 2023, and we will not be updating any forward-looking statements to reflect facts or circumstances after this call. I'll now turn the call over to Archie Brown.

Archie Brown, President and CEO

Thank you, Scott. Good morning, everyone, and thank you for joining us on today's call. Yesterday afternoon, we announced our financial results for the third quarter. I'll first provide some high-level thoughts on our recent performance and then turn the call over to Jamie to discuss further details. Overall, I'm pleased with our third quarter performance. Strong net interest income and robust fee income led to a 13% increase in net income from the third quarter of 2022. In our most recent quarter, we achieved adjusted earnings per share of $0.67, a 1.49% return on average assets, and a 23.8% return on average tangible common equity. As expected, higher deposit costs led to a slight reduction in earnings on a linked-quarter basis. Even so, our net interest margin was 4.33% for the quarter which was at the high end of our expectations. Loan growth was in line with expectations for the period, led by growth in the leasing and mortgage portfolios. We expect moderate loan growth over the remainder of the year. I am pleased by the continued stability of our deposit balances during the quarter. While the change in mix from noninterest-bearing to CDs and money market accounts continued, we experienced slight growth in total balances, and our loan-to-deposit ratio remained flat at 82%. Our fee income continued to exceed expectations for the quarter, with strong performance from wealth management, equipment leasing, Bannockburn, and mortgage banking. Credit trends were mixed during the period, and we experienced elevated net charge-offs. During the third quarter, we elected to sell approximately $32 million in commercial real estate loans and incurred a $6.1 million loss on the sale. We also recorded a $6.9 million loss on a large C&I loan that was negatively impacted during COVID and has been unable to rebound in the period since. Additionally, nonaccrual loan balances increased during the period due to the downgrade of one office loan whose major tenant vacated the space during the quarter. Last, assets remain low, and we expect provision expense to remain fairly stable in the fourth quarter. We continue to be pleased with our high net interest margin, favorable fee income trends, and robust earnings. During the quarter, our regulatory capital levels strengthened, and our strong earnings helped to maintain the tangible common equity ratio despite the negative impact to AOCI from the increase in market rates. With that, I'll now turn the call over to Jamie to discuss these results in greater detail. And after Jamie's discussion, I will wrap up with some additional forward-looking commentary and closing remarks.

Jamie Anderson, CFO

Thank you, Archie. Good morning, everyone. Slides 4, 5, and 6 provide a summary of our third quarter financial results. The third quarter was another good quarter, highlighted by solid earnings, strong net interest margin, and high fee income. Our balance sheet once again reacted positively to the interest rate environment. Our net interest margin declined as expected during the period but remained very strong at 4.33%. We anticipate net interest margin contraction in the coming periods due to continued deposit pricing pressure and changes in funding mix. Total loans grew 3.6% on an annualized basis, which was in line with our expectations. Loan growth was concentrated in the leasing and residential mortgage books with relatively stable balances in the other portfolios. Fee income remained strong in the third quarter with solid performances in wealth management, leasing, Bannockburn, and mortgage. Noninterest expenses increased slightly from the linked quarter due to higher employee costs, leasing business expenses, and fraud losses. As Archie mentioned, net charge-offs were elevated during the quarter and nonaccrual loans increased. Classified assets remain low as a percentage of assets and were relatively stable compared to the linked quarter. We recorded $11.7 million of provision expense during the period, which was driven by net charge-offs. Our ACL coverage remains conservative at 1.36% of total loans. From a capital standpoint, our regulatory ratios remain in excess of both internal and regulatory targets. Accumulated other comprehensive income declined $57 million during the period. As a result, tangible book value decreased $0.11 or 1%, while our tangible common equity ratio declined by 6 basis points. 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 $63.5 million or $0.67 per share for the quarter. Adjusted earnings include the impact of costs associated with our online banking conversion as well as other costs not expected to recur, such as acquisition, severance, and branch consolidation costs. As depicted on Slide 8, these adjusted earnings equate to a return on average assets of 1.49%, a return on average tangible common equity of 23.8%, and an efficiency ratio of 57.3%. Turning to Slide 9; net interest margin declined 15 basis points from the linked quarter to 4.33%. As we expected, higher funding costs outpaced increases in asset yields, primarily due to a 37-basis point increase in the cost of deposits. Asset yields increased 17 basis points due to higher rates and a more profitable mix of earning asset balances during the period. On Slide 10, you can see the increase in asset yields was primarily driven by a 15-basis point increase in loan yields. Additionally, the yield on the investment portfolio increased 6 basis points due to the repricing of floating rate investments and slower prepayments on mortgage-backed securities. As I previously mentioned, our cost of deposits increased 37 basis points compared to the linked quarter and we expect these costs to continue to increase in the fourth quarter but at a slower pace than we saw in the third quarter. Slide 11 details the betas utilized in our net interest income modeling. Deposit costs increased in the quarter, moving our current beta up 6 percentage points to 33%. Our modeling indicates that our through-the-cycle beta is approximately 40%. Slide 12 outlines our various sources of liquidity and borrowing capacity. We continue to believe we have the flexibility required to manage the balance sheet through the expected economic environment. Slide 13 illustrates our current loan mix and balance changes compared to the linked quarter. As I mentioned before, loan balances increased 3.6% on an annualized basis, with growth driven by Summit and mortgage loans. The other loan portfolios were relatively flat compared to the prior quarter. Slide 14 provides detail on our loan concentration by industry. We believe our loan portfolio remains sufficiently diversified to provide protection from deterioration in a particular industry. Slide 15 provides detail on our office portfolio. As you can see, about 4% of our total loan book is concentrated in office space, and the overall LTV of the portfolio is strong. We downgraded a single office relationship to nonaccrual during the quarter, which increased our nonaccrual balance to $27 million for this portfolio. Slide 16 shows our deposit mix as well as the progression of average deposits from the linked quarter. In total, average deposit balances increased $73 million during the quarter, driven primarily by a $253 million increase in money market accounts and a $119 million increase in retail CDs. These increases offset a decline in noninterest-bearing deposits and savings accounts. This was expected as the current interest rate environment has driven customers to higher-cost deposit products. Slide 17 illustrates trends in our average personal business and public fund deposits as well as a comparison of our borrowing capacity to our uninsured deposits. While personal deposits and public fund balances were relatively stable in the quarter, business deposits increased 3.4%, rebounding some from second-quarter levels. On the bottom right of the slide, you can see our adjusted uninsured deposits were $2.2 billion at September 30. This equates to 23% of our total deposits. We are comfortable with this concentration and believe our borrowing capacity provides sufficient flexibility to respond to any event that would stress our larger deposit balances. Finally, with respect to deposits, Slide 18 depicts average deposits by month. As you can see, deposit levels increased in July and August with increases in the personal and business deposit categories. Deposit balances were stable in the last month of the quarter. Slide 19 highlights our noninterest income for the quarter. Wealth Management had another record quarter, while mortgage also performed well. Summit and Bannockburn both had very strong quarters, and we expect this to continue through the end of the year. Noninterest expense for the quarter is outlined on Slide 20. Core expenses were a bit higher than we initially expected. The increase was driven by elevated employee costs and leasing expenses which are tied to fee income, as well as higher-than-expected fraud losses. Turning now to Slides 21 and 22. Our ACL model resulted in a total allowance which includes both funded and unfunded reserves of $162 million and $11.7 million of total provision expense during the period. This resulted in an ACL that was 1.36% of total loans, which was a 5-basis point decrease from the second quarter. Provision expense was driven by $16.4 million of net charge-offs which increased to 61 basis points of total loans in the quarter. As Archie mentioned, during the quarter, we elected to sell approximately $32 million in commercial real estate loans in an attempt to derisk the portfolio and charged off $6.1 million in the process. We also recorded a $6.9 million loss on a large C&I loan that was negatively impacted by the COVID pandemic. In other credit trends, nonaccrual loans increased during the period due to the downgrade of the office relationship I previously mentioned, while classified asset balances were relatively flat quarter-over-quarter. Our ACL coverage is 1.36% of total loans. We have modeled conservatively in prior quarters to build a reserve that reflected the losses we expect from our portfolio. We expect our ACL coverage to remain relatively flat in the coming periods as our model responds to changes in the macroeconomic environment. Finally, as shown on Slides 23, 24, and 25, regulatory capital ratios remain in excess of regulatory minimums and internal targets. During the third quarter, tangible book value decreased $0.11 or 1%, and the TCE ratio decreased 6 basis points due to a $57 million decline in accumulated other comprehensive income. Absent the impact from AOCI, the TCE ratio would have been 9.07% at September 30 compared to 6.50% as reported. Slide 24 demonstrates that our capital ratios will remain in excess of regulatory targets, including the unrealized losses in the securities portfolio. Our total shareholder return remains robust, with 35% 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.

Archie Brown, President and CEO

Thank you, Jamie. Before we end our prepared remarks, I want to comment on our forward-looking guidance which can be found on Slide 26. As indicated earlier, we expect loan growth to be moderate through the remainder of the year. We continue to be more selective in certain segments but we expect overall growth to be in the mid-single digits in the near term. For securities, we expect a modest decline in balances as we utilize the portfolio cash flows to support loan growth, and we expect total deposit balances to grow modestly over the near term. Regarding the net interest margin, we still see some uncertainty around the Fed rate path, loan demand, and deposit pricing competition. We expect modest margin contraction in the fourth quarter with our net interest margin in a range between 4.15% to 4.25% with no further Fed tightening expected. Specific to credit, we're still in a period of uncertainty regarding inflation and the impact of higher rates on the economy and our customers. Over the fourth quarter, we expect our credit cost to be similar to the third quarter, and ACL coverage as a percentage of loans to remain stable. We expect fee income to be in the range between $55 million and $57 million, including the leasing business. Specific to expenses, we expect to be between $121 million and $123 million, which includes the depreciation expense from the lease portfolio. Excluding the leasing expense, we expect expenses to be stable in the fourth quarter. Lastly, our capital ratios remain strong, and we expect to maintain our dividend at the current level. We're pleased with our results thus far in 2023 and continue to be encouraged by the higher net interest margin, favorable fee income trends, and overall earnings performance. As we close out the year, we believe we're well positioned to navigate the current economic environment and continue to deliver strong results. We'll now open up the call for questions.

Operator, Operator

Our first question comes from Daniel Tamayo with Raymond James.

Daniel Tamayo, Analyst

Maybe we start on the credit outlook. I'm just curious, given the elevated net charge-offs in the third quarter and then the guidance in the fourth quarter for a similar level, if that's should be considered a more normal number now? Or if not, how we should be thinking about what net charge-offs might look like next year?

Archie Brown, President and CEO

Danny, this is Archie. Maybe I'll start and either Jamie or Bill can pick up on my thoughts. We think in the near term, I think we're seeing things from a credit cost, or we expect to be somewhat stable. You've seen our nonaccrual trends move up slightly. We think there's some resolution to some nonaccruals in Q4. There may be some charge-offs related to that. So that's kind of where we have things stable. As we look further out, things look like they moderate back down or if you will call them back down. So I think right now, what we're saying for provision kind of where we've been in a range, it feels like it's pretty stable there.

Daniel Tamayo, Analyst

Okay, that's helpful. And then I guess, specific to that office loan that was downgraded in the third quarter. I was wondering if you could tell us if that was suburban or urban and if possible, what city that was located in?

Bill Harrod, Chief Credit Officer

Yes. That was suburban located north of Cincinnati in the Blue Ash area, which is a very commercial district.

Daniel Tamayo, Analyst

Okay. And I mean, any read-throughs from that you mentioned it was a large tenant that pulled out. I mean is that something you feel like provides any kind of clarity into any other offices in that same type of bucket? Or does that feel like a one-off to you?

Bill Harrod, Chief Credit Officer

Yes, it feels like a one-off. I mean that area is very robust. There's already interest in leases on that that we're trying to work through. But yes, I mean, the area is very good. We feel confident where we're at. We don't think it's systemic over the rest of our office book.

Daniel Tamayo, Analyst

Got it. Okay. Lastly, changing the subject to the expense base. I'm curious about how you view your ability to reduce some expenses if the revenue environment is pressured next year.

Archie Brown, President and CEO

Yes, Danny, this is Archie again. If there's pressure on revenue, some of it may come from fees, which are closely linked to our expenses and tend to be more variable based on fee performance. If we experience that pressure, it will likely lead to a decline in revenue. We are continuously looking for opportunities to cut costs or to avoid replacing staff when they leave through attrition. In 2024, we will likely increase our efforts in this area as we assess how revenue develops.

Operator, Operator

Our next question comes from Terry McEvoy with Stephens.

Terry McEvoy, Analyst

I apologize for a little bit late on the call. So just a couple of questions. Maybe, Jamie, the forward curve has some rate cuts. Is there anything to suggest that the deposit and loan betas that you experienced in, was it '19 to '21 are not a good proxy for us to use today as we kind of incorporate the prospects of lower rates?

Jamie Anderson, CFO

You are referring specifically to the deposit beta. On Slide 11, we present our historical betas from the 2019 to 2021 period, which reflect an average through-the-cycle beta of 33%. At this moment, I don't believe there is any indication that we should expect a different outcome in a declining rate cycle. Clearly, we will need to respond to market competition. However, we anticipate that the situation will remain similar in a declining rate scenario, likely in the low 30s range.

Terry McEvoy, Analyst

Okay. And again, this may have been discussed but did you have a reserve already in place for the CRE loan sale which is a $6 million charge-off and the C&I loan, that $7 million charge-off. And I guess I was a bit surprised to see the ACL decline quarter-over-quarter but I'm guessing there was some allocated result.

Jamie Anderson, CFO

Yes, there were some. Over the past few quarters, we had built up the reserve, and by the end of the second quarter, it was 141 basis points of loans, which was about 20 to 30 basis points higher than our peer group. We approached this conservatively and were possibly ahead of the group in terms of building that reserve. The loan sale essentially accelerated some of the charge-offs that we might have seen in the next two to four quarters, bringing them into the current period. Along with that, we had a charge-off on one C&I loan, which can fluctuate from quarter to quarter. However, with our reserve at 1.36% of loans, we believe that our reserve remains conservative and that we are positioned well for the future.

Terry McEvoy, Analyst

Okay. Maybe one last question, if I could. The size of the balance sheet or the size of earning assets over the next two to three quarters is expected to be relatively flat. The best way to consider this is that cash will be used to reduce the securities portfolio in order to fund loan balances. Or do you anticipate some growth?

Jamie Anderson, CFO

Yes. I would say over the next couple of quarters, that's a good assumption regarding earning assets. After that, the earning assets will maintain the securities portfolio for now, with plans to monitor the deposit flows. Following a couple of quarters during which the securities balances will decrease due to cash flow, the balance sheet will expand alongside the growth in the loan portfolio.

Operator, Operator

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

Jon Arfstrom, Analyst

Just a couple of margin questions here. Jamie, what kind of margin expectations do you have beyond the fourth quarter, assuming the Fed is done and I know you're saying it's a little bit uncertain, but one of the key questions is when do you think NII and the margin start to bottom up?

Jamie Anderson, CFO

Yes. Looking ahead to 2024, we anticipate the margin to reach its lowest point in the second quarter, assuming there are no further actions from the Fed. We expect it to stabilize in the range of 3.95% to 4%. As we begin to increase the earning asset base, we believe that starting in the third quarter, we will begin to see a growth in the dollars of net interest income.

Jon Arfstrom, Analyst

Okay. Helpful, very helpful on that. Slide 17 and 18, I think, are good slides. And I just wanted to ask on the business deposits. It looks like they bottomed out in kind of MASH time frame. What do you think is driving that increase again? Is it confidence? Is it rates from you guys? Is it businesses not having the opportunity to invest or being cautious? Is there any way to put a thumb on that?

Archie Brown, President and CEO

Jon, this is Archie. I mean, we have been competitive with rates and certainly have seen some mix shift, but you're right that they have balances of strength. And then interestingly enough, they've strengthened even while we have seen also businesses with liquidity take that liquidity and pay down lines. We saw a lot of that in the quarter. So I think businesses are by and large, liquid, not all, but many. And so they're either bringing more of that in because the rates are a little better on some of the products we're offering, or they're using some of that to pay down their lines. So yes, I think they're pretty healthy right now overall.

Jon Arfstrom, Analyst

Okay. And then just one for you, Jamie. I don't know if you have this or not, but Slide 23, the bottom right graph, also good because you're just showing us the numbers. But any idea of how much of the unrealized losses in the securities portfolio burn off over the next, call it, 4 or 5 quarters? So if we're sitting here at the end of '24, how much of that just naturally burns off?

Jamie Anderson, CFO

Yes. We discussed this yesterday. The overall loss in the portfolio and the impact on equity from AOCI is estimated to be in the range of $350 million to $400 million. Over the course of the year, approximately 20% of that is expected to diminish naturally. This estimate may be slightly conservative, but we anticipate around 20% will burn off under normal circumstances, although there are many variables related to rates assuming no changes in rates.

Operator, Operator

Our next question comes from Christopher McGratty with KBW.

Christopher McGratty, Analyst

Great. Archie, maybe Jamie, could you share some insights on the margins? It seems like you have a higher margin starting point, partly due to the mix of your assets, which might experience some credit volatility, but overall, the credit adjusted margins look good. How should we approach normalized credit costs? I believe someone asked about this earlier, but is it reasonable to expect that your credit costs might be slightly higher than your peers due to your higher margin?

Jamie Anderson, CFO

Yes, it's reasonable to say that over the long term, when considering the broader industry, our credit losses might be consistently 10 to 15 basis points higher than the typical 30 basis points over an extended period. However, our risk-adjusted returns show that our loan yields and overall asset yields are significantly higher than our peers in the long run. This is a trade-off we are willing to accept. There are times, like this quarter, where we experience slightly higher charge-offs, but our margin remains between 100 and 110 basis points above the peer median, which reflects the composition of our portfolio.

Christopher McGratty, Analyst

Yes, I completely understand. I have a question about the securities book. Your yield is a bit higher, and I assume there are floaters involved. I'm curious about the competition regarding that and whether you have taken any measures to hedge against downside risk or if you are considering making adjustments to the bond book in light of recent rate changes.

Jamie Anderson, CFO

Yes. About 15% to 20% of our investment portfolio is in floaters, which has significantly boosted the securities yield over the past year. Regarding our hedging strategy, we are not targeting the securities book specifically, but we are implementing overall protections. We have introduced approximately $600 million in macro hedges to guard against potential downturns, with plans to increase that to around $1.5 billion or even $2 billion for extreme downside protection. We are establishing floors in the 2% to 2.50% range to safeguard against scenarios similar to March 2020, when our margin fell to around 3.20% due to plummeting rates. Our goal is to ensure we have sufficient protection against extreme downside risks.

Christopher McGratty, Analyst

Okay. Maybe just one more question. Regarding the two charge-offs in the quarter and the $32 million loan sale, it appears to be about a 20% loss. What was the sub-asset class within commercial real estate? Additionally, for the C&I loss, what was the balance of that? I'm trying to calculate the loss rates on the relationships.

Bill Harrod, Chief Credit Officer

Yes. The loan sale included a hotel loan, office loan, and a health care deal. The commercial credit was a consumer retail company that had a multilevel marketing model that changed after COVID when the party circuit kind of went down after being very robust pre-COVID, and they couldn't change the model ultimately. Yes, I mean, it was a total of about $10 million.

Operator, Operator

Seeing no further questions, I will now turn the call back to Archie Brown.

Archie Brown, President and CEO

Thank you, Brianna. I want to thank everybody for joining today's call and following our story. We look forward to talking to you again next quarter. Have a great day.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.