Earnings Call Transcript - FFBC Q2 2022

Operator, Operator

Hello, and welcome to the First Financial Bancorp Second Quarter 2022 Earnings Conference Call and Webcast. My name is Breaka, and I'll be coordinating the call today. Operator Instructions. I now have the pleasure of handing the call over to our host, Scott. Please go ahead.

Scott Crawley, Host

Thanks, Breaka. Good morning, everyone, and thank you for joining us on today's conference call to discuss First Financial Bancorp's second 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 will 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 second 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 June 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.

Archie Brown, CEO

Thank you, Scott. Good morning, everyone, and thank you for joining us for today's call. Yesterday afternoon, we announced our financial results for the second quarter. Before I turn the call over to Jamie to discuss those results in greater detail, I'm going to say a few words regarding the quarter. I'm extremely pleased with our performance in the recent period, which was highlighted by a rapidly expanding margin, strong loan growth, and exceptional credit quality. For the quarter, we achieved adjusted earnings per share of $0.56, a 1.31% return on average assets, and a 21.26% return on average tangible common equity. Earnings improved from the first quarter as our asset-sensitive balance sheet was positively impacted by recent rate increases. In addition, credit quality was stable with lower net charge-offs and nonaccrual loan balances. This led to a small provision recapture for the quarter. We are encouraged by our fee income performance for the quarter which reflects the strength of our diverse businesses. Total fee income surpassed our expectations due to record foreign exchange income, higher income from limited partnership investments, and our growing leasing business. While second quarter mortgage banking income increased 35% from the linked quarter, we continue to experience headwinds due to the rapid rise in interest rates. In addition, recent overdraft program changes led to a modest reduction in deposit account service charges during the second quarter, and we expect some further decline in the third quarter as these changes are fully integrated. We're very pleased with loan growth in the second quarter. Loans excluding PPP increased by $191 million or 8.3% on an annualized basis. Loan growth was broad-based with increases in C&I, retail mortgage, and consumer banking. This more than offset a decline in the ICRE portfolio, which was driven by elevated prepayments. In addition, we were also pleased with Summit's growth in the quarter, which included a total of $50 million in leases and loans. Loan origination activity remains strong as we head into the third quarter. With that, I will turn the call over to Jamie to discuss the second quarter results in more detail. Jamie?

Jamie Anderson, CFO

Thank you, Archie. Good morning, everyone. Slides 4, 5, and 6 provide a summary of our second quarter financial results. The second quarter was highlighted by an expanding net interest margin, strong loan growth, increased fee income, and stable credit quality. As a result of the Fed rate hikes, our net interest margin increased by 30 basis points during the quarter. Given our asset-sensitive balance sheet, we believe this trend will accelerate into the third quarter as the Fed increases rates further. We were pleased with an 8% annualized loan growth during the period, excluding PPP balances. The growth was widespread across the portfolio with the biggest increases in C&I and residential mortgage. Fee income increased 21% during the quarter, surpassing our expectations. In particular, Bannockburn had a record quarter, while leasing business income increased by 19%. Mortgage banking income increased compared to the first quarter. However, we do not expect this trajectory to continue as originations will be negatively impacted by higher interest rates. Additionally, service charge income was relatively flat compared to the first quarter as we made several changes to our overdraft program that are expected to reduce fees in the coming periods. Noninterest expenses were slightly higher than our expectations, due primarily to incentive compensation tied to elevated fee income. We were pleased on the credit front as net charge-offs declined to 8 basis points and nonperforming assets declined to 31 basis points of total assets. These two factors drove $800,000 of provision recapture during the period. From a capital standpoint, our regulatory ratios remain in excess of both internal and regulatory targets. Similar to the first quarter, accumulated other comprehensive income declined significantly, 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 $53 million or $0.56 per share for the quarter. These adjusted earnings account for $1.1 million of losses on investment securities and $900,000 of Summit-related and other costs not expected to recover, such as severance and branch consolidation expenses. As depicted on Slide 8, these adjusted earnings equate to a return on average assets of 1.31%, a return on average tangible common equity of 21%, and an efficiency ratio of 61%. Turning to Slides 9 and 10, net interest margin increased 30 basis points from the linked quarter to 3.47%. 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 and a decline in PPP forgiveness fees. As a result of rising rates, asset yields surged during the period with loan yields increasing by 34 basis points. In addition, investment yields increased due to higher reinvestment rates and slower prepayments on mortgage-backed securities. Our cost of deposits was relatively flat when compared to the first quarter, where we expect these costs to increase in future periods 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 expected rate increases as approximately two-thirds of our loan portfolio will reprice fairly quickly. Slide 12 details the betas utilized in our net interest income modeling. And while we didn't realize a drastic increase in costs from the initial rate hikes, as additional rate increases occur, we expect our deposit beta to be approximately 30% over the full cycle. Slide 13 illustrates our current loan mix and balance changes compared to the linked quarter. As I mentioned before, loan balances increased 8% on an annualized basis, excluding PPP. With the exception of ICRE, every portfolio grew compared to the linked quarter. The largest areas of growth were in the C&I, retail mortgage, and consumer portfolios. However, we were also pleased with the trajectory of the consumer, franchise, and Summit books. Slide 15 shows our deposit mix as well as the progression of average deposits from the first quarter. In total, average deposit balances declined $246 million during the quarter, driven by a $136 million decline in brokered CDs and a $104 million decline in money market accounts. These were isolated to a handful of larger accounts. We were pleased with growth in lower transaction deposits during the quarter, which included a $36 million increase in noninterest-bearing accounts and a $31 million increase in savings accounts. Slide 16 highlights our noninterest income for the quarter. As I mentioned previously, second quarter fee income surpassed our expectations, primarily due to record foreign exchange income, higher mortgage banking income, and an increase in other noninterest income. In addition, Wealth Management remained elevated and derivative fees increased 69% from the prior period. While mortgage banking exceeded first quarter levels, increasing rates and record production in prior years have softened mortgage demand significantly. And we continue to expect industry-wide pressure on this business for the remainder of 2022. Deposit service charge income was steady in the second quarter. However, as I mentioned before, we expect reductions in this income going forward as program changes are fully realized. Noninterest expense for the quarter, as outlined on Slide 17, was relatively quiet on the noninterest expense front. On an operating basis and excluding Summit expenses, increased by $1 million compared to the linked quarter due primarily to additional incentive compensation resulting from higher fee income at Bannockburn. Turning now to Slide 18, our ACL model results in a total allowance which includes both funded and unfunded reserves of $135 million and $800,000 in total provision recapture during the period. This resulted in an ACL that was 1.25% of total loans at June 30. The provision recapture was driven by stable credit quality and the lower net charge-offs during the period. Net charge-offs as a percentage of loans decreased to 8 basis points on an annualized basis, while nonperforming assets declined to 31 basis points of total assets. Classified assets increased slightly during the quarter due to the downgrade of two credits in the hotel and health care industry. However, these borrowers have good liquidity and are exhibiting improving trends. Our view on the ACL and provision expense remains unchanged. We acted aggressively when building reserves in response to the pandemic and have been steadily releasing reserves as credit has stabilized. We expect increasing provision expense in the back half of 2022. Finally, as shown on Slides 20 and 21, regulatory capital ratios remain in excess of regulatory minimums and internal targets. During the second quarter, tangible book value and the TCE ratio continued to decline. These declines were caused by a $101 million decline in accumulated comprehensive income as a result of unrealized losses on the investment portfolio from rising interest rates. Absent this decline, the TCE ratio would have been 7.1% at June 30, compared to 6.4% as reported. We returned over 40% of our earnings to our shareholders during the period and believe our dividend yield is attractive to potential shareholders. We do not anticipate any near-term changes to the common dividend. However, we will continue to evaluate various capital actions as the year progresses. I'll now turn it back over to Archie for some comments on our outlook going forward.

Archie Brown, CEO

Thanks, 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 strong and we expect balances to grow mid to high single digits over the third quarter, while deposit balances are expected to decline modestly over the near-term. Our asset-sensitive balance sheet continues to position us very well to benefit from further increases in interest rates. A significant portion of our loan portfolio was indexed to short-term rates. And although there are many variables that can impact the magnitude and timing, we expect the margin to continue to expand to a range of 3.5% to 4% in the third quarter. As we get later in the cycle, we're expecting to see some pressure on deposit rates, which will moderate the margin expansion. Regarding credit, much uncertainty remains regarding inflation and the impact of rate hikes to the economy and our customers. Over the remainder of this year, we expect continued improvement in our credit quality trends, which were already strong, and an increase in provision expense. We expect fee income to be between $46 million and $48 million in the third quarter with continued strength in our fee-producing businesses. Rate headwinds will continue to put pressure on overall mortgage banking income, and we expect a further decline in overdraft income of approximately $1.2 million due to the updates to our program. Specific to expenses, we expect to be between $102 million and $104 million. This could fluctuate with fee income performance. As our operating lease portfolio grows, we will also see corresponding depreciation expense growth. Regarding Summit, our outlook is unchanged, and we expect the acquisition to have a minimal impact on overall 2022 earnings with a modestly positive impact in the third quarter. We continue to expect Summit to provide $4 million in annual originations, which should provide a strong lift to overall loan growth. Lastly, our capital ratios remain strong and we expect to maintain our dividend at current levels. Before I finish, I want to thank our associates for their excellent performance so far this year. And as we head into the back half of 2022, we are optimistic that our balance sheet is positioned to further benefit from additional rate increases and loan activity remains strong. We remain diligent in our credit monitoring and are prepared to manage a downturn in the economy, should it occur later in the interest rate cycle. With that, we'll now open up the call for questions.

Operator, Operator

Operator Instructions. We have the first question from the phone line from Chris McGratty from KBW. Your line is open.

Chris McGratty, Analyst

Hey, good morning.

Archie Brown, CEO

Hey, Chris.

Chris McGratty, Analyst

Jamie, maybe start with a margin noninterest income question. The margin upgrade was significantly above expectations. I'm interested in just kind of how you get there. Obviously, I think you've got the ability to shrink the bond portfolio. So I'm interested in kind of a comment about the size of the balance sheet and the funding of the growth. And then also, just more broadly, your net interest income went up $200 million this quarter. If we think about it that way, like, it would presumably, the sequential increase should accelerate in the back half of the year? I just wanted to confirm that was it.

Jamie Anderson, CFO

Yes, that's entirely accurate. Currently, we are not seeing a significant rise in deposit costs, although that will change, and we expect it to begin increasing in the third and fourth quarters. We anticipate that the margin from the second quarter to the third quarter will be higher than the increase we observed from the first quarter to the second quarter. From a funding standpoint, we still have borrowing capacity available in the wholesale market through short-term borrowing. Our strategy is to gradually reduce our investment securities portfolio to support growth in the loan sector and to address some of the deposit runoff. We do expect some runoff in the third quarter, projecting a decrease of about 2% to 3% in total deposits. This will be covered by both short-term borrowings and the gradual reduction of our securities portfolio. We will refrain from reinvesting cash flow from the investment securities portfolio during this period.

Chris McGratty, Analyst

That’s helpful. And how much is thrown off the bond book every quarter?

Jamie Anderson, CFO

Yes, at a minimum, it depends on some of the calls and whatnot. But at a minimum, it's about $50 million a month. So between $600 million and $700 million a year.

Chris McGratty, Analyst

Okay, great. And then if I could, could you provide the spot rates at June 30 for deposits loans, and also if you had like a June margin?

Jamie Anderson, CFO

So help me out when you're saying the spot rate when you're like …?

Chris McGratty, Analyst

Right. So where were loan yields for the month of June? Where were deposit costs for the month of June versus the average for the whole quarter?

Jamie Anderson, CFO

Yes, I understand. Let me start by finding those actual yields. For June, our net interest margin was 364, compared to the full quarter which was 347. Can you provide those two numbers quickly? As for June, that margin was increasing throughout the month due to the rate hike in the middle of it. If you look at the margin heading into the third quarter, or as of June 30 or July 1, it would have been closer to around 375.

Chris McGratty, Analyst

Okay. That's awesome.

Jamie Anderson, CFO

And then quickly on the loan yields. Our loan yields for the month of June were 434 and deposit costs were 11 basis points.

Chris McGratty, Analyst

Okay, is that 30% for interest-bearing deposits or for the total?

Jamie Anderson, CFO

That's complete. Yes. When we mention 30%, that figure pertains to the entire cycle. We have observed around 2% to 5% data up to this point, but that will begin to increase. For the full cycle, we are predicting a 30% beta.

Chris McGratty, Analyst

And that's on interest-bearing, Jamie, or total deposits sorry?

Jamie Anderson, CFO

That's on total.

Chris McGratty, Analyst

Okay. Wonderful. Thank you.

Jamie Anderson, CFO

Yes. You’re welcome, Chris.

Operator, Operator

Thank you, Chris. We now have a question from Scott Siefers with Piper Sandler. Please go ahead when you are ready, Scott.

Scott Siefers, Analyst

Good morning, guys. Thanks for taking the question.

Jamie Anderson, CFO

Hey, Scott.

Scott Siefers, Analyst

Jamie, I think I misunderstood the guide regarding how quickly the margin would reach that level. It's significant since it will take place in the third quarter. Previously, we anticipated an 8 basis points benefit from the rate hike, but it seems to be coming in much better than expected so far. Jamie, what surprises have you noticed as the margin continues to increase? By the end of the third quarter, based on the forward curve, it appears that we will mostly be done with rate hikes, though not completely. Will your assets still be sensitive at that point? I assume the answer is yes, but what kind of marginal benefit can we expect compared to what you currently have?

Jamie Anderson, CFO

Yes, I'll start by reiterating that we will remain asset sensitive at the conclusion of the rate hikes. Based on the current Fed Fund Futures and anticipated rate increases reflected in the market, we expect our margin to peak in the fourth quarter and possibly carry over into the beginning of the first quarter. In terms of surprises, previously, we discussed an expectation of an 8 basis point benefit to the margin for each 25 basis point rate hike, which assumed a more gradual approach to rate increases. However, with significant hikes of 50 to 75 basis points, we've seen minimal movement on the funding side of deposits, while two-thirds of the loan portfolio is repricing immediately. Additionally, 15% to 20% of our securities portfolio is also starting to reprice as they move past their floors. The overall impact stems from the scale and frequency of these rate hikes, which has caught everyone off guard.

Scott Siefers, Analyst

Yes.

Jamie Anderson, CFO

As we progress, the impact will lessen, and the 25 basis points we're receiving translates to a benefit of 5 to 6 basis points. However, the rapid pace of changes has caused the loan book to become somewhat overwhelming.

Scott Siefers, Analyst

Yes. Okay, great. All right. That's good color and I appreciate it. Certainly it was something you can maybe walk through sort of the puts and takes in fees as well. There's sort of a lot of moving parts between 4x, clearly presuming that's getting more toward a steady state now, but we would be curious to hear your thoughts. So maybe some of those that have been a little more volatile or I guess newer within the scheme of the business line.

Jamie Anderson, CFO

Yes, the foreign exchange business had a strong quarter at 13.5 million, which sets a record. We don't anticipate that level every quarter, as there may be fluctuations, but we believe they're likely to fall in the range of $11 million to $12 million per quarter. We're experiencing some pressure in the mortgage sector, and we expect a decline in that area in the latter half of the year, particularly in the third and fourth quarters. We have implemented changes in our service charges and overdraft program, which will result in about a $1 million decrease in overdraft revenue affecting service charges. On the Summit side, as they expand their balance sheet and shift to retaining leases instead of selling them, they now have both finance and operating leases. The income from operating leases contributes directly to revenue, while the income from leases that continue to be sold adds to fee income, which is growing at about 15% to 20% per quarter as their balances increase. This also results in an increase in related expenses, with depreciation expenses from operating leases adding about $1 million per quarter on that side. This is offset by the increase in fee income, which rises by approximately $1.5 million to $2 million per quarter, alongside the depreciation expense.

Scott Siefers, Analyst

All right, that's perfect. So thank you for all that color there. Appreciate it.

Archie Brown, CEO

Yep. All right. Thanks, Scott.

Operator, Operator

We now have a question from Daniel Tamayo of Raymond James. Please go ahead. Your line is open, Daniel.

Daniel Tamayo, Analyst

Hey, good morning, guys. Thanks for taking my question.

Archie Brown, CEO

Good morning.

Daniel Tamayo, Analyst

Let's begin with deposits. You mentioned that transaction deposits have decreased in the third quarter. There's still quite a bit of uncertainty regarding the loan deposit ratio. I would like to hear your broader perspective on where you anticipate that loan deposit ratio heading in the next year. Additionally, what are your plans regarding the runoff of deposits that are not considered core or may be more sensitive to interest rates? Thank you.

Archie Brown, CEO

Yes, Daniel, this is Archie. I'm not certain how much variability there is with these deposits and their movements. When it comes to core deposits, we didn't observe much change; however, brokered CDs did see some activity. We had about three larger business-focused money market accounts that temporarily left during the quarter. We expect more pressure on the rate-sensitive side. We will start to notice rate movements, and I believe our deposit ratio, currently in the high 70s, will move into the 80s. I'm not sure how quickly that will happen, but based on our current outlook, we anticipate moving into the 80s next quarter. We do have room to go lower, and we could comfortably reach the 90% range or low 90s. We will closely monitor pricing to ensure we retain all our accounts. Additionally, as Jamie mentioned, we have some flexibility in managing deposits or funding if necessary, particularly for the more specialty deposit accounts.

Daniel Tamayo, Analyst

Got it. Okay, thank you. And then switching gears here to capital. You talked about being comfortable with capital here. And on the regulatory side, certainly you've got a cushion there. But with the TCE ratio now in the mid-six range, does that impact your ability or willingness to invest in the business or in loan growth? Or is that just kind of put aside given the reason for getting down there?

Archie Brown, CEO

Yes, Daniel, it's Archie again. We don't think it changes anything in terms of how we're currently operating the business. We stopped buybacks at the end of the year more of the time, because we just acquired Summit, and we wanted to let some time settle and then with the, of course, the major rate movements and impact on AOCI. We've had to buy that off the table for now. We will continue to do that. But as far as funding the business and growing the business, our loan growth is solid, but it's not at a level that we think creates any sort of problems in terms of how we operate the business in the near-term.

Daniel Tamayo, Analyst

Okay. And not feeling any regulatory pressure with the TCE ratio in those levels? I'm assuming, I know the answer here, but …

Archie Brown, CEO

Yes, not at all.

Daniel Tamayo, Analyst

Okay. All right, terrific. That's all I had. I appreciate it.

Archie Brown, CEO

Thank you.

Operator, Operator

Thank you. We now have a question from Jon Arfstrom of First Financial Bank. Please go ahead, Jon.

Jon Arfstrom, Analyst

Well, with a quarter like that, I wish I was at First Financial Bank. RBC Capital Markets, it's who I represent, anyway. Jamie, the loan fees and accretion, is that included in that 3.85 to 4 thinking for the Q3?

Jamie Anderson, CFO

Yes, that would be the all-in margin, Jon, yes.

Jon Arfstrom, Analyst

Could you discuss the residual benefit of the most recent 75 basis point hike and how long it takes for that to be fully reflected in your margin? I'm curious about the timeframe for all those benefits to materialize.

Jamie Anderson, CFO

Yes, it's fairly immediate, maybe about a month or so for everything to follow through, depending on the resets. We have around 60% to 65% of the loan that reprices based on short-term rates like LIBOR. The timing will depend on the resets, but it’s not months; it’s weeks, likely between 2 to 4 weeks. So, it won't take long at all. That's why we anticipate a more significant acceleration in the margin in the third quarter compared to the increase from the first to the second quarter.

Jon Arfstrom, Analyst

I'm trying to understand that if we achieve 75 next week, we'll see two months of that, and then there will be some benefits carried into the fourth quarter, possibly along with some increases afterwards. That’s why I think you’re suggesting we might see a peak in the fourth quarter or the first quarter, correct?

Jamie Anderson, CFO

Correct. That's correct. Yes.

Jon Arfstrom, Analyst

Okay. Maybe for Bill or Archie. Just curious on the provision magnitude. What's your thinking there? And maybe an overall assessment of what your clients are saying? Because obviously, financial media and maybe the public has kind of a dour mood about the economy. And when we look at the bank numbers, it's obviously very clean, and you're telling a pretty good story. So help us think through the provision and then kind of what you're hearing from clients.

Archie Brown, CEO

Yes, this is Archie. I'll begin and continue along the lines of what Jamie discussed earlier. Credit is currently very strong, and we aren't noticing any significant issues in that area. From my recent discussions with clients, most of them report that business is quite good. However, they are still dealing with lingering challenges such as wage pressures, labor shortages, and supply chain disruptions. Despite these issues, their businesses remain robust. Looking ahead, they remain cautious, aware of the news and potential economic concerns, which is causing them to be somewhat proactive in addressing those worries. Nevertheless, when asked about their business status, they report it as strong.

Jon Arfstrom, Analyst

Okay.

Jamie Anderson, CFO

Jon, regarding the provision expense, our loan loss reserve to loans stands at 125. At the start, under CECL, it was 129, so we are only slightly below that level. We believe we are at the lower end of our coverage ratio now. Looking ahead, we think we have reached a turning point in terms of provision recapture, and we expect to see it shift in the opposite direction. Factors influencing future provision expenses will include changes in the Moody's forecast and trends in loan growth. These two elements will primarily determine how our provision expense will evolve moving forward.

Jon Arfstrom, Analyst

Okay. Okay. And Bill anything, I don't know, that you're concerned about or do you see things as very solid as well?

Bill Harrod, Chief Credit Officer

Yes, I currently view the situation as very solid, both with our customer base and our loan portfolio. While collections may appear challenging, there is nothing systemic that raises concern at this time.

Jon Arfstrom, Analyst

Yes, okay. All right. Thanks, guys. Appreciate it.

Archie Brown, CEO

Thanks, Jon.

Operator, Operator

Thank you. We now have a question from Terry McEvoy of Stephens. Please go ahead when you are ready.

Terry McEvoy, Analyst

Thanks. Good morning, everyone.

Archie Brown, CEO

Hey, Terry.

Jamie Anderson, CFO

Hey, Terry.

Terry McEvoy, Analyst

Jamie, we've talked a lot about the margin expansion as rates go up over the next couple of quarters. I'm just wondering how do you plan on managing kind of your rate sensitivity looking out into next year, assuming the Fed's done raising the rates, and ultimately how do you protect the margin? And why I ask that question at the bottom of Slide 12, you show the loan betas and the deposit betas and there was some margin compression during that period.

Jamie Anderson, CFO

Yes, that's a great question. We are currently examining this issue because, if we look back to March 2020 when the pandemic began, our margins significantly decreased due to the rate cuts. We are assessing various options across the board to address this, including mitigating asset sensitivity, possibly purchasing protective measures against downside risks, and extending our investment portfolio to manage that risk and our reinvestments. We are considering all these strategies to manage our approach moving forward while potentially reducing asset sensitivity as conditions change. While we haven't executed any specific plans yet, we are evaluating our options, and I anticipate you will see some developments in the next quarter or two.

Terry McEvoy, Analyst

Great. That was the only question left on my list. Thanks, guys.

Jamie Anderson, CFO

All right. Thank you.

Operator, Operator

Thank you. We have no further questions. So we'd like to hand it back to Archie Brown for some closing remarks.

Archie Brown, CEO

Thank you, Breaka. I want to thank everyone for joining today and your interest in our company, and we should have a nice day and a great weekend and we look forward to talk to you next quarter. Bye now.

Operator, Operator

Thank you for joining. That does conclude today's call. You may now disconnect your line.