First Interstate Bancsystem Inc Q3 FY2020 Earnings Call

Good day, and welcome to the First Interstate BancSystem Third Quarter 2020 Earnings Conference Call. Please note today's event is being recorded. I would now like to turn the conference over to Lisa Slyter-Bray. Please go ahead, ma'am.

Thanks, Rocco. Good morning. Thank you for joining us for our third quarter earnings conference call. As we begin, please note that the information provided during this call will contain forward-looking statements. Actual results or outcomes may differ materially from those expressed by those statements. I'd like to direct all listeners to read the cautionary note regarding forward-looking statements and factors that could affect future results contained in our most recent annual report on Form 10-K filed with the SEC and in our earnings release as well as the risk factors identified in the annual report and our more recent periodic reports filed with the SEC. Relevant factors that could cause actual results to differ materially from any forward-looking statements are included in the earnings release and in our SEC filings. The company does not undertake to update any forward-looking statements made today. A copy of our earnings release, which contains non-GAAP financial measures, is available on our website at fibk.com. Information regarding our use of the non-GAAP financial measures may be found in the body of the earnings release, and a reconciliation to their most directly comparable GAAP financial measures is included at the end of the earnings release for your reference. Joining us from management this morning are Kevin Riley, our Chief Executive Officer, and Marcy Mutch, our Chief Financial Officer, along with other members of our management team. At this time, I'll turn the call over to Kevin Riley. Kevin?

Thanks, Lisa. Good morning, and thank you to everyone for joining us today. This quarter, along with our earnings release, we have shared an updated investor presentation with additional disclosures that we believe will be useful. You can access the presentation on our Investor Relations website, and I encourage you to download a copy if you haven't already. I'll begin by highlighting the key points from this quarter, and then I'll hand it over to Marcy for more details on our financials. We continue to see positive signs of economic strength in our markets, leading to a strong quarter characterized by healthy balance sheet growth, notable contributions from various noninterest income sources, and generally improving asset quality. For this quarter, we reported a net income of $48.3 million, or $0.76 per share, and a pretax pre-provision income of $68.2 million. Unemployment rates in our service areas have shown significant improvement, with levels either matching or exceeding national figures. In the West division, Oregon led the recovery, reducing unemployment by 3.6% to 8% since June. Although Idaho experienced a slight increase, it remains low at 6.1%. South Dakota showed the most notable improvement, with its unemployment rate now at 4.1%, the second lowest in the country. Overall, we are seeing job growth returning, and our outlook for the region is optimistic. Looking at the seven primary state and national parks within our footprint, statistics show robust year-over-year increases in tourism through June, except for Glacier National Park. This trend aligns with the positive feedback we receive from our clients and communities. Many of our clients are experiencing record performance, representing diverse sectors such as auto dealers, contractors, and small manufacturers. Consequently, we have seen strong inflows of commercial deposits. In the third quarter, our deposits grew at an annualized rate of 16.3%, with a significant portion coming from noninterest-bearing sources, which increased by $372 million this quarter. Notably, 9% of the demand deposits and nearly 7% of savings growth were generated from new clients. These encouraging economic indicators are reflected in the quality of our assets, with declines in nonperforming loans and assets. As of October 16, we had only $77.1 million in loans in deferral status and $6.1 million in residential mortgages in forbearance, accounting for less than 1% of our outstanding loan balances. The positive trends in asset quality, combined with our earlier reserve building, resulted in a modest provision requirement for this quarter. We also experienced solid loan growth given the current macroeconomic conditions, with total loans rising by $120 million or 4.7% on an annualized basis. We remain conservative in our underwriting approach, and we have noted that the competitive landscape is slightly less intense. Many banks seem to be focusing on credit issues, which works to our advantage, allowing us to pursue quality lending opportunities without frequently encountering aggressive competitors. Our West division experienced the strongest loan growth, increasing by more than 3% compared to the prior quarter. Mortgage banking remains a significant contributor, with our revenues up 38% from the previous year. Of our closed loans, $158 million, or 27%, were funded through our online application process. This summer, we observed heightened interest in purchasing construction loans, which constituted nearly 50% of our production in the third quarter. The increase in purchase and construction loans aligns with our observations of a steady influx of people relocating to Montana and Idaho, positioning us well to benefit from this trend in the coming years. While our focus this year has been on navigating the pandemic, the performance and trends we've witnessed reaffirm the vision we established for our franchise in the rapidly growing Western division - Idaho, Oregon, and Washington. Our market division, which includes our established markets in Montana, South Dakota, and Wyoming, continues to provide a stable, low-cost deposit base, allowing us to deploy liquidity into areas with greater loan demand. This combination creates an effective platform for generating strong returns for our shareholders while maintaining a robust balance sheet concerning capital, liquidity, asset quality, and reserves. Given our solid financial performance and low-risk profile, we are positioned to return a significant amount of capital to our shareholders. During the third quarter, we repurchased 1.4 million shares of common stock, and our Board of Directors approved a 12% increase in our quarterly dividend. We are pleased to increase the capital returned to our shareholders while remaining in a strong position to manage through the pandemic. With that, I'll turn the call over to Marcy for more details on the financial figures. Marcy?

Thanks, Kevin, and good morning, everyone. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the second quarter of 2020, and I'll begin with our income statement. Holding true to our expectations, we saw an increase in our net interest income for the quarter, but with the growth in the balance sheet, there was additional pressure on our net interest margin. Our net interest income increased by $500,000 from the prior quarter due to higher average balances of interest-earning assets. A portion of the higher average balances was attributable to a full quarter of the PPP loans on our balance sheet, which contributed $2 million more in interest income in the third quarter than they did in the prior quarter. On a reported basis, our net interest margin decreased 23 basis points to 3.29% in the third quarter, which continues to be impacted by the strong inflows of deposits we've seen this year. This has increased our excess liquidity and the percentage of earning assets invested in the securities portfolio. Breaking down the major components of the change in our net interest margin, 18 basis points were attributable to the decline in earning asset yields, which was partially offset by a 2 basis point decline in deposit costs, and 7 basis points of the decline was related to the dilutive effect of our growth in deposits being deployed in lower-yielding cash and investment securities. Excluding the impact of interest recoveries and loan accretion, our operating net interest margin declined 24 basis points to 3.2%. Although we don't have much more room to bring down rates on our interest-bearing deposits, we continue to benefit from declines in our higher-priced CD balances and the positive mix shift resulting from the strong inflows of noninterest-bearing deposits. This should help us to continue to bring down our cost of funds and partially offset the declines we're seeing in yields on earning assets. With modest levels of loan growth, we have a focus on building the investment portfolio to be a larger percentage of the balance sheet, but depending on the pace of growth in our deposits, we may continue to see some margin pressure. Our noninterest income increased $5 million quarter-over-quarter to $44.7 million. Mortgage banking revenue was comparable to the prior quarter, while we had increases in all of our other major fee-generating areas. Payment services and service charges on deposit accounts increased as we saw more transactions and economic activity in our markets, while wealth management revenues increased largely as a result of the market recovery, coupled with strong client retention, strong investment results from our team, and growth in our retirement plan relationships. We also had a $1.9 million increase in swap fees that contributed to the higher noninterest income this quarter. Our pipeline for both refinance and purchase residential mortgage loans remains strong. We should have another good quarter of mortgage banking revenue, although not quite at the level we've seen over the past 2 quarters as we anticipate the seasonally slower activity in the winter months. Moving to noninterest expense, we had an increase of $3.9 million from the prior quarter. This was primarily due to higher salaries and wages, largely resulting from three items. First, we had a lower level of deferred loan costs, primarily due to the PPP loans that were originated last quarter. Second, we had a one-time $1.6 million adjustment to our mortgage commission. And third, we had a one-time $0.6 million adjustment related to an employment agreement. Excluding these items, our expenses were well controlled, and we still expect our run rate to be in the $96 million to $97 million range going forward. Moving to the balance sheet, our total loans increased $120 million from the end of the prior quarter with the growth coming from our commercial real estate, commercial construction, residential real estate, and indirect consumer portfolios. As of September 30, we had not been funded for any PPP loan forgiveness and still had $1.2 billion of PPP loans remaining on our balance sheet. As you'll see in our investor deck, we've submitted forgiveness applications for about 1,400 loans for a total principal balance of $219 million. Since the end of the quarter, we've received funding for 119 loans for a total of $3.6 million. Our total deposits increased $542 million from the end of the prior quarter, with most of the growth coming in noninterest-bearing and interest-bearing demand deposits. This has resulted in continued improvement in our mix of deposits with demand deposits now comprising 62% of our total deposits. Looking at asset quality, we saw decreases in most problem asset categories. Our nonaccrual loans declined $5.1 million, while our nonperforming assets declined $4 million. We did see an increase in special mention loans, primarily due to downgrades in the hospitality industry as we continue to keep a close watch on that portfolio. Our credit losses continue to be very manageable with $4.6 million of net charge-offs representing just 18 basis points of average loans in the quarter. We had special reserves of $2 million allocated against these credits. We recorded a provision for credit losses of $5.2 million, which covered net charge-offs, a $1.1 million increase to the unfunded loan reserve, and reflects a small decline in the allowance for credit losses. With the economic forecast stabilizing this quarter, this component of our allowance methodology did not result in a material impact on the provision expense. At the end of the third quarter, our allowance for credit losses was 1.43% of total loans, including PPP loans or 1.63% when PPP loans are excluded. And with that, I'll turn it back to Kevin.

Thanks, Marcy. Nice job. As we head into the end of the year, we believe we are in a good position to continue delivering consistent, strong financial results. Most of the deposit trends we have experienced over the past few quarters should continue. We expect continued balance sheet growth, excluding the impact of any PPP runoff, another good quarter of mortgage banking, well-controlled expenses, and a relatively stable level of provision expense. From an operational perspective, we continue to make progress with our efforts to modernize the bank and get more leverage from our core system upgrade we made last year that will allow us to add more features and capabilities. We expect to introduce a new digital small business banking platform in the coming months, which is a fully automated process from application through approval and funding. This new platform should help us improve our ability to better service our existing clients and add small business relationships. In 2021, we will also add a new loan origination system designed for the more complex commercial loans that will strengthen our ability to understand our loan pipeline, track the performance of borrowers, and share information between departments, which would enhance our efficiencies and productivity. At the branch level, we continue to make improvements to our operations to be more efficient. We see a lot of banks making announcements about significant branch consolidation, but for us, this has been an ongoing process for a number of years. We have continually been moving branches out of older, larger buildings in less desirable locations into smaller, more efficient, more modern facilities. And in 2021, we will have fully implemented our new teller platform that will help us to be more efficient in servicing our clients. Just as we have modernized the infrastructure of the bank to support the growth into a much larger institution, we've also been modernizing our branch network to enhance efficiency and ensure that we are well positioned to offer our clients a superior in-person banking experience. I am very proud of the way our team has responded to the challenges this year and has demonstrated to our markets and our customers that First Interstate is a bank that they can count on in good times and in bad. It's an opportunity to strengthen our existing relationships and form new ones that will help us continue to grow our franchise well into the future. So with that, I would like to open the call up for questions.

Today's first question comes from Jeff Rulis with D.A. Davidson.

I guess first question is just want to get your sense on the housing market in Montana, and lots of indications of out-of-state buyers kind of swooping in sight unseen on properties. I imagine sort of the limited supply offers some confidence of continued support, but I just wanted to get your sense for the level of where you think housing is and where it could go sort of the balance into '21.

Jeff, I wish I had a crystal ball that could tell me exactly what's going on, but all we're seeing right now is that housing - we have a kind of a shortage of housing in most of our markets as people are moving into, I think, more rural markets or smaller towns. So I don't know exactly where it's going to go. It really depends on how this pandemic plays out and what people do from working from home because people are feeling that they can work for Montana as well as they can work from home in Manhattan.

But anecdotally, I think the builders that we know are all very busy and scheduled out into next year. Realtors are busy still. I mean it's - it doesn't look like it's slowing down.

No. And Jeff, I would say in Rapid City, South Dakota, they're saying that they're going to be short 8,000 houses over the next 2 years because a new bomber unit got put to that Air Force base as well as some environmental companies hiring a bunch of people. So they're projecting to be 8,000 houses short.

Yes, a good backdrop. I think I saw a stat of, I think, 9,000 new driver's license applications in Montana through the summer months alone. So I guess you're getting not only part-time buyers but some current or permanent residents.

Not only...

Sorry. The expense side, Marcy, you got your comments on what you think we revert to on core, had some one-timers in there. Just trying to think about the - if it's at $96 million to $97 million quarterly run rate, how much is variable? If we think the mortgage book slows down a little bit and particularly into '21 maybe not by a ton and certainly not maybe by MBA forecast, but should we take a leg back? Does that alter the - that run rate expectation to the downside? And any other - I think you talked about some investments, Kevin, on the loan origination program, but where can you curb costs? I guess, overall, expense expectation run rate for '21 would be helpful.

Yes, we're currently in the midst of our budget process, so I'll be able to provide more clarity next quarter. However, we have been effective in managing our expenses this year, so I don't expect our expenses to decrease significantly from the current rate moving forward. I will share more details next quarter, but I wouldn't include that in the forecast.

I previously mentioned some technology investments and changes. However, similar to our past experiences, enhancing our infrastructure with technology has not led to a significant increase in expenses. We have eliminated various systems as we transition to a new one. This process has been balanced; in fact, when we upgrade our systems, we are not facing a substantial increase in technology costs. Instead, we are benefiting from moving away from costly systems and adopting a more efficient solution.

Our next question today comes from Matthew Clark at Piper Sandler.

We started on the deposit growth this quarter very strong. Wondering where you're seeing that growth coming from. How much of it's existing customers? How much of it is new? And where throughout your footprint might you be seeing it?

Well, it's actually pretty strong. And as we mentioned in the remarks, we do have some new customers both on the commercial and the consumer side. But it's - seasonally, our deposits grow in the third and fourth quarter. So it really plays into the seasonality that we normally see, but we're getting more than we normally see it seasonally. So it's - we believe it's going to continue going through the fourth quarter again. But then in the first quarter, as always, seasonally, we see it come down a little bit. So we think we're going to continue to follow that kind of trend and it's pretty broad-based.

Yes, it's across the footprint, Matt. And I think actually, Wyoming had our strongest deposit growth this quarter.

Okay. Great. And then just on the loan growth, also kind of solid and a little bit better, I think, than it's been running the last couple of years. I think you've talked about low to mid-single digits historically. But I guess how much is that pipeline up year-over-year? And do you think low single digits is no longer - do you think you can do better than low single digits at this stage given what you're seeing?

No one had predicted significant growth, but we are observing some positive trends in loan growth. We believe that mid-single digits or lower single digits would be a good target for the remainder of this year.

Okay. And just the uptick in classified. I know it's down year-over-year but - and only up, I think, 7 basis points linked quarter. But is that kind of related to some deferrals that have just migrated? Or is there anything specific that you could speak to?

Really, it's - it has some hospitality loans go in there, and we're being ultra-conservative when we're looking at these things. We're going to go through a real deep dive exam soon and we're going to really look at the hospitality, but we're just being conservative. So we're not overly concerned at this juncture because they've moved in there, but we're closely monitoring that industry.

Okay. And then just lastly, on the capital return, a lot more proactive of late. Does that kind of suggest that M&A is still fairly quiet? How are those conversations trended of late?

We're staying close to one another, and we're talking to people, but I would say that everybody is kind of on the sidelines at this juncture, and time will tell what happens. I think everybody is trying to see if valuations will come back and also how people are going to survive through their asset quality as this pandemic persists. So I think everybody's just kind of waiting - playing a wait-and-see game, but we're still staying close to the people we like.

Our next question today comes from Jared Shaw in Wells Fargo.

I would like to start by discussing COVID. Your markets seemed to have avoided major issues for a while, but it appears that some numbers are on the rise. Is the impact still relatively minimal? As we head into winter, do you believe an increase in COVID cases could impact the loan growth outlook?

Jared, I wish we had a crystal ball. It could, but I would tell you I don't think anybody has a stomach to shut down the economy again. I think that they're going to deal with it. And I know the cases are increasing out here, but I don't know what the outcome is going to be of this pandemic. But right now, it appears that things are going to continue just moving forward and operating as though they're just dealing with the pandemic.

Okay. You sounded pretty optimistic in terms of the current allowance level given the broader credit backdrop. If we start seeing credit losses increase, then do you think that the existing allowance is sufficient for that, that you'd be able to just cover those losses out of the existing allowance? Or should we expect that any charge-offs in the future are really still provided and we keep the allowance level flat, assuming no change in the broader economic model?

Yes. With no broader changes in what we see in our markets, the allowance is going to be adequate. Right now, we don't see any increase in charge-offs in the future. This quarter, we had a little bit of increase, but it was really two credits. One was totally expected, and we had reserved for it specifically. And actually, we had a larger specific reserve on it than when we actually took us a charge-off, and another one was a surprise. Somebody we got was caught - doing creating or doing fraud and got thrown pretty much in jail. So we ended up with an aircraft that we had to take a loss on, but it was just - that was just a surprise, but nothing that is out there that is really concerning that we see.

Okay. And then just finally for me, with the - can you talk about any success you've had cross-selling those new PPP clients that may have come from other banks? Is it too early to see results there? Or are you actually turning some of those into full-service customers?

Jared, we have seen an inflow on the deposit side. I don't have the info. They were - they are trying to get that for me. I don't have the inflow on the loan side, but we are seeing some positive client generation as a result of the PPP process.

Today's next question comes from Jackie Bohlen with KBW.

So just thinking about the size of the balance sheet and understanding that it's obviously heavily dependent on customer liquidity, so that's kind of where my questions are coming from. What is the tipping point? I think you mentioned in your prepared remarks that businesses are doing really well and it's driving strong deposits. What's the tipping point where they start reinvesting some of those deposits into their businesses? And so you get the growth, but maybe a little bit of balanced contraction.

Yes. That's an interesting question. I think everybody's kind of playing it safe right now. I think maybe when a vaccine comes out and the buyer slows down a little bit, people will reassess what they're going to do with their business. But I think a lot of people are really being conservative right now and just stacking up their acorns for a harsh winter, but I don't know. It's an interesting thing because we don't see a lot of companies going out and doing big, massive additions or something at this juncture, which I think is the prudent thing anyway.

Yes, yes. Okay. No, that's good to know. And do you know to the extent if ski resorts are planning to open this winter?

Yes. Actually, we've received some anecdotal information, and it seems like some of the ski resorts think they're going to have a better year this year than they had last year with the number of people. It's kind of interesting because the lodges are going to be closer, pretty much saying that your car is going to be your lodge. But they're really putting in together some ways to keep the mountains open, and right now they're anticipating they're going to have a great year.

And if our snowfalls - recent snowfall is any indication, they are going to have a good year.

Yes. We already have a ton of snow out here.

You already got snow. Wow. Okay. So it sounds like the tourism that you saw in the summertime could continue into the winter. And my thought is that just with your markets being well situated in terms of the virus, there's probably going to be an influx of people and there's a place for them to go and to hang out in a socially distant way. Is that fair?

That's fair to say. That's what it appears to be looking like. Time will tell as we move through the months.

Yes, yes. No, obviously, lots of unknown. And then just one last one for me. Just as you're getting all these new customers in terms of deposits and maybe some loan opportunities in the future, are you getting any new customers in the wealth management area?

We haven't seen new clients at this point, a substantial number of new clients, but it really is an area that we're focused on, and so I would expect to going forward.

Ladies and gentlemen, this concludes the question-and-answer session. I'd like to turn the conference back over to the management team for any final remarks.

Thank you for your questions today, guys. As always, we welcome calls from our investors and analysts, and you can please reach out to us if you have any follow-up questions. Thanks for tuning in today. Goodbye.

Thank you. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day.